Blinkered Policy

In la-la land, there are two banks “Mean and Lean (M&L)” and “Fat and Profligate (F&P)” who had similar balance sheets and profitability figures five years ago. Over the last five years, the two banks have focused on completely different strategies. While F&P has been more aggressive and often reckless in seeking growth, M&L has focused on prudent banking practices.

Over the last five years, the total asset of M&L has grown at a cumulative average growth rate (CAGR) of 15 percent. The top management, including the chief executive officer (CEO) of M&L has focused on quality over quantity while pursuing growth. M&L has maintained excellent lending standards, with rigorous credit analysis, while providing loans to its clients. Their credit analysis not only involves determining the client’s “ability” to pay but also their “willingness” to pay. Often, M&L has rejected loan requests because of either dodgy business proposals or because of the client’s past track record. Moreover, M&L has worked

on maintaining a diversified

lending portfolio.

In line with its prudent strategy, M&L has focused on growing its deposit mix judiciously focusing on both current and savings accounts (CASA) to lower its cost of funds and time deposits to address a potential asset-liability mismatch.

To maintain its rigorous banking standards, M&L has concentrated on retaining and hiring experienced staff; however, it has not indulged in a hiring spree to push its loan products. M&L’s perks and benefits for its staff are on a par with the average industry standards, and its Human Resource (HR) department has devised new and innovative, yet cost effective, ways of retaining quality manpower. Moreover, because of a large number of experienced and long serving staff, the top management of M&L has been able to seamlessly convey its strategic vision to middle and lower level management, which has resulted in operational synergies.

Over the last couple of years, lots of new banks and financial institutions have emerged in la-la land, and, as a result, staff attrition in the banking sector has increased rapidly. However, because of M&L’s focus on quality over quantity, flexible working hours and a not so strenuous job schedule, it has been able to minimize the employee turnover level. Experienced staff coupled with a motivating work environment has increased M&L’s staff productivity, helping to increase its bottom line.

M&L’s focus on quality over quantity in their loan portfolio has helped it to keep its non-performing loans (NPL) to a bare minimum level. Its judicious deposit mobilization has helped it to maintain its interest spread. As a result, the net profit of M&L has increased at a CAGR of 25 percent over the last five years. Shareholders of the

bank have been satisfied with the management’s ability to grow profit and deliver above average returns on equity.

Compared to M&L, F&P’s total asset has grown at a CAGR of 30 percent over the last five years. In order to purse this high growth, F&P has pursued a different strategy to that of M&L. The lending practice of F&P has been lax at best; and often, loan requests have been approved without proper due diligence. While seeking high growth, the top management of F&P has ignored maintaining a diversified loan portfolio. As a result, its portfolio is highly concentrated among a few vulnerable sectors (such as real estate).

In order to pursue rapid growth, F&P has poached a lot of staff from other banks by offering them a higher salary, which has resulted in higher than average salary expenses. However, the top management of F&P has not been able to properly convey its strategic vision to middle and lower level management resulting in lack of organizational coherence. Moreover, long working hours and a demanding schedule have taken their toll among F&P’s staff, reducing their productivity.

Recently, because of a sudden slowdown in the real estate sector, a few major loans of F&P have come under scrutiny. This, coupled with higher staff compensation, has severely undermined F&P’s bottom line. As a result, the net profit of F&P, after growing at a CAGR of 30 percent for the first three years, has decreased at a CAGR of 17 percent over the last two years.

Ignoring other financial information, for comparative purposes, the total asset of F&P is approximately 2.5 times that of M&L currently, while the total staff expense of F&P is two times that of M&L. However, the total profit of F&P is only half that of M&L.

Now, why on earth does Nepal Rastra Bank (NRB), given the above mentioned hypothetical yet plausible scenario, want to have the CEO of F&P earn a higher salary than that of M&L? To put it more bluntly, why does NRB want to have more F&P-like banks and less M&L-like banks in the future? Because by linking the CEO’s compensation to the total asset and average salary expense, NRB has paved the way for formation of bloated financial institutions with the management’s mandate to seek total asset growth irrespective of other factors.

This article was first published on 20th December 2010. Permanent Link:

http://www.ekantipur.com/2010/12/20/business/blinkered-policy/326772/

Fighting Inflation

Inflation averaged 13.2 percent in the fiscal year 2008-09, 10.5 percent in 2009-10 and, according to the Monetary Policy for fiscal 2010-11, is expected to be 7 percent in fiscal 2010-11. Given the persistently high inflation in Nepal for the last couple of years, the Nepali people, I feel, have started to take higher prices as given and adjust with them accordingly. However, having said that, one needs to think about the adverse impact of an inflationary environment and its wide ranging impact on export competitiveness to national savings to the exchange rate.

But before I get into the details of the adverse impacts of inflation, it’s interesting to compare and analyze the government’s inflation projection—set by Nepal Rastra Bank at the start of the fiscal year in its annual Monetary Policy announcement—and actual inflation for that particular year.

For fiscal 2008-09, NRB had projected an annual inflation rate of 7.5 percent; but the actual inflation for that fiscal year was, as mentioned above, 13.2 percent. Similarly, for fiscal 2009-10, NRB had projected an annual inflation rate of 7 percent while the actual inflation for the last fiscal year was 10.5 percent. For this fiscal year, NRB has again projected an inflation rate of 7 percent. What the average annual inflation for the current fiscal year will be remains to be seen. However, given the central bank’s track record, your guess is as good as mine.

Given the above mentioned context of a huge gap between the projected and actual inflation

rates during the last couple of years, it’s easy to realize that

NRB has lost its credibility especially in terms of fighting inflation. Keeping the supply side constraints aside, which is the inevitable excuse that NRB uses when the actual inflation is higher than the projected inflation, if NRB has projected inflation to reach a certain level, why then doesn’t it fight to keep it at that level?

If at the start of the year, I believe that inflation will be 7 percent (guided by NRB), I will plan accordingly; i.e., if I am a wage earner, I will demand a minimum 7 percent wage hike to at least maintain the purchasing power of my income. Similarly, if I am the owner of a manufacturing company, I will increase my product’s price by a minimum 7 percent so that my firm’s profit will at least remain the same in real terms.

However, if at the end of the year, I realize that inflation actually increased to 13.2 percent, then I will be worse off irrespective of whether I am a wage earner or the owner of a manufacturing

company. Hence, at the beginning of the next fiscal year, I start to mark up NRB’s inflation projection by a certain percentage so that I won’t be worse off again. If every decision maker, i.e., individuals and businesses in the country, starts doing the same, then the inflation level will shoot up and become unmanageable.

High inflation then has a multiplier effect throughout the economy. High inflation decreases after-tax real return and reduces the people’s incentive to save and invest. For example, if the tax rate is 25 percent, the interest rate on a one-year taxable bond is 10 percent and the inflation rate is 5 percent, then the before-tax real return will be 4.76 percent, and the after-tax real return will be 3.57 percent (this is what an investor actually cares about).

Now, if the inflation rate rises by 5 percent to 10 percent and the interest rate on a one-year bond also rises by 5 percent to 15 percent, then the before-tax real return will be 4.55 percent, and the after-tax real return will be 3.41 percent.In the latter case, even if the nominal return has increased to 15 percent, the after-tax real return is lower than in the former case because of high inflation, discouraging people from saving and investing.

High inflation also makes a country’s products less competitive in the international market and reduces exports. Because of its adverse effects on exports and imports, in the long run, it also puts downward pressure on the country’s currency.

