87099 NEPAL ECONOMIC UPDATE WITH A SPECIAL FOCUS ON “DEALING WITH EXCESS LIQUIDITY” APRIL 2014 NEPAL ECONOMIC UPDATE WITH A SPECIAL FOCUS ON “DEALING WITH EXCESS LIQUIDITY” APRIL 2014 Contents Summary........................................................................................................................................................................... 4 Review of recent economic developments........................................................................................................................7 Review of policies and short to medium term development challenges..........................................................................18 Short and medium term economic projections..............................................................................................................25 Bank support and activities...........................................................................................................................................26 Excess liquidity – A “Fortunate Problem” … if well managed.......................................................................................28 Part I: Managing Excess Liquidity in the Short Run................................................................................................... 30 Part II: Expanding the Reach and the Efficiency of Credit Markets............................................................................ 39 Figures Figure 1: Mid-year budget execution.................................................................................................................................. 8 Figure 2: Mid-year budget execution.................................................................................................................................. 9 Figure 3: Recurrent expenditures at mid-year..................................................................................................................... 9 Figure 4: Revenue mobilization at mid-year..................................................................................................................... 11 Figure 5: Revenue composition (mid-year) reflecting a shift in drivers.............................................................................. 11 Figure 6: Inflation in Nepal and India.............................................................................................................................. 12 Figure 7: Food and beverages inflation............................................................................................................................. 12 Figure 8: Growth in foreign trade..................................................................................................................................... 13 Figure 9: Exports, Imports and Trade Balance FY 2001-14............................................................................................... 13 Figure 10: Monthly Remittances Inflows and Movement of Migrant Workers................................................................. 14 Figure 11: Import capacity of reserves against monthly remittance inflow........................................................................ 14 Figure 12: Evolution of monetary aggregates, credit and interest rates.............................................................................. 14 Figure 13: Credit-Deposit Ratio of Commercial Banks.................................................................................................... 15 Figure 14: Total Credit and Deposit of Commercial Banks............................................................................................... 15 Figure 15: Real estate exposure as a share of total loan portfolio....................................................................................... 15 Figure 16: Non performing loans of commercial banks.................................................................................................... 16 Figure 17: Quarterly NEPSE Index.................................................................................................................................. 17 Figure 18: The proposed fast track alternative.................................................................................................................. 22 Figure 19: Despite high access Nepal has the lowest per capita consumption of electricity in South Asia.......................... 24 Figure 20: Commercial banks biased toward liquid assets................................................................................................. 31 Figure 21: Liquid funds of commercial banks................................................................................................................... 31 Figure 22: Structure of interest rates................................................................................................................................. 31 Figure 23: Monetary policy objectives.............................................................................................................................. 34 Figure 24: Access to finance indicators............................................................................................................................. 40 Figure 25: Household savings behavior............................................................................................................................. 40 Figure 26: Percentage of firms reporting access to finance as a major constraint................................................................ 41 Figure 27: Access to credit is low in Nepal........................................................................................................................ 41 Tables Table 1 : Selected Economic Indicators – 2010-2014....................................................................................................... 27 Table 2: NRB’s interventions to mop up liquidity in FY14............................................................................................... 35 Table 3: Loan origins........................................................................................................................................................ 41 Boxes Box 1: “National Pride Projects” progressing at slow pace................................................................................................. 10 Box 2: Definitions: credit slowdown and credit crunch.................................................................................................... 32 Box 3: Reverse repo and open market operations: Basic definitions.................................................................................. 35 Box 4: Ever-greening: lipstick on a pig?............................................................................................................................ 36 Box 5: The Use of Sterilization Bonds in Asia.................................................................................................................. 38 Box 6: Licensing, market structure and financial development........................................................................................ 43 4 N E PA L E C O N O M I C U P D AT E Summary T he enabling environment for development Specific priorities include: has improved but opportunities need to 1. Developing a growth promotion vision / be effectively leveraged through focused agenda: because the numerous challenges policy action. The successful election of a new facing Nepal make achieving clarity over parliament and subsequent formation of a popularly policy goals and priorities particularly difficult. mandated government provide a more conducive The Nepalese authorities have formulated environment for private sector activity and economic the aspiration of graduating to “developing policy. The uncertainties brought about by Nepal’s country” status by 2022, but have not prolonged political transition and electoral period articulated the vision for development that have acted as a break on private sector investment would underpin it and identify those policies and diverted attention of the bureaucracy away from and reforms that are the most urgent. In the difficult and important reforms. Going forward, absence of such clear prioritization, the process it will be important for the government to signal, of development planning is likely to remain un- from the start, that increased political stability will strategic. be put to profit to tackle the country’s formidable 2. Resolving Nepal’s ‘fiscal paradox’: Nepal, challenges. This will involve a balancing act to today, is in a paradoxical situation. It is the only ensure that the arduous process of constitutional country in South Asia to record a budget surplus drafting can be carried-out in tandem with regular (helped by buoyant revenue growth), its level of and improved government operations. indebtedness is modest, it is flush with liquidity (thanks to large remittance inflows) and yet it Nepal has significant resources in the form of struggles to maintain investment at already low remittances from abroad, but the economy cannot levels. Fiscal discipline is a means to an end, but use these resources in a productive manner to in Nepal it appears to be pursued as an end in enhance the overall welfare of all citizens. The itself, with the government unable to plan and budget process does not work -funds cannot be used implement the budget. This bottleneck needs to build decent infrastructure that would bring in to be addressed urgently. the private sector- and inefficiencies in the financial sector hinder the optimal allocation of resources 3. Boosting investment: Faster and sustained to private agents. In view of these challenges, the economic growth will not be possible without GoN should set a new course for policy and tackle higher levels of investment but Nepal’s model emerging risks. The appointment of a new Finance of growth appears premised on remittance Minister with deep experience and reformist financed consumption. The public sector credentials is a positive sign and initial declarations has a key role to play to unlock investment of Minister Mahat committing to “take forward the by: (i) providing a friendlier environment second round of reforms […] in partnership with for the private sector –domestic and foreign- the private sector” are also encouraging. to find it attractive to bid for projects in N E PA L E C O N O M I C U P D AT E 5 Nepal, and (ii) developing the essential while strong remittance inflows will continue to public infrastructure needed for firms to drive services sector expansion. thrive and private funds to be crowded-in. The fate of Nepal’s “National Pride Projects” Nepal’s internal and external balances are sound demonstrates that such synergies are not but not for the right reasons. currently taking place. l The combination of low expenditure and robust revenue growth accounted for a large 4. Tackling enduring financial sector risks and budget surplus and declining debt. With managing excess liquidity: Uncertainty over a significant increase in foreign grants the the true health of the financial sector remains overall government surplus ballooned to NRs the single most important macroeconomic 56.0 billon. Reflecting this comfortable fiscal risk for Nepal. First, although unlikely, a position the GoN did not issue any fresh financial sector crisis would have devastating T-Bills in the first half of FY14 and domestic effects on public finances and economic debt fell to NRs 217.61 billion. While much growth. Second, the ability of the financial of the blame for low rates of budget execution sector to provide adequate credit to deserving and important bunching had been blamed, borrowers is currently hampered by inter hitherto, on delayed budget approval, this was alia (i) distortionary policies (ii) low levels not the case in FY14 when a full budget was of effective access to finance, (iii) poor unveiled on day one of the fiscal year. In other risk management practices by monetary words, Nepal is yet to come to grips with deep authorities and banks amplified by deficient structural inefficiencies in the process of budget information, and (iv) limited recourses of planning, formulation and execution. banks vis-à-vis delinquent borrowers. As a result, the financial sector is operating at sub- l Nepal’s external position is comfortable thanks optimum and the current excess liquidity in to large remittance inflows. On the external the system is largely a reflection of this state side Nepal has benefited from the depreciation of affairs. of the rupee but also –and much more significantly- from a sharp further increase After a difficult year in FY13, the economy is in inward remittances, which are expected to poised to recover, albeit modestly. In FY13, Nepal amount to over 30% of GDP in FY14. achieved only modest growth of 3.6%. This was due largely to poor performance of the agricultural Monetary policy has sought to achieve a delicate sector as well as very modest levels of industrial equilibrium between controlling inflation and activity. The only source of relief came from the supporting economic activity but the optimal services sector. The main difference in FY14 is balance may evolve and call for corrections. expected to come from the agricultural sector with Significant inflation, close to double digits, expanded production on the back of a good harvest, appears to have become a feature of the Nepali 6 N E PA L E C O N O M I C U P D AT E economy. While expanded agricultural output As remittances have become a defining feature of may contribute to dampen inflationary pressure, the Nepali economy the country must learn to the significant growth in the money supply may manage excess liquidity. The significant buildup of eventually generate inflationary expectations and liquidity in the financial sector reflects both strong second round effects as well as translate into lower push factors (remittance inflows translating into a reserves. From that view point, the evolution of the build-up of net foreign assets) and weak pull factors quantity and quality of credit to the private sector (slowing credit growth and loose monetary policy). will be important to monitor. In the short term, the NRB will need to strike a delicate balance between encouraging sound credit For FY14, the outlook is cautiously optimistic. growth –so as to not compromise economic activity The previous assessment estimated that growth objectives- and containing inflation. At present this would reach 4-4.5% in FY14, essentially driven balance is particularly difficult to achieve because by increased agricultural output and improved of uncertainties over the true health of the banking execution of the budget. While the pace of capital sector, weak risk management systems and market expenditure may be below initial expectations, failures. In the short run, the NRB may need to inward remittance inflows have been significantly expand its toolset to deal with excess liquidity. In above projected levels and should provide an the medium run, resolving structural bottlenecks to additional boost to the services sector. On balance efficient credit market functioning is a precondition therefore, growth is projected to reach 4.5%, for monetary policy to operate more smoothly and especially if capital spending picks up in the second efficiently and for ample available resources to be half of the year. allocated to grow Nepal’s productive potential. N E PA L E C O N O M I C U P D AT E 7 Review of Recent Economic Developments E conomic growth is expected to recover in FY14, albeit from a low point. Agricultural potential has expanded in the first half of the year on the back of a good monsoon and the sharp increase in remittance inflows should support services sector growth as well. The structural bias toward consumption led growth – as opposed to investment- is expected to continue with relatively low levels of both public and private investment. Nepal, for the second year in a row, should achieve a twin surplus reflecting healthy developments (particularly domestic revenue mobilization) but also deep absorptive bottlenecks, which are really missed opportunities for growth. First, the slow pace of budget execution has translated into a sizeable budget surplus that is not leveraged to build the country’s infrastructure. Second, the sharp increase in remittances has more than made up for Nepal’s chronic trade gap but it has also resulted in a buildup of liquidity in the financial system that may be in excess of the private sector’s ability to translate it into sound credit. in FY13 compared to 4.5% in FY12) mostly aided Economic growth has slowed in by continuous growth in remittance transfers (15% FY13 and remains contingent growth from FY12 in dollar terms). mostly on exogenous factors. Agriculture output is expected to recover in FY14 Economic growth slowed in FY13 mainly on and services growth to continue at a healthy rate. account of low agricultural production and With a good monsoon, the production of Nepal’s depressed investment. The economy grew by two staple crops has expanded significantly. Paddy 3.6% in FY13 compared to 4.9% in FY12. production grew by 12% whereas maize production Owing to a weak monsoon and inadequate grew by 10% in the first half of the year as compared supply of agricultural inputs during the peak to the level at the same time in FY13. Sharp and plantation season, agricultural sector performance higher than anticipated inward remittance flows are was disappointing with growth of 1.3% in FY13 expected to drive services sector growth, particularly compared to 5% in FY12. Industrial sector growth wholesale and retail trade and social services. By slowed from 3% in FY12 to 1.6% in FY13 as contrast industrial activity is likely to remain private sector players held back investments due to lackluster owing to structural constraints –including political uncertainty. The only source of relief came irregular access to energy and difficult labor relations- from significant growth of the services sector (6% and to modest levels of public capital spending. 