Hemant Mishra/Mint
Hemant Mishra/Mint

Impact of lower interest rates on savings of Indian households

Significant rate cuts are not good as they not only discourage gross financial savings, but encourages borrowings

Significant rate cuts are not good as they not only discourage gross financial savings, but encourages borrowings

India’s corporate sector continues to clamour for interest rate cuts, but it is important to note what impact this will have on household savings, which account for more than two-thirds of total savings. Evidence shows that in the post-liberalisation period, household deposits, which account for bulk of gross financial savings (GFS), are closely associated with the nominal deposit rate, rather than the real rate. Analysis also indicates that when inflation rose above a threshold level (in the period after financial year, FY, 2008), households turned cautious and became vigilant of real interest rate. This finding, however, is not overwhelming because of limited data observations. Further, lower rates incentivize borrowings and investments (in real estate) by households, imply more financial liabilities and higher physical savings. These trends are detrimental for economic growth.

In the past few years, households have shifted from financial savings to physical savings. While a portion of the former finances corporate investments, the latter leads to relatively inefficient investments, dragging economic growth lower. It is, thus, imperative to encourage financial savings of households.

GFS is only a small part of household savings in India. What matters most is net financial savings (NFS) because financial liabilities are used to finance physical savings, which comprise the other part of household savings. After almost three decades, physical savings account for more than 60% of total household savings.

This is important because higher the physical savings, lower the real gross domestic product (GDP) growth. Household investments rose from 28% of total productive investments (all investments excluding valuables) in FY08 to 45% in FY13, while corporate investments fell from about 48% to 31%.

These movements had a bearing on efficiency of investments, which affected real GDP growth.

For any given amount of GFS, the higher the financial liabilities, the lower the NFS of households. The latter is what matters for the economy because NFS serves as raw material for the corporate sector’s investment. If households continue to consume more and save less, it will lead to higher inflation and inability to increase efficient investments without widening the current account deficit (CAD). Domestic savings are the primary source of financing domestic investments. In case, savings fall short (and assuming no significant widening of CAD), lower interest rates will not help in pushing investments higher.

Significant rate cuts are, thus, not desirable as they not only discourage GFS but also encourage borrowings, and lead to physical savings. The repo rate is unlikely to be cut below 7% by FY16-end. At best, it could be reduced to 6.5% by March 2017.

Edited excerpts from report Interest Rate & Household Savings-Thematic Report, by Nirmal Bang Equities Pvt. Ltd.

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