Interest Rate Structure in Nepal

A Case Study for Nepal

Economic Environment Analysis

Submitted to: Satyendra Timilsina Ace Institute of Management New Baneshwor

Submitted by: Sushil Bajimaya Nabin Shrestha EMBA, Fall 2011

Acknowledgement
I would like to express my sincere gratitude to our course instructor, Mr. Satyendra Timilsina for providing this opportunity to learn the trend of interest rates in our country. I would also like to thank different websites for providing their financial information freely in the internet. I would also like to thank the faculty and the administrative staffs of Ace Institute of Management for providing me help and support during our course of enrollment. Lastly, I would like to thank my friends in class for providing me a great company.

List of Tables and Figures

Table:
Table 1: List of Deposit and Lending Interest Rates...................................................................................... 6

Figure:
Figure 1: Trend Chart of Interest Rates in Nepal ......................................................................................... 7

Contents
Introduction .................................................................................................................................................. 1 Theoretical Background ............................................................................................................................ 1 Determinants of Market Interest Rates .................................................................................................... 1 The Equilibrium Interest Rate ............................................................................................................... 1 Interest Rate in Nepalese Context ................................................................................................................ 2 Pre-Interest Rate Phase (pre 1955)........................................................................................................... 2 Controlled Interest Rate Phase ................................................................................................................. 2 Transitional Interest Rate Phase ............................................................................................................... 3 Liberalized Interest Rate Phase................................................................................................................. 3 Interest Rate Trend Analysis ..................................................................................................................... 4 Impact of Interest Rate in Nepalese Economy ......................................................................................... 4 Conclusion ..................................................................................................................................................... 5 Annex ............................................................................................................................................................ 6 Tables and Charts ...................................................................................................................................... 6 References ................................................................................................................................................ 8

Introduction
Theoretical Background
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).

Determinants of Market Interest Rates

Market interest rate is determined by the demand for funds that can be loaned and the supply of the same. The demand of the fund that can be loaned and the market interest rate has positive relationship. As the demand for funds increases, the market interest rate also increases. Demand for funds comes generally from business for different investment purposes like increase in plant, equipments and inventories. In case of Nepal, there has been significant outflow of loan in real estate development sector. Similarly, market interest rate has negative relationship with the money supply. As the money supply increases in the market, the interest rate decreases. 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.

Interest Rate in Nepalese Context

Nepal began economic liberalization in mid 1980s with a view to enhance efficiency in economic activities. Since then, the Nepal Rastra Bank has been introducing many regulatory measures to make the financial sector progressive and efficient. 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 rate is closely tied with the banking history in Nepal. The history of interest rate can be broken down into four phases: a. Pre-interest rate phase b. Controlled interest rate phase c. Transitional interest rate phase d. Liberalized interest rate phase

Pre-Interest Rate Phase (pre 1955)

Prior to 1955, the domestic financial system was underdeveloped - it was dominated by unorganized/informal financial system generally driven by private individuals, Sahus (merchants) and landlords (Pant, 1964). To provide financial services, Nepal Bank Limited (NBL) which is the first commercial bank in the country, was established in 1937, and reflects the start of the formal financial system. Despite this beginning, the Nepalese financial system remained in an embryonic stage.

Controlled Interest Rate Phase

The establishment of Nepal Rastra Bank (NRB) in 1956 coincided with the period of planning (such as the first development plan from 1956 1960; GON (1956)). At the initial stage, the
2

financial system was still rudimentary and described as "predominantly a cash-economy" (NRB, 1965); however the further effort by GON of formalizing the financial system was reflected in the establishment of i) Nepal Industrial Development Corporation (NIDC) in 19593; ii) Rastriya Banijya Bank (RBB) 19664; and iii) Agriculture Development Bank in 19685; these institutions facilitated the elimination of the dual currency system in 1967, which predominated in Nepal (NRB, 1996). In that year, NRB also adopted a controlled interest rate determination regime, where the Bank used to fix deposit and lending rates of the commercial banks. Different rates were fixed for different instruments and purpose of the loan.

Transitional Interest Rate Phase

In early 1980s, Nepal experienced a series of balance of payment problem. To control the depletion of international reserve Nepal adopted the International Monetary Fund's (IMF) supported economic stabilization program in 1985, and subsequently entered into IMF's Structural Adjustment Facility; this presaged gradual reform measures in the financial sector (Thornton, 1987). In this regard, on November 16, 1984 NRB initiated a limited flexibility to commercial banks to fix the interest rates. Commercial banks were then allowed to offer interest rate on savings and time deposits to the extent of 1.5 and 1.0 percentage point above the minimum level. This form of limited deregulation on interest rate helped increase the competitiveness among banks and financial institutions.

