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Lazy banking at its finest

January 21, 2009 14:45 IST

Some years ago, RBI Deputy Governor Rakesh Mohan opined that Indian banks were engaged in 'lazy banking.' At that time I disagreed because I felt that banks will do whatever is most profitable and if laziness meant making outsized profits by parking their money in safe deposits of government securities, then they will do so.

Today, many years later, the banks are still practising lazy banking, but their behaviour can change if the RBI plays a positive role. If the repo rate is reduced to 3 per cent (as it should), deposit rates can be expected to reach 4.5 per cent. With a healthy 300 basis point spread, lending rates can approach 7.5 per cent, a historical low.

As I have documented in the past, there is a curious aspect to the Indian economic System (defined as commentators, policy makers and academicians). The System systematically thinks in a skewed fashion, and unlike any other System in the world.

In particular, it is trigger happy to bring the economy to a screeching halt by raising interest rates, but asleep at the wheel when the economy is in desperate shape – eg, confidence is at historic lows, industrial growth at zero and exports diving over a cliff.

With this asymmetry in mind, I want to make two points.

First, that with growth and inflation rates far below the RBI's target and expectations, the time is appropriate to bring monetary policy into sync with reality.

Second, the fear of the System that non-policy rates, in particular deposit rates, are sticky downwards appears to have little, if any, empirical foundation. It should be emphasised that some elements from within the System (see Sahu-Virmani, Structure of the Household Sector Asset Portfolio in India, Icrier Working Paper # 156, March 2005) reached the same conclusion some years ago.

Some facts

GDP growth has slowed down to somewhere around the 6 per cent range for the October-December 2008 quarter. This is considerably below all estimates of non-inflationary growth.

Second, WPI inflation for this fiscal year has averaged just 2.8 per cent on an unadjusted basis, and 2.1 per cent on a seasonally adjusted basis. For the last six months, the SA annualised rate of price inflation is minus 4.9 per cent. If the historical relationship between the CPI, WPI and GDP deflator holds, then the GDP deflator should average around minus 3.7 per cent for the last quarter.

But the System, including leading bankers, cries out: Why should the government reduce interest rates, there is already so much liquidity sloshing around. But there are two aspects to 'liquidity' -- quantity and price. While bankers have liquidity, the same cannot be said of the borrowers. For two reasons -- first, given the reluctance of banks to lend, the borrowers are starved of funds at the prevailing (high) price of money. In addition, there is a long queue of borrowers for whom borrowing, and investing would become more viable if interest rates were to be reduced from the astronomical (real) levels now prevailing in India.

The System counters with its second line of defence. We cannot reduce interest rates because the rupee will be under attack. Possible, but again counter to reality. The level of the rupee is affected by several factors, only one of which is the interest rate differential with the US. In any case, the difference in savings deposit rates between the US and India increased markedly in recent months, and at the same time the rupee depreciated by some 20 per cent!

The System, like a leech, never wants to let go. So in recent weeks, it has started arguing that it is of no use to reduce policy rates (the repo and reverse repo) because such reduction will have a near-zero impact on the deposit rate. If the deposit rate cannot be lowered, lending rates cannot be lowered. And why can't the deposit rate be lowered? Because deposit rates are linked to 'small savings' rates in the economy, rates that are politically controlled. With elections looming, it will be suicidal for the government to reduce deposit rates for widows and orphans.

The logic of the System's argument is that if higher deposit rates are available with small savings deposits, the public will move their commercial bank deposits en masse to SSD.

There are four realities which need to have occurred in the past in order for the System's forecast of large movement to be even approximately correct. First, SSD should be a large part of total deposits. Latest estimates suggest that, at Rs 129,000 crore (Rs 1,290 billion), small savings deposits are less than 15 per cent of total (bank + SSD) deposits.

Second, the share of SSD deposits peaked at 26.6 per cent in 1999.

Third, rates on commercial bank deposits declined by 400 basis points during 2001 to 2005, a period during which small savings deposits share also declined by 4 percentage points -- from 26.2 of the total to 22.9 per cent.

Fourth, the segment within small savings that carries the lowest rate of interest (post office time deposit rates today are 6.875 per cent) is also the segment with the highest deposits -- about 40 per cent of total SSD. Further, this segment has shown a rate of growth of 19 per cent between 2000 and 2008 compared to only a growth of 9 per cent for all small savings deposits. Yeh to ulti ganga beh rahi hai.

Where can we expect deposit rates to go if the RBI aligns with reality and reduces the repo rate to 3 per cent? The System has given all kinds of reasons for the deposit rates not going any further down from the elevated levels of  8.25 per cent at present. Yet, three different methods, based on Indian experience over the last decade, suggest that the deposit rate can be expected to go down to 4 per cent with the repo at 3 per cent. Sounds implausible?

Method 1

Historically (for the 95 months from November 2000 to September 2008) the gap between deposit rates and the repo rate has stayed within a narrow corridor of minus 1.6 and 1 per cent, with a mean of minus 0.2 per cent. By this method, deposit rates can go down to 4 per cent.

Method 2

Historically, the gap between the small savings and deposit rate has never exceeded 2.7 percentage points, a level last seen in March and April of 2004. At that time, the average small savings rate was 8 per cent, and the deposit rate was 5.25 per cent. We did not then hear the System complaining that the small savings rate was a floor to deposit rates. At present, the weighted small savings rate is 7.43 per cent; this yields a predicted deposit rate of (7.43 minus 2.7) of 4.7 per cent.

Method 3

If you look at the predicted and actual deposit rates based on a model where deposit rates are a function of the repo rate, small savings rate, growth in real incomes, and inflation (introduction of the rate on government securities does not affect the results.), the repo is by far the most important determinant -- each 1 per cent reduction in the repo leads to a 1.6 percentage point decline in the deposit rate.

There is a very close correspondence between the actual and predicted deposit rate (the explanatory power of the model is over 95 per cent). The deposit and repo are twin rates, moving in tandem both on the way down and the way up. The predicted deposit rate for the first quarter of 2009 -- between 3 and 4 .6 per cent. The range is large because there are so many unknowns that affect the prediction -- GDP growth, inflation, and the repo rate.

The System has no place to hide. Perhaps, being exposed, it will accept reality.

The author is chairman, Oxus Investments, a New Delhi-based asset management company. The views expressed are personal.

Surjit Bhalla