On balance, the July 17 monetary policy for the fiscal year 2020-21 drew more praise than criticism. Nepal Rastra Bank delivered the policy at a difficult time. In an economy badly hit by the Covid-19 pandemic, everyone was hoping for relief measures. It is impossible to please everyone. Still, kudos to the bank’s new leadership—the policy drew more cheers than jeers.

Among others, the existing moratorium on loan repayment was extended by six months to two years. The central bank’s refinance facility was raised and concessional rates were introduced. Banks and financial institutions’ CCD (credit to core capital plus deposit) ratio was raised from 80 percent to 85 percent. The cash reserve ratio was cut from 4 percent to 3 percent.

Several of these measures are geared toward enhancing banks’ liquidity. Banks are already sitting on tons of extra cash. Deposits continue to come in, but loan demand is not keeping up, although it has improved in recent weeks. In the first 11 months of the last fiscal year through mid-June, banks had Rs3,768.1 billion in deposits, up from Rs3,668.2 billion mid-April. Loans, on the other hand, contracted from Rs3,264.1 billion to Rs3,238.4 billion. In this context, the increase in the CCD ratio looks irrelevant on the surface, as banks are already operating at a substantially lower ratio. But once the economy gets back on its feet—timing notwithstanding—and loan demand picks up, this additional liquidity should help.

Not all liquidity is good

Nepal Rastra Bank also sought to increase liquidity in the stock market. Up until now, financial institutions were allowed to give out 65 percent of the value of shares in margin loans. This was raised to 70 percent. Plus, the value of shares to be used as collateral was based on the 180-day average price or the prevailing market price, whichever is lower; this is now 120 days. The primary motive behind the policy change is to support stocks by encouraging more lending. Here is the rub. Banks can issue up to 40 percent of their primary capital—comprised of equity capital and disclosed reserves—in these loans, which can amount to nearly Rs200 billion. As of mid-June, they had only issued Rs47.7 billion worth.

Additionally, beginning last September, 21 of the nation’s 50 brokers were allowed to extend margin loans. Nearly a year later, there are no takers. Broker loans come with restrictions. Unlike a cash account in which customers pay the full amount for the stocks they purchase, a margin account uses borrowed money, which entails interest cost. Currently, rates from banks are lower than what the brokers can offer. Further, not all Nepal Stock Exchange (NEPSE)-listed stocks are marginable. Regardless, in an obvious attempt to go toe to toe with the recent rise in financial institutions’ initial margin limit, the Securities Board of Nepal (SEBON), which regulates Nepal’s securities markets, is considering raising it from the current 50 percent to 70 percent.

Authorities have their priorities misplaced. They are trying to placate investors that are desperate for higher prices. NEPSE reached its all-time high of 1888 in July 2016 and bottomed at 1099 in March last year. Since that peak, rallies have failed to sustain. From last year’s low, the index went on to rally to 1668 in March this year. Then the novel coronavirus hit, owing to which trading was halted between March 22 and May 12. The post-pandemic low of 1150 was hit in June. Come July 19, investors reacted to the monetary policy by pushing NEPSE up 6 percent. The next day, in a typical ‘buy the rumour, sell the news’ phenomenon, it rallied another 5.2 percent intraday to 1556.19 but only to reverse and close 1 percent lower.

Margin debt cuts both ways

It is possible that the central bank’s new margin-loan policy lent a helping hand in the two-day euphoric jump in NEPSE. We will find out when mid-August numbers are reported in a month or so. The fact is, margin debt may help in the short term but can come back to haunt later, as it cuts both ways. The same way it helps on the way up, it hurts on the way down. In the end, unseasoned investors could be left holding the bag. That is the risk. Banks, on their part, will be more than happy to oblige should investors’ risk appetite grow and the demand for these loans rise. Flush with cash, banks are coming up with various plans to encourage auto and home loans. In fact, they treat margin loans as relatively safe, as they can quickly sell the shares held as collateral if needed.

At the policy level, short-term focus can hurt long-term success. NEPSE’s history only goes back to January 1994, hence does not offer an array of investing tools. Initially, focus on margin debt can put upward pressure on prices as loans are taken out. However, this helps create a lop-sided market. Other than to go to cash, there are currently no tools for bears to take. Shorting, for instance, is not allowed; in it, bears sell borrowed shares hoping the price drops and the shares can be bought back cheaper, pocketing the difference. In developed markets like the US, margin debt and short interest, at their extreme, are routinely used as contrarian signals. Shorts create downward pressure but can be a source of upward pressure as well when squeezed.

For markets to work efficiently, the shorts’ role is no less important than the longs’. A regulators’ job is to provide as many tools as possible for both sides, not to only wish for higher prices. In this respect, SEBON, which too is under a new leadership, has plans to begin a commodities exchange. In fact, it has already received six applications from interested parties. Unlike NEPSE, which at 58.7 percent is majority-owned by the government, the commodities exchange will be in private hands. NEPSE concurrently is working on a futures product involving an equity index. Currently, equities essentially are the only financial instrument available. Some bonds do trade in Nepal, but nothing major. Derivatives are non-existent.

SEBON and NEPSE should be commended for these efforts. In a nation that needs to attract foreign direct investment, the sooner genuine efforts are made toward gaining maturity, the better. At the same time, regulators such as Nepal Rastra Bank should be careful not to spoon-feed investors. It can learn a thing or two from its counterparts in developed markets. To deal with Covid-19 disruptions, the US Federal Reserve has essentially provided a backstop to equity investors. Despite a struggling economy, US stocks are near their highs; each time there is even a modest selloff, investors are now wired to expect intervention from the Fed, which is cornered. Nepal’s central bank should not want to fall into this trap, no matter how good the wealth effect argument.