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Revised Draft Report

Development of Financial Institutions in Nepal

Submitted to:

South Asia Network of Economic Research Institutes (SANEI)

Pakistan Institute of Development Economics Islamabad, Pakistan

Submitted by:

Mr. Bharat Prasad Devkota, Team Leader (Development Economist) Mr. Santosh Kumar Upadhyaya, Member (Financial Management) Mr. Mahendra Raj Joshi, Member (Economist)

Centre for Economic Development and Administration (CEDA) Tribhuvan University Kirtipur, Kathmandu, Nepal

E-mail: ceda@wlink.com.np Telephone: 00977-1-4331721 Fax: 00977-1-4331722

December 13, 2007

PREFACE

This study, "Development of Financial Institutions in Nepal", is a product of a team work. The

collection as well as collation of information, both quantitative and qualitative, proved quite

challenging tasks. The transition phase, through which Nepal is going on, was really an

experience while undertaking the task. The present form of the study could takes place due to

the painstaking endeavors of Mr. Santosh Kumar Upadhyaya and Mr. Mahendra Raj Joshi. Mr.

Upadhyaya had a special contribution in developing chapters on nonbanking financial

institutions and Nepal Stock Exchange, in particular. Finally, this endeavor would contribute to

understand the dimensions of financial institutions' development in Nepal in the present context.

Bharat Prasad Devkota Team Leader December 13, 2007

ACKNOWLEDGEMENTS

First and foremost, the study team would sincerely like to express gratitude to the South Asia Network of Economic Research Institutes (SANEI), Pakistan Institute of Development Economics, Islamabad, for entrusting the team to undertake this study. This study proved a challenging task to the team in terms of information collection because of the introduction of a new national income series covering 2001 onwards only, and divergence in information from the same institute. During the information collection process the following persons were kind enough to avail of necessary information to the team. Thus, we would sincerely like to acknowledge Mr. Bhola Ram Shrestha, Executive Director, Financial Institutions Supervision Department, Mr. Gunakar Bhatta Deputy Director, Research Department, and Mr. Rewati Nepal of Regulation Department of the Nepal Rastra Bank; Mr. Deepak Raj Kafle Chairman, Securities Broad of Nepal; Mr. Raj Man Shrestha, Deputy Chief Officer of Rastraya Banijya Bank; Mr. Srikrishna Shrestha, Chief Manager Inspection Department of Nepal Bank Limited; and Mr Prasiddha Suwal Section Chief, Loan Division of the Agricultural Development Bank Limited. The team would, last but not least, like to express appreciation to the Executive Director, Dr. Ramesh Chandra Chitrakar, for his kind support to make the study successful.

Study Team

December 13, 2007

Preface

Acknowledgements

Contents

 

Abbreviations

i

Overview

ii

Chapter 1: Introduction

1

1

Background

1

2.

Objectives of the Study

1

3.

Methodology

1

3.1

Conceptualization

1

3.2

Methods

2

4.

Information Processing and Analyses

3

5.

Limitations of the Study

3

6.

The Study Setting

3

Chapter 2: The Economy

4

2.1 The Setting

4

2.2 The Post 1990 Economy

6

2.2.1 The Size of the Economy

6

2.2.2 Per Capita Income

6

2.2.3 The Structure of the Economy

7

2.2.4 Annual Growth Rates of Population, National Income and Production

7

2.3 Production Efficiency and Poverty

8

2.4 Nepal in the Global Economy

8

2.5 Nepal in Global Competitiveness Ranking

8

2.6 Governance

8

2.7 The Wealth of Nepal

9

2.7.1 Natural Resources

9

2.7.2 Human Resources

9

2.7.3 Infrastructure Development

10

2.7.4 Institutions

10

Chapter 3: Central Banking

11

3.1

Introduction

11

3.2

Monetary Policy

11

3.2.1

Cash Reserve Ratio (CRR)

11

3.2.2

Bank Rate

12

3.2.3

Refinancing Rates

12

3.2.4

Interbank Transactions Rate

12

3.2.5

Open Market Operations

13

3.3

Money Supply

13

3.3.1

High-powered Money or Monetary Base (Mo)

13

3.3.2

Narrow Money Supply (M 1 )

14

3.3.3

Broad Money Supply (M 2 )

14

3.3.4

Government Financing: Size and Trend

14

3.3.5

Financial deepening

15

3.3.6

Monetary Authority Assets

15

3.3.7

NRB Monitoring and Supervision

16

3.4

Government Financing: Size and Trend

16

3.5

Three-year Average Growth Rates of Money Supply Components

16

3.6

Monetary Authority Assets

16

3.8

Foreign Exchange Reserves

17

3.9

Conclusions

17

Chapter 4: Commercial Banking

18

4.1.

Introduction

18

4.2

Assets' Growth of Commercial Bank

18

4.3

Interest Rate Structure

19

4.4

Deposits

19

4.5

Cash Reserve Ratio

19

4.6

Liquid Assets

19

4.7

Loans and Advances

19

4.8

Growth of Deposits

19

4.9

Banking Concentration

20

4.10.

Capital Adequacy

20

4.11

Conclusions

20

Chapter 5: Nonbank Financial Institutions in Nepal

21

5.1 Introduction

21

5.2 Growth of Nonbank Financial Institutions

21

5.3 Performance of Nonbank Financial Institutions

23

5.3.1 Development Banks

23

5.3.2 Finance Companies

24

5.3.3 Microcredit Development Banks

25

5.3.4 Saving and Credit Cooperatives

26

5.3.5 Insurance Companies

26

5.3.6 Money Changers (Foreign Exchange Bureaus)

27

5.3.7 Postal Savings Banks

27

5.3.8 Employees Provident Fund

27

5.3.9 Citizens Investment Trust (Mutual Fund)

28

5.3.10 Real Estate

28

5.3.11 The Condominium

29

5.4

Issues and Challenges

29

Chapter 6: Nepal Stock Exchange

30

6.1 Introduction

30

6.2 International Financial Centre

31

6.3 Securities Market in Nepal

31

6.3.1 Securities Issue

32

6.3.2 Rights Issue

33

6.3.3 Listing of Securities

33

6.3.4 Market Capitalization

34

6.3.5 Liquidity

35

6.3.6 NEPSE Index

37

6.3.7 Collective Investment Scheme

38

6.4 Primary Market

38

6.5 Policies Adopted by the Tenth Plan (2002-2007)

39

6.6 Relevant Issues and Challenges Observed in Nepalese Primary and Secondary market

39

Chapter 7: Challenges and Opportunities in Financial Institutions' Development

42

7.1 The Economy

42

7.2 Central Banking

42

7.3 Commercial Banking

43

7.4 Nonbanks

43

7.4.1

Summary

43

7.4.3

Major Issues

44

7.4.4

Recommendations

44

7.5

Nepal Stock Exchange

45

7.5.1

Summary

45

7.5.2

Conclusions

46

7.5.3

Major Issues

47

7.5.4

Recommendations

47

7.6

Conclusions

48

 

Select References

49

Annex

1

Appendix

14

Abbreviations

ADB

Asian Development Bank

ADBL

Agricultural Development Bank Limited

BSE

Bombay Stock Exchange

BIS

Bank for International Settlements

CBOs

Community Based Organizations

CIT

Citizens Investment Trust

CRR

Cash Reserve Ratio

CUS

Citizen Unit Scheme

DNI

Disposable National Income

FSAP

Financial Sector Assessment Program

GDP

Gross Domestic Product

GNI

Gross National Income

IFC

International Financial Centre

IMF

International Monitory Fund

INGO

International Non-government Organization

IPO

Initial Public Offerings

NBFIs

Nonbanking Financial Institutions

NBL

Nepal Bank Limited

NCM

Nepal Capital Market

NCMMF

Nepal Capital Market Mutual Fund

NEPSE

Nepal Stock Exchange Ltd

NGO

Nongovernmental Organization

NIDC

Nepal Industrial Development Corporation

NRB

Nepal Rastra (Central) Bank

NSE

National Stock Exchange

NYSE

New York Stock Exchange

OMO

Open Market Operation

PSB

Postal Savings Bank

RBB

Rastriya Banijya Bank

SAARC

South Asian Association for Regional Cooperation

SEBON

Securities Board of Nepal

SEC

Securities Exchange Centre

SMC

Security Marketing Centre

T-bill

Treasury-Bill

VDC

Village Development Committee

WEFs

World Economic Forum

Overview

1. Setting

This study examines to development of Nepalese financial institutions in the context of the overall governance environment. It provides on overview of the economy by discussing the economic performance in the post-1990 period, from 1990 to 2007 to the possible extent. In this contest, the wealth of the nation in terms of natural resources, human resources and man-made infrastructure and institutions is quite low. Then the highlight of the development of financial institutions, banks and nonbanks, has been derived through the analysis of available information, both quantitative as well as qualitative.

