Rate Hikes Not the Right Answer

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Rate Hikes Not the Right Answer

Interest rates are on a rising trend. Looking at the economic indicators, there is a very less chance of interest rates slowing down anytime soon. Through the monetary policy for the current fiscal year 2022/23, Maha Prasad Adhikari, Governor of Nepal Rastra Bank (NRB), announced that the central bank was raising its policy rates. The NRB's decision to tighten its monetary policy and hike policy rates also indicates that interest rates of banks will go up further in the current fiscal year.

One of the major reasons driving up interest rates is the shortage of loanable funds in the banking system. Though the demands for loans have gone up massively in recent months, particularly after the withdrawal of COVID-19 containment measures, the growth of deposit - a major source for loanable funds - has not picked up. This has created a mismatch between deposit mobilisation and loan disbursement of banks. With fewer deposits, banks are facing pressure to maintain their credit to deposit (CD) ratio - a prudential lending limit - within the regulatory limit of 90%. Such a ratio of most of the banks has either already been breached or close to the saturation level, limiting their capacity to extend credits. Panicked by the shortage of loanable funds, banks started raising interest rates on deposit accounts. However, that strategy to attract deposits did not work. Instead, it drove the interest rates higher. Though banks have reached an informal agreement through Nepal Bankers Association (NBA) to not increase interest rate on deposits for some time, it is unlikely to tame the rates for a long time. The central bank’s decision to raise cash reserve requirement (CRR) to four per cent from three per cent and statutory liquidity ratio (SLR) to 14% from 12% for commercial banks will put further pressure on the banking sector’s liquidity. Such increase on idle funds to be parked at the central bank without any return will contribute to high interest rates as banks pass on the cost of funds to the borrowers. The central bank has also sent a clear message that it does not want to see a further expansion of private sector lending. Its target of private sector credit growth for the current fiscal year is 12.6%, down from 19% in the previous monetary policy. While the central bank wants to use higher interest rates as a tool to discourage borrowing in its fights against inflation, there are concerns that higher borrowing costs will deter private sector investments at a time when the business sentiment is already low.  

Businesses are likely to suffer from the liquidity shortage in the banking industry. They will have to struggle to acquire loans from banks. Even if they manage to secure the bank financing, such borrowing will be costlier for them due to rising interest rates. Liquidity shortage and rising rates now cast a shadow over the economy that is recovering from the slowdown induced by the pandemic. This is a moment when the private sector needs support from the central bank and the government. Rather than ensuring the adequate availability of financing, the central bank is taking the opposite approach and tightening the noose on bank loans. If the interest rates continue to go up, businesses and industrialists warn that their cost of production could also increase. Such cost is ultimately passed on to consumers. This will only put additional financial burden on consumers who are already suffering from the rising prices.

One of the solutions to ease liquidity in the banking system is to attract foreign direct investment or foreign borrowing. As domestic savings is not enough to meet the financing demands, the government and central bank should become more liberal in allowing banks to borrow in foreign currency. Though the central bank allows foreign currency borrowing, bankers complain that terms and conditions, particularly related to interest rates, set by Nepal Rastra Bank have made it difficult for them to get such loans. This will not only address the shortage of liquidity, but also ease pressure on foreign currency reserves. Similarly, banks should also reduce their reliance on short-term deposits and find other solutions like issuing long-term debentures to address their asset and liability mismatch.

Madan Lamsal
[email protected]

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