Financial Liberalization and Financial Development in Nepal 23

Financial Liberalization and Financial

Development in Nepal
Dr. Khem Raj Bhetuwal∗

An efficient financial system can effectively mobilize and allocate resources leading to
robust economic growth. Financial liberalization improves the functioning of financial
system by increasing the availability of funds and allowing risk diversification and
increased investment. The indices of financial liberalization and financial development,
generated by the principal component analysis, depict a gradual process of financial
liberalization and a continuous financial sector development. The paper finds the
presence of bi-directional causal relationship between the liberalization of financial
sector and level of financial development in Nepal.

I. INTRODUCTION

A deep and efficient financial system can contribute robustly to sustained economic
growth and lower poverty (Beck, Levine, and Loayza 2000). An efficient and effective
provision of financial services requires that financial policies and financial system
structures be adjusted in response to financial innovations and shifts in the broader
macroeconomic and institutional environment. Thus, the financial system acts as the brain
of modern economy. Well developed financial systems ease the exchange of goods and
services by providing payment services; help mobilize and pool savings from a large
number of investors; acquire and process information about enterprises and possible
investment projects, thus allocating society’s savings to their most productive use;
monitor investments and exert corporate governance; and help diversify and reduce
liquidity and intertemporal risk (Levine, 1997, 2004). The proponents of liberalization
argue that the allocation of capital is more efficient in a competitive financial system and
that higher real interest rates stimulate saving, thereby raising the funds available to
finance investment (McKinnon 1973, Shaw 1973). In McKinnon's (1973)
Complementary Hypothesis, money and capital are complementary to each other. High
interest rate can mobilize more savings. According to Shaw's (1973) Debt Intermediation
View (DIV), high real interest rates are essential in order to attract more savings. Thus,
the McKinnon – Shaw framework of financial liberalization asserts that high interest rates

∗
Assistant Director, Financial Institutions Supervision Department, Nepal Rastra Bank, Email:
bhetuwal@nrb.org.np
24 ECONOMIC REVIEW

can avail more financing by sufficiently mobilizing scarce savings. Financial

interventionism in the 1960s and 1970s directed cheap credit to favoured sectors
(industry, exports, small enterprises, and agriculture), which deemed productive, but
discouraged consumption and trade as unproductive. In doing so, credit ceilings and high
reserve requirements were imposed and interest rate administered in order to contain
inflationary pressure due to cheap credit policy. However, financial interventionism could
benefit neither industry and exports nor the agricultural sector. Such credits at low rates
tended to be characterized by poor lending decisions, weak repayment discipline, and
corruption in the government, since those granted access to capital (usually at low rates)
may buy influence to protect their favored positions. Rather, it distorted financial
development and economic growth (Fry 1995, 1997).
However, financial crisis is more prone to financial liberalization. Financial fragility
aggravates unpleasant economic development, inappropriate economic policies and
balance of payment problems. Institutional development with effective legal enforcement,
prudential regulation in place, efficient bureaucracy and low level of corruption minimize
the reverse impacts of financial liberalization (Demirguc-Kunt and Detragiache, 1999).
Legal environment (including enactment and enforcement of laws) has important
influence on financial liberalization and financial development of a country. Reforms
including advancing investor protection are likely to promote financial development (La
Porta et al, 1998, 2002). Imperfect financial markets make external finance costly and
reduce investment. Financial development (Rajan and Zingales, 2003; and Love, 2003)
and banking sector liberalization (Laeven, 1999) help to reduce financing constraint and
raise investment.
Financial liberalization helps to improve the functioning of financial system by
increasing the availability of funds and allowing risk diversification and increased
investment (Bekaert et al. 2000). Moreover, financial liberalization helps to discipline
policymakers enticed to a captive financial market. Financial liberalization triggers
financial development, which facilitates economic growth (King and Levine, 1993;
Jayaratne and Strahan, 1996; Rajan and Zingales, 1998).
The process of reforms or liberalization varies across countries and is dependent upon
the prevailing politico-economic features. In some of the developing countries (the Latin
American countries, in particular) financial sector reforms started with interest rate
liberalization, whereas in Nepal the easing of entry barriers was followed by the
liberalization of interest rates on deposits and loans so as to foster competition. The
statutory liquidity requirement (SLR) was lifted in 1989 as part of financial reforms, but
re-imposed in 1991 for two more years. Deregulation of interest rates and credit control
began in 1986 and full deregulation took place only in 1989. Regarding international
financial transactions, current account convertibility was undertaken in 1993, whereas
move towards capital account convertibility has been cautious. The chronology of
financial reforms and financial liberalization index as illustrated in Appendix 1 and 2
respectively depict the financial reform process in Nepal.
The next section discusses the theoretical framework on deriving the indices of
financial liberalization and financial development. The objectives of the study and
methodology adopted are discussed in the third section. In the fourth section, the indices
of financial liberalization and financial development are developed, followed by the
interpretation in the fifth section. The sixth section analyzes the causal relationship
 Financial Liberalization and Financial Development in Nepal 25

between financial liberalization and financial development. The last section concludes the
study.