Nepal is on the southern aspect of the mid-Himalaya, lying between China in the north and India on the east, south and west. It is predominantly mountainous and landlocked, too. The country has, however, physiographic variations, and thus seven climatic zones, from subtropic to arctic within a distance of 150 km, with the elevation from 59 meters above the sea level to 8,848 meters – the Everest. Nepal is broadly categorized into the Mountain, Hill, and the Terai.

The government is unitary so far, and has been lingering on in transition since the early 2006. There are 75 administrative districts, 58 municipalities, and 3,915 VDCs. The total local administrative units or wards in the country are 36,039 altogether – 804 urban wards and 35,235 rural wards.

The Nepalese society is multicultural, and is being regarded as the "ethnic turntable of Asia", a la Tony Hagen, consisting of the Caucasians, Mongoloids, and natives. The upper caste Hindus predominate. The people speak either the Indo-Aryan or the Tibeto–Burman languages. And Nepali is the lingua franca, and other major languages are the Maithili, Tharu, Tamang and Newari.

Nepal is least developed, and has low economic size of nominal US$ 8.1 billion in 2006. And it falls into the low income economy category of the World Bank.

2 The Post-1990 Economy

2.1 The Size of the Economy

Nepal is least developed (among 50 countries) as well as a landlocked (among 40 countries). It is a low income (among 53 countries) country, too. This study deals with the post-1990 economic state of the country as it augured liberalization in the economy in the early 1990s, with the obvious implications for the development of financial institutions in the country as the pre-1990 economic scenario was primarily under the state dominance. The banking and nonbanking institutions then were virtually under the public sector, except a commercial bank, the joint- venture Nabil Bank, established in the late 1980s.

The size of the economy increased gradually over the years in the 1990s, and doubled in 16 years, that is between 1990 and 2006. Nevertheless, the low level of the economy implies a low level of financial transactions, and thus a limited financial sophistication and the consequent limited financial development.

The production activity was greater than the national income in the early 1990s as the ratio of GDP to GNI was greater than unity during 1990-2000, implying an increased foreign investment, especially from India. During 2001-2007, this ratio was less than unity, indicating the falling foreign collaboration in the national production activity. Such a fall could have been the effect of the insurgency taking place since the late 1996.

2.2 Per Capita Income

The real per capita income (GNI) level is low, 61 US cents or 38 Nepalese rupees a day in 1990, and 89 cents or about 89 Nepalese rupees a day in 2007. In nominal terms, the per capita income was $ 212 in 1990 and $ 290 in 2006, and $ 300 in 2007. Thus, Nepal remains one of the poorest countries in the world. Furthermore, the level of the per capita income has improved slowly.

2.3 The Structure of the Economy

The economy remains mainly agrarian as over a third of its GDP originates from agriculture. The share of agriculture in the GDP has declined over the years since 1990. The share of industry in the GDP peaked in the mid-1990s, but declined thereafter because of the insurgency. In fact, the activities in manufacturing, construction and mining decreased as indicated by their falling shares in the industrial GDP due to the nationwide insurgency in the country in the post - 1995 to date. The rising share of services in the GDP has been at the cost of the other sectors, not because of their improvements.

2.4 Annual Growth Rates of Population, National Income and Production

The population of Nepal increased by 2.26% per annum during 1990-2007. The population growth rate was higher in the 1990s than in the later period. The share of agriculture in the GDP has declined over the years since 1990. The national income (DNI) and production (GDP) declined. Their annual growth rates decreased at an increasing rates from one period to the other, and was due to the effect of the post-1995 insurgency, which has still affecting adversely the productions in all the sectors of the economy . Furthermore, the production in the early 1990s was slightly higher than that of the 1980s as the GDP during 1980–1990 increased by 4.6 percent per year. In general, the economic growth in the early 1990s was moderate, and the post- 1996 economic performance was quite low because of the nationwide insurgency, and its aftermath as the peace in the country remains elusive.

2.3 Production Efficiency and Poverty

The economy has low production efficiency. The agriculture productivity has remained low in relation to other SAARC members. Nepal's agricultural productivity (agricultural value added per worker) is low in relation to the South Asia, low income economies and the Sub-Saharan Africa. Its productivity grew by 0.54% per annum between 1991 and 2002, both mid-years of three-year averages, and this is quite low in relation to the Sub-Saharan Africa (0.61%), low income economies (1.30%) and the South Asia (1.33%). Thus, there is financing potential in the inputs and services delivery in agriculture. And the limited industrial activity is hardly well managed, and thus is plagued with low productivity, implying the potential for its financing.

The poverty level, which remains high as around one-third of the people are below the national poverty line, is ubiquitous. The insurgency, which has disrupted the production throughout all the sectors of the economy nationwide, could have made more people further poorer. This has

definite adverse implications in the functioning of the financial institutions. For instance, the banking services available to the rural areas are now no longer in existence, to a large extent.

3. Nepal in the Global Economy

Nepal ranks 50th in population size (28 millions in 2006). It is 108th in GNI size in 2006 (among 112 economies of the world, inclusive of Macao, Nauru, Taiwan, and Tuvalu, and 110th in GDP size. The country ranks 201st in nominal per capita GNI, and 185th in PPP GNI per capita in 2006. Among the 177 countries or economies in the world, the country stood at 138th in the 2004 human development rank and slid down to the 142nd in 2005. It ranked 112 th among 117 countries in per capita wealth in 2000. In brief, Nepal is at the bottom in development.

4. Governance

The country is quite fragile in governance. The political leadership lacks vision and direction and commitment toward the national development. Frequent changes in government leadership has plagued the country throughout the post-1990 till to date. The bureaucracy is weak and least competent, and devoid of incentives, pecuniary as well as non-pecuniary. There is almost no rule of law. And the country is now in transition, and in a mess, too. Bureaucratic inefficiency abounds whereas the extent of corruption is almost ubiquitous with an increasing tendency due to the absence of the rule of law.

5. The Wealth of Nepal

Nature and diverse ethnicity endow Nepal enough for development. The per capita wealth, consisting of "produced, natural and human and institutional capital", a la "Where is the Wealth of Nations" (The World Bank, 2006), was $ 3,802 in 2000 , and ranked 112th among 117 countries (Niger, Republic of Congo, Burundi, Nigeria, and Ethiopia, in a deseeding order, and with lower per capita wealth than that of Nepal). The low per capita wealth poses both the challenge as well as the opportunity to the country in the global context, and thus offers a scope to promote financing for the generation as well as maintenance of the national wealth.

5.1 Natural Resources

Nepal has a unique place in the world. It has 14 out of 17 highest mountain peaks (of above 8,000 meters), and offers unique scenic beauty as well as nature exploration opportunities. Tourism could have prospered but the insurgency did constrain. Thus, the financial sector involvement in the proper utilization of the Nepalese natural resources remained quite disturbed. Deforestation, which occurred at 1.6% a year during 1990-2005, has further been rapid in recent years, 2006 and 2007, due to a lapse in its management caused by the insurgency and its aftermath. Nevertheless, the scope of financing exists in the future

5.2 Human Resources

The population, of 28 millions in 2006, is increasing at 2% per annum. The population is young, with about 59% of the total population under 25.

The working age population (15-64 years) in 2005 was 57.3%, the young population (under 15 years) 39%, and the elderly (above 64 years) 3.7%. The labor force forms almost 68% of the working age population (15-64 years), and increased by 2.6% per year during 1990-2005.

