Global Financial Crisis: Its Implications for Nepal

Global Financial Crisis: Its Implications for Nepal and Role of the Government and NRB in Prevention, Mitigation and Resolution

A paper Presented at 

National Economic Concern Society Nepal 

By: Siddha Raj Bhatta 

Abstract

This paper analyses the possible impacts of the Global financial crises on the economy of Nepal and discusses the possible channels through which the Nepalese economy may be negatively affected by such turbulent happenings. It argues that despite the govt. officials’  and some economists’ claim that the financial crises would not hit the economy negatively due to the insulation of the Nepalese economy from the global investment market and global capital market, there may appear severe second round and third round effects of the prolonged crises that would lead to financial and economic instability in the economy and make the economy vulnerable to external shocks. Thus, the regulatory bodies like government and NRB should increase their role to maintain the financial and economic stability in the economy as soon as there are signals of financial crises in the world scenario. The paper suggests some policy reforms to prevent the economy from the harmful effects of global financial crises and to prevent such crises happen in the home country and also provides some suggestions to lessen the impact of the crisis and resolve the crisis.

1.     Introduction

Banking and financial crises have been a regular feature of modern economic history. According to one estimate, there have been 86 banking crises since the Great Depression that have spread beyond national borders. According to a World Bank study in 2001, the world has witnessed as many as 112 systemic banking crises from the late 1970s to early 2001(Kumar and Vashist,2009). Most crises, including the current one, share some common features. Some general examples include a search for increasingly higher yields in financial markets, a lax regulatory regime, a mismatch in appetite for risk and the capacity for bearing it, and the consequent build up of asset bubbles, usually in the real estate sector, which for various reasons is overlooked by the regulators. The recent financial sector crisis in 2008 shares most, if not all, of these features. However, what makes the current crisis exceptional is that it emerged at the very epicenter of global capitalism, the US, and its contagion spread very quickly to the entire global economy, unlike previous crises that were usually confined to a region or a small number of countries. This crisis has struck the minds of the policy makers and regulatory authorities around the world and even has led some one to think that capitalism is now at the end of its life.

The recent financial crisis began in August 2007, when investors lost confidence in the value of securitized mortgages in the USA. It resulted in liquidity crisis. American banks had provided loans even to financially weak customers thinking that even if 80 percentages of the mortgagers repaid the loan, mortgages could profit by seizing and selling the newly purchased houses placed as collateral. This was a blind follow of the American dream: ‘every American should have a house.’ But the story became different. When every Americans had a house, the sales of house went down. By January 2008, the inventory of unsold homes was 9.8 times the Dec 2007 sales volume. (Shrestra, 2009). Still, 4 million existing homes were for sale and about 2.9 million were vacant. Thus, there were fewer buyers and because of fall in demand, house prices fell. Thus, on the one hand, the loan takers were financially weak and thus did not pay the loan and on the other, the banks had to sell the seized houses at lower prices. This resulted in a heavy loss and led to collapse of the mega banks in USA. The depositors lost confidence of their deposits at banks and withdrew them. Thus, the banks had no money and faced liquidity crisis.

Some of the noticeable repercussions resulted from the financial crisis are:

a.       In USA, 533, 000 jobs were lost as of Nov. 2008.

b.      Unemployment in USA grew to double digit.

c.       About 100 companies in USA were shut down.

d.      Lehman brothers went bankrupt. The world’s largest bank HSBC lost $ 10.5 billion.

e.       Further effects were a heavy fall in the stock markets, collapse of many established financial institutions, fall in the demand for commodities, rising unemployment, etc. The severity of the current crisis can be gauged by the steep decline in the equity markets of advanced economies. The bursting of the sub-prime housing bubble caused Wall Street to lose a staggering US $8 trillion in market capitalization in a very short time. Global stock markets fell faster during the current crisis than in 1929.

2.      Causes of Financial Crises

Financial crises may emanate from the following causes (Jickling, 2010):

ü  Imprudent Mortgage Lending

ü  Housing Bubbles

ü  Global Imbalances in terms of trade.

ü  Lack of transparency and accountability in mortgage finance.

ü  Deregulatory regulation.

ü  Non-bank runs.

ü  Failure of risk management systems.

ü  Financial innovation

ü  Complexity

ü  Human frailty

ü  Bad computer models for forecasting.

ü  Excessive leverage.

ü  No systematic risk regulator.

ü  Fragmented regulation, etc.

3.     Transmission Mechanism

Economies like Nepal where the financial sectors are not closely integrated with the global financial system are not plagued with the first round adverse effects of the financial crisis and the banking system is also almost unaffected. However, it could not escape the second round effects that severely impacted their trade flows due to the collapse of output and trade in advanced economies.

