Thursday, January 31, 2013
Nepal’s financial industry needs to learn its lessons
The following article was published in The Kathmandu Post today on January 31, 2013 with the title "Lessons in finance". The unedited version is below.
Nepal’s
financial industry needs to learn its lessons
By: Mukesh Khanal
Nepali financial market took a tumble between late 2009 until late
2011. Nepal Rastra Bank (NRB) urged some banks and financial institutions
(BFIs) to merge. Some were allowed to go bankrupt, while some were rescued by
the NRB. Despite these setbacks, however, banks and finance cooperatives have
mushroomed continuously. Are these mushrooming BFIs adding any value to Nepal’s
financial market and growth? Is Nepali financial market making any
contributions to economic growth? If yes, how much is that contribution, and
how can it be measured?
BFIs pay interest to depositors, and that interest is considered the
“cost” that they incur. BFIs lend money to people and businesses, and interest
charged on these is considered their “earnings”. The difference between
earnings and cost is considered their “profit”, and this profit is considered
to be their contribution to national economic growth. This consideration is disingenuous
for a couple of reasons.
First, difference between earnings and cost is the value they have
added to our money deposited with them. It is not their profit because some
portion of this value addition is yet to be spent as “costs”. Some of this
value addition is spent to pay for various evaluations and monitoring costs
that BFIs incur while assessing, evaluating, re-evaluating and monitoring their
high-risk loans. These costs are not paid by borrowers of loans, but by the
BFIs themselves. So, BFIs end up spending a portion of their value addition on paying
such costs. Therefore, the number that NRB and BFIs report as contribution of
the financial industry to our economic growth is wrong. The actual contribution
is much less.
This misleading figure is the reason why we suffer through liquidity
crises, every now and then. In our recent liquidity crisis, the level of profit
and savings that BFIs showed to their shareholders was distorted due to the
above mentioned fudging of facts. They actually did not earn the amount of
profit that they claimed to have earned.
Second, interest rates charged on mortgages issued by BFIs have been
significantly higher than interests guaranteed on government issued long term
bonds and treasury bills. Money for providing mortgages comes from money
deposited by the accountholders. Since mortgages fetch high interests, BFIs
tend to give higher returns to their depositors as well to lure depositors into
depositing more money into their bank accounts. Therefore, entire financial
system rests on the shoulders of depositors and how confident they are with
their respective BFIs. A slight reduction in their confidence can mean a huge
reduction in available funds for BFIs. Thus, our entire financial cycle has a
very high risk associated with it. Rising instances of default—either by
depositors or by mortgage holders—takes our entire financial market on a
decline.
Many studies have disputed this general notion that risk-taking
behavior of BFIs is a “productive activity”.
In 2011, Andrew Haldane and Vasileios Madouros analyzed the worldwide
financial crisis of 2008, and discovered that investing capital in a risky
asset did not contribute to productivity. This suggests that Nepali investors
who purchase bonds from a company, or Nepali consumers who borrow from a bank
to buy houses, are taking financial risks but contributing “zero” to economic
activity. The reason for this being that nothing new is created from these
transactions in our economy. There is simply a reallocation of available
finances from one party to the other. Hence, loan portfolios have negligent
contribution—if there is one—in growing our economy.
Another chronic problem with Nepali financial system is that consequence
of risks is not borne by parties that take those risks but by others in the
society. BFIs utilize our money in issuing risky loans with much higher returns
than the interest they pay us for our deposits. If these risky loans get
repaid, they make tons of money. CEOs and shareholders of those BFIs get rich.
If these risky loans are not repaid, they go bankrupt. We lose most of our
money that we deposited with them. CEOs and shareholders of those BFIs do not
have to pay us the money that was ours but which they lost through their risky
behavior. Where’s the balance in rewards versus punishment in our BFIs?
Nepali financial system is structured in a way where CEOs get away with
their risky behavior without being held accountable for their actions. If BFIs
go bankrupt, CEOs know NRB will rescue them i.e. the public will rescue them.
If they earn ridiculous profits, CEOs know the profit will be solely their
shareholders’. So CEOs do not have to pay for their risky behavior, and so they
take more risks. Nepali financial system has created this “moral hazard”
situation where society has been paying the price for the follies of BFIs.