Agriculture absorbs most of the labor force, about 79%. However, farming is dependent on the vagaries of the monsoon as the all-season irrigation facility is limited. Furthermore, the level land, which is 21.8% of the total land area, has been encroached for urbanization, especially in the hill river valleys. Recently, the highly productive age (20-28) workforce in a sizable number is working abroad, and is fetching remittances. But it is unskilled, and earns less than the gainful remunerations.

The adult literacy is low (around 50%), especially of women. The enrollment levels are low, but the dropouts and failure rates are high. The repetition rate remains sizable.

The very foundation of the education sector remained disturbed in the past, and is still in a limbo. In fact, it is overpoliticized and thus mismanaged. Thus, the development of human resources remains, in fact, a fare cry so far.

5.3 Infrastructure Development

There was limited infrastructure development in the pre-1995. The insurgency has destroyed valuable infrastructure of the country. Regular supply of electricity is of a distant past. Potable water supply is hardly available. The institutions providing basic health services to the needy are in shambles. All these have financial implications and thereby enhance the future financing scope. The foreign aid would be crucial to develop the infrastructure.

5.4 Institutions

The institutional foundation was weak in the past. The post-1990 government tried, but could not develop institutions. Whatever institutional framework existed prior to 1997 was disturbed and then fractured by the insurgency. The creation of pragmatic institutions is a future challenging task, which would entail financing from aboard, in particular.

6. Central Banking

The functioning of the central bank, the NRB, has ever been precarious. It has limited scope in bringing price stability because of the open border with India, and managing the money supply, which depends on the deficit financing of the government. Regarding the creation of a friendly environment for a sound development of financial institutions, the central bank has hardly been effective because it has ever remained weak in monitoring and supervision. The mushrooming of financial firms – commercial banks, development banks, and finance companies– is cosmetic rather than of any substance; and their population raises the concern for efficiency and innovation. The long vacancy in the post of the governor of the central bank, the NRB, (since the mid-2007 to date, as of 29th November 2007) indicates the state of stewardship of the financial institutions.

7. Commercial Banking

The performance of the three dominant commercial banks –the Nepal Bank, the Rastriya Banijya Bank, and the Agriculture Development Bank – has improved in recent years. Other

private commercial banks are operating so far. There is no liquidity problem to them. Their operating costs are moderate. However, investing in non-government sectors has been the challenge because of the political uncertainty.

The commercial banks are concentrated in urban areas, and the political environment, especially the insurgency, has narrowed down their reach to rural areas. Also, the excess government intervention, especially in the Nepal Bank, has disturbed their smooth functioning.

8. Nonbanking Institutions

In the Nonbank sector, major challenge lies in maintaining financial stability. The effort should be oriented toward developing financial infrastructure, avoiding deceiving competitive policies, strengthening regulation of the NRB supervision, and widening the access of the financial services. At present, most of the nonbank financial institutions are concentrating their services in the Kathmandu Valley. Despite of the government policy to give permission to open nonbanks at the Kathmandu Valley only after opening one branch outside the Valley, the growth of Nonbank financial institutions during the last two decades has not witnessed any remarkable progress in terms of their numbers in rural areas. The overall performance of the nonbank institutions could be judged by considering the sources and the uses of funds. In Nepal, large scale of development lending is required to support the development of agricultural and industrial sector. All the nonbanks are aimed to improve socioeconomic status of the rural poor residing in most of the inaccessible areas. The deposit of the nonbank financial institutions grew significantly over the years even though the country needs to do a lot of homework to set up a strong foundation for making a healthy financial system.

9. Nepal Stock Exchange

The Nepalese security market is small, but growing one. During the last 13 years of its operation, the securities market has many ups and downs. The market capitalization of the listed stocks climbed from NRs. 13872.00 millions to NRs. 96,813.74 millions during the study period. In spite of expansion in size, the securities market is yet to create quality transformation gaining depth and maturity. The market lacks sectoral diversification, and an access to secondary trading services is limited. Transparency and efficiency of the issuer and market is not sufficient, while capacity of the regulator, exchangers and the players is limited. The market is dominated by active individual investors whereas the institutional investors are virtually absent. The market infrastructure supporting the trading, clearing and settlement are not adequate. Thus the effort to build a dynamic market is a challenging task requiring a lot of commitments and efforts of the government, regulator, maker-players and the investors. Nepalese capital market is focusing on reforming the laws, regulations and policies, building institutional capacity, above all visualizing a dynamic capital market in order to tap the inherent potential and managing the cross border issue and trading of securities. The government is responsible to frame securities laws and also has its role in formulating capital market development plan and addressing economic, fiscal and public borrowing policies bearing close linkages to the capital market growth. The banking regulation is closely linked to the capital market regulation. The Nepal Rastra Bank (NRB), the banking regulator, can play a pivotal role in promoting the growth of capital market, at least, for the early stage of the market development. The stock exchange is a place for providing efficient trading platform for the listed companies through its members. The present legal framework has defined the responsibility of the exchange in admitting securities for trading, providing membership to the brokers and the dealers, and providing trading, clearing and settlement of

securities. In order to enhance the supply of securities, a new system of securities' registration is indeed essential. Such a regulation sets the disclosure standards for going public through Initial Public Offerings (IPO) or secondary offerings through stock exchange, which encourages closely held companies to come to the capital market.

10.

Challenges and Opportunities in Financial Institutions' Development

10.1

The Economy

The economic performance during 1990-2007 has been dismal because of a high political uncertainty. The major critical challenge is how to establish a legitimate, functioning government through the enactment of a legitimate constitution.

10.2 Central Banking

The central bank is leaderless over a long time. Its monetary policy lacks effectiveness because of the government's financial requirement and open border with India. Its supervisory functions have been least effective.

10.3 Commercial Banking

The mushrooming in the banking has taken place. However, almost all the commercial banks are urban based, except the large three banks the Nepal Bank, the Rastriya Banijya Bank, and the Agricultural Development Bank Limited. However, a branch still covers a sizable population. The government intervention in the former two banks is least pragmatic.

10.4 Nonbank Financial Institutions

The mushrooming is also phenomenon here, too. There is an enough scope for their consolidation and better management.

10.5 The Nepal Stock Exchange

The NEPSE is young and needs proper supervisions as well as management. At present, it is dominated by the banking sector.

11. Conclusions

The government is in transition, and in shambles, too. And there is virtually no rule of law. The long vacancies in the posts of most secretaries in the government indicate precariousness in governance. The low remuneration compels bureaucracy to drive for implicit pecuniary gains. The gray economy is increasing.

First of all, this country needs two fundamentals- a functioning, legitimate constitution and a legitimate government, with a pragmatic policy environment. There ought to be a governor in the Nepal Rastra Bank.

CHAPTER 1 INTRODUCTION

1

Background

The financial sector in Nepal is just evolving. Recently, there has been a proliferation of formal financial institutions in Nepal. Also, the informal financial institutions, such as Guthis, moneylenders, and pawnshopers are in operation in the rural, and, to a limited extent, in the urban areas since long. Furthermore, the microfinancing has been expanding in the country since the 1990s.

The development of financial institutions has, however, been nascent. The prevailing political conflict, which began in 1996, has further constrained their development, and has confined banking in urban Nepal. It is generally held that the central bank supervision is weak. And the nonperforming lending is sizable, especially in the two major commercial banks, namely the Nepal Bank and the Rastriya Banijya (national commercial) Bank. The initiation of the banking sector reform through the Financial Sector Technical Assistance Project in the country indicates the precariousness of the financial sector here.

How the formal and informal financial institutions are functioning in Nepal is pertinent in the development of financial institutions as the sound financial development is of policy concern in Nepal and elsewhere. This study was concerned with the extent of sound development of the financial institutions in Nepal.

2. Objectives of the Study

The overall objective of this study was to examine the development of the structure of Nepalese financial institutions, and derive its implications for future research and policymaking. The specific objectives of the study were:

To evaluate the functioning of the central bank, Nepal Rastra Bank, in the promotion of financial development;

To examine the size, structure and performance of financial institutions;

To examine the size, activity and performance of the stock market; and

To derive implications for future research and policymaking.

