Don’t kick the canIt is best not to tinker with price discovery process
Never let a good crisis go to waste’ is a famous saying in English. In December, amidst a jump in interest rates on commercial-bank deposits and the consequent reaction by authorities and the Nepal Bankers Association (NBA), an opportunity to right the wrong probably got wasted. On December 20, the NBA, an umbrella association of 28 commercial banks in Nepal, reinstituted interest-rate ceilings on savings as well as individual and institutional fixed deposits. They have now been respectively capped at 6.5 percent, 9.25 percent and 8.5 percent. The restoration of the cap followed a spike in rates on individual fixed deposits after a December 4th NBA decision scrapped the then-cap of 11 percent. Following this, banks began competing for deposits by offering higher rates. For a while now, there has been a serious mismatch between commercial banks’ deposit collection and loan disbursement. The government’s inability to spend the earmarked budget on time does not help, even as growth in remittance flows is in deceleration.
Thus, the NBA’s December 4th decision to eliminate the cap on individual fixed deposits, a clear attempt to lure deposits, was viewed as a sign of growing maturity. It is only the past couple of decades that banking has seen increasing participation by the private sector. In the grand scheme of things, this is too short of a time to fully mature. The sector is still evolving. The decision to cap rates is a reflection of that. The problem is, the longer such practices go on, the deeper their roots go. Vested interests try to gain influence. Predictably, the rising rates on deposits, following the removal of the cap early last month, was met with resistance.
The Federation of Nepalese Chambers of Commerce and Industry promptly called on Nepal Rastra Bank (NRB), the central bank, to see to it that higher deposit rates do not lead to higher lending rates. Stock investors went on hunger strike. On December 6, the Ministry of Finance set up a committee to look into the issue. Rather than viewing the rise in rates as markets best at work, it was perceived as a crisis. Besides, how the ‘crisis’ got treated left a sour taste in the mouth.
Setting a bad precedent
On December 19, the committee submitted a report of 58 recommendations. Considering it took merely two weeks to see its completion, it is anyone’s guess what kind of research and due diligence went into it. By December 26, the NRB implemented several recommendations. Stock investors in particular had reason to be thrilled. The ceiling on loan-to-value ratio for margin lending was raised to 65 percent from 50 percent. In layman’s terms, this meant investors could now qualify for more loans against collateral of securities such as stocks and bonds. The NRB also allowed banks and financial institutions (BFIs) to extend margin loans of up to 40 percent of their core capital, up from 25 percent previously. BFIs were also required to factor in the value of rights and bonus shares for this purpose. These were all measures designed to create demand for stocks. The NepSE index, currently under 1200, initially rallied, but bulls were unable to sustain the uptrend. Having peaked at 1888 in July 2016, it fell 14.6 percent in 2018. One possible outcome of the NRB measures is an increase in leverage. Margin lending nonetheless cuts both ways. It can help when stocks are in an uptrend but itexacerbates matters on the way down.
Most importantly, the NRB has set a precedent. The authorities moved quickly to placate investors’ concerns. In the latter’s eyes, their agitation paid off. Now, let us say the central bank at some point in the future tries to roll back the recently implemented measures, investors likely will throw a tantrum, because they are now conditioned to believe that applying pressure yields positive results. Because the Nepse only began trading in January 1994, there are not enough data points to judge which past policies yielded desired results and which ones backfired. There is not much history to go back on to examine how investor psychology works. Because of this limitation domestically, mature markets that have endured enough can teach us a thing or two.
In the US, post-financial crisis of a decade ago, the Federal Reserve not only pushed benchmark interest rates to essentially zero but also embarked on quantitative easing (QE). Under the latter, it printed money to purchase treasury securities and mortgage-backed securities to push rates lower. Times were tough. Arguably, the US financial system was on the precipice of collapse. They did what they had to do to save it. Hindsight is always 20/20, but it is possible they kept the stimulus spigot on for a little too long. After QE1 was launched in December 2008, stocks—in free fall by then—stabilised but began to sell off as soon as QE ended. The Fed responded with QE2. Stocks steadied but once again began to revolt as QE2 came to an end. Investors demanded more policy morphine. The Ben Bernanke-led Fed obliged, and gave them QE3, which ended in October 2014, but it was not until October 2017 that the Federal Reserve actually began shrinking its balance sheet, which at $4.5 trillion had more than quadrupled from pre-crisis levels. US stocks are having a hard time adjusting to this new reality. In 2018, the S&P 500 large cap index fell 6.2 percent—its first annual decline in a decade—and was down 20 percent between September and December.
Sound policy, not hand-holding
There has been similar investor hand-holding in Japan and the Eurozone.
Under Haruhiko Kuroda’s leadership, the Bank of Japan (BoJ) adopted a much looser monetary policy. The balance sheet ballooned to ¥556 trillion, up from ¥165 trillion when Kuroda took over in March 2013. The goal was to drive rates lower, push investors up the risk curve and support stocks to unlock the wealth effect. In fact, the BoJ even buys equity exchange-traded funds. The Mario Draghi-led European Central Bank did not go as far, but under its QE program, which ended in December, it actively bought sovereign and corporate bonds; the balance sheet grew from €2 trillion in September 2014 to €4.7 trillion. The inevitable unwinding of these balance sheets is bound to have far-reaching consequences for capital markets in months and years to come. Meanwhile, a precedent has been set. As soon as bad times hit, equities will demand a policy response from these banks.
This is something the NRB, and other relevant Nepali policymakers, can learn from. ‘It is smart to learn from one’s mistakes, but wise to learn from the mistakes of others,’ is another famous saying in English. Kicking the can down the road is always tempting. But it is prudent not to tinker with the price discovery mechanism—be it in interest rates, stocks, or what have you.
Pandey tweets at @hedgopia.