8 N E PA L E C O N O M I C U P D AT E Economic activity has remained driven by consumption and weak investment continues to The Government of Nepal hold back the economy’s growth potential. While has not managed to tackle record levels of remittance inflows and a significant structural absorption problems increase in recurrent spending commitments of and has accumulated a large the government are expected to translate into consumption growth, both public and private treasury surplus. investment have been depressed in the first half While a full budget was adopted on day one of the of FY14. First, the timely adoption of the budget fiscal year, public capital expenditure has continued has not translated into faster utilization of the to lag significantly, relative to plan. The low level of capital budget and key priority projects remain at expenditure in FY13 was widely blamed on political a standstill. Second, despite ample liquidity in the instability and the GoN’s inability, as a result, to system and an accommodative monetary stance, adopt a full budget before the last quarter of the fiscal private sector credit growth has slowed as a result year (on the 9th of April, 2013). As a full budget of both weak demand (despite improving political was adopted on time in FY14, the expectation was stability) and reluctance of banks to lend. Finally, that both capital and recurrent expenditures would FDI inflows have been low even compared to FY13. grow significantly given pent-up demand and the freedom given to implementing agencies to use their There is a significant discrepancy between allocated budgets. This expectation has materialized investment commitments and realizations to the extent that spending has grown significantly indicating the potential for improvements in the in the first six months of the year relative to the second half of the year. Total domestic capital same time in FY13 (NRs 156 billion vs. NRs 104 investment commitments increased significantly in billion or a 50% increase). While this improvement the first half of the year (by almost 400% relative to was for recurrent and capital spending alike (Figure the same time in FY13) to reach NRs 183 billion. 1), it is however relative to very different bases. As Likewise FDI commitments also increased relative investment spending had lagged dramatically in to the same time in FY13 by 50%. In both cases FY13 the nominal increase in FY14 (NRs 11.46 the commitments have been overwhelmingly billion compared to NRs 7.66 billion in FY13) is no in the energy sector (95% and 70% of domestic cause for celebration and remains small in absolute and international commitments respectively). terms and relative to budgeted amounts. However, these additional commitments have not been reflected to date in either credit growth or Figure 1: Mid-year budget execution (nominal) FDI inflows. Total credit of Bank and Financial 180 Institutions (BFIs) to the private sector grew by 9% 160 140 in the first half of the year, compared with 12.3% 120 at the same time in FY13. Likewise FDI inflows NRs in billions 100 fell by 65.6% relative to the first half of FY13 80 60 amounting to a paltry NRs 1.3 billon (or just above 40 USD 13 million). 20 0 Total Exp. of Budget Recurrent Capital Financial FY 13 FY 14 Source: FCGO N E PA L E C O N O M I C U P D AT E 9 The budget at mid-year is under-executed, partic- Figure 2: Mid-year budget execution (relative to plan) ularly for capital. At mid-year, only 13.5% of the 600 capital budget and 36.8 % of the recurrent budget 500 have been used (Figure 2). As a result under spend- 400 NRs in billions ing of the budget is likely as is important bunching 300 of expenditure in the last quarter and especially in 200 30.17% 36.80% the last month of the fiscal year, calling into ques- 100 tion both the realism of the budget and the quality 0 13.47% 18.47% of the expenses that are actually / eventually real- Total Exp. of Budget Recurrent Capital Financial FY 14 Mid-year Expenditure Budget for FY 14 ized. Source: FCGO Figure 3: Recurrent expenditures at mid-year In view of the low budget outturn, the government has revised and lowered its spending targets. Total 60 expenditure is now expected to reach NRs 479.132 50 billion, which is 92.6% of the total budgeted 40 NRs in billions amount, with capital expenditure targets revised 30 downwards by 13.4 billion (a 16% decrease) and 20 recurrent spending by NRs 21.8 billion (a 6% 10 0 decrease). Comp. of Goods and Interest, Services Subsidies Grants Social Security Employees Services & Comm FY 13 FY 14 Source: FCGO Recurrent expenditure growth accounted for 83% of the total increase in total expenditure at six Multipurpose Project and the Kathamandu-Terai months, relative to FY13. In the first six months Fast-track project) have spent less than 1% of of FY14, recurrent spending reached NRs 130.1 their allocations. In this respect, they exemplify billion (vs. NRs 86.9 billion in the corresponding shortcomings in preparations and implementation period of FY13), driven inter alia by the public that affect the broader capital project portfolio of sector wage bill (following a 18% increase in the the government. Their fate underscores the need salaries of public employees as well as an additional to thoroughly re-evaluate the entire budget process NRs 1000 in monthly allowances) and significant from planning to formulation and execution growth in conditional and unconditional recurrent (see the “review of policies and short to medium grants to government agencies, committees and term development challenges” section for a fuller boards (Figure 3). discussion) as well as to potentially review the basis upon which the prioritization process is carried out. The fate of so called ‘National Pride Projects’ illustrates deep absorptive bottlenecks, especially Revenue growth has continued at a sustained for capital projects. Of the 21 projects that have pace, from a high base in FY13, albeit with a shift received allocations in the government budget in drivers. Six months into the fiscal year, domestic under this category, three projects (Bhairahawa revenue mobilization stood at NRs 163.4 billion or International Airport, Second International 39% of the ambitious target set for FY14 (NRs 424 Airport, and West Seti Hydropower Project) have billion). Sharp revenue growth continued in FY14 not spent anything at all in the first half of the year, (21.5% in the first half of the fiscal year compared while a further two projects (Bheri-Babai Diversion to 21.2% at the same time in FY13) albeit driven 10 N E PA L E C O N O M I C U P D AT E Box 1: “National Pride Projects” progressing at slow pace The Government of Nepal has accorded 21 infrastructure (like tarmacking) would be contracted out to the private sector. projects the status of ‘National Pride Projects’ to reflect their However, no private party has shown interest. On the other importance for Nepal’s Development. The budget allocations hand, Bhairahawa International Airport has nearly completed its for these projects represent 4.22% and 25.67% of the total and land acquisition and an international tender has been released. the capital budget respectively. However, the rate of utilization A detailed design for irrigation from the Bheri-Babai Diversion of budgets by these projects has been dismal. At mid-year, only Multipurpose project is being developed but the rate of progress 12.9% of the NPR 21.8 billion total allocation has been spent. suggests it will not use up its allocated budget for FY14. The vast Only two projects have exceeded the 50% utilization mark. majority of the funds utilized by the Bhudhigandaki Hydropower project have been spent on the engineering company preparing a Some projects have run into difficulties even before they detailed project report. could begin, while with most projects progress has been very slow. A feasibility study is still missing for the West Seti The Upper Tamakoshi Hydropower project is expected to come Hydropower project and work has not started on the Nijgar online in 2016 after problems while digging the main tunnel International Airport - while a detailed feasibility has already delayed it by a year. Melamchi Drinking Water has restarted been prepared, the BOOT (Build-Own-Operate-Transfer) tunneling work again after a new company was awarded the Committee has not been able to decide on the BOOT modality contract through rebidding. The original company contracted to implement the project. to dig the tunnel was dismissed in September 2012 due to its inability to fulfill contractual obligations. The Sikta Irrigation The Kathmandu-Tarai Fast Track link has stalled for lack of project was expected to be completed in FY14 but due to investors. The government had begun construction and opened problems with land acquisition and contract management it the track with the expectation that the remainder of the work has also been delayed. FY14 Budget Burn rate after Project* Allocation (NRP) six months Melamchi Drinking Water 5241300000 12.2% Hulaki Highway 2213417000 6.9% Upper Tamakoshi Hydropower 2000000000 0.0% Bhairahawa International Airport 1991565000 0.0% Mid Hill Highway 1922716000 22.5% East-West Railway 1403871000 23.0% Ranijamara Kulria Irrigation 1251919000 19.8% Sikta Irrigation 1142069000 25.9% Bheri Babai Diversion Multipurpose 1010080000 0.3% Pokhara International Airport 1000000000 20.0% North-South Highway (Karnali, Kaligandaki & Koshi Corridors) 510761000 26.8% Kathmandu Terai Fast Track 500309000 0.8% President’s Chure Conservation Program 500000000 2.1% Babai Irrigation 451000000 3.8% Bhudhigandaki Hydropower 261000000 62.3% Pashupati Area Development 250000000 59.0% Lumbini Area Development 198500000 27.2% West Seti 0 0.0% Nijgar International Airport 0 0.0% Total 21848507000 12.90% *19 projects are listed because North-South Highway comprises of 3 different projects: Karnali Corridor, Kaligandaki Corridor and Koshi Corridor. N E PA L E C O N O M I C U P D AT E 11 relatively less by customs and personal income Figure 4: Revenue mobilization at mid-year tax and more by other taxes and non-tax revenues 300 250 (Figure 4). The growth rate of customs revenue Percent Change 200 slowed to 20% in FY14 compared to 39.1% in 150 100 the same period in FY13, although the reasons are 50 unclear. Indeed, while import growth has slowed, 0 Value Customs Income Tax Excise Registration Vechile Tax Educational Other Tax Non Tax -50 Added Tax Fee Service Tax Revenue the deceleration was in fact modest (1.3 percentage FY 13 FY 14 points). Likewise mid-year growth in income tax Source: MoF receipts was only 11.8% compared to 30.3% at the same time in the previous fiscal year. A possibility Figure 5: Revenue composition (mid-year) reflecting a is that tax administration of customs and the PIT shift in drivers may have been relaxed somewhat in the run-up to 0.9 Value Added Tax 0.2 the election. The gap was made up to some extent 0.2 1.3 Customs by VAT which grew at 19.6% compared to 17.4% 1.4 12.7 Income Tax Excise 29.4 in the same period in FY13 -mainly due to the Registration Fee 13.1 positive impact of leakage control initiatives in Vehicle Tax Educational Service Tax VAT administration. A significant boost also came Health Service Tax 21.0 19.9 from non-tax revenues, which grew by a whopping Others Tax Non-Tax revenue 42.6% in FY14 as compared to a 6.6% decline in Source: MoF FY13, mostly on account of increases in dividends paid by public enterprises and added royalties from telecom companies. It appears likely that the increase in foreign grants (which more than doubled revenue target for FY14 will be met, especially if in the first six months of the year compared to the customs and PIT revenues pick up in the second previous) the overall government surplus ballooned half of the year. to NRs 56.0 billon. Reflecting this comfortable fiscal position the GoN did not issue any fresh The shift in drivers is reflected to some extent in the T-Bills in the first half of FY14 and domestic debt composition of revenue streams. VAT and customs fell to NRs 217.61 billion. taxes still accounted for almost half (49.3%) of the revenue mobilization by mid-year in FY14. Even Inflationary pressures have not though there was a slowdown in the collection of income tax, it still made up 21% of the total revenue subsided with the risk of second collected by mid-year (as compared to 22.8% of the round effects. total revenue collected in the same period in the previous year). The share contributed by excise duty Inflation stood at 9.7% (y-o-y) in January 2014, remained at 13.1% whereas the share of non-tax driven by rising food prices. This is in contrast revenue grew from 10.8% at the end of six months with FY13 when non-food items were pushing in FY13 to 12.7% in the same period in FY14. inflation up (Figure 6). At the end of the second quarter of FY14, the index for food and beverage The combination of low expenditure and robust prices had registered a 12.9% increase (y-o-y) while revenue growth accounted for a significant budget that of non-food item had grown only by 6.9%. In surplus and declining debt. With a significant particular, within the food and beverage category, 12 N E PA L E C O N O M I C U P D AT E Figure 6: Inflation in Nepal and India (y-o-y percentages) cereal grains and its products, vegetables, and meat and fish have seen sharp price rises (12.7%, 16.0 19% and 24.5% respectively). 14.0 12.0 10.0 A multiplicity of factors affected food prices Percent 8.0 during the review period. The price of meat 6.0 was driven upwards by avian-flu fears leading 4.0 authorities to impose a quarantine on imports 2.0 and to destroy vast numbers of animals. 0.0 Recorded increases in the prices of cereal Oct Oct Aug Aug Dec Dec Nov Nov Jan Jan Jan May May Feb Sep Feb Sep Apr Apr Jul Jul Jun Jun Mar Mar grains, however, are counterintuitive given that 2012 2013 2014 agricultural output is estimated to have improved India CPI Nepal CPI India Food Nepal Food significantly. Among the possible reasons for Source: NRB + CSO, India persistently high prices: (i) high demand in the run up to the election in November 2013 (reflecting both campaign-related expenditures Figure 7: Food and beverages inflation (by subcomponents) and ‘stock piling’ by households in anticipation of strikes); (ii) high food prices in India, allowing 40 (iii) hoarding of supply to the market by middle- 35 men. In parallel, the decline in non-food prices 30 growth is partly attributable to petroleum 25 % 20 products whose administered prices were left 15 unchanged during the first half of the year after 10 the increases in FY13 (Figure 7). 5 0 Jul/Aug Aug/Sept Sept/Oct Oct/Nov Nov/Dec Dec/Jan Higher food prices could generate second round effects. There is some evidence –logically FY14 Cereal Grains & its products Vegetables Meat & Fish Food and Beverage given the share of food items in Nepal’s CPI Source: NRB basket- that food prices are transmitted to non- food price inflation probably through changes in expectations and wages. Therefore, the speed at which food prices decline will need to be monitored closely. To reflect higher than expected inflation outcomes during the first half of the year the NRB has revised its annual inflation target to 8.5% (from 8%). N E PA L E C O N O M I C U P D AT E 13 Sharp remittance growth and Figure 8: Growth in foreign trade (mid-year) a slower deterioration of the 40 trade balance leading to a 30 20 record BOP surplus. Percent Change 10 0 -10 FY11 FY12 FY13R FY14P In the first half of FY14, Nepal accumulated a -20 significant current account surplus driven in part -30 -40 by a slower deterioration of the trade balance Ex. To Other Countries Im. From Other Countries Ex.To Indi a Im. From India and a significant increase in the rate of growth Source: MoF and NRB of remittance transfers. In the first six months of the fiscal year, exports of goods increased by 16% Figure 9: Exports, Imports and Trade Balance FY 2001-14 (In US $ Million) (against 10.2% at the same time last FY) while import growth was 23.3% (vs. 24.6% in FY13). 8000. 0 As a result the trade gap continued to grow, by 6000. 0 just under 25%, albeit at a slower pace than in the 4000. 0 corresponding period of FY13 (28%). Moreover, in 2000. 0 parallel, workers’ remittances grew by a whopping 0.0 34.4% since the beginning of the fiscal year, much 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2010 2011 2012 2013 2014 -2000. 0 in excess of the already impressive 22% growth Six months -4000. 0 registered in the first half of FY13 (a difference of NRs 68 billion). As a result, compared to the same -6000. 0 time in FY13, the overall current account surplus -8000. 0 Total Exports Total Imports Trade Balance increased by 1150% (a difference of NRs 50.6 Source: MoF and NRB billion). Nepal’s exports to India are more varied. Of the top The rupee’s depreciation and possible substitution 10 highest value exports to India, 4 grew at a rate by Indian importers resulted in significant export above 25% (Zinc Sheet 62.5%; Cardamom 38.6%; and moderate import growth (Figure 8). In the first Juice 25.8%; Shoes and Sandals 43.9%), while 6 months of FY14, exports to India grew significantly exports declined only in 2 products. Likewise the (by 18.45%) compared to the corresponding period depreciation of the rupee is likely to have caused the in FY13 (3.8%) driving the growth in total exports modest decline in the growth rate of imports, which to 16% at the end of six months in FY14. Since slowed to 23.1% from 25.2% in the same period in the INR is pegged to the NPR, the depreciation of FY13 (a predictably modest decline since the bulk of the Indian currency vis-à-vis other currencies made imports is from India for which there were no price Nepali products comparatively more attractive. effects at play). The depreciation of the NPR should have boosted exports to other countries as well but the product The trade balance continued to deteriorate in base of Nepal’s exports to other countries is very FY14, albeit at a slower pace. While exports grew narrow and further it is mainly in niche products significantly in the first half of the year, their overall like handicrafts, carpets and pashmina which have small size relative to imports (11.9% of total trade) relatively low price elasticity of demand. In contrast, meant that the trade deficit continued to grow by 14 N E PA L E C O N O M I C U P D AT E Figure 10: Monthly Remittances Inflows and Movement of Migrant Workers 24.4% at the end of first half of FY14, compared to 600 60000 28.4% in the first half of FY13 (Figure 9). 