How RBI Generated a ₹ 99,122 Crore Surplus for the Government

On May 21, the central board of directors of the Reserve Bank of India (RBI) approved the transfer of Rs 99,122 crore as surplus to the central government for the accounting period of nine months ending March 31, 2021 (July 2020-March 2021). 

This transfer to the government has raised a few issues. Let’s look at them point wise. But before we do that, I want to make a disclaimer here. This is a complicated topic and to make sure that I am able to explain it in simple English, I have left out a few details. At the cost of repetition, the idea is to explain the issues at hand, than get all the details right. So, to everyone who understands this inside out, apologies in advance.

Here we go. 

1) The RBI’s accounting year was from July to June, different from the April to March period that the central government follows. From 2021-22 onwards, the accounting year of the RBI will be the same as that of the government. Given this, the last accounting year of the RBI was for the period of nine months from July 2020 to March 2021, as it moved to the government’s accounting year.

Despite this shortening in the accounting year, the RBI surplus to the government has jumped big time. The surplus transferred to the government from July 2019 to June 2020, had stood at Rs 57,128 crore, for a period of full 12 months. Clearly, there has been a huge jump in the surplus transferred to the government, once we consider the fact that the last accounting year of the RBI was just nine months long.

2) The annual budget of the central government presented by the finance minister Nirmala Sitharaman on February 1, had assumed that the central government would earn Rs 53,511 crore as way of dividend/surplus from the RBI, the nationalised banks and the financial institutions (read the Life Insurance Corporation of India). A few months later, the surplus transferred just by RBI is much more than Rs 53,511 crore. So what gives?

3) Let’s first try and understand how the RBI managed to generate such a huge surplus, which was unexpected (or at least not made public) up until the budget was presented earlier this year. From July 2020 to March 2021, the RBI gross sold a total of $85.2 billion of its foreign exchange.

An accounting change made in 2019, thanks to the Bimal Jalan Committee report, now allows the RBI to pass a part of the profit made from selling foreign exchange, to the government as a surplus. The earlier system was different (for the sake of simplicity we won’t go there).

There is a certain weighted average price at which RBI has bought these dollars over the years. The RBI doesn’t reveal this detail. As per Ananth Narayan, Senior India Analyst at the Observatory Group, this weighted average stood at Rs 55.70, from July 2019 to June 2020.

It would be fair to say the weighted average would be a little higher in the last accounting year, more towards Rs 58-60 to a dollar. The RBI would have sold these dollars, from July 2020 to March 2021, at Rs 72-75 to a dollar, and thus made a profit of around Rs 15 for every dollar sold.

A part of this profit has been passed on to the central government as a surplus. So far so good.

4) While at the aggregate level, everything looks fine, if we start to look at the detailed data, this doesn’t pass the basic smell test. Take a look at the following graph, which basically plots the total gross dollars sold by the RBI every month from July 2020 to March 2021.


Source: Centre for Monitoring Indian Economy. 

The above chart makes for a very interesting reading. Close to 60% of the dollars sold during  the accounting year were sold in the last two months ($50.5 billion of the total $85.2 billion). More than 77% of the dollars sold during the year were sold in the last three months ($65.9 billion of the total $85.2 billion). 

What does this tell us? It tells us that the RBI sold a lot of dollars after the finance minister had presented the budget. And a good chunk of the surplus given to the government was probably thus generated. If I was a gossip columnist, I would have definitely speculated, whether one of the secretaries in the FinMin dialled RBI for more money, around the time the budget was presented.

5) As mentioned earlier, the facts stated above don’t pass the basic smell test. The RBI at various points of time needs to sell dollars in order to manage the dollar rupee exchange rate. While the RBI sold $65.9 billion from January to March, it also bought $61.8 billion during the same period. On the whole, this wouldn’t have made much of a difference in moving the foreign exchange market in a particular direction, when it comes to dollar rupee exchange rate.

