Sunday, August 7, 2011
Easing the Nepalese liquidity crisis
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The Republica link is here.
In case you have not heard it, Nepalese banking and financial system is going through a crisis phase. The central bank has liquidated a number of banks while urging others to merge. Although Nepal receives remittance money equivalent to almost 30 percent of its GDP, our banks seem to be running out of cash. Nepalese banking and financial system is under a liquidity crisis.
Where is all that remittance money going then? Well, the 2010 National Living Standard Survey’s preliminary finding shows that 79 percent of remittance income coming into Nepal is spent on household consumption. Only 2.4 percent is invested in capital formation activities. And, that is one of the reasons why banks in Nepal are having problems. People are not saving their money in banks; they’re spending it.
However, to put the blame of Nepalese liquidity crisis on the public is foolish. The main culprits of this crisis are the banks themselves. They used to have money in their vaults. In fact, they had so much money that they did not know what to do with it. So, they gave it to anyone who came asking for it.
So, who came asking for it? The land plotting and housing people did. In their bid to collect some quick cash as interest payments, the banks distributed the money without proper documentation and backing. Through reckless lending, they created the artificial asset bubble that we have experienced in the last few years. As long as the asset market was hot, the brokers and the banks were getting richer. But, like all good things, the merry did not last. Housing and land market has cooled off since last year. As a result, the brokers are unable to pay interests on their loans. Therefore, banks now have no money to collect and play with.
Historical data will show that liquidity creation right before any liquidity crisis is always high. This suggests that maybe the crisis isn’t really a crisis but a downward adjustment towards the equilibrium steady state. But, this is no time to point fingers or regurgitate history.
Like any financial crisis, the solutions for this mess are carried out by Nepal Rastra Bank (NRB) through its monetary policy. The NRB has been putting some efforts to mitigate the crisis by liquidating some banks and urging others to merge. It also lowered the Cash Reserve Ratio (CRR) from 5.5 to 5 percent. This was expected to infuse Rs 3-4 billion into the market and ease the liquidity crunch. However, that is akin to feeding peanuts to a starving elephant.
During normal conditions, the NRB’s monetary policy is effective in tackling liquidity problems. Approximately 90 percent of bank liquidity is created by large and medium sized banks. A monetary policy, however, does not significantly affect the liquidity creation of large and medium sized banks. These banks are impervious to most monetary policy tightening or loosening due to their own structural compositions. So, loosening the monetary policy by NRB will have insignificant effects in creating liquidity. Also, worldwide evidences show that monetary policy during a liquidity crisis becomes weaker in creating liquidity in banks of all sizes, not just the large and medium size banks.
NRB has two tools that it can use to minimize this crisis: interest rates and liquidity injection. So far, it has done very little in terms of liquidity injection. If it cannot infuse liquidity into the market, it can lower the interest rates. Lowering the interest rates will make it easier for everyone to borrow money. That would ease the crunch. The failure of NRB in cutting down the interest rates could be eroding the financial stability of Nepalese financial sector. That is why our banks could be going bankrupt.
Or, maybe the whole situation should be seen from a different angle. Maybe NRB’s reluctance in lowering the interest rates stems from the fact that lower interest rates in Nepal would encourage people to send money to India due to high interest rates in India. Their money could earn more interest income in India. It doesn’t help that the NRs and IRs are pegged, and the two currencies can be converted from one to another very easily. If the peg and easy convertibility could be avoided, lowering the interest rates in Nepal would definitely help ease the liquidity crunch we face today.
The other real danger of lowering the interest rates is that inflation, which is already very high in Nepal, can spiral out of control. NRB cannot lower the interest rates without giving the impression of loosening its anti-inflationary stance. It is difficult to convince the market that lower interest rates are being pursued without affecting NRB’s anti-inflationary stance.
Even if monetary policies could ease the crisis, they should not be pursued. A monetary policy 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. Today’s liquidity crisis in Nepal has the tendency to affect neither the inflation nor the real economy. Any monetary policy, such as lowering the CRR or lowering the interest rates, has a high probability of aggravating the inflation situation without contributing much to easing the liquidity. So, monetary policy is not the intervention that our market needs to solve this crisis.
Fiscal policy is a better solution for the current mess. The government could incur expenditure to purchase the debts of these struggling banks. If our government does not have enough cash, it should print money to make the purchases. Now, in most instances, printing money is not a good idea. If the money were to be spent on consumption, it could aggravate the inflation. But, my suggestion is to spend that printed money not on consumption but on asset purchase i.e. buying the private banks. Therefore, the printed money would be used in stabilizing the balance sheet of the Nepalese banking and financial system.
I am not advocating for changing the size of our financial balance sheet. I am simply advocating an alteration to the composition of the financial balance sheet. Unlike consumption expenditure, this will actually count as an asset purchase. Once the private banks are purchased and made public, the government can sell the banks back to private buyers when the financial system stabilizes, and the banks become sustainable. Through such intervention, the government can actually make capital gains on its investment.
This would be a win-win situation. The banks would survive, and the government would make some money during the process.
This opinion piece was published in the Republica on August 7, 2011
The Republica link is here.