These criticisms do not mean that our financial system is utterly
useless and a zero contributor. Researches around the world have shown that world’s
financial industries do provide some services, and hence they provide positive
value additions. However, he also discovered that these value additions have
been overstated. Contribution of any country’s financial industry—including
Nepal’s—to its economic growth has always been overstated. Rapid growth in
contribution to Nepali GDP by our financial sector in the last few years is a mirage.
Exceptionally high returns that Nepali financial industry experienced
before the recent liquidity crisis was not a result of increasing productivity
of our financial sector but a result of illusion of growth shown by high-risk
lending and borrowing. If current trend of high risk-taking in Nepali financial
sector continues, soon there will be another liquidity crisis worse than the
one that lasted from 2009 until 2012. The reason Nepali financial market has
not yet recovered fully from that crisis is because the risk-taking behavior
continues even today.
Labels: banks, BFIs, financial institutions, financial market, liquidity crisis, NRB
Thursday, January 5, 2012
Challenges of the Nepali economy in the next few years
The following was published in an online news portal www.hamrakura.com. The direct link to the web article is here.
Challenges of the Nepali economy in the next few years
Nepali economy has had a rough ride in the past few years. The
escalating Maoist conflict sent the economy into doldrums during 2006/07. The
economy went into a further fragile state due to the worldwide financial crisis
in 2007/08, the domestic liquidity crisis since 2009/10, and the real estate
crisis since 2008/09. Although the economy has recovered substantially, growth
has been poor when compared to neighbors, inflation has not stopped its goliath
run, and jobs are hard to come by for un-skilled or semi-skilled youths. Now
that the year 2011 is well behind us, let us look at some problems that the
Nepali economy will have to face in the coming year and beyond.
Urbanization
Urbanization is a boon and a curse. On one hand, urbanization is an
indicator of economic growth. On the other hand, it creates a crisis in terms
of delivery of public service goods and services because of increasing demand
for said goods and services that, in turn, constrain resources and create
crisis in delivery.
The escalating war between the Maoists and the Nepali state resulted in
a rapid internal migration of Nepalese citizens from rural areas to urban
centers. One of the
major problems that arose out of this internal displacement was the classic urban giantism problem in the
Kathmandu Valley. Unlike cities in China or India, the urban giantism problem
of Kathmandu and a few other cities was not because they provided more jobs and business opportunities, but because of safety and security that they provided to people’s lives and
properties. Despite the end
of the decade-long Maoist rebellion, that started this rapid urbanization
phenomenon, the urbanization trend has not stopped. It is on the rise.
Like many
other Least Developed Countries
(LDCs), urban
centers of Nepal receive disproportionately larger budget in terms of
development than rural areas. They have more
hospitals and schools. As a result, the rural-urban migration has resulted in the creation of slums and
makeshift communities in Kathmandu and other urban centers in Nepal. This has
made the
poverty situation worse. In
addition, the weak
economy implies that the poor and the hungry that arrive in today’s urban
centers and cities remain poor and hungry because the government cannot take care of their basic needs.
Urbanization
is happening, and is unavoidable. But, proper mechanisms can be put in
place through anticipation or progressive efforts. Basic amenities and services
should be provided all over the country so that people do not flock to urban
centers to receive such services and amenities. There aren’t enough roads
connecting different places in Nepal. Rural areas need roads to stay connected
with the rest of the country. Unless an inclusive approach is taken, Nepali cities will keep
experiencing rapid urbanization and crowding.
The Remittance
Economy
When the Maoist rebellion was at its throes in 2006, the state of
Nepali economy was in a mess, and was on the verge of collapse. The one thing
that saved the economy was remittance money flowing in from overseas. Thanks to
remittance, the consumption did not wane, and the economy stayed its course.
However, that does not mean remittance is always good.
The latest NLSS reported that 53 percent of Nepali households have at
least one member working away from home, out of which 32 percent work in
foreign countries. The reason why so many Nepalis go overseas for work is
because our state cannot provide them with jobs. However, that is not the worst
news to come out of NLSS-III. It is this: 79 percent of the total remittance
received by Nepali households is spent on consumption, and only 2.4 percent is
spent on capital formation activities.
