NRB Steps To Avoid Liquidity Trap

The banking sector is considered one of the significant pillars of the economy. The banking sector provides necessary funding for various other sectors of the economy such as industries, construction, real estate and the hospitality industry. However, deposits in commercial banks have been piling up for quite a long time. As a result, there are excess loanable funds in the banking sector. Major sectors like industries, big businesses, real estate, construction, hotels and tourism have not approached banks for loans as in the past. This has resulted in sluggish demand for credit. As of mid-November 2024, the average credit-to-deposit (CD) ratio of banks stood at 63 per cent.  As per the directives of the Nepal Rastra Bank (NRB), banks are allowed to maintain the CD ratio at 90 per cent. However, owing to low demand for credit, the CD ratio is lower than this figure.

As a demand for credit is declining, most banks have been reducing rates of interest on loans so much so that the interest rates have come down to a single digit in most cases. With a decline in such rates, rates of interest on deposits have also been on the decline. Banks are allowed to adjust rates of interest on a monthly basis. Still, they have found it heavy going to find borrowers. On the other hand, depositors relying on interest for their livelihoods have been hit hard. However, a liquidity trap may not emerge despite continuously declining rates of interest on deposits. A liquidity trap occurs when interest rates of deposits are almost zero or negative. 

Sluggish demand

Banks are stressed out nowadays. On the one hand, there is a sluggish demand for loans, while on the other, cases of loan default or delays in loan servicing are growing. As a result, both non-performing assets and non-banking assets are growing. As per the NRB data, industries, construction and wholesale and retail businesses have witnessed negative growth for the last three years. The banking sector has encountered snags, particularly since the outbreak of the COVID-19 pandemic. The health emergency played havoc with the economy, affecting its various sectors. Hotels, tourism, industries, real estate and other businesses were badly affected by the pandemic. Now, the disease has disappeared from the country but its after-effects are still being felt, especially in the economy. 

Many people have left their businesses, thinking that there is no environment to conduct business in the country. And the number of people going abroad for employment is snowballing. As per the data released by the Department of Foreign Employment, around 84,000 people left the country for foreign employment in the month of Mangsir. This indicates that around 2,800 people are leaving the country on a daily basis. A little over 170,000 people left the country for foreign countries for employment during the first quarter of this fiscal year.  

Remittances, sent home by migrant workers, are a good source of deposits. As remittances are increasing, the economy has been able to sustain itself to some extent. Further, they are also a source of foreign reserves. Remittances have also contributed to a pile-up in deposits in banks. During the first quarter of this fiscal year, remittances increased by 30 per cent. The trend of depositing money in banks for lack of investments is also catching up. People invest in the share market when it is booming but the condition of the share market is not so encouraging at present. There is no trend of investing in gold and silver in the country. The real estate market has been sluggish for the last few years. So most people tend to park their deposits in banks.

The NRB is the regulatory body for banks and financial institutions in the country. It has to intervene when there is a crunch in the banking sector. With idle money accumulating, banks are facing an excruciating situation, which has affected their earnings and profits. During the first quarter of this fiscal year, the interest earnings of banks plummeted by 6.09 per cent. Instead of keeping their funds idle, banks are now lending their funds to the NRB. In fact, the central bank has been mopping up funds from banks since the beginning of this fiscal year by deposit collection auction. However, the rates of interest are very low. But banks have no option but to lend even if at minimal rates of interest. 

Lending capacity

The NRB has a major role to play in preventing the economy from going off the track through various measures. It can adjust interest rates. If interest rates are high, there will be lower borrowing, which may contribute to cooling down the economy. If interest rates are low, borrowing will pick up, leading to high spending. The NRB can also regulate the economy through bond transactions (buying and selling). It injects funds into the economy by buying bonds. On the other hand, if there is excess money in the economy, it pumps it out of the economy by selling bonds. Likewise, the NRB can manipulate the lending capacity of banks by increasing or decreasing reserve requirements. Banks can be instructed to keep more funds in reserves to reduce their ability to lend. On the contrary, reserve requirements can be lowered to free up more funds to speed up lending. 

The NRB has adopted a strategy for absorbing excess funds from banks. If there are excess funds, inflation may emerge. Excess funds mean excess spending, creating an excess demand. An excess demand sends the prices of commodities soaring. Such a situation is not good for the economy. Poor people are the hardest hit during a state of inflation. So the NRB has been mopping up excess funds from banks. Should this strategy fail, it will have to adopt other viable strategies to keep the banking sector rolling.   

(Maharjan has been regularly writing on contemporary issues for this daily since 2000.)