Nepal Rastra Bank, the central monetary authority, finally introduced interest rate corridor in the country last week to guide short-term market rates and reduce interest rate volatility. Yet, IRC has not been able to draw much attention of banks and financial institutions, with instruments floated by NRB remaining undersubscribed. Why did banking institutions express little enthusiasm? And what are the objectives of the IRC? Rupak D Sharma of The Himalayan Times spoke to Nara Bahadur Thapa, chief of the Research Department at NRB, to get answers to these questions.

Nepal Rastra Bank (NRB) was planning to introduce interest rate corridor (IRC) when Yubaraj Khatiwada was the governor. What took it so long to introduce this mechanism?

Nepal’s banking sector has been flush with liquidity for the last three to four years. One of the main reasons for this is higher inflow of money sent by Nepalis working abroad. Today, share of workers’ remittance as percentage of GDP stands at 29.6 per cent, which is pretty big. The major players who should be making use of this financial resource are the government and the private sector. However, the government has either been maintaining a net budget surplus or very small deficit in the last few years. Because of this the government has been lowering its reliance on domestic debt to finance development. Instead, it is more focused on domestic debt repayment. This has left banks and financial institutions (BFIs) with excess liquidity. To mop up excess liquidity, NRB has been floating instruments, such as outright sale auctions and reverse repo. As these instruments were not adequate to soak up excess liquidity, NRB, around two years ago, launched an instrument called term deposit, with maturity period of 90 days. Since then we have also floated over Rs 49 billion worth of one-year instrument called NRB Bond. As use of these instruments could not effectively address the problem of excess liquidity, NRB, through the Monetary Policy of this fiscal year, made an announcement to introduce IRC. Based on this, IRC was launched last week.

The main objective of IRC is to stabilise interest rates. Do you think the corridor can achieve this goal?

IRC cannot stabilise interest rate movements overnight. But it will in the long run. NRB is currently using three different instruments to operate IRC. One is standing liquidity facility (SLF), which is being used as tool to inject liquidity whenever BFIs face shortage of funds. This rate is fixed by NRB and forms the upper bound (or ceiling) of IRC. On the other hand, the lower bound (or floor) of IRC is made up of two-week term deposit rate. This rate moves depending on the liquidity situation in the market. To fix this rate, we refer to weighted average interbank rate of commercial banks of two days ago. We then deduct 10 basis points, or 0.10 percentage point, from the average interbank rate and fix the two-week term deposit rate. Using this rate, we call on BFIs to park desired amount of excess funds at NRB. This way we mop up liquidity from the banking sector. Another instrument that we have used to operate IRC is repo. This is a tool to inject liquidity in the market for a period of two weeks. We also fix repo rate (or policy rate) based on weighted average interbank rate of commercial banks of two days ago. This rate is derived by adding two percentage points to this interbank rate and floats in the middle of SLF and term deposit rates.

Why did NRB decide to use weighted average interbank rate to fix two of the rates under IRC?

This is because interbank rates move depending upon interventions made by NRB to inject or absorb liquidity. In case of excess liquidity, interbank rates remain low, whereas in the case of liquidity crunch these rates go up. Many other countries also refer to it as call money rate, which is the same as interbank rate. In a country where inflation has hovered around seven per cent or more for the last few years, short-term interest rates have stood at less than a per cent. This means the market is not functioning well. Our intention is to correct this, hence, IRC. And we want to achieve this goal without disrupting the market. Another objective of IRC is also to develop robust short-term money market in the country, so that BFIs do not always have to knock on the doors of the central bank for liquidity management.

But BFIs have not responded well to IRC, as term deposit instruments launched twice last week remained undersubscribed. What could be the reasons for this?

