It is well known that banks cut deposit rates with great enthusiasm, but are more cautious when increasing them. Depositors suffer because of this asymmetric behaviour.

Look at what is happening right now. The interest rate on bank fixed deposits has been far lower than consumer price inflation over the past two years, thus ensuring that people who put a major part of their savings in the banking system have seen the real value of their savings shrink in this period. And the savings bank rate continues to be frozen at a miserably low 3.5%, one of the very few interest rates that are still fixed by government fiat to provide a huge subsidy to the banking system.

The Reserve Bank of India (RBI) has quite rightly indicated in its new monetary policy that interest rates have to go up if the battle against high inflation is to be won. The central bank only has control over its short-term policy rates, but assumes that its signals will eventually move the long-term interest rates that affect actual economic decisions to save, spend and invest. In other words, it assumes that banks will increase interest rates for both deposits and loans.

The actual transmission of monetary policy is never easy in India, especially since we have very shallow bond markets that are totally dominated by the government’s borrowing programme to fund the large fiscal deficit.

Banks have a clear incentive to quickly increase the rates at which they lend money to companies and individuals. There is less reason for them to give depositors more for their money. But two years of negative returns on bank deposits seem to have led to a revolt from middle India, even as companies withdraw money from banks to fund new projects. Deposit growth is slowing just as credit growth is picking up.

Citi economists Rohini Malkani and Anushka Shah say in a recent note the “Moderation in deposit growth is partly due to corporates withdrawing surplus deposits parked in banks, as projects delayed during the slump period are now restarting". There is no clear data as yet, but it is very likely that household savings have also started moving out of banks and into more attractive options such as equities, gold and real estate. More money also seems to have moved into government small savings schemes such as the Public Provident Fund, which offers better post-tax returns.

The imbalance between credit growth and deposit growth cannot continue for long. For the first time since 2005, the amount of new loans been given out by banks is higher than the amount of new deposit money coming into their vaults. The ratio of credit to deposits has been assiduously inching up since January. Banks will soon have to take extra efforts to get more deposits from households. The most straightforward way to do this will be to lift deposit rates from the current trough.

The Indian central bank is well aware of this problem, as it is the one big reason why supply of broad money (M3) is growing slower than what was targeted even though reserve money (M1) has been growing smartly. In its review of the Indian economy released on Tuesday, RBI did not mince words: “The deceleration in the growth of M3 continued up to mid-June 2010. This was on account of the deceleration of its major component, i.e. aggregate deposits. The moderation in the growth of time deposits was particularly sharp, which was partly a response to the low deposit rates, given high inflation."

Sluggish growth in deposits and money supply could impact the economy in the coming quarters. The smart growth revival will ensure that companies will need more credit from banks. The lack of adequate deposits to fund this credit growth could lead to a structural liquidity problem in the Indian financial system, which will be more serious than the temporary liquidity crunch we saw in June, when companies pulled out money from the financial system to pay more than Rs1 trillion to the government for 3G (third-generation) and wireless broadband spectrum.

Higher capital inflows could ease some of this funding pressure. Some of the household money that has gone into the stock market—either through direct share purchases, mutual fund investments or unit-linked insurance schemes—can be accessed by large companies. But there is little doubt that the sluggish deposit growth we have seen in recent months could put pressure on the banking system and hence the entire economy.

It is very likely that banks will start increasing deposit rates in the months ahead, even as inflation falls in response to the base effect and higher interest rates. This is good news to poor and middle-class households as well as retired people, whose interests are usually blanked out in most of the commentary on interest rate policy.

Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at

To read Niranjan Rajadhyaksha’s previous articles, go