This is a shorter and a more refined version of an earlier piece and is now submitted to Nepalnews' Guest Column. Not sure if it will get published. 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 and commentators have lent their opinion on the issue, but in my view, they seem to engender more confusion than clarity. The reason being that discrete economic concepts are used inter-changeably. Is Nepal suffering from liquidity crisis or from shortage of currency or from balance of payment crisis? They are all NOT the same. Let’s look at each and then figure out what's ailing Nepal.
Liquidity Crisis
In macroeconomics, the definition of liquidity goes beyond simple coins and notes. It includes broader credit instruments that grease the wheels of the economy. In strictly technical terms, coins and notes are also liabilities but of the Central Bank. Shortage of currency alone does not bring about liquidity crisis. For liquidity crisis to occur, 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 spread, the global benchmark of credit risk. A corporate analogy might make it 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 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 is only possible if the business is trusted by its counter- parties. If not, it will face liquidity crisis and go into bankruptcy.
Nepal is not experiencing liquidity crisis. Credit is still flowing through the system. Moreover banks are 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 depends on three factors; economic activity, price levels and velocity (how fast currency is re-cycled through the system). A rise in economic activity or price levels requires more currency. On the other hand, rise in velocity requires less. A sudden jump in economic activity or price levels or a sudden fall in velocity could cause currency demand to go up.
In most countries including Nepal, economic activity and price levels do not change suddenly or unexpectedly. Comments made about hoarding of currency because of Voluntary Disclosure of Income Scheme (VDIS) or to speculate on real estate suggest that velocity might have unexpectedly gone down but I doubt that to be the case for several reasons,
(a) it does not make economic sense in Nepal to hoard currency because of high inflation - cash under mattress is losing more than 10 percent of value every year.
(b) in financially under-developed country like Nepal, currency not credit is the main means of business transaction. As such, most of the currency in circulation in Nepal is already in the hands of public – Rs. 125 billion or almost 90 percent compared to less than 25 percent in the US.
(c) currency held by public has grown at a fairly steady rate since 2004. Although there have been intermittent jumps and falls they are nothing out of the ordinary.
(d) when NRB injected Rs 20-25 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 better 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 either through attracting foreign investment (FDI or portfolio investment) or through borrowing 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) 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.
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, and the surplus accumulates in NRB’s balance sheet. Foreign currency in NRB’s coffer has been growing steadily in tune of Rs 219 billion by Q3 2008-09. Remittance money converted to NRs goes into the banking system (as deposits) and increases the general money supply UNLESS NRB STERILIZES it but NRB does not seem to have done that. As such, money stock as measured by M1/M2 has been growing rapidly, at 20%+ since July 2008.CuA surplus turned to deficit in Q1 2009-10 (Jul'09 - Sep'09). This meant deposit growth stopped suddenly but banks were still making loans especially in the real estate sector resulting in an imbalance in money coming in (deposits) and going out (investments). The problem was further exasperated by NRB’s directives to banks and cooperative late in 2009 to (a) increase deposits ratio (b) lower loan-to-value ratio on real estate lending. Banks faced serious mis-match in assets (investments) and liabilities (deposits) side of their balance sheets which forced them to (a) raise interest rates on deposits to attract and retain them (b) turn to NRB, the lender of last resort.
NRB was happy to oblige because it can create money out of thin air; it has 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. 20-25 billion into the banking system. Incidentally, this amount equaled the amount of CuA deficit. News reports are not clear about how NRB did it, but going by conventional Central Bank practices, NRB likely increased banks' reserves at NRB (debit) - which banks can withdraw to fund deposits - and offset that with the creation of Treasuries (credit) (reports in the media about Treasury auctions and repos do not make sense because those activities withdraw NOT provide liquidity).
Conclusion
Interest rates (inter-bank and on deposits) rose to record heights in Nepal but that is not a reflection of liquidity crisis or shortage of currency. Rather it is a result of sudden increase in demand for deposits due to mis-match in assets and liabilities at financial institutions. The prescription for the problem is quite simple. NRB must pressure banks to reduce their enlarged balance sheets before assets/liabilities mis-match turns into a genuine liquidity crisis.
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