The Nepal Rastra Bank (NRB), the central bank, is soon introducing a guideline to commence operation of the refurbished interest rate corridor, which aims to keep all interest rates in the banking system within a band of 3 percent to 7 percent in the fiscal year 2017-18 which began on July 16.

A “matrix” to operate the corridor has already been approved, according to Nara Bahadur Thapa, executive director of the Research Department of the NRB. “The concerned department will introduce a guideline within mid-August,” he said.

The NRB had first introduced the corridor in the last fiscal year to guide short-term market rates and keep all interest rates within a certain range, thereby reducing interest rate volatility. This was expected to provide clear signal to bankers, policymakers, borrowers and depositors on movement of interest rates and raise predictability.

However, following introduction of the corridor, interest rates fluctuated wildly in the last fiscal year with average interbank lending rates shooting up to as high as 7 percent and plunging to less than 0.5 percent.

This happened because the NRB, at that time, had used average interbank lending rate of commercial banks as reference to fix reverse repo or floor rate. This practice has now been abolished and a fixed interest rate has been introduced to reduce interest rate volatility.

The interest rate corridor basically operates using three different rates. First is the standing liquidity facility (SLF) rate. This is the rate at which the NRB injects liquidity into the banking sector whenever there is shortage of funds. This rate has been fixed at 7 per cent; and it forms the upper bound, or ceiling, of the corridor.

Second rate used in the corridor is the repo, or policy, rate. This is the rate at which liquidity is injected into the market for a period of two weeks. This rate floats in the middle of the corridor. Until last fiscal year, this rate was fixed by adding 200 basis points, or 2 percentage points, to weighted average interbank rate of commercial banks. The latest Monetary Policy has fixed this rate at 5 percent.

The third rate used in the corridor is the two-week term deposit rate. This rate forms the lower bound, or floor, of the corridor.

Until last fiscal year, this rate was fixed by deducting 10 basis points, or 0.10 percentage point, from weighted average interbank rate of commercial banks. The latest Monetary Policy has fixed this rate at 3 percent.

These three fixed rates suggest that all interest rates should move between the band of 3 percent and 7 percent in the fiscal year 2017-18.

But whether the NRB will be able to control movement of interest rates within the proposed band depends on how frequently it introduces instruments to mop up and inject liquidity.

In the last fiscal year, for instance, the corridor was used only nine times to mop up liquidity and four times to inject liquidity. Worse, most of the instruments floated to manage liquidity remained undersubscribed.

“We did introduce adequate instruments to mop up and inject liquidity in the first half of the last fiscal year. But after the second half, commercial banks started breaching the regulatory limit on lending. In that abnormal situation, we couldn’t use the corridor because the corridor was introduced to manage liquidity in normal situation,” Thapa recently told the Post, adding, “We hope to make effective use of the corridor to reduce interest rate volatility in the current fiscal year.”