The decision to increase the interest rate on EPF to 8.65 percent is interesting because of the timing of this announcement. First, it comes before the general elections and strategically this is a good signal to send out to say that the government cares. Therefore making an announcement on February makes sense. The second is even more significant because it comes at a time when the government and RBI are working to get banks to lower their interest rates on lending.
What really stands out is that while the EPFO always looks at the savers’ side and works towards enhancing returns as it prepares people for post-retirement income, the banks’ focus has turned out to be on the lending side and rarely is there talk of protecting the savers. In a way, Rs 120 lakh crore of deposit money is less important than Rs 95 lakh crore of credit as the latter leads to growth while the former is taken for granted.
This leads to a major anomaly in the system. Bankers often contend that when any interest rate action is taken it applies immediately to all loans while deposits get re-priced only on renewal or fresh inflows. Therefore, there is inbuilt tardiness in the transmission mechanism.
This is a pertinent point. In fact, the way rates move is quite straight forward. The base rate and the MCLR are the two critical points which have to be calculated. The repo rate per se is not very effective in terms of affecting the cost of funds. The amount of money in this window is 1 percent of NDTL which is around Rs 1.4-1.5 lakh crore. 1 percent change in repo rate affects the cost of banks by Rs 1,500 crore, which in a total interest expense of Rs 6.5 lakh crore for the system is quite insignificant.
This is where the cost of deposits is important because if interest rates are lowered on these savings, then the cost of funds comes down to a greater extent and changes the MCLR which is then the standard used by banks for lending. Therefore, the clue to lower interest rates is technically speaking the deposit rate.
Now deposit rates are not unique and vary across banks across different maturity buckets. A generalised reduction in interest rates is the most effective. With Rs 120 lakh crore of deposits being looked at, it would be only the incremental deposits and those that come for renewal that would go with the new interest rates. Here too banks normally tinker with rates on different maturities depending on their respective ALM profiles. Therefore, the final impact would be quite low for banks even if there is a commensurate reduction in deposit rates by 25 bps as the cost of deposits would not come down commensurately.
This makes the link to MCLR weak and therefore it would not be right to expect lending rates to come down by 25 bps as almost the entire Rs 95 lakh crore would have to be re-priced. This makes the lending rate changes less prominently. This is the technical side of the story.
At the practical level, banks face a conundrum. While there is a temptation to lower deposit rates to attempt to bring down lending rates there are several problems. We have seen that deposits are no longer sticky and households and corporates tend to move to other avenues when returns are more attractive. Banks benefited from demonetisation but households moved over to mutual funds when they found returns to be high.
While some took a risk and moved to equity funds, the others were better off with debt funds where the returns were higher and came with some tax benefits on returns. Further, small savings always become a benchmark even though the size is much smaller than bank deposits being just about 7-8 percent of the latter.
The puzzle gets complicated when the banking system is looked at for this financial year. Growth in bank deposits has slowed down while bank credit growth has picked up. The reasons mentioned above partly explain why bank deposits growth has slowed down. The result was that there has been a perennial liquidity deficit in the system which had to be made up for by the RBI on a daily basis.
The liquidity adjustment facility (LAF) became very important as banks were funded through repo and term-repo windows. OMOs have peaked at around Rs 2.5 lakh crore. Therefore the situation has evolved to be one where lower deposit rates have deterred savings which in turn has made the RBI continuously provide liquidity by buying GSecs from the banks.
Now with the EPF announcing an increase in the rate by 10 bps is significant because the organization belongs to the government. Hence there is one view of the government which feels that savers have to get a higher return on their retirement funds, while the other view which is being forced on banks is to lower lending rates which cannot happen unless deposit rates are decreased.
This highlights two things. The first is that there is a strong view being pushed by the government on the market players to foster growth which is quite singular as normally such actions are done by them on their volition. But here it appears to be a definite tilt towards borrowers. The second is that monetary policy action today is not very effective in terms of impact as it is not able to move the banks without a fierce nudge coming from the top.
As there are limits on some of the investments in small savings as well as provident funds (allowing for the voluntary provident fund), such inconsistencies should not affect the system much, but the signals for the public at large surely appear to be confusing.
(The writer is a chief economist, CARE Ratings)
Updated Date: Feb 22, 2019 15:36:06 IST