Nepal Rastra Bank Moves to Absorb Excess Liquidity from Foreign Currency Purchases Through Sterilized Intervention

Kathmandu — Nepal Rastra Bank (NRB) has introduced a new approach to manage liquidity pressure created by rising foreign exchange reserves, encouraging commercial banks to invest in foreign government securities while preparing to conduct sterilized interventions in the foreign exchange market.

The policy, introduced through the monetary policy for fiscal year 2083/84, reflects the central bank’s effort to maintain a balance between strengthening foreign currency reserves and preventing excessive growth in domestic liquidity. As Nepal continues to receive strong foreign currency inflows, particularly from remittances and external earnings, the central bank faces the challenge of managing the additional Nepalese rupee liquidity created when it purchases foreign currency from the market.

The latest measure indicates a shift toward more active liquidity management rather than allowing foreign exchange accumulation to automatically expand money supply within the banking system.

Managing the Liquidity Impact of Growing Foreign Reserves

When the central bank purchases foreign currency from the market, it pays sellers in Nepalese rupees. This increases the amount of domestic currency circulating in the financial system and can improve liquidity conditions for banks.

While higher liquidity can support credit expansion and economic activity, excessive liquidity growth may create inflationary pressure, reduce the effectiveness of monetary policy, and create challenges in maintaining interest rate stability.

To address this issue, NRB plans to encourage commercial banks to invest in foreign government bonds. Such investments can help absorb part of the excess liquidity within the banking system while allowing banks to diversify their assets and improve foreign currency-related investment opportunities.

The move is particularly relevant as Nepal’s foreign exchange reserves have strengthened in recent periods due to continued remittance inflows, improved external sector conditions, and recovery in tourism-related earnings.

What Is Sterilized Intervention and Why Does It Matter?

Sterilized intervention is a monetary policy technique used by central banks to manage the impact of foreign exchange market operations on domestic money supply.

When a central bank buys foreign currency, it increases domestic currency circulation. Without additional measures, this expansion in money supply could contribute to inflationary pressure.

Under sterilized intervention, the central bank offsets this impact by using other monetary tools, such as selling government securities or conducting liquidity absorption operations. The objective is to manage the exchange rate and foreign reserves without allowing unwanted changes in domestic liquidity conditions.

For Nepal, this approach is significant because the country has experienced periods of both foreign exchange pressure and liquidity surplus. A stronger reserve position gives the central bank more room to intervene in the market, but it also requires careful management of the resulting domestic currency expansion.

Balancing Foreign Exchange Strength and Price Stability

The latest policy highlights the central bank’s attempt to achieve two objectives simultaneously: maintaining adequate foreign exchange reserves and preventing excessive liquidity growth.

Foreign currency accumulation is generally considered positive because it strengthens Nepal’s ability to finance imports, meet external obligations, and maintain confidence in the financial system.

However, reserve accumulation also creates a monetary challenge. If every foreign currency purchase results in additional domestic liquidity without adjustment, it may weaken inflation control and complicate interest rate management.

Through sterilized intervention, NRB aims to ensure that external sector improvements do not create instability within the domestic economy.

Interest Rate Framework Remains Unchanged

Alongside foreign exchange management measures, NRB has kept major policy rates unchanged under the new monetary policy.

The policy rate remains at 4.50 percent, the Standing Deposit Facility (SDF) rate at 2.75 percent, and the bank rate at 6 percent.

The central bank has also continued existing arrangements related to liquidity management instruments, including the Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Standing Liquidity Facility (SLF).

The decision indicates that NRB does not see an immediate need for a major change in interest rate settings. Instead, it appears focused on improving liquidity management through market-based tools.

Liquidity Management Becomes Central Bank’s Key Priority

The continuation of existing interest rate tools combined with new foreign exchange liquidity measures suggests that NRB’s current priority is maintaining stability rather than making aggressive policy changes.

The banking system has recently experienced periods of excess liquidity, while credit demand from the private sector has remained relatively weak. In such a situation, simply increasing liquidity may not translate into higher economic activity.

Effective liquidity management is therefore important to ensure that financial resources remain available while preventing instability in prices and interest rates.

Implications for Banks and Financial Markets

For commercial banks, investment opportunities in foreign government securities could provide another channel for managing excess funds. Banks may benefit from improved asset diversification while supporting broader monetary management objectives.

For the financial market, a more predictable liquidity framework could reduce sudden fluctuations in short-term interest rates. Stable liquidity conditions can help banks plan lending activities and improve confidence among businesses and investors.

However, the effectiveness of these measures will depend on implementation. The central bank will need to carefully monitor inflation trends, credit growth, exchange rate movements, and banking sector liquidity.

A More Active Approach to Modern Monetary Management

The latest policy direction shows Nepal Rastra Bank moving toward a more sophisticated approach to monetary management. Instead of relying only on traditional interest rate adjustments, the central bank is expanding its toolkit by combining foreign exchange operations, liquidity absorption mechanisms, and market-based instruments.

As Nepal’s external position improves, managing the side effects of foreign currency inflows will become increasingly important. The challenge for NRB will be ensuring that stronger foreign reserves contribute to economic stability without creating excessive liquidity-related risks.

The success of this strategy will depend on how effectively the central bank balances reserve accumulation, inflation control, banking system liquidity, and overall financial stability in the coming fiscal year.