Reforming small savings

Interest rates should be linked to market outcomes

The government has lowered the interest rates for depositors in various government-run small savings schemes, including the National Savings Certificate (NSC) and Public Provident Fund, by 10 basis points for the July-September quarter. Savings deposit rates have, however, been maintained at 4 per cent annually. The NSC will now fetch an annual interest rate of 7.9 per cent from the existing rate of 8 per cent, while the Kisan Vikas Patra will yield 7.6 per cent with maturity of 113 months. The government deserves credit for this move towards rationalising the interest rate transmission mechanism, in line with the promise in its manifesto for the 2019 general elections to “structurally lower the real cost of capital”.

 
The Reserve Bank of India (RBI) has now cut the headline repo rate three times, by 25 basis points each time. Thus, the repo rate is now 5.75 per cent. But the benefits of these cuts have not been fully passed on to borrowers. Many banks have argued that they are seeing competitive pressures from small savings schemes. For small savers, the schemes provide super-normal returns, thanks to the administered interest rate regime they are under. Thus, many prefer them to bank deposits. This means that banks cannot allow the spread between the rates they offer depositors and the rates published for the small savings schemes to grow too great. If the banks are thus constrained to offer higher rates to depositors than they normally would, there is a floor under which they will struggle to go in the rates they offer borrowers in turn — regardless of how often or how much the central bank cuts the repo rate. This is a severe handicap when it comes to monetary policy transmission, and it is one that has been pointed out by the RBI often enough.

The latest cut in the rates available to depositors in the small savings schemes should only be a first step. Interest rates across different segments should be automatically set to align with market-determined rates, so as to ensure that monetary policy transmission occurs seamlessly. The point behind small savings schemes is to allow savers access to low-risk opportunities by depositing their savings with the government. In other words, the rates these small savers are offered should be in line with the yields on government bonds. Unfortunately, political considerations frequently mean that the administered interest rates do not reflect changes in the yields on government bonds, which are driven by market forces. For example, the decline in yields on g-secs in the months leading to the election was not reflected in a change in the administered interest rates.

 

That the cut is not enough is evident from the fact that while bonds yields are down about 40 bps in the relevant quarter, the cut in small savings rates is just 10 bps. The government should, as soon as possible, put in place a formula for determining the returns on small savings schemes that directly link those rates to the yields on government securities emerging from the secondary bond market. This will remove political pressures from decisions and allow for smooth and seamless monetary policy transmission.