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.
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