This article was first published in the Kathmandu Post on Dec 6th 2010

Permanent Link: http://www.ekantipur.com/2010/12/06/business/fighting-inflation/326079/

Dissecting the budget

After much hue and cry and a delay of almost four months, Minister of Finance Surendra Pandey finally tabled the budget of Rs 337.9 billion for the Fiscal Year 2010/11 on Saturday.

Amidst the cacophony of political wrangling, it’s relieving to finally have a budget, which lays out key fiscal policies, irrespective of its form or issuance mechanism. Having said that, lets then discuss what this year’s budget has to offer and, after much ado, are there things to be cheerful about?

Segregating the composition of budget, Rs 190.32 billion has been allocated for recurrent expenditure, Rs 129.54 billion has been allocated for capital expenditure and Rs 18.42 billion has been allocated for principal repayment of foreign loans. In terms of sources, the government expects to raise Rs 216.64 billion from revenue collection, mobilise Rs 87.57 billion from foreign rants and loan, and borrow Rs 33.68 billion internally. To up the ante on revenue collection, the budget has focused on expanding revenue net and has proposed 2011 as ‘Tax Implementation Campaign Year’.

During the last fiscal year, Nepali economy reeled under Balance of Payment (BOP) crisis and had to seek help from the International Monetary Fund (IMF) under its rapid credit facility program to maintain external sector stability. While huge growth in imports of gold were largely to blame for the BoP crisis, which at one time was in deficit of almost Rs 24 billion. There were other glaring trends; for example, Nepal imported livestock worth Rs. 15 billion during the FY 2009/10.

Given the current mismatch between the import and export growth (in the FY 2009/10, Nepal’s merchandise export declined by 9.7% to Rs 61.13 billion while imports increased by 33.2% to 378.8 billion), Nepal will have to perennially face BoP crisis if the government doesn’t act to either revive Nepal’s export or curb import. Hence, this year’s budget should have focused on import substitution and export expansion programmes. However, few, if any, such specific programs can be found in the budget.

During the last few years, education sector has received substantial budgetary allocation and it has paid off handsomely as Nepal has made rapid headway in literacy rate. This year also, 17.1%, which is the highest sector allocation of the total budget, has been allocated for the education sector.

One of the factors for the underperformance of Nepali economy over last couple of years is lack of proper roads and transportation related infrastructure. Given the growth constraints due to lack of transportation related infrastructure, budget has proposed construction of Railway and Metro to kick start the development of mass transit system in Nepal. The focus on development of four- and six-lane highways in and around Kathmandu and border towns near India will however help to ease supply bottlenecks. Moreover, to tackle

the energy crisis, this budget has allocated funds for completion of Trishuli-3, Chameliya and Kulekhani-3, among others.

Recently, the government has shown adequate concern to revive the flagging capital market. Slew of new regulations (Mutual Fund and Central Depository System) have been issued during last couple of months to streamline and institutionalise security market. This budget has also introduced several new programs such as allowing Non Resident Nepalis (NRNs) to invest in capital market, regulating the commodity and derivative market and introducing regulation pertaining to credit rating mechanism. These will certainly help to move the capital market in the right direction; however, going forward, government should also allow overseas investors to invest in domestic capital market, as the mutual fund regulation already allows 25% of total Asset under Management (AUM) of a mutual fund to be invested in overseas market.

The budget has also proposed tax incentives to encourage merger and acquisitions (M&A) among financial institutions and insurance companies. One of the bones of contention while pursuing M&A in Nepal have been the issue of fixed asset revaluation and consequent capital gain tax on such revaluation. Hence, I believe, finance minister’s proposed tax incentive is likely to address this issue, among others.

Keeping in the mind the Nepal Tourism Year-2011 (NTY-2011), this budget has proposed various programs for a successful NTY-2011. However, with less than one and half month’s time before the start of the NTY-2011, it’s debatable whether there is sufficient time for implementation of these programmes. And, this brings home the point which has plagued fiscal policy making in Nepal for quite some time-lack of proper implementation of proposed program due to less time period after the budget announcement and before the end of the FY.

Recently a high level commission called ‘Commission to review Government Budget Management and Expenditure System’, submitting a report to Finance Minister Pandey, recommended the government to bring budget before May; i.e., at least one and half months before the end of the FY. As many programs announced in the budget goes either un-implemented or are implemented hastily towards the end of fiscal year to toe the line of budget’s speech, the aforementioned commission’s report rightly urged the government to table budget early so that it leads to better implementation.

Traditionally, in Nepal and unlike international practices, budget for the upcoming fiscal year is brought only towards mid July; i.e., towards the end of the fiscal year. And if there is change in government or any other political wrangling, budget, like this year, gets delayed jeopardising the whole economy. Hence hopefully, going forward, the upcoming government (when and if it gets formed) will heed the Commission’s advice and brings next fiscal year’s budget early.

First published in the Kathmandu Post on November 21, 2010
Link: http://www.ekantipur.com/the-kathmandu-post/2010/11/20/money/dissecting-the-budget/215085/

Yen and Yuan

In the years following the end of World War II, the Japanese economy witnessed tremendous growth which is often referred to as an “economic miracle”. Japan’s rapid industrialization in the post-war years embraced technological progress and Japanese industry focused on producing high-end technological equipment, innovative electronic products and most reliable automobiles. Rising economic productivity, because of technological progress, coupled with strong exports of renowned international products, such as Sony, Toyota

and Honda, among others, boosted Japan’s economic growth. Japan’s economy grew at an average annualized rate of 10

percent during the 1960s, 5 percent during the 1970s and 4 percent during the 1980s.

However, in order to boost their export related industries, the Japanese government had fixed the exchange rate between the Japanese yen and the US dollar at 360 yen to US$ 1 in 1949. But a high volume of Japanese exports to the US and Europe started causing international tensions in the 1970s. The global stagflation and oil crisis of the 1970s were causing economic woes in the US and other major developed economies in Western Europe. And because of an acute balance of payments crisis, the US had to withdraw from the gold standard and abandon the convertibility of its currency into gold in 1971.

Due to international pressure, Japan finally revalued the yen from 360 to 308 per US$ 1 in December 1971; and later, in February 1973, adopted a floating exchange rate system. However, in order to protect Japan’s industry, the Japanese government kept on intervening in the foreign exchange market and managed to keep the yen at around 250 to 300 to US$ 1. As a result, Japanese exports kept on surging — the share of exports in Japan’s gross domestic product increased from 11.7 percent in 1973 to 14.5 percent in 1984.

Flush with excess foreign

currency, the Japanese government bought US treasuries which helped keep the yields on US government bonds low.

Around that time, while Japan was enjoying economic prosperity, the US was facing economic problems. Although the US had emerged from a series of economic recessions in the 1970s and early 1980s, the artificially low exchange rate of the Japanese yen and the Deutsche mark were undercutting the competitiveness of American industry and stifling a full-fledged economic recovery. As a result, there was a lot of political pressure from the Americans on the Japanese to let the yen appreciate.

To followers of international policy issues, these events of the 1980s sound eerily familiar with what is happening now in terms of the Chinese yuan. The Chinese government, like the Japanese government in the past, has kept its currency artificially low for a number of years to promote Chinese exports. And the weak yuan has paid off handsomely to China as export-led economic growth has propelled China to the second largest economy in the world — a place which was till a few months back occupied by Japan. And like Japan in the 1970s and the 1980s, due to massive influx of foreign currency, the Chinese government has been buying US treasuries and helping to keep yields on US government bonds low. Although the US has been pressuring China for a long time to let the yuan appreciate, the current state of the US economy, with an unemployment rate in excess of 9.5 percent, has compelled US policymakers to raise their voice against a weak yuan.