II. THEORETICAL FRAMEWORK

The index of financial liberalization documents the trend and pace of financial
reforms. Most of the researchers have constructed their own indices of financial
liberalization based upon the chronological study of different financial systems.
Demirguc-Kunt and Detragiache (1999) have considered the deregulation of interest rates
as the liberalization of domestic financial sector and include liberalization of domestic
banking sector and opening up the stock markets to foreign investors. In a survey of
financial liberalization in 34 countries, Williamson and Mahar (1998) have identified six
different dimensions of financial liberalization: (1) elimination of credit controls, (2)
deregulation of interest rates, (3) lifting of entry barriers into the banking industry, (4)
bank autonomy, (5) pace of privatization of public sector banks, and (6) liberalization of
international capital transactions.
Kaminsky and Schmukler’s (2002) index of financial liberalization captures a wide
degree of intensity of financial liberalization, including the episodes of reversal and the
regulation on domestic financial institutions and non-financial corporations, multiple
exchange rates, and controls over capital flows. They have divided financial system into
three regimes (as fully liberalized, partially liberalized and repressed and ranked by 1, 2
and 3 respectively). The lower the index, the more liberalized is the financial system.
Demetriades and Luintel (1996 a, b) have directly measured the degree of control in
the banking sector of Nepal and India separately by applying the principal component
method and taking interest rate controls, liquidity requirements, directed lending, and
branch banking as the proxy of financial repression. They have mentioned ceilings, floor
and band on both lending and deposit rates. Bekaert et al (2000) have considered capital
account convertibility as the measure of financial liberalization. The indicator takes a
value between zero (pre-reform period) and one (post-reform period). Bandiera, Caprio,
Honohan and Schiantarelli's (1998, 1999) studies find eight different components: interest
rates, pro-competition measures, reserve requirements, directed credit, bank ownership,
prudential regulation, securities markets deregulation, and capital account liberalization.
They generate the index by using principal component method.
Abiad and Mody (2003) have indexed financial liberalization for 35 countries
including Nepal, over a period 1973 to 1996. They pursue political economy perspective
in explaining timing, pace and extent of financial sector reforms. They have considered
six policy dimensions as the inputs while indexing the degree of policy liberalization.
They are: (i) credit controls, (ii) interest rate controls, (iii) entry barriers, (iv) regulations
and securities markets, (v) privatization in the financial sector, and (vi) restrictions on
international financial transactions.
Ang and McKiibbin (2005) developed a single index of financial development by
using principal component method. The indicators of financial development are logarithm
of (i) ratio of liquid liabilities to GDP, (ii) ratio of commercial bank assets to total assets
of commercial bank and central bank and (iii) ratio of domestic credit to private sector to
GDP.
26 ECONOMIC REVIEW

III. OBJECTIVES AND METHODOLOGY

This paper aims to provide a better understanding of the liberalization process in

Nepal over the period 1975 to 2006. It captures various aspects of liberalization. It covers
several regulatory reforms and impositions of prudential regulation and other control
measures to provide information on the degree of financial liberalization while relating it
to institutional reforms. The principal component analysis is performed to reduce a large
number of correlated variables into the two indices of financial liberalization and
financial development so as to overcome the problem of muticollinearity.
The paper examines casual relationship between financial reforms and financial
development. Granger causality test is performed to find out the direction of causation
between the financial liberalization and financial development. Granger causality test
(Granger 1969, and Sims 1972) is used to test whether changes in one variable causes
change in another or both of them are endogenously determined. Given the two variables
financial development (X) and financial liberalization (Y), we estimate unrestricted and
restricted equations, as given below.

p q
Unrestricted Regression: Yt = ∑α Y
i =1
i t −i + ∑β X
j =1
j t− j + ut (1)

p
Restricted Regression: Yt = ∑α Y
i =1
i t −i +ut (2)

where, ut is white noise, p is the order of the lag for Y, and q is the order of the lag for X.

IV. INDICES OF FINANCIAL LIBERALIZATION AND FINANCIAL DEVELOPMENT

Different dimensions of financial liberalization and financial development are highly

correlated. It is obvious that correlation does not imply causation, but it is likely to be an
outcome of causality. The principal component analysis reduces a number of correlated
variables into a smaller set of uncorrelated principal components. It sufficiently deals
with the problems of multicollinearity. It expresses different dimensions of financial
liberalization and financial development in terms of two indices of financial liberalization
and financial development respectively. The new proxies of financial liberalization and
financial development are able to capture most of the information from the original series.
The method of principal components involves linear transformation of a large number
of policy variables, which are possibly correlated. In this method, a new series is
developed with standardized variables so that they are uncorrelated and they are ordered
in terms of variance. The standardized series is constructed by deducting the mean of the
variables and dividing it by the respective standard deviation. The variances of each
policy variable are divided by the square root of the sum of the variance to get the
loadings for each policy variable. Finally, the standardized series are multiplied by
respective loading. While generating the index of financial liberalization each dimension
is classified into four categories, fully repressed, partially repressed, largely liberalized
and fully liberalized and graded as 0, 1, 2 and 3 respectively.
 Financial Liberalization and Financial Development in Nepal 27