Take a look at the following chart, which plots the dollar rupee exchange rate from January 2021 to March 2021.


Source: Yahoo Finance.

As can be seen from the above chart, the dollar rupee exchange rate moved within a narrow  range of Rs 72.4-73.6, for the first three months of 2021.

So what does this really mean? The RBI sold lots of dollars after the finance minister’s budget speech, not because that was what was required in the foreign exchange market, but in order to generate an accounting surplus for a cash-starved government. If I were to put it in very simple terms, the RBI led by Shaktikanta Das, resorted to jugaad.

6) The way things stand the RBI is not allowed to directly finance the expenditure by printing money and handing it over to the government to spend. Hence, over the last couple of years, it has been resorting to different ways to do so. Selling and buying dollars in order to generate an accounting profit is one such way. 

If I were to be slightly flippant here I would ask a rhetorical question – Is RBI a central bank or is it a government sponsored hedge fund?

Another way of financing the government has been printing money and buying existing government bonds from banks and other financial institutions.

While this move does not hand over money to the government directly, it does ensure that the supply of money in the financial system goes up, and the newly created money can be used by banks and financial institutions to buy fresh government bonds. Hence, this is indirect monetisaton of the government’s fiscal deficit or the difference between what it earns and what it spends.

To conclude, while nothing can stop a central bank from printing money, the tactic of selling dollars in order to generate a profit depends on how much the rupee depreciates against the dollar. While the weighted average cost of the dollars that the RBI currently has, is less than Rs 60 to a dollar, it will only rise in the years to come.

Hence, for enough profit to be generated through this route, the rupee needs to depreciate against the dollar. But that’s where atma nirbharta will come in and limit the RBI’s hand. Strong nations have strong currencies, at least that’s the idea in the heads of the politicians who run the current government.

Everybody Loves a Good Interest Rate Cut…Except the Savers

My main life lesson from investing: self-interest is the most powerful force on earth, and can get people to embrace and defend almost anything – Jesse Livermore.

Late in the evening of March 31, the department of economic affairs, ministry of finance, put out a press release saying that the interest rates on small savings schemes for the period April to June 2021, have been cut.

The social media got buzzing immediately. And almost everyone from journalists to economists to analysts praised the decision. It was seen as yet another effort by the government to push down interest rates further.

With the state of the economy being where it is, lower interest rates are expected to perk up economic growth. People are expected to borrow and spend more. Corporates are expected to borrow and expand. At lower interest rates individuals who have already taken on loans will see their EMIs go down, leaving more cash in hand, and they are likely to spend that money, helping the economy grow.

That’s how it is expected to work, at least in theory. Hence, everybody loves a good interest rate cut… except the savers.

On April 1, the social media woke up to the finance minister Nirmala Sitharaman’s tweet announcing that “interest rates of small savings schemes… shall continue to be at the rates which existed in the last quarter of 2020-2021.” She further said that the order had been issued by oversight and would be withdrawn.

Later in the day, the department of economic affairs put out a press release to that effect.

The fact that lower interest rates are good for the economy is only one side of the story. They also hurt the economy in different ways. People who are dependent on interest income for their expenditure (like the retired senior citizens) see their incomes fall and have to cut down on their expenditure. This impacts private consumption negatively. 

While this cannot be measured exactly, it does happen. Also, a bulk of India’s household savings (close to 84% in 2019-20) are made in fixed deposits, provident and pension funds, life insurance policies and small savings schemes. Lower interest rates bring down the returns of all these products and this negatively impacts many savers.

As the economist Michael Pettis writes about the relationship between interest rate and consumption in case of China, in The Great Rebalancing:

“Most Chinese savings, at least until recently, have been in the form of bank deposits…Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”

The same logic applies to India as well, with lower interest rates being associated with declining consumption, at least for a section of the population.

This is not to say that interest rates should be higher than they currently are (that is a topic for another day), nonetheless the fact that lower interest rates impact savers and consumption negatively is a point that needs to be made and it rarely gets made. I made this point in a piece I wrote for livemint.com, yesterday. 