During the recently held annual meeting of the World Bank and the International Monetary Fund, the major discussions revolved around China’s currency policy. Given the state of the US economy and China’s massive trade surplus with the US, Americans feel that, by keeping the yuan artificially low, China is taking away jobs from the US. But China hasn’t budged so far. Recently, Chinese President Hu Jintao said that allowing the yuan to appreciate too quickly would undermine the competitiveness of Chinese industry and cause social unrest in his country as a lot of workers were dependent on it. A look back at what happened to Japan after it caved in to US demands gives an idea about why Chinese officials won’t bow to US demands.

In the mid-1980s, due to pressure from the US government, Japan had to yield. Amid growing geopolitical tension, the governments of Japan, the UK, West Germany, France and the US signed an agreement at the Plaza Hotel in New York City on Sept. 22, 1985, whereby they decided to intervene in the foreign exchange market to weaken the US dollar against the yen and the Deutsche mark. After the signing of the Plaza accord, the US dollar weakened against the yen by over 50 percent between 1985 and 1987. However, to keep its economy moving along, the central bank of Japan reduced the interest rate to prop up domestic demand which, however, adversely created an asset price bubble in Japan in the late 1980s. After the bubble burst in the early 1990s, Japan’s economy has been perennially underperforming for the last two decades.

China, with the benefit of hindsight, has understood

that allowing the yuan to appreciate too quickly would undermine its economic performance. Moreover, China, because of the size of its population, is nowhere near Japan — when it signed the Plaza accord — in terms of per capita income and has a lot of catching up to do. Hence, it’s unlikely that there will be a

Plaza-like agreement in the coming days, and more ugly exchanges between US officials and their Chinese counterparts are likely to persist for the foreseeable future unless another viable compromise can be reached.

This article was first published in The Kathmandu Post on 25th October 2010
Permanent Link: http://www.ekantipur.com/the-kathmandu-post/2010/10/24/money/yen-and-yuan/214110/

Unusually Uncertain

"Unusually uncertain” were the two words that Ben Bernanke, the Chairman of the Federal Reserve of United States, said about the state of economic recovery on July 21st 2010. After the remarks were released, the US stock market fell sharply which were followed later with subsequent fall in the Asian and European markets.

After showing signs of recovery in early 2010, the global economic outlook has deteriorated during the last couple of months. Economic growth in major advanced economies has been tepid at best, and the much talked about “green shoots” of recovery witnessed during mid 2009 hasn’t materialized into full scale economic expansion.

The unemployment rate in the US hasn’t budged from 9.5 percent to 10 percent range during the last one year. The high unemployment rate shows that business confidence is still low and companies aren’t hiring despite the recent surge in their profit. Household consumption accounts for over 70 percent of the US Gross Domestic Product (GDP) and because of struggling job market, households are chary of spending. As a result, savings rate in the US has increased after the global economic crisis: from a pre-crisis negative savings rate, the US household savings rate has recently increased to over 6 percent. One of the major reasons of global economic crisis was over-consumption of US households; hence, the increment in savings rate is good for the long run. However, in the short run, the US economy desperately needs its consumers to spend more to boost its growth prospects, which looks unlikely given the current US job market situation.

And, if leading experts are to be believed, US job market won’t improve any time soon. Mohammed El-Erian, chief executive officer and co-chief investment officer of PIMCO - the largest fixed income manager in the world - recently said that the US will witness a “lost decade” of jobs growth. Bill Gross, founder and Managing Director of PIMCO was first to coin the term “New Normal” in early 2009 to describe a prolong period of slow growth and high unemployment for the US economy.

When leading economists and central bankers from around the world gathered recently in Jackson Hole, Wyoming to discuss the future of the global economy, the mood amongst the members of this elite group was reported to be much somber. Having already taken unprecedented steps to bolster economic performance

after the crisis, central bankers have plenty to think about

given the daunting prospect of ‘double dip”. Speaking at the Jackson Hole Symposium, Bernanke reiterated his earlier comments about uncertain course of economic recovery and added that US growth will remain subdued for rest of the 2010 and that US economy will grow, albeit slowly, in 2011.

Few significant events have contributed to uncertain business environment which subsequently had an impact on economic performance of major economies. When the “green shoots” of the recovery first emerged during the second half of 2009, business confidence started to recover. However, much of the progress was dented when credit problems surfaced in Dubai in late 2009. Before the problems in Dubai were sorted out, Europe started to have its own debt problems. Overnight, the Credit Default Swap (CDS) - a risk measure of bond’s likely default - on the sovereign bonds of Portugal, Ireland, Greece and Spain (so called “PIGS” countries) increased to unprecedented levels. Much of the first quarter of 2010 was plagued with sovereign debt issues of Europe.

All these events have made businesses and investors wary about the next round of problems. As a result, business confidence has come down. And this has been reflected in the slow growth numbers. Recently, the US revised its second quarter economic growth from 2.4 percent to 1.6 percent. Japan grew at an annualized rate of paltry 0.4 percent. Yields on the US government bonds are incredibly low indicating investors’ flight towards safety.

What then does this slow growth and uncertain environment mean to the rest of the world, especially to emerging economies? If the recent economic performance of India and China is to be believed, then not much. India recently clocked an 8.8 percent growth in April-June quarter - highest growth figure after 2007. Indian policymakers are talking about the need to raise key policy rates to tackle high inflation. China has also been growing at its usual rapid pace. These are signs that, maybe, some of these emerging economies have started to decouple from the developed ones. However, it will be premature to assume that China, India and other emerging economies have fully decoupled from the US and other developed economies. One only needs to go as far as 2008 to see how the whole “decoupling” theory was turned on its head. Hence, as of now, “unusually uncertain” seem the right choice of words.

First published on the Kathmandu Post on Sept 13, 2010.
Permanent Link: http://www.ekantipur.com/the-kathmandu-post/2010/09/12/money/unusually-uncertain/212689/

The suspense is Killing Me

Do we have an incredibly resilient economy or are we on the verge of an economic collapse because of a disconnect between policymakers and the rest of the nation? I really hope that it’s the former and not the latter because it’s not very hard to comprehend what would happen to the level of business confidence and the state of the economy if any other country’s political situation were in as bad a shape as ours. Despite the insurgency, Tarai unrest, labour union problems, energy crisis and other exogenous problems, the business community in Nepal has preserved and continued with their operations.

Some factories have closed down; the manufacturing sector in particular has suffered especially due to chronic labour problems and the energy crisis; but the overall economy has moved on, albeit slowly. But how long can we go on like this? Yes, we are a resilient bunch of people; and we have taken messy politics, numerous bandas, labour union problems and the energy crisis in stride and continued with our day-to-day affairs. However, instead of policymakers recognizing the past and current plight of the business community and working towards facilitating business through new policy measures, they have been perpetuating a policy vacuum created by the political stalemate which is worsening by the day.

During the last two months, we have failed to elect a new prime minister after holding elections for the umpteenth time. And because of the delay in the formation of a new government, our annual budget—where the government announces key fiscal policy measures for the coming fiscal year—is in limbo. The business community eagerly awaits the annual budget as major policy changes are mentioned in it—such as those related to taxation, foreign trade tariff, infrastructure and agriculture, among others. Moreover, the budget also gives an idea about the economic policy rationale of the policymakers, i.e., whether the incumbent government is more market friendly or has a socialistic ideology.