The index of financial development consists of the ratios of liquid liabilities of the
financial system to GDP, credit to private sector to GDP, domestic assets of commercial
banks to the sum of domestic assets of Nepal Rastra Bank and commercial banks, and
private sector credit to total loans and advances of commercial banks. The subject matter
of financial liberalization is broader and it requires subjective judgment while
constructing the index of financial liberalization. The grading is also subjective.
However, some guiding principles have been adopted to reduce subjectivity. Interest rates
control, for example, was graded as fully repressed when it was determined by the central
bank and partially repressed when the interest rates were subject to a ceiling or floor or
allowed to vary within a band. It was largely liberalized when some of the interest rates
were allowed to be completely market driven and finally fully liberalized when all the
restrictions were removed completely. Each subcomponent is ranked between 0 and 3 and
their sum is divided by total number of subcomponents to reach into the common ranking
of every dimensions. Since each of the indices can take on values between 0 and 3, the
sum takes on values between 0 and 18 altogether.
The indices of financial liberalization and financial development are for the period
1975 – 2006. Financial liberalization index is derived from six different dimensions of
financial policy variables as suggested by Abiad and Mody (2003). The ratios of broadly
defined money supply to nominal GDP, private sector credit to GDP, private sector credit
to total loans and advances of commercial banks and total assets of commercial banks to
total assets of commercial banks and domestic assets of central bank are used to construct
the index of financial development (as used by King and Levine 1993a; Beck et al 2004;
Levine 2004). Data for nominal GDP is obtained from various issues of the Economic
Survey published by the Government of Nepal, broad money supply is used as proxy for
liquid liabilities, credit to the private sector and total assets of commercial banks,
domestic assets of Nepal Rastra Bank and total loans and advances of commercial banks
are taken from various issues of Quarterly Economic Bulletin published by the Nepal
Rastra Bank.

Index of Financial Liberalization

The index of financial liberalization captures the various policies implemented for
liberalizing the financial sector. This paper, therefore, considers six dimensions of
financial sector policies to arrive at a single index of financial liberalization.
(a) Entry Barriers (ENTRANCE): It covers licensing requirements, limits on foreign
participation in the banking sector, restrictions on bank specialization and establishment
of universal banking.
(i) Licensing requirements: Licensing was totally restricted before 1984 and ranked
by 0. Restrictions were eased as documented by 1 up to 1997, which increased to 1.50 for
2000 to 2002 and further to 1.75 in 2003.
(ii) Limits on foreign bank participation: Domestic private sector was allowed for
new entrance since 1998 and it is marked as 2 onwards.
(iii) Restrictions to bank specialization: Bank specialization was allowed after 1984
(graded as 1) with widening of private participation since 1998 (graded by 2). Bank
specialization is graded 0 before 1984.
(iv) Universal banking is not allowed yet and ranked as 0.
28 ECONOMIC REVIEW

(b) Interest Rate Controls (INTEREST): It is a policy variable that seeks to find out
whether there exists a direct control over interest rates (in the form of floor, ceilings or
interest rate bands). Complete administrative control over the interest rates before 1984 is
indicated by 0. Liberal attitude towards fixing interest rates within the range of 1 to 1.5
percent since 1984 to 1985 is ranked as 1. Similarly, partial deregulation between 1986
and 1989 is ranked by 2 and thereafter by 3 as complete deregulation.
(c) Credit Controls (CREDIT): This policy variable comprises of directed credit,
credit ceilings and reserve requirements (both CRR and SLR).
(i) Directed credit to the favored industries or sectors: Directed credit existed until
2001 and is graded as 0. As it was eased in 2002, it is ranked by 2; it is graded as 3 as it
was phased out gradually starting from 2003.
(ii) Credit ceilings toward other sectors: Credit ceilings were present till 1989 and
then removed. Therefore, it is graded as 0 before 1989 and 3 onwards.
(iii) High reserve requirements: It is the summation of cash reserve requirement
(CRR) and statutory reserve requirement (SLR). The reserve requirement below 10
percent of deposit liabilities is noted as fully liberalized, 10-15 as largely liberalized, 15-
25 as partially repressed and above 25 percent as completely repressed. It is ranked by 3,
2, 1 and 0 respectively.
(d) Regulations and Securities Market (REGULATION): This variable includes the
presence and magnitude of control measures (e.g. staffing, branching and advertisement)
and presence of prudential regulations in the banking system.
(i) Operational restrictions and prudential regulations: This explains whether or not
there are operational restrictions pertaining to staffing, bank branching and advertising,
among others and establishment of new securities markets. The absence of prudential
regulation in the banking sector until 1987 is graded as 0, presence of prudential
regulation up to 2000 as 1 and onwards as 2.
(ii) Securities market development: Existence of securities market since 1984 is
graded as 1 until 1993; stock market was reformed later and is graded as 2. Foreign
investors are not allowed to participate in the stock market.
(e) Restriction in International Financial Transactions (CAPITAC): International
financial transactions comprise presence of multiple exchange rates and restrictions on
current account & capital account convertibility.
(i) Restriction on current account convertibility: Current account was convertible
partially in 1992 and fully since 1993. Therefore, it is graded as 0 up to 1991, 2 for 1992
and 3 onwards.
(ii) Restriction on capital account convertibility: Capital account convertibility
captures four components: control on investment outflow, foreign direct investment
(FDI), portfolio flows and multiple exchange rates. Investment outflows and portfolio
investment are prohibited and ranked by 0 for the whole period. Foreign direct investment
was partially allowed (in the financial sector) since 1984; more sectors were opened since
1993. Therefore, it is graded as 0 before 1984; 1 up to 1993 and 2 onwards. Multiple
exchange rates were present until 1991 (ranked 0), brought into single rate in 1991
(ranked 1) and market forces were allowed to determine exchange rate since 1992 with
frequent interventions of the NRB (ranked 2).
 Financial Liberalization and Financial Development in Nepal 29