Also, borrowing is not just about lower interest rates. It is more about the confidence that the borrower has in his economic future and the ability to keep paying the EMI over the years. I wrote about this in the context of home loans, a few days back.

This leaves us with the question that why doesn’t anyone talk about the negative side of low interest rates. The answer lies in the fact that they don’t have an incentive to do so. Let’s try and look at this in some detail.

1) Fund managers: Fund managers love lower interest rates because it leads a section of the savers, in the hope of earning a higher return, to move their savings from bank fixed deposits to mutual funds and portfolio management services which invest in stocks. In the process, their assets under management go up. More money coming into the stock market also tends to push up stock prices.

All in all, this ensures that fund managers increase their chances of making more money and hence, they love lower interest rates because their acche din continue.

2) Analysts: Analysts love lower interest rates because it leads a section of the savers, in the hope of earning a higher return, to move their savings from bank fixed deposits to stocks. In order to buy stocks, they need to open a demat account with a brokerage. When the new investors buy stocks, the brokerage earns commissions.

Further, it also means that the interest cost borne by corporates on their debt goes down, leading to higher profits. The stock market factors this in and stock prices go up. Given this, analysts have an incentive to love interest rate cuts.

3) Corporates: Do I need to explain this? Lower interest rates lead to a lower interest outflow on debt that a corporate has taken on and hence, higher profits or lower losses for that matter. This explains why corporate honchos are perpetually asking the Reserve Bank of India to cut the repo rate or the interest rate at which it lends to banks.

4) Banks: Banks love lower interest rates simply because at lower interest rates the value of the government bonds they hold goes up. Interest rates and bond prices are inversely related. Higher bond prices mean higher profits for banks or lower losses in case of a few public sector banks. This is why bankers almost always come out in support of interest rate cuts.

This also explains why the bankers hate the idea of small savings schemes offering higher returns than fixed deposits. Lower interest rates on small savings schemes pushes the overall interest rates in the financial system downwards. 

5) Economists: Most economists are employed by stock brokerages, mutual funds, banks, corporates or think tanks. As explained above, stock brokerages, mutual funds, banks and corporates, all benefit from lower interest rates. If your employer benefits from something, you also benefit in the process. Hence, your views are in line with that.

When it comes to think tanks, many are in the business of manufacturing consent for corporates. Their economists act accordingly. 

6) Journalists: With the media being dependent on corporate advertising as it is, it is hardly surprising that most journalists love interest rate cuts. Further, the main job of anchors on business news channels is to keep people interested in the stock market because that is what brings in advertising. And this can only happen, if stock prices keep going up. In this environment, anything, like interest rate cuts, that drives up stock prices, is welcomed.

Of course, some mainstream TV news channels also run propaganda for the government. So, in their case every government decision needs to be justified. That is their incentive to remain in the good books of the government.

7) Government: The central government will end up borrowing close to Rs 25 lakh crore during 2020-21 and 2021-22. Hence, even a 1% fall in the interest rate at which it borrows, will help it save Rs 25,000 crore. It clearly has an incentive in loving low interest rates. 

The point is everyone mentioned above tends to benefit if interest rates keep going down or continue to remain low. Further, they are organised special interests with direct access to the mainstream media. The savers though many more in number aren’t organised to put forward their point of view.

Also, it is easier to do the math around the benefits of interest rate cuts and low interest rates than its flip side. As economist Friedrich Hayek said in his Nobel Prize winning lecture, there is a tendency to simply disregard those factors which “cannot be confirmed by quantitative evidence” and after having done that to “thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.”

That’s the long and the short of it. 

Why RBI is Doing Dhishum Dhishum With Bond Market

I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody. – James Carville.