The global economic crisis may lead to a sharp reduction in world trade and rapid decline in commodity prices. This is one of the main mechanisms through which LDCs can be affected. Foreign direct investment (FDI) flows may decline rapidly. The decline in FDI is the second channel through which the LDC economies may be affected. A third transmission mechanism, which can be of critical importance for some LDCs, is the slowdown in migrant workers remittance flows. As unemployment in the advanced countries increases and the end of commodity export boom in some of the labor importing developing countries reduces the demand for migrant labor, the labor exporting LDCs may experience noticeable declines in remittance flows. The economic crisis may lead to a sharp deterioration in the fiscal position of all advanced economies. This can put pressure of ODA budget of the OECD countries, which can potentially have dire consequences for the LDCs.

4.     Possible Impacts

Though, Nepal does not have direct link with the Global investment markets, there may appear severe second round and third round repercussions through falling exports, decline in tourism, loss of overseas employment and remittance, loss of FDI and foreign aid, additional debt servicing burden, etc. Some of the possible repercussions consist:

a.       Due to the high commodity and country concentration, if demand for commodities weakens in India, US and Germany, there will be a fall in exports and loss in employment in exportable industries. Thus, there will be a pressure in the Balance of Payments and foreign reserves which may lead to the depreciation of our currency. Fig. 1 shows the worsening trade deficit during the recent financial crisis.

Source: Economic Survey, 2010/11

b.      Depreciation of our currency may have severe repercussions to the economy as a whole in terms of rising cost of imports and additional burden in debt servicing.

c.       Tourism sector may be badly affected. If the countries of the west are struck by rising unemployment, falling demand and loss of confidence, the number of tourists coming to Nepal may reduce over time so that the tourist income may fall over time. The rate of increase in income from tourism in Nepal after the crisis has been presented in Fig. 2.

Source: Economic Survey, 2010/11

d.      Adverse effects will come from reduction in foreign employment and remittances.

e.       The earning of more than Rs. 47 billion in foreign banks will be affected as a result of drastic cut in interest rate in USA.

f.       If foreign aid falls, the development budget will be hampered as Nepal’s dependency in foreign aid for development budget is more than 50% over the planning period.

g.      Depreciation of national currency will have additional liability burden paying. In FY 2065/66, due to the financial crisis and the resulting appreciation of the US dollar, Govt.’s debt servicing liability increased by Rs. 1 billion.

h.      Nepal has high expectations on FDI. Due to the financial crises, FDI may fall as such; the big budget projects may be badly affected.  

i.        There could be spillovers of the stock markets. When stock markets fell in the world scenario, psychological impact may work and the stock market may crash. During the period September 2008 to January 2009, NEPSE fell from 1178 to 609. The psychological impact might be one reason for this fall.

5.      Implications of the Financial Crisis

The recent financial crisis has some important policy implications for the developing and underdeveloped countries:

a.       One important implication is that the era of self- regulation of the financial institutions is over and thus the role of monitory policy should be greatly altered.

b.      If left to itself, sometimes the market can be driven by whims and over optimisms: the result of which may be devastating. In such a case, there lies the utmost need of an effective monitoring, supervision and regulatory system to keep the things on the track.

c.       Even the LDCs should be better prepared to mitigate the negative impacts of the global financial crisis through the adoption of necessary countercyclical measures.

d.      In the age of globalization of trade, finance and labor, the countries are tied together so that crisis in one country will affect almost all countries. Thus, all the countries should have an interest on the quality of the economic and financial policies of other countries.

e.       One another implication is the lesson that if something is too good to be true, it probably would not be true eventually. If the times are extraordinarily positive and they continue for an extended period, there is high probability that the end will be painful. Thus, with the positive situations, one should be critical not whimsical.

f.       Government should have a mandate and tools for financial stability.

g.      A new financial structure is needed to cope with the increasing complexity of the financial intermediation.

h.      Banks should improve the risk management to reduce the buildup risks.

i.         Regulations should be compatible for the well functioning of the market.

j.        The banking and finance sector should be under complete regulation and supervision system. If there are any loopholes in the system, it may spread high contagion effects and the problem may extend locally, regionally and internationally.

k.      During the times of financial distress, maintaining the confidence in the public becomes an important task of the regulatory bodies.

6.      Role of the Government and NRB in Preventing, Mitigating and Resolving the Financial Crisis

The recent financial crisis of 2008 has struck the economic thinkers around the world with the question “Whether the process of capitalist economy led liberalization and globalization process has on its verge to collapse.” Some of the thinkers even took the crisis as the early symptoms of the end of capitalism. Anyway, this crisis along with the other crises has highlighted the importance of government’s effective regulation over the private sector. It has also prompted the policy to strengthen the supervision and monetary aspects of monetary policy. The following suggestions can be made that are to be adopted by the regulatory bodies to mitigate the potential effects of the global crises and to prevent the financial crises originate in the home country:

§  The Five necessary steps to mitigate the negative impacts of global financial crises include:

ü  Financial Market Reforms

ü  Revise BASEL Agreement with changing scenario.

