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Posted by: Deepa Vasudevan and Uma Shashikant on Wed, Jan 20th, 2016

The Importance of Small Savings

News reports suggest that interest rates on government’s small savings schemes may be reduced soon. This will be welcomed by banks, who often complain that the high rates paid on small savings schemes make it difficult to cut interest rates on bank deposits.  When banks are unable to reduce deposit rates, it reduces the  cascading benefits of the easy money policy of RBI,  as banks are forced to hold lending rates (rather than cut them) to protect their interest margins.

 

Poor monetary transmission was the story of 2015: the RBI has dropped its policy repo rate by 75 bps between April and December 2015; but bank lending rates have fallen by 35 bps only. One of the reasons for ineffective pass through of rate cuts is the rigidity in small savings rates. Rates on small savings are announced by the government at the start of the financial year, and they do not change until the start of the next year.

 

Since small savings rates do not respond flexibly to market factors, they tend to distort credit spreads in the market. Note the extremely high rate on the one-year Post Office Time Deposit (a popular short term small savings scheme) relative to other comparable assets as of December 2015. The other rates were not so remarkably low when the post office deposit rates were announced in early 2015 (See Pic below).

 

Comparable 1 year Interest Rates

A one year bank deposit pays 7%-7.25%; and the one year g-sec offered a slightly higher yield in December 2015. But a one year post office time deposit- despite being government guaranteed and therefore safer in nature- offers a stunning 8.4%, or over 1% higher than the bank deposit and g-sec, and even higher than the yield on a AAA corporate bond of the same maturity!  

 

A three year bank deposit offers an interest rate of 7% to 7.5%, but the post office deposit rate, at 8.4%, is nearly 100 bps higher.  Small savings schemes with five years and above are even more favoured, because some of them are eligible for tax deductions under section 80C. For 2015-16, the 5 year PO deposit and Kisan Vikas Patra offered 8.5%, the Public Provident Fund pays 8.7%, the Senior Citizen’s Savings Scheme 9.3% and the Sukanya Samriddhi Scheme offers 9.2%. A five year bank deposit will return 7 to 7.25% only. Even without taking into account the tax advantages, the rates on 5-year small savings are nearly 150 bps higher than comparable bank fixed deposits!

 

However, despite the higher rate, it is interesting to note that inflows into small savings increased by merely Rs.332 billion  in 2015 as against the Rs.8277 billion that banks garnered in deposits in the same year. Even if a cut in small savings rate were to shift Rs.100 billion from small savings to bank deposits, the addition to bank deposits would be barely noticeable. However, if deposit rates are cut too far below the rates on small savings schemes, banks run the risk of losing deposits to those schemes. The significance of small saving schemes, therefore, is not in terms of the potential to garner more deposits, but due to the artificial floor that has been created by the high rates. This is also a distortion to the yield curve, and hurts the pricing of debt in the markets.

 

The government proposes to introduce two key improvements. First, rates on small savings will be reset on a quarterly, rather than annual basis. More frequent changes in small savings rates will allow a better transmission of changes in the policy rate throughout the system. Second, rates on small savings instruments are presently set at a spread of 25 bps over the corresponding g-sec rate; and there is a probability that the spread may be reduced.[1] For instance, if the spread is lowered to, say, 20 bps, then the interest rate on the one-year PO time deposit should drop 90bps to 7.5% (based on average yields for December 2015).

 

The chief beneficiaries of the proposed cut in small savings rates will be banks and the government. Banks will have more freedom to lower rates and price them according to the demand and supply of funds. The government will have to pay lesser interest on its small savings liabilities. Borrowers from the retail market such as issuers of infrastructure bonds and other retail bonds, will not have to contend with the artificial floor created by the high small saving rate.

 

As for the small saver- the households- they will earn less interest, but as long as inflation remains benign, the real interest rate will be positive.  To reform the small savings system, then, appears to be a win-win situation for all economic agents.



[1] The exceptions are the 10-year NSC and the Senior Citizen’s Savings Scheme, where the spreads are usually higher. Newspaper reports quote senior finance ministry officials stating that the spread will not be changed for the Senior Citizen’s Scheme or Sukanya Samriddhi Scheme. For example see this source: http://indianexpress.com/article/business/small-savings-rates-set-to-fall-more-than-50-bps/

 

Sadashiv Potadar on Fri, Jan 22nd, 2016 8:16:34 pm

India has a better per capita savings rate in the world. We must make those unfortunate illiterates fully aware of the policy changes as they are affected most. The Central Government has been unable to control on a priority basis, the menace of chit funds and allied schemes, where these people fall prey and lose their valuable savings.

Nagesh K on Fri, Jan 22nd, 2016 2:01:42 am

Banks want interest rates on Small Savings to be reduced.But when Bank interest rates were more than Small Savings rates, Banks were getting deposits but they did not complain. What about high NPA's.

Harshil Roy on Thu, Jan 21st, 2016 8:20:09 am

This is a nice article but this disparity is going to be there. As you can see in the graph, the FD rate is less than G-sec yield. Now as per small savings rate mechanism rate on small savings schemes will be higher by 25 bps except two : for 10 year NSC it will be 50 bps and SCSS it will be 100 bps. So, if rates needs to be aligned with other instruments then the rate setting mechanism needs to be revised.

Jay Thakkar on Wed, Jan 20th, 2016 10:49:13 pm

Time and again you update us for Financial information.Your articles are very useful. Jay Thakkar

DB DESAI on Wed, Jan 20th, 2016 8:39:50 pm

I have not ready the article fully. I feel the rates should have been aligned to economic reality long back. There may be some concessions for certain category of investors upto a limit. All should be made to understand the reality. This will also help the mutual fund industry to get some new investors.

aruna sivakumar on Wed, Jan 20th, 2016 4:16:20 pm

the rates should remain the same and the agents should be compensated for mobilising senior citizens scheme as this is the only one which is highest now

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