When the Interbank Rate Breaks the Corridor
In the third week of Poush, the interbank weighted average rate prints at 6.82%, above the 6.50% upper bound of the interest rate corridor, even though the policy rate is 5.00% and the deposit collection rate is 3.00%. Over the previous three weeks, the government's cash balance at the central bank rose by NPR 84 billion as VAT and customs collections bunched. Commercial banks' credit growth is 11.4% year-on-year against nominal GDP growth estimated at 8.0%, and CPI inflation is 5.8%, with food inflation at 7.6%. The central bank has NPR 40 billion of Treasury bills maturing in seven days and NPR 60 billion outstanding under standing deposit absorption. Bankers' associations publicly demand a 100-basis-point CRR cut from 4.0%, arguing that the corridor is broken. The IMF resident representative warns that easing now could rekindle inflation. The monetary operations committee meets tomorrow.
1. Identify the most likely reason the interbank rate is above the corridor ceiling. Distinguish a system-wide liquidity shortage from a distribution or frictional problem, and state which data in the setup supports each interpretation.
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The ceiling is 6.50%, so a sustained 6.82% print means either the ceiling is not binding or the market is pricing a different marginal cost. Three data points matter. First, the NPR 84 billion government cash buildup is a system-wide drain: tax payments move deposits from banks to the central bank, reducing reserve balances. Second, credit growth of 11.4% exceeds nominal GDP growth of 8.0%, so loan demand is absorbing reserves faster than deposits are being created. Together these point to genuine liquidity tightness. But a pure system-wide shortage should push banks to the central bank's lending facility at 6.50%, not above it. The overshoot suggests frictions: collateral shortages, stigma in using the standing facility, or uneven distribution, with some banks holding excess reserves while others bid up the interbank rate. The maturing NPR 40 billion of T-bills will partly offset the drain, so the net system drain is about NPR 44 billion. The committee should treat the problem as mainly a liquidity and distribution issue, not assume the corridor has failed.
2. Calculate the net liquidity drain from the government cash buildup and maturing T-bills. If the central bank injects that amount through a 14-day repo and the reserve money multiplier is 4.2, compute the potential deposit expansion, and explain two reasons the actual credit effect will be smaller.
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Government cash buildup drains NPR 84 billion; maturing T-bills inject NPR 40 billion. Net drain = 84 - 40 = NPR 44 billion. A 14-day repo of NPR 44 billion neutralizes the net drain. Potential deposit expansion = 44 x 4.2 = NPR 184.8 billion. The actual credit effect will be smaller for at least two reasons. First, banks may hold part of the proceeds as excess reserves or use them to repay central bank borrowing rather than expand loans. Second, currency leakage, import payments and weak credit demand reduce the multiplier; capital and risk-weight constraints may also stop banks from expanding risk assets even when reserves are available. The repo therefore addresses liquidity, not credit demand.
3. Recommend whether the committee should cut CRR by 100 basis points or use a repo. Consider inflation at 5.8%, credit growth above nominal GDP growth, and the signal sent to markets. Give two risks of your recommendation.
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A repo is preferable. A 100-basis-point CRR cut releases liquidity permanently, is a blunt instrument and sends a strong easing signal when inflation is already 5.8% and credit growth of 11.4% is running ahead of nominal GDP growth of 8.0%. A repo is reversible, priced at the policy rate and can be calibrated to the estimated NPR 44 billion net drain. It also addresses the immediate frictional problem without changing the structural reserve requirement. Risks: (i) if inflation expectations are already drifting, even a repo may be read as tolerance of higher inflation; the central bank must communicate that it is liquidity management, not easing. (ii) If the problem is collateral shortage or stigma, a repo may not reach the banks that need liquidity; the central bank should widen eligible collateral or run a targeted auction. A CRR cut should be kept as a separate decision only if the drain proves persistent and inflation pressures ease.