Businesses plan their next projects incorporating these policy changes. However, due to the delay in the formation of a new government and announcement of the budget, which is overdue by more than two months, there is uncertainty in the business community. And this is the catch: Uncertainty kills business activities.

When the business community is confident that a particular government will last for a certain period of time, they can plan and invest accordingly. They can rest assured that the prevailing policies will be maintained and that their investment won’t be put at risk because of sudden changes in economic policy due to a change in government. However, when there is uncertainty whether a certain government will last or not, business persons generally prefer to wait and watch.

This results in lack of investment and other business activities, and stifles economic growth. In Nepal’s context, there is no certainty as to when a new government will be formed and how long it will remain.

Since the restoration of democracy in 1990, Nepal has had 17 different governments, 16 prime minister changes, a decade-long Maoist conflict, direct rule under former king Gyanendra, the April movement of 2006 and numerous strikes and bandas. Political parties have split to merge again, and political leaders have left their respective parties only to return subsequently. Because of the frequent changes in government, there hasn’t been any continuity in economic policy. The lust for power among political parties has made Nepal one of the most politically unstable countries in the world. It’s no wonder then that over 60 percent of the respondents to an enterprise survey of Nepali industry for 2009 conducted by the International Finance Corporation (IFC) have identified political instability as the major obstacle to their business.

Despite this, our economy has moved on largely due to the perseverance of the business community. The business community has persevered hoping that things will change for the better some day. But then at some time, the policy vacuum caused by the political instability will start to take its toll. In fact, I believe it has already started to happen. While our neighbouring countries are witnessing a dramatic economic growth because of business-friendly policy changes, we are languishing in uncertainty. But for how long can we afford to suffer thus? This resilience won’t last indefinitely.

This article was first published on Aug 31st, 2010 on the Kathmandu Post
Permanent Link:
http://www.ekantipur.com/the-kathmandu-post/2010/08/30/money/the-suspense-is-killing-me/212212/

Analyzing Deposit Insurance

At the height of the financial crisis of 2008, the US Federal Deposit Insurance Corporation (FDIC) decided to increase the deposit insurance limit from US$ 100,000 to US$ 250,000 to stem the general public’s eroding faith in the financial system. Many other countries followed suit. Australia and New Zealand, which did not have deposit insurance then, decided to introduce a 100 percent deposit insurance scheme.

As countries have realised the importance of deposit insurance, a number of countries with some form of deposit insurance scheme has increased multifold over the years. According to the International Association of Deposit Insurers (IADI), as of June 2009, 104 countries have instituted some form of explicit deposit insurance, up from 12 in 1974. Moreover, the IADI states that another 17 countries are considering implementing explicit deposit insurance in the near future.

With the recent introduction of the Deposit Guarantee Bylaw by the Deposit Insurance and Credit Guarantee Corporation (DICGC), Nepal will soon join the club of countries with deposit insurance. According to preliminary reports, Nepali banks and financial institutions (BFI) can now voluntarily decide to insure their deposits. However, the insurance scheme only applies to deposits of natural persons and not institutions or corporations. A ceiling of Rs. 200,000 per person has been applied, and BFIs registering for deposit insurance will be charged 0.2 percent or 20 paisa per Rs. 100 of deposit.

This is a welcome initiative as it will boost the general public’s confidence in the banking system. Deposit insurance is one of the most important tools to increase the public’s faith in the banking system. Diamond and Dybvig’s seminal research on bank runs and financial crises identified deposit insurance as the most viable tool to prevent bank runs and reduce contagion risk in the banking system. A run on the bank happens when the general public believes that a bank is about to go under and their deposits are at risk. As depositors rush to the bank to get their money out, the troubled bank isn’t able to fulfil all the withdrawal requests at once as a majority of their deposits are invested in long-term loans. The bank’s inability to pay its depositors creates further panic, and more depositors rush in to withdraw their savings, which ultimately leads to bank failure. Moreover, a bank run is contagious in the sense that it spreads from a troubled bank to the whole financial system like wildfire even when other banks are financially sound.

However, with deposit insurance, depositors know that they will get their money back, to the extent of the insurance coverage, even in the case of a bank failure; and there is no reason for depositors to participate in the bank run. Hence, to a large extent, deposit insurance helps prevent bank runs and contagious banking crisis by building depositor confidence. As the social and economic cost of a bank run and financial crisis are very high, institutions such as the International Monetary Fund (IMF) have been recommending deposit insurance as part of best financial practices for developing countries.

Having said that, deposit insurance, however, does create perverse incentives for both depositors as well as BFIs. Without deposit insurance, depositors are expected to carry out due diligence before putting their savings in any bank. Depositors punish financially weak and risky banks by asking for a risk premium in the form of a higher interest rate. The riskier the bank, the higher will be the risk premium, so banks are compelled to be financially sound and stable. With deposit insurance, however, depositors will no longer have to monitor the performance and activities of their bank as they will be compensated even if it were to fail. As banks face less scrutiny from depositors, they are free to indulge in risk-taking activities—a so-called moral hazard problem in economics. Banks are more than happy to pay nominal premium for deposit insurance as they no longer have to pay a higher risk premium for taking great risks.

Moreover, voluntary deposit insurance, like the one proposed in Nepal, creates another serious problem of adverse selection. The problem of adverse selection can be illustrated by the link between smoking status and mortality (adapted from Wikipedia). Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurance companies do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers. The average mortality of the combined policyholder group will be higher than the average mortality of the general population. From the insurer’s viewpoint, the higher mortality of the group which “selects” to buy insurance is “adverse”. The insurer raises the price of insurance accordingly. As a consequence, non-smokers may be less likely to buy insurance (or may buy smaller amounts) than if they could buy it at a lower price to reflect their lower risk. The reduction in insurance purchase by non-smokers is also “adverse” from the insurer’s viewpoint, and perhaps also from a public policy viewpoint.

The same scenario can arise in the context of Nepal with voluntary deposit insurance where riskier banks may buy more deposit insurance while less risky banks may buy less or opt out of deposit insurance. Even with insurance premiums adjusted for risk-based capital fund of banks, historical evidences have shown adverse selection to be a problem for voluntary deposit insurance schemes. In a classic paper published in 1995, Kumbhakar and Wheelock found that adverse selection was one of the major problems with voluntary deposit insurance. Their study found that risky banks are more likely to join voluntary deposit insurance despite the presence of insurance premiums that were inversely related to the bank’s capital to deposit ratio.

The problem of adverse selection is due to asymmetric information where the management of a bank has a better picture of the true risk level of its balance sheet than the regulators; and depending on the riskiness of the bank’s assets, it can decide whether to enrol in deposit insurance or not. In such a context, penalising banks with higher insurance premiums on the basis of their capital adequacy ratios, as is being prescribed in Nepal, may not work.

Because Nepal is entering such a scheme, these are invaluable lessons. From a public policy standpoint, riskier banks dominating the deposit insurance scheme will be a disaster as taxpayers will have to later foot the bill if these banks were to fail down the line.

