In the modern economy, the banking sector is considered to be the circulatory system of the economy and the liquidity (investable funds) flowing through it is like blood. Just as blood keeps the body alive and energetic by flowing vital air to all the tissues in the body, so liquidity keeps the economy running by flowing capital for economic activities.

Liquidity is the availability of investable funds in the financial system that can be used immediately. With sufficient liquidity, banks and financial institutions can easily extend credit, which increases investment in industry, business, agriculture and infrastructure development. When liquidity is scarce, credit becomes expensive or difficult to obtain, which increases the cost of investment and negatively impacts output and employment. 

The link between liquidity and the economy is the interest rate, which determines the cost of investment and the return on savings. This chain is highly sensitive or unstable, prone to change in just one or a few of the many socio-economic factors. When interest rates are reasonably low and predictable, investors are encouraged to borrow and expand production, and savers are encouraged to bring their capital into the financial system. On the other hand, high and unstable interest rates reduce the willingness of investors to take loans and expand their businesses, while extremely low interest rates can weaken the flow of savings. 

Just as human civilization is believed to have been sustained by the chain of hope (happiness, happiness and liberation) and the morale to work to achieve it, in the same way, the expectation of sustainable economic growth and development is sustained by the chain between investment and interest rate. Therefore, a balance between investable funds and interest rates is indispensable to keep the economy stable and predictable. 

For a developing economy like Nepal, sustainable economic growth and prosperity depend on a predictable investment environment and for that the balance between liquidity and interest rates is important. Adequate liquidity and stable interest rates reduce uncertainty or risk in business planning, make the cost of capital and returns predictable, and increase confidence for long-term investments. It attracts investors from both domestic and foreign markets and helps the nation move forward on the path of development at the expected pace.

The situation in Nepal

The imbalance between the demand and supply of investable funds (liquidity) in the banking system (sometimes shortage and sometimes excess) is a chronic disease of the Nepalese economy. Sometimes the interest rates are raised due to lack of liquidity in the market, sometimes the news that Rashtra Bank is forced to manage it due to lack of liquidity seems to be normal. Recently, the Nepali banking system has been facing high liquidity for the past two and a half years. According to a recently published report, during that period, the central bank has drawn excess liquidity worth about 3200 billion (3.2 trillion) rupees from the market and paid billions of rupees in interest.  The

is naturally reflected in the shadow interest rates of more liquidity. It's been a long time since the interest rates that have soared in the double digits due to excess liquidity in the banks have now come down to the single digits. However, the shadow of falling interest rates has not been seen in the loan demand. In such a situation, monetary policy should contribute to maintaining long-term economic stability along with efficient regulation and transparency of the financial sector while maintaining a balance with fiscal policy and macroeconomic indicators. In order to achieve sustainable economic growth, the monetary policy of Nepal Rastra Bank has failed to flow more liquidity to the productive sector and to manage the interest rate in a way that balances it with inflation, economic growth rate and international market conditions. 

Nepal's banking system is the main basis of economic growth. Banks and financial institutions collect deposits and lend to the productive sector, where liquidity and interest rates are two important policy indicators. Only balanced management of these two indicators can make the economy viable, make the investment environment predictable and ensure sustainable growth in the long run. However, despite being aware of this issue, the economy is becoming more unstable and risky when the National Bank is targeting only the real estate, stock market and vehicle sectors in its monetary policy. 

According to the latest report of Nepal Rastra Bank, the average loan-to-deposit ratio of commercial banks is now below the regulatory requirement, which shows that the banks have a high capacity to give new loans. Even though there is sufficient liquidity, credit flow has not increased in areas that require large investments such as manufacturing industry, agriculture, tourism, and infrastructure. As a result, new jobs have not been created as private sector investment in such areas has not increased. 

From this, it is seen that it will be difficult to meet the ambitious goal of the government to become a middle-income country by the year 2030 by fulfilling the technical conditions for upgrading in developing countries. On the other hand, when the fiscal year 2082/83 monetary policy took an expansionary path, excessive liquidity in the banking system risks curbing the expansion of the real sector of the economy, even if there is an artificial increase in consumer inflation and asset prices (eg, land or shares). 

What will be the solution?

Interest rates determine the cost of borrowing and the return on savings. Relatively low and predictable interest rates make it easier for investors to enter into new areas or make business plans to invest more. International experience shows that when interest rate fluctuations are low, long-term investment in manufacturing and processing industries and high-yield infrastructure is more likely to increase. 

Even in Nepal, the government is making a law on alternative investment mobilization in order to facilitate the flow of investment in such large industries. However, it is not possible to take it otherwise to mobilize investments in a systematic manner by creating laws, but a solution could be found so that results can be obtained from the current laws and systems. The solution is to adjust the tools of monetary policy to make the cost of capital (interest rate) for investors and the profit (interest premium) for banks and financial institutions stable or predictable. Going forward, the combination of liquidity and interest rates will directly determine the stability of the investment environment, the cost of capital will be clear and predictable, risk assessment will be easier for investors, and investor confidence in small, medium and large industries will increase. 

Now there is more liquidity in the banking system and interest rates are at their lowest level in four years. In such a situation, further lowering of the interest rate will not increase investment or expand the economy, it is also called a liquidity trap in economics. In liquidity and interest rate management, if the concept of interest rate corridor, which is currently used by the National Bank, is applied with some modifications, it seems that it will contribute to getting the economy out of the liquidity trap and achieving sustainable and inclusive economic growth. For that, the difference between the cost of deposits of banks (base interest rate) and the cost of investors' capital (loan interest rate) can be fixed (interest premium) to maintain stability in the loan interest rate. 

This does not mean going to an interest rate system directed against the open market principle by setting the base rate and loan interest rate by the National Bank. By leaving the responsibility of interest rate determination to the market system as it is now, by setting a minimum limit of interest rate premium (within the current or the maximum limit determined by the National Bank) stability can be provided in the loan interest rate. In doing so, in case the cost of deposit or the base interest rate increases according to the market, in the event that the specified minimum premium of the banks is not reached, the National Bank has to make an arrangement to deposit the equivalent amount of interest. This is not a new concept but similar to the minimum support price system currently being implemented in some agricultural products. 

What various studies have shown is that not only the interest rate but its stability or predictability is more responsible for increasing the demand for credit in the economy. This is the main reason why banks and financial institutions are not able to extend loans as expected, even though interest rates are low now. More importantly, the unpredictability of interest rates is the main reason for the lack of new lending to SMEs, known as the 'missing middle'. Therefore, instead of trying to manage liquidity only through open market operations (OMO) in the traditional way, the National Bank needs to pay attention to the development and use of some latest and sophisticated tools.