(f) Privatization of the Financial Sector (PRIVAT): Policies relating to privatization

explain the level of privatization of the public sector banks and financial institutions. It
was in 1998 that Nepal Bank Limited was divested by 10 percent to limit government
ownership to 40.5 percent. Therefore, it is graded 0 until 1997 and 1 onwards.
When controls were lifted, there were jumps of more than one unit along that
dimension. Reversal or impositions of controls were also recorded in the form of shifts
from a higher to a lower score. The index allows for distinguishing the dimensions of
financial sector reforms, year of major reforms undertaken and minor policy changes as
well as policy reversal. The financial liberalization index is fitted in Figure 1.

FIGURE 1: Financial Liberalization Index

2.5
2.3
2.0
1.8
1.5
1.3
1.0
0.8
Index

0.5
0.3
0.0
-0.3
-0.5
75

77

79

81

83

85

87

89

91

93

95

97

99

01

03

05
19

19

19

19

19

19

19

19

19

19

19

19

19

20

20

20
-0.8
-1.0
-1.3 Ye ar
-1.5
ENTR ANC E INTER ES T C R EDIT R EGULATION C AP IITAC P R IVAT

Source: Appendix 2.
Index of Financial Development

A well-developed financial system mobilizes savings and allocates resources

efficiently, diversifies risks, induces liquidity, reduces both information and transaction
costs and provides alternative to raising funds. There are an array of agents and
institutions involved in the activities of financial intermediation. In a diversified financial
system, the selection of variables to represent the level of financial services generated and
measures the extent and efficiency of financial intermediation is not an easy task.
Financial deepening can be measured by the intermediaries' ability to mobilize savings,
facilitate transactions, reduce information and transaction costs and manage risks.
However, valid and reliable data are not readily available and, hence, the proxy so far
taken is not perfectly satisfactory. Broad money supply (M2) is considered to be a proxy
for the liquidity in the economy.
The natural logarithms of the following variables are used as the proxies while
generating the index of financial development covering the period 1975 to 2006. They
are: (a) ratio of liquid liabilities of the financial system to GDP (DEPTH), (b) ratio of
credit to private sector to GDP (PRIVY), (c) ratio of domestic assets of commercial banks
to the sum of domestic assets of Nepal Rastra Bank and commercial banks (BANK), and
(d) ratio of private sector credit to total loans and advances of commercial banks
(PRIVATE).
30 ECONOMIC REVIEW

(a) Liquid Liabilities (DEPTH) is the ratio of liquid liabilities of the financial system,
i.e., the sum of currency, demand and time deposits liabilities of financial intermediaries
to GDP [King and Levine (1993a) have used this measure].
(b) Private Credit (PRIVY) is the ratio of commercial bank credit to the private
sector to GDP. It excludes credit to the public sector and cross claims of one group of
banks on another [however, King and Levine (1993 a, b) have used the credit issued by
the central bank and development banks as well].
(c) Bank (BANK) is the ratio of domestic assets of commercial bank to the sum of
domestic assets of commercial banks and the central bank. It measures the degree of
credit allocation by the commercial banks. The motive behind this measure is that
commercial banks identify profitable investment, monitor managers, facilitate risk
management, and mobilize savings more than the central bank.
(d) Private Sector Credit (PRIVATE) is the ratio of commercial banks’ credit to the
private sector to their total loans and advances. It measures the extent of bank credit to the
private sector out of their total loans and advances. The index of financial development is
illustrated in Figure 2.

FIGURE 2: Index of Financial Development

2.0

1.5

1.0

0.5

0.0
Index
75

77

79

81

83

85

87

89

91

93

95

97

99

01

03

05
-0.5
19

19

19

19

19

19

19

19

19

19

19

19

19

20

20

20
-1.0

-1.5

-2.0 Ye ar

-2.5
LDEP T H LBANK LP RIVAT E LP RIVY

Source: Appendix 2

V. ANALYSIS AND INTERPRETATION

Statistical examination of liberalization has two major challenges. Firstly, the policy
changes tend to be periodic and triggers for these events need to be identified. The events
move both ways, towards liberalization as well as reversals in the long-run process.
Secondly, identification of dynamic process also leads to cumulative transformations.
Since financial sector reform is an ingredient of overall economic reforms, it is difficult to
extricate its effects from the reforms in other sector of the economy. Further, the task of
reforms is not straightforward but with numerous pitfalls. Generally, it seems clear that
 Financial Liberalization and Financial Development in Nepal 31

financial liberalization has contributed to mobilize resources through the formal financial
system and improved efficiency of allocation.

