Suresh Krishnamurthy



into small savings and term deposits continue


mutual funds make more sense


evasion makes risk-free securities attractive


for tax deduction at source on interest


need equities, mutual funds and insurance plans

By nature, most Indians seem to like to see themselves as striving against odds, living within their means, sacrificing comforts and saving regularly. These, perhaps, are qualities that small savings and bank term deposits reinforce in the Indian psyche, which is why an investor feels safe opting for these schemes .

This explanation becomes necessary because of the unending allure of small savings and term deposits. Even after relentless changes in policies that have considerably eroded their attractiveness, the quintessential Indian sees something special in these instruments, which account for nearly 60 per cent of the annual savings by households. The inflows this financial year too have been robust.

This investment pattern is also significant for the economy. Only the rapid growth in term deposits has helped banks manage the robust growth in credit. Otherwise, interest rates would have shot up sharply. Similarly, State governments may be forced to borrow at markedly higher rates from the market if not for the inflows into small savings schemes.

Eroding efficiency

About this time last year, the Finance Minister enhanced the relative tax efficiency of instruments other than small savings and term deposits. Entire income from these instruments will need to be offered for tax. In addition, yields on these instruments have declined sharply over the past five years. Investors, though, have been undeterred.

According to the RBI, small savings receipts in the first nine months of the present financial rose 11.2 per cent. Deposit growth of banks has been placed at an impressive 17.3 per cent. In contrast to the remarkable inflows, the case for investing in small savings or term deposits is rather weak. Debt mutual funds would prove more tax-efficient and offer better convenience in terms of liquidity. Changes in taxation have had but little impact. Investments in National Savings Certificate have increased 4.3 per cent even after a sharp decline in their yield. Investments in Post Office Monthly Income Scheme have risen only by about one per cent. There is, however, a sharp increase in deposits under Senior Citizen Savings Scheme and Kisan Vikas Patra.

There are other reasons, too, for the continuing popularity of these instruments. One is the network of bank branches and post-offices. Distribution of other financial products is only now penetrating into Tier-2 cities. Another explanation could be tax evasion. If no tax were to be paid, returns from these instruments would be superior to debt mutual funds. There is probably a case for introduction of tax deduction at source (TDS) on interest from post-office schemes.

Household savings

There is one more explanation for the continuing popularity of these almost risk-free investments the household saving pattern. A little more than 50 per cent of annual household investments are made in physical assets predominantly real estate and a small portion in gold. Now, real estate investment fetches high returns most investors have been able to get low double-digit returns per annum. It is also highly risky.

To balance these risky investments in real estate, conservative allocation to risk-free instruments becomes necessary, especially if you are not going to pay tax on the interest income. This is probably why household investors prefer debt to equity.

Going forward, however, there is a case for investing in riskier financial assets such as stocks, in lieu of investments in physical assets. Continuing heavy investments in physical assets would only pull down returns from that segment.

Although the expected returns from financial assets are low, they would offer the benefits of diversification for the Indian investor, whose portfolio is now heavily loaded with real estate.

There is also a strong case for investing in debt mutual funds because of their tax efficiency. The environment is now strongly in favour of financial assets such as stocks, mutual funds and insurance plans. It is only a matter of time before the savvy Indian householder switches allocations. Its impact on the economy would, however, work itself out in unpredictable ways.

There will be some losers and some gainers but the effects would be most interesting to watch for.

(This article was published in the Business Line print edition dated March 26, 2006)
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