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Nepal Survey: Issues in Local Bond Market Development

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Nepal Survey: Issues in Local Bond Market Development PAKISTAN SURVEY CHAPTER 15 Nepal Survey: Issues in Local Bond Market Development MIKAEL KVIBÄCK he financial market in Nepal is relatively undeveloped. A tiny corporate bond market is in operation; that is to say, a few pri- T vate placements have been made. The government market is more developed, but prices are not market oriented. Generally speak- ing, activity in the financial market is hampered by four problems: the issuer and investor base is insufficient, infrastructure of laws, regulations, and institutions is weak; Nepal Rastra Bank (central bank) and the Securities Board of Nepal (Securities Board) have overlapping roles; and incentives and private initiative are not strong enough to drive market developments. A number of impediments discussed later in the report can be traced to these overarching problems. More specifically, the ability to develop the local corporate bond market is seriously constrained by a weak supply of and demand for the product. The number of potential blue chip issuers and the size of the collective investor base are insufficient to create an institu- tionalized market, and too few financial instruments are available in which to invest. An effective interest rate structure, a fundamental ingredient of an efficient and deregulated business environment, is absent, as are the credibility, accountability, and trust that come from solid corporate governance. In many countries that are moving to a more market-oriented economy, the required major changes in eco- 267 MIKAEL KVIBÄCK nomic strategy have been achieved, and the principal challenges now lie in building the infrastructure of laws, regulations, and institu- tions needed to implement that strategy. Much of this effort involves transforming the civil service and judiciary and improving the qual- ity of governance in the corporate and public sectors. Nepal has taken a few steps toward these ends, backed by international sup- port. But a more systematic approach is needed. Nepal could benefit from an efficient corporate bond market, as such a market would provide an outlet for resolving the country’s bad-loan situation. It would also bring necessary competition into the financial sector, particularly among financial intermediaries, which at present are almost wholly dominated by the local commercial banks. This review deals with the situation in Nepal today, the major impediments to developing the corporate bond market there, and some ways it might move forward. The overall conclusion is that Nepal should focus on developing a well-regulated private place- ment market, one that gives borrowers access to long-term, local currency funding by matching them up with investors who are look- ing for long-term local currency products. CURRENT STATE OF THE NEPALESE BOND MARKETS Nepal has two types of securities markets: government and corpo- rate markets. The Government Securities Market The government uses three instruments to meet its financing require- ments: short-term treasury bills, national savings certificates (NSC), and overdraft financing from the Nepal Rastra Bank (NRB). A glo- bal limit has been set on net domestic borrowing, which includes net new issuance of treasury bills and NSCs. The 91-day T-bills constitute the large proportion of these in- struments (and are issued through weekly auctions at which the primary dealers are the commercial banks). The NSCs are encashable on demand by the holder at par and have maximum outstanding maturities of seven years. This means that the effec- 268 NEPAL SURVEY tive term to maturity is considerably shorter as they are encashable at any time. In theory, overdraft lending is limited by a “gentleman’s agree- ment” between the Ministry of Finance and the NRB, but in prac- tice the limit is often exceeded to finance budgetary shortfalls. On a periodic basis, the overdraft is then converted into nonmarketable bonds, which are held on the NRB’s balance sheet. As a result of these arrangements, the Ministry of Finance has little interest in debt management and market development. A well-functioning primary market is fundamental to the creation of an active secondary market in government treasury bills and bonds. The T-bill primary market appears to be functioning effectively with transparency ensured and procedures for announcing upcoming auc- tions (on a weekly basis). Successful bidders are informed of their success in a simple and not unduly bureaucratic way. The retail mar- ket dominates the primary market in NSCs, while the NRB addresses their issues. NSCs are issued at a fixed price. If the issuance is undersubscribed by the retail market, the balance can be subscribed by institutional investors. The NRB and finance companies distribute the issues. Currently, there is a withholding tax of 5% on the final holder of T-bills at maturity. There is a repo market for T-bills with a maturity of up to seven days. Settlement is done manually. Secondary market activities in T-bills are low at present. The repo facility is not used by the