Views of a Nepali Economist

Recently, I wrote in Republica about the liquidity crisis that we are going through in Nepal (“Easing the Nepali liquidity crisis” published on August 7). I elaborated on why our banking and financial system is suffering from the crisis. Also, I wrote that conventional monetary policy does not help us in solving this crisis. Fiscal policy i.e. government expenditure is the best solution at hand today.

Some bankers, including those in the Nepal Rastra Bank (NRB), believe that lowering the Cash Reserve Ratio (CRR) and lowering the interbank lending rate will help ease the current liquidity crisis. In the previous article, I wrote about why lowering the CRR will not help ease the crisis. In this article, I wish to discuss why lowering the interbank lending rate will not help ease the liquidity flow in Nepal today.

Interbank lending rate is the interest rate that is charged by one bank to another when the former lends money to the latter. The interbank lending is a market where a bank that has “surplus money” sells it to another bank at a price. The price that the borrower pays is the “interest” on that loan. So, like any other market, whether the transaction occurs between the two is determined by the equilibrium of demand and supply.

There are two reasons why lowering the interbank lending rate will not help ease our liquidity crisis.

First, the interbank lending rate of 3 percent is too low. Since the interest rate is low, the banks that need money are willing to borrow as much as possible. This is basic economics: when the price for a product is low, demand always increases. However, the main player in this transaction is not the buyer but the lender who has to agree to give the money at the low interest rate.

If the rate is too low, like in the current context, the banks that have surplus money are not willing to loan it to others because the "price" i.e. interest they are getting is very low. So, they don't feel like selling their product. That is, the buyers and sellers are not agreeing at the price of 3 percent. So, no transaction is occurring in the interbank lending market these days in Nepal.

Second, if the market were not suffering from a crisis, the banks with surplus money would be willing to lend the money even at that lower interest rate. However, the current state of our financial system is such that there is uncertainty over the continued existence of many of these struggling banks and financial institutions. The skepticism on the part of richer banks is understandable. Think about it from the lender banks’ perspective. Why would a bank that has surplus money loan it to another bank that is undergoing a crisis, and which might not return even the principal amount of the loan let alone the interest?

What if the banks that borrow money go bankrupt anyway? This is why even banks that have money with them are refusing to loan it to others. And, this is making the liquidity crisis in Nepal even worse. The distrust and uncertainty is fanning the flame of liquidity crunch in Nepal.

I believe that the richer banks in Nepal have enough money to lend to struggling banks in order to ease the liquidity crunch. But, they are not sure that the struggling banks will survive. So, they are not willing to take the risk by lending to them. Therefore, if some bankers and the NRB seem to believe that lowering the interbank lending rate further is going to solve this liquidity crisis, they are forgetting their basic economic theory of demand and supply along with the cost-benefit risk analysis.

In my opinion, monetary policy is not a solution to this crisis. Even then, if the NRB is going to keep pursuing the monetary policy anyway, I believe that lowering the interbank lending rate is the exact opposite of what the NRB should be doing.

If I were making decisions in the NRB, I would actually increase the interbank lending rate. If it is increased, it will mean that the price that richer banks receive for lending the money to struggling banks will increase. This would mean that despite some of the uncertainty and distrust, a higher interbank lending rate would encourage the banks with surplus money to take a risk and lend some money to the struggling banks because the risk could bring higher rewards in interest income. The richer banks will be willing to sell more loans when the price of loans increases. Again, this is basic economics.

In fact, lowering any interest rates—conventional open market rates for purchase of short-term government debt by the central bank or the interbank lending rate—is fraught with additional danger. If the rates are lowered so much that it comes close to being zero percent, then we risk turning this liquidity crunch into a “liquidity trap”. The zero percent lower bound that a liquidity trap creates will severely constrain any monetary policy that the NRB wishes to pursue.

Lastly, we should learn some lessons from the US. The current US debt crisis is a product of the liquidity crunch that started in and around 2007 after the collapse of the real estate—housing and land—market. Like the US, our liquidity crisis has also occurred due to the slowdown of our real estate market. We could also face a debt crisis very soon if we do not solve this crisis. The current downgrading of the US credit status from AAA to AA resulted in an immediate 4 percent decline in the US stock market. Nepal’s economy could also suffer a similar blow if the current liquidity crisis is not contained, and if it is allowed to bring forth a debt crisis.

The only good thing going on for us is that credit rating agencies like Standard and Poor’s do not rate Nepal. If they did, we would be in a heap of economic trouble.