For about a month now, two news stories about the Nepali economy, liquidity crunch (limited availability of loanable funds in the banking sector) and low capital expenditure by the government have dominated the media. The latest data released by Nepal Rastra Bank, the central monetary authority, also points to a severe cash shortage in the market. In the first two months of the current fiscal year, the central bank injected a net Rs362.5 billion in the financial market, out of which Rs352.3 billion was from the bank's standing liquidity facility. By mid-September, deposits at banks and financial institutions (BFIs) increased by only 0.7 percent reaching close to Rs4.7 trillion, whereas credit disbursement increased by 5.7 percent. The actual liquid funds now available in the system is estimated to be only around Rs55 billion, which is also enjoyed by a few financially healthy banks.

One of the reasons for the liquidity volatility in the market is the overdependence of BFIs on institutional as opposed to individual retail deposits. For years, the share of institutional deposits in BFIs, mainly from two pension funds and the insurance industry, has constantly remained above 40 percent. This deposit share suddenly dropped by 2.7 percentage points, from 43.2 to 40.5 percent, which in nominal terms means about Rs130 billion exited from the banking system. The other two key factors that have hit liquidity so hard are reduced inflow of workers' remittances and a geometric rise in imports.

The net inflow of remittance decreased by 6.4 percent to Rs172 billion in the first two months of the fiscal year, causing a proportionate decrease in the foreign exchange reserve. According to the Department of Customs data for the first three months of the current fiscal year (as of October 15), the amount spent for imports by the country stood at Rs478.5 billion against Rs65 billion earned from exports. This data doesn't include many informal imports from markets across the open border with India. As a result, the cost of funds has effectively risen to 15 percent.

Low capital expenditure

A low level of capital expenditure has been a chronic problem in the Nepali economy, which is considered the most crucial reason for the recurring liquidity crisis in the banking sector. For example, in fiscal year 2020-21, total capital expenditure was hardly 50 percent of the capital budget. According to the Economic Survey 2020-21, such expenditure in the previous fiscal year, 2019-20, was only 46.2 percent, while aggregated capital expenditure at the federal, state and local levels was even lower, at 34.1 percent.

In the first 110 days of the current fiscal year, as of November 2021, capital expenditure stood at a meagre 4.53 percent of the allocation of Rs440 billion. This means the treasury has released only about Rs20 billion against an expected average of more than Rs100-125 billion in the first quarter. This is the amount that seems to be short in the money market to run business as usual and keep the interest rate from spiralling up into double digits.

There are several long-outstanding structural issues surrounding the low absorption capacity of the development budget including Nepal's budget-making practices, timely disbursement of funds and spending expending efficiency of the projects. On top of that, the government has failed to enact regulations required to facilitate development spending once it replaced the ordinance budget presented by the earlier KP Sharma Oli government with a finance bill that got ratified after causing a "budget holiday" hiatus.

Institutional inefficiency

The institutional inefficiency of the two most important public institutions responsible for running the country's economy, the Ministry of Finance and Nepal Rastra Bank, is at the centre of repeated systemic constrictions which is becoming increasingly costly to the economy. Ironically, both these institutions are now headed by non-economists trying to run the show only with their basic common sense and learning-by-doing experience. That, too, perhaps would have been manageable in regular times. Still, it is an extraordinary time for the economy trying to readjust with the putative post-Covid-19 new normal coupled with dramatic political transitions, both at the federal and provincial levels.

An utter lack of basic knowledge about the economy in Finance Minister Janardan Sharma and his imperviousness to addressing currently gnawing problems like the liquidity crunch, sluggish capital expenditure and hopping trade deficit is now openly debated in bureaucratic and donor circles. Instead, his keen interest in spotting possible extractive holes in the system to collect funds for "political financing" is the noticed modus operandi. His wielding of muscle to tamper with public procurement laws and practices is testimony to that.

Similarly, the central bank's failure, both in monetary management and regulatory oversight of the financial system, has added woe to the wounds. Although successive monetary policies have authorised Nepali banks to source loans from international BFIs when the system experiences such a crisis of funds, the policy has achieved very limited success. This is attributed to the very low credibility of the Nepali financial system, which is still out of the international (sovereign) rating radar and reported instances of regulatory arbitrage are rampant. This blame squarely falls on the shoulders of the regulator of the monetary system, the central bank.

The bank also appears toothless to discipline BFIs to set their interest rates straightway inversely proportionate to their profit margins and eliminate the salary and perks inequality between their employees and executives. It is paradoxical as BFIs continue to earn high profits but are unwilling to reduce the lending interest rate. Executive officers in BFIs are allowed to gobble up to 25-30 times higher salaries and benefits than their lower-level colleagues. This clearly is a regulatory failure.

In the immediate future, the government must find ways to substantially increase capital expenditure which, in turn, will automatically offset the present crisis of loanable funds. Nevertheless, the importance of policy and institutional reform in the medium and long runs must not be underestimated.