Experts Warn Nepal’s Economy Shows Signs of ‘Liquidity Trap’

Economists have said Nepal’s economy is showing signs of a “liquidity trap” as excess liquidity in the financial system, historically low interest rates and subdued inflation have failed to stimulate credit growth and economic activity.

A liquidity trap is an economic condition in which consumers and investors prefer to hold cash rather than spend or invest, even when interest rates are kept low to encourage growth. In such a situation, monetary policy becomes largely ineffective and economic activity slows.

According to Nepal Rastra Bank (NRB), the average lending rate of commercial banks fell from 9.07 percent to 7.38 percent over a one-year period until mid-November. Despite the decline, credit growth has remained weak, even as the central bank has adopted accommodative policies to boost lending.

Although the NRB had set a target of 12 percent growth in private sector credit for the current fiscal year, lending had increased by just 1.2 percent by mid-November—equivalent to Rs 65.04 billion. As a result, more than Rs 1250 billion in excess liquidity has accumulated in the banking system, central bank data show.

Bankers say credit demand has remained weak as the private sector continues to report sluggish market demand, discouraging businesses from borrowing and investing.

Inflation has also declined sharply. The consumer price inflation rate fell to 1.11 percent in mid-November, one of the lowest levels on record.

Speaking at a programme organised by the central bank on Wednesday, former vice-chairperson of the National Planning Commission and economist Prithviraj Ligal said the economy is exhibiting characteristics of a liquidity trap. He stressed the need for better coordination between fiscal and monetary policies to address the situation.

Ligal said excess liquidity trapped in the banking system could not be effectively mobilised, adding that issuing bonds to absorb liquidity merely shifts money to the central bank. He emphasised the need to create an environment that encourages credit expansion. He also noted that the financial health of both banks and businesses has deteriorated, and that existing loan restructuring and rescheduling facilities alone would not be sufficient to resolve the problem.

He further said the government formed after recent political movements failed to address economic challenges through a supplementary budget.

Former National Planning Commission member and economist Govinda Nepal suggested that the government should mobilise foreign exchange reserves in productive sectors and infrastructure development. Economist Kalpana Khanal warned that persistently falling interest rates could lead to capital flight and stressed the need to channel available financial resources into infrastructure projects.

Former National Planning Commission member and associate professor Ramesh Chandra Paudel said the current economic difficulties stem more from weak fiscal policy than from monetary policy, noting that government’s economic policy has been less effective than the central bank’s measures.

Presenting a paper on the overall economic situation, NRB Executive Director Dr Ram Sharan Kharel said that despite the central bank’s flexible policy stance, credit demand has not picked up.

Governor Dr Bishwo Nath Paudel said monetary policy alone cannot resolve all economic problems. “We are clear about our role. Monetary policy cannot perform the function of fiscal policy by pressuring banks or allowing bad loans to increase in the name of economic growth,” he said.