In simple parlance, interest is the cost of funds. If you are a lender, you will receive interest and if you are a borrower, you will pay interest. The interest is calculated in the percentage of the principal. Thus the percentage cost of the funds (principal) is known as the interest rate.
The interest rate is determined by the interaction of the demand and supply of money in an economy. Factors such as inflation, investment scenario, economic condition, fiscal and monetary policies influence the demand and supply of money.
Normally it is assumed that there is a time value of money, meaning that money today is worth more than tomorrow. This is because money can grow only through investing. An investment delayed today is an opportunity loss. Also, the prices are assumed to go up along with the increase in economic level. So, factors like inflation, economic growth, and investment spending justify the positive interest rate.
Through positive interest rates, people are encouraged to consume less and save more resulting in the increase of investment funds. And, all these processes contribute to a vibrant economy and are anticipated to bring economic growth and prosperity to the country.
However, the situation is different during deflationary spiral in the economy. A deflationary spiral is a downtrend price reaction to an economic crisis leading to lower production, lower wages, decreased demand, and further lower prices. Simply put, this is a situation of recession or depression in an economy.
In such an economic scenario, consumers anticipate that the value of their money will be worth more tomorrow than today. So, the hoarding of money begins. This will cause a lack of spending which will lead to an increase in unemployment, a decrease in business profits, and a decline in the price of consumer products. All of these results again in a sharp decline in demand, causing prices to fall even lower.
So, the central bank in a desperate and critical effort to boost the economy tries to increase consumption. For this, the central bank initially tries to lower the interest rate. Since the interest rate is independently determined by demand and supply in the market, the central bank attempts to lower the interest rate by lowering the interest on the excess reserve account maintained by commercial banks and other financial institutions.
During extreme deflation, despite a lower interest rate, it is unlikely that economy will revive back to normal that easily. If lower spending, lower prices, and lower demands still persist in the economy, the central bank will finally try this unconventional monetary tool. Commercial banks and other financial institutions will be charged interest if they keep their excess reserve in the central bank. Hence, this is the situation of a negative interest rate.
For example: when the interest rate is -2% p.a., depositors have to pay Rs 2000 p.a. if they have deposited Rs. 100,000 in banks.
In the last two decades, Japan, Switzerland, Sweden, Denmark, and even the Eurozone (ECB) have used negative interest rates to encourage spending in their economy. The Swiss government ran a de facto negative interest rate regime in the early 1970s to counter its currency appreciation due to investors fleeing inflation in other parts of the world.
In 2009 and 2010, Sweden and, in 2012, Denmark used negative interest rates to increase the money supply in their economy. In 2014, the European Central Bank (ECB) introduced a negative interest rate that only applied to bank deposits aimed to protect the Eurozone from falling into a deflationary spiral. The table below further portrays countries with negative interest rates.
Scenario in Nepal
When an economy has low or negative interest rates, it encourages people to spend and invest rather than save and hoard. Most of the developed countries have low-interest rates. This is meant to stimulate economic growth by making it cheaper to borrow money to finance investment in both physical and financial assets.
However, in the context of Nepal, the interest rate is very high. Nepal is a developing nation and lacks very basic infrastructures. To build these infrastructures, we need an enormous amount of capital. But borrowing funds at such expensive rates make every project costly.
At the present time, the interest rate is in an increasing trend. Obviously, at such high rates, businesses will hesitate to borrow much. This will lead to a decline in business investment and is likely to reduce employment opportunities in the country.
If this matter of liquidity crunch and the high-interest rate isn't addressed now, Nepal may witness an economic crisis very soon. Therefore, the central bank, financial institutions, and the government itself should take prompt actions to address the liquidity shortage in the country.