Credit Boom Gone Bust
It has been more than two years since the Nepalese economy has
faced unique challenges, as macroeconomic indicators such as inflation,
liquidity, interest rates, foreign exchange position, balance of payments, remittance inflow, and tourist arrivals are all supportive of economic growth. Still, the aggregate
economic activities remain sluggish with subdued domestic demand and lending
from the banking system, growing pressure on the government's fiscal position,
increasing youth out-migration, and growing pessimism in almost every sector of
the country. The inability of the government to make timely and effective
capital spending can be attributed to this economic slowdown, as it has, over
the period, remained the major issue concerning the economic growth of Nepal. However,
the current economic situation has exposed the results of the unregulated and
ineffective credit policy previously adopted by the central bank to a larger
extent.
In recent years, the credit to the private sector from the
banking and financial institutions of Nepal has reached about 95 percent of the
country's GDP, the highest among South Asian countries. The private sector
seems to be over-indebted, taking into account the credit disbursed by other
non-banking financial institutions as well. The credit to the private sector has
been growing with an average annual growth rate of 20 percent until the
outbreak of the COVID-19 pandemic in FY 2019/20 due to a series of expansionary
monetary policies adopted by the NRB. During and after the pandemic, NRB
responded to the crisis with an accommodative monetary policy that involved
unconventional policy measures, such as refinance facilities with flexible loan
restructuring and rescheduling programs, along with conventional policy measures, such as interest rate cuts and easing regulations. This has amplified the credit boom and
facilitated the economic recovery, as in two subsequent years the economy
expanded by 4.8 percent in FY 2020/21 and 5.6 percent in FY 2021/22, with the
growth of private sector credit of 26.3 and 13.3 percent, respectively.
However, the rapid expansion of credit led to the overheating of the stock
market and real estate bubbles, increased imports (which reached 45 percent of the
GDP in FY 2021/22), pressured the balance of payment, and the forex reserve was
depleted. In response, NRB made a policy reversal in FY 2022/23 with decisive
actions in monetary policy measures, asset classification, banking regulation,
and lending practices, with a gradual phase-out of unconventional policy
measures to curb credit growth and alleviate external sector pressure. Since
then, the vulnerabilities of the Nepalese economic and financial system have
been exposed, resulting in low credit demand, economic slowdown, declining
volume of trade, depletion of government revenue, downturn in the real
estate market, and growing serious problems in the financial system with
increasing cases of credit default, increased non-performing loans, and
increasing cases of fraud and non-professional activities along with the
collapse of several saving and credit cooperatives. This reflects the
credit-induced boom-bust cyclical pattern, a situation that arises when credit
expansion becomes too fast. That means when such a credit boom is too fast, it
is more likely to be concentrated toward household and non-tradable sectors
such as construction, real estate, and services and increased credit supply to
riskier borrowers, boosting the overall household demand rather than the
productive capacity of the economy, which leads to financial instability
through the accumulation of systemic risks, increased leverage, and asset price
bubbles that will ultimately end in a bust, amplifying the business cycles. If
we look at the sectoral distribution of private sector credit of the BFIs,
around two-thirds of the total credit is found to be allocated towards the
non-tradable sectors, whose productivity is very low compared to tradable
sectors. Likewise, more than two-thirds of the credit is secured by mortgaging the
land and buildings. In this situation, a slowdown in the real estate market put undue pressure on BFI's balance sheets and profitability, with increasing non-performing loans.
Historically, several credit booms ended in busts and
subsequent financial and economic crises worldwide, including the Nordic Crisis,
the Japanese Banking crisis in the early 1990s, and the most notable Global
Financial Crisis (GFC) of 2007/08. The GFC was preceded by a rapid expansion of
credit that ended in the collapse of the housing market and the subsequent
economic recession. Recent empirical evidence has also shown that the excessive
rise in credit leads to financial crises and economic recessions that also
persist for longer than normal economic recessions.
The cautious and restrictive policy measures adopted by the NRB from FY 2022/23 have helped to maintain the price and external sector stability but also resulted in an economic slowdown and increased risk of financial instability. In an attempt to stimulate the economy, NRB gradually eased out the policy measure by cutting off the policy rates, which has also resulted in declining deposit and lending rates of the BFIs. But further easing out the monetary policy could again put undue pressure on the external sector. In this scenario, the policy space available for monetary policy to stimulate economic activities remains quite low. Rather, it should focus on maintaining financial stability by preventing the contagion effect of the recent build-up in the financial sector on the border economy through an optimal mix of monetary and micro-macroprudential policies while promoting quality and productive utilization of credit rather than its growth. So it is up to the government to stimulate domestic economic activities through fiscal stimulus and much-needed structural and institutional reform programs.
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