This article was first posted in the Kathmandu Post on July 21st 2010.
Permanent Link: http://www.ekantipur.com/the-kathmandu-post/2010/07/20/oped/analysing-deposit-insurance/210683/

From the horse’s mouth

Sandy Weil, the legendary American banker and former chairman of the Citigroup, built the empire called Citigroup by buying other banks and insurance companies. After a series of acquisitions, which included Salomon Brothers in 1997, the US $73 billion merger of Weil’s Travelers group with Citicorp in 1998 led to the formation of a mammoth financial institution called Citigroup. That merger, the biggest merger in the global banking history till date, was largely a success owing to strong lobbying from Weil, who was successful in persuading Robert Rubin, then Treasury Secretary of the United States, to do away with the Glass Steagal Act.

The series of events which led to the formation of Citigroup is vividly captured in a recent book about Jamie Dimon, a former protégé of Weil and now Chairman of JP Morgan Chase, called The Last Man Standing: The rise of Jamie Dimon and JP Morgan Chase written by Duff McDonald. Dimon was the key man involved in all of Weil’s acquisitions that culminated in the Travelers-Citicorp deal in 1998. Dimon, who was later fired from Citigroup after a fallout with Weil, became the most important player in the Wall Street during the financial crisis of 2008 as his firm (JP Morgan Chase) bought Bear Stearns and Washington Mutual—mainly at US treasury’s behest—to quell the panic in the financial market. From Citigroup to JP Morgan Chase to Washington Mutual, the book provides intricate details regarding key recent mergers and acquisition (M&A) in the US banking history. The book exposes how it’s not only the right valuation and synergies that drive M&A but also the big fat egos of the top executives involved in these massive deals and their quest for power and fame.

At a time when voices are being raised in favour of introducing necessary regulations for M&A amongst financial institutions in Nepal, there are lessons to be drawn from this book as it provides key insights to what makes a good M&A deal for a financial institution and how, like in the case of Citigroup, mammoth financial institutions fail to generate synergy and subsequently flounder due to their unmanageable size. There is no doubt that the government should encourage M&A among financial institutions by introducing necessary regulations. However, both government and shareholders needs to scrutinise the M&A deals as there will be scope for creating a monopolistic entity as well as enrich top management at the cost of shareholders.

One area where M&A can possibly help Nepali banks is in increasing their capital base. The biggest problem with the banks in Nepal right now is that they have too little paid up capital to fund large scale projects. Even a small hydropower project needs consortium financing. Another area is cost cutting: duplication of space, technology and human resources can be drastically reduced. However, the major potential obstacle for M&A amongst Nepali financial institutions is lack of opportunities to create synergy. Synergy exists when two banks with different revenue models, different clientele bases, different geographic presence and different core expertise decide to merge.

For example, it makes sense to merge a bank with a strong presence in Eastern zone with another bank with a stronghold in Central zone. Or it makes sense to merge a bank with core expertise in retail lending to one with a large corporate loan book. Or it makes sense for a bank with large retail client to buy a bank with institutional clients, strong private banking and wealth management division. However, in Nepal almost all of the banks operate in the same geographic area, offer the same plain vanilla banking and have the same revenue model and, hence, the potential to create “synergy” is limited. Recently ICICI bank, a leading private sector bank in India, decided to buy Bank of Rajasthan because it wants to increase its presence in Northern and Western parts of India. This deal has business logic as there are opportunities, granted right valuation and proper execution, to create synergy and increase shareholder value.As the liquidity crisis in the banking system shows no signs of easing, recent conversations among bankers and policymakers have veered towards M&A as a potential tool to shore up the capital base of the banks—and strengthen their balance sheets in the event of systemic banking crisis—in order to capture the so called “synergies” that are possible due to M&A.

In a way, many people see M&A as a panacea to all of the current problems in the domestic banking sector. However, M&A doesn’t always increase shareholders value and more often than not M&A are guided by top management’s lust for more power and fame. Moreover, as banks grow large in size after M&A, the big size becomes hindrance to progress as executives fail to execute the deal property to realise the synergy. Citigroup is a classic example of an M&A deal gone woefully wrong.

For an M&A to work, in the words of Jamie Dimon, the deal needs to have business logic, the price must be right and, last but not the least, the top management should know how to execute the deal. Time and again, M&A, while destroying shareholders value, have only made CEOs, lawyers and consultants involved in the deal richer.

First Published in The Kathmandu Post on 27th June, 2010

Link: http://www.ekantipur.com/the-kathmandu-post/2010/06/26/oped/from-the-horses-mouth/209841/

Speculate This!!!

Recent comments from the Governor of the Nepal Rastra Bank (NRB) published in the Financial Times (FT) — a leading United Kingdom based newspaper — has once again put Nepali currency’s (NC) fixed exchange rate system vis-à-vis Indian currency (IC) into the spotlight. Though appropriate and beneficial for the Nepali economy in the long run, the governor’s quote on FT’s May 23 edition to the effect that Nepal needs to reconsider its long standing currency peg “in the medium term” and the subsequent issuance of a press release to neutralise the possible negative effects of the governor’s statement by the NRB next day — that categorically stated that the exchange rate peg would not be changed — has created a lot of uncertainty in the market.

In the same story, the governor also said that Nepal has no option in the short term but to maintain the currency peg, and the country would only be able to alter the peg when there is political stability, greater confidence in the economy, lower inflation and higher reserves. However, why would a speculator, or a smart investor, hold on to the NC when she knows that the currency would eventually be devalued?

For example, if someone can figure out that the current NC to IC peg of 1.6 would be changed to 1.8 in one year, she is better off taking her money out of the Nepali banks and putting in the Indian banks. Let’s assume that the investor can earn 6 percent in the FD account in India, then if she were to convert NC to IC at existing exchange rate her total return would be 19.25 percent (6 percent from FD, 12.5 percent from the appreciation of the IC, and 0.75 per cent from the interaction effect between FD return and IC appreciation) in the event of possible devaluation of the NC in a year’s time. When everyone starts doing this it would create a self-fulfilling prophecy, and then Nepal would have to abandon the currency peg sooner rather than later because of the acute shortage of the IC in the market and its inability of support the peg through the selling of the foreign currency reserves to satisfy the demand for IC.

Nepal will have to eventually devalue its currency at some point. The current level of the peg is just unsustainable. The growth differential between Nepal and India will compel the government to devalue. The million dollar question is: when? In a perfect world, as the governor said, it would be beneficial for the economy if Nepal can devalue when there is a stable political system, a well performing economy, lower inflation and higher reserves. However, there isn’t anything called perfect world in foreign exchange market. History is testament to this as evident from the events in Mexico in 1994 and Thailand in 1997. When there is a word out that the government is mulling to devaluate its currency, it won’t be the government that will decide when to devalue but the market. A speculator anticipating the devaluation would not stay idle and keep her money in NC — she will covert to IC. Taking the cue from the speculator, everyone would then follow the suit. When everyone starts doing the same, government will be left with no option but to devalue.

It’s a cardinal sin in the fixed exchange regime to even talk about possible devaluation even though it would likely benefit the economy in the long run. One cannot just talk about possible devaluation in the future and expect the market not to react, especially when the foreign reserves are dwindling. By just bringing forward the topic — which though has a lot of merit on its own right but which should not have been divulged in public — the governor has possibly put the fate of the NC in the hands of the speculators.

This article was first published in the Kathmandu Post on June 13, 2010

Link: http://www.ekantipur.com/the-kathmandu-post/2010/06/12/oped/speculate-this/209344/

Get your prorities right

Recently an incident in India caught my attention and made me think about how proactive the Indian government is towards protecting, as well as fostering, its economic interests while the leaders and the government of Nepal don’t really give a damn about the economy.

