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1 Economy Update Interest Rate & Household Savings-Thematic Report 11 June 21 Impact Of Lower Interest Rates On Savings Of Indian Households India s corporate sector continues to clamour for interest rate cut, but it is important to note its impact on household savings which account for more than two-thirds of total savings in the economy. Evidence shows that in the post-liberalisation period, household deposits, which account for bulk of gross financial savings, are closely associated with nominal deposit rate 1, rather than real deposit rate. Our analysis also indicates that when inflation rose above a threshold level (in post-8 period), households turned cautious and became vigilant of real interest rate. This finding, however, is not overwhelming because of limited data observations. Further, lower rates incentivise borrowings and investments (in real estate) by Indian households, implying more financial liabilities and higher physical savings. These trends, we find, are detrimental for economic growth. Overall, significant rate cuts will lead to lower net financial savings, which is contrary to what is required for the economy. Accordingly, we believe the Reserve Bank of India (RBI) does not have room to cut repo rate below 7% this year and.%, at best, by the end of 17. Shift in household savings from physical to financial savings: 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. Nominal deposit rate matters for deposits growth...: A look at households gross financial savings (GFS) reveals that deposits account for half of their savings, insurance and pension funds comprise another 3% and equities account for only %. Our analysis reveals that in post-liberalisation period (up to 13), nominal deposit rate (which is closely associated with repo rate), rather than real rate, is highly correlated with the growth in household (term) deposits....unless inflation rises above a threshold level: We also found out that real deposit rate was more important post 8, when inflation was high. It indicates that once inflation crosses a threshold level, households become more concerned, and thus real rate turns more pertinent. Nevertheless, this finding needs to be treated with caution because we have limited data observations (only six over 8-13). Further, the correlation (between deposits and real deposit rate) in post 8 period is statistically insignificant. Even if we accept this relationship in its entirety, it also points out that as inflation falls further, nominal rate will turn more important again. Lower rate encourages borrowing and physical savings: Apart from encouraging financial savings, it is equally important to discourage financial liabilities, which eventually lead to physical savings. For any given amount of GFS, the higher the borrowings, the lower the net financial savings which finance domestic investments. As household investments (equal to physical savings) are more inefficient than corporate investments, the higher the former, the lower is real gross domestic product (GDP) growth. Limited rate cuts by the end of 17: Significant rate cuts are, thus, not desirable as they not only discourage GFS but also encourage borrowings, and thus lead to physical savings. This is in contrast to the prescription for the economy. This analysis further reinforces our view that repo rate is unlikely to be cut below 7% by 1-end. Moreover, we believe that repo rate, at best, could be reduced to.% by March 217. Nikhil Gupta nikhil.gupta@nirmalbang.com A note on data methodology: We have used household term deposit data in the post-liberalisation period (beginning ) from RBI s annual publication known as Basic Statistical Returns (BSR) of scheduled commercial banks (SCBs). The data is released with a lag of almost 18 months, and thus the recent data available is only for 13. To calculate the weighted nominal deposit rate (WNDR), we have used maturity pattern of household term deposits as weights and deposit rates for different maturities. To calculate weighted real deposit rate (WRDR), we deflate WNDR by CPI-IW, for which historical data is available. Please refer to the disclaimer towards the end of the document.

2 A look at household savings in India To start with, it is important to analyse the composition of total savings. Broadly, there are three institutions which account for domestic savings households, private corporate and the consolidated public sector. Exhibit 1 below shows the details in this regard. Exhibit 1: Major components of India s domestic savings (2- = 1) % of GDP Total (1) = ()+() Gross financial savings (2) Household sector Financial liability (3) Net financial savings () = (2)-(3) Physical savings () Private corporate sector () Consolidated public sector (7) Total savings (8) = (1)+()+(7) NA NA NA NA NA Note: Data on 2- base is available up to 13 NA: Not available on 2- base; 1 data on 2- base is available only for household financial savings Source: Reserve Bank of India (RBI), Nirmal Bang Research Exhibit 2: Components of households GFS % of GFS Currency Bank deposits dominate financial savings of households...: Exhibit 1 shows households account for ~7% of total savings in the country. Therefore, it is imperative to understand the impact of monetary policy on the behaviour of household savings. Household savings can be divided into three parts gross financial savings (GFS), financial liabilities (FL) and physical savings (PS) (Please note this analysis is based on 2- base data). We will first look into the components of GFS, which are detailed in Exhibit 2. Total deposits (bank and non-bank) account for almost half of total financial savings. Interestingly, the share of deposits has risen from ~2% at the time of the onset of the boom period to % in 8 and % in 1 (the recent data available). Bank deposits Non-bank deposits Life insurance PF & pensions Shares & debentures Claims on government Units of UTI Total (% of GDP) Note: Data is based on stock, not flows Source: RBI, Nirmal Bang Research...while risky assets account for less than %: On the other hand, household savings in shares and debentures has fallen from a recent peak of.9% of GFS in 8 to 3.8% in 1. Overall, Indian households continue to prefer short-term safer assets over riskier assets to park their savings (Exhibit 3). The share of savings parked in short-term safe assets (bank/non-bank deposits and net trade debt) rose to an all-time high of %, while savings in long-term safe assets (life insurance, pension and provident fund plans) slipped from % a decade ago to 3% in 1. Further, the share of risky assets (shares/debentures and units of Unit Trust of India or UTI) fell to a three-decade low of 3.8%. Finally, higher inflation led to a gradual increase in currency holding of households. 2 Interest Rate & Household Savings-Thematic Report