500 50000 Record levels of remittance inflows are keeping 400 40000 Number of Migrant workers the current account in surplus, by a wide margin. In Millions of US $ 300 30000 Remittance increased by 34.4% in the first half of 200 20000 the year compared to 21.8% over the same period in the previous year (Figure 10). The growth in 100 10000 the number of migrant workers departing Nepal 0 0 together with favorable policy changes in destination 12M1 12M3 12M5 12M7 12M9 13M1 13M3 13M5 13M7 13M9 14M1 14M3 14M5 09M1 09M3 09M5 09M7 09M9 10M1 10M3 10M5 10M7 10M9 11M1 11M3 11M5 11M7 11M9 11M11 12M11 13M11 09M11 10M11 countries may have contributed. First, important Monthly departures of migrant workers destination countries revised upwards the minimum Source: NRB and DoFE compensation entitlements for migrant workers. Figure 11: Import capacity of reserves against monthly remittance inflow Second, the decision by Saudi authorities to grant 600 12 amnesty for illegal workers may have prompted a significant number of illegal Nepali workers to 500 10 return to Nepal with their life savings. Finally, 400 8 the depreciation of NPR has provided additional Months USD millions 300 6 incentives for migrant workers to send a larger 200 4 proportion of their income (and possibly some savings) in foreign currencies back to Nepal. 100 2 0 0 Reflecting the large balance of payment surplus, 12M2 12M4 12M6 12M8 13M2 13M4 13M6 13M8 14M2 14M4 14M6 11M6 11M8 11M10 11M12 12M10 12M12 13M10 13M12 reserve assets grew significantly (Figure 11). As Import Capacity in Months (Merchandise & Services) of January 2014, foreign exchange reserves were Source: NRB sufficient to cover the equivalent of 10.2 months of Figure 12: Evolution of monetary aggregates, credit and interest rates goods and services imports. Monetary policy has remained accommodative in the face of sharp remittances growth. % The massive increase in remittance inflows was only partly sterilized and resulted in a significant increase of the money supply. In the first half of FY14, broad money (M2) grew nearly twice as fast during the first six months of FY14 (9%) compared to the same period in FY13 (4.8%). Somewhat lower growth in net domestic assets (4.8% in the first six months of FY14 compared to 6.2% at the same time in FY13) was largely made up by a rapid build-up of net foreign assets, which grew at a fast Source: NRB N E PA L E C O N O M I C U P D AT E 15 Figure 13: Credit-Deposit Ratio of Commercial Banks rate of 16.5% (compared to 2% in the first half of Percentage FY13). Likewise, money supply grew significantly 90.0 in the first half of the year both on account of 85.0 currency and demand deposit growth (jointly by just under 9% during the first six months of the 80.0 % year vs. -0.5% at the same time in FY13) and 75.0 saving and call deposits (jointly 11.2% vs. 9.6%). 70.0 The financial system is 65.0 characterized by excess liquidity 60.0 with systemic weaknesses and FY07 Q4 FY07 Q1 FY07 Q2 FY07 Q3 FY 08 Q1 FY 08 Q2 FY 08 Q3 FY 08 Q4 FY 09 Q1 FY 09 Q2 FY 09 Q3 FY 09 Q4 FY 10 Q1 FY 10 Q2 FY 10 Q3 FY 10 Q4 FY 11 Q1 FY 11 Q2 FY 11 Q3 FY 11 Q4 FY 12 Q1 FY 12 Q2 FY 12 Q3 FY 12 Q4 FY 13 Q1 FY 13 Q2 FY 13 Q3 FY 13 Q4 FY 14 Q1 FY 14 Q2 uncertainty remaining. Deposit growth has outpaced credit over the past Figure 14: Total Credit and Deposit of Commercial Banks 12 months with excess liquidity building up in 1100 1000 the system (Figure 13 and Figure 14). In the last 900 12 months to Q2 of FY14, banks’ deposit grew 800 by 20.7% (NPR 174 billion) compared to credit NPR billions 700 growth of only 18.2% (NPR 126 billion). This 600 500 is a reversal from the trend observed at the same 400 time in FY13 when deposit and credit increased by 300 19.2% (NPR 135 bn) and 24.8% (NPR 137 bn) 200 respectively. As a result the market is in surplus, by around NPR 50 billion, above and beyond the Total Deposit LCY Deposit Total Credit 20% mandatory liquidity requirement. Source: Provisionals published by banks Figure 15: Real estate exposure as a share of total loan portfolio The NRB has acted to mop up liquidity albeit at levels significantly below market demand. In the first half of the year, the NRB has undertaken reverse repos worth NPR 118.5 billion and issued outright sale auction for securities worth NPR 8.5 billion and development bonds worth NPR 10 billion to address short and long-term liquidity % issues. The last round was subscribed by almost double the offered amount of NPR 19.5 billion with 25 banks bidding (total of NPR 38.9 billion) at an average rate of 0.23%. The rise in market liquidity and sluggish credit growth has impacted weighted T-bill (91 days) and average inter-bank rates considerably. T-bill 16 N E PA L E C O N O M I C U P D AT E Figure 16: Non performing loans of commercial banks 5% including two state controlled banks (ADBL and RBB). Total loan loss provision coverage vis- à-vis total NPLs was 113% for the commercial banking industry, including 9 banks with coverage of less than 100% and five banks with less than 90%. The overall capital position of the commercial banking industry remains sound. The average Capital Adequacy Ratio (CAR) is estimated to be 11.8% compared to 11.7% at the same time in FY13, albeit down from 14.2% recorded at the end of last fiscal year (mainly due to dividend Source: NRB & provisional financials published by FIs payouts and a significant increase in risk weighted assets - from NPR 785 bn to NPR 981 bn). All (91 days) rates ranged from 0.515% to 0.016% banks meet the minimum CAR of 10% except two and inter-bank rates from 0.24% to 0.15% in Q2 state controlled banks (representing 14.5% of the of FY14. In comparison, the T-bill rate was 1.6% banking system). These banks – NBL and RBB and inter-bank rate 0.95% as of end of Q2 FY13. – have improved their CAR y-o-y from -5.4% to 0.84% and -2.4% to 4.3% respectively as a result of Bank balance sheets are still vulnerable to real estate equity injection from the government and retained exposure as well as NPLs and reported figures may earnings as per their recapitalization plan. understate the extent of such vulnerabilities (Figure 15). As per reported figures, the total exposure to real Banks remain profitable but the NRB’s proposed estate (including home loans) declined y-o-y from policy to limit interest spreads could put pressure 15.1% of the total loan portfolio in Q2FY13 to 14.2% on returns. The commercial banking industry as of Q2FY14, with the share of home (mortgages) posted a record net profit of NPR 9.4 billion in loans – considered relatively safer- growing to make Q2 of FY14 compared to NPR 7.9 billion recorded up 47% of the total real estate exposure compared to in the same period last FY – a y-o-y growth of 36% one year ago. None of the banks have real estate 18%. Based on data of 23 (out of 31) banks, the exposure in excess of the NRB cap of 25%. average yield (from loans and investment) declined to 9.88% (compared to 10.1% in Q2FY13 and The share of NPLs increased marginally albeit 10.3% in Q4FY13) resulting from a decline in from a small –reported- base and with adequate interest spread to 4.3% (from 4.4% in Q2FY13 and coverage (Figure 16). The share of NPLs was 3.1% 4.6% in Q4FYE13) while there was no change in of the total loan portfolio as of Q2FY14, a marginal average (industry) cost of funds at 5.5%. However, deterioration relative to Q1 (2.8%) but similar to in terms of return on equity, there has been a gradual that of the same period in FY13 (3.2%). Only three decline for the last three quarters (shareholders of 27 banks (14% of the system) had NPLs in excess of private commercial banks received an average return N E PA L E C O N O M I C U P D AT E 17 Figure 17: Quarterly NEPSE Index FY06 - FY14 of 13.8% as of the first six months of the current fiscal year) due to low yielding investments made by banks resulting from lack of investible opportunities to extend loans and advances. The NRB’s move to cap the rates spread - BFIs have been told to reduce the spread rate to 5 percentage points by the end of the current fiscal year- and service charges will imply greater challenges for BFIs to increase or even maintain their returns. As of the first six months of the current fiscal year, 13 commercial banks had Source: NEPSE spreads of above 5pp. Q3 of FY14 pertain to 28 Feb 2014 The stock market has climbed holding new positions, availability of funds from to a historic high reflecting the banking system at reasonable interest rates, the improved investor sentiment formation of a new government and the majority of listed companies reporting good financial results. and easy access to financing but decreasing incentives for The master plan to reform capital markets has needed reforms. remained on the backburner. After more than two years since the five-year master plan on capital market was The securities market moved up on the expectation devised (2011), nothing substantial has materialized. of healthy quarterly reports of the listed companies The master plan was supposed to address most of the and improved prospects for political stability. The shortcomings of the Nepali securities market and to NEPSE posted a double-digit growth of 21.41% to bring it at par with international standards by 2016. reach a 63 months high of 831 points ( Figure 17), SEBON had sought international support to address reflecting increased investor confidence following structural problems troubling the overall market as the the formation of the new government. According to stock index had crashed. However, as the stock prices stockbrokers, this bullish sentiment is explained by have become bullish again, implementing the plan increased confidence of both old and new investors seems to have remained on SEBON’s backburner. 18 N E PA L E C O N O M I C U P D AT E Review of Policies and Short to Medium term Development Challenges T he new government will have to focus resolutely on removing constraints to public and private investment without which growth will not accelerate significantly in the near future.This review of policies and short to medium term challenges focuses on those areas where the major bottlenecks to unlocking investment-supported growth currently reside, namely public financial management (PFM) and infrastructure development. Specifically, it seeks to highlight feasible reforms that the new government could initiate. of FY14 suggests is that budget timeliness and added Improving PFM systems to unlock MoF scrutiny may be necessary but still insufficient more and better investment conditions for capital expenditure to proceed at the level and pace required. Poor execution of the capital Public investment is not per se constrained by budget in FY13 was blamed on the numerous delays lack of funds but rather hindered by weak PFM with which the full budget was eventually adopted (in systems and practices. The key question is what the fourth quarter of the fiscal year). The GoN made explains the state’s under-investment relative to commendable efforts to adopt a full budget on day potential. The answer lies in PFM systems that are one of FY14 and has also set up ad hoc mechanisms well defined on paper but dysfunctional in practice, for regular progress reviews but this has yielded only with critical gaps at all stages of budget planning, modest progress in the pace of spending. formulation and execution as well as deficient oversight capacity and systems. To address structural absorptive bottlenecks, the GoN should carry out an in depth review of the Address systemic weaknesses entire budget chain from planning to budgeting and execution. Below are insights from a recently in the budget preparation and conducted WB-ODI report that could serve as execution process a basis for such review. The basic finding is that, while formal budgetary guidelines and procedures While a budget was adopted on time in FY14 public exist, the budget process is practically in disarray: investment has continued to underperform indicating fundamental flaws in the incentives and systems 1. Budget planning and preparation entails for the government to efficiently use the funds set numerous and inefficient review steps. The budget aside for capital expenditure. What the experience ceilings approved by the MoF in January and N E PA L E C O N O M I C U P D AT E 19 presented to line ministries and agencies constitute, projects and programs not previously planned in theory, the basis for each ministry to submit their for – possibly in response to political pressure. budgets by the end of March. Not only does this The concerned departments, division offices typically not happen until May but the ceilings are and local bodies must then re-adjust their work often not adhered to (by wide margins). This in programs, re-write project implementation plans turn requires a round of evaluations by the MoF and develop new procurement plans, which must and NPC that stretches up to the beginning of the be sent afresh to the respective ministries and fiscal year (although the budget circular specifies the NPC for approval. Moreover reallocations March-April). Program and sector discussions on within budget headings are frequent during the the budget estimates are held between MoF, NPC fiscal year. Virement rules are extremely flexible, and the concerned ministry or agency to reconcile allowing line ministries to reallocate up to 25% the proposals (submitted in hard copies and of any particular line item within each budget inputted manually into the budget management heading, and there is no monitoring mechanism information system) within the constraints imposed to track changes thus made to the budget. by the aggregate ceiling for the central government. To enhance the credibility of the budget as a tool for policy The negotiated budget requests are compiled by implementation and provide implementing agencies with the MoF at the end of June when a draft annual clear marching orders at the beginning of the fiscal year, budget is prepared. At the same time the Resources the GoN should consider ways to limit the inclusion of Committee decides the final set of macroeconomic new projects after submission of the budget and curbing forecasts and corresponding adjustments are made virements powers of implementing agencies. to the overall revenues and expenditures estimates (and ministries’ allocations). 3. The authorization process for development To accelerate the pace of budget approval and ensure projects remains highly centralized and a closer alignment between policy priorities and bureaucratic, causing major delays in project budgetary allocations, the GoN should consider implementation. While the execution of salary enforcing adherence to budget ceilings, which may in payments may start on issue of the authorization turn require revising the bottom up process through letter by the MoF, line ministries and the NPC which ministries prepare their budget proposals. must further assess other expenditures – notably from the development budget – before project 2. The approved budget is de facto renegotiated implementation can start. Specifically, the throughout the year. The approved budget is not approval of P1 projects (with so called priority a predictor of actual spending but, in some ways, projects accounting for 90% of the total) the beginning of a new set of budget negotiations requires the adoption and vetting of feasibility (with new projects included throughout the studies, work plans and procurement plans by fiscal year) and a constant stream of reallocations the NPC, following approval of the annual and virements. While the ceilings outlined in the budget rather than ex ante. This approval Red Book are binding, the inclusion / exclusion process can take an additional 3 to 4 months of activities within these limits are subject and sometimes rolls into the last semester. to ongoing discussion and there is no hard To expedite capital spending, the GoN should consider deadline for inclusion of new capital projects. including in the budget only projects for which the full set Line ministries, departments and local bodies of feasibility studies, work plans and procurement plans complain that the NPC and the MoF change has been prepared and approved by the NPC ex ante. the budget at the last minute by including 20 N E PA L E C O N O M I C U P D AT E 4. Weak fiduciary capacity at the level of Amplify good governance implementing agencies as well as deliberate initiatives begun under the manipulation further slow-down capital projects’ implementation. While cumbersome technocratic government. approval processes and budget release procedures are partly to blame, delays are also To boost growth and service delivery, the GoN the result of poor preparedness on the part must focus on improving both the quantity and of implementing agencies, with insufficient the quality of public spending. Important steps attention devoted to feasibility studies and other in the right direction were taken by the previous elements of project preparation. Moreover the technocratic government, which ought to be process can also be manipulated. As unspent leveraged and amplified. This is important not balances increase at the end of the fiscal year, only for ethical (spending people’s money well) but budget holders gain additional freedom to also for efficiency reasons as poor public financial expedite spending including by diverting it to management distorts allocative decisions resulting lower priority projects and breaking down of in poor value for money. Interestingly, the ministries the capital budget into multiple small projects with the highest amount of reported irregularities (with weaker procurement and oversight (as per OAG) are also those in charge of delivering constraints). Approved projects are often the infrastructure that the country critically needs. unfinished, resulting in wastage of resources Specifically, low hanging fruits for reform include: and poor development outcomes. l Strengthening internal audit by separating, 5. Budget process bottlenecks are compounded by within FCGO, the audit and treasury implementation and procurement weaknesses, functions. Internal control systems remain particularly for investment and at the local inadequate. In FY13, the cumulative backlog level. Significant local-level discretion by user of unsettled irregular expenses incurred by committees over contractor