The Reserve Bank of India (RBI) is unhappy with the bond market these days. Well, it hasn’t said so directly. A central bank rarely does. But a series of newsreports across the business media suggests so. (Oh yes, the RBI also leaks when it wants to).

The bond market wants the RBI to pay a higher yield on the government of India bonds it is currently issuing. The cost of the higher yield will have to be borne by the government of India, something that the RBI doesn’t want.

And this is where we have a problem (don’t worry I will explain this in simple English and not write like bond market reporters or experts tend to, for other bond market reporters and other bond market experts). Government bonds are financial securities which pay an interest and are issued by the government in order to borrow money.

Let’s try and understand this issue pointwise.

1) The government’s gross borrowings for 2020-21, the current financial year, had been budgeted at Rs 7.8 lakh crore. In May 2020, after the covid pandemic broke out and the tax collections crashed, the number was increased to Rs 12 lakh crore. The final borrowings are expected to be at Rs 12.8 lakh crore. In 2021-22, the gross borrowings of the government are expected to be at Rs 12.06 lakh crore.

Hence, over a period of two years, the government will end up borrowing close to Rs 25 lakh crore. It isn’t surprising that the bond market wants a higher rate of return or yield as it likes to call it, from government bonds, given that the financial savings in the country will not expand at the same rate as government borrowing is expected to. Also, there is no guarantee that the government will stick to borrowing what it is saying it will borrow. That’s a possibility the market is also discounting for.

2) Take a look at the following chart which plots the 10-year bond yield of the government of India. A 10-year bond is a bond which matures in ten years and the return on it on any given day is the per year return an investor will earn if he buys that bond on that day and holds on to it until maturity.

Source: www.investing.com

As can be seen from the above chart, the 10-year bond yield has largely seen a downward trend since January 2020, though since January 2021 it has gradually been rising. As of the time of writing this, it stood at 6.14%, having crossed 6.2% on February 22.

Media reports suggests that the RBI wants the yield to settle around 6%. The bond market clearly wants more. This explains why in the recent past bond auctions have failed with the bond market not buying bonds or the RBI refusing to sell them at yields the bond market wanted.

3) The question is why does the bond market now want a higher rate of return on bonds than it did in 2020. There are multiple reasons for it. Bank lending has largely collapsed during this financial year and has only improved since October. Between March 27, 2020 and January 29, 2021, the overall bank lending has grown by just Rs 3.34 lakh crore, with almost all of this lending carried out during the second half of the financial year.

This forms around 27% of the deposits of Rs 12.3 lakh crore that banks have managed to raise during the period. Clearly, the banks haven’t been able to lend out a large part of their fresh deposits.

Hence, it has hardly been surprising that a bulk of the bank deposits have been invested in government bonds. During the period Rs 6.94 lakh crore or 56% of the deposits have been invested in government bonds. Along with banks, other financial institutions have had few lending/investment opportunities, leading to a lot of money chasing government bonds, which has led to lower returns on them.

Over and above this, the RBI has flooded the financial system with money by cutting the cash reserve ratio (CRR) and by also printing money and buying bonds (something it refers to as open market operations), thereby driving down returns further.

4) What has changed now? The budget expects India to grow by 14.4% in nominal terms (not adjusted for inflation) in 2021-22. Even in real terms (adjusted for inflation), India is expected to grow by at least 10%. This basically means that bank and other lending will pick up. At the same time, the government borrowing will continue to remain high at Rs 12.06 lakh crore. Hence, there will be more competition for savings in 2021-22 than has been the case during this financial year, given that savings are not going to rise suddenly. Hence, yields or returns on government bonds need to go up accordingly. QED.

5) There is another point that needs to be made here. Thanks to the RBI wanting to drive bond yields and interest rates down, there is excess liquidity in the financial system right now. Lending to the government is deemed to be the safest form of lending. If lending to the government becomes cheaper, interest rates on everything else also tends to go down.

As of February 23, the excess liquidity in the financial system stood at Rs 5.7 lakh crore. This is money which banks have parked with the RBI.

