Nepal’s banking sector is currently facing a shortage of loanable funds. The possible reasons for this situation are large investments in unproductive sectors and money earmarked for government expenditure resting in banks. Government transactions are conducted through Nepal Rastra Bank and two other government banks. Most of the money received from tax collection and the funds and budgets allocated for line ministries and local bodies are parked in the non-private sector as they are unspent. A common government practice is to keep the money piled up until the end of the fiscal year, and then spend it hurriedly.

Around a year ago, more than Rs250 billion remained frozen with the exchequer. The government allocated Rs335.2 billion for capital spending for the current fiscal year. Of this, Rs117.9 billion had been spent as of April 12, according to the data of the Financial Comptroller General Office. This means that the government has utilised only 35 percent of the capital budget nine months into the fiscal year. Such inability of the government to spend will further prevent banks from providing loans and eventually slow down the national economy.

There are two schools of thought regarding the relation between interest rates and inflation. While one school of thought believes that an increase in the interest rate is directly proportional to inflation, the other believes that an increase in interest rates actually helps to increase savings which in turn stabilises inflation.

In the current scenario, Nepali banks are tackling the liquidity crunch by paying higher interest rates on savings and fixed deposits. But it should not be forgotten that an increase in the interest rate will discourage the country’s productive sector. The cost of production will increase, leading to a competitive disadvantage against imported goods. Imports could even eat into remittance which is the biggest source of cash for Nepal. Due to the liquidity crunch, industries that have already been hit hard by

earthquakes, Madhes riots and the trade blockade will suffer a further drop in production, and ultimately slow down the entire economy.

A study of the trends in other countries also shows that the higher the interest rate, the higher the inflation rate. For instance, Ukraine with an interest rate of 15.25 percent has 49 percent inflation, Myanmar with an interest rate of 10 percent has 8.9 percent inflation, India with an interest rate of 7.3 percent has 6.8 percent inflation, China with an interest rate of 2.5 percent has 5.4 percent inflation, US with an interest rate of 2 percent has 1.5 percent inflation, UK with an interest rate of 1.9  percent has 2 percent inflation and Japan with an interest rate of 0.1 percent has 0.4 percent inflation.

As these figures show, a higher interest rate will result in inflation. The Monetary Policy of Nepal Rastra Bank (NRB) aims to bring inflation down to less than 7.9 percent from 9.9 percent, and it is working. This is a good position. Nevertheless, certain mechanisms are required in order to keep inflation down. NRB, as a regulator of banks and financial institutions (BFIs), should prioritise specialised lending and subsidies for agriculture, hydropower and tourism. The current provision for agricultural loans to farmers is praiseworthy. However, similar focus must be provided to other sectors too. Agricultural loans have swelled by 31 percent, but bank loans to the tea sector dropped—14.4 percent between January 2017 and January 2018. Neglecting cash crops like tea will hit industrial growth.

Likewise, many other crucial productive and constructive sectors were ignored. Schemes prioritising spending on the productive sector while discouraging unproductive spending should be implemented. Further, the government should release the piled up funds to expedite development works. As a major player in the national economy, the government must make wise use of the funds to ease the liquidity crunch in the banking system. Inflation is inevitable if the shortage of loanable funds is not managed in a sustainable manner. A shortage of loanable funds will prevent BFIs from meeting credit demands, ultimately affecting the national economy. Only increasing the interest rate is not a durable solution; in fact, the policy may even backfire.

Regmi is an advocate