Explained: Are rising FD rates ending, and what should investors do?

The withdrawal of the Rs 2,000 note will likely result in a spurt in liquidity. How are the subsequent changes likely to impact you? Read more to find out

New Delhi: As banks have started accepting Rs 2,000 notes now that the currency has been withdrawn from circulation, the higher deposit base is likely to result in a temporary spurt in liquidity, which means the era of rising fixed deposit rates may be ending soon. Even the Reserve Bank of India's Monetary Policy Committee (MPC) will likely keep rates unchanged this week, as inflation has moderated  into the RBI's tolerance band.

Most Rs 2,000 notes are likely to be initially deposited with banks and are expected to improve the deposit base, which in turn will improve the system liquidity. Even the notes that are not directly deposited into banks could move to high-value spends such as gold or jewellery, high-end consumer durables, and real estate (which then reaches bank deposits), according to  Kotak Mahindra Bank economist Upasna Bhardwaj.

 

"We expect the domestic banking system liquidity to remain flush with the RBI's decision to withdraw Rs 2,000 notes, the recent variable rate repo auction, and our view of a flat balance of payments this year. Given this, and with considerable uncertainty around the commodity prices path and global growth, the RBI is likely to retain the liquidity tightening stance, as signalled by the comment that the MPC will "remain focused on the withdrawal of accommodation", said Santanu Sengupta, an economist at Goldman Sachs.

Let's first understand how changes in repo rates and the economy's liquidity situation impact your bank deposit rates:

Deposit rates are linked to the rate of inflation: These rates inch up or go down depending on inflation. The Reserve Bank of India (RBI) loans money to commercial banks for a brief period at an interest rate called the repo rate. The increase in repo rate increases bank loan interest, which staggers credit retail. The interest rates on fixed deposits increase if repo rates are increased. However, some banks do not increase the deposit rate despite negative returns from the rising inflation, as that can affect the bank's bottom line.

The liquidity situation: With adequate liquidity, banks do not have to focus on retail fixed deposits for their needs as opposed to times of tight liquidity when banks have to turn to their own deposits.

"Deposit rates usually rise when banks face liquidity challenges but tend to fall when the challenges subside. Several factors, such as the repo rate, interbank lending rates, deposit growth, credit growth, inflation, and the domestic economy can help us determine whether liquidity challenges being faced by banks in India are subsiding," said Adhil Shetty, CEO of BankBazaar.

As per RBI data, the total value of Rs 2,000 notes in the system is Rs 3.62 trillion. "Notes of Rs 1 to Rs 1.5 trillion will come back into the system as deposits," according to Axis Bank chief economist Saugata Bhattacharya. He believes this should take the overall deposit growth to over 11 per cent in FY24.

A note by Axis MF states that due to the withdrawal of notes, deposits with banks would increase in the near term to a tune of around Rs 1.5 to 2 trillion (net of exchange), which will lead to a fall in certificates of deposits (CD) issuances and deposit rates of banks. "Rates for the short end of the curve up to 3 years can fall by 20-30 bps as along with this liquidity surplus we are also near the peak of interest rate cycle and can expect cuts in the last quarter of this FY," it said.

Even State Bank of India's chief economic adviser Soumya Kanti Ghosh expects almost the entire amount of Rs 3.6 trillion to return to the banking system. "The decline in currency in circulation or the consequent increase in banking liquidity will ensure that there is no immediate need for CRR cut," said Ghosh.

Short-tenor deposits likely to be impacted more 

"The recent de-recognition of the Rs.2000 currency note as well as a surge in FPI /forex  inflows in the month of May is likely to have aided in easing the overall liquidity conditions and a cooling off in the short-term rates in recent weeks. Some of this could rub-off on bank deposits although the impact of this will be higher for shorter tenor deposits as opposed to longer ternor deposits," said  Aashay Choksey, Vice President & Sector Head- Financial Sector Ratings, Icra.

Banks have already begun reducing FD rates

Public sector bank, Punjab National Bank (PNB), has already revised its interest rates on fixed deposits of less than Rs 2 crore. The bank has cut the interest rate on one-year deposits by five basis points (bps). The fixed deposit schemes will fetch an interest rate of 6.75 per cent from June 1, 2023, as opposed to 6.80 per cent earlier.

In May, the bank decreased the interest rate on FDs maturing in 666 days to 7.05 per cent from 7.25 per cent. For the schemes for senior citizens, the bank has slashed the interest rate by five bps on deposits maturing in 1 year to 7.25 per cent from 7.30 per cent.

Private sector bank Axis Bank has also cut its fixed deposit interest rate on select tenures by up to 20 basis points. On deposits maturing in one year five days to less than 13 months, the interest rate has been slashed to 6.80 per cent from 7.10 per cent earlier, a reduction of 20 bps. On deposits of 13 months and less than two years, the bank will offer 7.10 per cent interest from the earlier 7.15 per cent. These changes became applicable from May 18, 2023.

The rising rate cycle will be paused

Since May 2022, the repo rate has been hiked by 250 basis points, and banks have also increased the interest rates of fixed deposits during this period, but at a slower pace. In April, RBI kept the repo unchanged at 6.5 per cent, which is likely to continue in this week's policy meet too.

"Lending costs and availability of liquidity can lead to a rise and fall in fixed deposit (FD) interest rates. FD interest rates are close to peaking in the current cycle of interest rate hikes. Most banks are now offering above 7 per cent to regular customers, while senior citizens can get over 8 per cent on FDs. These rates are a vast improvement from what FDs were offering last year.... Certain recent events such as withdrawal of Rs.2000 banknote, a pause on repo rate hikes by the RBI, lowering inflation, and economic growth are all indicators that higher fixed deposit rates may not last long. Thus, in the likely event of high liquidity, banks may soon start decreasing their FD rates," said Adhil Shetty, BankBazaar's CEO.

So, what should you do if the FD rates change?

For fixed deposit investments, it is always advisable to align your investment based on interest rate trends.

When the fixed deposit interest rates rise, it is across all tenures. Long-term FDs see a greater interest rate increase than short-term FDs.

When FD rates are high, opt for a longer tenure, but when interest rates drop, choose a shorter tenure for locking your funds, said Shetty.

"You can ladder your FD by breaking a large deposit into small parts of different time gaps. This will help you gain periodic liquidity while taking advantage of the volatility in the interest rate. This will give investors better returns when they reinvest for longer terms," explains Bank of Baroda.

What is laddering? 

Bank FD laddering is a strategy where you can spread your fixed deposit investments across different maturities to maximise returns and maintain liquidity

For example, Shivani has Rs 5 lakh in her savings account. She could make a single deposit with it. But she will have to lock it into one tenure at one rate. This would mean low returns. On the other hand, with laddering, Shivani splits the money into five deposits at different rates. Each deposit will renew at different intervals of one, two, three, four and five years. It will ensure better average returns. For example, the one-year deposit will return 4.5 per cent. The two- and three-year deposits will return 5 per cent. And the others will return 5.7 per cent.

"With  laddering, one deposit will mature each year. She can put it to its intended use, such as paying for her daughter's college fees etc. She could also choose to renew the deposit at the prevalent rate, which would hopefully be higher. The thumb rule is - when the rates are high, go for longer tenures with your deposits. When they are low, ladder them and wait for higher returns," said Shetty.