3 Exhibit 3: Reclassification of components of households GFS Exhibit : Components of household savings Note: Short-term (ST) safe assets comprise bank /non-bank deposits and trade debt (net). Long-term (LT) safe assets comprise life insurance, pension & provident fund plans and claims on government. Risky assets include shares & debentures and units of UTI. Source: Central Statistical Organisation (CSO), RBI, Nirmal Bang Institutional Equities Research Cash ST safe assets LT safe assets Risky assets Physical savings rise faster than financial savings: As discussed above, gross financial savings are only a part of household savings in India. What matters most is net financial savings (NFS). This is because financial liabilities are used to finance physical savings, which comprise the other part of household savings. After a period of almost three decades, physical savings account for more than % of total household savings (Exhibit ). This is important because higher the physical savings, lower the real GDP growth. Exhibit confirms this. The logic is simple. Household investments are less efficient than investments by private corporates. Higher the household investments (or physical savings), the more inefficient investments are, and thus lower GDP growth. Household investments rose from 28% of total productive investments (all investments excluding valuables) in 8 to % in 13, while corporate investments fell from ~8% to 31% in the same period. These movements had a bearing on efficiency of investments, which impacted real GDP growth. Exhibit : Inverse correlation between household physical savings and real GDP (% of total HH savings) Net financial savings (NFS) Physical savings (% of total HH savings) (%, YoY) Physical savings Real GDP (RHS) Note: Data shown is based on three-year simple-centred moving average 3 Interest Rate & Household Savings-Thematic Report

4 Lower interest rates and their impact on household savings We have found out that Indian households continue to remain extremely conservative parking almost half of their financial savings in deposits, another 3% in insurance and pension plans and less than % in risky assets. Further, we found out that physical savings have overtaken financial savings in the recent past, which has a detrimental impact on the economy. Therefore, the prescribed medicine for the economy is to give incentives to households to shift back from physical savings to financial savings. (Please note we are deliberately looking to shift savings composition rather than pushing overall household savings because of its potential adverse effect on consumption). In simple words, we should discourage borrowings (which imply physical savings) and encourage deposits (largest component of gross financial savings). In this context, we will look at the impact of lower interest rates on household savings. Lower interest rates encourage higher liabilities and physical savings: As stated above, financial liabilities should be discouraged. This is because households generally borrow to invest in real estate, which constitute physical savings. Exhibit shows the strong positive relationship between physical savings and financial liabilities. According to the monthly sectoral deployment of credit by scheduled commercial banks (SCBs), more than % of personal loans are for housing purposes. (Please note that SCBs credit does not help in understanding the movement in household financial liabilities because the former - as per official data released - constitutes less than a third of the latter). For any given amount of GFS, the higher the financial liabilities, the lower the net financial savings (NFS) of households. The latter is what matters for the economy because NFS serves as raw material for the corporate sector s investment (It could also be consumed by the public sector to cover its fiscal deficit, which we choose to ignore here). In case, households continue to consume more and save less, it will lead to higher inflation and inability (notwithstanding the willingness of the corporate sector) 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. There is another way to look at it. Let s say, the corporate sector is extremely upbeat and just want to invest. If this is the case, then lower household savings will harden interest rates because of higher demand for funds and insufficient supply. This is, in fact, one of the reasons, why rising interest rates are sometimes seen as a healthy sign of economic recovery. Exhibit : Physical savings and financial liabilities move together Exhibit 7: Deposit rate moves with repo rate (% of GDP) (% of GDP) 2 (%) Physical savings Financial liabilities (RHS) Repo rate Nominal deposit rate* Note: Data is based on stock variables, not flows. Financial liabilities % of GDP and physical savings assumed at 2% of GDP in 191. We can change these numbers, but it will not change the trend and recent ratios. * Data is on 2- base up to 13, physical savings for 1 is our estimate * Nominal deposit rate for households is weighted deposit rate on term deposits of households. Weights used are based on maturity of term deposits. Lower interest rates discourage gross financial savings: Apart from encouraging financial liabilities and physical savings, a significant fall in interest rates discourages GFS. This is because, as stated above, deposits comprise more than half of GFS which tend to give lower returns with the reduction in policy rates. The first step for this analysis is to see if deposit rate follows the movement in repo rate. Exhibit 7 above shows that it does, which sets the base for our argument. We have already explained the importance of net financial savings of households for India s economy. Keeping this in mind, it is necessary to make sure that easy monetary policy does not discourage household financial savings at a time when it encourages corporate investment. Unfortunately, the current monetary policy does not seem to be meeting these criterions. Interest Rate & Household Savings-Thematic Report

