FINANCIAL MARKETS
External Impediments

By Ajay Ghimire

This article discusses two most critical, external obstacles impeding the development of our financial markets. They are: deeply rooted corruption in the public service institutions, and an extremely sluggish and unpredictable legal system. (Besides, the markets also face equally, if not more, critical internal problems which I will discuss at some other time).

Implications of Corruption

That corruption is rampant in most of the public service institutions is well known and widely accepted belief. For the purpose of this article I am assuming, with almost zero probability of going wrong, that widely accepted belief of rampant corruption is true.

The first implication of corruption is that it shifts the competition from productivity improvement to evasion and avoidance of tax and duty. The shift takes place because marginal benefit individuals and businesses gain by evading and avoiding government duty is larger than that they could earn from improving productivity of other factors of production. Consequently resources are spent on duty and tax evasion rather than on productivity improvement. As result, productive individuals and businesses that can not effectively evade taxes -- for lack of skill or desire -- are gradually edged out from entrepreneurial activities. And the overall productivity of the economy and the productivity growth rate tend to dip way below the optimum.

The second implication of corruption is that even well-intentioned entrepreneurs cannot allocate resources to productive activities. The reason is that even those unwilling to be influenced by corruption do not have adequate and meaningful information to make the right policy and administrative decisions. The lack of information arises because individuals and businesses do not make available the real financial data to other market participants. The implication is unreliable accounts at both micro and macro level, which makes effective policy-making exceedingly difficult. Further, as true information is not divulged, the information gap between businesses and the other market participants tends to be high. This high information gap results in very high costs of financing. Another implication is that activities are financed on the strength of unrelated collateral and not that of the profitability of the activities. The consequences of such a situation are: (a) the volume of entrepreneurial activity in the economy lessens, (b) only the rich can get financing, and c) financial resources are not invested in the most productive activities.

The third implication of corruption -- especially that in the government’s revenue collection units – is that the hurdle rate for engaging in any entrepreneurial activity is inflated. The reason: most activities are performed without any written contracts -- to hide the true figures to evade taxes. Fulfillment of obligations by one party to the other engaged in a chain of activity is guided by relationship only. The only economic consideration guarding against non-fulfillment is reciprocity in the next round. If one party in the contract, especially the creditor, wants to get out of the business the counter-party, the debtor is most likely to default in his obligation. This increases the cost of exit from any business inflating the required rate of return for doing any business. Again the consequences are reduction on volume of business activity and distortions in resource allocation.

The fourth implication of the corruption is the degeneration of the value system in society. When easy money, earned through foul means or corrupt practices, floats in the economy, relative financial value of productive labour diminishes. Consequently, incentives to work hard and invest in productive skills decreases. Individuals in the society tend to become more opportunists and wait for the opportunity to make some easy money. This degeneration in value system adversely affects economic productivity.

The fifth implication of corruption is capital flight. Nepali society seems to have become indifferent to the means of amassing wealth. The wealth collected through foul means has the same value, if not more, as that earned fairly. Therefore, not all money made under the table will culminate in capital flight. However, a substantial chunk does go outside the country aggravating capital scarcity in this capital scarce economy.

Another effect of corruption is inequity -- money that would have been distributed to a larger segment of the society gets confined to few hands. Such a situation triggers more inequities in a society where income distribution is already highly skewed.

Legal Inefficiencies

It is a common belief that the legal remedial process is arduous and time consuming. Public perception on the effectiveness of the law enforcement agencies is also very low. Chronic defaulters of contractual obligations cruising in Mercedes-Benz and living in palatial bungalows are common phenomena in Nepal. Again I assume to be true what public perceive about our legal system and the law enforcement agencies.

The first implication of deficiency in speedy legal redress and law enforcement is that cost of default in contractual obligation is low. The consequence is high defaults in contractual obligations. The result is high default premium required by the party to the contract results in high cost of performing contractual obligations. In terms of the effect on the financial markets, the cost of financing any venture is high with consequent distortions in the capital allocation. The result is lowered economic productivity.

