The Hindu Business Line : Govt savings instruments: Cutting interest rates not bankable

The hypothesis that the interest rates of government savings schemes constitute a floor for banks’ rates needs to be tested rigorously before it is accepted as a basis for policy-making. Rather, the solution to reducing bank lending rates should come from cutting the cost of banking services, says A. SESHAN.

It is an exaggeration to say that banks lose out in deposit mobilisation because of the attractive rates of government-saving schemes.

Commercial banks have requested the government to lower interest rates under the National Savings Scheme (NSS) to facilitate reductions in deposit and lending rates. The argument is that a better return on savings in the former than from the latter is a hindrance to deposit mobilisation. The matter needs to be investigated analytically as it has policy implications that will impact millions of savers.

The first empirical fact that emerges from an analysis of the Indian situation is that savings depend on income, not on the interest rate. This is, of course, the other side of the Keynesian concept of the marginal propensity to consume (MPC) at the level of the individual.

MPC refers to the proportion consumed out of an incremental income. Obviously, the higher the MPC the lower the marginal propensity to save (MPS) as together they make up income. The point that income, and not interest rate, decides savings is buttressed by the fact that the savings rate has been going up steadily over the years due to the rising Gross Domestic Product, though there have been years when the interest rates were low.

The desire to save is a sociological factor in India and other developing countries. While people everywhere do save for the rainy day and to meet contingencies and prefer additional future income over current consumption, there is an innate desire for most of us to leave something behind for our children when we pass on. This motive is something that is missing in the West, where one often comes across instances of wills being written in favour of charities or even pets. Theories on savings for countries like India need to reckon with this factor.

Looking back, financial institutions, like banks, for mobilisation of savings came into being less than a couple of centuries ago. Did not people save in pre-banking days? They did, often hiding their money in the earth or under their pillows. It did not fetch any interest, although a few might have taken to money-lending. Thus, savings happened even when there was no interest or return.

Rate relevance

Does it mean that interest rates are irrelevant as a policy variable? No, they are still important because they influence investment directions for the flow of the savings.

In other words, a rational individual weighs the risk-return-liquidity factors of various channels and decides on the optimum allocation.

Financial savings accounted for 47.5 per cent of the total in 2006-07 (Quick Estimates) the balance being physical. Of these, net bank deposits are the most important, accounting for 30.8 per cent of total financial savings and the share of net claims on government (including NSS) was 8.5 per cent.

An analysis of the trends in the last two avenues of savings shows that they compete, their growth rates being inversely related. There were substantial declines in the growth of the amount collected under NSS whenever returns from bank deposits were more attractive.

But when the NSS rates were high relative to those of deposit rates the impact on bank deposits was not as significant as in the previous case, even if there was a decrease in the growth rate. In other words, there is an asymmetry in the mutual relationship of the two channels of investments.

One needs to reckon with all the factors that impact deposit growth, such as currency-deposit ratio, cash reserve ratio, fiscal deficit and inflow of foreign capital.

Government savings

The one cardinal fact of absorption of savings by government is that it is akin to the open market operations of the central bank when the money is kept there.

The money goes into the account of the government. But it does not remain there forever. It gets spent by government over a period of time which, in turn, is reflected in the growth of currency, bank deposits and other financial instruments. Further, government deposits in the banking system are significant.

According to the RBI survey of ownership of bank deposits, the government sector accounted for Rs 3,90,673 crore, or 14.5 per cent, of the total in the system, as at the end of March 2007.

The deposits of the Central and State governments amounted to Rs 1,30,091 crore, the balance being owned by local authorities, quasi-government bodies, etc. They are like any other deposits and the deposit multiplier works in their case too. In other words, it is somewhat of an exaggeration to say that banks lose out in deposit mobilisation because of the attractive rates of government saving schemes; the money returns to the system with a time-lag, subject to the public preferences for deposits vis-À-vis currency and other factors.

The hypothesis that the interest rates of government savings schemes constitute a floor for banks’ rates needs to be tested rigorously before it is accepted as a basis for policy-making.

In fact, a misunderstanding, intentional or otherwise, of the underlying process of deposit mobilisation led in the past to banks demanding tax benefits for bank deposits similar to those available for mutual funds (MF) under Section 80C of the Income-Tax Act.

Funds diversion

Bankers claimed that deposit mobilisation was affected due to the “diversion” of funds from banks to mutual funds to take advantage of fiscal benefits. But this is illogical. When an investor draws a cheque in favour of a mutual fund, the money is shifted from one bank to another. It never leaves the banking system.

However, the government acceded to the demand of the bankers in the Union Budget for 2006-07 and included term deposits with a duration of five years in the instruments eligible for income deduction for tax purposes under Section 80C, subject to a maximum of Rs 1 lakh.

This, no doubt, contributed to the growth of long-term deposits proving the point that the yield decides the channels of investment.

There is no strong lobby for depositors, like the several that exist for borrowers, although the former number several times the latter. As a result, it is the latter’s view that often prevails in policy decisions, especially at the time of framing the Budget and the Credit Policy. Despite the false publicity about declining levels of price rise, based on the Wholesale Price Index, the truth is inflation close to double digits, as revealed by the Consumer Price Indices.

The average citizen is now getting a negative real return on his savings. It would be unjust to him if the government were to heed the demand for any reduction in the administered deposit rates of NSS. Then, how does one reduce the lending rate? The net interest margin has remained stable at 3 per cent for many banks. The international benchmark is around 2 per cent.

Further, with the proliferation of ATMs and online banking, the transactions at bank branches have come down for the leading banks, which have gone in for massive computerisation. One large private sector bank claims that customers visiting its branches are only around a fourth of the earlier number.

Has this resulted in any cost reduction in banking services? That is the area which needs to be looked into, both by the Government and the Reserve Bank of India, in collaboration with the Indian Banks Association.

The solution to the problem is in the reduction of the cost of banking services as well as in interest rate spreads.

(The author is a former officer-in-charge of the Department of Economic Analysis and Policy, RBI. blfeedback@thehindu.co.in)

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