Tweak the formula for small savings rates

The announcement relating to further lowering of the small savings rate did come as a shock to those who depend on fixed income for a living. This would have been a double-whammy as rates were lowered by 70-140 basis points (bps) last year and the new cuts were in the range of 90-110 bps.

This has been withdrawn which is good, but the reasons are unclear. This is important because if the withdrawal is due to the ongoing State elections there is a good chance that it could be invoked post July1 (this is often done for fuel prices when elections are on). Hence there is need to introspect.

Two sets of issues need to be discussed. The first is whether such a change was justified given the present scenario relating to interest rates and inflation. The second is whether the approach of determining these interest rates on small savings needs a review.

Small savings rates are supposed to be altered every quarter after a review. The fact that they were considered for April means that the immediate past should have had a bearing on the determination of interest rates. However, it has been observed that post the announcement of the Budget followed by the credit policy, yields on G-Secs have been going up. The reason is that the market got jittery on account of the large borrowing programme of the government — both Centre and States.

Also, with the economy likely to revive next year, demand for bank credit would be better.

Therefore, yields moved up and the projections for the 10-year paper was in the region of 6.5-7 per cent. Further, inflation has been moving upwards, which again means that there would be pressure on interest rates and the RBI would have to work hard to not increase the repo rate. Banks have actually been contemplating increasing interest rates on deposits. In this situation it did appear that the best case would be for no-change in rates.

Determination of rates

The second issue is more fundamental as it questions the basis of the determination of these interest rates. The small savings rates are linked to rates in the government securities market.

This would have been justified in case the rates here were truly market determined. The true cost of capital is based on demand and supply. When demand goes up, the price should increase. This is rudimentary economics. However, this has not happened in our context.

The RBI has ensured that rates are kept low by fine tuning the market with the most evident instrument being Operation Twist. Liquidity remains unchanged but the yield curve is pushed downwards. The very large liquidity infusions have kept interest rates artificially low, and that has helped borrowers a lot. In the process, savers find their income denuded as they are hit by the double-whammy of cumulative inflation and lower nominal returns.

We do need to de-link the small savings rates from the G-Sec market and look at alternatives. The problem in India is that there is too much control in pricing of financial instruments, be it currency, bonds/loans or farm products that the market forces do not reflect the underlying reality.

Even in terms of credit, by lowering the rates sharply, the scarcity of capital is not priced right, and lenders tend to mis-price risk which leads to a different set of problems like NPAs (non-performing assets).

What could be the options? The motivation of small savings is to reach out to the lower income groups, fixed income households including senior citizens, those seeking some kind of social security through PPF and non-sophisticated households.

The outstanding sum under small savings was ₹10.5 lakh crore which is less than 7 per cent of outstanding bank deposits. Therefore, the numbers being spoken of is not high. On an annual basis less than ₹1 lakh crore is added to these savings.

The options

Keeping this in mind the G-Sec market appeared to be a right fit when the committee worked out the formula, but as seen today it is not truly reflective of the situation. One way out is to link it with the repo rate straight away which is the overnight rate and keep the small savings rate above this benchmark based on different maturities.

The second way out is to link it with the average of the deposit rates of the three lowest paying banks and three highest paying banks. This is necessary as if is often felt that PSBs move together at the same pace and hence to bring about diversity this approach can be considered.

A third way out is to link with the inflation rate beyond a threshold. This would mean saying that the NSC or the Senior Citizen Scheme earns a minimum of 6 per cent with a top-up of a fraction of the inflation number.

Ideally, the CPI inflation number would have been suited, but we have seen this number come below even 4 per cent in some months. And given that individuals are hit by cumulative inflation and not juts spot inflation, such thresholds could be considered.

Further, the setting period needs reconsideration. While keeping it as a year runs the risk of big jumps either way, quarterly changes still seem the best way out.

And this should be done on a regular basis and not skipped, as otherwise the system can be subjected to big shocks like this time as it can be deduced that there could not have been a 90 bps decrease in rates in the last quarter. Evidently action was not taken along the way.

But the important thing is that the interest rates should be divorced from the G-Sec market because the yields here are not truly reflective of the cost of capital as the central bank by virtue of also being banker to the government and manager of public debt has to work to keep cost down.

While there can be no argument here, these numbers should not be translated administratively to the other sectors as a benchmark.

The writer is Chief Economist, CARE Ratings. Views are personal

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