Liquidity Crisis in Nepal: Where Did the Money Go?

Article by Deepak Luitel

Over the past few months, there have been frequent write-ups related to the Nepalese banking sector and multiple discussions on whether BFIs have sufficient funds available to extend credit in the economy. The present condition of the credit crunch has hit the banking sector severely, which has forced the banks to increase the interest rate on deposit rates to attract new deposits to keep the structural balance of deposit and credit.

So, why this sudden credit crunch in the banking sector? Is it due to the decrease in the growth rate of remittance or is it due to the massive increase in the growth rate of imports, or the inability of the government to spend the budgeted amount on capital expenditure, or capital flight, source less cash transferred to other countries, or combination of all the above-mentioned factors?

However, pinpointing one probable cause may not be sufficient to explore the depth of the current issue. There is a shred of empirical evidence that suggests, the rate of remittance inflow in recent times has decreased. Based on the last seven months’ data, ending mid-Feb 2021/22, we evidenced the number decreased by 4.9% to NPR 540.12 billion when compared with last year’s fiscal number was up by 10.9%.

Remittance is a leading contributing factor to the increased disposable income of individuals as well as a country’s GDP. (i.e., about 30% of GDP). The deep drop in remittance inflow has increased concern that any further drop in the figure could lead to structural imbalance at the macro level.

Similarly, to curb the massive import growth, the central bank (NRB) in its monetary review on Dec-2021 issued a circular that requires importers to keep a 100% margin amount to open a letter of credit (LC). The central bank’s move to discourage imports to stop money outflow from the economy can be considered a defensive strategy to maintain foreign exchange reserves.

However, if we look at recent seven months’ data, merchandise imports increased 42.8% to NPR 1147.6 billion compared to an increase of 0.01% a year ago. Whereas exports increased 88.30% to NPR 131 billion. Increasing imports and declining remittances have resulted in pressure on liquidity. In addition, the federal government has demonstrated weak initiative in spending money on development activities.

This would have triggered a ‘trickle-down’ effect in the domestic economy with the money for these activities following through banking networks into the vein of the local economy. For this year’s budget, the government has allocated NPR 378.09 billion for capital expenditures. However, the government has spent only 22.76% in the first seven months of the current fiscal year. The sluggishness of spending money on development activities creates a deficit of capital formation and hinders economic growth.

Shifting from a macro-economic perspective to an industry perspective, let us explore the banking sector. Plentiful theories are floating in the market regarding the cause of the ongoing “credit crunch” or “liquidity crisis”.

So, what exactly is the problem? Have the banks focused excessively on increasing their credit portfolio and failed to match up with deposit collections? How effective is this from the banking strategic perspective? During the pandemic period and soon after, there was a time when banks had excessive liquidity in their hands, due to the lack of flow of credit as most of the businesses were shut down. This resulted in BFIs aggressively expanding their lending horizons at lowered interest rates to unproductive sectors. With each passing month of this fiscal year, BFIs continued to roll out their aggressive expansionary lending strategy.

However, this expansion exacerbated the supply side of the funds available. Eventually, this has resulted in continuous demand for credit as the economy reopened from the covid-19 lockdowns and banks were unable to materialize these loans, without having a balanced backing from the deposit side. Looking at key statistics, most BFIs’ credit to deposit ratio is at the edge of the regulatory requirement of i.e.,90.79% and a weighted average of 6.99% inter-bank rate, reaching an all-time high of March 18-2022.

This indicates that BFIs are struggling to manage the funds to ease the current pressure. In addition, a mid-review document has tightened risk weight for unproductive sectors to curb investment in sectors like real estate and the stock market. With the issuance of the directive, BFIs have been bound to expand their business portfolio in a real value-added sector that contributes to GDP growth.

This ‘short-term’ problem may have long-term ramifications for not just the banking sector but the overall national economy. With the government unable to implement capital expenditure efficiently and in a timely manner and banks unable to extend loans to the productive sector of the economy, the overall economy might face severe contraction with the value of imports increasing at an alarming rate.

From the consumption side of the economy, current high-interest rates of deposits will have an impact on consumption levels. As an added incentive to save disposable income will shrink, resulting in a slowdown of the economy and a decrease in inflation. As a misfortune, where the international uncertainty created by Russia -the Ukraine war has put pressure on the supply bottleneck of oil will remain the leading attribute to raise the price of oil and a possible consequence will further add-up cost-push inflation.

The cost of oil production reflects that consumers would have to pay more high prices for every essential good from daily staple food to gold. Lastly, the current inflation rate (i.e.,5.7%) isn’t going away is due to the increase in the cost of raw materials. Therefore, a higher cost of production will decrease the aggregate supply in the economy and will take over to demand-pull inflation where higher demand triggers inflation.

Luitel can be contacted via luiteld6@gmail.com.