On Friday, April 9, the Securities and Exchange Board of India (SEBI) decided to ban 14 Indian insurance companies from selling a particular product called Unit Linked Insurance Product (ULIP). Next day, reacting negatively to the SEBI’s move, Insurance Regulatory and Development Authority (IRDA) of India asked the 14 insurance companies to ignore SEBI’s ban and do business as usual. The tussle between the India’s two regulatory authorities created a sort of panic among market participants during the weekend as the insurance companies are one the major institutional buyers in the Indian equity market. Indian business news channels and online news portals were carrying out discussions as to what would happen next when the markets would open following Monday.

The root cause of the dispute was that since part of the money in the ULIP plan is invested in equity market, SEBI, as a regulator of the securities market, wanted these kinds of equity linked product to come under its own purview. However, IRDA, as a regulator of insurance companies would have none of it as it felt that SEBI was trying to enter into its jurisdiction. In fact, releasing a circular last Saturday, the IRDA chairman assured the policy holders of the 14 insurance companies that the ULIP’s are “safe and secured.” The war of words between these two regulators was played out openly in media over the course of the weekend.

Fearing that the prolonged tussle between two powerful regulators could send a wrong message to market participants and dampen investor’s confidence, the Indian Ministry of Finance called on IRDA and SEBI’s chief on Monday, 12th of April, for a meeting and status quo was restored and market breathed a sigh of relief.

Though, according to recent developments, the matter is in the process of moving to the High Court of India as to who should actually regulate the ULIP, this incident shows how serious the Indian government is towards its economic priorities. If the Indian Ministry of Finance had not initiated the meeting and if status quo wasn’t restored, war of words between the two regulators as to who should regulate the product would have continued sending wrong signals to investors and market participants in general. Moreover, it would have also sent a wrong to foreign investors who are now major buyers in Indian equity market. By reacting swiftly, the concerned officials were able to reduce uncertainty in the market.

Though corruption in India is still rampant and ministers are still involved in shady deals as evident from the recent Indian Premiere League (IPL) fiasco, the Indian establishment has however understood that it should get its basic economic priorities right to further strengthen its economic progress. By giving top priority, the progress that India has made towards development of infrastructure and capital market in recent years is remarkable.

This is one of many examples which demonstrate that Indian bureaucracy and Indian government have indeed come a long way. Long gone are the days of license Raj when things would happen in snail’s place. Indian government now realises that in order to push its economic growth towards the next level, it needs to be proactive in every sense. In order to realise its place as one of the top two economy in the world by 2050, India is changing — and how!

I believe bureaucrats and policymakers in Nepal can take a big lesson from an incident like this.

This article was first published in The Kathmandu Post on April 25 2010
Link: http://www.ekantipur.com/the-kathmandu-post/2010/04/24/Oped/Get-your-priorities-right/207576/

Where's all the money?

There have been lots of seminars, discussions and numerous articles on the recent “liquidity” crisis in our banking system. Rising imports, stagnating exports, capital flight and unspent capital expenditures, among others, have been identified as the primary reasons for the current crisis. Some have also identified the currency note shortage last Dashain when depositors could not withdraw adequate amounts of cash from their respective banks as being another critical reason for the current liquidity problems because many depositors could have lost faith in the commercial banks’ ability to meet their demand for deposits. In this article, I will try to shed some light on the role of banks as financial intermediaries where they take short-term deposits and provide long-term loans, and the potential liquidity crisis that banks could face from this inherent mismatch between their assets and liabilities.

A commercial bank is primarily involved in mobilising deposits and providing loans, i.e., they channel deposits from individuals into loans for borrowers. In the process, they earn a profit from the spread between the average cost of their deposit aka “cost of funds” and the average lending yield. The higher the spread between the lending yield and the cost of funds, the higher will be the bank’s profit. Banks can mobilise deposits either through low-cost current and savings accounts (CASA) or through high cost fixed deposit (FD) accounts. So it’s in a bank’s interest to mobilise as much deposits as possible from low-cost CASA to widen their interest spread. However, since there is no withdrawal limit on CASA (as they are demand deposits), the average deposit on such accounts can be highly volatile. FD accounts, on the other hand, have fixed tenures, so banks can plan beforehand when and by how much there could be potential deposit withdrawals from these accounts. Because of the respective trade-offs between the cost and volatility of both CASA and FD accounts, commercial banks try to find the optimum balance between the two whereby they can minimise their cost of funds.

When a commercial bank mobilises deposits, it can invest that amount either in liquid assets such as government bonds or lend it out to borrowers who are interested in either meeting their working capital needs or investing in manufacturing businesses, real estate, hydro power and so forth. Generally, government bonds (read T-bills) have a lower yield than the average lending rate on the loan portfolio of commercial banks. So it’s in a bank’s interest to allocate as much of their assets to higher yielding loans than government bonds. However, because most of these capital intensive manufacturing plants, hydro projects and real estate ventures have long durations, banks have to wait for a substantial period before they get their principal back. T-bills, on the other hand, have a lower maturity period, and they can even be used as collateral to borrow funds from the central bank. Hence, like in the case of deposits, banks try to find the optimum balance between high yielding but longer duration loans with low yielding but liquid government bonds.

Now, as mentioned above, it’s in a bank’s interest to mobilise as much deposits from low-cost CASA as possible. As a demand deposit, funds in CASA have immediate maturity; however, banks believe that depositors’ unpredictable needs for cash are unlikely to occur at the same time. With this belief, they are able to make loans to projects with a long duration. In the process, banks are borrowing short-term and lending long, which results in an asset-liability mismatch. Almost all banks have some sort of an asset-liability mismatch on their balance sheets. When banks do lend out demand deposits for long-term projects, a systemic risk can arise in the banking system if an individual bank cannot meet the withdrawal demand of its depositors. Trust is paramount in the banking system. Every depositor trusts banks to deliver cash when they come forward with a withdrawal slip. If the depositors feel that their savings is at risk, then a sudden surge in deposit withdrawals and the bank’s inability to meet the unexpected demand can lead to the self-fulfilling crisis of “bank run”.

One way out for banks would be to follow a “narrow bank” concept, i.e., invest all their demand deposits in short-term assets. However, this not only affects the profitability of a bank due to lower yields on short-term assets but also reduces its ability to lend out to productive sectors such as manufacturing, and that affects the overall economy. Hence, the concept of narrow banking has been discredited in most countries (however, because of the recent financial crisis, voices have emerged to move towards narrow banking).

In the context of the ongoing liquidity crisis in Nepal, the trust of depositors in the banking system has been undermined due to the currency shortage last Dashain. As a result, many depositors who had to haggle with bank officials to withdraw their own savings during the festival haven’t channelled their savings back into the banking system. According to Diamond and Dybvig’s seminal research on banking crises, one of the most potent tools to build the general public’s trust in the banking system is deposit insurance. As of now, there is no provision of deposit insurance from the government side although the last budget did mention it.

To address the problem of an asset-liability mismatch in Indian banks, which is stifling infrastructure development, the Indian government announced the concept of “take-out” financing during the last budget of 2009/10. Under the Indian government’s take-out financing scheme, India Infrastructure Finance Company Limited (IIFCL) — an Indian government owned entity — will buy out long-term loans from banks. Minimising asset-liability mismatches, this scheme enables banks to enter into long-term project financing as they can sell their loans to the IIFCL after a certain time frame. Though the recent initiative of Nepal Rastra Bank to provide refinancing is a welcome step, a similar kind of take-out financing scheme is necessary to mitigate the liquidity problems that arises from an asset-liability mismatch in banks as well as encourage banks to lend towards productive sectors.