selection and the government offices, committees and district financial terms of contract awards has frequently development committees (DDCs) increased to been associated with leakage and inefficient use of NRs 204 billion (or 12% of GDP). funds. There are reports of loss and leakage of funds through the inflation of user costs of construction Separating the treasury and internal audit functions and the as well as over-charging by user-committees which creation of a distinct internal audit cadre would strengthen then subcontract. Procurement and contracting the audit function and reduce the risk of both erroneous are weak in terms of both competition among and inappropriate actions - by creating additional layers of contractors and technical capacity for proper review and by ensuring that authorizations to spend and procurement planning. the review of such authorizations are not carried out by the same service or person. To improve procedures and capacities for procurement planning and management, the GoN could consider l Strengthening the Office of the Auditor developing national norms and rates for project General. The OAG has prepared and submitted costing to replace the current district-by-district proposed improvements to the audit legislation regime and establishing minimum technical standards governing its operations. The proposed for contracted works and enforcing them through legislation would give the OAG the level of technical monitoring. independence called for by the International N E PA L E C O N O M I C U P D AT E 21 Organization of Supreme Audit Institutions two big and critical infrastructure sectors: transport (INTOSAI). The OAG would for example and energy. Given limited resources the focus should be able to hire, promote and fire staff without be on maximizing the impact of every rupee spent going through government, and have financial and on creating the conditions for private finance to and administrative independence. This is a complement and leverage public resources. pre-requisite to effective audit, as the auditor currently depends (for its budget) on those Tackle issues in the transport sector same people it is responsible for auditing. As next step the GoN should review the proposed The quality of Nepal’s road infrastructure is legislative improvements and submit an Audit Bill to particularly poor relative to other low income Parliament for its consideration. countries. Some 80% of respondents to the WB’s 2010 Logistic Performance Index survey ranked l Restore and resource key parliamentary Nepal’s roads as low or very low quality and 100% committees. In the absence of an elected ranked the cost of road transport as high or very Parliament since April 2012, the key high. Improving connectivity throughout Nepal functions of the Finance and Public Accounts is not only important for growth but also for Committees of Parliament have not been inclusiveness in order to ensure physical access for exercised. In particular the Annual Reports of all to social and economic services and facilities the Auditor General have not been tabled for including markets, educational institutions or review. In FY12, irregularities of government health centers. In the short- to medium-term the offices and organized entities, committees and GoN could consider the following policy priorities: DDCs amounted to NRs 35.1 billion or 19% of total audited expenditures. The Ministry of l Reviving the proposed fast track linkage Physical Infrastructure and Transport (MoPIT) between Kathmandu and the Tarai plains and the Ministry of Federal Affairs and Local project. Although it is of vital economic Development (MoFALD) were found to have significance the project appears to have stalled. the highest amounts of reported irregularities At present goods and passenger transport (respectively 20% and 13% of the total). vehicles make a 250km detour to avoid the Tribhuvan highway (between Hetuada and With the new assembly in place, it is now imperative Kathmandu) that has steep gradients and to restore the functions of the PAC and its ability to unfavorable alignment for larger vehicles. address reported irregularities. The initial feasibility study for a ‘fast track’ alternative estimated potential time savings of Developing strategic infrastructure 4-5 hours, fuel savings of US$30 per one way trip for a heavy truck and some 32 million Infrastructure is central to any development vision liters of fuel saved in the first year of operation for Nepal. Not only is it at the core of the challenge to alone. At a more macro level the project would unleash private investment but it is also a fundamental greatly facilitate trade with India and the transit pillar in building the bridge from economic growth of goods to and from Kolkata and reduce the to inclusion and shared prosperity – with a direct cost of imports and exports (inland transport impact on the lives of the poor and the marginalized. and transshipment costs account for over 60% Necessary actions would need to address both a of export costs in Nepal). Rough cost estimates quantity and quality deficiency, particularly in the suggest that building the fast track will require 22 N E PA L E C O N O M I C U P D AT E approximately US$ 1 billion. Given the transport sector occurs in the last trimester of project’s importance and complexity it is clear each fiscal year. This fact evidences that the that much preparatory work will be needed budgeting, planning, procurement, and contract which should begin now. management processes applied throughout the transport sector need to work more smoothly. In particular the GoN could consider (i) enacting The capacity of local government entities and new legislation to manage the unique institutional, the accountability framework that applies to their regulatory and operational challenges that the fast track transport sector investment activities also require entails, and setting up a separate authority to manage significant improvement. Roughly 30 paisa of the project – with a clear business and procurement every rupee that the GoN transferred to support plan; (ii) preparing the technical ground including : local government-led transport sector investment a detailed alignment survey, basic design of structures triggered some form of audit observation from the and tunnels, social and environmental safeguards, (iii) Office of the Auditor General. Throughout the making a plan for financing such a huge investment transport sector, there are instances of overlapping including recosting the project, carrying out a fiscal institutional roles and mandates. For instance, assessment and identifying external partners. the department responsible for strategic road network and bridges takes up local road network l Resolving overlapping institutional roles and and bridges and vice versa. This is particularly mandates in the transport sector is key to unlock challenging for urban transport interventions and improve public infrastructure spending. that simultaneously aim at improving physical Institutional limitations and overlapping roles infrastructure, traffic management, and policies and responsibilities severely hamper Nepal’s that fall under different ministries or departments. ability to make sound capital investments in At present, four different line ministries and the transport sector. According to the World roughly 23 different departments, divisions, or Bank’s 2011 Roads Sector Public Expenditure local government bodies have jurisdiction over Review, roughly 70% of spending in the issues relating to urban transportation in the Figure 18: The proposed fast track alternative N E PA L E C O N O M I C U P D AT E 23 Kathmandu valley. Reducing this complexity Initiate reform in the power sector can help make meaningful urban transport interventions less unwieldy. Unreliable and poor power supply is probably the In order to reduce such complexity and streamline single greatest obstacle to development and growth the process of investment project implementation the in Nepal. All political parties have recognized that, GoN should consider (i) placing urban transport pledging in their electoral manifestos to reduce load in Kathmandu under one single institution (new shedding hours within 3 years. The task however is or rebooted), (ii) taking measures to ensure that huge and it should begin now. Below are a few areas departments under MoPIT and MoFALD stick to that the new government could consider addressing investments only along roads under their official remits, as a matter of priority. (iii) making local government bodies more accountable regarding investment decisions and implementation. l Launching a process for electricity tariff reform: The Nepal Electricity Authority (NEA), l Addressing Kathmandu’s growing urban a vertically integrated government owned utility, transport challenges. Although improving suffers from severe financial losses and cannot, urban transport may not appear to be a short therefore, generate financing for investment term priority given Nepal’s overall low levels of in critical power generation, transmission urbanization, the pace at which Nepal’s cities and distribution infrastructure. Since 2002, are growing (particularly in the Kathmandu almost no transmission line has been built and valley) is the highest of any South Asia country. only 92MW have been added to the system. Addressing this medium- to long-term challenge NEA owns 66% of the generation capacity in will therefore require resolute action now. the country and has the monopoly of power Managing rapid motorization more effectively transmission and distribution (therefore it is is critical for improving transport and the a single buyer for privately generated power). urban environment in the Kathmandu valley. While private investment is no doubt needed The number of vehicles registered annually in to increase generation, lack of transmission the valley grew by 14% each year between 2001 capacity, exposure to foreign exchange risk and and 2010, especially personal motorcycles and risks of NEA payment default (in addition to at the same time public transportation has other country risks) are major bottlenecks for increased dramatically with close to a million such sizeable private investments. The current trips made every day via bus services. tariff charges to consumers are about 25% below the cost of supply by NEA which accumulated In order to meet the challenge of urban transportation net losses of 8.55 billion in FY12 alone. With on time, before it is too late, the GoN should develop such dismal financial performance, it would be a plan to (i) provide more appropriate pedestrian difficult to provide comfort to private developers infrastructure as walking accounts for nearly 40% of for which NEA is the off-taker of power all trips in the valley and Kathmandu was identified generation. Tariff reform is therefore imperative, as one of the least ‘walkable’ cities in Asia; and (ii) but it must be combined with actions to reduce improve public transport facilities and bus services for T&D operating losses and structured in a way those relying on public transportation. that minimizes public resistance (legitimate to the extent that service is poor) and does not generate unwanted redistributive effects. 24 N E PA L E C O N O M I C U P D AT E The tariff reform would need to consider a stepped approach corporate policy for compensation, the process of to deal with social impacts and allow tariff adjustment, making decisions for compensation above 10%, with indexation to inflation and foreign exchange rates, such as in urban and peri-urban areas, has been and tariff categories restructure and allow cross-subsidies unduly long and difficult. among consumer categories to address impacts on the poor. As a matter of priority the GoN / NEA should formulate a transmission line ROW compensation policy that l Introducing compensation policies for provides justifiable compensation for restricted land transmission lines right of way (ROW): On- use within the legal framework of Nepal taking into going transmission line projects have suffered account land location and use. extensive delays in construction due to disputes on compensation payments for land under the ROW. l Producing a road map on power sector One World Bank-funded transmission line project development: Hydropower and transmission has been under implementation for 10 years but projects have long lead times in preparation, still could not be completed due to disputes over a financing and construction; so a strategic vision 3.8 km ROW stretch. While government laws and is needed for power sector development to guide regulations allow full compensation for acquiring policy and regulation efforts and investments. The land for tower foundation under the transmission strategic vision or the road map should clearly projects, NEA does not have a clear corporate indicate the GoN’s objectives of power sector policy for the compensation for land under the development and how these objectives could be ROW. As is common practice in many countries, achieved. The rich hydropower resources available NEA provides full compensation for losses of in Nepal make it possible to provide reliable, properties, trees and crops for ROW clearance. affordable and sustainable electricity supply and to In addition, NEA also provides 10 % of the land generate huge export revenues (which in turn can be value as compensation for the restricted use of the invested in infrastructure development and service ROW. This practice has worked well in remote delivery). While public investments are needed, rural areas where the land is used predominantly such as in transmission lines, it is impossible to for cultivation. However, ROW compensation achieve these objectives in Nepal without private has become a serious issue in urban and peri- sector hydropower participation and policy reforms urban areas, where land has significant value are needed to create an enabling environment for appreciation potential due to the growing real- such private investments. As Nepal’s hydropower estate market in Nepal. In the absence of a clear generation has strong seasonality, there is also a Figure 19: Despite high access Nepal has the lowest per need to develop seasonal storage hydropower plants capita consumption of electricity in South Asia for effective power trading with India, Bangladesh 2942 Per capita Electricity or China. The power trading would allow to export Consumption in kWh surplus generation during the wet season to make large sized hydropower projects financial viable, and import of electricity to meet domestic demand 644 806 during the dry season when hydro-generation is 457 445 279 93 low. Power trading would help to reduce the trade deficit and enhance regional integration. China India Pakistan Srilanka Bangladesh Nepal Asian Average The GON should produce a power sector road map with full cabinet endorsement. N E PA L E C O N O M I C U P D AT E 25 Short and Medium term Economic Projections G rowth is expected to recover to 4.5% in growth dividends from increased political stability will FY14, mostly on account of favorable materialize mostly at the tail end of the fiscal year or exogenous developments, and despite into FY15. lackluster public spending. Overall economic growth is expected to recover from the slow-down External developments are unlikely to affect the experienced in FY13 and to reach 4.5% in FY14, outlook significantly, other than via their possible above the initial forecast made at the end of FY13 effect on remittance inflows. While higher growth but below the GoN’s own projection of 5.5%. in India and expansion in developing-country Agriculture output is expected to grow significantly markets may boost exports, their small base means reflecting more clement weather patterns (a timely that the overall impact will be modest. With limited and adequate monsoon) as well as improved supply exposure to foreign capital, Nepal will not be affected of agricultural inputs, particularly fertilizers. meaningfully by tighter financial conditions. Despite Likewise and more importantly given the sector’s their importance in Nepal, the drivers of remittance contribution to overall value added, growth in inflows remain largely unknown: much in the same the services sector is expected to be boosted by way as the sharp increase observed in the first half much higher than anticipated remittance inflows, of the year was unexpected one cannot assume that particularly education services and retail trade. such growth can be sustained over time. Much uncertainty remains on the extent to which Given the trend observed during the first half of investment may pick up in the second half of the year, it is likely that the budget will end the the fiscal year. The slow pace of budget execution, year in surplus. With robust revenue growth, the particularly for capital projects reflects a combination increase in total expenditure is expected to translate of structural factors (weaknesses in budget preparation into a smaller overall surplus (equivalent to 0.3% of and implementation) but also circumstantial elements. GDP against 2% in FY13). Focus on policy implementation was overshadowed by the elections (which took place in November) for which Inflation in Nepal tends to follow India’s but a significant number of key civil service personnel inflationary pressure could build up if record remittance (including technical staff from line ministries) were inflows observed in the first 6 months continue and deployed to prepare and supervise the ballot. With if monetary policy does not adapt. Overall inflation the electoral period now over and a government in for FY14 is expected to remain significant – at 9.8%. place, the pace of project execution is expected to Although the impact of this year’s good harvest will pick up. Likewise, it is also likely that private players be to drive down food prices, the expected accelerated have been withholding planned investments until a pace of public spending in the latter part of the year clearer picture of the political environment could be combined with relatively loose monetary policy is likely formed. Indeed, during the first half of the fiscal year to translate into inflationary pressures. Moreover, this there has been a sharp discrepancy between domestic assumes that the NRB stands ready to act decisively, and external investment commitments and actual should the large build-up of liquidity in the system realization. The length of the lag between the improved translate into asset bubbles and expectations. The political outlook and its translation into fresh domestic Special Focus section of this Economic Update looks and external investments will determine whether the precisely at the policy implications of excess liquidity. 