Do Foreign Currency Accounts Help Relax Credit Constraints? Evidence from Nepal

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Published date	01 August 2018
Author	Nephil Matangi Maskay,Sven Steinkamp,Frank Westermann
DOI	http://doi.org/10.1111/1468-0106.12183
Date	01 August 2018

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DO FOREIGN CURRENCY ACCOUNTS HELP RELAX

CREDIT CONSTRAINTS? EVIDENCE FROM NEPAL

NEPHIL MATANGI MASKAY Nepal Rastra Bank

SVEN STEINKAMP*Osnabrück University

FRANK WESTERMANN Osnabrück University and CESifo

Abstract. We analyse a novel bank-level data set from Nepal, where domestic and foreign currency

(FX) deposits are reported separately on the liability side of commercial bank balance sheets. In a

panel regression analysis, we estimate semi-accounting-identities that allow us to identify the mar-

ginal sources of ﬁnancing for various asset positions. We ﬁnd that banks hedge against FX exposure

via their sectoral lending composition: banks with a large share of FX deposits primarily lend to

ﬁrms in traded-goods sectors. Loans to non-traded sectors are mostly ﬁnanced by domestic deposits.

While earlier studies have documented a positive impact of FX accounts on ﬁnancial development,

our analysis suggests that this does not need to imply that severely credit constrained sectors are

the main beneﬁciaries of this process.

1. INTRODUCTION

Foreign currency accounts have been shown to have a positive impact on ﬁnan-

cial sector development (see De Nicoló et al., 2005). In Nepal, the issue of for-

eign currency (FX) accounts has also gained attention in policy discussions, as

the country has been receiving increasingly large amounts of remittances from

the working population abroad in foreign currency, amounting to more than

28% of GDP in 2013. Recently, policy-makers have, therefore, suggested pro-

moting foreign currency accounts as a means to channel more remittances into

the domestic banking system (see e.g. the South Asian Association for Regional

Cooperation (SAARC), 2014; Pant, 2011).

However, does this policy really help to intermediate ﬁnancial resources to

sectors of the economy that suffer most strongly from credit constraints? Could

it lead to a back-door introduction of foreign currency risk exposure in countries

with only partially liberalized capital accounts? In this paper, we address these

questions using a novel data set from Nepalese commercial banks’balance

sheets.

To motivate the exercise, we refer to the World Bank Enterprise Surveys

(WBES), which help to illustrate that credit constraints in Nepal are asymmetric

across sectors: small ﬁrms in non-traded sectors face severe credit constraints,

*Addressfor correspondence: Sven Steinkamp,Osnabrück University,Rolandstr. 8, 49069 Osnabrück,

Germany. E-mail: sven.steinkamp@uni-osnabrueck.de. We would like to thank the participants of

the annual conference of the Research Committee on Development Economics of the German

Economic Association (VfS) in Passau 2014, the VfS annual conference in Münster 2015, and, in

particular, our discussant Martin Brown for helpful comments and suggestions. Furthermore, we

are grateful for comments received at the presentation at the Nepal Rastra Bank, as well as several

interviews at the NRB, in particular Rajendra Pandit and Prakash Kumar Shrestha, the Himalayan

Bank, as well as the Remitters Association in Nepal.

Paciﬁc Economic Review,••:•• (2016)

doi: 10.1111/1468-0106.12183

while large traded-sector ﬁrms have relatively easy access to credit.1This obser-

vation conﬁrms previous ﬁndings in the literature for the case of Nepal.2It is

consistent with the view that traded sector-ﬁrms, which have part of their reve-

nue in foreign currency, have easier access to bank credit, as well as alternative

external ﬁnancing opportunities. In contrast, ﬁrms in the non-traded sectors are

usually small and rely more heavily on bank credit.

In the main part of the paper, we analyse a panel data set of commercial

banks’balance sheets. This unique data set is interesting for two reasons. First,

we are able to identify the foreign currency share of the banks’various asset and

liability positions, including the foreign currency (FX) deposits, which will be

our key variable of interest. Second, it also contains a detailed breakdown of

lending by sector, as well as other assets in domestic and foreign currency.

In this data set, we show that banks with large positions in FX deposits are

hedged against foreign currency risk in two ways. First, banks hedge their risks

directly by investing in non-resident and foreign exchange assets. Second, they

are also hedged via their sectoral lending composition: they lend more to ﬁrms

in traded goods sectors such as manufacturing. They also lend relatively less

to non-traded sectors, including the deprived sectors, which are recorded sepa-

rately and have been targeted by various support programmes. These indirect

hedging activities reduce the potentially positive impact of foreign currency ac-

counts on relaxing credit constraints, as foreign currency deposits are

intermediated primarily to the less constrained sectors.

In our panel regressions, we use the balance sheet data to estimate an account-

ing semi-identity that allows us to identify the marginal sources of ﬁnancing of

various positions on the asset side of the banks’balance sheets. We demonstrate

that lending to the non-traded goods sector and to the deprived sectors of the

economy has largely been ﬁnanced from domestic rather than foreign currency

deposits. This key ﬁnding is robust to alternative speciﬁcations that include in-

strumental variables (IV) regressions, different types of ﬁxed effects, and

differencing the data. Looking at economic subsectors, we ﬁnd that this result

is mostly driven by the construction, wholesale and retail-trade sectors, as well

as by direct lending to the deprived sectors. The manufacturing sector, on the

other hand, reacts signiﬁcantly to changes in FX deposits, but not to domestic

deposits in most speciﬁcations.

We also illustrate that these hedging effects coexist with a positive indirect ef-

fect of FX deposits on total lending that results from an additional creation of

domestic deposits. This strong complementarity has its roots in the institutional

design of FX accounts in Nepal: as remittance-transfer companies are allowed

to hold FX deposits only for a limited time, a substantial share of the incoming

remittances are converted to domestic sector deposits. This indirect effect helps

1See Appendix I for a formal probit analysis. Traded goods sectors include, for instance, the

manufacturing sector, the mining sector and agriculture. The main non-traded sectors are construc-

tion and services.

2See, for instance, Tornell and Westermann (2005), Schneider and Tornell (2004), Beck et al. (2008)

and Brown et al. (2011).

N. M. MASKAY ET AL.2

Paciﬁc Economic Review

, 23: 3 (2018) pp. 464–489

doi:10.1111/1468-0106.12183