Some years ago, RBI Deputy Governor Rakesh Mohan opined that Indian banks were engaged in “lazy banking”.

At that time I disagreed with Rakesh because I felt that banks will do whatever is most profitable and if laziness meant making outsized profits by parking their money in safe deposits of government securities, then they will do so. Today, many years later, the banks are still practicing lazy banking, but their behavior can change if the RBI plays a positive role. If the repo rate is reduced to 3 percent (as it should) deposit rates can be expected to reach 4.5 percent. With a healthy 300 basis point spread, lending rates can approach 7.5 percent, a historical low. Think what that will do to India's economic growth, and less importantly, to the government's chances of reelection?

As I have documented in the past (too many times for anyone's liking) there is a curious aspect to the Indian economic System (defined as commentators, policy makers, and academicians). The System systematically thinks in a skewed fashion, and unlike any other System in the world. In particular, it is trigger happy to bring the economy to a screeching halt by raising interest rates, but asleep at the wheel when the economy is in desperate shape - e.g. confidence at historic lows, industrial growth at zero, and exports cliff diving.

With this asymmetry in mind, I want to make two points in this article. First, that with growth and inflation rates far below the RBI's target and expectations, the time is appropriate to bring monetary policy into sync with reality. Second, that the fear of the System that non-policy rates, in particular deposit rates, are sticky downwards appears to have little, if any, empirical foundation. It should be mentioned that some elements in the System (see Sahu-Virmani, Structure of the Household Sector Asset Portfolio in India, ICRIER Working Paper # 156, March 2005) reached the same conclusion some years ago.

Some facts: GDP growth has slowed down to somewhere around the 6 percent range for the quarter just ended, Oct-Dec 2008. This is considerably below all targets rates of non-inflationary growth of the System. Second, WPI inflation for this fiscal year has averaged just 2.8 percent on an unadjusted basis, and 2.1 percent on a seasonally adjusted (SA) basis. For the last 6 months the SA annualized rate of price inflation is -4.9 percent - yes, negative -5 percent. If historical relationship between the CPI, WPI and GDP deflator holds, then the GDP deflator should average around -3.7 percent for the last quarter. All these facts stare the System, in its face.

But the System cries out, including leading bankers: why should the government reduce interest rates, there is already so much liquidity sloshing around. This argument, like so many others, I do not fully comprehend. I had thought that there are two aspects to "liquidity" - the quantity and the price. While bankers have liquidity, the same cannot be said of the borrowers. For two reasons - first, given the reluctance of banks to lend (they get more brownie points from the regulators if they buy government securities than if they lend to India Inc) the borrowers are starved of funds at the prevailing (high) price of money. In addition, there is a long queue of borrowers for whom borrowing, and investing, would become more viable if interest rates were to be reduced from the astronomical (real) levels now prevailing in India.

The System refuses to give up. It counters with its second line of defense. We cannot reduce interest rates because the rupee will be under attack. Possible, but again counter to reality. The level of the rupee is affected by several factors only one of which is the interest rate differential with the US. In any case, the difference in savings deposit rates between the US and India increased markedly in recent months, and at the same time the rupee depreciated by some 20 points! If ever the simplistic hypothesis of increase interest rates to protect the currency failed, it was in recent months. Experts who have looked at this issue (both within and especially outside the System) contend that at least for the last twenty years, financial markets correlate economic growth with the strength of the currency. Which in today's world means that if we cut interest rates further, economic growth will be positively affected, and so will the rupee.

The System, like a leech, never wants to let go. So in recent weeks, it has started arguing that it is of no use to reduce policy rates (the repo and reverse repo) because such reduction will have a near zero impact on the rate that really matters in the economy - the deposit rate. If the deposit rate cannot be lowered, lending rate cannot be lowered. Hence, no reduction in borrowing rates and no impact on investment. And why can't the deposit rate be lowered? Because deposit rates are linked to "small savings" rates in the economy, rates that are politically controlled. With elections looming, it will be suicidal for the government to reduce deposit rates for widows and orphans.

There is some truth to the political argument, but not to much else. The logic of the System's argument is that if higher deposit rates are available with small savings deposits (SSD), the public will move their commercial bank deposits en masse to SSD.

There are four realities which need to have occurred in the past in order for the System's forecast of en masse movement to be even approximately correct. First, SSD should be a large part of total deposits. It is not. Latest estimates suggest that, at 129,000 crores, small savings deposits are less than 15 percent of total (bank + SSD) deposits. Second, the share of SSD deposits peaked at 26.6 percent in 1999. Third, rates on commercial bank deposits declined by 400 basis points during 2001 to 2005, a period during which small savings deposits share also declined by 4 percentage points - from 26.2 of the total to 22.9 percent. Fourth, the segment within small savings that carries the lowest rate of interest (post office time deposit rates today are 6.875 percent) is also the segment with the highest deposits - about 40 percent of total SSD. Further, this segment has shown a rate of growth of 19 percent, 2000 to 2008, compared to only a growth of 9 percent for all small savings deposits. Yeh to ulti ganga beh rahi hai - and that happens often when a reality check is imposed on the System's expert opinion.

Where can we expect deposit rates to go if the RBI aligns with reality and reduces the repo rate to 3 percent? The System has given all kinds of reasons for the deposit rates not going any further down from the elevated levels of 8.25 percent at present. Yet, three different methods, based on Indian experience over the last decade, suggest that the deposit rate can be expected to go down to 4 percent with the repo at 3 percent. Sounds implausible?

Method 1: Historically (for the 95 months from Nov. 2000 to Sept. 2008) the gap between deposit rates and the repo rate has stayed within a narrow corridor of -1.6 and 1 percent, with a mean of -0.2 percent. By this method, deposit rates can go down to 4 percent.

Method 2: Historically, the gap between the small savings and deposit rate has never exceeded 2.7 percentage points, a level last seen in March and April of 2004. At that time, the average small savings rate was 8 percent, and the deposit rate was 5.25 percent. Did not hear the System then complaining that the savings rate was a floor to deposit rates. At present, the weighted small savings rate is 7.43 percent; this yields a predicted deposit rate of (7.43 - 2.7) of 4.7 percent.

Method 3: The chart documents the predicted and actual deposit rates based on a model where deposit rates are a function of the repo rate, small savings rate, growth in real incomes, and inflation. The repo is by far the most important determinant - each 1 percent reduction in the repo leads to a 1.6 percentage point decline in the deposit rate. Note the close correspondence between the actual and predicted (the explanatory power of the model is over 95 percent). The two are twin rates, moving in tandem both on the way down and the way up. The predicted deposit rate for the 1st quarter of 2009 is between 3 and 4 .6 percent - the range is present because there are so many unknowns that can affect the rate - GDP growth, inflation, and the repo rate.

The System has no place to hide. Perhaps, being exposed, it will accept reality.

The gap in interest rates below is the difference between small savings rate and the average deposit rate