3. Methodology

3.1

Conceptualization

Prudential institutional development is crucial to realize rapid economic growth and reduction of poverty as sound institutions promote dynamic processes of economic development (This section is based on the review of the relevant literature). In fact, sound banking and other financial institutions improve resource allocation and thus stimulate economic growth. Also, prudent regulatory mechanisms promote healthy financial development. Sound financial institutions provide timely and factual information and analyses, enable risk sharing and

manage the liquidity provision. Four major financial crises of the late twentieth century - the Latin American in the early 1980s, and Mexican, Asian and Russian in the 1990s – arose because of unsustainable buildup of the short-term foreign debt. They highlight the fact that prudent institutional and regulatory frameworks are critical for sound functioning of financial institutions. The promotion of a sound financial system would be pertinent to achieve rapid economic growth without confronting any financial volatility. These have been the recent regional as well as global experiences as well as concerns. Thus how to fathom financial system's soundness so as to contain a potential financial crisis is the fundamental concern. Such an effort would enable to build an inclusive world economy. The regional financial coordination could be a prelude toward that direction. In this context, it would be pertinent to examine the size, activity, and efficiency of Nepalese financial institutions- monetary authority (the central bank), commercial banks, and nonbank financial institutions. Such an exercise would enable to provide a prudential approach in the prevailing financial structure and financial development in examining the prevailing financial structure and its development in Nepal. While undertaking the exercise it would be pragmatic to group financial institutions into four categories, namely,

a. Central bank

b. Depository banks

c. Non bank financial institutions

d. Stock market

3.2

Methods

This study utilized both quantitative and qualitative techniques to generate information regarding the structural development of financial institutions.

i) Qualitative Approach

A critical review of pertinent documents, of Nepal as well as others was made to trace out the institutional development of financial institutions over time, especially since 1990. The structure and functioning of the central bank, Nepal Rastra Bank, were examined through the checklist tool to generate both qualitative as well as quantitative information. Furthermore, this exercise was pursued, keeping in view the initiations made under the joint World Bank – IMF Financial Sector Assessment Program (FSAP) introduced in Nepal in May 1999. In this context, efforts were made to understand the working mechanisms between the IMF and Nepal. The thrust in the qualitative approach was to obtain information from the selected financial institutions – Nepal Rastra Bank, Nepal Bank, Rastriya Banijya Bank, Agricultural Development Bank of Nepal, Employees Provident Fund, Citizen Investment Fund, Nepal Rastriya Bima Sansthan on their experiences and perceptions regarding their development.

ii) Quantitative Approach

This approach utilized both micro-prudential and macro-prudential indicators developed in the IMF, to the possible extent. The collection of information was made, to a degree, in line with the IMF's recent Monetary and Financial Statistics Manual, developed to promote the adoption of harmonized monetary and financial frameworks among member countries. The CAMELS framework was adapted, to the possible extent, to analyze the health of selected main financial institutions, namely capital adequacy, asset quality, management soundness, earnings, liquidity, and sensitivity to market risk (CAMELS).

4.

Information Processing and Analyses

This study generated required information through both primary and secondary sources. The main secondary information sources were the Nepal Rastra Bank, and the Nepal Stock Exchange. The primary information, mainly qualitative in nature, were obtained from concerned agencies, the list of which is given in Annex 1, and were on the experiences and perceptions of institutional heads and department or division chiefs, with regard to the functioning of the formal as well as informal financial institutions.

5. Limitations of the Study

This study has adopted macro approach and thus micro studies are a few. It has utilized simple statistical tools, such as percentages and ratios. The use of three-year averages is utilized to smooth annual fluctuations in quantitative information. Access to "user –friendly" (standardized) information in time remained in fact truly an arduous task. New national account covering 2001 to 2007 only compounded the task further.

6. The Study Setting

Chapter one deals is introductory and with the background, study objectives and, methodology, and limitations of the study. Chapter two provides an overview of the Nepalese economy, together with its immediate post-1990 onwards- performance, challenges and opportunities. Chapter three deals with the functioning of the central bank and its interrelationship with the Ministry of Finance and the National Planning Commission. Chapter four provides an analysis of the functioning of the commercial banking, depository banking. Chapter five examines how the nonbanking financial institutions are performing, particularly of development banking, financial companies, financial cooperatives and microfinancing institutions. Chapter six assesses the evolution and performance of the Nepal Stock Exchange. Chapter seven, finally, provides challenges and opportunities inherent in the development of financial institutions in Nepal, and suggests implications of this study for future policy making and research.

CHAPTER 2 THE ECONOMY

2.1 The Setting

Nepal is situated on the southern aspect of the mid-Himalaya, and appears elongated rectangular in shape. It has an 800 km long border with the Tibetan Autonomous Region of China in the north and a 1,751 km long open border with India in its eastern, southern and western sides. The total surface area of the county is 147, 181 square kilometers, with the land area of 143,000 square kilometers. Nepal has physiographic variations, resulting in seven climatic zones, from subtropical to arctic climates within a distance of 150 km from Musaharniya of Dhanusha district in the south (59 meters' elevation of above the sea level) to the Everest (8,848 meters) in the north. About 18.2 percent of the land area is barren and rocky while the inland water covers 4,181 square kilometers, or 2.84 percent of the surface area.

Nepal is predominantly mountainous as the mountain zone (with the elevation from 4,877 to 8,848 meters above the sea level), is 35 percent, proper hill zone (610 to 4,876 meters) 41 percent, the Kathmandu Valley (at 1,400 meters in altitude) 0.6 percent, the Inner Terai 5 percent, and the Terai (59 to 600 meters) 18 percent (Table 2.1).The level land is 21.82 percent, of which most are in the Terai. Nepal has, however, been categorized into three broad physiographic regions, namely the Mountain, the Hill (inclusive of the Kathmandu Valley), and the Terai (including the Inner Terai, lying between the Shiwalik Range and the Mahabahrat Range).

The government is unitary so far, and has been lingering on in socalled transition since the early 2006. For the administrative purpose, Nepal is divided into 75 districts. At the local level, there are 58 municipalities – 1 metropolis (Kathmandu), 4 submetropoles (Lalitpur, Pokhara, Biratnagar, and Birgunj), and 53 municipalities, most of which are in the plains- the Inner Terai and Terai, with 804 wards altogether, the lowest administrative units. And the total Village Development Committees (VDCs) in the rural Nepal are 3,915, with 35, 235 wards.

Nepal has a multicultural society with ethnic, linguistic and cultural diversity, and has thus been called the "ethnic turntable of Asia" (Toni Hagen), because of the habitation of the Caucasians, indigenous or natives, and Mongoloids. In Nepal, the upper caste Hindu forms about 32.8%the Hill Hindu 30.9% and the Terai Hindu 1.9%; the Hill Janajati (indigenous) 31.7%; the Newar 5.5%; Dalit 11.8%the Hill Dalit 7.1% and the Terai Dalit 4.7%; the Terai native 9.8%; the Tharu 6.8%; the Muslim 4.3%; and the others 4.1%. The main ethnic groups in the country are the Chhetri (15.80%), Hill Brahmin (12.74%), the Magar (7.14%), the Tharu (6.75%), the Tamang (5.64%), the Newar (5.48%), the Muslim (4.27%+ Churaute 0.02%), the Kami (3.94%), the Yadav (3.94%), the Rai (2.79%), the Gurung (2.39%), the Damai (1.72%), the Limbu (1.58%), the Thakuri (1.47%), and the Sarki (1.40%). Linguistically, they speak either the Tibeto –Burman languages or the Indo-Aryan. The country's lingua franca, however, is Nepali, which is spoken by 17 millions spread in 4 countries. The other major languages are the Maithili, Bhojpuri, Tharu, Tamang, Newari Bantawa, Magar, Abdhi, Limbu, and Gurung.

