Why Are Banks Wooing You?

When he didn't respond (Mr Saver has lost count of how many relationship managers he has had in the past few years!), the gentleman landed up at his doorstep and started pleading with him to open fixed deposits with the bank, observes Tamal Bandyopadhyay.

Let's call him Mr Saver. He represents the saving community in India, the world's fourth largest economy.

There's a spring in his steps these days. The relationship manager of his bank had been chasing him, sending WhatsApp messages non-stop.

When he didn't respond (Mr Saver has lost count of how many relationship managers he has had in the past few years!), the gentleman landed up at his doorstep and started pleading with him to open fixed deposits with the bank.

The rate for one- to two-year FDs has risen to 8 per cent for Mr Saver, a senior citizen.

This is a large private bank. Many are offering similar interest rates on FDs or even higher.

The customers are familiar with calls from the banks selling mortgages and personal loans but, when it comes to deposits, no efforts are made, as the flow has been quite automatic.

Suddenly, the scenario has changed. The banking system is wooing Mr Saver.

His two-year FD will get him 8 per cent interest. As the inflation for the next financial year is projected at 5.3 per cent, he will earn 2.7 per cent on his deposits. That's a real interest rate for him.

Of course, he needs to pay tax on his interest income and so, his actual earning will be much less but the real interest does not account for tax outgo.

It's the difference between the nominal interest rate and the expected inflation rate.

In other words, it represents the real return on savings and the real cost of borrowing.

For the saving community globally, high inflation has been eroding the value of money.

Everyone is talking about the 'real' interest rate.

In India, how much interest should one get from the government's small savings schemes and how much from bank deposits and other saving instruments?

In the February monetary policy statement, after summing up all the steps taken to fight inflation, and outlining the key developments on the monetary policy front over the last one year, Reserve Bank of India Governor Shaktikanta Das said: 'As a result of all these measures, the real policy rate has been nudged into positive territory; the banking system has moved out of the Chakravyuh of excess liquidity; inflation is moderating; and economic growth continues to be resilient.'

Inflation-adjusted 'real' interest rate matters the most as inflation reduces the value of future cash flows.

'The real rate is arguably the most fundamental indicator of the stance of monetary policy,' economists Christina Romer and David Romer had written in a 2004 paper.

Early February, US Federal Reserve Chairman Jerome H Powell mentioned in a news conference how 'real rates' had turned 'positive' across the board.

Before that, in November, he had said, 'We will be looking at real rates, for example, all across the yield curve and all other financial conditions as we make that assessment.'

They had been negative for many months as the policy rate as well as treasury and money market rates weren't keeping up with inflation.

Now, interest rates have risen while inflation has begun to fall.

The exact quantum of real rate depends on the state of the economy, but how do we calculate the real rate?

What is the ideal benchmark rate to calculate it? Should it be bank deposit rates?

If not bank deposits, the central bank's policy rate? The 10-year bond yield? Or the yield of a one-year treasury bill?

A March 2020 International Monetary Fund paper says while there are many different interest rates in financial markets, the policy interest rate set by a country's central bank provides the key benchmark for borrowing costs in the country's economy.

Central banks vary the policy rate in response to changes in the economic cycle and to steer the country's economy by influencing many different (mainly short-term) interest rates.

Higher policy rates provide incentives for saving, while lower rates motivate consumption and reduce the cost of business investment.

Savers seeing their money losing its purchasing power is not new in India.

Between 2012 and 2014, for three successive years, the average inflation was 8.22 per cent, making the real interest rate negative for savers.

Between 2015 and 2019, the real rate was mostly positive as the policy rate was higher than inflation rate.

For instance, between August 2018 and September 2019, the inflation rate was lower than 4 per cent while policy rate hovered between 5.4 per cent and 6.5 per cent.

Former RBI governor Raghuram Rajan spoke about keeping the real interest rate at 1.5-2 per cent.

At an analysts' conference in 2015, after presenting the monetary policy, he explained that the benchmark could be a one-year treasury bill yield for calculating the real interest rate (one-year treasury bill yield vis-a-vis expectations of inflation over the one year ahead).

Of course, he added that 'the natural real rate is a moving object... It depends on the state of the economy... I do not think this... is cast in stone'.

If we take the one-year treasury bill yield as the benchmark, then we have a positive real rate of 1.96 per cent now (7.26 per cent minus 5.30 per cent).

But unlike the policy rate, which is determined by the rate-setting body of the RBI, the treasury bill yield depends on many factors, including liquidity in the system and foreign funds flow.

Assuming an average crude oil price (Indian basket) of $95 per barrel, CPI inflation is projected at 6.5 per cent in 2022-23 (5.7 per cent for the January-March quarter).

On the assumption of a normal monsoon, inflation is projected at 5.3 per cent for 2023-24 -- 5 per cent for the first quarter, 5.4 per cent for second and third quarters and 5.6 per cent for the fourth. The risks are evenly balanced.

The inflation target is 4 per cent with a band of 2 per cent on either side.

Retail inflation jumped sharply in January, surpassing the RBI's upper tolerance level of 6 per cent after two months, to 6.52 per cent, its three-month high.

It was at an eight-year high of 7.79 per cent in April 2022 and had been above the upper limit of the central bank's flexible inflation target for 10 months in a row between January and October 2022, triggering an explanation by the central bank to the government why it has failed to achieve the target for three successive quarters.

When it dropped below 6 per cent for two months in November and December, there were all-round celebrations and also self-congratulations for keeping it lower than many developed markets.

To Das's credit, he has not shifted the goal post from 4 per cent to 6 per cent.

By raising the policy rate yet again in February to 6.5 per cent, he has demonstrated the RBI's determination to continue its fight against inflation till the genie is bottled.

While the debate will continue about what should be the benchmark rate to calculate real interest rate, both for the lenders and the savers, shouldn't all rates be higher than the rate of inflation?

If this is ensured, it will have a positive impact on the savings to GDP ratio, which is at its 19-year low now.

Also, as an incentive for savers, on the line of debt mutual funds, if indexation benefits are given to the depositors who are keeping money with the banks at least for three years, it will be win-win both for the depositors as well as the banking system.

Tamal Bandyopadhyay, a consulting editor of Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd.