Praying for a 'happy accident'
by: Bhim Prasad Bhurtel
None of the economic theories work in Nepal
The Nepali economy has been somewhat jittery in recent months. There has been a liquidity crunch for the past five months while inflation has been tormenting the public for the past 18 months. The Balance of Payment (BoP) deficit reached Rs 20 billion due to diminishing growth rate in remittance inflow caused by global financial meltdown and deteriorating exports and escalating imports in the first quarter of fiscal year 2009/10. Foreign trade deficit reached nearly Rs 100 billion and export-import ratio soared to 84:16. The symptoms indicate that the economy is headed for a serious crisis.
The government recently formed a taskforce headed by the National Planning Commission’s vice chairman to formulate counter policy measures to mitigate possible crisis. Nepal Rastra Bank (NRB) issued a new directive to commercial banks and financial institutions to fix a ceiling on real estate and housing lending to prevent possible financial systemic failure. NRB is also mulling to hike up interest rates. Meanwhile, controversies are rising over NRB’s directive to forestall up-and-coming systemic failure of the financial system. Some of the economists believe that NRB took a hasty decision and it will directly affect the growing housing and real estate sector in the short run and the whole banking and financial system eventually. Whatever may be the arguments, it is apparent that the real estate and housing bubble will create problems in the economy in the future.
Although I am not a fan of Lucacian rational expectation hypothesis, it is worth reflecting upon the theory. The hypothesis is one of the important monetary economic theories and was developed by Nobel Laureate Robert Lucas in the aftermath of the oil crisis of the 1970s. The major argument of the hypothesis is that monetary policy never works. I doubt whether NRB’s directive will help prevent a possible financial system collapse.
First, our economy has been perennially experiencing low growth. The incentives to make business investments are very limited in the real sector as the economies of scale do not work in an entrepreneur’s favor due to the limited size of our economy. Our market is in no position to compete with the huge markets of India and China. Political instability and uncertainties also contribute in limiting private sector investment in the real sector. Investment in infrastructure such as hydropower, highways and railways are a few possible alternatives but policy ambiguity, long gestation period, uncertainties and risks due to economic and non-economic factors act as retarding factors.
The major argument of the Lucacian hypothesis is that monetary policy never works. I doubt whether NRB’s directive will help prevent a possible financial system collapse.Besides, our economy is suffering from supply deficiency due to various bottlenecks. The counter policy measures of demand-deficient economy may not work in a supply-deficient economy. Economic stimulus ignites the economy at times of effective demand deficiency. However, our case is totally different when compared to others because of supply deficiency, liquidity crunch with high inflation and BoP deficits.
Second, the main factor for an increase in investments on real estate and housing are availability of easy and cheap bank loans due to inward remittances and the lack of real sector investment incentives and opportunities. So, remittance is one of the key factors leading to asset price bubble in real estate and housing. Our remittance is almost the size of our budget contributing to maintain gross national consumption and maintain BoP. Due to the lack of investment incentives and innovations in diversifying the portfolio management in real and productive sectors, the main share of remittance is spent on consumption. Remittance is substantially contributing to the mushrooming of the banking and financial institutions. Banks and financial institutions’ portfolio on real estate and housing has reached Rs 114 billion, which is 12 percent of gross domestic product of our country. The cooperative sector’s portfolio on the same is nearly Rs 35 billion.
Third, donors and INGOs are spending a substantial amount of money in Nepal. A total of Rs 12 billion has been spent to support the constitution-drafting process. Similarly, donors and I/NGOs have been investing a huge amount of money in other development sectors. A remarkable portion of their spending goes in the form of salaries of Nepali staff, which is spent partly on consumption and the rest on investment on real estate and housing.
Fourth, cooperatives such as Oriental, Guna and Kantipur are as huge as commercial banks in terms of their asset and liabilities, according to a recent remark of the NRB governor. They are not regulated by NRB. Their portfolio is huge on the real estate sector. They will continuously invest in real estate and housing in the future and it will nullify the effects of the policy measures that NRB has come up with.
Fifth, the open border with India causes problems in money and capital market and BoP. Imports are paid through the banking system. Conversely, more than 40 percent exports to India are done through smuggling causing extreme pressure on our BoP. The underground capital flight also deteriorates BoP.
Lastly, our investors’ behavior is irrational. Provincial capitals will be established in certain areas after we delineate federal units which will lead to a rise in real estate prices by another 300-400 percent because people will rush to invest in these capitals.
What are the solutions?
First of all, to monitor the financial and banking system and keep it away from danger, an Early Warning System should be formulated in coordination with the Ministry of Finance, NRB and the association of banking and financial institutions. Second, fiscal measures in coordinating monetary measures should be applied. Tax and non-tax measures should be applied to control the real estate asset pricing bubble. Similarly, remittance should be channeled to productive sectors, Diaspora Bond should be issued to raise funds for ambitious infrastructure projects, which also could increase employment. Third, monetary measures should put a ceiling on real estate and housing lending and interest rates.
Likewise, monetary and capital market legislations and policy should be simplified to attract development investment. Fourth, real sector development incentives should be given to private sector investment through fiscal measures such as subsidies and tax exemptions. The political and security situation must also be improved. Fifth, the market should be monitored and smuggling and underground businesses should be controlled. Sixth, necessary legislation and guidelines should be formulated in giving mandate to NRB for regulation of cooperative sector. Seventh, national economic integration should be done by removing the supply side bottlenecks. The policy should concentrate to expand the supply side and to eliminate economic repression and market imperfections.
Last but not least, the present situation definitely demands policy-based precautionary measures and bold steps. However, they must not overlap each other. One policy measure to solve a problem should not augment another problem in the economy. For example, solving liquidity crunch should not create a problem of toxic mortgage. I may sound cynical but I believe that even such policy measures might not work well because none of economic laws are applicable in the Nepali economy. I think, as Lucas thought, if policies work here, that will simply be a happy accident.