TABLE 1: Correlation Matrix

VARIABLES DEPTH BANK PRIVATE PRIVY ENTRANCE INTEREST CREDIT REGULATION CAPIITAC PRIVATE
DEPTH 1.000
BANK 0.621 1.000
PRIVATE 0.667 0.774 1.000
PRIVY 0.740 0.956 0.906 1.000
ENTRANCE 0.581 0.923 0.800 0.929 1.000
INTEREST 0.412 0.836 0.721 0.820 0.883 1.000
CREDIT 0.673 0.837 0.846 0.909 0.869 0.853 1.000
REGULATION 0.677 0.917 0.844 0.950 0.963 0.904 0.934 1.000
CAPIITAC 0.797 0.832 0.771 0.887 0.831 0.775 0.865 0.889 1.000
PRIVATE 0.783 0.749 0.711 0.811 0.775 0.503 0.645 0.741 0.692 1.000
Source: Appendix 2

The financial policy variables (credit controls, interest rate controls and controls on
international financial transactions) and indicators of financial development are highly
correlated with each other. Table 1 shows the correlations among different components of
financial liberalization and financial development. The method of principal component is
applied to overcome the problem of multicollinearity among the policy variables
(financial liberalization and financial development) while quantifying them and
constructing the indices of financial liberalization and financial development.
Figure 1 shows the gradual liberalization of the financial sector with partial
repression. The reform process has been stretching for more than a decade. Although the
process of reforms began in the mid-1980s, the major reforms took place in the late 1980s
and comprehensive reforms undertaken after the restoration of democracy in 1990. This
index, thus, jointly evaluates the liberalization of the domestic financial sector, the stock
market and international financial transaction.
As shown in Figure 2, the index of financial development clearly depicts the
development of different variables. The level of financial development was less than
average of the overall period before 1993. Among the different variables, LBANK
increased more than the others prior to 1981. It was mainly due to the increase in bank
lending to the public enterprises and the government. It declined after the initiation of
economic stabilization programme in the early 1980s. After liberalization, total domestic
assets of commercial banks increased more than that of the central bank. LPRIVATE has
an increasing trend but the pace is rather slow over time. LPRIVY has a declining trend
before 1980. However, it improved gradually after the initiation of reforms with a smooth
growth path until 1994. The emergence of new banks and financial institutions in private
sector after 1994 contributed to the growth of the ratio of private credit to GDP since
1994. Further, its growth is affected due to poor investment environment after 1998.
LDEPTH (ratio of M2 to GDP) shows an increasing trend at the level above zero since
1989. Its trend is smooth in comparison to the other variables. The declining trend in
1980s improved gradually in the late years of the decade. However, it moved down in the
year 1992 due to the adoption of contractionary monetary policy during 1991.
32 ECONOMIC REVIEW

The index of financial development (FINDEV) shows that the development was
attributed to the expansion of bank branches before 1980. However, there was a setback
in the process of financial development during the early 1980s. An improvement can be
observed after the establishment of joint venture banks and partial deregulation of interest
rates. The index of financial development shows a variable path of development of the
financial system in Nepal. The index turned positive by 1994; however, the extent of
development is stagnant with a change each year being less than unity. When the indices
of financial liberalization and financial development are put together in Figure 3, both
indices are seen to move together.

FIGURE 3: Index Financial Liberalization and Financial Development

10

2
Indices

0
75

77

79

81

83

85

87

89

91

93

95

97

99

01

03

05
-2
19

19

19

19

19

19

19

19

19

19

19

19

19

20

20

20
-4
Year
-6
FINLIB FINDEV
-8

Source: Appendix 2

VI. GRANGER CAUSALITY TEST

The indices of financial liberalization and financial development have a rising trend,
indicating increase in the degree of financial liberalization and the level of financial
development. It refers to the change in the policy i.e. change in the degree of financial
liberalization promotes financial development. At the same time, the level of financial
development will demand further financial liberalization. In this light, the simple Granger
causality technique is applied to find out whether or not there exists any causal
relationship between the two series.
TABLE 2: Granger Causality
Granger Causality Tests with Two Lags
Sample period: 1975- 2006
Null Hypothesis: Obs F-Statistic Probability
FINDEV does not Granger Cause FINLIB 30 2.778 0.081
FINLIB does not Granger Cause FINDEV 5.121 0.014
The Granger causality test between the financial liberalization and financial
development series suggests that the direction of causality is from financial liberalization
 Financial Liberalization and Financial Development in Nepal 33

to financial development, since the computed F-statistics (5.121) is greater than the
critical value (3.35). The computed F-value of FINDEV to FINLIB (2.78) is not
significant statistically and suggests that there is no reverse causation from financial
development to financial liberalization at 5 percent level of significance. At 10 percent
level of significance, the critical F-value (2.49) is lower than the computed F-value in
both the equations indicating bi-directional causality. It shows the existence of bi-
directional causality between the FINDEV and FINLIB. However, at the 1 percent level
of significance as usual, there is unidirectional causation from financial liberalization to
financial development.

