Bank Credit and Economic Growth in

Nepal: An Empirical Analysis#

Neelam Timsina

Abstract

This study examines the impact of commercial bank credit to the private sector on the economic
growth in Nepal from supply side perspectives. The study has applied Johansen co-integration
approach and Error Correction Model using the time series data for the period of 1975-2014. The
empirical results show that bank credit to the private sector has positive effects on the economic
growth in Nepal only in the long run. Nevertheless, in the short run, it has been observed a
feedback effect from economic growth to private sector credit. More specifically, the growth in
real private sector credit by 1 percentage point contributes to an increase in real gross domestic
product by 0.40 percentage point in the long run. The empirical results imply that, policy makers
should focus on long run policies to promote economic growth – development of modern banking
sector, efficient financial market and infrastructure so as to increase the private sector credit
which is instrumental to promote growth in the long run.

Key Words: Economic Growth, Bank Credit, Co-integration

JEL Classification: E23, G21, C32

# The earlier version of this paper is available at www.nrb.org.np under NRB Working Paper
series, NRB-WP-22, 2014.

Director, Nepal Rastra Bank, Research Department, Central Office, Baluwatar, Kathmandu,
Nepal. Email: neelam@nrb.org.np

Acknowledgement: I would like to express my sincere thanks to Mr. Guna Raj Bhatta, Assistant
Director of Monetary Division, Research Department for his valuable inputs in setting
methodological frameworks.
2 NRB ECONOMIC REVIEW

I. INTRODUCTION

Economic growth is one of the major objectives of macroeconomic policy. It is the

crucial means of uplifting living standards as well as achieving economic development.
Economists define economic growth from various perspectives. Some economists view
that it is an increase in the national income or the level of production of goods and
services by a country over a certain period of time. Generally economic growth is defined
as an increase in gross domestic product (GDP). Therefore, GDP is considered as proxy
of economic growth in the study.

Credit is the aggregate amount of funds provided by commercial banks to individuals,

business organizations/industries and government for consumption and investment
purposes. Individuals obtain credit for both consumption and investment purposes,
business organizations/industries borrow loans to invest in plant and machinery where as
government borrows loans to spend for recurrent as well as capital expenditure purposes.
More specifically, credit is understood as the provision of resources such as granting a
loan by the creditor/lender to the debtor/borrower where the debtor does not reimburse
the lender immediately, thereby generating a debt, and instead arranges either to repay or
return those resources at a later date (Mishra at all, 2009). Credit is considered as a key
to economic growth especially in developing countries as it lubricates the economy.
Therefore, the role of bank credit in economic growth has been accepted by many
researchers as various economic agents are able to invest money in various investment
opportunities.

Economic growth has been one of the major macroeconomic objectives of the
government of Nepal. Nepal Rastra Bank (NRB) considers that monetary policy should
also support growth. NRB always directs commercial banks to flow their credit to
productive sector. Credit channel of monetary policy is considered very important and
effective in Nepal. In this channel, money supply is expected to affect real variables
through the means of bank balance sheet and availability of credit. A large body of
evidence suggests that financial sector development plays a huge role in economic
development. Okwo (2012) examined the effect of bank credit to private sector on
economic growth in Nigeria and found that bank credit to private sectors has a statistical
strong positive relationship with GDP as expected. Bank credit to private sector promotes
economic growth through capital accumulation and technological progress by increasing
the savings rate, mobilizing and pooling savings, producing information about
investment, facilitating and encouraging the inflows of foreign capital, as well as
optimizing the allocation of capital (World Bank, 2013). One of the major indicators for
measuring financial development of a country is private sector credit to GDP ratio. The
role of credit provided by banks to private sector is considered more efficient to support
economic growth rather than the credit provided to government. Therefore, private sector
credit is taken as the proxy of bank credit here in the study.
 Bank Credit and Economic Growth in Nepal: An Empirical Analysis 3

Bank credit has significant role in economic growth. Especially in developing countries
like Nepal, it caters resource need for economic growth. Hence, NRB and the government
have adopted many policies and programs to increase economic growth through the use
of bank credit. NRB has been playing a leading role to determine the proportion of bank
loans and advances to productive sectors (agriculture, energy, tourism, industry). The
main objective of this provision is to stimulate economic growth in the country. However,
the relationship between private sector credit and economic growth has not yet been
assessed properly in the Nepalese context. In this regard, this study attempts to fulfill the
gap. Therefore the main objective of this study is to examine the effects of commercial
bank credit to private sector on economic growth from supply side perspectives as well as
to suggest ways of improving bank credit to private sector so as to achieve better
economic growth in Nepal.