On February 5, the RBI governor, Shaktikanta Das, had said: “A two phase normalisation of the cash reserve ratio (CRR) – which I am going to announce – needs to be seen in this context.”

The banks need to maintain a certain proportion of their deposits with the RBI. It currently stands at 3%. In April 2020, the RBI had cut the CRR by 100 basis points to 3%. One basis point is one hundredth of a percentage. With the banks having to maintain a lower proportion of their deposits with the RBI there was more liquidity in the financial system, which helped drive down yields and interest rates.

Now the RBI wants to increase the CRR in two phases. Assuming it wants to increase the CRR to 4%, this means that more than Rs 1.56 lakh crore (using data as of February 23) will be pulled out of the financial system by banks and be deposited with the RBI, in the months to come.

The bond market is discounting for this possibility as well, even with Das saying: “systemic liquidity would, however, continue to remain comfortable over the ensuing year.” What this basically means is that the RBI will continue to carry out open market operations by buying bonds and pumping money into the financial system as and when it deems fit.

Having said that, the overall liquidity in the financial system will go down, simply because once the RBI withdraws more than Rs 1.56 lakh crore through raising the CRR, it isn’t going to pump in the same amount of money back into the system, through open market operations, simply because then there would have been no point in increasing the CRR.

6) If your head is not spinning by now, dear reader, then you are clearly a bond market veteran. (Now isn’t the stock market so much simpler). Basically, the RBI is trying to play two roles here. It is the government’s debt manager and banker. At the same time, it also has the mandate of maintaining the rate of consumer price inflation between 2-6%. And at some level these objectives go against each other.

As the government’s debt manager, the RBI needs to ensure that the government is able to borrow at lower rates. In order to do that the RBI now and then floods the system with more money and drives down rates.

The trouble with flooding the system with more money in an economy which is recovering from a huge economic shock, is higher inflation as there is the risk of more money chasing the same amount of goods and services. Of course, with the manufacturing sector having a low capacity utilisation, they can always start more machines and pump up more goods, and ensure that inflation doesn’t shoot up. But the risk of inflation is there, given that money supply (M3) as of January 29, had gone up by 12.1%, year on year.

Over the years, there has been a lot of debate around whether the RBI should continue being the debt manager to the government or should that function be split up from the central bank and another institution should be created specifically for it, with the RBI just concentrating on managing inflation. I guess, in times like the current one, this suddenly starts to make sense.

7) Okay, there is more. The yield on the 10-year US treasury bond has been rising and as I write it has touched 1.33% from around 0.92% at the end of 2020. A major reason for this lies in the fact that the bond market is already factoring in the plan of the newly elected American president Joe Biden to spend more money in order to drive up economic growth.

Of course, with bond yields rising in the US, there is bound to be an impact everywhere else, given that the American government bond is deemed to be the safest financial security in the world. This has added to further pressure on the yields on the Indian government bonds.

8) After the finance minister presented the budget, the bond market realised that the government has huge borrowing plans even in 2021-22 and that even this financial year it would borrow Rs 80,000 crore more than the Rs 12 lakh crore it had said it would.

Accordingly, the 10-year bond yield moved up from 5.95% on January 29 to 6.13% on February 2, a day after the budget was presented. The RBI carried out open market operations worth Rs 50,169 crore between February 8 and February 12, on each of the days, to increase the liquidity in the financial system and push the yield below 6% to 5.99% on February 12.

But the yields have gone back up again and stand at 6.14% at the point of writing this. Interestingly, the yields on state government bonds have almost touched 7.2%.

Clearly, the bond market has made up its mind as far as yields are concerned. The way out of this for RBI is to print more money and buy more government bonds and drive down yields. Of course, this needs to be done regularly and by following a certain routine.

That’s the trouble with printing money. A major lesson in economics since 2008 has been that printing money by central banks leads to printing of more money in the time to come, given that the market gets addicted to the easy money.

