What’s the truth behind India's low deposit growth?

“Introducing a Special Edition Fixed Deposit, offering high interest rates of 7.35%* p.a.…”

That’s a WhatsApp message I got from my bank this week.?

And when I turned to the news, I saw that my bank wasn’t alone in this fight. Because the headlines said, “Several Indian banks are increasing interest rates on fixed deposits to attract more customers…”

Looks like the battle for deposits is still on!

And I say ‘still’ because that has been the story of India’s banking system over the past year or so. There’s a mismatch – the credit growth rate is far higher than the deposit growth rate. Or on the face of it, it looks like people want to borrow money from banks but they’re not inclined to park money in the banks.

So the question on everyone’s mind is why aren’t deposits growing as quickly?

Well, the most common theory is that the mutual fund industry is to blame for the banks’ mess. Or rather, because bank deposit rates aren’t lucrative enough for people anymore, they’re using their new found awareness to invest into mutual funds via SIPs and they’re dabbling in stocks as well.?

Bankers are pointing out that this is the problem. And even the former RBI Governor Shaktikanta Das and the Finance Minister Nirmala Sitharaman have talked about this shift in investor behaviour that could turn into a problem for banks.?

Seems to make sense, right?

But hold on…not every one is buying into this perspective. Some folks such as Hitendra Dave, the CEO of HSBC’s India operations, call it an ‘oversimplified argument,’

"...because even the mutual fund buys something, that is sold by somebody, so that liquidity comes back into the system. So, I think it would be a good idea to actually do a study as to what typically causes deposit creation. And I think unless, because if we keep blaming SIPs or mutual funds, we might be solving the wrong problem, in my sense."?

So, the counter argument by Mr Dave and others here is that if you buy a stock, the money simply changes hands between you and the seller. Your bank account is debited, their bank account is credited. So in effect, the flows into the capital markets stay within the banking system.

That means, it shouldn’t hurt the overall ‘deposit’ base either. So maybe blaming mutual funds and stocks is an easy argument but not the right one.?

So, what gives??

Well, at an individual level, banks will need deposits to ensure that they’re about to meet the needs of those who come asking for loans. Because the long standing theory is that banks function by raising deposits, keep a bit as reserves for emergencies, and then lend out the rest to those who want to borrow. But on an aggregate or system wide level, there could be a couple of other factors at play that’s hurting the growth of deposits.

1. It’s the RBI.?

See, to put it very simplistically, one way in which aggregate deposits in the economy are created is when the RBI injects money and increases what’s called the ‘reserve money’. But as analysts at Nomura pointed out, the RBI has significantly tightened its supply of money. During FY23 and FY24, the cumulative net fresh money created by the RBI was just ?0.6 lakh crore when compared to the massive ?20 lakh crore it created during FY20 to FY22.?

And as the image shows, the fresh money created by the RBI in relation to the bank deposits was far below the 20-year average.?

So if the RBI doesn’t create fresh money in the same manner as before, that hurts the growth in deposits. And as the folks at Nomura put it,

“The banking system cannot be held accountable [regarding slow deposit growth] for this discretionary call by RBI to moderate money supply.”

2. It’s the government.

See, banks buy government bonds from the RBI. And the money goes out of the banking system when this occurs. The only way it comes back in the form of deposits again is when the government spends this money. It might spend it on infra development which means it goes into the bank account of some construction company.?

But, as Ashish Gupta, the CIO of Axis Asset Management, recently highlighted, the share of government deposits in the banking system has dropped from 14% to 9%.??

Now this could be because the government is practicing a ‘Just in Time (JIT) model’ to improve how effectively it manages its cash. So it keeps a higher balance with the RBI and a lower balance with banks.?

But also, it means that if there is a slowdown in government spending as we’ve seen in the recent past, it could hurt the aggregate deposit creation too.??

So yeah, there’s definitely more than what meets the eye when it comes to the actions of the RBI and the government in this whole debate of bank deposits. And maybe as Hitendra Dave said, we might be solving the wrong problem if we lay all the blame at the doors of mutual funds and stocks.?

What do you think?