ü  Create Comprehensive Regulation.

ü  Reduce Market Risk.

ü  Adopt Fiscal Stimulus Packages.

§  Policy attention needs to focus on creating as much additional fiscal space as possible to prop up the domestic economy while preserving macroeconomic stability.

§  A careful look at expenditure priorities is in order. Public spending that creates jobs, especially for the poor, will be essential. Important examples include rural and other infrastructure (rural roads, irrigation facilities, rural power); basic urban services; and well-designed safety net programs.

§  The ongoing efforts to increase the efficiency and effectiveness of the banking sector must continue. These measures should aim to lower intermediation cost, reduce non-performing loans, improve banking services, and strengthen prudential regulations.

§  In the face of sliding world demand, efforts to raise domestic productivity and competitiveness become critical factors for protecting export market shares. The scope for increasing the competitiveness of the South Asian economies is large and includes policies to improve the availability of infrastructure, lower the transaction cost of private investment through better governance, and reduce restrictions on trade and investment.

§  Greater attention should be given to improving implementation capacity and corruption prevention in public spending becomes even more important.

§  Financial Stability should be maintained by:

ü  Effective use of SLR for liquidity management

ü  Sectoral credit instruments e.g. sectoral refinance facilities.

ü  Revising the credit ceiling on real states and housing loans to reduce concentration risk.

ü  Revising the Single Obligator Limit (SQL).

ü  Regulation of margin lending.

ü  Deposit insurance.

ü  Effective Implementation of BASEL II.

ü  Adopting Risk-based Supervision instead of traditional supervision.

ü  Encouragement to the stress testing by the banks.

ü  Effective use of Prompt Corrective Action (PCA).

ü  Ensuring Corporate Governance.

ü  Proper Licensing Policy.

ü  Encouragement to the merger and acquisition to improve the quality rather than the quantity.

§  Banks’ liquidity needs should be addressed.

§  The aggregate market risk should be controlled.

§  The financial market should be intervened to maintain stability. It can be in terms of entry barriers, transactions on the type of products banks can deal with, restrictions on excessive and undesirable lending and deposit conditions. This intervention has many positive effects in maintaining the stability of the financial system.

§  An effective and prudential regulatory system should be established when the country is moving toward greater opening and liberalization of its financial system. The financial market is more fragile because it buys and sells credits and promises not commodities. Thus, there arises the need for more concentrated supervision and regulation.

§  Revising the licensing and branching policies for the BFIs.

§  Integrated policies for proper development of housing and real estate.

§  The government and NRB should prevent the asset price bubbles especially in real estate and should take corrective policy actions on time.

§  Early warning system should be established to prevent financial crises.

§  Coordination between fiscal and monetary policy for effective liquidity management.

7.      Conclusion:

The recent financial crisis has struck the mind of the policy makers in the industrial capitalist countries that only policy reforms would not suffice to get rid of the crisis and to prevent future financial crises. The need is of the institutional reforms. The govt. and other regulatory authorities should be given more roles in the instances of market failures and signals of financial crises.

8.     References:

Cho, Yoon Je (2010). “The Role of State Intervention in the Financial Sector: Crisis Prevention, Containment, and Resolution.” ADBI Working Paper Series, No. 196, February 2010.

Claessens Stijn (2009). “Policy Insights from the Financial Crisis.”  PEGGED, Policy Brief No. 6, June 2009.

Flaaen Aaron and Boosworth B. (2009). “America’s Financial Crisis: The End of Era” ADB working paper.

Green, King and Dawkins (2010). “The Global Economic Crisis and Developing Countries.” Oxfam Research Report 2010.

IMF (2009). “The Implications of the Global Financial Crisis for Low-Income  Countries.”A Policy Report March 2009.

Jickling, M. (2010). “Causes of the Financial Crisis” Congressional Research Service.

Kumar and Vashisht (2009). “The Global Financial Crisis: Implications for India and Policy Responses”, ADB working series, November, 2009.

Pomerleano, M. (2009). “What Is the Impact of the Global Financial Crisis on the Banking System in East Asia?” ADBI Working Paper Series. No. 146

Shrestra, S. (2009), “Global Financial Crisis’ Mirmire Monthly,NRB, Vol. 37, No. 282.

Steil Benn (2009). “Lessons of the Financial Crisis’ Council Special Report No. 45, March 2009.

Truman E.M. (2010). “The Global Financial Crisis:  Lessons Learned and Challenges for the Developing Countries”. Peterson Institution for International Economics.

UNO (2009). “The Impact of Global Financial and Economic Crisis on LDC Economies”