VII. CONCLUSION

The analysis of several financial sector policies with the help of a single index of
financial liberalization states that financial sector reforms is a process rather than a single
moment event. It is clear that after the introduction of financial sector reforms in 1980s,
the Nepalese financial sector has widened. The elimination of direct administration of the
prices of financial products and private sector participation has contributed to this
expansion. Financial liberalization is a process of removing restrictions taking several
years to complete. Further, it is also characterized by reintroduction of restrictions at
times, but only temporarily. Institutional reforms do not predate liberalization but they are
vital for the success of financial sector reforms. It covers information on the quality of
institutions as well as laws governing the functioning of the financial system. Improved
quality of institutions is likely to reduce financial instability. This analysis shows that the
process of financial reforms in Nepal is rather slow. During recent years, reforms are
concentrated mainly on improving the financial health of large state-owned banks as well
as capacity enhancement of central bank and other institutional improvement. The
reorganization and reforming the Nepal Stock Exchange has raised the scope of financial
market in Nepalese financial system. Global revolution in information technology and the
country's integration with the rest of the world requires the financial sector to be more
competitive and updated with recent financial products.
The estimated indices show liberalization of the financial sector and thereby steady
financial development in Nepal. Financial development is not only caused by policy
changes in the financial sector, but it largely depends on the demand of financial services
in the economy. The development of the financial sector is vital for economic
development of a country. But it cannot be achieved in isolation with the other sectors of
the economy. Simultaneous growth in all the sectors of the economy can raise more
demand of financial services and it can stimulate financial development. Unidirectional
causality from financial liberalization to financial development (at 5 percent level of
significance) found from the Granger causality test depicts this practical situation. At 10
percent level of significance, there is bi-directional causal relationship between financial
liberalization and financial development.
34 ECONOMIC REVIEW

APPENDIX 1: Chronology of Financial Sector Reforms

1. Removal of Entry Barriers

1A. Policy Measures Year Desired Objectives

Entry barriers were eased for joint venture banks. 1984 Increase private sector participation to foster
competition in the financial sector
ADB/N was allowed to undertake commercial 1984 Foster competition in mobilizing resources from the
banking activities urban areas to lend in the agricultural sector.
Establishment of Citizen Investment Trust 1991 Mobilize contractual saving
Establishment of Regional Rural Development 1993 Enhance access of rural poor to the formal credit
Banks
1B. Legal and Institutional Reforms
Enactment of Finance Company Act 1985 1985 Avail consumer credit and promote competition
Establishment of Credit Information Bureau 1989 Discourage risky lending, enhance recovery of loans
Creation of Rural Self Reliance Fund 1991 Improve rural credit system
Introduction of Privatization Act 1994 Minimize government’s role in public sector utilities
Enactment of International Financial Centre Act 1997 Develop a regional offshore financial centre
Enactment of Financial Intermediaries act 1999 Formalize the informal finance
Enactment of Nepal Rastra Bank Act 2002 Increase autonomy
Establishment of Debt Recovery Tribunal 2003 Reduce NPL
Enactment of BFI Ordinance 2004 Umbrella Act to remove legal fragmentation

2A. Interest Rate Controls

Year Desired Objectives
Interest rate regulated by NRB. To make deposit interest rates on savings competitive
Minimum rate on saving and one year fixed deposit 1966 to that of India.
were fixed at 4 and 6 percent.
Interest rates were revised upwards to minimize the Encourage saving mobilization.
impact of the negative real rates. 1971
• Interest rates on savings and one year fixed
deposit interest rates increased by 0.5 and 1.5
percentage to 5 and 8.5 percent respectively.
• Interest rates on call deposit were introduced.
• Slack season and busy season rates were fixed at
3.5 and 4.5 percent respectively.
Introduction of new lending rates ranging from 7 to 1971 Encourage investment
13 percent
Introduction of subsidized interest rates 3.5 to 10 Protect agricultural and industrial sectors.
percent for agricultural and 7.5 percent for industrial 1971
sector.
Interest rates raised upwards on savings 1974 Maintain positive real interest rate
Upward revision of overall interest rate structure of Effectively mobilize domestic saving and control
commercial banks at 15 percent per annum on fixed 1975 capital flight
deposit and higher bank loans 15 to 18 percent
Deposit rates sliced down gradually 1977 Reduce the lending rates
Commercial banks were restricted from accepting 1978 Discourage capital inflow to ease monetary control
deposit from foreign institutions
 Financial Liberalization and Financial Development in Nepal 35

