Nepal’s Minsky moment

Kalpana Khanal:
The phrase “Minsky moment” was a buzzword in financial news reports during the recent global financial crisis. The phrase refers to American economist Hyman Minsky (1919-1996), known as a rather pessimistic contrarian for arguing that markets are inherently unstable and long stretches of good times just end in bigger collapses. In other words, Minsky recognised that stability is unstable. Central to Minsky’s view of how financial meltdowns occur is his Financial Instability Hypothesis (FIH, 1985), which has come to be known as “an investment theory of the business cycle and a financial theory of investment.”

According to Minsky, investment in real capital assets is typically financed by borrowing funds from banks and other financial institutions—that is, by going into debt. This borrowing for investment sets up a two-way money flow: a cash inflow to the borrowing firm from earning on its (real) capital assets and a cash outflow from the same firm to pay debts to its creditors. Cash inflows from real capital assets fluctuate and are uncertain, whereas cash outflows to creditors are fixed and certain. Firms heavily dependent on external financing are especially vulnerable because of their high ratio of debt to income. A sharp fall in the value of capital assets, perhaps as a result of less-than-expected earnings, disrupts the cash inflow and may trigger widespread debt deflation.

Minsky’s best-known contribution is his three-way classification of income-debt relations for economic units into hedge, speculative, and Ponzi. A hedge position is one in which the cash flows arising from the liability structure can be fully met out of the prospective income flows from assets; both interest and principal payments can be met as they come due. A speculative position is one which can meet interest payments, but principal will have to be rolled-over until some date in the future, at which time income flows are expected to rise. Finally, a Ponzi unit cannot even make interest payments out of current and near-term income flows, so they are capitalised as outstanding debt grows. A Ponzi position can be fraudulent and there is no likely scenario in which all commitments can be fulfilled—as in a pyramid scheme. A Ponzi scheme more likely results from unanticipated events such as a rise in floating interest on liabilities, or expected cash flows which are not forthcoming. This classification scheme plays a major role in Minsky’s theory of the endogenous transformation of the financial structure of the economy to fragility, subject to a rising risk of financial crises.

Minsky believed that over periods of prolonged prosperity, the economy moves from financial relations that make for a stable system to relations that make for an unstable one. During good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure engaged in speculative and Ponzi finance. The net worth of Ponzi units quickly falls down. Consequently, units with cash flow shortfalls are forced to try to make a position by selling out a position. This is likely to lead to a collapse of asset values. FIH is a model of capitalist economy that doesn’t need outside shocks to generate business cycles.

In the midst of a real estate boom, Minsky’s FIH is relevant to Nepal’s context. Nepal’s liberal monetary policy, particularly from 2007 to 2010, encouraged the rapid expansion of private sector credit. With political uncertainty and a generally poor business climate, a large portion of additional financing went to the retail/commerce and real estate sectors. Much of real estate investment is seen to be speculative and was often funded by banks and under-regulated cooperatives. The liberal licensing policy of the Nepal Rastra Bank created tough competition among financial institutions. Newer banks attempted to take aggressive risks to expand their market shares, which in turn forced remaining banks to take similar risks.

Concerned about the rapidly increasing exposure of banks to real estate, the NRB intensified supervision and regulation activities. Recently, the NRB imposed a cap limiting commercial bank lending in the real estate sector through two directives. In January 2010, it raised the Statutory Liquidity Ratios for commercial banks to eight percent. In 2009, it limited real estate credit to 25 percent and residential loans to 15 percent of total credit. It also required banks to reduce combined real estate and housing loans to 30 percent and 25 percent in 2011 and 2012 respectively. Even though the NRB efforts had some intended effects, private credit kept on increasing. By December 2009 the average credit-to-deposit ratio of commercial banks was 89 percent—a historical high.

World Bank (2010) data reveals that much of the real estate boom was financed by credit—exactly in line with Minsky’s FIH. Commercial bank credit to real estate increased by 127 percent to Rs 39 billion by January of 2010, while credit to housing rose by 25 percent to Rs 37 billion. Credit to the construction sector doubled from 2007-2009 from Rs 19.7 billion to Rs 44.8 billion. Loans under other categories were also linked to land—in fact 70 percent of all commercial bank loans were collateralised by real estate.

In the meantime real estate prices have been rising rapidly since fiscal year 2007 when the peace process began. The average prices of commercial property increased six-fold from 2007 to January 2010. The higher land prices had a temporary positive impact on bank performance indicators, since many loans are collateralised by land. The inflated prices raised collateral value and turned many non-performing loans (NPL) to good loans—without actual repayments. With the rise of the collateral value the commercial bank, the NPL ratio is now three percent, compared to over 30 percent in 2002. However, with the reduction of land prices this ratio will be affected.

In this context, the NRB’s intervention is a small step towards correcting deregulation prevalent in the banking system. In addition to this, as suggested by Minsky, it is necessary to rely on income and not debt for financing investments. The government should favour small to medium size banks and should discourage predatory lending by profit seeking financial institutions. The government should come up with debt relief strategies for small household loans. Lessons must be learnt from the current real estate boom. The government must make an effort to de?financialise and downsize profit seeking financial institutions, discourage off?balance sheet activities, and follow institutions and practices that favour stability.

Khanal is a PhD student of economics, University of Missouri at Kansas City

source:The Kathmandu Post,10 March 2011