A Report
On
Interest Rate Structure
in
Nepal
March 17, 2008
THEORETICAL REVIEW
When a bank or other financial institution lends money, it requires you to repay funds lend (principal), plus an additional payment called interest. Market interest rate simply refers to the rates of interest paid on deposits and other investments, determined by the interaction of the supply of and demand for funds in the money market. In other words "it is the cost of borrowing funds at the percentage of amount borrowed."( Baye & Jansen, 2000, p.73).
The interest rate that prevails in the bond market is determined by the demand for and the supply of bonds .The basic demand and supply model shows the relationship between bond quantity and price in the market for bonds and quantities of loanable funds and interest rate in the loanable fund market"(Hubbard , 1997,p113-115)
Bay and Jansen (2000) suggested that "the prudent investor should consider the real interest rate while making the loan, the nominal interest rate is the interest rate stated in the loan contract. The real interest rate is the nominal interest rate –expected rate of inflation.
DETERMINANTS OF MARKET INTEREST RATES:
Market interest rate is determined by the demand for loanable fund and the supply for loananable fund. Demand for loanable fund and market interest rate has negative relationship. Demand for funds comes generally from business to be used to finance investment in plant, equipment and inventories. When the demand for loanable fund increases market interest rate decreases thus demand for loanable fund curve slopes downward.
Similarly there is positive relationship between supply of fund and interest rate. Supply of funds basically comes from savers and primary household. When the supply of funds increases interest rate increases and vice versa. So supply curve slopes upward. The interaction of demand and supply of loanable fund determines the market interest rate.
Thus can be explained better with the help of following figure:
Market
Interest
Rate
Time
Determination of Market Interest Rate
Interest Rate in case of Classical Theory
Not every Rupees earned in the course of the production is spent for consumption of goods and services; some portion of this income is saved. Classical theory provides the mechanism that presumably ensure that planned saving will not exceed planned investment. This mechanism is interest rate. So we can say that both saving and investment are the function of rate of interest.
Saving has a direct relationship with the rate of interest where as investment has indirect relationship with rate of interest.
For every prospective investment project, management estimates the expected rate of return before allowance for the cost on the project. With a relatively high rate of interest, relatively few of the available projects promise a rate of return greater or equal to the interest rate. So relatively fewer projects are taken hence there is less investment.
So the function of investment and savings will determine the rate of interest.
Interest Rate in case of Keynesian
Supply for Money
Money supply is the quantity of currency and money in bank accounts in the hands of the non-bank public available within the economy to purchase goods, services, and securities. The rate of interest is the price of money. The two are related inversely, such that, as money supply increases interest rates will fall. When the interest rate equates the quantity of money demanded with the quantity of money supply, the economy is working at the money market equilibrium.
The money supply includes coin, currency, and demand deposits (checking accounts). Some economists consider time and savings deposits to be part of the money supply because such deposits can be managed by governmental action and are involved in aggregate economic activity.
There are three monetary aggregates defined as M1, M2, and M3. M1 includes the transaction deposits of banks and cash in circulation. M2 adds savings accounts, small time deposits at banks, and retail money market funds. M3 adds large time deposits, repurchase agreements, Eurodollars, and institutional money market funds.
Components of money supply
M1 (Narrow money)
One measure of the money supply that includes all coins, currency held by the public, traveler's checks, checking account balances, automatic transfer service accounts, and balances in credit unions.
M2 (Broad Money)
One measure of the money supply that includes M1, plus savings and small time deposits at commercial banks, and non-institutional money market accounts. A key economic indicator used to forecast inflation, since it is not as narrow as M1 and still relatively easy to track. All the components of M2 are very liquid, and the non-cash components can be converted into cash very easily.
M3
One measure of money supply that includes M2 plus large time deposits, repos, of maturity greater than one day at commercial banks and institutional money market operations.
In an economy money supply is determined not only by central Bank's policy, but also by the behavior of households which hold money and of banks in which money is held. Money supply includes both currency in the hands of public and deposits at banks that households can use on demand for transactions, such as checking accounts. That is, letting M denotes the money supply, C currency, and D demand deposits, we can write
Money Supply = Currency + Demand Deposits
M = C + D
Demand for Money
Money demand depends on three factors:
- Transaction demand
- Precautionary demand
- Speculative demand
Transactional Demand
Money would be held as a medium of exchange for use in transactions, i.e. to pay bills. Transactional motives refer to the demand for money to bridge the gap between periodic receipts and payments. Transactional demand would vary positively with the volume of transactions (TD) and income was assumed to be a good measure of TD. It is some fraction of total income and is positively related with the change in income.
TD= f(Y) and f'(Y)>0
Precautionary Demand
Individuals always have a demand for cash on hand to meet emergencies and unexpected contingencies – medical or repairs. Accordingly some cash will always be held in cash. It is also some fraction of total income and will vary positively with income.
