Despite Absorbing Billions in Liquidity, Interest Rates Remain at Floor, Burden on Depositors

Kathmandu. Although Nepal Rastra Bank has withdrawn billions of rupees from the market to manage excess liquidity in the banking system, its efforts to bring interest rates near the policy rate have not been effective. As excess liquidity piles up in the system, short-term interest rates have centered on the lower bound of the interest rate corridor. The direct impact is being borne by depositors.

Through its monetary policy, Nepal Rastra Bank aims to keep interest rates around the policy rate. Currently, the policy rate is 4.25 percent. The upper bound of the interest rate corridor is 5.75 percent and the lower bound is 2.75 percent. However, the market interest rate has fallen below the policy rate and reached around the floor rate of the corridor.

Weak demand for loans in the banking system has meant that funds from deposits and other sources cannot be invested. As a result, excess funds are piling up with banks and financial institutions. To manage this money, Nepal Rastra Bank has been continuously absorbing liquidity through various monetary instruments.

Nepal Rastra Bank has raised 4 trillion rupees through a 1-year bond. Similarly, it has been absorbing liquidity through 30 billion rupees under the Standing Deposit Facility (SDF) and about 7.5 trillion rupees through deposit collection instruments. Even after absorbing liquidity in such large volumes, the market interest rate has not been able to rise toward the policy rate.

Instead, banks have started competing at lower interest rates to park funds at Nepal Rastra Bank. In the bidding through deposit collection instruments on Ashwin 12, 14, and 16, the average interest rates were 2.73, 2.72, and 2.72 percent, respectively. That is, banks are willing to park money at Nepal Rastra Bank even at interest rates below the lower bound of the corridor, 2.75 percent.

This shows that the current problem is not limited to excess liquidity alone. Even though Nepal Rastra Bank is absorbing liquidity, its impact on the interest rate structure has not been as expected. While the policy rate stands at 4.25 percent, the short-term market rate is around 2.7 percent. This indicates a growing gap between the monetary policy signal and the actual market condition.

The Standing Deposit Facility provided by Nepal Rastra Bank to manage excess liquidity has become a means of some relief for banks. However, it has not been able to manage all the excess money in the system. Although banks and financial institutions can park up to 88 percent of the total amount collected from depositors at Nepal Rastra Bank, the remaining 12 percent must be kept as free funds.

According to the banking sector, the facility to park money at Nepal Rastra Bank has helped prevent interest rates from falling further to some extent. But banks still have excess funds. Since banking transactions are closed on Saturdays and Sundays and public holidays, the excess money in the system cannot be parked at Nepal Rastra Bank, and its burden keeps shifting to the next day.

On the other hand, the interest rate on Treasury bills has fallen to an average of one to one and a half percent. In deposit collection instruments, banks are bidding as low as 2.60 percent, 2.65 percent, and 2.70 percent. This shows how deep the pressure of excess liquidity in the banking system is.

However, its biggest impact has been on depositors. Currently, the average interest rate on deposits is 3.15 percent and the average interest rate on fixed deposits is about 4.5 percent. Meanwhile, the inflation rate has reached 5.96 percent. Compared to inflation, the interest rate on ordinary deposits is lower by about 2.8 percentage points.

This means the interest earned by keeping money in the bank has not been able to preserve the real value of money. Although the interest rate on fixed deposits is relatively higher, it too has not been able to beat inflation. In other words, savers are earning interest by keeping money in the bank, but in real terms, their purchasing power is declining.

When interest rates are low, borrowers get the immediate benefit. Lower loan interest rates reduce the cost of business and investment. However, if interest rates remain excessively low for a long time, there is a risk that returns for savers will decline and the attraction of saving in banks may weaken.

Therefore, the challenge for Nepal Rastra Bank now is not just absorbing excess liquidity but also demonstrating its impact on interest rates. If there is no effective coordination among the policy rate, the interest rate corridor, and liquidity absorption instruments, the signal that the policy rate sends to the market may weaken.