Addressing a public function last week, Nepal Rastra Bank Governor Maha Prasad Adhikari said the scarcity of loanable funds in the banking sector would more likely worsen than improve in the coming months. This is an ominous prediction from the chief of the country's monetary authority when the interest rate on commercial borrowing has crossed the business viability rule-of-thumb limit of 15 percent.

Taking full advantage of a perfectly competitive market, banks are offering 17-18 percent interest on fixed deposits to large institutional depositors despite the central bank's moral suasion not to cross the 12 percent mark and 13.13 percent ceiling unofficially set by the Nepal Bankers' Association. The question is how much banks will be charging their borrowers when they are paying 17-18 percent interest to their depositors.

Such high rates on deposits create long-term liability. The banking sector will be unable to reduce the interest rate even in the longer time horizon. The impossibility of market correction indicates an unsustainable future for the country's financial sector.

Two immediate ramifications loom large. The productive sector which aims for a rate of return of even 20 percent cannot borrow funds at this rate of interest. This will have a direct impact on industrial output. The only potential borrowers will be speculators, mainly in properties, further pushing the economy into the danger zone.

Crises galore

A volatile liquidity market has been something of a permanent feature in Nepal's banking industry. A deepening crisis of corporate governance in the entire financial system is an even greater danger. First, there is massive insider lending by private sector banks. The major beneficiaries are the kith and kin of the promoters. Although this sector often boasts that it is the best regulated sector of the economy, lapses by the oversight authority are pervasive, and regulatory arbitrage by bankers is common.

Second, large investments are generally concentrated in the speculative market while small ones are focused on consumer financing—vehicles and private housing. Barely 20 percent of the total outlay of about Rs5 trillion has been in the productive sector, which explains Nepal's low productivity and slow economic growth. Third, corrupt practices in lending, including in mortgage evaluation, loan processing and disbursement, have become “accepted” norms.

These problems are the result of attaching little importance to financial education in the country. Although the world has gone far ahead in terms of institutionalising financial education with defined objectives of financial literacy, consumer protection and system stability, Nepal's fiscal and monetary authorities seem to be utterly uninterested in incorporating it in fiscal governance.

Nepal's liquidity market is caught between the proverbial devil and the deep blue sea. All three tiers of government—federal, provincial and local—have persistently failed to spend the capital budget which is the single largest source of liquidity in the financial market. Also, a decent level of capital expenditure would have acted as a catalyst to increase private investment. Capital expenditure by the federal government in the first five months of the current fiscal year reached a meagre 9 percent of the allocation. The performance of the provincial and local governments is equally lacklustre.

At the same time, a geometric rise in merchandise and services imports has led to a massive outflow of liquidity. According to Nepal Rastra Bank, the trade deficit during the first four months of the current fiscal year amounted to Rs477.92 billion, while net services income in the same period recorded a deficit of Rs23.30 billion. The data shows payments of Rs33.06 billion, including Rs22.61 billion for education.

Considering the number of No Objection Certificates issued by the Ministry of Education to Nepali students going abroad, this figure seems to be an undercount. For example, 82,000 No Objection Certificates were issued only between January and June 2022. Assuming that each student took out $30,000 worth of convertible currency, the outflow in just the first six months of this year would come to more than a whopping $3 billion.

What next?

Both the fiscal and monetary authorities must realise that patchwork solutions to address problems of this magnitude will not work. A serious and comprehensive review of the key policies and stocktaking of practical issues are required. The suboptimal efficiency of public financial management has been a chronic issue, and it has not improved with the devolution of fiscal authority to the subnational units.

This warrants an independent set of policy reviews and calibration. Regulations have completely failed to discipline highly speculative markets, including property, stock and commodity. The regulatory authority of key regulators of the financial markets has been hindered by a pervasive conflict of interest. The situation is such that it is difficult to distinguish between regulators and market players.

The trend of outmigration to developed countries among students seems to have reached a point of no return. Without stopping this outflow of financial and human resources, Nepal's liquidity crisis may not ease for a long time. Labour market distortions in the form of high wages, skilled manpower shortages and foreign hires have already surfaced. But what is more worrisome is not the problems in the financial sector, but the unwillingness of policymakers to read the writing on the wall.