That is, the remittance income that our country receives each year
finances our consumption, and only a small fraction is actually invested in a
useful manner.
Another fact: over 65 percent of those that go to work overseas are
between the ages 15 and 29 while the rest are between the ages 30 and 44. This
does not bode well for our own economic development. How can our economy foster
if the best and the ablest of our labor force goes overseas to build some other
country’s economy? And, it does not look like we are going to see an improvement
in this regard. The Youth Charter designed by our very own National Planning
Commission has 6 bullet-points to help the youths of this country. One of those
bullet points says something to the effect of “to train and provide our youths
with skills that will enable them to land jobs overseas”.
The Youth Charter designed by the NPC explicitly says that one of the
best things it can do for our youths and our economy is to train and educate
our youths just enough so that they can land overseas jobs as laborers. If that
is the best our country can do for our youths, we have no hope. How about
mentioning something like “to create jobs at home for our youths so they don’t
have to toil as menial workers in lands with no laws”?
And, then, there’s something called the spoil effect that we have
to deal with. A study in Kosovo has shown that remittance money sent by family
members from overseas made the youths reluctant towards seeking higher
education. It also reduced their incentives to work. Similar results have been
observed in studies done in remittance heavy economies like the Philippines,
Egypt and Somalia. The spoil effect, essentially, suggests that an easy
availability of remittance money sent from abroad by family members distorts
the work efficiency and working mentality of the recipient young family
members. What good is our remittance economy if we risk losing an entire
generation of our youths to poor education and poor skills due to the spoil
effect?
Nepali
Agricultural Decline
The share of agriculture in national GDP has been on a perpetual
decline. Agriculture contributed 72 percent to the Gross Domestic Product (GDP)
in 1975. Today, it contributes only about 30 percent to the GDP. The situation
is dire due to the fact that we still lag behind in the adoption and use of
technology in our agricultural practices. Agriculture in Nepal cannot compete with highly subsidized and
technologically superior large producers like China and India.
This decline would not be worrisome in itself. But, the reason why
agriculture’s decline is much more worrisome in our case is because 65 percent
of our labor force is still engaged in agriculture. This
is not going to change soon because this labor force does not have the skills
and education to get hired by other sectors. Nepali agricultural labor
force is mostly uneducated/under-educated and unskilled/low-skilled. Most of
this labor force lives in rural areas, and therefore, lacks basic education,
training and healthcare.
Our
liberalization policies and free trade agreements will push a large chunk of
the agricultural labor force into poverty. Although globalization benefits the
world, the fact remains that underdeveloped and developing countries, like
Nepal, have been unable to use it to their benefit. Lack of infrastructure to
transport goods to the market and vulnerability to risks posed by
liberalization make it harder for Nepal to benefit from it when compared to
countries that are already developed.
Agriculture can no longer remain our
leading economic sector. Sooner or later, as in all other nations that have
developed before us, other sectors are bound to surpass agriculture as Nepal’s
leading contributor to its GDP. However, instead of giving up on agriculture
altogether, the government should train and educate the agricultural labor
force in a way that the transition from agriculture vis-à-vis services and
industry should be a smooth flow instead of a painful process.
Liquidity
Crisis Will Return
As the NLSS-III showed, most Nepalis spent the remittance income on
consumption and spent only a small fraction in capital formation activities.
The same is true of any type of income, and not just remittance. So, one of the
reasons why the Nepali financial system went through a liquidity crisis since
late 2009 until late 2011 is because of the Nepali public’s reluctance in
saving their money in banks and financial institutions (BFIs). However, the
main culprits of the recent liquidity crisis are the banks themselves who used
to have surplus money in their vaults, but gave it away recklessly to whoever
came asking for it. And, those that came asking for it were the housing and the plotting people.
Nepal Rastra Bank (NRB) did its best to mitigate the crisis. It
suggested bank mergers hoping that the merger would create a larger institution
that would experience lower costs due to economies of scope and scale, increase
in market power, diversification, and reduced operational expenses. The belief
was that the newly created larger bank would free up vital cash and other
resources to infuse more liquidity into the market while ensuring lower costs,
maximum efficiency and stability. However, no conclusive evidence exists of
such perceived gains occurring in real life.
