Savings deposit: Last frontier
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Posted on December 6, 2010 | Author: Mythili Bhusnurmath | View 1008
Deregulating the interest rate on savings bank deposits will incentivise households to hold savings in financial assets and fund the investment needs of a fast-growing economy
To achieve double-digit and inclusive growth, we need to raise the level of national savings and channel those savings into investment,’ said Reserve Bank of India governor D Subbarao in his inaugural address at the Bancon conference in Mumbai on Friday.
What’s up? Hasn’t our high savings rate has been one of our biggest boasts all these years?
After all, Indian households save more than other emerging markets like China (15%) or Brazil (5%) and 2% for Britain and 1% for the US, respectively.
So, why did the governor choose to draw attention to increasing the savings rate and more important channelling savings to investment?
The reason is that a substantial share of domestic savings is held in the form of physical, rather than financial, assets.
The household sector is the main contributor to our high savings rate, (accounting for as much as 70% of gross domestic savings at the end of March 2008-09).
But it holds 54% of its savings in relatively unproductive physical form — land, gold, silver.
What is worse, this ratio seems to be increasing, rather than decreasing, over the years.
How can this trend be reversed? Increasing trust in financial markets is one answer.
It would encourage the household sector to increase its savings in the form of financial assets such as equities, insurance, pension products, etc, is an obvious answer. But this cannot be done overnight.
In the short-term, therefore, the only option is to encourage households to save more in the form of bank deposits that command a high degree of trust and account for a lion’s share of household financial savings.
It is in this context that we need to look at an issue that has been on the backburner for years — deregulating interest rate on savings bank deposits —as perhaps a quicker and easier option.
Agreed, we’ve made a beginning. In the mid-year review of its monetary policy last month, the RBI announced it would be preparing a discussion paper on the pros and cons of savings bank interest rate deregulation.
But the central bank has far more pressing problems on hand. On the macroeconomic front there is the growing size of the current account deficit which, coupled with volatile capital flows and persistent inflationary pressures, is testing its skills.
And in the financial sector arena, we have the travails of the microfinance sector and now the housing loan scam.
So, deregulating the saving bank interest rate is unlikely to be top-of-the-mind for the RBI for now. As it has been in the past as well!
In its April 2002 monetary policy statement, the bank first mooted the idea.
But it did not pursue it as it feared deregulation could lead to more competition and increase the cost of funds to banks.
It returned to the subject in its April 2006 policy; but again opted to maintain status quo, though it was more forthcoming regarding its own position.
‘In principle, deregulation of interest rates is essential for product innovation and price discovery in the long run.’
It’s been more than four years since then and there’s been no action on this front.
The net result is that while interest rates have been freed on all deposit products for a long time now, the interest rate on savings bank deposits alone continues to administered (read fixed by fiat, presently 3.5%).
This goes against the grain of market-determined interest rates and interferes with the monetary transmission mechanism.
In addition, there is a real cost to the economy as there is very little incentive for households to hold their savings in savings bank deposits.
They would rather hold it in the form of cash or in some physical form.
Meanwhile negative real interest rates on fixed deposits — the result of a combination of high inflation and low nominal rates (thanks to the flood of liquidity) — have taken their toll on deposit growth.
But any hike in fixed deposit interest rates to remedy the situation is bound to push up costs of funds dramatically.
Savings bank deposits, in contrast, offer a cheaper source of funds and contrary to widespread belief, tend to be fairly stable, despite being withdrawable on demand.
They are a vital part of the staple diet of banks. But they are not aggressively marketed.
That could change once banks are given the freedom to set their own interest rates.
Today, faster growth in credit (22% year-on-year) relative to deposits (15%) has led to a severe resource crunch for banks.
The RBI has been tweaking liquidity periodically by offering additional support under its liquidity adjustment facility. Government, on its part, has promised an additional capital infusion of . 6,000 crore into government banks.
But these are at best temporary sops.
A longer-term solution to the resource crunch would be increase the flow of household savings into banks by deregulating the interest rate.
How would this help? For one, increased competition among banks would lead to product innovation and make the humble savings bank deposit a far more sought-after investment avenue for households.
For instance, banks could design separate products for customers who want to have savings (with liquidity and ease of operations) as opposed to those who are looking mainly at ease of transactions.
Fears that deregulation would inevitably push up interest costs for banks and thereby affect bank profitability adversely are unfounded.
Competition does not necessarily mean higher interest rates as rates are a function of market conditions. However, there would be better price discovery and as a result, greater incentive for households to park their surpluses in savings bank deposits.
Experience has shown the core nonvolatile portion of saving bank deposits is very high.
In effect, therefore, banks will get stable funds at a far lower cost than in the case of fixed deposits.
Even if the cost does go up marginally, it would still be lower than in the case of fixed deposit funds so overall banks will benefit.
Thus, deregulation of interest rates on savings bank deposits will lead to deposit growth and product innovation, possibly even resulting in more financial inclusion as banks tailor savings bank deposit accounts to customers’ needs.
It could be a win-win for both banks and customers. Customers will have more choice and banks, more funds.