Understanding the Liquidity Crisis in Nepal

Commentary by NepaliEconomy.com
By NepaliEconomy.com

The so-called "liquidity crisis" in Nepal has been hogging news headlines since last summer and the situation seems to be getting worse. Several policymakers, commentators and editors have lent their opinion on the issue but there seems to be no definitively convincing one.

NepaliEconomy.com will analyze the facts and will try to give a more comprehensive understanding of the issue. After doing so, it came with the following conclusions,
(a) Nepal does not suffer from liquidity crisis.
(b) Nepal also does not suffer from lack notes and coins.
(c) Nepal seems to have Current Account deficit which is causing slowdown in growth in money supply (M1 and M2). This seems to be an unexpected event because banks seem unprepared for it. While their loan growth is growing briskly, deposits are not because remittance money has stopped. They had to ask Nepal Rastra Bank (NRB), the lender of last resort, to replenish their coffer.
(d) NRB has injected Rs. 20 billion into the banking system but this is a stop-gap measure. This crisis shows that there are structural problems in the country, which easy money from abroad in the form of remittances has concealed namely (i) mis-management of monetary policy (it seems that remittances have been not be sterilized effectively) (ii) free-wheeling banking system (iii) unrealistically strong NRs which is causing trade deficit to persist especially with India.

What has been said thus far?
In one of the first commentaries on the issue, Mr. Achyut Wagle (Cash Crunch , 22 May 2009) defined liquidity crisis as the shortage of higher denomination Rs 500 and Rs 1,000 notes (make up more than 90 per cent of about Rs 137 billion in circulation) going off the market because of (a) Voluntary Disclosure of Income Scheme (VDIS) and (b) over-subscription of IPOs.

A December 17 2009 article in Kantipur citing government sources gave several reasons for the liquidity crisis (which it did not define but can be surmised as shortage of cash) (a) lending to unproductive sectors (b) money going to India (c) delay in budget endorsement (d) diminishing remittances. An editorial in Republica on 26 December 2009 defined liquidity crisis as shortage of cash (again) and blamed that on trade imbalance. Interestingly at a seminar organized by NepaliTimes on December 30 2009, the bankers and government officials gathered there avoided making reference to shortage of cash; rather they dwelled on fancier topics like repos and treasury auctions. Some of the reasons given for the crisis included (a) trade imbalance (b) diminishing remittances and (c) over-investment, and the solution to be treasury bill auction.

On January 10 2010 Deputy Governor of Nepal Rastra Bank (NBR) and a short-listed candidate for NRB Governor Mr. Bir Bikram Rayamajhi gave 3 reasons for liquidity crisis (a) political instability (b) ATM machines (c) over-investment. In a column on 15 January 2010 Artha Beed (aka Sujeev Shakya) defined liquidity crisis as shortage of cash, which resulted from (a) inability of NRB to print notes on time and (b) mushrooming cooperatives for wanton lending and for causing notes to vanish from the system.

NepaliEconomy.com does not find any of the aforementioned comments particularly insightful in explaining the crisis because discrete issues are confusingly used inter-changeably. Is Nepal suffering from liquidity crisis or from shortage of currency or from balance of payment crisis? They are NOT all the same. Lets look at each of the concepts first and then figure out what's ailing Nepal.

Liquidity Crisis
In macroeconomics (and in economics in general), the definition of liquidity goes beyond simple coins and notes. It includes broader credit instruments (along with business sentiment or animal spirit that drives them) that grease the wheel of the economy. In strictly technical terms, coins and currencies are also liabilities but liabilities of the Central Bank. Shortage of cash does not bring about liquidity crisis. For liquidity crisis to occur, the credit system of the country must be broken because of mis-trust amongst counter-parties. It happened in the US and Europe in late 2008 following the collapse of Lehman Brothers and AIG which led to an explosion in EuroDollar spreads, the global benchmark of credit risk (there are other metrix also like OIS Spreads). A corporate analogy might make it more clearer. Just because a business does not have cash to pay for employees or vendors does not mean that it has liquidity problem; the owner of the business can easily go to a bank or to another creditor to get the money, or he/she might just issue IOUs to his/her employees and vendors. That can only happen if the business is trusted by its counter- parties. If not, it will have a liquidity problem and go into bankruptcy.

NepaliEconomy.com argues that Nepal is not experiencing liquidity crisis. Credit is still flowing through the system because credit-sensitive sectors like real estate and autos are still going strong (at least based on news reports). Moreover banks are still doing brisk business. There are no stories of a bank run in Nepal.

Shortage of Currency
The amount of currency (coins and notes) needed in an economy is a function of three factors; economic activity, price levels and velocity (how fast money is re-cycled through the system). A rise in economic activity or price levels requires more money. On the other hand, rise in velocity requires less money. A sudden jump in economic activity or price levels or a sudden fall in velocity could cause money demand to go up.

In most countries including Nepal, economic activity and inflation do not change suddenly or unexpectedly. Comments made by Nepali columnists/editors about hoarding of money because of VIDS or to speculate on real estate suggest that velocity might have unexpectedly gone down but NepaliEconomy.com doubts the validity of those arguments for these reasons,

(a) it does not make economic sense in Nepal to hoard money because of high inflation - cash under mattress is losing about 10 percent value every year.

