Centre’s reliance on small savings makes rate transmission difficult

The government’s increased reliance on small savings is bad news for rates transmission no matter what the Reserve Bank of India (RBI) instructs banks.

The central bank has lowered repo rate by 135 basis points since February, but the banks have lowered their lending rate by less than 50 basis points. This comes even as the money market had passed on the lower rates fully.

Banks, however, for long, have complained that they cannot lower their lending rates if deposit rates cannot be lowered too. And, deposit rates cannot fall much below the small savings rates offered by the government itself.

The reliance on small savings comes at a higher cost for the Centre, as these savings have a higher interest rate than government bonds.

The interest rates for National Savings Certificates and Kisan Vikas Patras range between 7.6 per cent (for 5 years) and 7.9 per cent (113 months).

The Sukanya Samriddhi Account Scheme comes with an interest rate of 8.4 per cent. Compared to this, the 10year government bond yields closed at 6.60 per cent on January 31.

The government plans to bridge its deficit using small savings worth ~2.4 trillion both in fiscal year 2019-20 and 2020-21. This is financing roughly 30 per cent of the deficits for both the years.

Small savings would also be used to finance the Food Corporation of India (FCI), which is borrowing ~1.1 trillion in 2019-20 and ~1.4 trillion in 2020-21.

That would mean that the scope to lower interest rates in small savings is marginal, as that would turn off investors at a time when the government is also giving an option to avail lower income tax rate for forgoing exemptions.

The sheer supply of government and public sector unit bonds would continue to put pressure on the bond market, even without considering state government bonds.

Including redemptions, the government will be borrowing ~8.1 trillion from the market in fiscal 2020-21. Extra-budgetary resources raised through bonds, which would be fully serviced by the government, are pegged at another 0.8 per cent of gross domestic product (GDP) in FY21.

Central public sector enterprises would borrow another 1.9 per cent of GDP in FY21, based on budget estimates for their capital expenditure.

This would take the total public sector borrowings requirement (excluding state governments) to about 6.2 per cent of GDP in FY21, said Gaurav Kapur, chief economist of Indusind Bank.

“Financing this large borrowings requirement through domestic resources (largely net household financial savings) could exert upward pressure on interest rates. But measures to open up certain debt securities without restriction for foreign investors would help,” Kapur said.

In such a scenario, banks won’t be under any obligation to lower their lending rates, especially because the bond yields cannot be softened much even after measures by the RBI. The surplus banking system liquidity now stands at over ~3 trillion. And if the RBI buys bonds from the secondary market under its open market operations (OMO) programme, it will add more liquidity to the system, which could fuel inflation.

To bring down inflation, the textbook prescription is to increase interest rates, which theoretically brings down the growth rate of the economy even further.

“Rate transmission would face more challenges and banks may increasingly differentiate widely between good borrowers and others in the coming days,” said Soumyajit Niyogi, associate director, India Ratings and Research.

“Challenges like minimal expectation of rate cut and OMO purchase, elevated small savings rate, high supply of central and state bonds and pressure on corporate performance, amid weak economic environment, will make it very difficult for banks to respond on transmission,” Niyogi added.

According to Anubhuti Sahay, the RBI would likely maintain status quo on its monetary policy in the February policy. It would most likely continue with its accommodative stance for now. The central bank would rather focus on transmission of policy rates, she said.

According to Abhishek Gupta, economist at Bloomberg, any rate cut would only come in June. But the central bank would most likely assure the market that bond yields would be contained using special operations and buyback of bonds.

“In our view, the burden of recovery now falls solely on the RBI. With inflation breaching RBI’S target at present, any rate cuts by the central bank are likely to be delayed and contingent upon inflation falling below the upper end of its 2-6 per cent target range,” said Gupta.

Bond yields will also be under pressure due to ~2.7 trillion of switches in FY21, which increases duration risk.

“While most of the switches are likely to be with the RBI, we expect such largescale switches to exert a steepening pressure on the government yield curve,” Sahay said.

In this environment, banks’ marginal cost is unlikely to come down, which would prevent them from lowering their marginal cost of fundsbased lending rate (MCLR).