Interest rates are on their way around the world. In this environment, many economists, analysts and fund managers have cast doubt on the effectiveness of monetary policy in controlling inflation. The same enthusiasm to question its effectiveness was missing in early 2020 when interest rates were coming down in the aftermath of the Covid pandemic. Given that monetary policy is hardly a science, this lack of balance is surprising.
The world is currently facing the side effects of dovish monetary policies being run by central banks since the beginning of 2020. The crypto bubble continues to burst. And so burst real-estate bubbles all over the world. In all this, the stock market survived to a great extent.
The low interest rate environment following the Covid outbreak changed the incentives that affect how people invest their savings. Let us look at it in the Indian context. Data from the Reserve Bank of India (RBI) tells us that nearly two-fifths of incremental financial savings in 2020-21 were invested in fixed deposits.
In 2021-22, the incremental proportion of investments in deposits fell to a little over 27%. The main reason for this was falling interest rates on fixed deposits. The weighted average interest rate on fixed deposits was 6.38% in 2019-20. It had fallen to 5.03% in 2021-22.
This encouraged people to look at other avenues of investment with higher risk than usual. In 2020-21, only 2% of the total proportion of incremental financial savings went to mutual funds. The other 1.2% went directly into buying the stock. In 2021-22, these increased to 6.3% and 1.9% respectively.
This tells us that people bought more stocks (directly and indirectly) in search of higher returns. It is also worth remembering that the stock prices peaked around October 2021. Therefore, a significant amount of money invested in stocks was invested before, around, and after the peak of stock prices. This, as anyone who understands the basics of investing will tell you, is not the best way to go about it.
Therefore, short to medium term risk has increased when it comes to household balance sheets. It didn’t matter until now, given that stock prices have remained strong. But even with this, it is not necessarily a good thing for the economy as a whole.
There have also been other changes in the way people invest. In 2020-21, about 8.9% of the incremental savings were invested in small savings schemes (excluding Public Provident Fund or PPF). This increased to 13.3% in 2021-22. Further, in 2020-21, 17.3% of financial savings were invested in pension and provident funds (including PPF). This increased to 22.7% in 2021-22.
The explanation for this is simple. The rate of interest on various Government Provident Fund, PPF and small savings schemes was and is higher than that of fixed deposits. In 2021-22, the interest rate on PPF was 7.1%, while an investor got 5.03% from a fixed deposit. Senior Citizens Savings Scheme and Sukanya Samriddhi Yojana offered even more, at 7.4% and 7.6% respectively. This encouraged people to invest in such schemes.
What is the implication? Typically, when an investment manager runs an investment plan, the funds raised are invested in certain financial assets. The returns they make, after deducting fees and expenses, are shared with investors.
Small savings schemes are not run like this. The fresh money coming into these schemes in any given year is used to encash investments maturing in that year. What is left goes directly into the budget of the central government and is used to finance the fiscal deficit.
This means that the money that has been invested in small savings schemes post-Covid will have to be redeemed in the years to come. Given that the redemption is done through fresh funds, the government needs to ensure that more and more funds keep coming into small savings schemes in the years to come. The only way to ensure this is to offer a higher rate of interest than fixed deposits.
This only adds to the pyramid nature of these government-backed schemes. Furthermore, in a dovish monetary policy environment, it limits banks’ ability to lower interest rates as much as the RBI wants them to.
Also, higher savings through Provident Fund (other than Public Provident Fund) also means higher government payments in the coming years. In such a situation, the liability of the government increases.
This does not mean that central banks should not have cut interest rates when Covid hit. not at all. But he should have made an effort to communicate the unintended consequences arising from overly flawed monetary policy. Take the case of the US Federal Reserve. It barely talked about the real-estate bubble it helped deflate after early 2020 while it was inflating. But now with the deflation of the bubble, the Fed is everywhere trying to take credit for it.
The same is true for many economists, analysts and fund managers, who have become cheerleaders for central banks to cut and maintain interest rates too low without talking about the risks involved. It is important to talk about the overall results of economic actions and not just profits.
Vivek Kaul is the author of ‘Bad Money’.
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