Why deposit rates should not be reduced?

It has become fashionable to raise a clamour that bank lending rates are too high and are hurting the business climate.

The Government is pressuring public sector banks to reduce lending rates. To achieve this, banks have started reducing the rates paid on deposits to protect their margins.

Effect on depositors

There are an estimated 30-35 crore individual private citizens who maintain deposit accounts with banks. A large proportion of these are not 'high net worth' citizens.

It is estimated that of the about Rs 40 lakh crore deposits of scheduled commercial banks, at least Rs 20 lakh crore, if not more, is contributed by individuals. Add to this the deposits of Rs 5-7 lakh crore with post offices, non-scheduled co-operative banks, credit societies, etc.

Thus, 35-40 crore citizens contribute at least Rs 25 lakh crore deposits with all banks. These depositors include salary earners in the private and public sectors, businessmen, farmers, pensioners and senior citizens, etc.

Negative returns

If banks aggressively cut the present deposit rates for reducing lending rates, over 35 crore citizens will suffer huge losses.

Even at the current rates, with a maximum of 8 per cent on deposits of three years or more and a paltry 3.5 per cent on savings accounts, these depositors are suffering huge losses in real (adjusted for inflation) terms because the present CPI-based inflation is at over 10 per cent and there are no signs of it falling any time soon.

In other words, depositors, instead of receiving interest, are paying interest on their own savings in real terms.

It may be argued that since depositors choose to keep their savings with a bank for reasons of safety they should not expect returns in line with the principle of 'higher returns for higher risk' compared to investors in the stock market. Fair enough.

But individual depositors in banks are fully justified in expecting that their return in real terms should not at least fall below zero. In the US, for example, the CPI-based inflation is negative and the depositors are getting a small but positive real return on their deposits.

Effect of Lending rates

As it is, quite a few borrowers such as small-scale industries, exporters, farmers and house buyers are getting loans at concessional rates, at less than 10 per cent.

Similarly, large corporates are getting loans below the PLR (prime lending rate). Only companies whose financial planning is poor are paying interest at 13-14 per cent on their borrowings.

Even at such rates, for most businesses the pre-tax interest cost as a proportion of sales works out to 5-6 per cent and they still make reasonable profits. This is further reduced by the tax shield of 2.5-3 per cent. For financially well-managed businesses this cost is even lower. Therefore, interest cost as a proportion to sales will get reduced only fractionally if lending rates are reduced by, say, 2 or 3 per cent.

Credit availability

It is not interest rates per se but the availability of credit that is more important to a business.

Adjusted for wholesale price index-based inflation - this is the most relevant index for businesses - the real cost as a proportion of sales was negative till recently for most businesses as the WPI inflation was always more than 3.5 per cent. Thus, these borrowers were getting a real positive return on their borrowings.

We thus have a situation of depositors paying and borrowers receiving interest in real terms. It is only in the last two-three quarters that the WPI inflation has been less than 3.5 per cent. This should have been reflected in the CPI inflation, but that has not happened. The WPI inflation will soon rise to over 3.5 per cent and the businesses will again start receiving real interest on their borrowings.

This paradox is because of the large difference between the rates for the two types of inflation. This is probably due to the deep structural inefficiencies in the economy. In most advanced countries, the difference between the two rates is marginal.

There is, therefore, no case for reducing deposit rates unless the CPI-based inflation falls significantly to, say, 2-3 per cent.

Punishing 40 crore citizens by reducing deposit rates will be "exploitative and exclusionary" banking, and certainly not "inclusive banking."

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