Table 2.1:

Area, Households, Population Density and Administrative Unites

Region

Surface

Land area:

Level land

House-

Population

House-hold

Population

Administrative Units

VDCs

area: squ.

squ. kms

area: squ.

holds 2001

2001

size (persons)

Density:

Districts

Muni-

Kms %)

(%)

Kms (%)

(%)

(%)

2001

persons per squ. kms

cipa-lities

Mountain

51,817

50,351

200

(0.64)

7.52

7.29

5.28

33

16

2

544

(35.21)

(35.21)

 

Hill Proper

60,446

58,730

2,180

38.49

37.17

5.26

146

36

22

1,892

(41.07)

(41.07)

(6.99)

Kathmandu

8,99

8,72

820

(2.63)

8.12

7.11

4.76

1,882

3

5

114

Valley

(0.61)

(0.61)

 

Inner Terai

7,335 (4.98)

7,122

5,500

6.44

6.47

5.47

210

3

5

148

(4.98)

(17.63)

Terai Proper

26,684

25,925

22,500

39.43

41.96

5.79

374

17

24

217

(1813)

(1813)

(72.11)

Nepal

147,181

143,000

31,200

4,253,220

23,151,423

5.44

162

75

28

3,915

(100)

(100)

(100)

Note: Each Village Development Committee (VDC) has 9 wards, thereby 35,235 wards in rural Nepal. A municipality consists of 9 to 35 wards, hence 840 urban wards. Source: Based on information of the Central Bureau of Statistics.

2.2

The Post 1990 Economy

2.2.1 The Size of the Economy

Nepal is least developed (among 50 countries) as well as a landlocked (among 40 countries). It is a low income (among 53 countries) country, too. This study deals with the post-1990 economic state of the country as it augurs liberalization in the economy, with the obvious implications for the development of financial institutions in the country as the pre-1990 economic scenario was primarily under the state dominance. The banking and nonbanking institutions then were virtually under the public sector, except a commercial bank, the joint- venture Nabil Bank, established in the late 1980s.

The size of the economy increased gradually over the years in the 1990s, and doubled in 16 years, that is between 1990 and 2006 (Table 2.2). Nevertheless, the low level of the economy implies a low level of financial transactions, and thus a limited financial sophistication and the consequent limited financial development.

Table 2.2: National Economic Level Indicators

   

Economy's Size

   

Per Capita

 

The

National Income and Production

Nominal GNI

At 2001 US dollars

At 2001

End-

Nepalese rupees

year of

Nominal, US

At 2001 Nepalese rupees

US

PPP

GNI

GDP

GNI

GDP

the

dollars

dollars

US

fiscal

GNI,

GDP,

GNI,

GDP,

dollars

year

Billions

Millions

Billions

Millions

1990

4.0@

3,628

253.0

257,088

212

960*

223

198

13,991

14,220

1995

4.5@

4,232

326.0

330,289

210

1,145

255

224

16,116

16,327

2000

5.6

5,450

417.7

417,992

230

1,360

290

253

18,452

18,465

2001

5.9

5,525

443.2

441,819

250

1,780

300

260

19,144

19,071

2006

8.1

8,052

513.8

509,911

290

1,630

320

270

19,867

19,716

2007

8.3*

8,253*

525.9

522,666

290*

1,710*

324

272

19,888

19,966

Notes: 1. @ is adjusted based on the 2000/2001 World Development Report of the World Bank 2. GNIs or GDPs prior to 2001 are based o the ratios of the pre-2001 figures to that of the 2001 GNI or GDP of the old series. 3. Asterisk (*) is based on the growth rates given in the 2007 Economy Survey. Sources: 1 World Development Reports (of relevant years), The World Bank. 2. Economic Surveys (of recent years), Ministry of Finance, Kathmandu.

The production activity was greater than the national income in the early 1990s as the ratio of GDP to GNI was greater than unity during 1990-2000, implying increased foreign investment, especially from India. During 2001-2007, this ratio was less than unity, indicating falling foreign collaboration in the national production activity. Such a fall could have been the effect of the insurgency taking place since the late 1996.

2.2.2 Per Capita Income

The real per capita income (GNI) level is low, 61 US cents or 38 Nepalese rupees a day in 1990, and 89 cents or about 89 Nepalese rupees a day in 2007 (Table 2.2). In nominal terms, the per capita income was $ 212 in 1990 and $ 290 in 2007. Thus, Nepal remains one of the poorest countries in the world. Furthermore, the level of the per capita income has improved slowly.

2.2.3

The Structure of the Economy

The economy remains mainly agrarian as over a third of its GDP originates from agriculture (Table 2.3). The share of agriculture in the GDP has declined over the years since 1990. The share of industry in the GDP peaked in the mid-1990s, but declined thereafter because of the insurgency. In fact, the activities in manufacturing, construction and mining decreased as indicated by their falling shares in the industrial GDP due to the nationwide insurgency in the

country in the post -1995 to date. The rising share of services in the GDP has been at the cost of the other sectors, not because of their improvements.

Table 2.3:

Structure of the Economy

Economy's Structure

Mid-end year of the fiscal year (of three-year averages)

 

1990

1995

2000

2006

1. Agriculture

48.78

41.04

39.22

37.10

2. Industry

16.64

21.96

21.37

18.96

2.1 Manufacture

6.20

9.34

9.11

6.99

2.2. Construction

9.37

10.74

10.11

9.40

2.3. Electricity, gas and water

0.60

1.35

1.65

2.11

2.4. Mining

0.48

0.54

0.50

0.46

3.

Services

34.58

37.00

39.41

43.94

 

Total

100.00

100.00

100.00

100.00

Source: Economic Surveys (of recent years), Ministry of Finance, Kathmandu.

2.2.4 Annual Growth Rates of Population, National Income and Production

The population in Nepal during 1990-2007 in creased was 2.26% per annum (Table 2.4). The population growth rate was higher in the 1990s than in the later period. The share of agriculture in the GDP has declined over the years since 1990. The national income (GNI) and production (GDP) declined (Table 2.4). Their annual growth rates decreased at an increasing rates from one period to the other , and was due to the effect of the post-1995 insurgency, which has still affecting adversely the productions in all the sectors of the economy . Furthermore, the production in the early 1990s was slightly higher than that of the 1980s as the GDP during 1980–1990 increased by 4.6 percent per year. In general, the economic growth in the early 1990s was moderate, and thepost-1996 economic performance was quite low because of the nationwide insurgency, and its aftermath as the peace in the country remains elusive.

Table 2.4:

Annual Average Real Growth Rates (Three-Year Averages) (Percent)

Period (Mid-

   

Per Capita

 

years)

GNI

GDP

Per GNI

GDP

Population

1990-1995

5.18

5.17

2.85

2.84

2.27

1995-2000

5.01

4.665

2.67

2.33

2.28

2000-2006

3.46

3.36

1.19

1.10

2.25

1990-2006

4.48

4.33

2.17

2.03

2.26

Source: Appendix Table B3

2.3

Production Efficiency and Poverty

The economy has low production efficiency. The agriculture productivity has remained low in relation to other SAARC members. Nepal's agricultural productivity (agricultural value added per worker) is low in relation to the South Asia, low income economies and the Sub- Saharan Africa. Its productivity grew by 0.54% per annum between 1991 and 2002, both mid-years of three-year averages, and this is quite low in relation to the Sub-Saharan Africa (0.61%), low income economies (1.30%) and the South Asia (1.33%). Thus, there is financing potential in the inputs and services delivery in agriculture. And the limited industrial activity is hardly well managed, and thus is plagued with low productivity, implying the potential for financing it.

The poverty level, which remains high as around one-third of the people are below the national poverty line, is ubiquitous. The insurgency, which has disrupted the production throughout the sectors of the economy nationwide, could have made more people further poorer. This has definite adverse implications in the functioning of the financial institutions. For instance, the banking services available to the rural areas are now no longer in existence.

2.4 Nepal in the Global Economy

Nepal ranks 50th in population size (28 millions in 2006). It is 108th in GNI size in 2006 (among 112 economies of the world, inclusive of Macao, Nauru, Taiwan, and Tuvalu, and 110th in GDP size. The country ranks 201st in nominal per capita GNI, and 185th in PPP GNI per capita in 2006. Among the 177 countries or economies in the world, the country stood at 138th in the 2004 human development rank and slided down to the 142nd in 2005. It ranked 112 th place in per capita wealth in 2000(among 117 countries).In brief, Nepal is at the bottom in development.