There may be few reasons. First, the portion of excess liquidity in the banking sector has gone down to around Rs 11-12 billion lately. If this amount is divided among 28 commercial banks, excess liquidity in each bank will stand at less than Rs 500 million. So, banks may prefer to hold on to excess liquidity of this scale, as lending has been going up since the trade disruptions along Nepal-India border points ended (in February). Also, NRB mopped up over Rs 49 billion towards the end of last fiscal year by floating one-year NRB Bond, which helped manage excess liquidity. Another reason is BFIs here expect us to introduce instruments, such as repo and reverse repo, as in India, with fixed rates. Indian central bank mops up or injects liquidity equivalent to one per cent of demand and time deposit liabilities of banks at one time. Of this, 25 per cent include overnight repo or reverse repo, which come with fixed rates, while the rest 75 per cent come with variable rates — or rates determined by the market. Also, in India, public debt stands at over 65 per cent of GDP, while fiscal deficit of state and central governments hovers around seven to 10 per cent of GDP. These are not the cases in Nepal. So, we cannot simply emulate what India is doing. Against this backdrop, BFIs should cooperate with us.

One surprising element in the latest episode was that BFIs shunned term deposit even when returns on these instruments were higher than those offered by other NRB tools. What is your take on this?

I’m also surprised. For instance, return on 91-day treasury bill floated last week stood at 0.16 per cent. In contrast, return on 14-day term deposit introduced under IRC stood at 0.3045 per cent. This is not rationale behaviour. But this may be because BFIs are not familiar with this system. We hope things to change in the coming days.

Although rates of term deposit launched under IRC are relatively higher, they are still in the lower side, aren’t they? How long do you think will it take for rates to go up?

The problem of excess liquidity cannot be solved in an instant. This is because one-time large scale liquidity absorption could destabilise the market. So, we have to gradually let the interbank rates go up so that the interest spread in the corridor could narrow down. In other words, our objective is to muster support of the market to gradually change market behaviour. That’s why we need support of market participants.

You just raised the issue of narrowing the spread in IRC. But the formula used by NRB has permanently fixed interest spread between repo and term deposit rates at 2.1 per cent. Isn’t that wide?

NRB injects liquidity by adding two percentage points to weighted average interbank rate and mops up liquidity by deducing 0.10 percentage point from weighted average interbank rate. (In other words, if average interbank rate is one per cent, then repo rate would stand at three per cent, while term deposit rate would stand at 0.9 per cent.) Some complain that NRB directs BFIs to maintain interest spread of five per cent but maintains a wider interest spread itself. This is not true, because the interest spread in IRC is 2.1 per cent. However, in the financial market, there is a range of interest rates. And we have to make them coherent as well. So, once we start managing the liquidity, differences between a range of interest rates, including SLF, will narrow down. That’s what we are expecting. Currently, the spread in IRC appears wide because SLF rate (ceiling rate) stands at seven per cent, whereas term deposit rate (floor rate) stands at less than a per cent. One way to bridge the gap is by reducing SLF rate. Against the backdrop where inflation stands in double digits, reducing SLF rate would send a wrong signal to the market. So, we cannot reduce SLF rate at the moment. On the other hand, we cannot fix repo rate (or mid rate) at four or five per cent because it would destabilise the market and initiate the process of disintermediation. We don’t want this to happen because our objective is also to ensure proper growth of the financial sector with as little intervention as possible. So, it will take some time for the spread to narrow down. India, for instance, maintained a spread of three per cent when it first launched IRC in 1999.

But the spread between mid and floor rates in India has now come down to 0.5 percentage point, isn’t it?

It took India 17 years to narrow down that spread. In contrast, we have just launched the IRC.

Lastly, what is your take on liquidity situation in the country in the coming days, against the backdrop of lower growth in remittance income, probability of higher public spending in post-earthquake reconstruction and likelihood of higher domestic borrowing?

If the budget implementation goes well, abnormalities in liquidity situation will start disappearing. The budget has allocated ample funds for reconstruction. If reconstruction activities gather pace, imports will go up, pushing up government’s revenue. On the other hand, lots of reconstruction works are donor funded. This means flow of funds from abroad will increase if reconstruction activities pick up, which will prevent balance of payments from recording a deficit. Also, plans to mobilise Rs 111 billion in domestic debt will push up short-term interest rates. So, proper budget implementation will bring about lots of positive changes. That’s when fiscal and monetary policies should move in a coordinated manner so as to ensure fiscal, price and external sector stability, and availability of adequate liquidity for economic growth. So, the possibility of injecting liquidity in the banking system cannot be ruled out if budget is implemented properly.