Understanding The Relationship Between Interest Rates And FD Rates In India

The Reserve Bank of India's (RBI) three-day Monetary Policy Committee meeting will conclude on Friday. The wider market expectation is that the central bank will keep its repo rate unchanged at 6.5% this time also. However, this is just the market consensus, in this article we will discuss how any hike or cut in interest rates impacts Fixed Deposit rates in India.

Mostly it is seen that when the repo rate rises, FD interest rates follow suit, and vice versa. Usually when the repo rate increases both Banks as well as Non-Banking Financial Companies (NBFCs) also raise the interest rates they offer on Fixed Deposits (FDs).

Interest rates on FDs have jumped significantly in the last year, all thanks to the repo rate hike by 250 basis points (bps) since May last year. The central bank has increased interest rates by 250 basis points (bps) in just a 10-month period ending in February 2023. If the RBI continues to maintain the status quo on the repo rate this time also, then this will be the third time when the central bank will keep interest rates unchanged.

In this scenario, the three back-to-back pauses in repo rate hikes and the withdrawal of Rs 2,000 notes from circulation in June 2023, are expected to put a hold on rising FD interest rates.

Recently, in its report titled 'State Of The Economy,' the RBI said that there has been an increase in the share of term deposits offering 7% and above returns in the recent period. As a result, the growth of term deposits picked up while savings deposits decelerated, reflecting the relative attractiveness of term deposits in an increasing interest rate environment.

Fixed deposits with longer tenures are more affected by changes in interest rates than those with shorter tenures. This is because the longer the tenure, the more time the deposit is exposed to changes in interest rates.
In response to the 250 bps hike in the policy repo rate since May 2022, 32 domestic banks have revised their repo-linked external benchmark-based lending rates (EBLRs) upwards by a similar magnitude. The 1-year median marginal cost of funds-based lending rates (MCLRs) of SCBs increased by 155 bps from May 2022 to August 2023. Concomitantly, the weighted average lending rates (WALRs) on fresh and outstanding rupee loans increased by 193 bps and 112 bps, respectively, during the period May 2022 - July 2023. On the deposit side, the weighted average domestic term deposit rates (WADTDR) on fresh and outstanding deposits increased to 232 bps and 151 bps, respectively, during the same period. During July 2023, the SCBs increased their WALR on fresh rupee loans by 24 bps, whereas the WADTDR on fresh deposits remained broadly unchanged.

How has the Withdrawal of Rs 2,000 notes impacted FD rates?

The RBI decision to withdraw the highest denominations Rs 2,000 notes from circulation has also impacted the interest rates of fixed deposits. The move to withdraw Rs 2,000 notes from circulation was expected to add a sizeable quantum to the overall liquidity in the banking system.

Later to absorb excess liquidity from the banking system following the withdrawal of the Rs 2,000 currency notes, the Reserve Bank of India (RBI) announced the discontinuation of the Incremental Cash Reserve Ratio (I-CRR) on September 8 in a phased manner to manage the system liquidity without disrupting the money markets. I-CRR, introduced on August 12, mandated banks to keep a 10% incremental cash reserve ratio as part of RBI's strategy to absorb excess liquidity from the banking system following the withdrawal of the Rs 2,000 currency notes.

In consonance with the strategy of calibrated withdrawal, surplus liquidity in the banking system moderated considerably since August 12, 2023, following the imposition of the incremental CRR (I-CRR) which impounded liquidity of about Rs 1.13 lakh crore from the banking system. Liquidity increased towards the end of the month and in early September in response to larger government spending but moderated thereafter.

The shrinkage in surplus liquidity was also reflected in overnight money market conditions. From August 17 to September 12, the weighted average call rate (WACR) firmed up and breached the ceiling of the LAF corridor on 5 occasions.

In the short term, liquidity conditions are expected to remain tight as the festive season will keep currency demand high.