Your money – FD Floating Rate: Is it a good idea?

By Hemanth Gorur

Next to gold, Fixed Deposits (FD) are favorites of investors across India. Security of investments and predictability of income are two reasons that have appealed to investors. However, FD interest rates have remained subdued over the past few years. In a rising interest rate environment, floating rate FDs seem to offer the possibility of higher returns as well as security and predictability. However, this must be viewed in the context of deposit rate drivers.

What is driving the movement of deposit rates?
Movements in key interest rates in the economy are one of the main drivers of lending rates and, to a lesser extent, deposit rates. The repo rate – the rate at which the Reserve Bank of India (RBI) lends to all banks – is one of the main interest rates in the Indian economy. The RBI resorts to repo rate cuts when needed to stimulate economic activity and raises the repo rate when inflation threatens to soar beyond its comfort levels.

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As a general rule, the transmission of movement from repo rates to lending rates is faster and higher than that to deposit rates. This is because each bank will try to keep its lending rate as high as possible and its deposit rates as low as possible in order to increase its net interest margin (NIM). The second factor in the movement of deposit rates in any bank is the credit-to-deposit (CD) ratio of the bank. It is the ratio of total bank credit to its aggregate deposits.

If this ratio is low, it means the bank has more room to lend and less room to take deposits, which in turn may keep its lending and deposit rates down. The third factor is the extent to which a bank’s loans are tied to the repo rate. The higher this percentage is in a scenario of rising interest rates, the more room it has to allow its deposit rates to increase while protecting its profitability.

Evolution of key interest rates and inflation
Due to global supply shocks, inflation has remained above target levels over the past six months and well above the RBI’s 6% comfort zone. In its latest announcement, the RBI maintained its inflation projection at 6.7% for this year, and indicated that inflation could approach its peak. The RBI has raised the repo rate three times in the past three months, raising it by 1.4%. With this frontloading of monetary policy bringing the repo rate to 5.4%, the central bank expressed its confidence in controlling inflation.

Can variable rate FDs help in the current situation?
Lending and lending rates may continue to grow alongside rising repo rates, but not at the same pace as the repo rate. Banks’ CD ratios have fallen from around 78% in March 2019 to around 72% in March 2022. Struggling with lower CD ratios, most banks are trying to increase their loan portfolios and believe that demand loans may not decrease. Coupled with competitive pressure, there may therefore be a lower than normal increase in lending rates, and therefore also in deposit rates.

Furthermore, according to an RBI report from March this year, foreign banks have around 74% of their loans linked to the repo rate, while private banks have around 61%, so they are more likely to have higher increases in their deposit rates than the public sector. banks, which are only about 33% tied. So variable rate FDs can help in the current situation, but to a limited extent. Investors can wait for global supply shocks to subside and buy competitive deposit rates from banks with higher CD ratios and a link between the lending rate and the repo rate.

The writer is the founder, Hermoneytalks.com

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