The second implication of inefficient legal system is that business relations are likely to be confined within close circles of acquaintances rather than among the most productive and efficient partners. The result is lower efficiency and productivity in the economy. This applies to the financial market as well. Managers of financial intermediaries are likely to allocate resources to their acquaintances rather than to the most productive activities.

Recommendations

The need to root out corruption has been heard in umpteen political speeches. But this appeal to ethics to reduce, let alone root out, corruption has failed miserably. Time and again leaders have emphasized that tax administration should be made more efficient and that special tribunal be formed to examine irregularities. There has been little consideration that, given our constraint, the cost of fine tuning administration to desired level of efficiency is very high. The focus thus should be on reducing the need for effective administration, reducing the benefit from tax evasion and avoidance, and increasing the cost of non-compliance.

Simple policy changes could help achieve the objectives. One immediate step would be to simplify the duty and tax structure with the objective of reducing the benefit of evasion and reducing, if not eliminating, the discretionary power of the tax officials. Steps to increase the cost of evasion and default should accompany this step of simplification of tax structure.

For example, in property buy and sell transaction reduce the effective tax to two per cent from prevailing 15 per cent. The agreed upon price must be made available to the land revenue office seven days before the day of transaction. The asking price must be made public and market participants should be allowed to bid for the property. If the seller still insists on selling to the original buyer and not to the highest bidder, then the revenue at the rate of two percent on the highest bid must be given to the government before the property transfer takes place. The revenue collection at the rate of two percent on market price should be much higher than that collected at the rate of 15 per cent on artificially deflated price.

Another example, for the sake of illustration, would be to eliminate tax on profit and impose tax on revenue at the rate of say one per cent flat. Assessment of revenue is much simpler and less costly than assessment of profit. There is no need to waste time and resources to examine whether certain expenses would be allowed tax deduction or not. Assessment and tax returns filed by the individuals and businesses should be taken at the face value. However, if evasion is found during the random evaluation process, and established by the court of law, then heavy penalty, say, confiscation of all the properties in the name of the defaulter, should be imposed.

Market players in the financial system have recommended for separate tribunal to settle financial disputes. The implicit assumption is that the tribunal would be able to settle the disputes more efficiently in terms of both time and quality of settlement. However, since the tribunal also functions within the same environment of corruption and other inefficiencies, I have reservations about the said tribunal’s ability to bring about radical changes in dispute settlement. Nevertheless, the fact that the new tribunal would have only financial disputes to settle can bring about marginal improvement in efficiency. However, monopoly power of the said institution is also likely to make it lax and ineffective at best and corrupt at worst.

An alternative experiment would be to allow the private sector to register and operate organizations for settling disputes in contractual obligations. A central regulatory body with statutory power should regulate the dispute settlement agencies so registered. All business contracts should specify the law governing the contract and the dispute settlement agencies that would be referred to for settlement. Such contracts should be registered in the dispute settlement agencies specified. Once there is competition for providing efficient dispute settlement services the quality and efficiency of dispute settlement is likely to improve. The verdict given by the dispute settlement agencies should be enforceable by law with the right to appeal only to the apex court. Further, all judgement from the legal system should be allowed to be critically analysed by the market on post-fact basis. Without external pressure to maintain quality and efficiency, people and institutions passing the judgement tend to get lax.

Conclusion

Deep-rooted corruption in the economy -- especially in the fiscal administration-- and inefficiency in contract enforcement are the two major external impediments preventing the evolution of more efficient financial system in Nepal. In our effort to reduce corruption we should focus more on simple policy changes that reduce the incentive to evade rules and increase the cost of default than on strengthening administration. Efforts directed toward strengthening the administrative efficiency through ethical appeals have failed. There is no reason why the approach should succeed in the future.

Another external impediment is the inefficient legal system. An effective approach to increase the effectiveness of the legal system, at least for settlement of contractual disputes, would be to create a structure that makes the market for dispute settlement services competitive. Without external market pressure, institutions with monopoly power in providing any service tend to get lax and ineffective and eventually corrupt.

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