The Hindu Business Line : Advantages of freeing EPF investment

IT IS indeed ironical that the interest on employees' provident fund (EPF) has been cut by one per cent at a time when the bond market was doggedly expecting a rate hike. The Government claims that it is still paying a higher rate on the EPF compared to the secondary bond yields. The two are, however, not comparable. The EPF is a long-term savings rate while secondary bond yields reflect the short-term interest rate view and the liquidity needs of bond investors. The comparison would be unfair even if the bond yields were smoothened, unless the term risk was clearly priced.

The Government forces such a comparison because it borrows in both the markets. The problem is that the interest rates on the EPF are not in line with the inflation levels in the economy. Moreover, investments by the EPF are regulated. This provides no scope for earning higher returns during a low interest-rate regime forcing rate cuts during such periods. It is best that the Government removes the restrictions on the EPF investments. Instead, a broad investment framework should be designed taking into account the varied risk preferences of the account-holders. This will also lead to development of the financial market.

Regulated investment: EPF account-holders at present are not exposed to market risks because they enjoy a fixed return on their contributions. The flip side is that these account-holders cannot earn a higher return when the market conditions are good. The problem does not end here. There is essentially no competition for long-term funds in the market. The Government appropriates these funds through regulations on investment by the EPF. As per the Employees' Provident Fund Association Web site, total assets amounted to Rs 1.10 lakh crore as on March 31, 2003. If the Government were to remove the restrictions on investments, the returns on EPF would be market determined. That is, the contributors can earn market or higher-than-market returns. The downside is that the account-holders will not enjoy assured return. Importantly, such a free-market structure could lead to a host of secondary benefits.

Financial market development: Portfolio management will be easier if the money managers classify employee accounts into various maturity-range buckets. This will help in fixing the investment horizon and free the money managers from worrying about intermediate gyrations in asset prices. Such investments may even bring stability to the market.

A case in point is the May 17 stock market crash. Asset prices tanked that day because there were only sellers and no buyers. If EPF money managers are value buyers, they may add stocks to their portfolio when the market crashes. Such a demand would provide a balance to the market and prevent severe asset price declines. It can work the other way too.

When asset prices are rich, the EPF money managers may want to sell pricey assets and move to cheaper ones. Such buy-sell strategies can ensure that asset prices do not wander far from their perceived intrinsic value. Of course, the EPF money managers will have to insist on high corporate governance from the companies they invest in. That will help in controlling risk on the equity portfolio.

Then, there is the bond market. At present, the demand for corporate bonds comes primarily from mutual funds. Since demand is small, the secondary market for corporate bonds is non-existent. If the EPF money flows into such bonds, construction of a primary corporate bond yield curve would be possible.

This could lead to the development of a term structure of credit spreads. Such a curve can help banks price such products as credit-default swaps and credit-spread options. It will also help credit-rating agencies track risk migration.

(Feedback can be sent to bvenky@thehindu.co.in)

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