The rest of the paper is structured as follows. The second section describes the theoretical
framework. The third section reviews the related literatures. The fourth section presents
the status and trend of bank credit to private sector. The fifth section presents the data and
methodology and the sixth section shows results of the study. The last section concludes
the study.
II. THEORETICAL FRAMEWORK

Bank credit contributes to economic growth in several ways. For example, credit is an
important link in money transmission; it finances production, consumption, and capital
formation, which in turn affect economic activity. The transmission mechanism of
monetary policy can be strengthened, and the monetary policy objectives attained to a
large extent, if the financial system is well-operated and regulated. Credit extended to the
private sector in an environment of banking discipline will be instrumental in tapping the
productive potentialities and development prospects of the economy. It thereby ushers to
inculcate economic growth, generating employment opportunities, and strengthening the
competitiveness of the economy (Basyal, 2009). It is a means of generating self
employment opportunities, strengthening informal activities. Ademu (2006) explained
that credit can be used to prevent economic activity from total collapse in the event of
natural disaster such as flood, draught, disease or fire. By using credit, farmers increase
agricultural production by investing money in seed, fertilizers, tractor, and pump set etc.
Industrial production can be increased by using credit. Moreover service sectors need
credit to flourish. In fact all components of GDP need credit to grow. In performing the
financial intermediation role, it has been argued that by virtue of this function that banks
generate economic growth by providing needed resources for real investment (Kinnon,
1973).Sustainable economic growth depends on the ability to raise the rates of
accumulation of physical and human capital to use the resulting productive assets more
efficiently and to ensure the access of the whole population to these assets (Fitzgerald,
2006). This is possible only by having access to bank credit. Banks perform the act of
financial intermediation that collect money from the surplus sector in the form of deposits
and lend it to various sectors of the economy leading to economic growth. Extension of
credit is one of the major functions of banking institutions.
4 NRB ECONOMIC REVIEW

Neo-classical growth theory states that labor and capital are the major factors of
production. I.e. Y = f (K,L) where Y denotes aggregate output, K denotes aggregate
capital stock, and L is the labor force. If technology and human capital are added, then
equation becomes : Yi,t = AKα(Lh)1−α. ( Mankiw, Romer, and Weil, 1992). Bank credit
facilitates to acquire more capital in this production function. When a new technology is
available, the labor and capital need to be adjusted to maintain growth equilibrium. To
acquire new technology and thus to increase total factor productivity, the role of credit
provided by banks would be of immense help. Private sector credit fosters growth
through increasing investment and an efficiency/productivity. The capital accumulation
channel is particularly important for underdeveloped and emerging countries, while the
productivity channel is mostly relevant for advanced countries.

In standard neoclassical theories investment-savings is the engine of growth. In these

theories, there are no capital market frictions and thus financial intermediation is not
explicitly modeled. However these models assume that savings translate directly to
investment and thus one could argue that finance affects growth primarily through capital
deepening (investment) (Papaioannou,2007). A different class of theoretical models
argues that financial development may foster growth by raising human capital
accumulation. In Galor and Zeira (1993) model income inequality and credit market
frictions impede growth, since not all individuals can invest in education. They argue thus
that financial intermediation can spur growth (and eventually decrease inequality) by
fostering human capital accumulation.

III. LITERATURE REVIEW

A large body of literature is available on the extensive empirical work with regard to the
nexus between finance and economic growth. Largely, this task has been performed by
King and Levine (1993) and Levine(1997). They showed that financial development has
predictive power for future growth and interpret this finding as evidence for a casual
relationship that run from financial development to economic growth. Although the
literature regarding the role of financial development on economic growth has grown
rapidly in recent time, studies that examine bank credit or access to private sector credit
and how it affects the economic performance of industries or economic sectors have been
overshadowed by the increasing number of empirical studies that largely focus on
financial development and growth. Nevertheless, private sector credit is one of the
important indicators of financial development. Therefore the literatures on finance-
growth nexus are helpful for the study on bank credit –growth nexus. King and Levine
(1993) provided the evidence that financial sector proxied by the ratio of bank credit
granted to the private sector to GDP, affects economic growth both through the
improvement of investment productivity ( better allocation of capital) and through higher
investment level. Financial system could impact positively on real economic performance
by affecting the composition of savings (Bencivenga and Smith, 1991), providing
information (Greenwood and Jovanovic, 1990), and affecting the scope for credit
rationing (Boyd and Smith, 1997).
 Bank Credit and Economic Growth in Nepal: An Empirical Analysis 5

