A damper on savings

Reduced rates mean a disincentive to save especially for households in the banking sector 

Early October the State Bank of India and a clutch of public sector banks reduced their interest rates, both deposit and lending, ostensibly after the Reserve Bank of India has set the tone. 

The RBI on September 29, 2015 reduced a key rate, the Repurchase rate (also known as the Repo Rate) 6.75 per cent from 7.25 per cent. Repurchase is a process, where the Reserve Bank of India provides liquidity support to banks, through a purchase and sell-back of government securities. It is done with through overnight purchase of government securities held by the banks and the same is sold back the very next day.

So if a security is purchased at Rs 100 from the banks, it is sold back the very next day at Rs 106.75, based on the new RBI rates. The new rates essentially imply that the cost of overnight borrowing for the banks have reduced by 0.5 per cent.

That regulatory rate reduction in effect translates into a cue for systemic banks to reduce their respective interest rates. But the rate reduction itself was clearly prompted by intense pressure from the Finance Ministry. 

On September 19, 10 days before the RBI’s monetary policy review meeting, Finance Minister Arun Jaitley was quoted by Press Trust of India as saying, “Any policy planner would like a cheaper cost of capital, but that’s not a decision which I would like to influence at this stage because it’s a decision which RBI has to take.”

The Finance Minister reiterated the same stance on the eve of the RBI’s policy announcement leaving Governor Raghuram Rajan little flexibility. Mr Jaitley told the Financial Times in London on September 22: “Inflation is very much under control. Common sense says that interest rates should come down.” 

As a result, the country’s largest public sector bank reduced its deposit rates to just 7.25 per cent for one year maturity. In January 2014, one-year term deposits earned nine per cent. For non-residents’ one-year term deposits the interest rates are barely 4.21 per cent.

But the reduction in deposit rates is expected to have an impact on domestic savings. Households comprise the largest chunk of domestic savings and comprised about 18 per cent of India’s Gross Domestic Product of Rs 126 lakh crore (U S $ 2.10 trillion) or Rs 23 lakh crore in 2013-14.

Reduced rates mean a disincentive to save especially for households in the banking sector. Banks, particularly public sector banks, remain the single largest repository of household savings. Progressive reductions in interest rates though have actually contributed to bringing down household savings. Household savings were 26 per cent 2009-10 and have since continuously fallen.

Other financial instruments, mutual funds and capital markets comprise a minuscule component of household savings.  In fact, although capital markets have boomed touching new records over the last two years, investments in alternative capital markets have remained low.

A Neilson survey released in December 2014, titled Building the Mutual Fund Market In India: The Need For Financial Literacy, says only about nine per cent of urban households invest in mutual funds. In rural households investment in mutual funds or for that matter in equities would, therefore, be even lower in view of risk aversion. 

Yet despite the falling household savings, if interest rates were still reduced, one major reason appears to be to accelerate the process of savings in alternative financial instruments, including equities. However, institutional play, particularly foreign institutional investors and the consequent the extreme volatility in capital markets is likely to deter retail investors. 

Institutional play imply neither equities nor mutual funds are capable of assuring investment security. In both mutual funds and equities risks are entirely with the saver. Bank savings on the other hand offer an implicit sovereign guarantee cover for securing investment.

With the reduced deposit rates there is a possibility of further migration to physical savings. In rural India at least 60 per cent of household savings are in the form of physical savings, the preferred vehicle being gold in view of the high liquidity. Other than bank deposits, few other financial instrument are as liquid. That, in turn, would leave banks with a reduced corpus to lend, implying intermediation becomes difficult.

Unlike the OECD (Organisation for Economic Cooperation and Development) nations that are over leveraged, India’s household income to ratio is still positive apparent from the high household savings. OECD nations on the other hand have a disposable income to debt ratio of over 130 per cent (Source: OECD Fact book 2014, Economic, Environment and Social Statistics).

This means that OECD nations are collectively savings deficit, whereas India is savings surplus. But there also appears to be other reasons for the government pressure. Since last year, inventories have been piling up in various sectors, white goods, automobiles, even in realty. The single evidence of inventory build-up in the industry is the whole sale price index.

The core or manufacturing sector inflation is negative at two per cent (minus two per cent) since July this year. Wholesale inflation for non-manufactured goods becomes negative, when there is a large stock of unsold goods in factory stockyards.

This implies that manufacturers were prepared to sell the goods even at reduced prices to liquidate stocks. That is already happening, evident from the massive advertisement campaigns offering discounts, from automobiles to white goods and apartments.

A reduced lending rate is expected to provide a stimulus for purchase of these goods and in turn help companies liquidate their inventories. Nomura India’s economist, SonalVarma concurred, “The RBI has front-loaded this rate cut, using the available room for monetary easing to kick-start domestic demand.” This, in turn, translates to better earnings for the companies, the single reason for stock indices to react positively to any cut in regulatory interest rates.

In turn, the underlying assumption is that the reduced lending rates would help bring down the debt overhang of over- leveraged companies. This means that companies would be in a position to refinance high interest loans with low interest funds. What, however, is clearly unrealistic is the assumption that bad loans would disappear from bank balance sheets. Those loans would still need to be recovered as most banks admit, including borrowings by Kingfisher and Deccan Chronicle Holdings.

What also appear unrealistic are expectations that the reduced interest would spur capital investments. After all interest rates alone contribute to investment. If Zero Interest policy interest rates in the U S and negative rates in Europe have not kicked off investment, it is unrealistic that low rates will have any effect in India.

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