Financial Liberalisation in Nepal

Abstract

This study examines the overall impact of financial liberalisation on Nepal�s financial system and economy. The study is specifically directed towards analysing the rationale of executing a financial liberalisation policy; preparing an account of the evolution, process and sequencing of the financial liberalisation; and evaluating the impact of the various liberalisation measures on financial and economic developments of Nepal with cointegration and causality tests. The study makes significant contributions in the area of the impact evaluation of financial liberalisation. Most of the previous studies focus on the economic growth aspect of financial liberalisation in detail, but attach less importance to the redistribution of income and stability of the financial systems. To bridge this gap, an aggregated framework for impact evaluation, which includes all of the three dimensions, is implemented in this study. The framework implemented in this study is useful not only for the impact evaluation of financial liberalisation policy, but also for other public policies. A summary index of the financial liberalisation comprising eight policy instruments is employed in this study. As some of these instruments have not been immediately fully employed, the index is designed to take into account their gradual implementation. The instruments are interest rate deregulation, removal of entry barriers, reduction in reserve requirement, easing in credit controls, implementation of prudential rules, stock market reform, privatisation of state-owned banks and external account liberalisation. A sequential procedure has been applied to test for unit roots on time series data. This procedure helps to determine the optimal test method for each time series under consideration and reduces the risk of model misspecification and biased results. The empirical test results obtained using the Nepalese quarterly data from 1970-2003 suggest that financial liberalisation in Nepal has had a mixed impact on the financial system and the national economy. The number of per capita bank branches is found to be positively associated with the widening of the financial sector, which in turn affects financial development positively. The real deposit interest rate affects the volume of time deposits (savings) positively, but the increase in gross domestic product does not affect time deposits. The volume of time deposits affects the volume of bank loans positively, but the lending rate does not have a significant impact on the volume of bank loans. Collectively, the financial liberalisation measures are positively associated with per capita income as well as with industrial development. The population density per bank branch is found to be positively associated with the volume of bank credit to the poor, while the overall measures of financial liberalisation are negatively associated with such credit. The results also suggest that financial liberalisation is positively associated with the credit-deposit ratio of the commercial banks. However, the higher credit-deposit ratio is not only associated with higher return, but also with higher risk. Therefore, it can be argued that financial liberalisation has brought instability in the Nepalese financial sector. The overall finding of this study is that financial liberalisation is positively associated with growth, but negatively associated with income equality and financial stability. However, the study does not find any causal relationship between financial development and economic growth in Nepal. Hence, the financial liberalisation in Nepal has not facilitated a financial development to the extend that contributed significantly to the economic development of the country.

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