NRB in its open market operations. In the absence of a secondary market in government bonds, there is no effective yield curve. The Corporate Securities Market Nepal has a number of privately placed corporate bonds. The Na- tional Provident Fund provides term loans, which are quite similar to privately placed bonds. Because of the present undeveloped state of the capital market, both individuals and institutions place far more of their savings in bank deposits and fixed-interest government se- curities than they would if the capital market were more developed. Long-term savings that should be invested in the capital market are going into short-term instruments. The fact that the central bank is able to raise money at negative real interest rates shows that there is no lack of liquidity in the economy at present. 269 MIKAEL KVIBÄCK IMPEDIMENTS TO BOND MARKET DEVELOPMENT Impediments to bond market development can be divided into three main groups: those around the bond market, those across the finan- cial system, and those inside the bond market. Around the Bond Market Impediments in this group relate to the political situation, the mac- roeconomic situation and broader laws and regulations. The Political Situation. To accelerate the rate of economic growth, the government has committed itself to deregulating the economy, introducing more market-oriented approaches to economic activity, and reducing its controls over economic affairs. But to succeed at this plan, it needs to intensify its effort to dispel policy uncertainty, instill business confidence, and build on recent progress by further strengthening governance institutions. Stronger and mutually sup- portive regulatory policies are needed to consolidate stability. Since no substantial political changes can be anticipated at the present time, the impediment just described will not go away that easily, although a growing economy might help to shorten the transition period. The Macroeconomic Situation. Three areas of macroeconomic con- cern are the relatively poor state of the economy, the fiscal deficit, and debt management. Nepal’s economy has achieved modest growth in recent years. Since fiscal 1994/5, GDP growth has ranged be- tween 2.8% and 5.4%. Economic growth runs at about 3%. The two largest export industries are carpets and garments, which have grown rapidly in recent years. Despite the transition to democracy, which has caused a certain amount of political instability (five governments since 1994), the macroeconomy has remained relatively stable, with low rates of inflation and a reasonably stable currency.1 1 The principal unit of currency is the taka (50 taka equal 1 U.S. dollar), which has frequently depreciated to boost exports and to maintain a competitive edge. The currency is convertible. Exchange control policy rests within the Min- istry of Finance and is administered by Bangladesh Bank. 270 NEPAL SURVEY The establishment of parliamentary democracy in 1990 opened the door to a program of sweeping economic reforms, carried out be- tween 1991 and 1994. This embraced policies on finance, foreign and domestic trade and investment, industry and foreign exchange, and a start to privatization. A change of government then led to a hiatus in privatization and set back macroeconomic stabilization, but the governments in power since September 1995 have relaunched both programs. Major state-owned enterprises are active in the ser- vice sector, banking, insurance, telecommunications, the international airline, and oil and fertilizer importation and distribution. Most of these enterprises have been designated for privatization, which in some cases has already begun. Foreign interest in the hydropower sector has opened tremendous possibilities. However, Nepal is still a small and very poor country, bordered by two of the largest countries—and economies—in the world, In- dia and China. It is at an early stage of economic development: 40 percent of its 22 million inhabitants are classified below the poverty line, agriculture accounts for some 42% of GDP, and more than 80% of the population live in the countryside. With a per capita income of about US$204, it is poor even by South Asia’s relatively low stan- dards of per capita national income (around US$336). Although inflation has declined sharply from the 20% level reached in the early 1990s, inflation has hovered near the double- digit level over the past five years. Moreover, the country has a large current account deficit relative to GDP. The fiscal budget for 1999/ 2000 amounts to approximately US$1.1 billion, with a budget defi- cit of approximately 30%. About 75% of the deficit is financed through foreign loans and grants, the balance through domestic borrowings. In addition, development activities remain slow, and the country is facing an increasing incidence of poverty, human suffering, and in- efficiencies of government institutions. The agricultural sector has been hampered by low productivity while growth in the manufac- turing and service sectors has been hindered by a lack of infrastruc- ture, power shortages, and a relatively high cost for capital due to inefficiencies in the financial sector.
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