The NRB also lowered the Cash Reserve Ratio (CRR) from 5.5 to 5
percent, and claimed that this move would infuse Rs 3-4 billion liquidity into
the market in order to ease the liquidity crunch. However, the NRB's tactics of
lowering the CRR was undertaken to provide the bankers an accounting gimmick
that could free up some cash in order to show profit, however minimum, to their
shareholders. Any cash that opened up due to lower CRR would simply be invested
in acquiring government treasury bills to ensure that SLR remained at 15
percent. The move was a sham.
One move that could have mitigated the crisis was if the NRB had
lowered the interest rates to make it easier to borrow money. However, NRB
could not lower the interest rates without giving the impression of loosening
its anti-inflationary stance. If the rates were lowered so much that it came
close to being zero percent, it risked turning the liquidity crunch into a
“liquidity trap”. Also, a low interest rate would mean that people would hoard
cash in their homes instead of depositing in their banks since interest rates
signal the returns they would get on their deposits. That would make the crisis
even worse. In addition, a low interest rate would also cause capital flight
from Nepal to India where Indian banks provided higher interest rates. The
capital flight scenario was highly plausible given the constant pegging of NRs
with IRs, the high volume of traffic crossing the border between India and
Nepal, and the easiness of converting NRs into IRs.
The above reasons make the NRB’s monetary policies
ineffective in its fight against financial crises like the liquidity crisis. In
addition, economists, like Paul Krugman, believe that monetary policies should
be pursued only if a financial disturbance has the potential to affect
inflation or the real economy. It should not be pursued to solve a financial
distress. The liquidity crunch that we saw recently in Nepal had the tendency
to affect neither the inflation nor the real economy. Therefore, there is
serious doubt as to whether the NRB’s policies mitigated the recent liquidity
crunch or if it was just the market correcting itself. In either case, majority
of loans provided by our banks are still in the real estate sector. Until the
lending portfolio of our banks do not change, we will be going through another
round of liquidity crunch in the coming couple of years.
(Copyright) Mukesh Khanal
Labels: capital flight, central bank of nepal, crisis, CRR, economy, financial institutions, housing, IRs, jobs, liquidity crisis, monetary policy, NPC
Friday, September 2, 2011
Links for September 2, 2011
.
1. Nepal's 238 percent tax on imported vehicles is a waste of taxpayers' money
2. Nepalese Commercial banks show low trust on other Financial Institutions
3. US Ambassador to Nepal says "It's the economy, stupid."
4. British Army announces Gurkha troop reduction
5. China promises to promote tourism in Nepal
6. Department of Customs suspects capital flight using fake bills
7. Food security situation remains stable in Nepal
8.Tourist arrivals via air up by over 26 percent in August...Some Numbers
*arrivals from South Asian region have gained robust growth of 38.7 percent
*India 50 percent
*Bangladesh 20.9 percent
*Sri Lanka 11.7 percent
*Pakistan 1 percent
*arrivals from other Asian regions have also registered growth by 57.2 percent
*China 157.6 percent
*Malaysia 95.2 percent
*Thailand 55.6 percent
*Singapore 51.6 percent
*Japan 9.5 percent
*Arrivals from South Korea declined by 10.7 percent
*arrivals from Europe registered overall positive growth of 0.9 percent
*Germany 51.5 percent
*Belgium 28.2 percent
*Denmark 16.2 percent
*Italy 9.3 percent
*Sweden 7.5 percent
*UK 3 percent
*Arrivals from France declined by 13.8 percent
*Arrivals from Netherlands declined by 11 percent
*Arrivals from Russia declined by 31.2 percent
*Arrivals from Spain declined by 10.3 percent
*arrivals from Australia registered growth of 19.7 percent
*arrivals from New Zealand registered growth of 7 percent
*arrivals from USA registered growth of 16.9 percent
*arrivals from Canada registered growth of 33 percent
*49,858 foreign tourists departed from TIA in August 2011.
*52,811 Nepali arrived while 64,326 departed from TIA in August 2011.
