Savings normally flows into assets that are generating better yield. When interest rates on fixed-income investments such as bank fixed deposits are high, the household savings generally flows more into them. However, in the current scenario, something contradictory seems to be happening. According to a research report from State Bank of India’s Economic Research Department – Why negative real rates could now be the norm?, authored by Dr. Soumya Kanti Ghosh, Group Chief Economic Adviser, State Bank of India, people are increasing their savings even as we are facing negative real interest rate but people are saving money as a precautionary motive.
The report suggests that there is a large empirical literature of the determinants of household savings in India. In particular, it is largely believed that positive real interest rates act as an enabler of household savings if the substitution effect, in which saving increases as consumption is postponed to the future, dominates the wealth effect in which savers increase current consumption at the expense of saving.
Interestingly the incremental small savings deposits have significantly slowed down as a percentage of incremental commercial bank’s deposits in current fiscal with people keeping the money more in liquid bank deposits rather than locking them in financial savings. This is intriguing as it shows financialisation of household savings happening in select instruments (perhaps in the stock market too!)
This paradox of high savings even as real interest rates have turned negative has important lessons in the Indian context. Our empirical results show that for the period FY00 to FY20 a change of at least 2% in real deposit rate was required to change the saving rate by 1%.
This result is in conformity with earlier results also that shows large changes in real rates are always required to jumpstart household savings. In fact, small changes in deposit rates hardly make any difference and hence it is always costly to keep real interest rates at high levels for a significant period.
This has happened in the past also when rate cuts lagged inflation trajectory and it is thus essential that we keep real interest rates at negative right now, as such will also have a sobering impact on asset quality. We believe in the current scenario, this will be appropriate for financial markets as a negative real rate is unlikely to hurt household financial savings given the uncertainty surrounding pandemic.
According to the report, there is a further twist to the tale. Causality analysis in India between income per capita and savings rates shows that such causality runs mostly from income to savings. This implies that high GDP growth and an increase in per capita income can only significantly improve the savings rates in India in the long term.
Thus the recent jump in household savings might not be sustained as it now seems that growth disruptions will continue for at least in H1 of current fiscal implying that both Q1 and Q2 growth numbers will be washouts.
Despite all this, we believe an August rate cut is unlikely. With the 115 bps reduction in repo beginning February, banks have already transmitted 72 bps to the customers on fresh loans in the interregnum which is perhaps a milestone in terms of the fastest policy rate transmission in India.
Large banks have transmitted as much as 85 basis points. This has happened because of a proactive RBI using liquidity among others as a tool to serve its policy objective. We believe that the MPC could now well debate what further unconventional policy measures could be resorted to in the current circumstances to ensure financial stability is continued to be addressed.