Let’s see how the RBI comes out of this predicament, given that it has promised an “accommodative stance of monetary policy as long as necessary – at least through the current financial year and into the next year”.

9) We aren’t done yet. Other than being the debt manager to the government and having to manage the consumer price inflation between 2-6%, the RBI also needs to keep a look out for the dollar rupee exchange rate.

During the course of this financial year, the foreign institutional investors have brought in $35.4 billion to invest in the stock market. When they bring money into India they need to sell their dollars and buy rupees. This increases the demand for the rupee and leads to the rupee appreciating against the dollar.

When the rupee is appreciating against the dollar, the RBI typically sells rupees and buys dollars, in order to ensure that there is enough supply of rupees going around. In the process, the RBI ends up building foreign exchange reserves and it also ends up pumping more rupees into the financial system, thereby increasing the money supply, and pushing up the risk of a higher inflation.

Over and above this, the open market operations of buying bonds and cutting the CRR, this is another way the RBI ends up pumping money into the financial system. All this goes against its other objective of maintaining inflation.

One dollar was worth Rs 74.9 sometime in mid-November 2020. It has been falling since then and as I write this, it stands at Rs 72.4. What this means is that in the last few months, the RBI has barely been intervening in the foreign exchange market.

This brings us back to the concept of trilemma in economics, which the RBI seems to have hit. Trilemma is a concept which was originally expounded by the Canadian economist Robert Mundell. Basically, a central bank cannot have free international movement of capital, a fixed exchange rate and an independent monetary policy, all at the same time. It can only choose two out of these three objectives. Monetary policy refers to the process of setting of interest rates in an economy, carried out by the central bank of the country.

This explains why the RBI is letting the rupee appreciate, in order to ensure free movement of capital (at least for foreign investors) and an independent monetary policy. Let’s say the RBI kept intervening in the foreign exchange market in order to ensure that the rupee doesn’t appreciate against the dollar. In this situation, it would have ended up pumping more rupees into the financial system and thereby risking higher inflation in the process.

A higher inflation would have forced the RBI to start raising interest rates in an environment where the economy is recovering from a huge shock and the government is looking to borrow a lot of money. This would have led to the RBI losing control over its monetary policy. Clearly, it didn’t want that. (For everyone wanting to know about the trilemma in detail, you can read this piece, I wrote in September last year).

10) Finally, an appreciating rupee has multiple repercussions. People like me who make some amount of money in dollars, get hit in the process. (I would request my foreign supporters to keep this in mind while supporting me. Okay, that was a joke!)

Further, it makes imports cheaper, going against the entire narrative of atmabnirbharta being promoted right now. If imports become cheaper, the local products will find it even more difficult to compete. Of course, cheaper imports is good news for the consumers, given that the main aim of all economics is consumption at the end of the day.

An appreciating rupee also hurts the exporters as they earn a lower amount in rupee terms, making it more difficult for them to compete globally. And all this goes against the idea of promoting Indian exports and exporters to become a valuable part of global value chains and boosting Indian exports.

To conclude, and I know I sound like a broken record (millennials and gen Xers please Google the term) here, there is no free lunch in economics. That’s the long and short of it. All the liquidity created in the financial system to drive down yields on government bonds to help the government borrow at lower rates, is having other repercussions now. And there isn’t much the RBI can do about it.

Of course, if the bond market keeps demanding higher yields, the RBI’s dhishum dhishum with it will get even more intense in the days to come . If you are the kind who gets a high out of these things, well, continue watching this space then!

Why Large Corporates/Industrial Houses Owning Banks is a Bad Idea

 

An internal working group (IWG) of the Reserve Bank of India (RBI) has suggested that large corporate/industrial houses may be allowed to promote banks. Does this huge leap of faith being made by the Indian central bank, given their current extremely cautious and conservative approach, make sense? Let’s try and understand.

Why should large corporates be allowed into banking?

