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Turning focus on plight of depositors - Outside View by S.S. TARAPORE

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Turning focus on plight of depositors
Oct 5, 2015

Governor Raghuram G.Rajan's announcement on September 29, 2015 reducing the policy repo rate from 7.25 per cent to 6.75 per cent has deservedly received praise from the government, banks, industry, financial analysts and the media. The Reserve Bank of India (RBI) has convincing reasons for its action, but the impact on bank depositors needs consideration.

Monetary Policy Report (September 2015)

It is unfortunate that in these days of instant response, the impressive RBI staff work in the Monetary Policy Report (September 2015) does not get adequate attention. Bankers, government officials, financial analysts and economists would do well to carefully read this document.

The report cautions that high volatility seems to have become the new normal and global risks have heightened significantly.

Inflation expectations, based on the RBI's quarterly survey of urban households for September 2015, reflect inflation expectations of 10.8 per cent one year ahead. While it is true that there is a strong influence of inflation of the previous six years, it also confirms the widely held belief that inflation indices grossly understate actual inflation. The report projects that Consumer Price Inflation (CPI) will rise from its present trough of 3.66 per cent in August 2015 (on a year-on-year basis), to 4.5 per cent in September 2015 and average 5.8 per cent in the fourth quarter of 2015-16. Furthermore, it is projected that inflation will average 4.8 per cent in the last quarter of 2016-17.

The report draws attention on turning points in growth cycles. There are, admittedly, formidable difficulties in measuring potential output and the turning points in the cycle.

Economists in India would do well to understand the Hayekian theory of the cycle, wherein, at the upper turning point of the cycle, there is a shortage of savings. The art of good management is to tighten monetary policy well before the upper turning point of the cycle is reached. Delayed tightening, after the upper turning point has been reached, is counterproductive as it merely accelerates the downturn. A greater appreciation of Hayekian analysis would enable monetary authorities to undertake early monetary tightening during the upturn of the cycle.

The report refers to the transmission of policy impulses to deposit and lending rates. RBI would do well to see its archives for work in the 1980s and 1990s on the cost of funds and the return on funds. These studies showed that margins in the Indian banking system were much higher than in the industrial countries of Europe but were strangely close to those in the US. Problems of bank depositors during the lowering of interest rates

In India, about 60 per cent of gross domestic savings are accounted by the household sector and bank deposits account for over 60 per cent of financial savings.

When overall interest rates are reduced, in the context of low inflation, it is argued that bank depositors should be satisfied with lower nominal deposit rates. While assessing interest rates, in India, the focus is invariably on year-on-year inflation rates. When savers put their money in term deposits, they invariably invest for 1-3 years. To these savers it is the medium-term inflation rate which is relevant. As such we should look at the three-year inflation rate.

The average inflation rate, and not the point-to-point inflation rate, should be used. As indicated, in earlier columns, we should use the medium-term average inflation rate; say over a period of three years, weighted with a distributed lag. Illustratively, the weightage could be 3 for the latest year 't' , 2 for the year 't-1' and 1 for year 't-2'.The inflation rate so worked out would be relevant when considering the appropriate level of deposit rates. It is often argued that a 1.5-2.0 per cent real rate would be appropriate for savers. While this may be appropriate for the industrial countries, given that in a country like India, where there is a shortage of savings, and capital is relatively scarce, recognition of natural factor proportions would warrant a somewhat higher real rate of interest, say 3 per cent. Moreover, when bank deposits are the predominant element of household sector savings there is all the more reason for caution when lowering deposit rates.

A callous argument is that bank depositors are trapped and have nowhere to go and that they will part with their savings at any rate. Such an approach could result in a depositors' revolt. We need to learn from the experience during the previous NDA regime. Deposit rates were brought down savagely and there was considerable unrest. It was thanks to the then President of the BJP, Mr. Rajnath Singh, who warned the government that they were alienating large tracts of the population, that the thoughtless reduction of deposit rates was put to an end.

At present, there is considerable pressure on banks to reduce lending rates. A precondition for this would be reductions in deposit rates. What should bank depositors do? First, depositors should lock in longer term deposits. Secondly, depositors should switch to the Post Office and other small savings schemes before these rates are lowered (it is unlikely that the rates for government schemes would be reduced before March 2016). Thirdly, savers should move to non-financial assets; in this context the Gold Bond which is to be issued by government shortly should be of interest to depositors; of course for broader and more important reasons the government should not understate the interest on these bonds (3.5-4.0 per cent would be the appropriate rate).

It is all a game of conjectural variation with different economic agents sizing each other up. This is a war depositors must fight to survive.

Please Note: This article was first published in The Freepress Journal on October 05, 2015. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.

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