From the bank’s side, there should also be proper and rigorous focus on asset-liability management. Most commercial banks in Nepal don’t follow the concept of duration management in their balance sheets. Much of their senior management’s focus is towards increasing the absolute volume of deposits and loans rather than properly managing asset-liability to maximise profits. When mangers focus only on increasing the deposit or loan volume, adverse interest rate movements can seriously undermine a bank’s profitability and its asset quality.

However to be fair to bankers, they also don’t have tools to properly manage the mismatch between assets and liabilities. Generally, interest rate derivatives, currency derivatives and swaps are used extensively by foreign banks to match their assets with their liabilities. With Nepal Rastra Bank’s recent decision to allow commercial banks to use derivative instruments, I am hopeful that in the days ahead, banks will be better equipped to deal with asset-liability mismatch problems.


This article was first published in The Kathmandu Post on April 12, 2010

Link: http://www.ekantipur.com/the-kathmandu-post/2010/04/11/Oped/Wheres-all-the-money/207127/

Spending or Saving??

Why do Chinese save more than Americans? Why are economists urging China to increase its domestic consumption and turn the economy from an export oriented one to a domestic demand driven one? When does a nation over-consume and create a global imbalance like the way the US did during the consumption binge of the mid-1990s, and when does a nation's overall domestic consumption become so low that the long-term sustainability of its high growth begins to be doubted because of lack of domestic demand as is happening in China?

The savings rate is a key determinant of the overall economic growth of a country. Developed economies (read the US) generally tend to have a low savings rate while developing economies (read China and India) tend to have high savings rate. Because the developing economies need to invest in infrastructure and other capital intensive sectors to generate higher future growth, these economies tend to have a high savings rate. On the other hand, the developed economies already have key infrastructure and capital intensive businesses in place, so they generate future growth via current consumption.

However, this does not imply that all the developing economies have a high savings rate. Neither does it imply that all the developed economies have a high consumption rate. This also does not imply that a country necessarily needs a high savings rate to enable it to invest in infrastructure and capital intensive businesses as it can borrow from outside or attract foreign investments. However, because of the actual or perceived high credit risk, the developing countries generally fail to generate sufficient capital from outside sources and, sans adequate domestic savings, face resource constraints to invest in capital intensive sectors. Hence, for a developing economy, a high savings rate is a critical factor in determining future growth.

In the last decade, the average domestic savings rate in Nepal as a percentage of the total Gross Domestic Product (GDP) stood at a meagre 10 percent. In India, the average savings rate is around 30 percent. In fact, the average savings rate in India has increased from around 14 percent in the 1960s to around 30 percent in 2009. In a recent paper, Kaushik Basu, chief economic advisor to the government of India, identified the rising savings rate from the 1960s as one of the key enabling factors for higher economic growth in India. Similarly, in China, the average savings rate is around 40 percent. The average savings rate in China has been historically high and increased from around 30 percent in the 1970s to around 40 percent in 2009.

Advanced economies like the US and countries in the euro zone, however, have a much lower savings rate. Though there is no optimum savings rate per se, it has been empirically established that emerging and developing countries require high savings to mobilise capital towards productive sectors. With a high savings rate, there is enough capital for investment in productive sectors which propel the economy to a higher growth trajectory. Even in neoclassical growth theory, savings is a key component of long-run, steady state level of output per capita -- an economy with a high savings rate tends to become rich over a period of time compared to those with a low savings rate.

Why then do some economies have a higher savings rate than others? What makes an average person in India vis-à-vis Nepal save more of his personal income? Since it has been empirically established that the developing countries need a high savings rate, why do countries like Nepal consume more when saving for tomorrow can provide higher returns?

From a basic economic theory, a rational individual decides to save when the expected gain from the future payoff from current savings is higher than the utility from the current consumption. If the present value of the expected future payoff provides the agent higher benefits than the current consumption, he will decide to save. So the typical savings decision is an inter-temporal one and hinges on two important things: (1) Expected future payoff and (2) The discount rate used to calculate the present value of the future payoff.

A higher expected future payoff and a lower discount rate leads to higher savings. However, in the case of Nepal, both these factors make savings unfavourable. The expected future payoff is lower because of political instability and an unfriendly business climate. If the probability of getting killed or extorted tomorrow is higher, then the expected future payoff will be lower. Similarly, if the probability of business closures, shutdowns or labour strikes is higher, the expected future payoff will again be lower.

Likewise, the rate used to discount the expected future payoff is high in Nepal. The discount rate generally depends on a nominal interest rate adjusted for time period of the economy. Because of a high inflation rate, the discount rate has been on the higher side making savings less desirable. The discount rate is, to some extent, inversely related to the degree to which the general public perceives that the future will be prosperous and beneficial and trust other participants, especially the policymakers, in the economy to exercise economic prudence. Because of lack of economic prudence as well as perceived direction, or lack of it, of the economy, the discount rate has moved up making saving in Nepal unfavorable in the eyes of the average person.

(This article was first published on the Kathmandu Post on March 29, 2010)
Link: http://www.kantipuronline.com/the-kathmandu-post/2010/03/28/Oped/Spending-or-saving/206604/

20 years later...

The Economist magazine recently published an article on Japan’s two “lost” decades of economic stagnation and the title of the article was aptly named “To lose one decade may be misfortune…” After growing at a blistering pace from 1960’s to 1980’s, Japanese economy has been languishing for the last two decades and, according to the Economist’s article, in the third quarter of 2009 nominal GDP of Japan – until recently the second largest economy in the world – sank below its level in 1992, reinforcing the impression of not one but two lost decades in the land of Samurai. While Nepal’s economy might not be significant to get Economist’s attention, anyone who is following the Nepalese economy can rightly argue that Nepal also had its two lost decade – from 1990 to 2009.

India and Nepal started the economic liberalization programs around the same time in the early 1990’s. While the reasons behind the path towards economic liberalization in these two South Asian neighbors may have been different – India decided to open up its economy after facing a severe Balance of Payment (BOP) crisis in 1991 while Nepal embraced economic reforms as a part of change agenda of newly elected democratic government after abolishment of Panchayat regime – the motive behind the economic reforms program were same: to push the respective economies towards higher growth and ensure long lasting economic prosperity. 20 years later, the difference is palpable to everyone. While the continuity of economic reforms program started by then Indian Finance Minister Dr. Manmohan Singh in 1991 have paid rich dividends in terms of higher Indian economic growth for the last two decades, discontinuity of reforms agenda brought forward by then Finance Minister Mr. Mahesh Acharya, coupled with political instability and lack of rule of law, have brought Nepalese economy to a point of collapse. Because of its economic transformation during last two decades, India is now in the global radar, Indian companies are in global stage and CEOs of Indian companies are involved in major global business deals. Though at times reforms have been slow because of the coalition nature of recent Indian government set ups, the piecemeal approach to economic reforms have however provided much needed macroeconomic stability and shielded the economy from any undue shocks of sudden liberalization.

