Reddy’s rate mantra turning small savings schemes into big losers

MUMBAI: It’s a paradoxical situation for the Reserve Bank of India. By hiking interest rates, it has managed to curb money growth through credit creation. But high interest rates on bank deposits have taken the sheen off small savings, which in turn is adding to the money supply.

In its effort to ensure price stability and curtail money growth through credit creation, RBI has been hiking benchmark policy rates for over a year at regular intervals. This, in turn, has forced commercial banks to hike both lending as well as deposit rates.

Interest rates on bank deposits are now ruling higher than small savings schemes, making the former more attractive. For instance, bank deposits maturing in 2-3 years now fetch as high as 10%. But interest rate on most small savings schemes, such as postal term deposits and public provident fund, is fixed at 8%.

So while high interest rates have helped curtail unproductive spending and borrowing by reining in money supply growth, it has created a new channel for flow of funds from small savings schemes.

As per the current practice of compiling data, while bank deposits comprise a major chunk of money supply, small savings — including postal term deposits — are not counted in money supply. Hence, fund flows to bank deposits are counted as money supply. Postal savings deposits are also included in money supply.

Data shows a gradual shift away from small savings. For instance, annual growth in outstanding (net of redemptions) small savings was 7.5% in February this year compared to 15% in FY06 and 21% in FY05. The base of small savings is, however, much smaller. Bank deposits, on the other hand, have been growing. Annual growth in bank deposits in February this year was 24.5%, compared to 22.8% in FY06 and 18.7% in FY07.

This could pose another challenge to RBI with regard to monetary management. Though it is not easy to quantify the monetary impact of flows from small savings schemes to the banking system, analysts do admit there has been some impact. But they stress that such shifts from an asset class that is not captured in the monetary data to another which is included does not alter the macro picture significantly. The central bank’s measures have anyway brought down money supply growth, they say.

RBI, through its various communications, has been highlighting that the system of administered interest rate is diluting the effectiveness of monetary policy. In other words, administered interests such as those on small savings whose rates are fixed by the government are rarely in alignment with the banking system. Such a system ends up disrupting the smooth impact of any monetary policy measure, especially interest rate changes.

Analysts say the central bank is aware of this limitation of the interest rate channel and, hence, has been resorting to CRR hikes of late, asking banks to park a higher portion of their deposits with it.