Schumpeter (1971) identified banks' role in facilitating technological innovation through

their intermediary role. He argued that the role of bank of channelizing resources from
surplus sector to deficient sector plays crucial role in promoting growth. Several others
such as (Kinnon 1973), Shaw (1973), Adekanye (1986), Fry (1988), King and
Levine(1993), and Adeniyi (2006)have focused on the significance of private sector
credit to economic growth. Similarly studies by Gurley and Shaw (1967), Goldsmith
(1969), Jayaratne and Strahan (1996), Kashyap and Stein(2000), Beck et al.(2000), Beck
et al (2003), Driscoll (2004) etc, found that financial development can foster economic
growth by raising saving, improving allocative efficiency of loanable funds, and
promoting capital accumulation. In their opinion, well developed financial markets are
necessary for the overall economic advancement of less developed and the emerging
economies. King and Levine (1993a) said that the banking sector's development in
Europe was not only correlated with economic growth but was also a cause of long-term
growth. Adekanye (1986) argued, by providing credit; banks are rendering a great social
service which leads to increase in production, capital investment and improving living
standard. Akpansung (2011) by using two stage least square, found that private sector
credit impacts positively on economic growth in Nigeria. However, lending interest rate
impedes economic growth. Moreover, that paper recommends the need for more financial
market development that favours more credit to private sector with minimal interest rate
to stimulate economic growth.

A low rate of expansion of the credit volume is not only a symptom of weak economic
growth, but can also be one of its causes (Bundesbank, 2005). Bayoumi and Melander
(2008) found that a 2.5 percent reduction in overall credit caused a reduction in the level
of GDP by around 1.5 percent. Dey and Flaherty (2005) used a two stage regression
model to examine the impact of bank credit and stock market liquidity on GDP growth.
They found that banking development is significant determinant of GDP growth.
However Koivu (2002) found that growth in credit has not always been sustainable and in
some cases it may have led to a decline in growth rates. Murty at al (2012) by using
multivariate Johansen co integration approach, examined the long run impact of the bank
credit on economic growth of Ethiopia and found that bank credit to the private sector
affected economic growth through its role in efficient allocation of resources and
domestic capital accumulation. Thus the policy makers should focus attention on long run
policies to promote economic growth – the creation of modern banking sector so as to
enhance domestic investment, which is instrumental to increasing output per capita and
hence promoting economic growth in the long run. Ugoani (2013) examined the power of
bank credit on economic growth in Nigerian perspective and found that bank credit has
significant relationship with economic growth and socio-infrastructural development. He
argues that on the one hand, bank credit is the oil on the wheel of economic growth. On
the other, there is strong empirical evidence that the development of sound financial
markets and institutions has significant relationships with long term economic growth.

Financial sector plays a key role in channeling savings into productive investment
especially in the formal sectors of the economy. The banking sector is well recognized as
6 NRB ECONOMIC REVIEW

a key conduit of financial intermediation in the economy. Access to credit enhances the
productive capacity of businesses (Were Nzomi and Rutto, 2012). Private sector credit is
considered as proxy of bank credit in many international studies. Beck and Levine (2001)
measure bank development as bank credit to private sector divided by GDP. Also the
endogenous growth theory sheds light on the role of finance on economic growth. Solow
(1956, 1957) in his two factor neoclassical growth model incorporated the role of credit.
The supply of credit, both in terms of volume and in terms of credit standards applied on
loans to enterprises, have significant effects on real economic activity. In other words, a
change in loan growth has a positive and statistically significant effect on GDP
(Cappiello, Kadareja, and Sarensen, 2010). In the same way that financial services
increase income of poor by expanding the supply of financial services which can be
accessed by the poor. It will generate income growth for the poor, thus having a direct
impact on poverty reduction (Jalilian & Kirkpatrick, 2001). The role of private sector
credit as transmission channel of monetary policy cannot be ignored. Monetary policy
may affect real economic activity, and ultimately inflation, via its impact on the banking
sector credit through a number of transmission channels (Brunner and Meltzer, 1963 and
Bernake, 1983).

IV. THE STATUS AND TREND OF BANK CREDIT

TO PRIVATE SECTOR IN NEPAL

A significant portion of credit in Nepal is provided through the banking system, though
there are some institutions such as savings and credit cooperative societies, finance
companies, development banks and micro finance institutions. However, availability of
time series data for the latter institutions is very limited. Therefore, in this study, private
sector credit provided by commercial bank only is taken into consideration.