26 N E PA L E C O N O M I C U P D AT E Bank Support and Activities A new Country Partnership Strategy The current portfolio consists of 17 projects with (CPS) for fiscal years 2014-17 is under net commitments of US$1.5 billion, and three preparation. The last Country Assistance regional projects with net commitments of about Strategy (CAS) covered FY04-07, and was followed $240 million. The average project size is $86 by three Interim Strategy Notes (in 2007, 2009, and million, near the Bank-wide IDA average of about 2011). The new strategy proposes a major shift in US$87 million. Under IDA16 (FY12-14), Nepal’s World Bank Group (WBG) support away from short- total IDA allocation is about $630 million, and term post-conflict assistance towards establishing the similar indicative financing levels are expected for foundations for increased and inclusive growth. Based IDA17 (FY15-17). Cumulative disbursements as on Nepal’s progress to date, there is a compelling case of January 31, 2014, were $633 million (about 46% to provide assistance under a longer-term partnership of net commitments) for the national and about strategy, while maintaining the flexibility needed $15million (about 6 % of net commitments) for the to accommodate a fragile country environment. regional projects. The portfolio also includes three To do this, the strategy aims to consolidate the active trust fund projects with commitments above WBG’s current engagement in basic services while $5 million each. The total commitment of these shifting focus on the binding constraints to growth: three projects is $87.5 million of which $15.06 inadequate infrastructure (especially energy and million (about 17.2 % of net commitments) have transportation), a poor investment climate, a fragile been disbursed. financial sector and a poorly skilled workforce. Given the reality of the Nepali economy, it will also focus Pipeline Program: The FY14 lending pipeline on agriculture, which accounts for over one third of includes a total of $221 million in new GDP and employs three-quarters of the population commitments across three projects of which two (including the bulk of the poor). It also aims to shift ($150 million) have already been approved by the the Bank’s engagement in the social sectors from Board on December 23, 2013. They include the providing financing for access to services to providing Strengthening of the National Rural Transport knowledge and solutions for improving quality, Program Project ($100 million) and Additional governance and providing equal opportunities. Financing for the Irrigation and Water Resources Management Project ($50 million). The Rural The new CPS will focus on two pillars—(i) Water Supply Project of about $71 million is increasing economic growth and competitiveness; planned for Board submission in May 2014. This and (ii) increasing inclusive growth and providing would provide for the full commitment of the opportunities to increase prosperity—while also entire IDA16 allocation to Nepal. Several strategic seeking, in a crosscutting manner, to enhance pieces of analytical support have been completed governance, accountability and citizens’ empowerment. or are nearing completion, including Policy Notes Given Nepal’s fluid political situation, the CPS has for the New Government, Competitive Industries been developed through extensive consultations with Diagnostic, Mapping of Local Service Delivery, key stakeholders, including political parties, and is Medium Term Expenditure Framework and TA for aligned around Nepal’s development priorities. Hydropower Scale-up. N E PA L E C O N O M I C U P D AT E 27 Data sheet Table 1 : Selected Economic Indicators – 2010-2014   2010 2011 2012 2013 2014   Estimated Projected Annual percent change GDP 4.8 3.4 4.9 3.6 4.5 CPI (period average) 9.5 9.6 8.3 9.9 9.8 Broad Money 14.1 12.3 22.7 16.3 19.7 Private sector credit 14.2 13.1 11.3 20.2 19.7 Workers’ remittances (USD) 14.8 13.8 39.6 15.4 14.2 In percent of GDP Total Revenue and Grants 18 17.6 18.6 19.2 20.9 Expenditure 18.8 18.5 19.2 17.2 20.7 Net incurrence of Liabilities 1.8 2 2.2 -0.9 1.3 Foreign 0 -0.3 -0.2 -0.3 0.5 Domestic (above the line) 1.7 2.3 2.4 -0.6 0.9 Current Account -2.4 -0.9 4.8 3.3 2.4 Trade Balance -25.5 -23.4 -24.3 -27.1 -33.3 Workers’ remittances 19.8 18.5 23.3 25.5 30.9 Gross official reserves (in months of goods and services) 5.4 5.8 7.2 7.6 7.8 Public Debt 35.4 33 34.1 31 30 Source: WB / IMF/ NRB  28 N E PA L E C O N O M I C U P D AT E Excess Liquidity – A “Fortunate Problem” … If Well Managed S ince the turn of the decade Nepal has Abundant liquidity comes at a cost for commercial experienced a liquidity squeeze, which banks (in the form of deposit) who will only hold almost brought about a financial crisis, it if they need to improve their balance sheets and/ followed by a build-up of excess liquidity. In or consider the risk profile of borrowers to be too a recent review of monetary policy the NRB high. But such liquidity can be rapidly mobilized Governor characterized such excess liquidity as for lending if these parameters change and can a “fortunate problem”. However, the volatility translate in asset bubbles fueling inflation. -from scarcity to abundance- is problematic for the private sector and symptomatic of inefficiencies in The question is what characterizes ‘excess’ the financial sector. This note looks at short and liquidity. It is not only an academic one but has medium term challenges it poses for policy important policy implications. At minimum it describes a situation where banks chose to The buildup of liquidity in Nepal’s financial hold liquid assets above and beyond statutory system reflects strong push and weak pull factors. requirements. This may be purely rational if banks The steady and impressive growth of remittance are worried about their balance sheets and anticipate inflows - in FY14 as in previous years - has translated a deterioration in borrower credit worthiness such in a significant buildup of liquidity in the financial that the holding of excess liquidity amounts to an system as banks appear reluctant to extend credit to additional self-imposed precautionary behavior. At the productive sector, despite cheap access to funds maximum, however, it may be the case that banks and policy encouragements. The NRB’s response so in fact involuntarily hold excess liquidity because far has been muted and geared toward striking a of information asymmetries (keeping rates sticky), delicate balance between supporting credit growth poor alternatives (such as bonds or viable demand on one hand and controlling inflationary pressures for credit), lack of competition, and/or missing on the other. safety nets (such as a well-developed interbank market and operational lender of last resort Excessive liquidity can potentially be of concern function by the NRB). It can also be that banks are for both growth and inflation. Bank liquidity irrationally conservative in their appetite for risk. can be a source of concern for growth to the extent that it amounts, de facto, to a tightening of Achieving a sound diagnostic of Nepal’s situation the money supply. Other things equal, excessive is not easy and many of these features could be liquidity (money held by banks rather than simultaneously at play. Given Nepal’s recent near extended as credit) means less lending to support financial crisis it is likely that psychological factors non-government productive investment –for a are making banks more risk averse than they given money base- and therefore slower overall otherwise might be. At the same time one should economic growth. However, at the same time, it also recognize that much uncertainty remains as is also potentially a source of inflationary pressure. to the true state of the financial sector (including N E PA L E C O N O M I C U P D AT E 29 health of banks’ balance sheets) and quality of loose management of money growth – intended to demand for loanable funds. Finally, it is clear that keep interests low and encourage credit expansion, there are substantial market inefficiencies. Given (ii) targeted policy measures to encourage banks to such ambiguity, thoroughly diagnosing the patient’s extend credit and access to finance, combined with condition should be a prerequisite to prescribing (iii) ad hoc interventions to mop up liquidity in remedies and the first therapeutic imperative, in the system through open market and reverse repo the meantime, should probably be to ‘do no harm’. operations. This course of action is equivalent to walking a fine line between pro-active support In the short term, monetary prudence may be to economic growth and containing inflationary the wisest course of action. Given persistently pressures, but it does not amount to a clear and high inflation and the overall healthy growth predictable course of action. Moreover it has rate of the economy, the most immediate risk resulted in high interest rate volatility, which may is that inflationary expectations could build-up have adversely affected the propensity of banks to and become, eventually and increasingly, harder extend lending and of private agents to borrow. to control. Relative monetary restraint (such as through sterilization of inflows) may come with Ultimately, building the systems required for banks to a price tag in terms of growth in the short term safely and sustainably expand credit is a sine qua non but would be unlikely to result in a vicious spiral. condition to strike the best possible balance between Monetary expansion is a riskier choice. If banks economic growth and inflation control objectives. A are indeed excessively conservative and the growth patient has greater chance to recover from a temporary potential of the economy is solid, then monetary illness if she is in good health to start with. Building- expansion could yield important dividends. up the ‘immune system’ of the financial sector should However, if banks are correctly assessing the risk therefore be of paramount importance and there are of further extending credit and the economy many avenues to do so in Nepal. By contrast, policy susceptible to asset bubbles (in the absence of measures intended to force banks to simultaneously productive avenues for credit expansion combined strengthen their balance sheets and to expand credit with weak safeguards) then loose monetary policy (via interest rate caps) and direct it to underserved combined with additional policy directives to boost clients (via directed lending to priority sectors) credit could spur inflation and possibly a return to may be inefficient and possibly counterproductive. financial sector stress. Ultimately the key is to establish a strong enabling environment that creates opportunities for banks to The NRB, sooner rather than later, may need lend for productive purposes. to clarify its overarching strategy to deal with persistently large private inflows. With remittance This special focus section proposes a number of inflows showing no sign of abating -characterized steps: to clarify the monetary policy stance in the by both large volumes and volatility- and liquidity face of high liquidity as well as to develop market building up in the system, the NRB has followed alternatives to potentially distortionary policies to a course of action characterized by (i) an overall allow the credit market to work more efficiently. 30 N E PA L E C O N O M I C U P D AT E PART I Managing Excess Liquidity in the Short Run N epal’s financial system is currently characterized by excess liquidity reflecting a combination of conjunctural and structural factors. On the one hand, bank lending to the private sector has slowed –with lending rates adjusting sluggishly to available liquidity- possibly remaining below optimal levels. On the other hand, high external inflows of cash into the economy are creating significant pressure that could translate into prices if banks are unable to channel this liquidity to sound investments and if the monetary authorities do not act to effectively and predictably manage the overall level of liquidity in the system. In the short run, therefore, it may make sense for the NRB to clarify its monetary stance by articulating a liquidity management strategy in relation to both growth (credit) and inflation goals as well as financial stability and development objectives. This may call for creating new instruments to manage excess liquidity, which has become a feature of the Nepali economy. system. Due to quick and effective intervention by From symptoms to diagnostic: the NRB –including large scale liquidity support excess liquidity, credit through multiple lending windows and regulatory slowdown or credit “crunch”. forbearance - and thanks to a favorable environment (notably continuing large flows of remittances In mid-2011, a financial sector crisis nearly which contributed liquidity to the system), a full- unfolded in Nepal. Withdrawals of deposits from blown financial crisis was averted. smaller financial institutions and severe liquidity constraints across the banking sector exposed the Over FY13 and FY14, excess liquidity has been vulnerabilities of the financial system and required building up in Nepal’s financial system. Nepal’s urgent intervention by Nepal’s central bank and banking sector appears to be increasingly biased bank regulator, the Nepal Rastra Bank. The World toward holding liquid assets rather than supporting Bank, together with the International Monetary productive investment through lending. Deposit Fund (IMF), was called on by the NRB and the mobilization increased by 8% in the first half of Government of Nepal to provide assistance, both the year vs. 5.3% at the same time in FY13; by technical and financial, to support efforts to contain contrast domestic credit growth slowed to 7.3% the developing crisis and to provide longer-term over the first 6 months of the fiscal year under support for institutional and regulatory changes the influence of both lower levels of government that would contribute, over time, to a more robust borrowing and slower growth of claims on the N E PA L E C O N O M I C U P D AT E 31 private sector (9% in the review period vs. 12.3% Figure 20: Commercial banks biased toward liquid assets in the first half of FY13). As a result, the loans-to- 45 deposits ratio has been declining over time. Three 40 35 commercial banks (8.8% market share) recorded 30 Credit to Deposit Ratio (in LCY) in excess of 25 90% in the second quarter of FY14 compared to 20 five commercial banks (9% market share) in the 15 10 previous quarter and eleven banks (30 percent 5 of the market) in the previous year. At the same 0 2006 2007 2008 2009 2010 2011 2012 2013 time, treasury bills accounts of commercial banks Liquid assets to total assets Liquid assets to demand and savings deposits Liquid assets to total deposits increased significantly, almost doubling between Source: NRB / IMF FY11 and FY13. Reflecting these trends the interest rate spread between risky assets (private sector loans) and low risk assets (T-bills, deposits at NRB) Figure 21: Liquid funds of commercial banks widened significantly. 250000 Banks appear to be withholding credit by 200000 maintaining high lending rates despite slower 150000 credit growth. Indeed, while credit to the private 100000 sector remains high, the rate of credit growth has decreased significantly from FY13. Also, the large 50000 interest spread between risky assets and low risk 0 assets is significant, indicating reluctance from Liquid funds Cash in hand Balance with NRB Balance held abroad 2008 2009 2010 2011 2012 2013 banks to use the price mechanisms to attract Source: NRB greater demand for loanable funds. That is not because of involuntary rationing (although the NRB has imposed some limits to real estate related Figure 22: Structure of interest rates lending) but rather appears to be a voluntary 8.5 9 8.1 behavior, possibly linked to psychological factors, 8 Interest rates (%) 6.8 8.2 7 a reassessment by banks of default risk and balance 6 5.1 6.6 sheet weaknesses, and/or imperfect competition in 5 4 2.8 the sector. 