Liberalized Interest Rate Phase

Controlled interest rate regime was completely abolished on August 31, 1989. Banks and financial institutions were now given full autonomy to determine their interest rates on deposits and lending. This coincided with the period of economic liberalization, which saw a huge surge in the number of banks and financial institutions. Although the NRB has given the autonomy to determine the interest rate, the bank had intermittently issued directives in regard to anomalies in the interest rate determination as there existed a high interest rate spread between deposit and lending rates. Therefore, the objective of interest rate deregulation to lower the financial intermediation cost was not met. The promulgation of Nepal Rastra Bank Act 2002 attempted to address development in the financial market. But, the continuing high level of interest rate spread suggested that greater financial sector
3

development (FD) had not brought efficiency in the financial system. To address this, NRB attempted to maintain the interest rate spread of commercial banks at a desired level through using moral suasion only. Additionally, in the spirit of interest rate deregulation, the provision of interest rate spread of 5.5% was withdrawn by the NRB in 2003. Since then no such direct or indirect restriction is implied as far as determination of interest rate is concerned, although NRB has shown intermittent concern regarding interest rates.

Interest Rate Trend Analysis

We carried out trend analysis from the year 1975 to 2010 only as the data for that period only was available. The data and trend chart are attached in the annex. Table 1 in annex tabulates the average lending and depositing interest since 1975 to 2010. The chart shows that there was a sharp decline in interest rates from 1997 to 2005, this period being the duration of Maoist insurgency in the country. The interest rates have stabilized and remained almost constant since then till 2010.

Impact of Interest Rate in Nepalese Economy

Based upon the available data, we can draw the following conclusion as the impact in Nepalese economy:
a. The investment did not grow during the observation period due to the Maoist

insurgency.
b. The economic growth was stalled during the observation period. c. Low interest rates for depositor means that the banks had huge deposits whereas low

credit interests means that there was very less loan outflow. However, with the end of Maoist insurgency in the country, banks have been able to diversify their investment portfolio and hence there has been steady growth in loan disbursements. The current lending interest rate of commercial banks averages around 17 percent and the interest rate for deposits averages around 8 percent. The overall interest rate of the country has averaged around 6.40 percent from 2003 to 2013.

Conclusion
As per the observation, during the Maoist insurgency period, the country was almost in liquidity trap. But however, with the Maoist joining the mainstream politics and the end of insurgency, there has been steady increase in investment in the country which has also increased the interest rate as well. After the end of the insurgency, there has been slight increase in the deposit interest rates. Lending interest rates, however, have been stable from 2006 to 2010.

Annex
Tables and Charts
Structure of Interest Rate (Percent per Annum)
Table 1: List of Deposit and Lending Interest Rates

Year 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1994 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975

Deposit 3.60 2.50 2.40 2.30 2.30 2.30 2.60 4.80 6.00 7.30 8.90 9.80 9.60 8.80 11.90 12.50 12.50 12.50 12.50 12.50 12.50 12.50 12.30 12.00 12.00 12.00 12.00 12.20 14.60 13.60

Lending 8.00 8.00 8.00 8.00 8.00 8.10 8.50 7.40 6.80 7.70 9.50 11.30 14.00 14.50 12.90 14.40 15.00 15.00 15.00 15.70 17.00 17.00 17.00 15.50 14.00 14.00 14.00 14.00 14.00 13.00 12.00

18.00 16.00 14.00 12.00 10.00 Deposit 8.00 6.00 4.00 2.00 0.00 2010 2008 2006 2004 2002 2000 1998 1996 1990 1988 1986 1984 1982 1980 1978 1976
Figure 1: Trend Chart of Interest Rates in Nepal

Lending

References
1. Tulsi Jung Basnets Blog: http://jungtulsi.blogspot.com/2008/03/interest-rate-structure-innepal.html, viewed on 29th March, 2013 2. Interest Rate Pass-through in Nepal, Nephil Matangi Maskey, Ph.D., https://docs.google.com/viewer?a=v&q=cache:iVc4jCo13JoJ:red.nrb.org.np/publications/econo mic_review/Economic_Review_(Occasional_Paper)-No_22,_April_2010%2B1_Interest_Rate_PassThrough_In_Nepal%5BNephil_Matangi_Maskey,_Ph.D,_Rajendra_Pandit%5D.pdf+interest+rate s+trend+in+nepal&hl=en&pid=bl&srcid=ADGEESgLrWU5mC_FtateUMxDa51MLVJu1kuFKatGr3aFsP66vH5_ZIvjcCBvTrEKXn3Q3dEBWVcVSrhi1kX6JwRjSCJnb39OvKeDIr-0UmeDh7F4oRb2IKLQQ5kwg6b4D_FjkNQXx&sig=AHIEtbQweNnDd0gZcBaej4rQJ6B_22MZnw 3. Trade Economics Nepal Interest Rate http://www.tradingeconomics.com/nepal/interest-rate, viewed on 29th March, 2013 4. Interest Rate Structure of Commerical Banks, Nepal Rastra Bank: http://bfr.nrb.org.np/bfrstatistics.php?tp=interest_rate_structure&&vw=15, viewed on 6th April, 2013 5. Fact Fish: http://www.factfish.com/statistic-country/nepal/lending%20interest%20rate viewed on 7th April, 2013 6. Fact Fish: http://www.factfish.com/statistic-country/nepal/deposit%20interest%20rate viewed on 7th April, 2013