The ratio of bank credit to private sector and nominal GDP has not increased steadily
over the study period in Nepal. Before 1980s, such ratio was very low. The financial
sector of Nepal witnessed revolutionary changes in 1980s. A broad based program of
reforms was launched since 1980s. The banking sector in Nepal had been transformed
from a highly dominated inefficient state-owned sector to a dynamic private sector. NRB
and the Government of Nepal took a number of steps to further enhance the pace of this
transformation process of the development of financial sector in the country. A
substantial increase in private sector credit to GDP ratio took place only after
implementation of financial liberalization in early 2000s.The last five years from 2009 to
2014 recorded ratios of 44.0 percent, 41.7 percent, 40.3 percent, 41.2 percent , 45 percent
and 47 percent respectively.
 Bank Credit and Economic Growth in Nepal: An Empirical Analysis 7

Chart 1
Private Sector Credit to GDP Ratio (Nominal Term)
50.0
45.0
40.0
35.0
30.0
percent

25.0
20.0
15.0
10.0
5.0
0.0

2001
2003
2005
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999

2007
2009
2011
2013
year

Source: Data from Quarterly Economic Bulletin July,2013 (NRB) and figure from Author's calculation.

It has recorded significant increases only in 2009, 2013 and 2014. The stringent measures
adopted by NRB to limit the real estate and margin lending loan of the banking sector,
short term nature of loans, low growth of remittances and resulting liquidity crunch, low
growth of government expenditure etc. were accountable for the low private sector credit
to GDP growth in year 2010 and 2011.

In Nepal, economic growth rate is low compared to other developing countries (Annex 5).
Real GDP growth rate is only 3.6 percent in 2013 and 5.2 percent in 2014. Average real
GDP growth rate is 4.08 percent over the last twenty years. One of its main reasons is low
private sector credit growth. Private sector credit (provided by commercial banks) is only
47 percent in 2014 but it was 21 percent of nominal GDP on average over the sample
period. Therefore, to boost the economic growth of the country, private sector credit
should be increased to productive sector.
8 NRB ECONOMIC REVIEW

Chart 2
Private Sector Credit and GDP Growth (Nominal Term)
50.0

40.0

30.0
percent

20.0
Pvct
10.0
GDP
0.0

2010
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008

2012
2014
-10.0

-20.0
year

Chart 2 shows that there is positive relationship between nominal private sector credit and
nominal GDP. As private sector credit increased, GDP also increased, but at a lower rate.
Except some years their growth rate also seems to move in the same direction. Chart 3
also shows that real private sector credit has positive relationship with real GDP during
the period 1975-2014.

Chart 3
Private Sector Credit and GDP Growth (Real Term)
40.0

30.0

20.0
percent

10.0 GDP
PVCT
0.0
1998
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996

2000
2002
2004
2006
2008
2010
2012
2014

-10.0

-20.0
year

Up to now, the Nepalese banking system does not seem to have the investment bank for
long term loans, venture capital for viable projects, which in turn leads to inadequate
economic growth. Moreover, Nepal is experiencing still a significant credit transaction in
informal sector despite government's efforts to channel credit to the productive sector
 Bank Credit and Economic Growth in Nepal: An Empirical Analysis 9

through commercial banks, development banks, finance companies and micro credit
development banks.

Sector wise Distribution of Bank Credit to Private Sector

Sector wise distribution of private sector credit has great meaning to economic growth.
Generally it is assumed that credit to productive sector caters economic growth where as
credit to consumption sector can not contribute in this regard. In Nepal, of the total
private sector credit provided by commercial banks in July 2014, wholesale and retail
trade constituted 22 percent followed by production (20 percent), others (16 percent),
construction (10 percent), finance, insurance & fixed assets (8 percent), service industries
(8 percent), transportation, communication & public services (4 percent), agriculture
sector (4 percent) and metal, machinery, tools & fitting (1 percent).

Though agriculture constitutes

Chart 4
32.40 percent of GDP in Nepal,
Sectorwise Distribution of Bank Credit (July, 2014)
only 4 percent of total private
Agriculture
sector credit was provided in Local
4% Mines
this sector as of 2014. Though Government 0%
0%
Nepal Rastra Bank has made Others
policy provision that banks Consumable 16%
Loan
should provide at least 20 5% Productions
percent of their total loan to 20%
Service
productive sector and at least 12 Industries Construction
percent of their loan to 8% 10%
agriculture, energy and tourism Finance, Metal,
Insurance & Wholesaler & Machinary,
sector, this percent was merely Fixed Assets Retailers Tools and
6 percent only. Commercial 8% 22% Fitting
1%
banks seem to provide only 5 Transportation
Transportation
percent of their total loan to Communications
Equipment
& Public Services
consumption sector (very small 4% Production &
Fitting
figure in total) which helps to 2%
establish the relationship
between bank credit and
economic growth.

