24 May 2022, NIICE Commentary 7927
Soniya Gautam
Without having completely recovered from the economic disruptions caused by the pandemic, Nepal has to overcome strenuous impediments to improve its economic condition with the ongoing liquidity crisis within the Banks and Financial Institutions (BFIs). A reoccurring liquidity crunch in the nation is a result of a deficit in the balance of payment and trade. Currently, the liquidity crisis is the result of BFIs’ excessive lending of loans at lower interest rates to help the economy recover from COVID-19. With this lending strategy, banks started providing working capital to not only profit-yielding businesses but also to others. The delayed repayment and renewing of such loans, along with the expansion of credit without repayment, have significantly contributed to the liquidity crisis. However, there are multiple other facets that have facilitated the current conditions that will be analyzed in this commentary.
Determinants Facilitating the Liquidity Crisis in Nepal
Excess Liquidity and Credit Disbursement
Liquidity in banks started to increase as a result of the government’s imposed nationwide lockdown in March, with little to no financial activity. According to Nepal Rastra Bank (NRB), liquidity reached approximately Rs 200 billion between the middle of April and the end of June. In an attempt to clear up the excess liquidity from markets, interest rates on loans were decreased. Without evaluating the outcome, with inactive assets in the system, loans were granted easily, leading to disproportionate inflation in certain sectors like the real estate industry and the Nepal Stock Exchange (NEPSE). As per the Nepal’s Ministry of Finance’s Economic Survey 2020/2021, the market capitalization increased by 92.4 percent in 2021 compared to that of 2020. With the policy to ease financial pressure, extending loan repayment and interest payment affected the deposit growth in the banks. The constant demand for credit aggravated the supply side of loans, which banks were unable to meet without having a balanced deposit to back them up, even after BFIs’ decision to increase deposit interest rates. Despite the interest rate modifications, deposit collection in BFIs did not increase as anticipated, leading to the ongoing liquidity crunch.
Balance of Payment and Trade
A recent survey, ‘Current Macroeconomics and Financial Situation of Nepal’, conducted by the economic research department of Nepal Rastriya Bank (NRB), reports that the Balance of Payments (BOP) remained at a shortfall of Rs.258.64 billion (USD 2.17 billion) in the survey period, against an overflow of Rs. 68.01 billion (USD 565.8 billion) in a similar time period of the earlier year. Furthermore, it states that the export-to-import ratio increased by 11.3 percent from 8.6 percent along with the increase in the total trade deficit. Payments made to organizations abroad for imports were not counterbalanced by profit made through trade. Consequently, this prompted a lack of liquidity. This suggests that Nepal over the past year has excessively inclined towards importing goods, which is evident with the discrepancy between export and import. The effect of a trade deficit in a developing nation like Nepal, which is not self-sufficient, impacts the economy negatively, leading to inflation and a decrease in GDP.
Remittances, Exchange Rates, and Foreign Exchange Reserves
Based on the survey by NRB, the foreign exchange reserve decreased by 16.3. That could have been due to inflation, balance of payment, trade deficit, government instability, or interest rates. It is difficult to track down one particular factor, but rather it is the amalgamation of all these factors in the case of Nepal, with a decrease of 2.63 percent in the Nepali currency. Nepal imposed curbs on certain luxury imports with the aim of preserving the foreign exchange reserve.
Remittance is another integral external sector that helps in acquiring foreign exchange money, increases the purchasing power of individuals, and has its fair share of contribution towards the growth of the nation’s GDP. Nepal, even with its labor agreement with many countries and with an increase in the number of workers recruited to different nations, still faces a decrease in remittance flow. The steady drop in remittance inflows could be due to the COVID-19 restrictions and policies. The economy’s being highly dependent on remittances has negatively affected the economy as the funds from the remittance would allow mobility of cash inflows and ease the liquidity situation.
What’s Next?
The increase in imports over the years has been alarming. The amount of foreign currency getting out of the nation is raising concerns about an emergency. The nation might be heading towards Sri Lanka’s economic condition as it faces an increase in import/export imbalance, a deficit in the balance of payment, and diminishing remittance inflows and foreign exchange reserves. Along with the Russia-Ukraine war, the prices of products have increased, precipitating inflation. The government has taken steps to decrease the wide ratio of export and import; the import of a wide range of ready-made alcohol, ready-made cigarettes and tobacco items, and bites like Lay’s potato chips and Kurkure, has been restricted along with other luxury items. The government has made it mandatory for traders to maintain a 100 percent margin when opening a letter of credit to import certain products in order to reduce the import of minor non-essential items. The government should maintain policy measures to help resolve fiscal imbalances, increase spending efficiency, stimulate private sector development, and bring the impact of the epidemic and liquidity crisis on the financial sector into sharper focus to help limit adverse risks.
Soniya Gautam is a Research Intern at NIICE.