2.5 Nepal in Global Competitiveness Ranking

Nepal is least competitive in the global context. It was ranked in the 110th position among 125 countries in the world Global Competitiveness Rank (of the WEF's 2006 Global Competitiveness Report), and 114th among in 131 countries in 2007. It also ranked 111th position among world's 121 countries in the Business Competition Index in 2006, and 120th among 127 countries.

In fact, the information provided in the Worldwide Governance Indicators, 1996-2006 of the World Bank indicates the decline in the quality of governance in the country. The transparency International in terms of the 2007 corruption perceptions Index ranks Nepal in the 131st position among 180 countries worldwide. In the 2008 Doing Business of the World Bank Nepal is placed in the 111th position among 178 economies. In short, Nepal's position rendered fragile due to very weak governance.

2.6 Governance

The country is quite fragile in governance. The political leadership lacks vision and direction and commitment toward the national development. Frequent changes in government leadership has plagued the country throughout the post-1990 till to date. The bureaucracy is weak and least competent and devoid of incentives, pecuniary as well as non-pecuniary. The

government employees' remuneration levels have ever remained low, and insensitive to the inflation. The increase in the basic pay-scales of the employees during 1973-2007 was a meager 1% per annum in the aggregate, and basic pay-scales of senior officer–joint secretaries and secretaries – in real terms were lower in 2007 than those of 1973. Since the public sector remuneration levels effect the private sector ones in general, it was hardly pragmatic to keep the public sector remuneration levels low. There is almost no rule of law. And the country is now in transition, and in shambles, too.

2.7 The Wealth of Nepal

Nature and diverse ethnicity endow Nepal enough for development. The per capita wealth, consisting of "produced, natural and human and institutional capital", a la "Where is the Wealth of Nations" (The World Bank, 2006), was $ 3,802 in 2000 (among 117 countries). Nepal ranked 112th among 117 countries (Niger, Republic of Congo, Burundi, Nigeria, and Ethiopia, in a deseeding order, and with lower per capita wealth than that of Nepal). The low per capita wealth poses both the challenge as well as the opportunity to the country in the global context, and thus offers a scope to promote financing for the generation as well as maintenance of the national wealth.

2.7.1 Natural Resources

Nepal has a unique place in the world. It has 14 out of 17 highest mountain peaks (of over 8,000 meters above the sea level), and offers a unique scenic beauty as well as nature exploration opportunities. Tourism could have prospered, but the insurgency constrained. Thus the financial sector involvement in the proper utilization of the Nepalese natural resources remained quite disturbed. Deforestation, which occurred at 1.6% a year during 1990-2005, has further been rapid in recent years, 2006 and 2007, due to a lapse in its management caused by the insurgency and its aftermath. Nevertheless, the scope of financing exists in the future.

2.7.2 Human Resources

The population, of 28 millions in 2006, is increasing at 2% per annum. The population is young as about 59% of the total population is under 25.

The working age population (15-64 years) in 2005 was 57.3%, the young population (under 15 years0 39%, and the elderly (above 64 years) 3.7%. The labor force forms almost 68% of the working age population (15-64 years), and increased by 2.6% per year during 1990-2005.

Agriculture absorbs most of the labor force, about 79%. However, farming is dependent on the vagaries of the monsoon as the all–season irrigation facility is limited. Furthermore, the level land (Table 2.1), which is 21.8% of the total land area, has been encroached for urbanization, especially in the hill rive valleys. Recently, the highly productive age (20-28) workforce in a sizable number is working abroad, and is fetching remittances. But it is unskilled and earns less than the gainful remunerations.

The adult literacy is low (annex Table A 1) especially of women is under 25 years. The enrollment levels are low, but the dropouts and failure rates are high. The repetition rate remains sizable.

The very foundation of the education sector remained disturbed in the past, and is still in a limbo. In fact, it is overpoliticized and thus mismanaged. Thus the development of human resources remains, in fact, a fare cry so far.

2.7.3 Infrastructure Development

There was limited infrastructure development in the pre-1995. The insurgency has destroyed valuable infrastructure of the country. Regular supply of electricity is of a distant past. Potable water supply is hardly available. The institutions providing basic health services to the needy are in shambles. All these have adverse financial implications, and thereby enhance the future financing scope. The development of infrastructure would be quite essential, and it would require foreign aid.

2.7.4 Institutions

The institutional foundation was weak in the past. The post-1990 government tried, but could not develop institutions. Whatever institutional framework existed prior to 1997 was disturbed and then fractured by the insurgency. The creation of pragmatic institutions to promote a sustainable economic growth and poverty alleviation would be quite challenging, and this would entail external financing, particularly aid.

CHAPTER 3 CENTRAL BANKING

3.1 Introduction

The central bank, the Nepal Rastra Bank (NRB), has been in operation since the early 1956 (established on 26th April 1956). It manages the money supply and the monetary policy of Nepal, subject to the financing requirements of the government, and is responsible to maintain price stability, and to promote sustainable economic growth. It is also entrusted with the responsibility of managing the foreign exchanges. However, it has a fixed exchange rate system with India rupee, which is aligned with the US$ but operates with the market mechanism for other currencies. It pursues banking policies and regulates credit creation through the conventional monetary instruments-the reserve ratio, benchmark interest rate, and open market operations through sells or purchases of securities, i.e. government bills and bonds. In addition, the NRB provides banking services to the government and commercial banks (inclusive of interbank transactions), undertakes supervision of the financial system, and renders, last but not least, advisory services to the government on monetary and financial policies.

3.2 Monetary Policy

The fundamental tenets of the NRB are to maintain price stability, and promote sustainable external and financial systems, and thereby to create enabling environment for high and sustainable economic growth. It has been pursuing its policies on these tenets through the adoption of monetary policy instruments, such as the cash reserve ratio (CRR), the refinance rates, and open-market operations for governments bonds – treasury bills, development bonds and national savings certificates. Also, it supervises, regulates and monitors all the financial institutions plus recognized /licensed NGOs and financial cooperatives. Thus, the NRB provides norms for capital adequacy, liquidity, loan classification and provision, and reporting as well as auditing requirements under its supervisory and regulatory functions.

3.2.1 Cash Reserve Ratio (CRR)

The cash reserve ratio (CRR) is an instrument of the NRB to control money supply. Cash reserves are held as required with the NRB and on a commercial bank's vault, and earn no interest. The cash reserve with the NRB is an interest-free loan from a bank to the NRB.

The required /mandatory CRR was 12% and total domestic deposits prior to April 1998, and the "vault cash" was 3% of total deposits. The mandatory CRR was 6% in 2000 and 5% in 2007 (The CRR was 8% in the UK and 12.5% in the US$ in the late 1990s). There has been a downward trend in the mandatory CRR (table 3.1). In general, it indicates relaxation in the control of he money supply.

The central bank assets are growing. It lacks, however, leadership and direction. Thus, its monitoring as well as supervisory roles have not been pragmatic, to the possible extent.

The NRB pursues monetary instruments such as the cash reserve ratio (CRR), the bank rate, refinancing rates applicable to export, agriculture and sick industries, and open market operation (OMO). The CRR is mandatory. The refinance rates as well as the bank rate have a downward trend, to some extent. The CRR has remained steady at 5% since 2005. Since 2004 the refinance rate is 1.50% to sick industries and 3.50% to exports and rural development banks: the refinance rate is lower against foreign currency loans, 3.25% (all these rates were of the mid-July 2007.).

The short-term interest rates are the 91-day Treasury-Bill (T-bill) rate and inter-bank interest rate. The T-bill rate has a downward trend, and is 2.77% with a range while the inter-bank interest rate is 3.03% (these rates prevailed in the mid-July.).

Table 3.1: Mandatory Cash Reserved Ratio and Structure of Interest Rates Percent per annum

Interest Rates

1990

1995

2000

2007

1. Mandatory cash reserve ratio

6.00

6.00

6.00

5.00

2. Policy rates

   

6.50

 

2.1. Bank rate

6.50

6.50

6.50

6.25

2.2. Refinance rate

9.00

9.00

6.5-7.5

1.50

2.2.1 Rural development banks

5.00

4.50

4.50

3.50

2.2.2 Refinance rate against local currency loan

5.00

4.50

4.50

3.50

2.2.3 Refinance rate against foreign currency loan

2.00

2.00

2.00

3.25

2.2.4. Sick industries

   

3.00

1.50

3. Interbank transactions rate

   

4.00

3.03

4. Treasury Bills (91 days)

6.20

7.35

4.66

2.42

5. Lending rate (average)

12.41

12.85

10.50

8.50

6. Deposit rate (average)

10.50

5.02

5.40

3.25

Source: Quarterly Economic Bulletin (various issues) Nepal Rastra Bank.

