Effect of Monetary Policy of Nepal Rastra Bank on Real Estate Sector

1. Introduction Monetary policy is one of the important macroeconomic policies through which the monetary authority of a country controls the supply of money, availability of money, and rate of interest in order to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy is referred to as either being an expansionary or a concretionary; where the former increases the total supply of money in the economy, and the later decreases the supply of money. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. Furthermore, monetary policies may be described as: accommodative, if the interest rate set by the central bank is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.

Nepal Rastra Bank (NRB), the central bank, unveiled its monetary policy for FY2011 on 28 July 2010.2 According to NRB, the policy is aimed at addressing the deteriorating external position due to the lagged effect of the global economic crisis on remittance inflows and exports, And the persistently high inflation amidst a liquidity crunch in the banking sector. The policy is also aimed at enhancing access of rural and marginalized communities, including women, to Financial Services and channeling investment away from real estate to more productive sectors like agriculture and hydropower. More specifically, the policy aims to improve the Current Account deficit (of approximately 2.5% of GDP) to a surplus of approximately 1% of GDP and reduce inflation to 7% by the end of the fiscal year. So far as real estate is concerned NRB has put a cap on it-credit flows to the housing sector have been relaxed and the extension of fresh loans to Land transactions have been tightened. Banks and FIs will now have to reduce their Real estate-related loans to 10% of total lending by FY20131.

Monetary Policy for FY2011: A Synopsis and Potential Implication, the analysis prepared by Yubraj Acharya and Neelina Nakarmi of Nepal Resident mission, ADB. Available at www.adb.org.np. The details of monetary policy is on www.nrb.org.np

The first section of this paper provides the background of monetary policy & highlights the key features of monetary policy. It then goes to shed light on the real estate market and the lending limit issued by NRB on real estate sector (which is in tabular form). The next section deals with the possible challenges in ensuring that the policy meets its goals. The last section is recommendations which deals with the solutions to the identified challenges.
2. Real Estate Market

In the past Nepalese believed in secured life with secured Government job and self earned house. The tradition is still being followed as people take owing plenty of lands and house, a matter of pride and reflection of social status. People invest there most of savings on purchase of lands and houses. So there is a real estate bubble which is a type of economic bubble that occurs periodically in local or global real estate markets. It is characterized by rapid increase in valuations of real estate property such as housing and land until they reach unsustainable levels relative to income followed by a reduction in price levels. It happened so in the case of our country and there occurred a real estate boom with no price consistency and the reasons where only due to flexible credit facility from Banks and Financial Institutions, no alternative source for investment, local savings and donor agencies NGO/INGOS. Following data are from the statistics of Nepal Rastra Bank (NRB) that shows the commercial banks loan to residential construction and real estate: Fig: 1 Banks loans in realty sector (Rs in Billion) July2007 July 2008 26.41 10.73 July 2009

Residential Construction Real Estate

16.38 2.48

34.95 24.76

The figure: 1 shows a huge boom in recent period of time. According to Officials at Department of Land Reforms and Management, the reasons for boom were: The growth to rapid migration to urban areas. The change in lifestyle of growing high-end and middle income groups. Sharp growth of professionals and high-end middle income groups, who preferred developed houses and apartments over self constructed buildings.

To overcome monetary inflation, liquidity crunch and boom in real estate bubble the monetary policy 2010/11 by NRB has put a cap on credit limit for Banks. Thus, the policy states that real estate lending is divided as: (1) Residential Real Estate (RRE) (2) Commercial Real Estate (CRE) including construction completed CRE (3) Land and Land Development Real Estate (LRE)2 a. Real Estate Lending Limit: (1) RRE: Max two third of Fair Market Value (FMV) (2) CRE: Max 60 percent of FMV (3) LRE: Max 60 percent of FMV b. Real Estate Exposure Limit: (1) RRE & CRE: Max 25 percent of total loan portfolio (2) LRE: Max 10 percent of total loan portfolio (3) RRE + CRE + LRE: Max 25 percent of total loan portfolio So, the ceiling made to real estate sector by NRBs monetary policy has negatively impacted Banks and Financial Institution (FI) and the economy. Stricter rules for credit exposure and lending limit have decreased the overall loan portfolio of Financial Institution and nonperforming loans of the banksi. Without realizing the alternative sector for investment and putting a limit can further worsen our economy. As a result there is two fold increase in interest rates (10% to 18%) pushing up the cost of homes & discouraging sales and the employment opportunity is lost for the people involved in real estate sector.