(b) in financially under-developed country like Nepal, most of the money in circulation are already in the hands of public. Of Rs 137 billion in circulation, Rs 125 billion is held by public and $12 billion by banks i.e. almost 90% of currency circulation is with public compared to less than 25% in the US. Likewise currency circulation makes up 16% of GDP of Nepal compared to only 6% of the US.

(c) cash and notes in Nepal's commercial banks has been rising steadily. The latest data shows they have about Rs 12 billion or 1.3% of GDP. In December 2007 it was only Rs 7 billion or 1.0% of GDP.

(d) when NRB injected Rs 20 billion into the banking system, it did not put that amount of coins and notes into banks' vaults; instead it just credited banks' accounts at NRB - it is an accounting exercise. Moreover, NRB does not have coins and notes in its vaults because all the notes and coins outstanding in the country belong to NRB. To say NRB's interventions helped deal with currency shortage makes absolutely no sense.

Balance of Payment Crisis (BoP)
Balance of Payment (BoP) tracks the amount of money going out of the country called "debit" (paying for imports of goods and services, repatriation of income by foreigners and purchase of foreign assets) and coming into the country called "credit" (getting paid for exports of goods and services, income from foreign assets, foreign aid, remittances and selling of foreign assets or domestic assets to foreigners). In economic parlance, debit must equal credit or Balance of Payment must balance but how it does is the more important question.

To answer the "how question", it is important to look at BoP from "flow" and "stock" prospective. The flow part of BoP is called Current Account (CuA). It includes money flows due to trade, income from foreign assets and unilateral transfers (remittances and foreign aid). The "stock" part of BoP is called Capital Account (CaA). It includes transfer of money due purchases and sales of assets which can be divided into financial and non-financial assets, and government and non-government assets.

Nepal must run CuA surplus because it does not have the wherewithal or the resources to finance deficit - no foreigner in the right mind will invest in Nepal (either through FDI or through portfolio investment) and Nepal does not have credibility to borrow in the international debt market. Fortunately for Nepal, it has been running CuA surplus on the back of strong remittances. The latest data from NRB website for Q3 2008-09 (Jan'09-Mar'09 period) shows Rs 18 billion CuA surplus made up of Rs 50 billion trade deficit, Rs 4 billion net foreign income (from foreign assets) and Rs 64 billion transfer of which Rs 56 billion was remittances. But apparently that surplus has turned into deficit in the first 4 months of this fiscal year (Jul'09-Sep'09) in the tune of Rs 20 billion on the back of slowing remittances and rising trade deficit (this data is unfortunately not available on NRB website).

Remittances come to Nepal in foreign currencies and NRB converts them to NRs. Foreign currency earned this way is used to pay for imports of goods and services. Since Nepal has been running CuA surplus, foreign currencies have been accumulating in NRB's coffers in tune of Rs 219 billion by Q3 2008-09. The remittance money converted to NRs goes into the banking system (as deposits) and increases the general money supply UNLESS NRB sterilizes it, but that seem not to be the case. As such, money stock as measured by M1 and M2 has been growing rapidly, at 20%+ since July 2008 - that could one of the causes of 10%+ annual inflation in Nepal.

CuA surplus turned to deficit due to slowing remittances and rising trade deficit in Q1 2009-10 (Jul'09 - Sep'09) and this must have come as a total surprise to policymakers and bankers. This caused a sudden stop in deposit growth but since banks were still making loans aggressively especially in the real estate sector there was imbalance in money coming in and going out. Suddenly bankers found out that there was a mis-match in their assets and liability side of the balance sheet. That's when they had to turn to NRB, the lender of last resort, for help to soar up their deposit base.

NRB can create money out of thin air because they have the legal monopoly to do so. A person or a business can only write checks (debit) against their deposits (credit) at a bank. Even a bank can only write checks against its reserve balance at NRB but NRB can write checks to itself. In doing so, it creates money. NRB has injected Rs. 20 billion into the banking system. Incidentally, this amount equals the amount of CuA deficit. News reports are not clear about how NRB injected that money, but NRB likely increased banks' reserves at NRB (debit) - which banks can withdraw to fund deposits - and offset that with the creation of Treasuries (credit) - yes, central banks can create Treasuries out of thin air and that's called writing checks to itself (reports in the media about Treasury auctions and repos do not make sense because those activities withdraw NOT provide liquidity).

Conclusion
Without having access to the latest economic/financial data NepaliEconomy.com concludes the following,

(a) Nepal does not suffer from liquidity crisis.
(b) Nepal also does not suffer from lack notes and coins.
(c) Nepal seems to have Current Account deficit which is causing slowdown in growth in money supply (M1 and M2). This seems to be an unexpected event because banks seem unprepared for it. While their loan growth is growing briskly, deposits are not because remittance money has stopped. They had to ask Nepal Rastra Bank (NRB), the lender of last resort, to replenish their coffer.
(d) NRB has injected Rs. 20 billion into the banking system but this is a stop-gap measure. This crisis shows that there are structural problems in the country, which easy money from abroad in the form of remittances has concealed namely (i) mis-management of monetary policy (it seems that remittances have been not be sterilized effectively) (ii) free-wheeling banking system (iii) unrealistically strong NRs which is causing trade deficit to persist especially with India.