2B. Interest Rate Liberalization

Year Desired Objectives
Banks were free to offer interest rate on deposits 1984 Promote competition; increase deposit rate.
above a band of 1 to 1.5 percent than fixed by the
Nepal Rastra Bank.
Banks were allowed to fix their own interest on both 1986 Enable the market to determine interest rate
deposit and loans within a floor and ceilings competitively
respectively.
Inter-bank borrowing was allowed. 1986 Enable banks to manage short term liquidity
problems
Complete deregulation of interest rates. 1989 Market forces determine interest rate freely
Redesigning of Nepal Rastra Bank refinance 1989 Solve liquidity problem of banks
facilities
Treasury bills auction 1988 Deny cheap funds to the government
Narrow down interest rate spread 1993 Reduce the spread between deposit and lending rates
Abolition of spread regulation 2002 Allow efficient allocation of credit

3. Credit Control and Deregulation

3A. Credit Ceilings Year Desired Objectives
Credit ceiling of 13.5 percent (to that of previous 1986 Contain inflation by reducing money supply and
year) was imposed so that no commercial banks could curbing down aggregate domestic credit
expand their credits in excess
Abolition of credit ceiling 1989 Freeing banks to extend credit
3B. Directed credit
Priority Sector Credits
5% of Total Deposit 1974/75
7% of Total Deposit 1976/77 Avail credit to small and medium projects and
diversify risk of credit concentration, encourage
8% of Total Lending 1981/82
productive sector, avail credit to excluded and
10% of Total Lending 1985/86 small sectors of the economy
12% of Total Lending 1991/92
While deprived sector credit would remain intact, Reduce operating cost and loan default and
priority sector credit will be gradually phased out by increase profitability of the banking sector, and
2007/08 as follows: make efficient use of fund
7 percent 2002/03
6 percent 2003/04
4 percent 2004/05
2 percent 2005/06
2 percent 2006/07
3C. Cash Reserve Requirement
9 percent Until 1989 Gradually reduce the CRR so as to free more
2 percent 1990-97 resources to avail credit to the private sector.
0 percent 1998-2001
9 percent 2002
6 percent 2003-04
5 percent 2005-06
3D Statutory Liquidity Requirement (SLR): Lifted 1989 Allow banks to choose portfolio of their own.
Reintroduced 1991 Mop up excess liquidity from the economy.
Abolished 1993 Remove direct control
36 ECONOMIC REVIEW

4. Regulation of Financial Institutions and Securities Market

4A. Prudential Norms for Banks
I. Capital adequacy ratio, income recognition, 1988 Achieve financial stability through market
loan classification and loan loss provisioning, discipline while discouraging risk exposure and
and single borrower limit maintain accounts uniformly with that of
international practice.
a. Capital adequacy ratio 5.0 % 1988 Ensure sound and healthy financial system in line
8.0 % 1991 with international best practices
12.0% 2002
onwards
b. Core capital adequacy ratio of risk 1991, 1992 Increase franchise value of banks and hence
weighted assets and off-balance sheet and 1993 reduce their vulnerability
transaction 2.5%, 4.0 %, 6.0 %
II. Allocation of risk factors on off-balance-sheet 1991 Safeguard solvency of the financial system
items.
III. Risk based loan classification and provisioning 1989 Promote stability.
for loss
IV. Interest income recognition on cash basis 1989 Discourage overspending tendency
V. Single borrower obligation 1989 Control banks’ risk exposure and widely avail
credit

4B. Securities Market Reform

Establishment of Securities Exchange Centre 1977 Develop the capital market for long term
investment.
Enactment of Securities Exchange Act 1984 Enhance the capital market.
Nepal Stock Exchange Ltd (NEPSE) revamped 1994 Develop a modern securities market.
Formation of Security Exchange Board 1994 Regulate the stock market activities.
Introduction of Code of Conduct for Security 2003 Encourage self-discipline.
Agents
Issued directives on transaction of securities 2004 Regulate securities market prudently.

5. Privatization in the Financial Sector

New industrial policy further eased entry 1992 Encourage private sector participation in the
barriers in all the sectors of economy including financial sector
financial sector
Divestment of 10 percent of public sector 1998 Encourage private participation in the bank
share from Nepal Bank Limited and improve work culture and efficiency
 Financial Liberalization and Financial Development in Nepal 37

6. Restriction on the International Financial Transactions

6A. Reforms in the exchange rate regime: Market determined exchange rate
i Devaluation of NRs against US$ by 14.7% 1985 Encourage exports
ii Partial convertibility of current account 1992 Achieve article VIII status in the IMF
a. At a ratio of 65: 35
b. At a ratio of 75:25
c. Full convertibility of Rupee in current account 1993
6B. Foreign currency denominated bank accounts
Nepali citizens permitted to open foreign currency Lower the cost of international transactions
accounts
i Up to 30 % of earning in convertible currency 1992 Encourage inflow of forex in banking system
ii Up to 50 % of earning in convertible currency 1993
iii Up to 100 % of earning in convertible currency 1994
6C. Borrowing in convertible currencies from commercial Provide incentive to exports and promote
banks competition
i Short term loans for export-industries and small 1993
scale power generating entities
ii Import of raw wool for carpet industries and 1993
specified imports from India
iii Amortization of principal and interest in FC 1994

Sources: Acharya et. al (1998) and various publications of Nepal Rastra Bank and Government of Nepal.
38 ECONOMIC REVIEW