The IWG feels that allowing large corporates to promote banks can be an important source of capital. In a capital starved country like India this makes sense. Further, these corporates can bring “experience, management expertise, and strategic direction to banking”.

The group also noted that internationally “there are very few jurisdictions which explicitly disallow large corporate houses”. All these reasons make sense, but there are major reasons as to why the RBI in the last five decades hasn’t let large corporates enter the banking sector in India. At the heart of all this is the conflict of interest it would create.

Why have large corporates not been allowed into banking?

The IWG spoke to experts on the issue: “All the experts except one [said] that large corporate/industrial houses should not be allowed to promote a bank.”  The corporate governance in Indian companies isn’t up to international standards and “it will be difficult to ring fence the non-financial activities of the promoters.”

There will be a risk of promoters giving loans to themselves. Before bank nationalisation in 1969, some of the private banks were owned by large corporates. As Professor Amol Agrawal of Ahmedabad University puts it: “Since the private banks were run by big industrialists, they gave loans to themselves.”

What does history have to say in this regard?

As Pai Panandikar, an Advisor in the Finance Ministry, wrote in August 1967, regarding these banks : “Internal procedures… vest large discretionary powers in the Boards of Directors who have often acted as sources of patronage in deciding credit matters.”

A survey showed that 188 individuals served as directors on boards of 20 leading banks and held 1452 directorships of other companies. These individuals had directorships in 1100 companies.

What did these large discretionary powers lead to?

In an October 1967 report commissioned by politician Chandrashekhar, then the Secretary of the Congress Party, it was found that of the total bank loans of Rs 2,432 crore in 1966, Rs 292 crores was the debt due from the bank directors and their companies.

In fact, if indirect loans and advances were included, the actual debt-linked to directors was Rs 600-700 crore. There is a danger of something similar happening even now given the weak corporate governance structures.

*As of March 31, 2018.
Source: Rajya Sabha Unstarred Question No: 1492, Answered on 18 July 2018.

What does this mean in the current scheme of things?

As of March 2018, the domestic bad loans of Indian banks peaked at Rs 9.62 lakh crore. Of this, around 73.2% or Rs 7.04 lakh crore, were defaults made by industry.

The corporates have been responsible for a bulk of the mess in the Indian banking sector. Given that, handing over banking licenses to them is not a sensible idea, especially when the ability of banks to recover bad loans is limited.

Why No One is Worried About Savers

Economists are like sheep. They like to move in a herd.

If one of them says that the Reserve Bank of India (RBI) and banks need to cut interest rates in order to revive the economy, largely everyone else follows.

This basically stems from the fact that the practitioners of economics like to think of the subject as a science, having built in all that maths into it over the decades.

In science, controlled experiments can be run and results can be arrived at. If these experiments are run again, the same results can be arrived at again.

The economists like to think of economics along similar lines. But then economics is not a science.

Take the case of the idea of a central bank and banks cutting interest rates when the economy of a country is not doing well. Why do economists offer this advise? The idea is that as banks cut interest rates, people will borrow and spend more.

At the same time corporates will borrow and expand, by setting up more factories and offices. This will create jobs. People will earn and spend more. Businesses will benefit. The economy will do better than it did in the past. And everyone will live happily ever after.

Okay, the economists don’t say the last line. I just added it for effect. But they do believe in everything else. Hence, they keep hammering the point of banks having to cut interest rates to get the economy going, over and over again. The corporates who pay these economists also like this point being made.

The trouble is that what the economists believe in doesn’t always turn out to be true. Or to put in a more nuanced way, there is a flip side to what they recommend. And I have seen very few professional economists talk about it till date. In fact, low interest rates hurt a large section of the population especially during an economic recession and contraction.

In India, a section of the population, is dependent on the level of interest rate on bank deposits (especially fixed deposits). Currently, the average interest rate on a fixed deposit is around 5.5% per year.

