Central bank to introduce IRC by August 16

Kathmandu, July 21

Nepal Rastra Bank (NRB), the central monetary authority, is mulling over introducing the highly touted interest rate corridor within August 16 to formally deal with the problem of frequent fluctuations in interest rates.

NRB is making the move in line with the announcement made through the monetary policy of this fiscal year as a measure to keep interest rates within a band and reduce interest rate volatility.

“We have laid the groundwork to introduce the corridor within mid-August. We now need the governor to sign a few memos that explain when and how operations to mop up or inject liquidity would be conducted. Once that is done we’ll launch the corridor,” Min Bahadur Shrestha, executive director at NRB’s Public Debt Management Department, which oversees open market operations, told The Himalayan Times.

The interest rate corridor, or IRC, will basically try to ensure that excess liquidity in the banking system does not exceed around Rs 20 billion. But if there is shortage of cash, interventions will be made to inject liquidity.

This mechanism of keeping a stern eye on liquidity situation, the central bank hopes, will prevent interest rates from suddenly hitting rock bottom or going through the roof. This will ultimately lift deposit rates, benefiting depositors who complain about losing money by parking savings in banks due to negative real interest rate, and stabilise lending rates, giving some respite to borrowers, who gripe about sudden hikes.

To ensure interest rate stability, NRB will basically make use of three different rates.

First is the standing liquidity facility (SLF) rate or the rate at which NRB provides loans to banks and financial institutions (BFIs) for a maximum of five days in case there is severe shortage of cash.

Second is the two-week repurchase (repo) rate, which will also function as policy rate. This is the rate at which NRB provides loans to BFIs for two weeks in case of liquidity crunch in banking system.

Third is the two-week term deposit rate, or the rate at which NRB borrows money from BFIs for a period of two weeks in case of excess liquidity in the banking system.

These three rates make up the IRC. Simply put, SLF rate will form the upper bound, or ceiling, of the corridor. Two-week repo rate will move in the middle of the corridor. And two-week term deposit rate will form the lower bound, or floor, of the corridor.

“In an ideal condition, the difference between the ceiling and floor rates should not exceed one per cent,” said Shrestha. This means: if SLF rate is, say, six per cent, then two-week term deposit rate should hover around five per cent, while two-week repo rate should stand at 5.5 per cent.

But that is not going to happen when the IRC is launched here, because of low interbank rate of commercial banks, which determines two-week repo and two-week term deposit rates.

Weighted average interbank rate of commercial banks has remained suppressed for a long time because of excess liquidity in the banking system — a result of a lethal combination of rise in flow of money sent by Nepalis working abroad and lower demand for loans from private sector coupled with inadequate supply of instruments to mop up excess liquidity.

It stood at 0.8 per cent today.

Considering today’s interbank rate, two-week repo rate would stand at 2.8 per cent, while two-week term deposit rate would stand at 0.7 per cent. This is because repo rate is fixed by adding 200 basis points, or two percentage points, to weighted average interbank rate of two working days ago, while term deposit rate is fixed by deducting 10 basis points, or 0.10 percentage point, from weighted average interbank rate of two working days ago.

In contrast, the SLF rate, which is fixed by NRB on its own, currently stands at seven per cent.

So, if the IRC were to be launched at this moment, the wedge between the ceiling and floor rates would stand at 6.3 per cent. And this has concerned bankers because the primary objective of IRC is to ensure that the three interest rates move within a close range, so that other interest rates, including deposit and lending rates, move around that band to ensure interest rate stability.

“Once we launch the corridor, our main objective would be to reduce the wedge. For this, we will float two-week term deposit instruments every week to mop up excess liquidity. Continuation of this for a month or two will bring down the gap between ceiling and floor rates of the corridor to around four per cent,” Shrestha said, adding, “We’ll then increase the frequency of issuance of these instruments to twice a week. And ultimately we will float these instruments every day. Once we start absorbing liquidity in this manner, interbank rates will start going up, thereby, pushing up two-week term deposit and repo rates. This will reduce the wedge between different rates in the corridor.”

Initial plan

  • Two-week term deposit instruments would be floated every week to mop up excess liquidity
  • NRB hopes continuation of this for a month or two will bring down the gap between ceiling and floor rates of the corridor to around 4 per cent
  • The frequency of issuance of these instruments would then be increased to twice a week
  • Ultimately the central bank will float these instruments every day