V. DATA AND METHODOLOGY

Secondary data that captured the whole population of all commercial banks in Nepal for
the period 1975 –2014 are used in the study. Secondary data are gathered from Quarterly
Economic Bulletin and Quarterly Financial Indicators (NRB).

In Nepal, the bank credit is allocated to both the public and private sector of the economy.
However, private sector credit is considered to be more effective to stimulate economic
10 NRB ECONOMIC REVIEW

growth. Several studies such as Beck et al (2005), Levine(2002), Odedokun (1998), King
and Levine(1993), Boyreau-Debray (2003), Liang (2007) and Crowley (2008) have
suggested that bank credit to the private sector is more significant for economic activities
than bank credit to the public sector. Therefore, in this study bank credit to private sector
is taken as appropriate variable. Since the paper attempts to assess relationship between
private sector credit and economic growth, variables such as bank credit to the private
sector (lnrpvct), economic growth (lnrgdp) are taken as the main variables. Government
expenditure (lnrgexp) and interest rate (ir) have been included in the study as control
variables. Mathematically, GDP = f( pvct, gexp, ir). Murty et al (2012) suggested this
type of variables to examine the effects of private sector credit on growth. Also, Okyo et
al (2012) emphasized the interest rate and inflation as control variables in their study. The
study has applied co-integration approach error correction model and granger causality
for the empirical examination of the relationship between the private sector credit and
economic growth.

Empirical Model

Firstly, we form the following regression equation to estimate the effects of private sector
credit on real gross domestic product. Government expenditure and interest rate are taken
as control variables.

Where,
lnrgdpt = α0 + α1lnrpvctt+ α2lnrgexp t + α3ir t+ μ
rgdp = real gross domestic product
rpvct = private sector credit provided by banks in real terms
ir = interest rate
rgexp = real government expenditures

Unit root test and co-integration tests should be performed first before performing the
ordinary least square method. If the variables are found I(I) and co-integrated to each
other, then co-integration and error correction test should be run. If the variables are
found I(I) but no co-integration found between the variables of interest, then it is better to
run OLS. Therefore in this case we first perform the unit root test and co-integration test.

Unit Root Tests

The pre-requisite of co-integration test is the stationarity test of each individual time
series over the sample period. Co-integration analysis has increasingly become the
appropriate methodological approach for analyzing time series data containing stochastic
trends. Hence before turning to the analysis of the long run relationships between the
variables, we should check for the unit root properties of the data, as non stationary
behavior is a prerequisite for including them in the co-integration analysis.
 Bank Credit and Economic Growth in Nepal: An Empirical Analysis 11

Table 1
ADF Test Results (Unit Root Tests)
Intercept Intercept and Trend
Level First Difference Level First Difference
Variables t-stat p-value t-stat p-value t-stat p-value t-stat p-value

lnrgdp
-0.2191 0.9275 -6.2461 0.0000 --1.5065 0.8103 -6.1634 0.0000
lnrpvct
-0.5403 0.8722 -4.6902 0.0005 -3.0366 0.1361 -4.738 0.0026
lnrgexp
-1.6497 0.4483 -6.1444 0.0000 3.6743 0.0363 -5.9839 0.0001
ir
-1.3167 0.6119 -4.6169 0.0006 -2.7912 0.2091 -4.5509 0.0043
Source: Author's computation

ADF statistics in the above table shows that all the variables included found to be I(1)
with one variable lnrgexp having deterministic trend. Hence, although it can be modeled
at first difference with OLS and extracting trend and cycles for trend-stationary variables,
this is possible only if variables are not co-integrated. The Johansen co-integration test
has been carried out as follows to identify whether there exists a co-integrated
relationships.
Table 2
Johansen's Cointegration Test (LNRGDP LNRPVCT LNGEXP IR )
Trace Statistics Maximum Eigenvalue
Hypothesized Trace 0.05 P-value Max- 0.05 P-value
No. Statistic Critical Eigen Critical
of CE(s) Value Statistic Value
None* 58.3249 47.85613 0.0039 26.1242 27.58434 0.0759

At most 1* 32.2006 29.79707 0.0259 17.1239 21.13162 0.1662

At most 2 15.0767 15.49471 0.0577 14.1104 14.26460 0.0528

At most 3 0.9663 3.841466 0.3256 0.9663 3.841466 0.3256

* denotes the rejection of null hypothesis at 5 percent level of significance. Trace test
indicates 3 cointegrating equations at o.05 level whereas maximum Eigen Value test
indicates 1 cointegrating equation at o.05 level.