1. Possible Challenges in ensuring that the policy meets its goals3

In a slight deviation from last years policy that treated land and house transactions in a similar manner, the monetary policy for FY2011 relaxes credit flows to housing sector that has relatively higher value addition and tightening fresh loans to land transactions, which have many backward and forward linkages. This policy is expected to discourage speculative spending on land and eventually rein in the real estate bubble

The data is taken from Real Estate in Nepal and NRB Cap Krishna Sunuwar.htm

Most of the points cited here is taken from -Monetary Policy for FY2011: A Synopsis and Potential Implication, analysis prepared by Yubraj Acharya and Neelina Nakarmi of Nepal Resident mission,ADB. Available at www.adb.org.np

Recent stress testing report on Nepali banks by the IMF had suggested that Nepal banking system carried high credit and liquidity risks with some banks facing high solvency risk. Nearly all banks would be below the minimum capital adequacy ratio if the largest borrower defaulted. A 30% fall in real estate prices could increase private banks nonperforming loans by more than 20 percentage points as majority of these loans were issued in the past two years at an inflated prices. Five to nine banks would become illiquid within three to five days of deposit withdrawals, depicting the vulnerability of the banks liquidity position to standard shocks. Given the fixed exchange rate with the Indian rupee and the virtual free flow of capital between India and Nepal, monetary autonomy of NRB is limited. Not surprisingly, the pass through from changes in interest rate and cash reserve ratio to prices has been limited in the past. Therefore, the increment in the bank rate from 6.5% to 7% may not yield discernible positive results. In turn, the increase in the policy rate may further raise lending rates and discourage investment, much needed for economic revival. The policy envisions bringing remittances from India through the banking channel. While this is a welcome objective, given that as much as 40% of total remittance inflows to Nepal are estimated to come through informal channels currently, the lack of a clear policy to turn this goal into reality may simply raise unrealistic expectations. Although the policy has directed Financial Institution( FI) to double their lending to productive sectors such as agriculture, energy, tourism and small and cottage industries by FY2014, the directive may not yield desired results in absence of political stability and an appropriate regulatory framework for monitoring. A successful materialization of this goal may require measures beyond monetary policy (such as an effective public-private partnership framework), which will in turn require a broader consensus on the economic agenda by key political parties matched with an enhanced capacity of government agencies.

2. Recommendations National Action Plan for Policy Management should be designed immediately by a think tank (National Planning Commission or Ministry of Finance). Primarily, it should be a strategic management action plan that seeks to implement forcefully a special package programme and a set of policy priorities institutionalized for the next 2 years. It should be designed to usher transformational leadership under the theme of public private partnership by drawing into the key economic ministries like agriculture, tourism, supplies, industry and finance, including the central bank, Nepal Rastra Bank. Direct and indirect possible impacts of the global financial and economic crisis on Nepal. Some general features may also include key elements like severe strictness measures; banning of all types of strikes (bandhs); guaranteeing uninterrupted flow of goods and services to markets; getting the public services to enhance their work hours and productivity to cope with the crisis; deepening and broadening financial and economic reforms like never before; providing financial liquidity and better bank regulation and supervision, not least, rehabilitating, promoting and developing entrepreneurs, to the

maximum to create self-employment and reduce under-employment through cottage or pavement enterprises or small and medium enterprises. A proper coordination with the fiscal policies to ensure the effectiveness of monetary policy with setting up a committee to look after both the policy is needed to work over.

Reviewed by: Vivek Tibrewal