3.2.2 Bank Rate

The bank rate (the discount rate in the US) is an interest rate charged by the NRB to its borrowing banks which need to replenish their temporary reserve requirements. This monetary instrument is used to control money supply. This bank rate remained steady at 6.50% in the1990s, implying no need to change the money supply. However, its lowering in recent tears implies an easy monetary policy.

3.2.3 Refinancing Rates

The NRB has adopted different refinancing rates. The refinancing rate to commercial banks were high and steady at 11% in the early 1990s and then declined to about 7% in 2000 (Table 3.1). It, however, used different refinancing rates to rural development banks and local currency borrowing exporters, and to foreign currency borrowing exporters. Nevertheless, the rates declined in recent years, and the sick industries are the most favored ones. In general, this refinancing is for the targeted activity promotion.

3.2.4 Interbank Transactions Rate

This rate eases the flow of funds from creditors to the needy. This rate has a downward trend in the early 21st century (Table 3.1).

3.2.5

Open Market Operations

The NRB utilizes this tool for short-term liquidity management as it is a flexible short-term monetary instrument. The auctioning of Treasury –bills (T-bills) was first introduced in 1988. The auctioning of T-bills, and a fixed –price offer of development bonds and national savings certificates were initiated since September 1989. The available information of recent two years indicates a sizable net liquidity absorption by the NRB as commercial banks are flooded with excess liquidity because of limited financing opportunities.

Table 3.2: Open Market Operation

NRs billions

 

1990

1995

2000

2006

2007

A.

Liquidity Absorption

na

na

na

20.01

32.74

a.1 Sale auction

na

na

na

13.51

18.40

a.2 Reverse repo

na

na

na

6.50

14.34

B. Liquidity injection

na

na

16.3*

1.28

2.00

C. Net liquidity absorption

na

na

na

18.73

30.74

* as of 2001

3.3 Money Supply

The money supply facilitates economic transactions. The money supply has various dimensions. The monetary base or high –powered money changes the money supply d- narrow money (M 1 ) or broad money (M 2 ), and recently very broad money (M 3 ).

3.3.1 High-powered Money or Monetary Base (Mo)

This money consists of currency in circulation and cash reserves (cash in hand, balance with the NRB and foreign currency in hand) of commercial banks. It helps the central bank, the NRB, to influence the money supply, and also the deficit financing of the government. The monetary base to GDP and GNI ratios increased sharply between 1990 and 1995 mid-years of three-year averages, and thereafter they move up gradually (Table 3.3). Their levels of upward change during 16 years remains moderate, implying caution in the money supply expansion. The monetary base in Nepal during 1990-2006, mid-years of three-year averages, increased at 13.47% a year, and could be considered a moderate growth rate (Table 3.3). This growth rates consist of a relatively high growth rate of 18.38% during 1990-95, and consequently did slowdown at 13.55% during 1995-2000 and 9.48% during 2000-06. It indicates cautiousness of the monetary authority in the post-1995.

Table 3.3:

Three-Year Average Annual Nominal Growth Rates, %

 

1990-95

1995-00

2000-06

1990-2006

1.M0

18.38

13.55

9.48

13.47

2. M1

18.31

13.26

11.02

13.95

3. M2

20.48

17.85

11.2

16.11

4. Domestic Credit Supply

19.3

17

12.1

15.84

4.1. Real Sector

25.89

20.35

13.87

19.55

4.2. Private Sector

28.58

20.81

13.76

20.44

4.3. Net claims on

       

a. Government

10.89

18.04

24.81

18.21

b. Government non-financial enterprises

-3.33

3.58

19.86

7.11

c. Government financial enterprises

13.71

17.89

3.06

10.84

5. CPI

11.17

7.69

4.41

7.51

6. GDP Deflator

10.65

6.22

4.72

7.01

7. GDP

16.34

11.16

8.24

11.63

8. GNI

16.35

11.53

8.34

11.79

9. GDI

na

na

9.73*

na

10. Government Spending

14.25

11.53

9.02

11.42

11. Budget Deficit

-5.45

-10.7

-3.27

-6.23

12. Imports of Goods & Services

27.27

10.3

8.11

14.48

12.1.

Merchandise Imports

26.82

11.32

7.63

14.49

13.

Exports of Goods & Services

34.29

10.86

-0.1

13.2

13.1.

Merchandise Exports

27.66

23.57

1.97

16.16

Note:* Refers to the growth rate between 2002 and 2006,The mid-years of fiscal years.

3.3.2 Narrow Money Supply (M 1 )

The narrow money (M 1 ), consisting of the fiat money (coins and paper notes) and demand deposits held by the public, increased by almost 14% a year during 1990-2006, the mid-years of three-year averages (Table 3.3). It has a similar trend in relation to GDP and GNI (Table 3.3), a high upward move during 1990-95, and then gradual upward movement. The annual growth rates of M 1 exceed those of Mo, except during 1995-2000, in which M 1 's lags behind that of Mo's. This discrepancy is due to a slow growth of the public demand deposits, in particular.

3.3.3 Broad Money Supply (M 2 )

The broad money supply is the sum of M1 and time deposits, and indicates monetization of the economy. The ratio of M2 to GNI in 2006 was 0.5351, and M3 to GNI 0.5736, implying low level of monetization of the economy (Table 3.4). In developed economies, the M2 to GNI ratio are greater than unity (This ratio exceeds 2 in Taiwan and Hong Kong).

Table 3.4: Ratios of Money Supply Components to GDP and GNI

Mid-end-

M

0

M

1

M

2

Total net

Net

Net

year of

GDP

GNI

GDP

GNI

GDP

GNI

assets to

domestic

foreign

three fiscal

GNI

assets to

assets to

years

GNI

GNI

1990

0.1288

0.1310

0.1258

0.1280

0.2853

0.2901

0.2901

0.1942

0.0959

1995

0.1405

0.1429

0.1368

0.1391

0.3393

0.3454

0.3454

0.1879

0.1575

2000

0.1562

0.1562

0.1502

0.1501

0.4550

0.4550

0.4550

0.2632

0.1918

2006

0.1673

0.1664

0.1748

0.1739

0.5351

0.5321

0. 5376

0.3385

0.1991

3.3.4 Government Financing: Size and Trend

The size of the government in the national economy, in terms of the government expenditure to GDP, is moderate. And it declined somewhat in 2006 compared to 1990 (Table 3.5). It implies dominance of the private sector. Also, the size of the state declined somewhat in the late 1990s, and then increased perhaps due to a squeeze in the private activities because of the post-1995 insurgency.

The budget deficit in relation to GDP has a downward trend. This is because of the sizable decline in development activities after the insurgency in the late 1996. Regarding the deficit financing sources, the foreign loans prevailed overall, except in the post-2000, and it is the aftermath of the same phenomenon, the insurgency.

Table 3.5: Government Spending and Deficit Financing Sources

Mid-end-year

Government

Budget deficit

Deficit financing sources

of

three

fiscal

expenditure

Foreign loans

Domestic loans

Cash use

years

1990

 

18.22

8.22

5.32

2.39

0.50

1995

 

16.64

5.02

3.62

0.83

0.58

2000

 

16.91

4.92

2.94

1.42

0.57

2006

 

17.66

3.71

1.42

1.98

0.31

3.3.5 Financial deepening

The ratios of the currency held by the public and the currency in circulation to narrow money supply (M1) have a gradual downward trend (Table 3.6a). This indicates gradual financial deepening.