1. Nepal's 238 percent tax on imported vehicles is a waste of taxpayers' money
2. Nepalese Commercial banks show low trust on other Financial Institutions
3. US Ambassador to Nepal says "It's the economy, stupid."
4. British Army announces Gurkha troop reduction
5. China promises to promote tourism in Nepal
6. Department of Customs suspects capital flight using fake bills
...The department has unearthed fake abbreviated customs declaration forms...there could be two reasons behind producing fake abbreviated customs declaration forms: to produce legal documents to the imported goods through illegal points or to misuse foreign currency
The department has suspected capital flight by two Birgunj-based firms — Shyam Galla and JB traders and arrested them. It is estimated that some Rs 300 million has been misused by Shyam Galla and Rs 160 million by JB Traders
The issue had come into the light after police on August 29 nabbed five people with fake customs declaration forms. They were trying to get more than Rs 7.52 million transferred to India on the basis of the counterfeit documents.
7. Food security situation remains stable in Nepal
...attributed to a good harvest of winter crops (April-June) and employment opportunities generated by development aid...wheat and barley production increased by 12.2 per cent and 9.6 per cent respectively compared to last year
...but, 28 Village Development Committees (VDCs) in the south-western belt of the district as highly food insecure...because of...a 60 per cent reduction of wheat and spring paddy production due to a dry spell, which was cumulative to the 2010 reduction of 40-60 per cent in the main paddy production.
Parts of the Eastern Hill and Mountain districts are reported as moderately food insecure...Most of the Mid and the Far Western Hill and Mountain districts reported a food secure situation...a seasonal deterioration is reported in part of the Eastern Hill and Mountain districts where the winter crops of wheat and barley are cultivated in limited areas and do not play a vital role in food security...situation in upper Dolpa and some Village Development Committees in the northern and the southernbelt of Baitadi are likely to deteriorate to the highly food insecure phase during the next cycle as there will be no incoming harvest and employment opportunities as well as market supply will be affected by monsoon
According to the central bank, High food prices remain a concern. The year-on-year inflation, measured by the Consumer Price Index, increased by 8.8 per cent in mid-June 2011 whereas the indices of the cereal subgroup increased by 10.4 per cent.
8.Tourist arrivals via air up by over 26 percent in August...Some Numbers
*arrivals from South Asian region have gained robust growth of 38.7 percent
*India 50 percent
*Bangladesh 20.9 percent
*Sri Lanka 11.7 percent
*Pakistan 1 percent
*arrivals from other Asian regions have also registered growth by 57.2 percent
*China 157.6 percent
*Malaysia 95.2 percent
*Thailand 55.6 percent
*Singapore 51.6 percent
*Japan 9.5 percent
*Arrivals from South Korea declined by 10.7 percent
*arrivals from Europe registered overall positive growth of 0.9 percent
*Germany 51.5 percent
*Belgium 28.2 percent
*Denmark 16.2 percent
*Italy 9.3 percent
*Sweden 7.5 percent
*UK 3 percent
*Arrivals from France declined by 13.8 percent
*Arrivals from Netherlands declined by 11 percent
*Arrivals from Russia declined by 31.2 percent
*Arrivals from Spain declined by 10.3 percent
*arrivals from Australia registered growth of 19.7 percent
*arrivals from New Zealand registered growth of 7 percent
*arrivals from USA registered growth of 16.9 percent
*arrivals from Canada registered growth of 33 percent
*49,858 foreign tourists departed from TIA in August 2011.
*52,811 Nepali arrived while 64,326 departed from TIA in August 2011.
Labels: banks, capital flight, china, customs, financial institutions, food security, gurkhas, imports, tourism, vehicle tax
Thursday, June 30, 2011
Rights Shares: Wrong News
Issuing rights shares has become too common in Nepal now-a-days. Everest Finance, Birat Laxmi Bank and Bank of Asia published notices for rights shares on April 8. Malika Bikas Bank on April 10, and Royal Merchant Banking and Finance Limited on April 20 could not sell the rights shares issued to promoters, and had to start auctioning them. Kaski Finance Limited on April 13, Lord Buddha Finance Limited on April 18, Sunrise Bank Limited on April 20 announced opening for rights shares. There are more examples from the months before.
On the face of it, the concept of issuing rights shares seems harmless and innocuous. The shareholders buy more shares from their company, often at lower prices, and help raise capital for their company. And, that is all that the CEOs, Directors and promoters of these financial institutions think will happen when they announce rights shares. It is clear that they have not learnt any lessons from the history of rights shares issued by other financial institutions.
