Liquidity should be aligned with long-term economic growth objectives.

--BY AR BHATTARAI

Nepal needs massive investment for its economic growth. We should be very careful while designing economic policies that must support the long-term economic growth objectives of the government. The current level of investment, though meeting the annual target set by the government, will not be sufficient to lead us to achieve the Sustainable Development Goals (SDGs). 

Due to frequent liquidity pressure and ad-hoc pricing of assets and liabilities by BFIs, a general feeling exists in that there is an immediate need to understand the behaviour of BFIs and explore the links between economic growth and sound financial system, financial markets, and the real economy. Furthermore, it demands proper interpretation of available data to predict the future growth prospects as numbers can be misread or numbers can mislead us.
The current liquidity situation might have a long-lasting impact on financial markets. It needs to be addressed properly to avoid greater damage to the country’s economy.

Nepali BFIs perhaps depend on short-term liabilities with high re-pricing risks. However, they have accumulated assets with longer maturity. This has resulted in a mismatch in huge asset liabilities. Even in such extreme situations, liquidity receives relatively little focus from most macroeconomists.

While it is mentioned in money and banking texts, liquidity is generally characterised as a short-term problem that can be handled by the effective use of a few monetary tools.

Way Forward
Option 1: Withstanding to the prevailing prudential guidelines, reduction of Cash Reserve Ratio (CRR) will increase liquidity but won’t increase the lending capacity of BFIs. Decreasing the current CRR level will reduce the cost of handling deposits whereas, upwards revision of credit to Core-capital-cum-Deposit(CCD) ratio will increase loanable funds. If Nepal Rastra Bank (NRB) reads only those ratios, borrowers do not have to pay more interest on loans and banks can increase saving deposit interest rates without incurring incremental costs. It will be a win-win strategy for all.

Option 2: NRB can simply replace CCD ratio by implementing a liquidity ratio of 15 percent (3 percent CRR and 12 percent SLR). This will release about Rs 200 billion into the banking system.

However, there is a huge risk associated with the behaviour of BFIs. They may take the additional flow of liquidity as an opportunity to invest more in unproductive sectors. Therefore, NRB should direct BFIs to invest at least 40 percent of their portfolio in productive sectors. To implement this, NRB should redefine the productive sector. Similarly, to discourage consumer financing, NRB should increase risk weight on consumer financing to 200 percent. Additional risk weight will discourage BFIs to lend money to unproductive sectors hence reducing pressure on balance of payment (BOP).

Options 3: Do nothing and leave it to market mechanisms to make corrections. This alternative may damage the economy in the short-term but BFIs and market players will learn costly lessons. However, no central bank can stay out of the market and behave like a mere observer. The NRB must respond to unnatural market movements.

Chartered Accountant Bhattarai is a former banker. This article was originally published in his personal blog in December 2017.