In case you have not heard it, Nepalese banking and financial system is going through a crisis phase. The central bank has liquidated a number of banks while urging others to merge. Although Nepal receives remittance money equivalent to almost 30 percent of its GDP, our banks seem to be running out of cash. Nepalese banking and financial system is under a liquidity crisis.
Where is all that remittance money going then? Well, the 2010 National Living Standard Survey’s preliminary finding shows that 79 percent of remittance income coming into Nepal is spent on household consumption. Only 2.4 percent is invested in capital formation activities. And, that is one of the reasons why banks in Nepal are having problems. People are not saving their money in banks; they’re spending it.
However, to put the blame of Nepalese liquidity crisis on the public is foolish. The main culprits of this crisis are the banks themselves. They used to have money in their vaults. In fact, they had so much money that they did not know what to do with it. So, they gave it to anyone who came asking for it.
So, who came asking for it? The land plotting and housing people did. In their bid to collect some quick cash as interest payments, the banks distributed the money without proper documentation and backing. Through reckless lending, they created the artificial asset bubble that we have experienced in the last few years. As long as the asset market was hot, the brokers and the banks were getting richer. But, like all good things, the merry did not last. Housing and land market has cooled off since last year. As a result, the brokers are unable to pay interests on their loans. Therefore, banks now have no money to collect and play with.
Historical data will show that liquidity creation right before any liquidity crisis is always high. This suggests that maybe the crisis isn’t really a crisis but a downward adjustment towards the equilibrium steady state. But, this is no time to point fingers or regurgitate history.
Like any financial crisis, the solutions for this mess are carried out by Nepal Rastra Bank (NRB) through its monetary policy. The NRB has been putting some efforts to mitigate the crisis by liquidating some banks and urging others to merge. It also lowered the Cash Reserve Ratio (CRR) from 5.5 to 5 percent. This was expected to infuse Rs 3-4 billion into the market and ease the liquidity crunch. However, that is akin to feeding peanuts to a starving elephant.
During normal conditions, the NRB’s monetary policy is effective in tackling liquidity problems. Approximately 90 percent of bank liquidity is created by large and medium sized banks. A monetary policy, however, does not significantly affect the liquidity creation of large and medium sized banks. These banks are impervious to most monetary policy tightening or loosening due to their own structural compositions. So, loosening the monetary policy by NRB will have insignificant effects in creating liquidity. Also, worldwide evidences show that monetary policy during a liquidity crisis becomes weaker in creating liquidity in banks of all sizes, not just the large and medium size banks.
NRB has two tools that it can use to minimize this crisis: interest rates and liquidity injection. So far, it has done very little in terms of liquidity injection. If it cannot infuse liquidity into the market, it can lower the interest rates. Lowering the interest rates will make it easier for everyone to borrow money. That would ease the crunch. The failure of NRB in cutting down the interest rates could be eroding the financial stability of Nepalese financial sector. That is why our banks could be going bankrupt.
Or, maybe the whole situation should be seen from a different angle. Maybe NRB’s reluctance in lowering the interest rates stems from the fact that lower interest rates in Nepal would encourage people to send money to India due to high interest rates in India. Their money could earn more interest income in India. It doesn’t help that the NRs and IRs are pegged, and the two currencies can be converted from one to another very easily. If the peg and easy convertibility could be avoided, lowering the interest rates in Nepal would definitely help ease the liquidity crunch we face today.
The other real danger of lowering the interest rates is that inflation, which is already very high in Nepal, can spiral out of control. NRB cannot lower the interest rates without giving the impression of loosening its anti-inflationary stance. It is difficult to convince the market that lower interest rates are being pursued without affecting NRB’s anti-inflationary stance.
Even if monetary policies could ease the crisis, they should not be pursued. A monetary policy 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. Today’s liquidity crisis in Nepal has the tendency to affect neither the inflation nor the real economy. Any monetary policy, such as lowering the CRR or lowering the interest rates, has a high probability of aggravating the inflation situation without contributing much to easing the liquidity. So, monetary policy is not the intervention that our market needs to solve this crisis.
Fiscal policy is a better solution for the current mess. The government could incur expenditure to purchase the debts of these struggling banks. If our government does not have enough cash, it should print money to make the purchases. Now, in most instances, printing money is not a good idea. If the money were to be spent on consumption, it could aggravate the inflation. But, my suggestion is to spend that printed money not on consumption but on asset purchase i.e. buying the private banks. Therefore, the printed money would be used in stabilizing the balance sheet of the Nepalese banking and financial system.
I am not advocating for changing the size of our financial balance sheet. I am simply advocating an alteration to the composition of the financial balance sheet. Unlike consumption expenditure, this will actually count as an asset purchase. Once the private banks are purchased and made public, the government can sell the banks back to private buyers when the financial system stabilizes, and the banks become sustainable. Through such intervention, the government can actually make capital gains on its investment.
This would be a win-win situation. The banks would survive, and the government would make some money during the process.
This opinion piece was published in the Republica on August 7, 2011
Labels: central bank of nepal, liquidity, liquidity crisis, nepal rastra bank, Nepalese Economy
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