The move, made after many years, follows hike in deposit rates by banks, rising bond yields, and two repo rate hikes by the Reserve Bank of India (RBI).
The government had kept the rates constant for two quarters, after reducing them by 20 bps in the January-March quarter. Schemes such as the Public Provident Fund, National Savings Certificate, and Kisan Vikas Patra will be affected.
"The government's decision (was) expected. It is a measure to align with the existing liquidity conditions and catch up with rising deposit rates of banks," said Rajeev Ahuja, executive director, RBL Bank.
The annual interest rate for PPF and NSC will now be 8 per cent, up from 7.6 per cent. KVP will give an interest of 7.7 per cent and mature in 112 months, against 7.3 per cent in 118 months earlier.
Annual interest on savings deposits has been retained at 4 per cent. Experts said the decision to hike rates is in line with the rise on the yield on government bonds. It pointed to an increasing rate environment.
"This will make small savings schemes more competitive. Banks might also increase interest rates, which have already increased mildly. Lending rates have also been rising slowly, especially with improving credit demand," said Prakash Agarwal, director and head, financial institutions, India Ratings.
This is, however, unlikely to lead to an immediate deposit rate hike by banks.
"Banks have been increasing deposit rates for some time now," said Ahuja, adding the function of small schemes and bank deposits were different. The former tend to be for small periods.
Asutosh Kumar Mishra, banking analyst with Reliance Securities, said only a little money from small savings schemes moves to banks, as they form very small portions of people's total savings and are cumbersome to operate.
"In the past, too, we saw that a difference between the rate on small savings schemes and bank deposits does not necessarily have a big effect on the latter," he said.
However, if the liquidity crunch continues, banks would have to spike interest rates.
"Credit growth is strong, but deposit growth is muted. If this situation continues, banks will need to raise deposit rates," said Ahuja.