The Nepal Rastra Bank (NRB), the central monetary authority, has warned to scrap a provision that allows commercial banks to park funds in foreign banking institutions if they fail to bring the money back to the country at times when the market is facing liquidity shortage.

The NRB has allowed commercial banks to park up to 30 percent of their core capital in foreign banks and financial institutions, or invest the amount in secure financial instruments, under the facility called non-deliverable forward contract. The tenure of such deposits and investments must not exceed 90 days, but the contracts can be renewed every three months. The facility was introduced during the time when the NRB was unable to float adequate instruments to mop up excess liquidity from the banking system, which led to rapid fall in interest rates.  

This year the situation is a bit different, as the NRB, on behalf of the government, has been aggressively floating debt instruments, such as bonds and treasury bills, to raise credit from the domestic market. The domestic debt collection cycle, which used to begin in the third quarter of the fiscal year in the past, began early this year due to concerns that the government may face shortage of funds following decision to transfer first tranche of grants of Rs75 billion to newly-formed local bodies in the beginning of the fiscal year. 

Following this, NRB, on behalf of the government, has raised Rs25.1 billion through treasury bills and another Rs67 billion through development bonds since mid-July, when fiscal year 2017-18 began. On top of this, Rs84.7 billion has also been mopped up from the market through seven-day reverse repo, a money market instrument. These moves have squeezed the size of excess liquidity at banks and financial institutions to around Rs30 billion, according to the NRB. This has prompted average interbank rates of commercial banks, the rates at which Class ‘A’ financial institutions borrow money from each other, to exceed 3-percent mark from around 1.3 percent in the last week of October.

As the portion of excess liquidity is becoming smaller, yields on development bonds have also surged to five-year high of 6.2 percent, while even 91-day treasury bills have started generating returns of over 3 percent.

“As interest rates are going up in the domestic market, commercial banks should start bringing in the money that they have parked abroad,” said Nara Bahadur Thapa, executive director of the Research Department of the NRB. “If they fail to do so and if their acts create liquidity shortage here, we will scrap the provision that allows them to deposit the funds abroad.”

Commercial banks have parked or invested around Rs70 billion abroad, under the facility introduced by the NRB. Thapa said the NRB was committed to creating stability in the financial sector by absorbing excess liquidity rapidly to prevent banks and financial institutions from breaching the regulatory lending requirement, which triggered severe shortage of loanable funds last fiscal year. Currently, banks and financial institutions cannot lend more than 80 percent of local currency deposit and core capital. 

“If we introduce adequate instruments to mop up 20 percent of funds required to maintain the liquidity ratio — this, however, excludes funds required to maintain cash reserve ratio — banks and financial institutions will not be able to violate the 80 percent lending requirement even if they intend to,” said Thapa, adding, “Rapid absorption of funds from the market will also keep interest rates at a higher level.”

The NRB is lately focusing on keeping interest rates at a higher level to ensure depositors get good returns even after adjusting inflation. In this regard, the NRB is planning to introduce revamped interest rate corridor soon, Thapa added. 

Once the corridor is launched, short-term interest rates are likely to remain high because the floor of the corridor has been fixed at 3 percent. A higher floor rate indicates the NRB does not intend to see short-term interest rates falling below 3-percent mark. This move is expected to give a lift to all the interest rates in the banking sector, including retail deposit and credit rates. “If interest rates go up in the country, commercial banks will automatically bring in the money parked abroad, because returns hover around 4 percent abroad,” Sanima Bank CEO Bhuvan Kumar Dahal said.