Setting the record straight

Dogmatic bankers were wrong, deposit is interest elastic

The whopping rise in deposit mobilization by commercial banks in recent months has once again proven that Nepal’s deposit mobilization is in fact interest elastic, which means that interest rate plays a vital role not only in sustaining but also attracting additional deposits to banks. When Nepali banking industry suddenly started facing shortage of liquidity mainly as a result of over two-fold growth in loan disbursements compared to mobilization of additional deposits about nine months ago, some traditional bankers made arguments that the problem was a product of eroding confidence in Nepal’s banking system due to the prolonging political instability and pointed fingers toward a new central bank’s provision that required a valid source of income while depositing amount worth more than 1 million rupees. In the last quarter of 2009, numerous reports appeared in local newspapers, highlighting the disappearance of over Rs 10 billion rupees from the banking system. Many bankers argued that depositors were withdrawing their bank deposits and stockpiling them in their homes as they felt their deposits were not secure in the banking system.

The orthodox bankers had dismissed the role of negative interest rate – inflation being higher than the interest rate offered by banks – for the disappearances of the deposits and had argued negative interest rates had existed for some years and even during that period banks were enjoying a hefty growth in deposit mobilization. Somehow, they were of the view that interest rates play little or no role in sustaining and luring new deposits, thus deposit mobilization in Nepal is interest inelastic. Initially, the theory grained some ground, putting numerous pressures on the central bank. Higher-ranking central bank officials, including the governor, were heard saying that the central bank is considering options to relax its provision on declaring sources of income.

However, many economic commentators had refused to buy the theory and had argued the growing mismatch between inflows and outflows of resources from banking system, which fuelled a record liquidity shortage, was due to prolonged negative interest rate. The slowly unfolding scenarios reflected in terms of encouraging increment in banking deposits have proved that the orthodox theories were wrong. Granted, the lingering political uncertainty was weakening depositors’ confidence on banks that caused deposits to disappear from banking system. But my questions is: Has there been any significant development to justify that the country was moving toward political stability within the last one month when banking system experienced a record Rs 25 billion rise in deposits? No. The level of political stability in fact has worsened lately compared to last year.

The traditional bankers underestimated a simple and time-tested economic theory that says money flows where returns are high.

As far as the eroding depositors’ confidence toward banking system is concerned, what measures have the government or the central bank taken recently that dramatically restored depositors’ confidence toward banking system? Nothing. Has the central bank relaxed or suspended the provision to declare source of income to deposit more than Rs 1 million? No.

Now, the simple question is: Why has there been such an impressive growth in deposit mobilization? And, the straight forward answer is, liquidity shortage compelled the banks, which were smartly making profits out of wide spread rate, to offer higher interest rates. Some of the banks are offering up to 11.5 percent interest in one-year deposit at a time when average inflation rate is expected to hover around 10 percent in the coming months. For the first time in many years, depositors at some banks are enjoying positive interest rate, though the average interest rate at one year’s deposits is still below the current inflation rate.

The traditional bankers underestimated a simple and time-tested economic theory that says money flows where returns are high. That was what actually happened last year. As a result of lengthening negative interest rates for years, depositors started exploring options for higher returns. In that process, some of the small depositors were attracted toward cooperatives that were offering double the interest rates that banks were offering while some others opted to invest in the stock market that at least was ensuring returns equivalent to bank’s interests. However, for big depositors, investments in land and apartment businesses in partnership with banks’ lending emerged as the favorite choice as it was generating multi-fold returns.

Similarly, a large chunk of deposits withdrawn from banks last year made it way into the Indian financial institutions operating in the bordering cities that were offering up to 12 percent interest on one-year fixed deposits – more than double of what domestic banks were offering. The fact that the collection of Indian currency has increased remarkably in Nepali banks operating in bordering cities in recent months proves that the deposits that crossed the border to Indian banks are coming back to Nepali financial institutions.

All these prove that unlike the claims made by traditional bankers, Nepal’s deposit mobilization is interest elastic. Had it not been responsive to interest rates, why would such a huge amount of banking deposits creep into cooperatives and bordering Indian banks? Of course, the response to change in interest rates among Nepali depositors is much slower than that is seen in other economies. That is the reason why depositors waited for years before starting to shift their deposits to either cooperatives or Indian banks and speculative businesses for high returns. Banks too, after raising deposit rates, had to wait for five months to see deposits coming to them.

Everyone should be aware, especially dogmatic bankers, that it is not the right time to rejoice the rise in deposits. As the economy has already learnt a bitter lesson of sustained negative interest rates, the most serious challenge for monetary authorities is to keep it positive so as to prevent reemergence of the same ills that shook the very foundation of the economy. As the banks amass more deposits, it is time for the monetary authorities to take some measures to check the possibilities of another downward trajectory of interest rates. I propose that the central bank should direct commercial banks to keep minimum interest rate on one-year deposit rate equal to bank rate, which is currently fixed at 7 percent.

premkhanal@gmail.com