PD= f(Y) and f'(Y)>0
Speculative Demand
Speculative demand for money refers to demand for holding certain amount of cash in reserve to make speculative gain out of purchase and sale of bonds and securities. The amount people prefer to maintain idle cash balance for speculative purpose depends on rate of interest in the economy. There is an inverse relationship between speculative demand for money and rate of interest.
The Equilibrium Interest Rate
Given the money supply and the income level, at some particular interest rate the sum of the transactions and speculative demands for money will just equal the supply for money. The interest rate that equates the supply of and demand for money is the equilibrium interest rate.
As the money supply increase, the interest rate will decrease. But after the certain decrease in interest rate with increase in money supply, the interest rate will remain constant. As above, interest rate will not decrease below ro with increase in money supply. This is called liquidity trap. Here the interest rate is already at an irreducible minimum for the time being. Therefore, expansion of the money supply cannot cause the interest rate to fall below the rate given by the trap. Below this level, people will hold more money for speculative purpose and less in securities.
INTEREST RATE IN NEPALESE CONTEXT
Nepal began economic liberalization in mid 1980s with a view to enhance efficiency in economic activities. With the advent of liberalization, the financial sectors need some progress and prudent regulatory measures have been introduced by the NRB.
Since then, Nepal adopted liberal financial policy to determine the interest rates both in government securities and deposits and lending through market mechanism. To date, NRB administers the interest rate of long-term government bond. In an open economy, market forces determine both the level and structure of interest rates.
Interest rates in Nepal are deregulated and banks are free to set their own deposit and lending rates. The ministry of finance has imposed a rule on banks limiting the maximum spread between borrowing and lending rates to 5% at the most.
Interest Rates in Nepalese Commercial Bank
Interest rates in Nepal are deregulated, and the banks are free to set their own deposit and lending rates. Spreads between lending and borrowing rates continued to widen in recent years, while the overall performance of the banking system showed little improvement despite the growth of private banks from in the 1990s.
However, the Ministry of Finance has imposed a rule on banks limiting the maximum spread between borrowing and lending rates to 5% at the most. But the average lending and deposit rate's spread shows more that 5%. It is an example of the kinds of directed regulations that are used instead of market-oriented approaches.
This spread shows that there is enough Liquidity in the market. There are no any investment opportunities so borrowing has decreased. As there is enough Liquidity in market, banks are not proving with higher interest rate for saving as well. So because of all this change, the spread between Lending and saving has been almost constant
Structure of Interest Rate (Percent per Annum)
Year | Deposit | Lending Rate |
Mid-Jul 2003 | 2.5-6.0 | 8.5-14.0 |
Mid-Oct 2003 | 2.5-5.5 | 8.5-14.0 |
Mid-Jan 2004 | 2.5-5.5 | 8.5-14.0 |
Mid-Apr 2004 | 2.25-5.0 | 8.5-14.0 |
Mid-Jul 2004 | 2.0-5.0 | 8.5-13.5 |
Mid-Jul 2005 | 1.75-5.0 | 8.25-13.5 |
Mid-Jul 2006 | 2.0-5.0 | 8.0-13.5 |
Mid-Oct 2006 | 2.0-5.0 | 8.0-13.5 |
Mid-Jan 2007 | 2.0-5.0 | 8.0-13.5 |
Mid-Apr 2007 | 2.0-5.0 | 8.0-13.5 |
Observation and Trend Analysis:
From the analysis of the data of Monetary Survey and Interest Rate Structure, money supply is increasing and the interest rate is almost constant which almost the condition of liquidity trap.
The trend analysis of these data shows that the change in the interest rate in both in lending and saving is almost constant for last 5 years from 2003 – 2008. This can be explained by different approaches as:
- Condition for Investment
The lack of investment opportunities can be the major reason for this. Nepal has just passed through 10 years Maoist conflict so during this period of time many firms had to close down. Political instability has made the environment unfavorable for investment in Nepal. So because of less investment, borrowing has decreased and as there is no any promising sector for investment. Banks are not being able to attract many depositors with higher interest rate.
- Economic Growth
Year | ||||
2002/2003 | 2003/2004 | 2004/2005 | 2005/2006 | 2006/2007 |
3.95 | 4.68 | 3.12 | 2.80 | 2.50 |
So from above chart, we can see that the economic growth in Nepal has been very less and it's decreasing in last three years. In 2006/2007 GDP figure is just 2.5. Hence, low economic growth also signifies the unfavorable conditions for investment. So people prefer to save money than to invest in certain projects, resulting in low interest rate in the market.
Conclusion
As per our observation we can say that Nepal is in almost Liquidity trap, people are holding money because there are no any projects where they can invest and moreover the environment for investment is unfavorable. So increase in money supply doesn't have any effect on the interest rate because there is enough liquidity in the market.
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