3 3.0 3.6 3.7 2 1.2 1.2 1 0.9 0.9 0 Understanding the drivers of the credit slowdown FY 07 FY 08 FY 09 FY 10 FY 11 FY 12 FY 13 T-bills (91 days) Interbank Rate – and whether Nepal’s situation can in fact be characterized as a mild credit crunch1- is not straightforward as both demand and supply factors may be at work. On the one hand political uncertainty, especially since the dissolution of the first Constituent Assembly and in the run-up to the 1 Arguably Nepal is not in a full credit crunch scenario as the term usually refers to situations in which a drastic reduction of credit (against the backdrop of deleveraging) precipitates a sharp contraction in real economic activity. By comparison, Nepal’s slowdown is relatively mild. 32 N E PA L E C O N O M I C U P D AT E elections, may have led private operators to postpone market remains subdued– adds to the constraints investment decisions; likewise the depreciation of that banks face in assessing the true extent of their the Nepali rupee may have led importers to reduce exposure and need for additional protection beyond their demand for letters of credit. On the other hand those imposed by regulation. Perceptions could also however, the supply of credit may also have fallen be playing a part including the experience of crisis (for any given level of interest rate –i.e. leftward shift (an impaired loan portfolio) and/or heightened of the supply curve) due to balance sheet weaknesses uncertainty (leading to regard previously normal of banks and/or heightened perception of default loans as having now excessive risk). These two risk. The banks’ continued exposure to real estate – dynamics maybe re-enforcing each other since the whose valuation is particularly hard and where the most typical form of collateral is real-estate. Box 2: Definitions: credit slowdown and credit crunch A credit slowdown can be defined as a general supply phenomena, it is difficult to disentangle decline in credit growth that may have been supply from demand effects since some of the generated by either demand or supply factors, same factors that reduce the willingness to lend or both. Broad changes in the demand for may also restrain the desire to borrow. credit may be cyclical (varying with the pace of economic activity) or structural (induced by A credit crunch implies changes in the relationship changes in the tax code etc.). Credit supply can between credit availability and interest rates: (i) be influenced by changes in financial regulations, less credit may be available over a wide range structures, and institutions. Monetary policy of interest rates -- a condition consistent with a and autonomous shifts in lender and borrower leftward shift in a credit supply schedule, or (ii) psychology will have an impact on both credit the reduction in credit availability may bear little supply and demand. relation to the level of rates -- a condition that takes place when allocation occurs via non-price Unlike credit slowdown, which is a fairly mechanisms. Since credit is normally allocated general term, credit crunch specifically refers to across potential borrowers by the interest rate, a reduction in the available supply of credit. the term credit rationing is commonly used During a period of credit crunch, lenders become for situations in which the supply of credit is reluctant to lend either because of funding allocated through non-price mechanisms. In problems stemming from disintermediation, or general, credit rationing episodes are considered because regulators have urged credit restraint. to be a subset of credit crunches in which the The reluctance to lend may also stem from interest rate is not the price underlining the the lenders’ own balance sheet weaknesses credit allocation mechanism. Credit crunches (capital constraints) and their reassessment of that are characterized by credit rationing may borrowers’ average credit quality. Although be difficult to alleviate through monetary policy credit crunches are often deemed as primarily alone. Source : “Is there a credit crunch in East Asia”, W. Ding, I. Domac, G. Ferri, WB Policy Research Working Paper, August 1998 N E PA L E C O N O M I C U P D AT E 33 Understanding the reasons behind the recent to demand shocks, inflationary pressures could credit growth slowdown and/or the stickiness quickly become difficult to contain. of lending rates at which banks extend credit is imperative in order to assess the most appropriate l On financial sector stability: the effect is monetary policy response. In very schematic terms, ambiguous: to the extent that banks can have the monetary policy dilemma can be expressed access to cheap money, high levels of liquidity as follows. On the one hand, if sound demand provide a boon to the banks’ ability to rebuild for credit exists in the economy which is not their balance sheets; at the same time, if materialized either because investors are postponing adequate safeguards are not in place banks investment and /or banks are excessively risk averse, could be tempted to engage in overly risky then maintaining a relatively loose monetary policy lending practices. may be justified. On the other hand, if banks are worried about balance sheet weaknesses and assess l On monetary policy effectiveness: by the existing demand for credit as too risky (given affecting the ability of monetary authorities to such balance sheet weaknesses) then loose money stimulate demand and stabilize the economy combined with policy directives to expand lending during downturns: with banks already highly could exacerbate financial sector woes and feed liquid (i) further attempts by the monetary asset bubbles and inflation. authorities to stimulate demand would likely prove futile, and (ii) the ability to regulate the Monetary policy choices money supply via reserve requirements and the money multiplier are also proportionately From a policy standpoint determining what weaker. constitutes ‘excessive’ liquidity is particularly difficult and the outcome of the diagnostic has The monetary policy stance, therefore, involves important implications. In theory, the buildup of a tradeoff between the objectives of avoiding an liquidity, in excess of regulatory requirements, can unnecessary slowdown in growth on one hand have at least four sets of adverse consequences albeit and controlling inflation on the other hand. with different implications for policy: Maintaining a relatively loose monetary policy and allowing the excess liquidity to remain is consistent l On growth: as the bias toward liquidity with emphasis on the first objective. Draining implies a higher cost of borrowing (or credit off excess liquidity is consistent with a priority rationing) leading businesses and households on the second objective. In addition, in Nepal, to defer investments or current expenditure and the NRB has identified two additional objectives possibly to sectoral shifts in the composition of namely, financial development and stability. lending at the expense of smaller and less well Loose monetary policy is consistent with both, established clients (flight to quality) however its combination with policy directives to cap the spread that banks can maintain between l On inflation: since it increases the capacity of deposit and lending rates is not and even possibly the banking sector to boost credit in response counterproductive. 34 N E PA L E C O N O M I C U P D AT E Figure 23: Monetary policy objectives Growth (Credit) There is an inherent tension between growth / credit expansion objectives and price stability targets exacerbated if demand for credit is not sound. Financial Financial Loose monetary policy is consistent with credit Stability development growth and financial stability and development goals but its combination with interest spread caps could be detrimental to both. Price Stability inflation Striking the right balance implies understanding have weak solvency –if at all- or there are few the drivers of banks’ unwillingness to extend credit sector with viable investment opportunities, and bias toward holding more liquid assets. On then banks are being rational in denying them the one hand, banks may be purely rational in their credit, hence expanding the money supply choice, holding excess reserves as a precautionary may run the risk of increasing the fragility measure. On the other hand, banks may be acting of the financial sector, creating speculative irrationally if their bias for liquid assets is above bubbles and driving up inflation especially and beyond what statutory requirements and what when combined with policy directives to boost precautionary measures would call for. The extent credit. to which banks are acting ‘rationally’ has important implications for monetary policy. l Lastly, if banks are involuntarily holding excess liquidity (potentially because of asymmetric l If banks are irrationally restricting credit, information or an underdeveloped bond despite sound balance sheets and worthy market), then the most appropriate response demand for loans, then loose monetary policy is to tackle these inefficiencies directly to allow may in fact be required. To support the same the credit market to function more smoothly. nominal aggregate demand, a higher base is needed the less inclined bankers are to lend. Mapping Nepal neatly within this typology is hard because these factors are likely to be simultaneously l However, if banks are adequately assessing at play. Little is known about the true health of the risks of expanding lending, then loose financial sector and credit growth, though slower, monetary policy would be risky. If borrowers has far from collapsed. N E PA L E C O N O M I C U P D AT E 35 What to do in the short term? l On the one hand the NRB has deliberately not The response of the monetary authorities to date fully sterilized the reserves build-up leading to has been muted. In the face of large remittance low interest rates and a widening spread vis-à- inflows and persistent inflationary pressures the vis Indian rates. NRB has adopted a muted response, clearly displaying reluctance to face the cost of sterilization l On the other hand it has acted – with increased in terms of credit and economic growth. Massive frequency- to drain off the excess via reverse inward remittances are sustaining a large current repo and open market operation, to contain account surplus, reflected in the buildup of net inflationary pressures in the face of weak credit foreign assets. At the same time, food prices have growth. remained high despite an improved agricultural Table 2: NRB’s interventions to mop up liquidity in FY14 production outlook. The NRB’s response to date Reverse Repo Auction Amount (NRs Rate has involved a delicate balancing act between million) (%) maintaining a relatively loose monetary policy to September 2013 15,000 0.07 support credit growth while preventing the buildup October 2013 20,000 0.05 of ‘excessive’ liquidity through ad hoc interventions. December 2013 29,500 0.06 January 2014 54,000 0.68 Box 3: Reverse repo and open The NRB appears to have adopted a wait and market operations: Basic see position, to gauge whether demand for credit definitions will pick up. The decision of the NRB to maintain loose monetary policy is presumably premised on Both instruments are used to decrease the the belief that: money supply in the economy l Inflationary pressures are in fact manageable Reverse repo: The Central Bank agrees to because driven mainly by food prices, energy borrow money from commercial, giving them prices and the value of the rupee (i.e. all largely a vehicle to park their funds with the NRB, exogenous) and much less so by domestic thereby decreasing the supply of money in credit growth, while the market. However this is only a temporary absorption of money (i.e. for the duration of l Sound pent up demand for credit exists which the loan). either (i) requires more time to materialize and/or (ii) has been prevented by excessive Outright sales auctions: The Central conservatism on behalf of banks. Bank sells government securities and thus withdraws money over the longer term. This strategy, however, has the potential to be risky, on at least two counts: 36 N E PA L E C O N O M I C U P D AT E l First, much is still unknown about the true Therefore, in the short term the NRB should carry out health of Nepal’s financial sector and a better an in-depth review of weaknesses of BFIs and build diagnostic is needed. While officially reported/ its capacity to provide effective supervision. With recorded problem loans represent a modest support from DfID and in preparation for the Second 3.8% of the total, ever-greening is believed Financial Sector Stability Development Policy Credit, to be widespread. Currently, the quality of the NRB has started carrying out an in-depth review outstanding loans is assessed essentially on the of BFI balance sheets, which will shed light on the basis of “past due days”, which is particularly extent of these problems. Over time, banks and the prone to missing (and perhaps encouraging) NRB should also move increasingly toward carrying ever-greening of bad loans2. Moreover, the out Asset Quality Reviews so that the assessment of decision to suspend dividend payments in overall portfolio health and decisions on new loans institutions reporting NPLs over 5% may should be made on the basis of detailed analysis of the have prompted bank managers to underreport borrower’s repayment capacity (rather than history). and constituted in fact a disincentive to adequate and transparent risk assessment – Second, additional policy measure to fix the spread possibly driving a wedge between the NRB’s between deposit and lending rates and direct assessment of BFI health and the institutions’ lending toward deprived and “priority” sectors own understanding of their risks. may compromise both the objective of restoring balance sheet health and allowing sound demand for credit to be met. Of specific concern are (i) Box 4: Ever-greening: lipstick on a pig? the establishment of a margin cap (of 5 percentage points between deposit and lending rates) designed to It is quite common, and appropriate, for banks to revisit the protect customers, and (ii) requirements for banks to original terms of a loan when corporate clients that are in fact lend to deprived sectors. The margin cap, affects both solvent are faced with a temporary liquidity shortage. In Nepal the ability of banks to rebuild balance sheet strength however this practice has been largely indiscriminate and unrelated and to use price mechanisms to discriminate between to an assessment of borrowers’ ultimate repayment capacity. good and bad as well as safer and riskier demand for Ever-greening refers to such practices whereby banks extend new loans. The requirement to lend to deprived sectors has loans to customers to allow them to remain current on obligations translated in commercial banks’ lending to class D and from previous (bad loans), motivated solely by the objective to cooperatives, which are poorly regulated and often avoid provisioning charges (that would be deducted from capital). unable themselves to find appropriate destinations for As a result, bank balance sheets appear healthier than they really their funds. are (because the quality of loans is essentially measured in relation to default on payments due but artificially so). In the short run, therefore, it might make sense In a recent statement, warning banks against engaging in such for the NRB to: practices, Reserve Bank of India Governor Raghuram Rajan said that one ‘can put lipstick on a pig but it doesn’t become a l Closely monitor the evolution of bank princess’. balance sheets and new loans and stand ready Source: Business Today “Raghuram Rajan warns bankers on ever-greening of bad loans” to tighten monetary conditions. Given the 16/11/13 relatively favorable macroeconomic outlook (and particularly the absence of recessionary risks), 2 In principle the number of overdue days provides a simple, objective benchmark for asset quality but in the case of Nepal there is some evidence that banks do not ‘play by the rules’ and, in the absence of strong supervision, trade each other’s bad loans booking them as fresh credit. N E PA L E C O N O M I C U P D AT E 37 Nepal is in a fortunate position that it can afford and sustained rise in inward remittances and to be relatively conservative in its monetary policy corresponding buildup of net foreign assets – stance. In other words, tighter monetary policy is other things equal- is steadily growing the money unlikely to feed into a vicious recessionary circle base. At the same time this overall steady rise is (where lower credit depresses output, which combined with short term fluctuations driven by leads banks to be even more cautious, which remittances and asset bubbles (and their bursting), depresses output further). In coming months which discourage investors from making long the NRB should pay close attention to both term investments (due to the un-predictability the volume of private sector credit growth and of funding) and bank lending (due to the its quality. The impact of credit expansion on unpredictability of supply of credit). inflation and financial sector health will depend a lot on the quality of underlying projects. Of The instruments deployed so far by the NRB are well particular importance will be the evolution of suited for handling such inflows in the short term but the housing market. So far growth of credit in not for strategically managing them over time. The this sector has been biased toward home loans NRB has acted with increasing frequency in FY14 to relative to developments indicating that banks absorb excess liquidity in the system via reverse repo remain cautious. However any indication that and open market operations (outright sale auctions) credit remains constrained over time or that it but these are short term fixes, in fact more typically may be feeding speculative ventures would call used for fine tuning purposes -to smooth the interest for tighter monetary conditions. rate fluctuations caused by temporary variations in liquidity- than for long term management. As such l Reconsider the proposed cap on interest rate they are different from so-called structural operations margins. The proposed cap on interest spreads that are used to adjust a central bank’s long term is consistent with growth objectives but position vis-à-vis the financial sector. possibly detrimental to stability goals as well as to the objective of extending access to finance In order to manage liquidity predictably and (which is was ostensibly meant to promote). efficiently over the long run, the use of dedicated instruments may become necessary. While In the medium run, the NRB may want to open market and reverse repo operations may be consider developing (and/or making explicit) a suited to fine tune liquidity management they clear strategy for action with adequate tools to are ill adapted to manage liquidity in the face of manage excess liquidity. The NRB should develop persistent and large pressures stemming from the its toolkit to deal with excess liquidity in a way that inflow of remittances. The result is high interest provides clarity and stability with respect to goals rate volatility and lack of clarity –on the side of (inflation and growth) and adopt corresponding market players- on medium to long term prospects targets for bank liquidity and interest rates. (possibly fueling excessive holding of liquidity). In Nepal, the large buildup of liquidity in the l The NRB may want to consider formulating system reflects to a large extent structural push an explicit strategy for managing excess factors. While excess liquidity can result from liquidity: that strategy should make explicit temporary shocks, in Nepal this is increasingly a how credit growth and inflation control structural feature of the economy. The phenomenal objectives are traded off against one another 38 N E PA L E C O N O M I C U P D AT E Box 5: The Use of Sterilization Bonds in Asia In the wake of the Asian Crisis, a number of Asian economies have accumulated large FX reserves to sustain exchange rate regimes, leading