India: Interest Rate Corrections - Is it for the Benefit of Depositors?

2005

D Tripati Rao

Finally the Indian stock market is learning to live with the Left as seen by its buoyant upward trend. The expectation-driven, euphoric and seemingly unstoppable stock market has recently touched a new historic height crossing the 9000 mark. Two factors are driving these expectations. First, as per the upwardly revised estimates of projected growth for 2005-06, the Indian economy is poised to achieve 7 to 7.5 per cent growth pulled up by another year of good agricultural production and a belated monsoon bringing good rains. The consumer goods sector and the automobile industry are upbeat expecting a sustained post-monsoon demand coming from farming sector spending bolstered by robust rural income earnings. FIIs (Foreign Institutional Investors) are on a binge, pumping money into an equity market expecting good returns. Every IPO (Initial Public Offering) is over subscribed multiple times over thanks to book-building and 'discretionary' allotment. Secondly, India has been outperforming other emerging markets.

The US economy has sustained positive growth for several quarters. In fact, to check the strong US domestic demand fuelled by rising household consumption, loan demand and a heated real estate market, the US Federal Reserve has in successive stages (so as not to precipitate overheating) hiked up interest rates to 4.0 per cent - the highest since 2001. With rising oil prices hardening at a higher level, the inflation 'beast' is once again raising its head across the globe. The OECD projects a further increase in the short-term global interest rates. Given these developments, Indian monetary authorities have revisited interest rate policy with a 25 basis point hike in the reverse repo rate to 5.25 per cent. But this has once again been without recourse to any direct measures so as not to spoil the coming post-harvest season. However, what many commentators are rather conspicuously overlooking is the use of monetary instruments to signal upward interest rate corrections. In this context, it remains to be seen whether such interest rate corrections made by the Reserve Bank of India (RBI) are benefiting just the commercial banks without the passing on of savings products to finally benefit ordinary customers.

During the period of the low interest rate regime, bankers had become active traders of Gilts (government securities); and the low interest rate regime has pushed the secondary market for Gilts. In last February when interest rates showed a rising trend, the RBI bailed out the banks by permitting them to transfer securities from a 'trading' category to a 'maturity' category. This means that, in both rise and fall situations, it is only banks which have benefited - with the active support of the RBI. Hence, leaving aside the issue of the direction of interest rate trends corresponding to the business cycle phase, such corrections made by the RBI are not benefiting ordinary customers. The last time the reverse repo was increased by 25 basis points almost all the banks parked depositor's funds safely with RBI through the reverse repo mechanism without any upward correction in deposit interest rates. Given that the equity market has for a long while been a 'sellers market', funds have flowed rather easily into banks' kitties with banks benefiting from the low cost of funds and the high cost of lending. In fact, banks have taken advantage of the situation by increasing interest rates on loans but without passing on a corresponding increase in deposit interest rates, justifying this by citing the signal of the reverse repo increase.

Banks like the State Bank of India (SBI), following on from the Housing Development Finance Corporation Limited (HDFC) and the Standard Chartered Bank, have given a positive signal by raising their home loan rates. However, is this short-term increase in interest rates to benefit ordinary retail depositors? Do we have really a linear risk-return relationship? Further, with the introduction of various liquidity management instruments like LAF (Liquidity Adjustment Facility) and CBLO (Collaterised Borrowing and Lending Obligations), banks have become more comfortable in managing their liquidity and idle cash ratios have reduced. In that case, ideally banks should have passed on the benefit of the reduction in the holding cost of liquidity to customers by narrowing the gap between the risk free rate and the interest rate on deposits. Probably, it is worthwhile for the RBI to nudge the banks to align deposit rates also with the signal rate. Besides, in its effort to bring corrections in the yield curve, the government has reduced the interest rate on small savings and hence the fixed incomes of many pensioners have shrunk. But with the rate of inflation increasing in the last couple of years, is it not the responsibility of the government to increase the income of pensioners by raising the small savings rate? Unions in the organised labour sector have negotiated a better rate through the EPF (Employees Provident Fund) by bringing political pressure to bear, but what about the large number of poor unorganised pensioners and small depositors? A substantial reduction in interest rates on bank deposits, small savings, provident funds, and other debt instruments has already resulted in a decline in the interest income of this section of the community by some 50 to 60 per cent in the recent past.

By now it is clear that if anything the interest rates will only move upward given both the growth in domestic demand, rising inflationary expectations and successive hikes in the federal fund rate as well as in global short-term interest rates. Will the RBI take recourse to successive increases in the reverse repo rate or leave it to the market to make corrections? While small depositors have paid a price for the reduction in interest rates in the past, are they not going to benefit from the current rise in interest rates? Is the risk-averse common man-on-the-street to benefit from an increased interest rate on small savings? During times when interest rates are going up, will the RBI bailout the banks by once again permitting them to transfer securities from the 'trading' category to the 'maturity' category? When will short-term corrections yield benefits for the common man?

WATCHPOINT: Will the RBI step in to allow pensioners and small depositors to benefit from increases in interest rates on loans?

 

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