Interest rate cut imminent

Banks often quote that higher interest rates on National Savings Schemes (NSS) maintained at post offices and employee/public provident fund trusts has been the main deterrent to lower their deposit rates. So, banks could pass on only around 70 basis of interest rate cut to borrowers when RBI had actually reduced repo rate by 125 basis points in 2015. Hence, reduction in interest rates on NSS, EPF and Senior Citizen Schemes from April 1, 2016, is a concrete positive policy step to take the economy towards lower interest rates

The buoyancy in the markets indicates strong headwinds towards rate cut. Besides creating better eco-system for ‘ease of doing business’ in collaboration with the state governments and enhanced e-governance, further policy reforms are under way. One of the key competitive hurdle for banks to further cut interest rates has been effectively addressed.

Banks often quote that higher interest rates on National Savings Schemes (NSS) maintained at post offices and employee/public provident fund trusts has been the main deterrent to lower their deposit rates. Having recorded a stymied growth rate of deposits at 11.4 per cent in FY14, 12 per cent in FY15 and 10 per cent in first 11 months in FY16, banks are apprehensive that they may lose market share if they cut deposit rates any further.

Since lending rates of banks are linked to deposit rates, further cut is becoming difficult. Hence, reduction in interest rates on NSS across the board of post offices including on Employees Provident Fund (EPF) and Senior Citizen Schemes from FY17 ( effective April 1, 2016) is a concrete positive policy step to tow the economy towards lower interest rates.

Policy shift on Interest on National Savings Schemes

It marks the highest reduction of 130 basis points on certain term deposits of varying maturity/schemes of NSS, the lowest is pegged at 25 basis points in short term deposits. The interest on savings bank deposits with post offices is kept intact at 4 per cent. The move is intended to align the rates on NSS of government of India with market rates.

The more significant feature is the policy shift whereby these interest rates will now be subject to review and reset on quarterly basis. Thereby, structure of interest rates now proposed will remain in force from April 1 to June 30, 2016. Earlier, the returns on NSS instruments were linked to the market in 2011, and since then have been adjusted annually. This was done so that the interest rate on these could be pegged to the average government securities (G-secs) yield with similar maturity in the preceding year. Cutting down frequency of review to quarterly basis is intended to align the interest rates on NSS with markets at a faster pace.

Linkage of Interest rates on NSS

Since interest rates on NSS are an important segment to augment gross domestic savings, it becomes a strong basis to determine benchmark interest rates on deposits by other financial sector competitors. Hence, due to continued better interest rates on NSS compared to banks, it was becoming difficult to cut deposit and lending rates.

Consequently, banks could so far pass on only around 70 basis of interest rate cut to borrowers when RBI had actually reduced repo rate by 125 basis points during 2015. RBI has been directing banks to recast their base rates to effectively transmit monetary policy signals. Due to such latent umbilical connect of interest rates on NSS with bank deposit rates, the present policy shift will now be a great enabler to transit to lower interest rates in the economy.

Macroeconomic stability

In terms of the macroeconomic stability and other market indicators, economists have enough reasons to anticipate that RBI will cut repo rate in the range of 25 - 50 basis points. In addition, the stance of RBI policy will be to accelerate flow of credit to productive sectors of the economy while strengthening its focus on asset quality and balance sheet clean up drive by the end of the fiscal. Among the key indicators, (a) the CPI led inflation stood at 5.18 per cent year-on-year in February of 2016, lower than 5.69 per cent in January and below market expectations of 5.60 per cent. While the Whole Sale Price Index (WPI) has registered a negative year-on-year (YOY) growth for the 16th month in a row.

As against this, while the CPI inflation in urban India was 4.30 per cent, it was high at 5.97 per cent in rural India. The consumer inflation eased for the first time in seven months, reaching the lowest since October 2015 due to a slowdown in food cost. (b) The Union Budget FY17 amply indicated its intent to stick to the rigor of fiscal discipline by anchoring fiscal deficit at 3.5 per cent in FY17, down from 3.9 per cent likely in FY16. The revenue deficit will be brought down to 2.3 per cent from 2.8 per cent during the same period. (c) Going by the Real Effective Exchange Rate (REER) calculations, rupee is indicatively still overvalued against trade weighted basket of currencies of 36 countries. (d) Current Account Deficit (CAD)of Q3 of FY16 stands comfortable at 1.3 per cent as against 1.5 per cent recorded in the previous fiscal in Q3. These are some of the driving factors to drive down interest rates.

Lending rates

RBI had earlier prescribed in December 2015 a new methodology for computing base rate on the Marginal Cost of Fund Based Lending Rates (MCLR) to be effective from April 1, 2016. This method itself can bring down base rates in some banks for new customers for short term loans. It mandates banks to add a spread over their marginal cost of funds and a tenor premium. A system of uniformity is being mooted to remove any aberrations in computation of base rate and to remove any inherent draw back. Such improved methodology will add to the ecosystem to lower interest rates.

Keeping the foregoing factors in view and market perception; depositors have to understand the merits of low interest dynamics instead of merely looking at interest rates per se. In the low interest dispensation, while borrowers can look forward for softer interest rates, depositors too can be left with more purchasing power.

Going by the low inflation, a lower interest rate on term deposits leaves more purchasing power when seen them in combination. A high interest rate on term deposits of 10 per cent with high inflation of 9 per cent will provide a net return of 1 per cent. But a 7 per cent interest in a low inflation regime of 5.5 per cent will increase the net yield to 1.5 per cent. Moreover, the low interest rates will be able to spur the growth with long term positive impact on employment and poverty. Therefore the ability to manage low inflation creating economic environment for softer interest rate regime requires a more robust tact of fiscal prudence and rigor in monetary management. Thus, the central bank is well poised to demonstrate its continued policy persuasion to put the economy on faster growth track setting benchmark to its global peers.

(The author teaches at the National Institute of Bank Management (NIBM), Pune. The views are his own)