5 Exhibit 8 and 9 below show the movements of household term deposit growth with weighted nominal deposit rate (WNDR) and weighted real deposit rate (WRDR) 1. Further, we have looked at the role of expected inflation also. RBI started conducting a survey known as inflation expectation survey of households (IESH) in September 2, and the quarterly data is available since September 2. Thus, we have annual data available since 8. Using this data, we have calculated expected real deposit rate (ERDR). The relationship of ERDR with household deposit is shown in Exhibit 1 below. The key findings are given below: a. Based on the last two decades data, household term deposits are significantly and positively related with nominal deposit rate rather than real deposit rate (Please see Exhibit 11 below); b. The entire period, however, could be divided into three phases on the basis of inflation 199s, - 8 and 8 onwards. Retail inflation averaged 9.8% in 199s,.3% in early 2s and 9.% over While nominal rates were more closely related with deposit growth in the first two periods, real rate is more important in the recent period. c. One way to explain this is that there were limited options for households to park their savings in 199s, and, thus, notwithstanding high inflation they kept their savings in the form of deposits (form of financial repression). In 2s, however, with sufficient avenues, households became more concerned about inflation, as and when it rose beyond a threshold level. Consequently, real rate turned more important for depositors after 8. d. However, our finding is not overwhelming because of two statistical reasons. Firstly, there is limited number of observations (only six) and secondly, although the correlation between deposit growth and real deposit rate is high, it is statistically insignificant. Analytically, if we accept this finding, it implies that if inflation falls further, nominal rate will become more relevant rather than real rate. This is a strong conclusion, which, unfortunately, demands caution because of above mentioned factors. e. Therefore, whatever be the case, the key takeaway from this analysis is that nominal deposit rate cannot be ignored if household savings are to be taken into consideration. Exhibit 8: Nominal deposit rate and household deposits (%, YoY) (%) Exhibit 9: CPI-based real deposit rate and household deposits (%, YoY) (%) (2) () HH term deposits WNDR (RHS) Note: Data used is three-year simple moving average HH term deposits Note: Data used is three-year simple moving average WRDR (RHS) Exhibit 1: Expected real deposit rate and household deposits (%, YoY) (%) HH term deposits ERDR*(RHS) * Expected real deposit rate is three-month forward expectation (2) () () (8) (1) (12) (1) (1) Exhibit 11: Statistical inferences (pair-wise correlation) Household term deposits (% YoY) WNDR WRDR ERDR Contemporaneous.992* With a one-year lag.1** (.1) Contemporaneous.812*.13 NA With a one-year lag.81* (.11) NA Contemporaneous With a one-year lag (.9) * Significant at 1% ** Significant at % Interest Rate & Household Savings-Thematic Report

6 Conclusion: Limited room to cut policy rate The objective of this report was to understand the importance of interest rate on the savings behaviour of households. Although the demand for interest rate cut by the corporate sector is pervasive, its impact on households is rarely discussed, let alone understood. Shift physical savings into financial savings: As discussed earlier in this report, households account for ~7% of total domestic savings in the economy, and thus it is important to ensure their growth, as a portion of their savings - net financial savings (NFS) - finance domestic investments. In the past few years, households have shifted away from NFS to physical savings, which has reduced the efficiency of total investments in the country, leading to lower GDP growth. Thus, it is imperative to encourage financial savings. Nominal deposit rates matter for household savings...: A look at households GFS shows that deposits account for ~%, insurance and pension funds comprise another 3%, while equities account for less than %. Our analysis reveals, in post-liberalisation period, nominal deposit rate (which is closely linked with repo rate), rather than real rate, is highly correlated with households deposit growth....but higher inflation makes real rate relevant: Nevertheless, in the most recent period (post 8), real rates based on Consumer Price Index or CPI and expected inflation - emerge more important than nominal deposit rate. One possible explanation is high inflation, which turned households more careful. Unfortunately, we have limited data observations which demands caution. Further, although the correlation coefficient of deposit growth with real rate is high, it is statistically insignificant. Nevertheless, even if we accept this analysis in its entirety, it implies that as inflation eases in the future, nominal rate will become more important. RBI has limited room to cut repo rate: Overall, the importance of nominal deposit rate cannot be ruled out. Even if high inflation has made real rate more relevant, with inflation moving to lower trajectory, nominal rate could once again turn more important. This is what makes us believe that the central bank has limited room to cut repo rate from the current level of 7.2%. We believe there is scope for one more rate cut to 7.% in 1. Later on, there is not much possibility of a rate cut in 17 at best, the repo rate can be reduced to.% by March 217. Interest Rate & Household Savings-Thematic Report

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