India’s growing deposit shortage is beginning to cause concern among bankers and policymakers alike. The lenders’ anxiety is more justified than that of the authorities.
Drawing inspiration from a two-decade-old Chinese strategy, the central bank is tightening the money supply to curb inflation. However, this approach is inadvertently creating a new obstacle for credit and investment. Meanwhile, the government is exacerbating the deposit shortage by heavily taxing savers and keeping the revenue out of the financial system. Bankers are also contributing to the issue by offering insufficient returns to savers.
Yet, it’s the behavior of the lenders that is under scrutiny. The finance ministry is urging banks to launch special campaigns to attract household savings, while the Reserve Bank of India has cautioned them about the potential risk of “structural liquidity issues.” One emerging concern is technology. The RBI has advised banks to assume that any account linked to a smartphone is more susceptible to rapid deposit withdrawals.
Starting next year, banks in India will be required to hold more secure assets, such as cash and government securities, to mitigate the risk of withdrawals from internet-enabled accounts. While this measure could potentially slow down credit growth across the banking system, certain lenders facing a liquidity crunch will need to take additional steps to manage their situation. For instance, HDFC Bank Ltd., India’s largest private bank, is planning to sell 100 billion rupees ($1.2 billion) of its loans to reduce its loans-to-deposit ratio, which has remained above 100% for four consecutive quarters.
Beyond concerns about technology, the Reserve Bank of India (RBI) is more troubled by what it sees as excessive risk-taking. For over two years, credit growth has outpaced deposit growth, with retail interest in the stock market surging during this period. As RBI Governor Shaktikanta Das pointed out in July, households that traditionally relied on banks to save or invest their money are increasingly turning to capital markets and other financial intermediaries.
However, this explanation doesn’t fully address the issue. When a bank account is debited to purchase securities, the seller’s account is credited, keeping the money within the banking system. Although the distribution of funds among banks might shift, and the composition of deposits may change, the overall amount of money doesn’t leave the system, except for withdrawals at ATMs. Moreover, the use of cash in transactions is declining.
Loans inherently generate their own deposits. For example, a new mortgage will eventually be credited to the property seller’s account. While loans for foreign education or buy-now-pay-later credit used to purchase imported goods might cause funds to exit the local banking system, these scenarios don’t lead to a sustained deposit shortfall. A more significant drain likely stems from taxes that are held in the government’s account with the central bank. This is why state-run banks are urging New Delhi to allocate its funds in ways that can be reintroduced into the banking system.
The Reserve Bank of India (RBI) may have inadvertently contributed to the deposit shortage by slowing down its money supply. The overall sum of the RBI’s liabilities—such as currency held by the public and the reserves banks maintain in their accounts with the central bank—expanded 2.3 percentage points slower than the 9.7% growth in nominal gross domestic product during the June quarter. Last month, the rate of money creation plummeted to below 4%.
This is unusual. Typically, the central bank’s monetary base, often referred to as high-powered money because it drives credit growth, tends to outpace GDP growth. Notable exceptions to this trend in recent years include the 2013 taper tantrum and the sudden demonetization in 2016 that eliminated 86% of the currency in circulation.
In China, restricting the monetary base was more of an intentional strategy in economic management than an oversight. Following Beijing’s 2001 entry into the World Trade Organization, the subsequent investment boom could have led to a current account deficit by depleting domestic savings. However, China continued to amass higher surpluses.
In a 2007 study, Michael Mussa, a former chief economist at the International Monetary Fund, identified the central bank’s balance sheet as the key to understanding this phenomenon.
Central banks in developed economies with floating exchange rates typically purchase government securities to inject new money into the system. However, this can lead to inflation, necessitating higher interest rates to curb demand. China, on the other hand, aimed to run its economy at full throttle, maintaining an undervalued currency to boost its export competitiveness. Instead of buying bonds, the People’s Bank of China (PBOC) accumulated incoming dollars. Since purchasing dollars from banks increased the yuan supply, the PBOC then absorbed some of that liquidity to prevent inflation.
By tightly controlling the monetary base, particularly between 2004 and 2006, the PBOC limited households’ purchasing power, which would have otherwise surged with rapid economic growth. This forced households to save more at low, state-regulated deposit interest rates. Through this engineered increase in national savings, China was able to self-fund its growing appetite for investments.
Does India have a similar plan in mind? The goal of Prime Minister Narendra Modi is well known: to set the economy on a Chinese-style, investment-led growth trajectory. 60% of India’s GDP currently comes from private final consumer spending. Fifty years ago, that figure was about eighty percent. That said, the percentage of output that is invested in is still approximately 31%.
While China’s capital formation rate peaked at 45% in 2013, Modi’s goal might be to elevate India’s investment-to-GDP ratio to 36%, a high reached before the 2008-09 Global Financial Crisis. That post-crisis recovery was short-lived, ending abruptly in 2013 as domestic savings were depleted and foreign investors hesitated to fund India’s substantial current-account deficits.
Since then, the current account has stabilized, and banks are now well-capitalized, unlike a decade ago. However, a new challenge may be emerging. The current deposit shortage among lenders could act as a brake on credit-driven investment—unless authorities devise innovative methods to keep banks liquid while controlling money creation.