The Johansson cointegration tests for cointegration shows conflicting results with trace
test and maximum eigenvalues test. The trace test indicates a 2 cointegration relation,
however, eigenvalue shows none. Hence it is desired to test the cointegration relation
only with the variables of interest, credit flow and its impact to GDP. The test results for
cointegration between economic growth ( lnrgdp) and private sector credit (lnrpvct) are as
follows:
12 NRB ECONOMIC REVIEW

Table 3
Johansen's Cointegration Test (LNRGDP LNRPVCT)
Trace. Maximum Eigenvalue
Hypothesized Trace 0.05 P-value Max- 0.05 P-value
No. of CE(s) Statistic Critical Eigen Critical
Value Statistic Value

None* 15.6358 15.4947 0.0476 15.5774 14.2646 0.0308

At most 1 0.05843 3.8414 0.8090 0.0584 3.8414 0.8090

Both the results consistently show a single co-integration relationship, at a highest level
of confidence which further confirms the earlier test of co-integration with four variables.
Hence, it can be decided that there exists a long term relationship between private sector
credit and country real GDP.

Causality Test

A number of studies have been carried out to examine the direction of causality between
bank credit and economic growth. Mishra at al (2009) examines the direction of causality
that runs between credit market development and economic growth in India through the
application of Granger Causality Test and find that credit market development spurs
economic growth. Mukhokadhya and Pradhan (2010) assess the causal relationship
between financial development and economic growth of seven Asian developing
countries and concluded that no general consensus can be drawn about finance growth
relationship in developing countries. Odedokun (1989) find the case of unidirectional
causality from the real sector to the financial sector and concludes that money is causally
prior to income.

Here in the study, Granger Causality Test has been conducted to find out the direction of
causality between the bank credit and economic growth. The results show evidence of
unidirectional casual relationship from GDP to private sector credit (annex 3, annex 4).

With different lag structure at 2 and 5 lags, the estimated F-stat suggests that private
sector lending does not Granger causes the real GDP but the other way is true. Hence, the
preliminary relationship is something different than expected. Nepalese economic growth
is led by feedback effect from the growth, rather than multiplier effect that of investment.
Based on these results, a bivariate error correction model is being estimated in the
following sections. Using the representation theorem of Engle and Granger (1987) to
establish a link between the co-integration and Error Correction Model (ECM), we can
show the long-run relation as:
 t  ln rgdpt    1 ln rpvctt
….. (1)
 Bank Credit and Economic Growth in Nepal: An Empirical Analysis 13

By transforming the equation 1, we can develop an error correction model as:

l l
 ln rgdpt  nrgdp   ln rgdp t 1   a1h  ln rgdpt h   b1h  ln rpvctt h  uln rgdp.t …… (2)
h1 h1
l l
 ln rpvctt  ln rpvct   ln rpvct t 1   a2 h  ln rpvctt h   b2 h  ln rgdpt h  uln pvct.t ..... (3)
h1 h1

Where, u ln rgdpt and u rpvct.t are stationary white noise processes for some number of lags l.
The coefficients in the co-integration equation give the estimated long-run relationship
among the variables and coefficients on the error correction model (ECM) describe how
deviations from that long-run relationship affect the changes on them in next period. The
parameters  ln rgdp and  ln rpvct of the equation (2) and (3) measure the speed of
adjustment of private sector credit and economic growth respectively towards the long-
run equilibrium

VI. RESULTS

Estimates of the equation (1) for co-integration

 t  ln rgdpt 1  8.153  0.410 ln rpvctt 1 ….. (4)
(0.0087)*

The error correction estimates of equation (2) and (3) have been presented as follows:
 ln rgdpt  0.056  0.0553ˆt 1  0.0149 ln rpvctt 1  0.004 ln rpvctt  2  0.0878 ln rgdpt 1  0.215 ln rgdpt  2 (5)
…..
. (0.012) (0.07) (0.046) (0.005) (0.188) (0.199)
Adj. R2 = 0.054, F-Stat = 0.35

 ln rpvctt  0.181 0.916ˆt 1  0.534 ln rpvctt 1  0.0786 ln rpvctt  2  1.39 ln rgdpt 1  1.59 ln rgdpt  2 … (6)
(0.0329) * (0.215) * (0.125) * (0.134) (0.505) * (0.53) *
Adj. R2 = 0.59, F-Stat = 9.05

Note: * Significant at 5 percent or lower level.