Ours, however, is a complete different story. What failed and divisive politics, political instability, and lack of strong rule of law can do to a country’s economy is evident from the current economic misery of Nepal. The failed and divisive politics of the last 20 years has taken its economic toll. After the restoration of the democracy in 1990, there were a lot of aspirations from the general public that political change would lead to economic prosperity. The economic liberalization programs initiated by the then Finance Minister Mr. Mahesh Acharya in 1991 under the Nepali Congress government paid dividends in terms of higher economic growth for ensuing couple of years. As a part of the economic reform process under the tenure of Mr. Acharya, financial sector was liberalized and privatization programs initiated during Panchayat regime supported under World Bank’s Structural Adjustment Program were expedited. These reform agendas were a boarder part of newly elected Nepali Congress government to liberalize the economy and propel it towards higher growth trajectory. As a result of these initiatives Nepalese economy expanded by 8% in 1994 – one of the highest recorded period of economic growth in the country.

However, after the collapse of Nepali Congress government in 1994 these reform agendas were not pushed forward. Moreover, infighting among political parties as well as politicians within a same party for power forced economic agenda to the backseat. The lust for power among political parties has made Nepal one of the most politically instable countries in the World. During the last twenty years, we have had more than 17 government changes. Over 60% of respondents to the recent enterprise survey of Nepalese industries for 2009 conducted by the International Finance Corporation (IFC) have identified political instability as the major obstacle to their business.

It’s a no brainer that political stability facilitates economic growth. Political stability in terms of longevity of government and less political wrangling provides continuation of economic policies. When business community is aware of the fact that a particular government can last for a fixed period of time, they can plan and invest accordingly. They feel assured that, due to the continuation of policies, their investment won’t be at risk because of sudden change in economic policies due to change in national government. However, when there is uncertainty regarding whether a certain government can last or not, businessmen generally prefer to wait and watch. This results in lack of investments and other business activities and stifles economic growth. For example, after the Congress led United Progressive Alliance (UPA) got a majority in the recent national election in India in May 2009, the Indian stock market erupted and SENSEX jumped by more than 2000 points in a single day. Though, the Indian business community generally favors the more market friendly Bharatiya Janta Party (BJP) because of the historical socialist tendencies of the Indian Congress party, the market still reacted positively because they had been afraid of long run negative implications of political instability resulting from hung parliament.

Currently, Nepalese economy is in dire straits. The banking sector is facing acute liquidity crisis, remittance growth – a major saving grace to domestic economy over the last decade – is plateauing, trade deficit is rising exponentially, foreign exchange reserves are depleting, Balance of Payment (BOP) is in record deficit, manufacturing sector is declining, agriculture sector is stagnating, inflation is high, and the list goes on and on. The current economic mess is largely due to political instability and myopic economic policies of respective past governments. From the last 20 years, it’s evident that discontinuity of liberal economic reforms as well as incoherency in economic policy due to frequent changes in government leadership has stifled country’s economic potential. Unless the political parties and leaders get their act together, the basic reasons behind the current economic stagflation will persist. The bottom line is there won’t be any economic prosperity without political stability.

(This article was first published on Evolution - A 17th anniversary supplementary issue of The Kathmandu Post on Feb 19th 2010)

Calling all Countrymen

After the Nepal Rastra Bank’s (NRB) decision to curtail the real-estate lending of commercial banks and other financial institutions, prominent real estate developers were recently quoted in The Post (“NRB checks won’t slowdown realty business: Developers,” Dec. 20, Page 9) arguing that NRB’s action wouldn’t result in any significant slowdown in real estate sector as long as remittance inflows continue. Moreover, one developer even argued that due to limited investment avenues to deal with big remittance inflows, huge capital flight could ensue. Coming from top developers and businessmen involved in real estate sector, these arguments underscore the point that remittance inflows — Rs. 210 billion in Fiscal Year (FY) 2008/09, almost 21 percent of GDP — are largely being channeled into unproductive sectors. Apart from speculative investment in real estate, remittance is also largely being used for consumption purpose which is helping fuel recent expansion of imports.

According to official statistics, remittance inflows have helped alleviate poverty in Nepal by 11 percentage points in the period between 1995 and 2004, however, since most of the remittance income has been used for consumption, the long-run benefit of remittance is questionable. Given the paltry growth of manufacturing sector in the last five years, remittance driven consumption has increased our reliance on imports. Moreover, as mentioned above, because of the absence of other investment avenues, remittance flows have helped create a massive real estate bubble. If and when the remittance inflows stop growing, we will be in trouble because of our over-reliance on imports and possible crash of real estate sector. We are not channeling remittance to expand our industries to sustain rising consumption, build new roads and bridges for additional vehicles, and develop new hydropower plants to cater to burgeoning energy demand.

In the December 2009 issue of International Monetary Fund’s (IMF) Finance and Development magazine, there is an interesting debate on the role of remittance in development. In the debate, Ralph Chami (associated with IMF) and Connel Fullenkamp (associated with Duke University) argue that remittance inflows around the world have predominantly been directed towards consumption and not investment activities. “For years, many countries have received huge amounts of remittances, relative to their gross domestic product, but there is not one example of a country that has exhibited remittance-led growth. Where is the remittances success story?” ask Chami and Fullenkamp. Though they applaud the role of remittance in poverty alleviation, they further argue that many remittance-receiving regions report anecdotal evidence of local real estate price bubbles funded in large part by remittances.

To ensure that remittance ends up in productive sectors, policymakers need to understand the role, if any, of remittance in overall economic growth, and linkages, if any, between remittance and asset bubble. If, as the developers suggest, remittance is being used for (speculative) investments in real estate and if, as the NRB’s recent import data suggest, remittance is fueling imports, how then do we ensure that remittance ends up in productive sector? One of the best possible ways to channel remittance in productive sector is via “Diaspora bonds” argues Dilip Ratha, lead economist at World Bank’s Development Prospectus Group. Many have argued that remittances have not fostered tangible economic growth because many of the high remittance recipient countries don’t have proper policy and institutions to channel remittance into productive sector. In an IMF working paper “Do workers’ remittances promote economic growth” published in July 2009, Barajas, Chami et.al find that, at best, remittances don’t have any impact on economic growth. The authors argue that the result may suggests, among other things, that many countries do not yet have the institutions and infrastructure in place that would enable them to channel remittances into growth-enhancing activities.

The idea of diaspora bond — raising money by issuing bonds to overseas citizens — is not a new concept. India, Israel, Sri Lanka, South Africa and Lebanon, among others, have time and again tapped their diaspora to raise funds. While the motives for the issuance of funds have varied, according to Ratha, these diaspora bonds have provided much needed capital for the government of these countries. Israel in particular has been very successful in raising huge amount of money from their Jewish diaspora and utilising the collected funds for development activities. The Ministry of Finance (MoF), in its annual budget for Fiscal Year 2066/67, has also proposed an idea of “Infrastructure Development Bond” whereby it will raise Rs. 7 billion through Nepal Rastra Bank (NRB) from Nepali workers in Middle Eastern countries, South Korea and Malaysia. According to the MoF, funds raised through issuance of such bonds will be used to finance infrastructure projects. Though there could be issues regarding concept of selling bonds via overseas Nepali embassies and other issuance modalities, the overall idea needs to be applauded. If carried out properly and timely, it could be an important policy tool to channel remittance into productive sectors and foster economic growth. At a time when infrastructure funding is scarce at best, it’s high time we tap remittance inflows and make something productive out of it.

This article was first published in the Kathmandu Post in Jan 7 2010
Link: http://www.kantipuronline.com/2010/01/08/Oped/Calling-all-countrymen/305971/