to large increases in their balance sheets. In order to maintain monetary stability central banks have resorted to sterilization through non-market and market based approaches. Among the latter sterilization bonds –mostly the sale of own securities by CBs- have been increasingly popular and seen as a way to deepen local bond markets and develop a yield curve while avoiding the negative impact of non-market measures on financial intermediation. In Korea, “Monetary stabilization bills” were issued for the first time in 1961 and used as the primary method to remove excess liquidity, reaching an amount equivalent to 20% of GDP in 2005. China issued central bank bills, alongside other instruments (including reserve requirements, open market operations, etc) beginning in 2003. In China market based issuance has also been combined with targeted issuance to specific commercial banks experiencing abundant liquidity and fast credit growth. While the Reserve Bank of India is not allowed to issue its own securities a new instrument was created in 2004, namely the “Market Stabilization Scheme” – or government treasury bonds and medium-term dated securities used solely for sterilization purposes (with the proceeds from the auction placed on a separate cash account). Adapted from: Aaron Mehrotra “On the Use of Sterilization Bonds in Emerging Asia” BIS paper No66 and reflect that position in targets for overall liquidity absorption spurred by large external bank liquidity capital inflows via issuance of additional T-Bills and securities. (Box 5). An additional l The NRB may also need to develop new benefit would be the development of capital instruments to effectively and strategically markets with greater ability for market players manage excess liquidity. Given the sustained to develop a yield curve. nature of inward remittances and the GoN’s commitment to the peg (when a flexible n In parallel, the NRB could consider exchange rate would automatically act to introducing an interest rate corridor to limit correct external imbalances) ad hoc mopping volatility above or below a desired / targeted up of liquidity may (i) not be sufficient to level. This would be done by setting a floor absorb the very large inflows, nor (ii) provide rate (through a deposit facility) as well as a the level of predictability that is needed for the ceiling rate (lending facility). market to function effectively. Over the longer run, given the cost of sterilization, n This would involve developing longer term the best option is to tackle the inefficiencies that treasury bonds explicitly issued to absorb are at the source of involuntary or ‘excessive’ excess liquidity. The proposed ‘sterilization liquidity. While developing the toolset needed for bonds’ would have longer maturities although effective liquidity management, the GoN should at the cost of higher interest rates. In fact this carry out structural reforms to improve the overall has been the path followed by India when, in credit environment and the investment climate 2003, it introduced a new scheme known as to make sure that banks can expand lending in a the Market Stabilization Scheme to sterilize sustainable and safe manner to viable investments. N E PA L E C O N O M I C U P D AT E 39 PART II Expanding the Reach and the Efficiency of Credit Markets T he Central Bank’s policy stance is consistent with the interpretation that commercial banks are excessively cautious in their credit allocation decisions and thus simultaneously restricting the economy’s growth potential and hurting customers by maintaining high spreads between deposit and lending rates. Specific policy measures, such as the proposed cap on interest rate spreads and directed lending to deprived sectors and priority sectors are meant to correct such market inefficiencies. However they run the risk of introducing additional distortions and should be evaluated carefully. Moreover such interventions are at best ‘second best’ while a more sustainable option would be to improve the ability of the market to function efficiently. The section below contains recommendations on how such an agenda could be pursued to improve access to finance, release under-exploited economic potential and help banks diversify their risk. Nonetheless significant gaps remain in the Access to finance is broad by coverage of financial services, both in terms of some measures but limited in access and effective use. Access gaps are most fact for specific categories of acute in the more remote and geographically clients (households and firms) isolated parts of the country, which as of yet remain underserved by formal financial institutions. and in practice under-exploited. Despite the relatively large deposit base, financial services are concentrated among the urban and Nepal’s financial sector has been growing rapidly, male population. Of the urban population, 51% and in most respect access to financial services has a bank account, compared to 22% of the rural compares favorably to other low income country adult population. Similarly, a persistent gender gap peers. The aggregate amount of deposits, credit and exists: while about 30% of Nepali adult males have number of branches and ATMs has been increasing a bank account, only 21% of females do. Moreover, steadily over the past few years. Deposits and credit access to deposit accounts does not necessarily are 65% and 55% of GDP respectively, somewhat mean that they are used for savings. An average of higher than the South Asia averages and exceeding 18% of adults in Nepal save money, but only 10% the predicted value for a country of Nepal’s GDP do so at a formal financial institution, and most per capita and population, by a significant margin. of the savings are intended for emergencies (Figure Accessibility in general has improved: the number 25). of BFI branches per 100,000 adults in Nepal has doubled from 3 in 2004 to 8 in 2012. 40 N E PA L E C O N O M I C U P D AT E Figure 24: Access to finance indicators Private credit/GDP (2012) Private credit/GDP (Nepal) 60% 55% 70% 49% 59% 60% 54% 55% 50% 46% 52% 50% 40% 41% 40% 36% 32% 30% 25% 26% 27% 28% 30% 20% 16% 15% 15% 20% 11% 10% 10% 0% 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Nepal Mozambique Uganda Ghana Niger Madagascar SA Average SA Median Nepal Expected 25th percentile Expected median Expected 75th percentile Domestic bank deposits/GDP (2012) Domestic bank deposits/GDP (Nepal) 70% 65% 80% 57% 67% 61% 65% 60% 56% 70% 61% 60% 53% 50% 48% 40% 50% 44% 40% 42% 42% 40% 40% 30% 24% 30% 20% 18% 20% 13% 20% 10% 10% 0% 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Nepal Mozambique Ghana Uganda Madagascar Niger SA Average SA Median Nepal Expected 25th percentile Expected median Expected 75th percentile Number of branches per 100,000 adults Number of branches Per 100,000 adults (BFIs; 2012) (BFls in Nepal) 14 9 8 12 11 12 8 7 7 10 8 6 5 5 8 5 6 4 4 4 6 3 3 3 3 4 4 3 2 2 2 1 0 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 Nepal Ghana Mozambique Uganda Madagascar SA Average SA Median Nepal Expected 25th percentile Expected median Expected 75th percentile Source: Finstats, accessed February 2014 Figure 25: Household savings behavior Saved for emergencies Saved for future expenses Saved using a savings club Saved any money in the past year (% age 15+) Saved at a financial institution in the past year (% age 15+) 100% 100% 80% 80% 60% 60% 54% 40% 36% 40% 27% 28% 22% 18% 17% 19% 20% 20% 15% 10% 12% 7% 3% 1% 0% 0% Nepal Bangladesh Afghanistan Sri Lanka Pakistan Lao PDR India Nepal Bangladesh Afghanistan Sri Lanka Pakistan Lao PDR India Source: Findex, accessed January 2014 N E PA L E C O N O M I C U P D AT E 41 Table 3: Loan origins   Nepal Bangladesh Afghanistan Sri Lanka Pakistan Lao PDR India Loan from a financial institution in the past year 11% 23% 7% 18% 2% 18% 8% Loan from a private lender in the past year 19% 7% 6% 3% 2% 5% 7% Loan from an employer in the past year 2% 1% 8% 3% 6% 2% 5% Loan from family or friends in the past year 33% 11% 30% 13% 23% 16% 20% Source: Findex Figure 26: Percentage of firms reporting A large fraction of household access to finance as a major constraint borrowing occurs outside of the Nepal (2013) 40.1 formal sector. Afghanistan (2008) 36.6 Bhutan (2009) 30.3 Some 11% of loans come from a formal financial Sri Lanka (2011) 30.3 institution (Table 4) – a proportion higher than Bangladesh (2013) 22.8 the South Asia average (9%) but still low. Most of Pakistan (2007) 17.7 household borrowing comes from informal sources India (2006) 15.8 such as friends and family (33%) or other private 0 10 20 30 40 50 lenders (19%), well above the South Asia average. Source: Enterprise Surveys, World Bank Access to finance is a major and worsening constraint for firms, particularly small and Figure 27: Access to credit is low in Nepal medium enterprises (SMEs). Some 40% of firms Percentage of firms with Checking/savings account Loan/line of credit recently surveyed in the World Bank’s Enterprise 100% 89% 93% 86% Survey 2013 considered access to finance to be 86% 73% 80% 80% 65% a major or severe obstacle to their operations, 60% 59% significantly higher than the 5% reported in 2009. 40% 85% 84% 40% 32% This proportion is also higher than reported by 20% 9% 3% firms in regional peer countries (Figure 26). While 0% Nepal 2013 Bangladesh 2013 Afghanistan 2008 Sri Lanka 2011 Pakistan 2007 Bhutan 2009 Lao PDR 2012 the percentage of firms with a checking or savings account has increased from 2009 to 2013, the share of firms with a line of credit or loan has fallen in Access to banking services In Nepal (2009 vs. 2013) 100% the same time period. Compared to their regional 90% peers, large Nepali firms have very favorable access 80% % of firms with checking/ 70% to credit – in large part due to the close affiliations 60% savings account % of firms with line of between industrial groups and banks. All the large 50% credit/loan from fin. 40% Institution firms surveyed in Nepal’s Enterprise Survey had a 30% 74% 39% 86% 35% 20% checking or savings account, and 84% had a loan 10% or line of credit. However, although 85% of SMEs 0% 2000 2013 have a savings or checking account, only around Source: Enterprise Surveys, World Bank 35% had a loan or line of credit from a financial 42 N E PA L E C O N O M I C U P D AT E institution in 2013 due to the higher collateral The Nepali authorities have been actively requirements for SMEs (mostly in the form of fixed promoting access to financial services through a assets of the owner of the enterprise). wide range of (i) institutions, (ii) policies and (iii) funds and subsidized credit schemes. Retail electronic payments and innovative delivery channels such as e-banking and mobile banking The Nepali authorities have pushed the access to are only slowly gaining traction. As of yet, Nepali finance agenda by directly assuming ownership in customers rely primarily on conventional delivery a variety of financial institutions: channels. Over 75% of adult Nepalis withdraw their money through conventional branch tellers, l Regional Rural Development Banks while over 81% deposit their money by the same (Grameen Bank replicators3): Purbanchal, way. The use of ATMs is low – only 1% of adults Sudur Pashchimancal, Pashchimanchal, in Nepal deposit money through ATM, while Madhya Pashchimanchal and Madhyamanchal almost 12% withdraw money through ATMs, a Grameen Bikas Banks were established in 1992 proportion lower compared to Pakistan (32%) to bring the rural population into the formal or Sri Lanka (15%). Banks in Nepal are taking financial channel and to channel micro-credit various initiatives for retail electronic payments in to micro-industries, agro business and trading the spheres of internet and mobile banking, cross- among others in the rural area. In October border inward remittances and cards. 2012, it was decided to merge the five banks and form a national level development bank, The authorities have actively although the merger has not yet taken place. Four Grameen replicator banks are insolvent, promoted improved access have high NPLs (unlike the rest of the sector), to finance but there are high operating costs, low productivity and shortcomings to the current unionized labor. approach l National Cooperative Bank Limited (NCBL): The NCBL was established in 2003, as the only The Government of Nepal (GoN) and the Nepal umbrella bank in the cooperative movement of Rastra Bank (NRB) strongly recognize the Nepal to provide banking and financial services importance of the financial sector in advancing to all cooperatives. It was established under the economic growth and poverty reduction. The Cooperative Act, 1992 (first amendment, 2000) authorities have taken an active interest in and received a banking permit from NRB. The promoting access to finance and financial inclusion. GoN has a small equity ownership of NPR10 Over time, the strategic direction of the policy million. The bank works with 6,309 member package has undergone marked changes. In recent cooperatives in 72 out of 75 districts. years, the Nepali authorities have moved away from a strategy centered on liberal licensing policies (Box l The Small Farmers’ Development Bank is 6) toward more interventionist administrative a government-owned apex institution that measures. 3 These are microfinance institutions (MFIs) modelled after the Grameen Bank model of uncollateralized group lending. There is one bank for each region of the country. The five banks fall in the class D category. N E PA L E C O N O M I C U P D AT E 43 Box 6: Licensing, market structure and financial development In the past, the NRB has pursued a liberal bank decomposition of the lending-deposit spread for licensing policy, which set the stage for the entry class A banks is that there is considerable variety in of a large number of new financial institutions. terms of deposit rates (i.e. funding costs), but that The liberal licensing policy has promoted entry of lending rates are fairly uniform across the board. It many smaller financial institutions - attracted by the appears that size is associated with lower funding prospect of high dividend pay-outs - particularly in costs and higher efficiency, as is illustrated by the the B and C categories. The banking system now lower overheads of the larger private banks. These comprises 31 class A banks (i.e. regular commercial efficiency gains are however not or only partially banks), 86 class B banks (i.e. development banks) channeled through to the end users as larger banks and 59 class C banks (i.e. finance companies). also have higher profit shares. The state-controlled Although there are differences in permissible class A banks are a notable exception to this activities and prudential requirements, particularly pattern. Their funding costs are among the lowest minimum required capital, all categories are in the sector, but their overheads and provisions are allowed to accept deposits from the public. among the highest in the sector. The low funding costs plausibly reflect widespread expectations The common perception is that the liberal bank among depositors and other liability holders of licensing policy has fallen short of expectations implicit state support. The high overhead costs in terms of financial deepening and access to reflect large and unionized workforce, lack of finance. The entry of new players has had only automation and an ongoing restructuring agenda limited impact in terms of motivating banks to while the high provisions reflect a diminishing but venture out of the narrow readily bankable sector still high exposure to non-performing assets. As of the economy. As a consequence, the upper a consequence, the state-controlled class A banks end of the market (i.e. the large corporates) has have the highest lending-deposit spreads in the become more crowded, while a significant portion sector in large part due to their inefficiencies. of the economy remains seriously underserved by the financial system. Liberal licensing has also The liberal licensing policy remains in force for contributed to the emergence of a fragmented the so-called class D financial institutions. Class banking structure, with many banks, particularly D financial institutions comprise entities engaged in the B and C classes, that appear too small to be in microfinance activities, covering a diverse set of professionally run and remain commercially viable. financial NGOs (FINGOs), a limited number of A moratorium for new licenses has been in effect cooperatives, microfinance development banks and for class A, B and C banks since 2011. regional rural development banks (MFIs) that are regulated by the NRB. In fact, the NRB is encouraging There are indications that the fragmented market Class D institutions to set-up in under-served areas by structure of Nepal’s banking system may be fast-tracking licensing for Class D institutions in 22 inefficient from a financial development point districts. Currently, there are 35 MFIs, 33 FINGOs of view. When viewed in comparison with peer and 15 cooperatives licensed by NRB. While the countries, the lending-deposit spread appears to be NRB supervises a limited number of cooperatives, the below the averages for regional and income group vast majority of cooperatives fall under the auspices of peers. The picture that emerges from a detailed the Department of Cooperatives (DoC). 