Values in parenthesis indicates the standard errors of the respective estimates

The estimates of the model show interesting results. By rearranging the estimates of co-
integration equation (4), it can be inferred that one percentage point increase in the real
private sector credit may cause the increase in real GDP by 0.41 percentage points over
the long run equilibrium relationships. Nevertheless, the short run equilibrium effects are
more induced by the feedback effects of GDP growth to the private sector lending, not
from the private sector lending to GDP growth, which is against our hypothesis. All the
coefficients of error correction estimates with the dependent variable as ∆lnrgdpt are
found to be insignificant including  ln rgdp , very low adjusted R2 value (0.054) and
insignificant F-Stat (0.35). In the contrary, with the dependent variable ∆lnrpvctt, the
14 NRB ECONOMIC REVIEW

error correction estimate is significant showing that the estimate of  ln rpvct is 0.916;
significant at 5 percent or lower level. It includes relatively high R2 value (0.593) and F-
Stat (9.05). It indicates that any deviation in real GDP in any given time will affect the
real private sector lending by 0.916 in the next period and the effect of such deviation in
private sector credit to the real GDP is almost zero. Hence, the finding is that, although
there is a long-run relationship can be observed from private sector lending to overall
growth of the economy, there is no immediate multiplier effect from investment to
growth and such a long-run relationship became only possible through feedback effects.
Diagnostics tests shows estimations are valid. Residuals Plots move around zero (annex
6). LM Test for Autocorrelation shows no serial correlation in error terms (annex 7).Since
p-value is higher while we include up to three lags, we do not reject null, in favor of this,
there is no serial correlation in residuals (annex 7).

Spikes of the correlogram graphs are also found to be within the bands (annex 9) and
also, all inverse roots of AR Polynomial lie inside the circle (annex 10 ).

VII. CONCLUSION

Credit is an important link in monetary transmission as it finances production,

consumption, and capital formation, which in turn affect economic growth. Especially in
developing countries like Nepal, it caters resource need for economic growth. NRB and
the government have adopted many policies and programs to increase economic growth
through the use of bank credit. However, the relationship between private sector credit
and economic growth has not yet been assessed properly in the Nepalese context.

Applying Johansen co-integration approach and estimating Error Correction

Model, the study found that the banks credit to private sector has positive impact on
economic growth only in the long run. Nonetheless the short run equilibrium effects are
more induced by the feedback effects of GDP growth to the private sector lending, not
from the private sector lending to GDP growth, which is against the proposed hypothesis.
The empirical results imply that, policy makers should focus attention on long run
policies to promote economic growth such as development of modern banking
sector, efficient financial market, infrastructures so as to increase private sector
credit which is instrumental to promote growth in the long run.

*****
 Bank Credit and Economic Growth in Nepal: An Empirical Analysis 15

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 Bank Credit and Economic Growth in Nepal: An Empirical Analysis 19

APPENDICES

1. Co-integration Test (Four Variables)

Date: 10/20/14 Time: 14:39
Sample (adjusted): 1977 2014
Included observations: 38 after adjustments
Trend assumption: Linear deterministic trend
Series: IR LNRGDP LNRGEXP LNRPVCT
Lags interval (in first differences): 1 to 1

Unrestricted Cointegration Rank Test (Trace)

Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.497158 58.32488 47.85613 0.0039

At most 1 * 0.362774 32.20065 29.79707 0.0259
At most 2 0.310181 15.07670 15.49471 0.0577
At most 3 0.025108 0.966282 3.841466 0.3256

Trace test indicates 2 cointegrating eqn(s) at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values

Unrestricted Cointegration Rank Test (Maximum Eigenvalue)

Hypothesized Max-Eigen 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None 0.497158 26.12422 27.58434 0.0759

At most 1 0.362774 17.12396 21.13162 0.1662
At most 2 0.310181 14.11042 14.26460 0.0528
At most 3 0.025108 0.966282 3.841466 0.3256

Max-eigenvalue test indicates no cointegration at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values
20 NRB ECONOMIC REVIEW

2. Co-integration Test (Two Variables)

Date: 10/20/14 Time: 14:42

Sample (adjusted): 1977 2014
Included observations: 38 after adjustments
Trend assumption: Linear deterministic trend
Series: LNRGDP LNRPVCT
Lags interval (in first differences): 1 to 1

Unrestricted Cointegration Rank Test (Trace)

Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.336304 15.63582 15.49471 0.0476

At most 1 0.001536 0.058428 3.841466 0.8090

Trace test indicates 1 cointegrating eqn(s) at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values

Unrestricted Cointegration Rank Test (Maximum Eigenvalue)

Hypothesized Max-Eigen 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.336304 15.57739 14.26460 0.0308

At most 1 0.001536 0.058428 3.841466 0.8090

Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values
 Bank Credit and Economic Growth in Nepal: An Empirical Analysis 21

3. Pairwise Granger Causality Tests (With two lags)

Sample: 1975 2014
Lags: 2

Null Hypothesis: Obs F-Statistic Prob.

