Fine-tuning our finances

Fine-tuning our finances
The KTP, 27-Oct-10
Rewat Bahadur Karki

Since the middle of 1980’s, Nepal, as a part of its partial liberalisation policy, started opening up its banking/financial sector (FS). Following the restoration of democratic system in 1990, a more reform-oriented policy of financial liberalisation was adopted. Since then the Nepali financial sector has witnessed rapid development. Up until 1985, there were only eight banks and financial institutions (BFIs), comprising two commercial banks, two development banks and four other financial institutions. This number went up to 15 in 1990 and after that it has steadily increased, reaching 292 by mid-July in 2010. Of the total, 263 BFIs including 27 commercial banks, 79 development banks, 79 finance companies and 18 microfinance banks are regulated by Nepal Rastra Bank (NRB), while 29 financial institutions including 25 insurance companies are regulated by the Insurance Committee, the Securities Board and the government. In recent years, ratio of total BFI assets to gross domestic product (GDP) has exceeded more than 120 percent while total deposits and credit to GDP ratio too has increased accordingly.

Nevertheless, such a high concentration of BFIs in a small economy with a GDP of Rs. 1,200 billion poses a major threat to financial stability. This is so because most of the money is now in non-productive sectors including real estate, accounting and auditing systems are weak and unreliable, the supervisory capacity of NRB has been undermined and the much-vaunted financial sector reform (FSR) has been clouded in uncertainties. Thus, crafting a stable, modern and reliable financial sector is a major challenge. But there are steps that can be taken to strengthen the sector. The first of the four steps I propose is merger and acquisition, or, in other words, unification of most BFIs, so that the number of BFIs is manageable and the financial sector is strong. Although NRB has for the

last couple of years talked up this option frequently while announcing its monetary policy, virtually no progress has been done on this front. A separate merger and acquisition act providing special tax breaks and other benefits has to be brought into effect, as in Malaysia and the Philippines in the 1990’s, where merger and acquisition policies were quite effective in bringing down and consolidating the number of commercial banks.

The process of financial sector reform in two major public banks—the Nepal Bank Limited and the Rastriya Banijya Bank—including restructuring of NRB and capacity enhancement of financial sector started in 2002. But the process has been halted as NRB cancelled the appointment process of CEOs of these two banks. Due to this cancellation, DFID and the World Bank, which were providing technical and financial support from the very beginning of FSR, have withdrawn their support from this process. These two banks are now being run on an ad hoc basis. In order to restructure or privatise the banks, the appointment of bank restructuring advisor is crucial, but the process has already been delayed. The reform process of these banks which have an important role in the Nepali economy has to be expedited without delay. In order to consolidate the progress made by these banks so far and further the reform process, it is important that they be studied and evaluated by international audit firms. Similarly, undue political interference and appointment of non-professionals in the BFIs has to stop for smooth functioning of the financial sector. This is my second suggestion.

My third suggestion is strengthening the accounting and auditing standards of BFIs. Although attempts have been made to improve BFI accounting and auditing standards, these have not met international standards and reliability mainly due to weak supervisory capacity of NRB and ineffectiveness of the government accounting and auditing boards. Questions are frequently raised about the reliability of financial and disclosure statements of BFIs. Strengthening these standards is a must to restore the credibility of the banks and financial institutions. The current system which deputes the same auditors to the BFIs for three consecutive years has rendered this system weak and unreliable. Discontinuity of year-on-year auditing by the same auditor will help issuance of real and reliable auditing reports. In order to enact this reform, the auditing and accounting boards have to be strengthened and their supervisory capacity enhanced.

My fourth suggestion concerns the supervisory capacity of NRB. The number of BFIs has increased tremendously but as the supervisory capacity of the central bank has not been enhanced accordingly. Along with the other major functions of central bank such as regulating the BFIs, managing foreign exchange and domestic currency, and advising the government, NRB’s supervisory role has also been given special importance but this role has been rather politicised too. The two supervisory departments of NRB have been rendered virtually ineffective because of frequently transfers of officials and excessive politicisation. Hence, it would be wise to set up a financial supervisory authority (FSA) including these two supervisory departments, following in the footsteps of countries like South Korea, UK, Sweden and other Scandinavian countries. As this body would specialise on supervision, there would be proper check and balance as regulatory and supervisory institutions will be separate and independent .The poorly supervised large government institutions like Employee Provident Fund and Citizen Investment Trust then can be surpervised by the FSA.

Urgent attention is needed be strengthen the financial sector through merger and acquisition, speeding up the financial sector reform, standardisation of auditing, and establishment of an independent supervisory authority. This approach will ultimately strengthen and stabilise the financial sector in particular and the economy in general.

Karki is former economic advisor to IMF and NRB as well as ex-CEO of Nepal Stock Exchange

The Neocolonial Path to Power

The Neocolonial Path to Power
Himal Southsian, August 2010
By: Dipak Gyawali

Nepal’s strategy of developing its power sector based on capacity-building to meet the needs of its own commerce and industry is far from perfect, but it is a better long-term bet than Bhutan’s much-touted model.