The inflation as measured by the consumer price index in September stood at 7.34%. Hence, the actual return on a fixed deposit is in negative territory. It has been in negative territory through much of this year. This doesn’t even take into account the fact that interest earned on fixed deposits is taxable at the marginal rate. After taking that into account the real return turns further negative.

This hurts people living off interest income, in particular senior citizens. Senior citizens whose fixed deposits have matured in the recent past have seen their interest income fall from around 8% per year to around 5.5% per year, in an environment where food inflation is higher than 10%.

The only way to keep going for them is to cut monthly expenses or start using their capital (or the money invested in fixed deposits) for regular expenses. It is worth remembering that India has very little social security and health facilities for senior citizens, as is common in developed nations.

Lower interest rates also impacts a large section of the population which saves for the future through bank fixed deposits. It is worth remembering that it is this section of the population which actually drives the private consumption in the country. When returns on their savings fall, the logical thing is to cut consumption and save more. If this is not done, then the future gets compromised on.

Lower interest rates hurt institutions like non-government organisations, charitable trusts etc., which save through the fixed deposit route.

The stock market wallahs love lower interest rates because a section of the population continues to bet on stocks despite the lack of company earnings. The price to earnings ratio of the stocks that constitute the Nifty 50, one of India’s premier stock market indices, is currently at more than 34.

Such high levels have never been seen before. It’s not the chances of future high earnings which have driven up stock prices but the current low interest rates, leading to more and more people trying to make a quick buck on the stock market. The government likes this because it feeds into their all is well narrative.

At the same time, given that the government is cash-starved this year, the stock market needs to continue to be at these levels for it to be able to sell its stakes in various public sector enterprises to raise cash.

Between March 27 and October 9, the deposits of banks (savings, current, fixed, recurring etc.) have increased by a whopping Rs 7.4 lakh crore or 5.4%. In the same time, the total loans of banks have shrunk by Rs 38,552 crore or 0.4%. This basically means people are repaying loans instead of taking on fresh ones, despite lower interest rates.

In this environment, with banks unable to lend out most of their fresh deposits, it is but natural that they will cut interest rates on their fixed deposits. You can’t hold that against them. That is how the system is adjusting to the new reality. But what has not helped is the fact that the RBI has been trying to drive down interest rates further by printing money and pumping it into the financial system.

Between early February and September end, the central bank has pumped more than Rs 11 lakh crore into the financial system.

Not all of it is freshly printed money, but a lot of it is. This has apparently been done to encourage corporates to borrow. The bank lending to industry peaked at 22.43% of the gross domestic product (GDP) in 2012-13. Since then it has been falling and in 2019-20, it stood at 14.28% of the GDP. Clearly, Indian industry hasn’t been in a mood to borrow and expand for a while. Hence, the so-called high interest rates, cannot be the only reason for it.

The real reason for the RBI pumping in money into the financial system and driving down interest rates has been to help the government borrow money at low interest rates. As tax collections have fallen the government needs to borrow significantly more this year than it did last year.

All this has hurt the saver. But clearly unlike the corporates and the government, the savers are not organised. Hence, almost no one is talking about them. In the latest monetary policy committee meeting, there was just one mention of them.

One of the members had this to say: “With retail fixed deposit rates currently ranging between 4.90-5.50 per cent for tenors of 1-year or more and the headline inflation prevailing above that for some months now, there has been a negative carry for savers.”

We already know that no economist talks about this phenomenon or more specifically the fact that low interest rates and high inflation should have led to a cut down in consumption. How big and significant is that cutdown? How is it hurting the Indian economy?

Is this cutdown in consumption more than the loans given by banks because of low interest rates?

These are questions that need answers. But the problem is that to a man with a hammer everything appears like a nail. For economists interest rates are precisely that hammer which they like using everywhere. This situation is no different.

The trouble is their hammer doesn’t necessarily work all the time.

A shorter version of this column appeared in the Deccan Chronicle on October 25, 2020.