If you observe the share prices of the financial institutions that have issued rights shares in the past, a couple of patterns are immediately noticeable.
First, financial institutions, generally, tend to announce rights shares when the price of their shares starts falling. The falling share prices cause the institutions to come up with extra cash to balance their accounts. So, the institutions that tend to announce rights shares are usually the ones that seem to be in trouble.
Second, share prices tend to fall even further after the announcement of rights shares. So, announcing rights shares could help the institutions collect some capital, but it lowers the price of each unit of share in the market. Although the intention of announcing rights shares might have come out of necessity for generating more capital, the announcement actually ends up hurting the financial institutions’ standing in the market.
This trend holds true for almost all the financial institutions that have announced rights shares in the past. So, the evidence suggests that issuing rights shares does not help the financial institutions. Why, then, do Nepalese financial institutions keep issuing rights shares? Is it because the promoters don’t care about the share price stability? Or is it because they wish to raise large capital, flee with it, and leave the public shareholders hanging high and dry?
However, the worst feeling to come out of this is the realization that these institutions fail to apply the knowledge of basic economics into their equation. Issuing rights shares is a bad idea, and it will eventually result in a decline in share prices of the institution that issues such shares. How? Well, let’s look at the first thing that every introductory Economics course teaches us about demand and supply.
The theory of demand and supply states that price of a share is determined by how much shares are available in the market and how much demand is for those shares. Initially, the supply of shares is given by S1 and demand is given by D1. The market price and total quantity traded is determined at the point where suppliers and buyers agree on the price and quantity of the shares to be traded. Demand and supply of shares become equal at point E1. Therefore, the total shares bought and sold in the market is q1, and the price paid and received for each share is p1. This is what introductory Economics teaches us about market price and quantity determination of any product, whether it is a packet of Wai-Wai noodles or a share of a bank.
When financial institutions issue rights shares, there occurs an increase in the total number of shares available for trade in the market. This causes the supply of shares to shift from S1 to S2. Since demand is still D1, a new equilibrium is created at E2 where total number of shares traded is q2, and the price of a share is p2. Therefore, when supply of shares increases in the market, the price that each share fetches decreases. It does not matter whether all the rights shares that were announced get sold or not. The basic economic theory suggests that the mere existence of an increased supply of shares will drive the price of a unit of share downwards.
Now, those in charge of managing the financial institutions might argue that all is not bad with a lower price if they can generate a large amount of capital. However, they should realize that raising large amount of cash is not their only job. They are responsible for austerity and fiscal stability of their institutions in the long run. A decline in their share prices helps neither their austerity nor the long run fiscal stability.
Also, there is another half to this story that makes the situation even worse. Psychologists have studied human behavior for years, and have concluded that when it comes to handling stress from risks and confrontations, humans have two natural instincts: fight or flight. They have observed that very few fight, and that most choose to flee. This fleeing-from-danger element of human psyche causes a cascading effect in the market price when the rights shares are announced.
Once the price of a share falls from p1 to p2, the general public, that owns the shares of that institution, starts panicking. The dominant natural instinct of “flight” kicks in. Realizing that the price of a unit of share has fallen, the shareholders sell their shares to avoid incurring any more losses on their investment due to any further decline in share prices. Thus, a perfectly logical human reaction results in a lower demand for shares of this institution. The demand curve shifts from D1 to D2. And, a new equilibrium occurs at E3 where q1 number of shares is traded at a price p3.
So, the number of shares traded in the market, which is q1, is the same as before the announcement of rights shares. However, the new price p3, which a unit of share now fetches, is much lower than the initial price of share, p1. And, this is why issuing rights shares is a bad idea. The financial institutions are not doing anyone any favors by pursuing this approach of capital generation. It hurts the shareholders, it hurts the financial institutions themselves, and it hurts the overall financial market of Nepal. Last decade’s data of share market prices of financial institutions before and after the announcement of rights shares shows the pattern repeating itself again and again.
This opinion piece was published in The Republica daily on May 1, 2011.
Labels: banks, financial institutions, rights shares, share market
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