Table 3.6a:

Select Financial Deepening Indicators

Mid-July

Currency held by public to M1

Currency in circulation to M1

Private to

Credit to GDP %

domestic credit

1990

68.33

74.01

 

39.4*

 

15.2

1995

68.19

74.37

 

58.1

 

22.0

2000

69.11

74.86

 

69.3

 

32.2

2007

65.92

74.12

 

80.3

 

30.82

 

Table 3.6b:

Credit Supply, Remittances and All that

 

Mid-July

Domestic Credit

Workers'

Private sector

Private

Real sector

supply total

remittances

credit supply

remittances

credit

1990

 

29,661.6

 

Na

11,687.6

1,747.9

27,656.2

1995

 

72,184.7

 

Na

41,943.1

5,063.6

68,363.2

2000

 

158,001.1

36,818

109,447.6

12,662

149,498.3

2007

 

376,692.5

100,145

273,477.4

na

 

In nominal terms, the private sector credit supply increased (Table 3.6b). The nominal growth rates in the domestic credit supply, especially to the real sector, and that of workers' remittances have been high. Their growth rates are hardly matched by the nominal GDP growth. This gap is very interesting, keeping in view the time lag involved. In brief, the growth of the credit supply is compatible with the nominal GDP growth.

3.3.6 Monetary Authority Assets

The total net assets in the economy increased by 16.19% a year during 1990-2006, mid-years of three-year averages. The growth rate of net foreign assets, 17.0% per year, was dominant over the net domestic assets, which grew by 15.74% a year. Thus, the foreign assets prevailed in the money supply in the economy. It implies limited role of the NRB monetary instruments in influencing the money supply. The use of the Indian currency in the private sector transactions has further limited the NRB role in the money supply.

3.3.7

NRB Monitoring and Supervision

The monitoring and supervisory functions of the NRB have been evolving. The NRB has been least effective in undertaking these tasks. The information flow and functioning of the financial institutions indicate an enough scope for improving these functions.

3.4 Government Financing: Size and Trend

The size of the government in the national economy, in terms of the government expenditure to GDP, is moderate. And it declined somewhat in 2006 compared to 1990 (Table 3.7). It implies dominance of the private sector. Also, the size of the state declined somewhat in the late 1990s, and then increased perhaps due to a squeeze in the private activities because of the insurgency.

The budget deficit in relation to GDP has a downward trend. This is because of the sizable decline in development activities after the insurgency in the late 1996. Regarding the deficit financing sources, the foreign loans prevailed overall, except in the post 2000, and it is the aftermath of the same phenomenon, the insurgency.

Table 3.7: Government Spending and Deficit Financing Sources

Mid-end-year

Government

Budget deficit

Deficit financing sources

of

three

fiscal

expenditure

Foreign loans

Domestic loans

Cash use

years

1990

 

18.22

8.22

5.32

2.39

0.50

1995

 

16.64

5.02

3.62

0.83

0.58

2000

 

16.91

4.92

2.94

1.42

0.57

2006

 

17.66

3.71

1.42

1.98

0.31

3.5 Three-year Average Growth Rates of Money Supply Components

Be considered a moderate growth rate (Table 3.5). This growth rate consists of a relatively high growth rate of 18.38% during 1990-95, and consequently slowdown at 13.55% during 1995-2000 and 9.48% during 2000-06. It indicates cautiousness of the monetary authority in the post-1995.

3.6 Monetary Authority Assets

The total net assets in the economy increased by 16.19% a year during 1990-2006, mid-years of three-years' averages. The growth rate of net foreign assets, 17.0% per year, was dominant over the net domestic assets, which grew by 15.74% a year. Thus, the foreign assets prevailed in the money supply in the economy. It implies limited role of the NRB monetary instruments in influencing the money supply. The use of the Indian currency in the private sector transactions has further limited the NRB role in the money supply.

3.7 NRB Monitoring and Supervision

The monitoring and supervisory functions of the NRB have been evolving. The NRB has been least effective in undertaking these tasks. The information flow and functioning of the financial institutions indicate enough scope for improving these functions. The NRB pursuing banks to maintain capital adequacy ratio of 8%.

3.8

Foreign Exchange Reserves

The foreign exchange reserves of Nepal improved over the years since 1990 (Table3.8). Thus, its imports coverage improved, too. Nepal has been comfortable situation in foreign exchange reserves as they cover around 10 months of imports of goods and services. In nominal terms, the foreign exchange reserves grew by 11.53 per cent a year during 1990-2007 whereas the imports of goods and services increased by 14.80% per annum–from NRs. 21,073.6 millions in 1990 to NRs. 220,166.3 millions in 2007 (the end years of the respective fiscal years, i.e. Fy. 1989-90 and Fy 2006-07).

Table 3.8: Foreign Exchange Reserves

Year, mid-July

Nominal * $ millions

Imports coverage, months

Amount

Three year

Merchandise

Goods and

average amount

goods

services

1990

294.0

291.9

4.84

3.93

1995

683.3

657.9

6.17

5.04

2000

927.9

901.9

6.87

5.87

2006

1,775.0

1,760.7

8.96

7.45

2007

2,029.1*

na

na

na

Note: Asterisk (*) denotes estimates Sources:1. Quarterly Economic Bulletin Vol. 41. No. 3, Nepal Rastra Bank, 2007

2. Current Microeconomic situation, Nepal Rastra Bank, September, 2007

The Nepalese currency depreciated in the early period up to 2006, and thereafter, it started appreciating (Table3.9).

Table 3.9: Nepalese Rupees Exchange Rate per US Dollar

Fiscal year and (Mid-July)

Period end

Period average

Buying

Middle

Buying

Middle

1990

29.10

29.20

28.54

28.64

1995

50.45

50.70

49.70

49.94

2000

70.40

70.75

68.74

69.07

2006

72.08

72.39

72.03

72.32

2007

70.05

70.35

70.19

70.49

Sources:1. Quarterly Economic Bulletin Vol. 41. No. 3, Nepal Rastra Bank, 2007

2. Current Microeconomic situation, Nepal Rastra Bank, September, 2007

3.9 Conclusions

The functioning of the central bank, the NRB, has ever been precarious. It has limited scope in bringing price stability because of the open border with India, and managing the money supply, which depends on the deficit financing of the government. Regarding the creation of a friendly environment for a sound development of financial institutions, the central bank has hardly been effective because it has ever remained weak in monitoring and supervision. The mushrooming of financial firms–commercial banks, development banks, and finance companies – is cosmetic rather than of any substance; and their population raises the concern for efficiency and innovation. The long vacancy in the post of the governor of the central bank, the NRB, (since the mid-2007 to date, as of 29th November 2007) indicates the state of stewardship of the financial institutions.

CHAPTER 4 COMMERCIAL BANKING

4.1.

Introduction

The modern commercial banking was introduced in 1938 with the establishment of the Nepal Bank Limited (NBL). The establishment of the Rastriya (national) Banijya (commerce) Bank (RBB) in 1966 was to promote banking further to semi-urban and rural areas of Nepal. The participation of foreign banks through joint –ventures begun since 1984 when the Nabil Bank was created. Then there came Nepal indo-Suez Bank in 1985 and Nepal Standard Chartered Bank in 1987. The mushrooming of banks did happen since the early 21st century.

At present, there are twenty commercial banks in the country (10 in 1990). A few of them are international in nature, some foreign ones are less so, and many more of national origin. Nevertheless, the NBL, RBB, Nabil, Standard Chartered Bank and the Himalayan Bank are major commercial banks. Since 2006 the Agricultural Development Bank came into this category and is now termed as the Agricultural Development bank Limited (ADBL).

4.2 Assets' Growth of Commercial Bank

The total assets of all commercial banks increased by 19.14% a year during 1990-2007 (Table 4.1). The growth of assets was high during 1990-95, and then the growth rate declined.

Table 4.1:

Nominal Assets of Commercial Banks

Year

NRs Millions

Annual Growth%

1990

26687.9

-

1995

83795.5

25.71

2000

210894.8

20.27

2007

439735.4

13.03

Table 4.2a:

Commercial Banks' Total Deposits and Its Annual Growth Rates

Mid-year of fiscal three years

NRs Millions

% per year

1990

21,885.0

-

1995

61,045.5

22.77

2000

154,530.3

20.41

2007

334,453.3

11.66

1990-07

 

17.40

Table 4.2b:

Commercial Banks' Total Deposits and Their Annual Growth Rates

Year

Demand

Savings

Time

Marginal

deposits

1990-95

22.85