The Pulse | Economy | Environment | Risk Intelligence | South Asia

Greening the Nepali Financial Sector: Strike While the Iron Is Hot

Nepal’s economic policy makers must seize the moment to prepare for a green revolution.

Greening the Nepali Financial Sector: Strike While the Iron Is Hot
Credit: Samrat Khadka via Unsplash (CC0 license)

The economic consequences of the COVID-19 pandemic are estimated to drag Nepal’s economic growth to up to 1.5 percent in 2020, down from an estimated 7.1 percent in 2019. The continued extension of the nationwide lockdown has already started battering businesses such as hotels, restaurants, housing, airlines, the entertainment industry, and other sectors with large capital investments and high fixed overheads. If the pandemic lingers, the economic revival that has been achieved in the aftermath of the 2015 earthquake could be entirely wiped out. There will be layoffs, furloughs, and risk of bankruptcy of a number of businesses where Nepal’s financial institutions are deeply invested.

As an immediate response, the Ministry of Finance is expected to undertake an expansionary fiscal policy, and the Central Bank has already rolled out a number of monetary relief measures such as a reduction in the cash reserve ratio for banks and financial institutions, a rate cut to maintain liquidity in the market, an extension of loan repayment deadlines, and the removal of penal charges for outstanding loans, among others. One can expect to see additional fiscal and monetary reforms in the months to follow, depending on how Nepal and its primary trading partners fare in the aftermath of this pandemic. The international creditors have also started providing needed support such as time-bound suspension of debt service payments, maintenance of current credit ratings and continued low cost funding.

While the Oli government has so far been able to avert human casualties because of a timely lock down, the financial and economic ramifications of the same demand a very strong and result-oriented comprehensive recovery package. Both the Ministry of Finance and the Central Bank, led by highly technocratic executives, are believed to be capable of crafting such a package within the next few weeks. What hardly anyone is thinking of at this stage is green financial reform as a part of this broader post pandemic economic reform package. The ‘green’ here means resilient to climate change and extreme weather shocks. There are three reasons why such reform is warranted.

First, Nepal’s financial system is dominated overwhelmingly by banks and most of their assets lie in the segments of our brown economy that are highly exposed to potential climate and environmental risks: agriculture and forestry, construction and real estate. The majority of these investments have not taken into consideration long-term environmental risk, including climate change. This is bad given that Nepal is one of the world’s top ten countries most affected by climate change as per the Global Climate Risk Index 2020, and the economic cost of climate change in Nepal could run into the billions of dollars by 2050.

Second, Nepal’s economy is heavily reliant on international finance, primarily lending from development finance institutions, foreign direct investment, and long-term commercial debt. The continuity of such external financing could be shaped by domestic policies and regulations in the creditor countries. This could anytime be constrained by whether or not Nepal’s investment projects are resilient to environmental and climate risks as most of the creditors are embracing progressive climate and environmental reforms. For example, Norway has already put climate change at the center of its foreign aid strategy and funding in 2019. The lack of external development capital will significantly hamper the socioeconomic development of Nepal – the very cushion that is absorbing risk for the private financial players in the country.

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Third and most importantly, there is a genuine business opportunity in the green sectors. For instance, the International Finance Corporation has estimated a total climate-smart investment opportunity of more than US$40 billion in Nepal through 2030. The opportunities range from renewable energy to green buildings, electric vehicles, solid waste management, and climate smart agriculture. Such investments could help diversify our banks’ investment portfolio, increase our industrial competitiveness in the export market and boost employment opportunities domestically.

The Government of Nepal should immediately start crafting fiscal and monetary reforms that not only re-stimulate the national economic engine, but also address the long term environmental and climate risks. The short-term financial stimulus should be tied to reducing long term environmental impacts. This will increase the resiliency of Nepal’s economic and financial system, preventing irreparable damage in times of crisis. The analysis of data from the International Monetary Fund’s Policy Tracker shows that the countries are starting to identify climate-related measures as a component of their COVID-19 related economic responses.

To start with, the government of Nepal should establish an independent Green Fiscal and Monetary Commission that provides inputs to the upcoming reform. The Commission should include environment and climate scientists, financial supervisors and regulators, business federations, and representatives from the civil society. The Commission could consider some of the measures listed below as a part of the reform package.

On the fiscal policy side, a balanced supply and demand side subsidy for green technologies could result in uptick of green industry, creating both jobs and increasing government revenue in the long run. Such subsidies, however, need to be designed without negatively impacting debt sustainability. One way of doing that would be through environmental tax reforms in major polluting sectors and redirecting the generated revenue to offer those subsidies. The government should also compensate any negative impact of tax reforms by reducing pre-existing taxes for low income households and less polluting industries. This in turn will incentivize businesses to adopt green production lines, opening new export markets. Another important area of fiscal intervention could be the creation of science based fiscal buffers to climate proof existing and future infrastructure to avoid expensive climate adaptation and resiliency measures in the event of climate catastrophe.

On the monetary policy side, the Central Bank should start with its own environmental and climate risk assessment, determine the consequences of such risks on financial stability, and ensure that such risks are adequately reflected in its collateral frameworks and asset portfolios. The Central Bank should provide a low and stable interest rate environment for investments in a green economy, create innovative risk sharing instruments to support investment in climate proofing technologies, and lower reserve and liquidity requirements for banks that invest in green and low-carbon projects.

The environmental and climate risks are a potential exogenous shock to our financial system, just as was COVID-19. The difference is that the former will be lengthier and is expected to be far more disruptive than the latter. To start building a resilient financial system, the government of Nepal should strike while the iron is hot and take a decisive green leadership on fiscal and monetary policy reform.

Prajwal Baral is a sustainable finance and clean technology expert, and is Managing Partner of Hornfels Group, a technology investment consultancy.