RBI has cut interest rates three times this year so far. While rate cuts are welcomed by the Indian corporate sector, their impact on households is less discussed. This column analyses the relationship between deposit rates and financial decisions of households. It finds that lower rates reduce net financial savings of households, which in turn reduces the resource pool available to the corporate sector.
The Reserve Bank of India (RBI) has cut policy repo rates three times in 2015 so far1
. Subdued growth in industrial production, lower retail inflation and weak bank credit growth are some of the arguments provided for monetary easing. What matters now is how much more room does the RBI have to cut policy rates in the future? Whether lower rates boost industrial activities is a debatable question (RBI 2013
), its impact on households is rarely discussed in India. Since households account for more than two-third of total domestic savings in the country, which is the primary source of domestic investments, it is imperative to understand the impact of monetary policy on household savings behaviour.
Interest rates and household finances
There are three ways in which policy rates affect household savings – through their impact on gross financial savings (GFS), gross financial liabilities and gross physical savings of households.In order to understand the impact of policy repo rate on household financial savings, we must look at the components of GFS (Figure 1 below). Indian households park more than half of their financial savings into deposits (bank and non-bank), which are directly linked with policy repo rate. Another 35% goes into long-term safe assets such as insurance and pension funds, approximately 10% is held in cash and the remaining 5% is accounted by risky assets like equities. Lower policy repo rate leads to lower deposit rate, which reduces the return on deposits. On the other hand, equities may get a boost but they are unlikely to compensate for the loss in household savings due to lower return on deposits.
In contrast, in the case of US households, more than 45% of the financial assets are risky, and only about 15% are in the form of deposits (US Federal Reserve, 2014). Therefore, in this case, any policy action which boosts equities, even though it makes deposits less attractive, will help increase the return on household savings.
Figure 1. Reclassification of components of households’ Gross Financial Savings
Notes: (i) Short-term (ST) safe assets comprise bank and non-bank deposits and trade debt (net) (ii) Long-term (LT) safe assets comprise life insurance, pension and provident funds and claims on government (including government securities, small savings funds etc.) (iii) Risky assets include shares and debentures and units of Union Trust of India (UTI).Data sources: Central Statistical Organisation (CSO), RBI
Secondly, lower interest rates encourage household borrowings. The higher the financial borrowings by households, the lower is the net financial savings (gross financial savings minus gross financial liabilities), which finance corporate investments (and fiscal deficit).Thus, lower rates not only impact gross financial savings adversely, they also makes borrowings more attractive, leading tofurther lowering of net financial savings. This is at odds with what is required for the Indian economy.
Finally, borrowings of households are directly linked with their physical savings, as the former finance the latter. Household investments (or physical savings, primarily in the form of real estate), in general, are less efficient than corporate investments. A higher proportion of household investment in total investment implies lower efficiency of total investments, which acts as a drag on economic growth (Figure 2). Household investments rose from 28% of total productive investments (all investments excluding valuables) in FY2008 to 45% in FY2013, while corporate investments fell from about 48% to 31%. These movements had a bearing on the efficiency of investments, which impacted real Gross Domestic Product (GDP) growth.
Figure 2. Inverse correlation between physical savings and GDP
Note: Data shown is based on three-year simple centred moving average.
Source: CSO, RBI.
Real vs. nominal rates
Finally, it is generally argued that real deposit rates matter for household deposits, rather than nominal deposit rate2 Evidence, however, rejects this argument. Analysing annual data for the last two decades (FY1993-FY2014) from RBI’s Basic Statistical Returns, I find that household term deposits are significantly and positively related with nominal deposit rate. The correlation coefficient is as strong as 60%, which is highly significant. The coefficient with real deposit rate, on the other hand, was 5% and insignificant. Post-FY2008, however, things have been different -real deposit rate then became more important than nominal deposit rate.
One could also argue that expected inflation, not current inflation is more important for depositors. Unfortunately, the data for expected inflation (from RBI’s ‘Inflation Expectations Survey of Households’) is available only from FY2008 onwards, implying seven observations. If we check the correlation for those seven observations, the conclusion is the same: real rates using expected inflation are more closely related with household deposits as compared to real rates using current inflation; however, the coefficients are insignificant in both cases. One way to explain this is that inflation rising above a threshold level makes consumers more aware of its adverse effects, which make real rates more important. Nevertheless, if we believe so, it also implies that if inflation continues to falls in the future, nominal rates will become more relevant than real rates. Therefore, the importance of nominal deposit rate cannot be undermined. Notwithstanding the importance of this finding, it has its limitation because of insufficient data.
RBI has limited room to cut rates in the future
In conclusion, unlike in the US, Indian households hold most of their financial savings in deposits, which are adversely affected by lower policy interest rates. Moreover, lower rates incentivise borrowings, which are eventually parked into physical savings (or household investments). A higher proportion of household investment in total investment implies lower efficiency of total investment, which acts as a drag on economic growth. All these movements lead to lower net financial savings by Indian households, implying a lower pool of financial resources available for the corporate sector, restricting their ability of invest (unless current account deficit is widened, since the only way to finance the gap between domestic savings and investments is through foreign borrowings). Lastly, empirical evidence, based on limited available data, suggests that nominal interest rates, especially in low-inflation environment, should not be ignored, as they tend to be closely related with household deposits. These findings suggest that the RBI has limited room to cut rates in the future - believe that the repo rate is unlikely to be lower than 6.5% by the end of March 2017.
- Repo (short for repurchase) rate is the rate at which the RBI lends to commercial banks. It was cut by 0.25 percentage points each in January, March and June this year.
- Nominal deposit rate is calculated as the weighted rate of household term deposits by different maturities. Real deposit rates are obtained by deflating nominal deposit rates by the rate of retail infl