44 N E PA L E C O N O M I C U P D AT E channels funds to farmer cooperatives to be 3.5% of Class, A, B and C banks’ loan portfolios on-lent to small farmers. It is categorized as respectively have to be lent to this sector. a “D” class bank. Besides providing funds to l Productive Sector Lending: the NRB has cooperatives and MFIs, it also supervises its issued new regulation requiring class A client cooperatives’ and MFIs’ activities to institutions to lend 20% of their portfolio ascertain adherence to prudential regulations to agriculture, energy, tourism, cottage and and provides technical and capacity building small industries (of which 12% has to be lent assistance to its client institution. to agriculture and energy) by mid-July 2015.5 l State-controlled banks: The three class A The NRB has also directed development state-controlled banks – Rastriya Banijya banks and finance companies to raise the level Bank (RBB), Agriculture Development Bank of their lending to the productive sector to Limited (ADBL), Nepal Bank Limited (NBL) 15% and 10% respectively by mid-2016. – account for 22% of class A banks total assets, l Cap on the deposit-lending spread: The NRB has 20% of deposits, and 18% of lending. The issued directives instituting a cap of 5 percentage state also owns NIDC Development Bank, a points of the interest rate spread of class A banks. class B bank. These state-controlled banks do The NRB has directed all class A banks to reduce not have a specific developmental mandate their interest rate spread to 5pp to curb the but do provide certain public services4, and as increasing gap in the interest rate the borrowers a consequence have been competing with each have to pay and the interest rate depositors get. other and against private banks. l Cap on fees and commissions: The NRB is also The NRB has introduced several new policies drafting a regulation to restrict the ability of BFIs aimed at reallocating banking credit towards to charge fees and commissions, in order to lower underserved productive sectors, and lowering the the cost of financial services. This is considered a cost of credit, in addition to pre-existing deprived pre-emptive move so that BFIs don’t start charging sector lending targets: more fees and commissions to compensate for loss in the income from reducing the interest rate l Deprived Sector Lending: The policy has spread. NRB is preparing to instruct the banks been in place since the 1990s, whereby NRB to reduce fees for cards, collateral evaluation and mandates that a percentage of the total loan insurance, and stop charging fees on inactive portfolio of banks and financial institutions accounts and is seen as move towards seeking (BFIs) be lent to the “deprived sector”, defined more transparency from the banks. as “low income and especially socially backward women, tribes, lower caste, blind, hearing l Branch Expansion Policy: NRB has instituted impaired and physically handicapped persons, a branch expansion policy where a bank or marginal and small farmers, craft-men, labor and financial institution must establish three branches landless families”. Currently, 4.5%, 4%, and outside the Kathmandu valley to open a branch 4 RBB and NBL are the main agents of the government for expenditure disbursements and revenue collection. They also claim to be promoters of access to finance in remote areas. ADBL and NIDC were originally established to focus on agriculture and manufacturing respectively. 5 Productive sector lending comprises (i) agriculture lending that goes to sectors such as cash crops, tea, coffee, tobacco, fruits and floriculture, livestock, bee keeping, fertilizer and pesticide enterprises, cold stores, irrigation and fishery, among others., (ii) lending to the energy sector including hydropower and renewable energy projects, (iii) tourism, covering trekking, travel agencies, mountaineering, rafting, camping, resorts, hotels and recreational activities, and (iv) cottage and small industries refers to industries having a fixed capital of less than Rs 30 million. N E PA L E C O N O M I C U P D AT E 45 inside Kathmandu valley (an increase from is funded by a one-time loan from a third of the two branches outside the valley in the previous deprived sector lending requirement in 2010. It policy). These three branches should include at was set up to facilitate self-employment programs, least one branch in one of the 14 under-served and providing orientation, vocational and skills districts designated by the NRB6, one branch development training to the unemployed youths. outside any district headquarters or municipality, YSEF helps provide collateral free loan up to NPR and one branch as per the bank’s own interest 200,000 for an individual and up to NPR 5,000,000 outside the Kathmandu valley. NRB accords a for a group (max. 25 people) at low interest rate to priority to open branches outside the ring-road run commercial farming, agro-based industry or or in the VDCs inside Kathmandu valley. service oriented self-employment programs. If the payment of interest and the loan is made on time, l Branch Expansion Loan: The NRB is offering YSEF reimburses 60% of the interest amount. a 6-month interest free loan to BFIs to open branches in 22 remote districts, and no prior l Credit guarantee schemes: The Deposit and approval is needed from the NRB to open these Credit Guarantee Corporation (DCGC) has a twin branches. For Class D institutions, up to NPR. mandate of deposit insurance and credit guarantees. 2 million at zero interest; for Class A, B, and The credit guarantee component offers three C institutions, loans of up to NPR 5 million schemes: livestock insurance, SME credit guarantee for opening branches in headquarters of those and a Microfinance credit guarantee. The SME districts and NPR 10 million for expanding credit guarantee scheme has very little uptake, due branches outside district headquarters. to the settlement mechanism where the guarantee can only be invoked once the SME loan is declared Finally various public sector agencies are involved in non-performing, a process which takes more than a the subsidization of a diverse set of credit schemes year. The Microfinance credit guarantee scheme is somewhat more used. However both schemes are l The Rural Self-Reliance Fund (RSRF) is an apex subject to adverse selection and high transaction fund that provides wholesale credit at relatively costs because they are not portfolio-based. low interest rates to cooperatives, FINGOs, MFIs, and ADBL operating in rural areas. It was set up in 1991 by the NRB and the government of Nepal to ease credit access to self-entrepreneurs, cottage The policies currently industries and SMEs to help in the reduction of implemented or envisaged poverty in the country. It can extend wholesale imply tangible risks in terms loans to cooperatives and NGOs working as of effectiveness, unintended financial intermediaries and long term wholesale loans to MFIs and Agriculture Development distortions and stability Bank Limited. The borrowers should be based A lot has been achieved in Nepal to expand the frontier in rural areas and priority should be given to the of outreach but much remains to be done. Although areas that fall in the poverty map created by the the GoN and the NRB have initiated many programs National Planning Commission. and policies, they do not amount to an overall strategy l The Youth Self-Employment Fund (YSEF) is and coherent approach towards access to finance. managed by Ministry of Finance (MOF), and Policies, regulations and laws, introduced to enhance 6 The underserved districts are: Bhojpur, Okhaldhunga, Manang, Rukum, Salyan, Jumla, Mugu, Humla, Kalikot, Dolpa, Jajarkot, Bajhang, Bajura and Darchula. 46 N E PA L E C O N O M I C U P D AT E access to finance do not seem to be founded on The introduction of the 5pp intermediation evidence-based analysis of the underlying problems or spread would impact the banking sector’s capacity an appreciation of best practices from other countries. to internally rebuild capital buffers through Also, there is little monitoring as to whether policies earnings. It is common knowledge that banks in have achieved their intended purpose. Nepal frequently “evergreen” non-performing assets. As a consequence, banks are not setting The current set of policies raises several serious aside the necessary provisions, which leads to a concerns in terms of effectiveness, and distortionary potentially serious overstatement of reported capital side effects. The combination of deprived and adequacy figures. It is unknown which banks are productive sector targets with the envisaged most impacted. The diagnostic review that is to introduction of the cap on the deposit-lending spread take place later this year should bring greater clarity imply restrictions on banks’ room to maneuver through to the true financial state of the banking system. both prices and quantities. Of particular concern is However, preliminary evidence suggests that the channeling of large amounts of funding through the true capital adequacy for the banking sector deprived sector lending, which may discourage eligible could be significantly lower than reported. The MFIs from developing products and targeting clients introduction of a fixed intermediation spread could beyond those specified in the policy, leaving a segment therefore squeeze profitability at a time when there of the market unserved by formal financial institutions. is a likely need to rebuild capital through earnings. In addition, the interest rate spread cap could also prove counterproductive, as it likely induces banks to reduce In part, these problems are symptomatic of their exposures to sectors that carry a higher interest the obfuscation of promotion and prudential rate. Among the sectors likely to be affected are SMEs responsibilities, with the former taking and long term finance – precisely two segments that are precedence over the latter. This is also illustrated currently underserved by the banking system. Lastly, in the mandate of the NRB’s class D supervisory restrictions on banks from charging fees in mobile department, which explicitly includes regulatory banking will likely dissuade them from investing in as well as promotional activities. Similar issues innovative delivery channels, due to the inability to affect the DoC that considers itself both promoter recoup their investment costs – although such channels and regulator of the cooperatives under its hold significant promise for expanding outreach in the purview. Typically, the promotional activities take geographically remote areas of the country. precedence over the regulatory responsibilities. Current policies are also associated with a series What needs to be done? of stability risks. To comply with the deprived Strengthen the enabling sector requirements, class A, B and C banks are building up a significant exposure to not only class environment for the market to D financial institutions, but also to the largely operate smoothly and efficiently. unregulated cooperative sector which is known to be problematic. The deprived sector targets may be The difficulties that Nepal is experiencing in leading to an oversupply of credit to the bottom terms of limited reach of the financial system of the pyramid, possibly setting the stage for an and the high cost of finance are, to a large degree, Andhra Pradesh type microfinance crisis, with typical for low income countries. At a fundamental incipient signs of personal indebtedness. level, the lack of depth and the high costs of finance N E PA L E C O N O M I C U P D AT E 47 reflect a series of structural weaknesses in the overall of a Registrar’s Office, and the operation of an lending environment that exacerbate information electronic registry, which is pending. Banks have asymmetries between lenders and borrowers. reported numerous cases of multiple charges on the The sectors that are typically underserved by the same movable collateral. This has resulted in many financial system, particularly SMEs and households, disputes, prolonging debt enforcement, and explains are among the most impacted. the over-collateralization of loans and the over- reliance on immovable collateral. To minimize the need for potentially distortionary policies and let the markets allocate credit efficiently To advance innovations in retail electronic the emphasis should be to strengthen the enabling payments in the spheres of internet and mobile environment. Administrative measures to influence banking, cross-border inward remittances the amount and cost of credit to underserved sectors and cards, it is an urgent priority to establish does not address the root causes. Put differently, the interoperability of cards, switches and mobile current set of policies target the symptoms of deeper payments, as well as to incentivize other innovations. structural weaknesses, rather than addressing the issues at the very root. Specific areas of action would In addition, weaknesses in the debt enforcement and include: improving the credit information bureau insolvency framework weigh heavily on the lending (CIB) and implementing the long-overdue secured environment. Although the passage of new laws has transactions framework. helped to improve the regulation of NPLs, there are several inconsistencies between the various pieces of Financial infrastructure improvements reduce the regulation, creating confusion amongst creditors, and information asymmetry that constrains access leading to time-consuming court disputes. Also, the to credit and raise the costs and risk of financial 5 specialized Commercial Benches of the Court of intermediation. CIB’s information is only collected Appeal are typically ill-prepared to deal with matters quarterly, above an NPR 1 million (US$ 10,000) pertaining to companies law in large part due to the threshold, thereby excluding exactly those smaller very short tenure of the judges. As a consequence, borrowers that stand most to gain7. Many banks there is poor continuity in knowledge and weak reportedly do not meet these requirements without uniformity of judgments. The effectiveness of the penalty, undermining the quality of information. Debt Recovery Tribunal (DRT), which is used by both In addition, the lack of a unique identifier means secured and unsecured creditors, is compromised by that verification of information is time-consuming onerous threshold requirements, and time consuming and prone to error. proceedings, reducing the likelihood of creditor recovery. While the enactment of the Insolvency The implementation of a secured transactions Act 2006 was an important landmark, providing framework and collateral registries could make the the legal framework for corporate liquidations and use of collateral more feasible, particularly the kind restructurings, liquidations under the Act are rare and of lower value movable collateral that is more suited those that take place are excessively long. to microenterprise loans. The Secured Transactions Act has been in place since 2006 but has not yet been Complementing these improvements in the implemented. The law provides for the establishment enabling environment, there is also substantial 7 The CIB is launching a Microfinance bureau in July 2014, but the enabling NRB regulations have yet to be issued. 48 N E PA L E C O N O M I C U P D AT E scope for making markets work better. While the could potentially lead to a steady build-up of risks outcomes of the spread decomposition analysis in various parts of the financial system. These point to an imperfect functioning of markets, challenges justify a recalibration of the policy stance, these should be addressed by strengthening the and likely require a stronger separation between preconditions for markets to function. This points potentially conflicting regulatory and promotional to a need to establish a more robust competition mandates. More specific measures to reconsider authority8 and also to enhance transparency in the include (i) the discontinuation of the liberal disclosure of the effective cost of financial services licensing policy for class D financial institutions, in an environment characterized by low levels of (ii) the deprived sector lending targets, which lead financial literacy. This could be done by designing to the build-up of exposures of the banking system a methodology to calculate, disclose and monitor to risky and under-regulated cooperatives, and the cost of basic financial products in a standardized which has set the stage for a microfinance credit and comparable manner for typical user-groups. boom, and (iii) the cap on the intermediation These measures could usefully complement newly spread which could limit bank profits and affect the introduced transparency and disclosure guidelines, ability of banks to provision adequately and build and would be helpful in enabling consumers to their capital. make educated financial decisions by facilitating the comparison between different providers and similar Lastly, it would be helpful to adopt a more types of financial products. Similarly, to promote structured and strategic approach to public policy true competition in loan pricing, the practice by interventions aimed at strengthening access to banks of charging prepayment penalties for regular finance. The starting point for public policy should loans could be restricted so that consumers can more be a thorough gap analysis, explicitly specifying easily switch between various suppliers. in detail the unmet demand for financial services (i.e. “market failure”). The assessment should Overall it would make sense to restore the balance then inform policies aimed at strengthening the between stability and development objectives of provision of suitable financial products at affordable policy. A natural goal for any policy framework prices. Cost and benefit of new policies should aimed at improving financial access is to maximize, be assessed systematically and built around the on a sustainable basis, the availability to as wide strategic priorities emerging from the gap analysis. a range of users as possible of suitable financial New measures should be subjected to a more products at affordable prices. It is equally crucial, rigorous impact assessment, while the effectiveness however, to ensure that policies to improve access of existing measures should be assessed periodically. do not compromise soundness and stability of the The different institutions, programs, policies and financial system. directives also need to be analyzed and reviewed collectively, to eliminate contradictions and Until the liquidity crisis of 2011, developmental unintended side-effects. The upcoming Financial objectives appear to have taken precedence over Sector Development Strategy (FSDS) provides stability. However, even the more recent set of a window of opportunity for developing a more policies aimed at strengthening access to finance, coherent and effective access to finance framework. 8 The Competition Promotion and Market Protection Act was enacted in 2007 and a Board was set-up, but it is either weak or non-functioning.   Laxmi Ngakhusi Cover: The World Bank Group Nepal Office P.O. Box 798 Yak and Yeti Hotel Complex Durbar Marg, Kathmandu, Nepal Tel.: 4226792 Fax: 4225112 Email: infonepal@worldbank.org www.worldbank.org/np www.facebook.com/WorldBankNepal