APPENDIX 2: Indices of Financial Liberalization and Financial Development

FINANCIAL LIBERALIZATION FINANCIAL DEVELOPMENT
ENTRANCE INTEREST CREDIT REGULATION CAPIITAL PRIVATE FINLIB LDEPTH LBANK LPRIVATE LPRIVY FINDEV
1975 -1.31 -1.29 -1.14 -1.25 -0.90 -0.49 -6.37 -0.29 -2.22 -0.24 -1.51 -4.26
1976 -1.31 -1.29 -1.14 -1.25 -0.90 -0.49 -6.37 -0.39 -1.85 -1.13 -1.72 -5.08
1977 -1.31 -1.29 -1.14 -1.25 -0.90 -0.49 -6.37 0.21 -1.23 -1.67 -1.46 -4.15
1978 -1.31 -1.29 -1.14 -1.25 -0.90 -0.49 -6.37 -0.27 -1.17 -1.39 -1.32 -4.15
1979 -1.31 -1.29 -1.14 -1.25 -0.90 -0.49 -6.37 -0.26 -1.02 -1.27 -1.16 -3.71
1980 -1.31 -1.29 -1.14 -1.25 -0.90 -0.49 -6.37 -0.16 -0.76 -0.23 -0.71 -1.86
1981 -1.31 -1.29 -0.89 -1.25 -0.90 -0.49 -6.12 0.15 -0.71 -0.30 -0.55 -1.41
1982 -1.31 -1.29 -0.89 -1.25 -0.90 -0.49 -6.12 -0.13 -0.61 -0.24 -0.65 -1.63
1983 -1.31 -1.29 -0.89 -1.25 -0.90 -0.49 -6.12 -0.73 -0.30 -1.15 -0.75 -2.92
1984 -0.04 -0.62 -0.89 -0.59 -0.78 -0.49 -3.42 -1.02 -0.37 -0.88 -0.74 -3.01
1985 -0.04 -0.62 -0.89 -0.59 -0.78 -0.49 -3.42 -1.45 -0.38 -0.82 -0.65 -3.30
1986 -0.04 0.04 -0.41 -0.59 -0.78 -0.49 -2.26 -1.50 -0.31 -0.47 -0.53 -2.81
1987 -0.04 0.04 -0.41 -0.59 -0.78 -0.49 -2.26 -1.30 -0.29 -0.47 -0.48 -2.54
1988 -0.04 0.04 -0.41 0.06 -0.78 -0.49 -1.61 -0.90 -0.25 -0.32 -0.41 -1.88
1989 -0.04 0.71 0.33 0.06 -0.78 -0.49 -0.21 -1.03 -0.08 0.28 -0.21 -1.04
1990 -0.04 0.71 0.08 0.06 -0.78 -0.49 -0.45 -1.00 -0.02 0.16 -0.23 -1.09
1991 -0.04 0.71 -0.41 0.06 -0.78 -0.49 -0.94 -0.39 0.04 -0.45 -0.21 -1.02
1992 -0.04 0.71 0.33 0.06 0.29 -0.49 0.86 -0.03 -0.13 -0.55 -0.18 -0.89
1993 -0.04 0.71 0.33 0.06 1.00 -0.49 1.57 0.03 0.24 -0.82 -0.11 -0.67
1994 0.38 0.71 0.82 0.72 1.00 -0.49 3.14 0.33 0.31 -0.30 0.16 0.51
1995 0.38 0.71 0.82 0.72 1.00 -0.49 3.14 0.26 0.45 0.76 0.54 2.01
1996 0.38 0.71 0.82 0.72 1.00 -0.49 3.14 0.31 0.46 1.13 0.75 2.66
1997 0.38 0.71 0.82 0.72 1.00 -0.49 3.14 0.35 0.45 1.14 0.79 2.73
1998 0.81 0.71 0.33 0.72 1.00 1.25 4.80 0.62 0.76 0.97 0.95 3.31
1999 0.81 0.71 0.33 0.72 1.00 1.25 4.80 0.74 0.91 0.98 1.01 3.64
2000 1.23 0.71 0.33 0.72 1.00 1.25 5.23 0.98 1.14 0.90 1.12 4.14
2001 1.23 0.71 0.33 1.37 1.00 1.25 5.88 1.01 1.29 0.69 1.21 4.20
2002 1.23 0.71 0.82 1.37 1.00 1.25 6.37 0.93 1.33 0.62 1.25 4.13
2003 1.65 0.71 1.06 1.37 1.00 1.25 7.04 1.17 1.37 0.76 1.35 4.65
2004 1.23 0.71 1.80 1.37 1.00 1.25 7.35 1.21 1.16 1.38 1.42 5.18
2005 1.23 0.71 1.80 1.37 1.00 1.25 7.35 1.29 0.99 1.51 1.51 5.30
2006 1.23 0.71 1.80 1.37 1.00 1.25 7.35 1.25 0.77 1.42 1.50 4.94

Sources: Quarterly Economic Bulletin, Economic Survey and own computations

 Financial Liberalization and Financial Development in Nepal 39

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