LNRGDP does not Granger Cause LNRPVCT 37 7.57364 0.0020

LNRPVCT does not Granger Cause LNRGDP 0.00338 0.9966

4. Pairwise Granger Causality Tests (With five lags)

Sample: 1975 2014
Lags: 5

Null Hypothesis: Obs F-Statistic Prob.

LNRGDP does not Granger Cause LNRPVCT 34 3.87323 0.0108

LNRPVCT does not Granger Cause LNRGDP 1.60409 0.1988

5. Economic Growth in Developing Countries

Countries 2009 2010 2011 2012 2013 2014

China 9.2 10.4 9.3 7.8 7.7 -
India 8.5 10.5 6.3 4.7 5.0 -
Indonesia 4.6 6.2 6.5 6.3 5.8 -
Malaysia -1.5 7.4 5.1 5.6 4.7 -
Nepal 4.5 4.8 3.4 4.9 3.6 5.2
Source: World Bank
22 NRB ECONOMIC REVIEW

6. Residuals Plots move around zero.

LNRPVCT Residuals
.12

.08

.04

.00

-.04

-.08

-.12
1980 1985 1990 1995 2000 2005 2010

LNRGDP Residuals
.06

.04

.02

.00

-.02

-.04

-.06
1980 1985 1990 1995 2000 2005 2010

7. VEC Residual Serial Correlation LM Tests

Null Hypothesis: no serial correlation at lag order h
Sample: 1975 2014
Included observations: 36

Lags LM-Stat Prob

1 9.450576 0.0508
2 5.579553 0.2328
3 5.590300 0.2319

Probs from chi-square with 4 df.

 Bank Credit and Economic Growth in Nepal: An Empirical Analysis 23

8. Vector Error Correction Estimates

Date: 10/20/14 Time: 14:37
Sample (adjusted): 1978 2014
Included observations: 37 after adjustments
Standard errors in ( ) & t-statistics in [ ]

Cointegrating Eq: CointEq1

LNRGDP(-1) 1.000000

LNRPVCT(-1) -0.409841
(0.00877)
[-46.7222]

C -8.153330

Error Correction: D(LNRGDP) D(LNRPVCT)

CointEq1 0.055931 0.916661

(0.07941) (0.21503)
[ 0.70431] [ 4.26285]

D(LNRGDP(-1)) -0.087868 -1.392763

(0.18502) (0.50100)
[-0.47491] [-2.77997]

D(LNRGDP(-2)) -0.215248 -1.595705

(0.19596) (0.53063)
[-1.09841] [-3.00717]

D(LNRPVCT(-1)) -0.014957 0.534695

(0.04599) (0.12452)
[-0.32525] [ 4.29405]

D(LNRPVCT(-2)) 0.003950 -0.078660

(0.04950) (0.13404)
[ 0.07980] [-0.58684]

C 0.056417 0.180577
(0.01218) (0.03297)
[ 4.63310] [ 5.47649]

R-squared 0.054060 0.593335

Adj. R-squared -0.098511 0.527744
Sum sq. resids 0.013521 0.099137
S.E. equation 0.020884 0.056551
F-statistic 0.354324 9.045982
Log likelihood 93.91664 57.05943
Akaike AIC -4.752251 -2.759969
Schwarz SC -4.491021 -2.498739
Mean dependent 0.042574 0.104796
S.D. dependent 0.019926 0.082290

Determinant resid covariance (dof adj.) 1.36E-06

Determinant resid covariance 9.52E-07
Log likelihood 151.4944
Akaike information criterion -7.432128
Schwarz criterion -6.822591
24 NRB ECONOMIC REVIEW

9.
Autocorrelations with 2 Std.Err. Bounds
Cor(LNRPVCT,LNRPVCT(-i)) Cor(LNRPVCT,LNRGDP(-i))
.4 .4

.2 .2

.0 .0

-.2 -.2

-.4 -.4
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12

Cor(LNRGDP,LNRPVCT(-i)) Cor(LNRGDP,LNRGDP(-i))
.4 .4

.2 .2

.0 .0

-.2 -.2

-.4 -.4
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12

10.
Inverse Roots of AR Characteristic Polynomial
1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5
-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5