TANSTAAFL

Over the financial year 2019-20, the Reserve Bank of India (RBI) cut the Repo rate (the rate at which RBI lends money to commercial banks) by 1.85%, from 6.25% at the beginning of the year (April 1, 2019) to 4.4% by March 31, 2020. The reductions in the Repo rate not only resulted in reductions in the rates of commercial banks but were also used by the Government to reduce the administered rates over the year on all the small savings instruments – post office savings, savings certificates, and public provident fund. The aggressive rate reductions were effected to spur economic growth by helping the supply side of the economy. The blind spot of the policy was the significant reduction in the income on savings of the household sector. Already reeling under COVID-19 induced job losses and cut in compensations, the reduction in income on financial assets has dealt a serious blow to demand from the household sector. The article provides an estimate of the income lost by the household sector on its financial savings and argues for urgent changes in the monetary and fiscal policies as to when it comes to policymaking “There ain't no such thing as a free lunch”!  

The Rate Cuts in FY 2019-20

While the commercial banks decide the interest rates on bank deposits, the interest rates on small savings instruments are decided by the Central Government. The rates prevailing on these instruments and bank deposits at the beginning and the end of FY 2019-20 are presented in Table 1 (the rates offered by SBI, State Bank of India, are used as a proxy for rates on bank deposits).

The decline in the interest rates and the resulting decline in the interest income from the instruments are computed and presented in columns 4 and 5 respectively in Table 1. To illustrate how these computations were done, let us consider the case of PPF. The interest rate on PPF declined from 8% to 7.1%, implying a decline of 0.9%. This works out to a decline in interest income of (0.9/8) = 11.25%. The highest decline in interest income of 21.43% was for the 1-year time deposit with the post office.

The Quantum of Income Lost in FY 2019-20

The aggregate amount of income lost by the household sector would depend on the amount of savings through different instruments –the figures for the same from the Budget 2020 documents - are presented in Table 2.

The total balance in savings was Rs. 91,82,740 crore at the start of the FY 2019-20. It increased during the year by Rs. 10,42,921 crore to close at Rs. 1,02,25,661 crore by the end of the year. The loss in income on the amount held at the beginning of the year in an instrument is computed by multiplying the amount with the average decline in the interest rate on that instrument. To illustrate how these computations were done, let us consider the case of PPF. The balance in PPF savings at the start of the year was Rs. 5,69,611 crore. The average decline in the PPF interest rate for the year was 0.90%/2 = 0.45%. Hence the loss of income on the PPF savings balance at the start of the year was Rs. (5,69,611 x 0.45%) = Rs. 2,563 crore. The amount of inflow into PPF during the year was Rs. 84,770 crore. The loss of income on this amount would be (84,770/2) x 0.45% = Rs. 191 crore. The loss on each of the instruments and the total loss are presented in Table 3.

The Extant Situation

The decline in interest income has continued in FY 2020-21. If the interest rates were to stay the same as at the end of FY 2019-20, then the decline in interest income in FY 2020-21, as compared to the income expected at the start of FY 2019-20, would be over 85,000 crore (a little more than twice that for the previous year), as the reduced rates will apply to a larger amount of savings for the entire year. The interest rates in fact have been reduced further, worsening thereby the plight of the household sector. The RBI reduced the Repo rate by another 0.4%. It was 4% as on October 1, 2020 against 4.4% on April 1, 2020. Pressured to pass on the reductions, banks dropped their rates further. The SBI savings deposit rate as on October 1, 2020 was 2.75% and the 1-year term deposit rate was 4.9% (from 3% and 5.7% respectively on April 1, 2020).

The declining rates were accompanied by high inflation rates in the economy. The consumer price inflation between December 2019 and September 2020 has averaged over 6.75%. The rate reductions have therefore resulted in ‘financial repression’ that is defined by Wikipedia as "policies that result in savers earning returns below the rate of inflation" in order to allow banks to "provide cheap loans to companies and governments, reducing the burden of repayments".

The Policy Choices

The economic downturn had already resulted in a significant decline in the income of the households due to lower compensation for work and job losses. Added to that, the decline in their financial income by about 13%, from the aggressive rate reductions, has accentuated their misery. Particularly hard hit are the low and middle-income households and households that derive a large part of their income from savings. These households typically spend a major part of their income on food – and the food inflation is running at a double-digit percentage. The overall high inflation prevailing in the economy (the inflation rate for September 2020 was 7.34%, well above the average inflation rate of 6.75% for the year) and the newer costs (perhaps the single biggest ‘new’ cost imposed on families is the cost of education of children) arising from operating from home are driving such households into destitution.

The consumption by households and therefore the demand of the household sector in the economy is supported by the income and the borrowing of the households. The significant reduction in the income of the households implies that the households have become much less creditworthy. Lower-income and the resulting lower capacity to borrow (and the unwillingness of lenders to lend due to enhanced credit risk) are resulting in a significant decline in the consumption of households and therefore the aggregate demand of the household sector. And yet the policy belief continues that the loss of income would be made up by additional borrowing by the households to revive demand. This belief is implicit in the press release by the RBI on October 9, 2020, “The MPC also decided to continue with the accommodative stance as long as necessary – at least during the current financial year and into the next financial year – to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward.”

The policy statement would imply that the ‘financial repression’ would continue for the next two years unless the RBI revises the inflation target downwards – and is able to achieve the target. The RBI was working with an inflation target of 4% - 6% when the Repo rate was 6.75%. This target has not yet been changed. The target cannot be the same when the Repo rate has been brought down to 4%! If the ‘decision’ is to continue with a lower Repo rate for the next two years, then there is a need to revise the inflation target downwards, to maybe 3% - 4%, in line with the decline in the Repo rate, to mitigate the suffering of the households from declining income. More important would be to bring the inflation rate down to 3%.  

An economy is driven by monetary policies (set by the RBI) and fiscal policies (set by the Central Government). The Government has thus far been hesitant in taking bold fiscal policy initiatives to set the economy on the right course. India’s GDP in the first quarter of FY 2020-21 contracted by a massive 23.9%, which was the first GDP contraction in four decades. The forecast is that the full-year GDP may contract by about 10% if the economic recovery is robust in the remaining quarters. However, in view of the demand destruction in the household sector, the economic recovery is appearing fragile. There is therefore an urgent need to bolster aggregate demand in the economy through fiscal expansion – an increase in government spending to create economic assets and jobs in the economy – to overcome the economic contraction. The Government may draw inspiration from ‘The Golden Gate Bridge’ in San Francisco, that was constructed through public funds to fight the Great Depression of 1929 – 33, by providing employment to people while creating a world-renowned monument of beauty and economic utility that captures the spirit of enterprise and the never-say-die attitude of a nation.

Let me conclude by saying that there is a pressing need to review policy initiatives on the above lines to heal the economy and mitigate the hurt people are facing.

Sources of Information:

Small Savings Interest Rates: FY2019: https://dea.gov.in/sites/default/files/Q2_0.pdf

Small Savings Interest Rates: FY2020: https://dea.gov.in/sites/default/files/RoI%20Q1%202020-21%20%281%29.pdf

SBI: Deposit Rates:

https://sbi.co.in/documents/26242/65574/SB+rates+for+10+years+%283%29.xlsx

https://sbi.co.in/web/interest-rates/savings-bank-deposits

Balances in Small Savings Instruments: Budget Documents: https://www.indiabudget.gov.in/doc/rec/annex11.pdf