Many Nepalis would be shocked to hear that Bhutan will face load-shedding from the coming winter. The citizens of Nepal have, after all, been told for decades that Bhutan has done a great job of developing hydroelectricity, that it has earned significant money by exporting electricity to India, and thus it has been able to achieve the highest per capita income in Southasia. Conversely, Nepal has been ridiculed for wallowing in ‘empty nationalism’ and stirring ‘needless’ controversies over the Mahakali Treaty of 1996 (for water sharing on the Mahakali River) as well as hydropower projects such as the West Seti, both of which involve export of electricity to India.

The socialist and communist leaders of Nepal, seemingly suffering from a sense of moral and intellectual inferiority, have been unable to give a fitting reply from the standpoint of their ideologies. Such a reply would need to point out that it is questionable whether a development path that requires relinquishing defence and foreign policy to a foreign power is beneficial for the country in the long term. Party intellectuals advising politicians and political parties who only see revenue inflow and ignore vital diplomatic and strategic issues are in truth unwittingly pleading to be colonised. Nepal’s chronic load-shedding problem should then come as no surprise when these ‘Brahmins behind the throne’ fail to see the political economy hidden behind the load-shedding that is imminent in Bhutan.

At first glance, Bhutan certainly appears to have achieved better hydropower development than its Himalayan neighbour. Three times smaller in landmass and with a population one-fiftieth of Nepal’s, the current generating capacity of Bhutan (at 1488 megawatts) is twice that of Nepal. The Punatsangchhu-I hydro plant, under construction with a 60 percent grant and 40 percent soft loan from India, will add another 1020 MW by 2016. Such cheap development capital means that Bhutanese consumers pay a mere INR 1.30 per unit of electricity, allowing them to cook food and heat homes with electricity. Currently, about 70 percent of the 123,000 households in Bhutan have access to electricity, and by 2013 the entire country is expected to be electrified.

In comparison to Nepal, these would be considered significant achievements. And so, one may well ask, if these are the facts, why is the Bhutanese model wrong? And, incidentally, how is it that the country is on the threshold of load-shedding? Though Bhutan has twice the electricity-generation capacity of Nepal, around 80 percent of its electricity is exported to India, leaving only about 300 MW for consumption in Bhutan. Of this, only 80 MW is for domestic use, while the rest goes to southern Bhutan to be consumed by various Indian-owned industries, such as cement factories, lured here by the availability of cheap electricity. Subsidised electricity has led to booming demand, which grew by 19 percent from 2007 to 2008, increasing a further 27 percent in 2009 and 54 percent in 2010. As a result, Bhutan will be compelled to reduce its consumption by around 25 MW via load-shedding this coming dry season, worsening as demand continues to escalate till 2016, when Punatsangchhu-I comes online.

Innovative hydrocrats
This five-year load-shedding scenario is a planning failure born of a faulty political economy. But Bhutan’s supply problems are mild, unlike Nepal’s chronic power crisis precipitated by its unstable politics. While no magic wand can make electricity shortages disappear, Bhutan has already begun to take appropriate corrective measures. Importing electricity from India remains an option, but it is an expensive one, as Thimphu will have to import power at almost twice the rate at which it exports. India, despite its close friendship with Bhutan, cannot provide cheap power to its smaller neighbour due to its own 10,000 MW electricity shortage in the grid of North India, a fact not understood by today’s Nepali politicians.

The search for demand-side management options has led to other alternatives to Bhutan’s load-shedding problem: biogas for cooking and solar panels to heat water to reduce power consumption during peak hours every day. Economic incentives are being looked at to encourage industries to develop their own captive hydropower. Another option would be to build ‘pump storage’ schemes below existing power plants, which would pump water up to reservoirs during the night for use during next day’s peak time. Bhutan has also put forth the idea of an ‘energy bank’, whereby it would store surplus power generated during the rainy season in India, dipping into this ‘account’ in the dry months. Such a system of ‘energy barter’ would be far cheaper for Bhutan than direct purchase, and Thimphu is already in negotiations on this issue with New Delhi. Nepal’s Water and Energy Commission likewise initiated a policy of energy barter in 1992, but the mirage of the Mahakali and political infighting has left such innovative thinking in limbo.

Exploring new power policies beyond the straitjacket imposed by hegemonic Indian plans, Bhutan’s hydrocrats have initiated medium-sized plants more suited to Bhutan’s economy. The 126 MW Dagachu and the 208 MW Nikhachu schemes are being developed using a public-private partnership model supported by the Kyoto Protocol’s Clean Development Mechanism, which has come about in the wake of international concerns over global climate change. Recent changes in water policy require all power exporters to give 15 percent of their energy free to the Bhutanese grid as royalty. Such changes demonstrate the evolving Bhutanese understanding that an export-oriented policy alone does not strengthen a country’s energy security. Yet while there is immense potential to develop small- and medium-sized hydropower schemes, agreements with India preclude this option on cost grounds. Consequently, rather than ending load-shedding in two years, Bhutan has been compelled to wait until 2016 to achieve this goal.

As in Nepal, vagaries of the weather possibly related to climate change have led to severe winter droughts in recent years, and Bhutan’s rivers have been drying out significantly from January to May. Since the country only has ‘run-of-the-river’ hydropower plants, without monsoon water stored in reservoirs, they do not produce more than a third of their installed capacity in the dry season. If reservoirs are built that store the monsoon flow, more power can be generated in the dry season when the capacity of run-of-river plants has drastically reduced production. But, as is also the case in Nepal, Bhutan has limited locations on which small- and medium-storage hydropower plants can be built, and the locations that do exist might not be economically viable due to rapid reservoir sedimentation. Also, large reservoirs permanently flood fertile and populated valleys, and Thimphu seems reluctant to go this route. The feasibility study of the 4000 MW Sunkhosh is now complete, but Bhutanese officials do not seem interested to push it. During a recent four-day stay in Thimphu, this writer heard a uniform refrain from many officials: We cannot be confrontationists like you Nepalis – but inundation projects are our last priority, to be done only if the pressure from India becomes too strong to resist.

Slow, small but sure
A multipurpose hydroelectric storage project is similar to a factory that produces multiple goods. If the costs incurred in the construction of the factory, including the loan and interest repayment, are included in the price of just a single item, it will yield little profit, and could even fail to sell in a competitive market. Furthermore, if other goods produced are then distributed free of cost, there is likely to be disagreement and infighting between the various consumers. Besides electricity, storage dams provide flood control, irrigation, fisheries, navigation and tourism, from which different economic actors benefit in varying degrees. As Nepal (and India) has not built any significant multipurpose project, its policymakers have no idea how these benefits can be allocated in an equitable manner, nor how the political, economic, social and environmental issues need sorting out.

Thimphu, on the other hand, seems more aware of these concerns. It has taken a position in its talks with New Delhi that at least 50 percent of the benefits of a storage dam are in areas outside the electricity sector, which must be accounted for.

For example, the regulated water released in the dry season would lead to massive agricultural expansion in the plains, and flood-control benefits would result when the summer peak flood is lopped off to be stored in the reservoirs. As Bhutan does not have any Tarai plains, it is the downstream riparian areas that will reap the non-power benefits from reservoir projects in upstream Bhutan. New Delhi hopes to capture these valuable benefits from regulated water released from storage reservoirs in the dry season and, through its river-linking plan, to transport such waters to the dry western part of the country. This would also ensure that Bangladesh does not become a ‘free rider’ beneficiary, benefiting from the regulated dry season flow coming from Bhutanese dams. While the Bhutanese model of developing its hydropower for export in return for royalties might have been profitable in earlier years, it is today creating more problems than benefits.

The export-oriented path that Bhutan has taken cannot be an option for Nepal, unless it forsakes its independent foreign and defence policies. From a political-economic perspective, the Bhutanese model is one of neocolonial resource extraction. If the much ballyhooed ‘new Nepal’ were to adopt a similar policy, it would be tantamount to its political masters admitting their incapacity to develop Nepal as a self-reliant and independent economy. Growth in hydroelectricity production cannot be the sole standard by which to measure success. After all, a plantation economy using slave labour can produce more efficiently than an independent economy crawling along the path of capacity development. A rent-seeking, royalty-earning model might enrich governments, politicians and senior bureaucrats for some time, much like the Arab sheikhdoms, but it does nothing to develop national capacity – which is what development is, in the true sense.

Even though Nepal’s demand for electricity currently far outstrips supply, the development of small and medium hydropower plants over the last three decades has led to significant ‘upstream-downstream’ sector capacity built in the economy. Despite state indifference due to the Nepali hydrocracy’s infatuation with foreign aid, the survey, design, geo-technical engineering, contracting, construction and some equipment manufacture and maintenance are now done by Nepalis in small factories and consultancy services, for projects from a few hundred kilowatts to some 20 MW. The importance of such capacity is evident from the fact that Bhutanese power managers, during visits to the Bhutanese gomba (monastery) located in the Boudha area of Kathmandu, also take the opportunity to visit nearby factories to procure services for plant maintenance in Bhutan. The biggest complaint of Bhutanese officials, on the other hand, is that their contractors, rather than working to build national capabilities in these areas, only serve as rent-seeking middlemen for Indian contractors, thus defeating the commendable government policy of ‘Bhutanisation’.

In Nepal, the hydropower sector is soon to test its political leadership, with a new electricity bill pending in Parliament. If passed as drafted, the Electricity Act would reward exporters of electricity with tax breaks but would penalise those developing hydropower for Nepali consumption. This would push Nepal inexorably towards a neocolonial political economy similar to that of Bhutan’s, and away from the slow but self-reliant development path pursued so far. Fortunately, thanks to the activism shown by members of the National Association of Community Electricity Users Nepal (NACEUN), members of Parliament from across the political spectrum have tabled 142 fundamental amendments that would re-define the Act towards a self-reliant, ‘national capacity enhancement’ model. We may not have to wait too long to see which historic path the country will take, the Bhutanese or the Nepali.

Mr. Gyawali was Nepal’s Minister for Water Resources during 2002-03.