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Consensus mounts for small savings rate cuts

BUDGET 2001

Will India bite the bullet and take the politically unpopular step of cutting interest rates on government-run small savings schemes to bring down lending rates?

Speculation is rife that Finance Minister Yashwant Sinha will take the plunge when he unveils the federal budget on Wednesday, setting the stage for lowering lending rates now starting at 11.5 per cent.

An annual Economic Survey presented to Parliament last Friday reiterated what the central bank and industry have long been saying -- high returns on tax-free postal and provident fund accounts are keeping lending rates too high.

Yields on 10-year government bonds have declined by 3.5 points since 1995 to about 10 per cent and core inflation has fallen by a similar amount, but interest rates on small savings have fallen by only one to two percentage points, a recent Bank of America study showed.

The Public Provident Fund (PPF), General Provident Fund for government employees and the bigger Employees' Provident Fund all pay tax-free interest of 11 per cent which, at the highest tax rates, translates into a annualised return of over 17 per cent.

That compares with the 4.5-11 per cent offered by banks on deposits up to five years.

The Reserve Bank of India (RBI) set the ball rolling with a half-point cut in the bank rate to 7.5 per cent on February 16.

But analysts and traders believe more cuts in the trend-setting bank rate will follow only if the government picks up the gauntlet on small savings.

"The probability of another cut in the bank rate increases if the government reduces rates on small savings," Bank of America's head of research M R Madhavan said, adding that reduced government borrowing would also help.

Earlier this month, a government-appointed economic advisory body, which includes RBI governor Bimal Jalan, also stressed the need to cut provident fund and postal savings rates.

Such a move would also be in keeping with an ambitious fiscal discipline bill that the cabinet has tabled in parliament.

HARD SELL

Still, achieving political consensus would not be easy as Sinha would have to convince the ruling coalition's difficult allies and opposition parties to agree to cut returns on the popular instruments.

These high-yielding deposits make up for the lack of a pension system for millions of non-government employees.

Moreover, the contribution small savers make to government funding is significant. Receipts this year from the small saver schemes are estimated to cover almost 30 per cent of the federal government's gross fiscal deficit for 2000-01 (April-March), budgeted at Rs 1.113 trillion.

The balances in small savings deposits and provident funds this year are estimated to total Rs 2.48 trillion, or 21 per cent of total government liabilities.

HOW LARGE A RATE CUT?

Rates on the PPF and post office deposit schemes were last reduced by one percentage point in January 2000, and bond traders have priced in a minimum one point cut this time too.

The economic survey called for rates on small savings schemes to be benchmarked against equivalent market instruments.

"The administered interest rates on pension and provident funds must take account of the inflation rates, the effective term of the deposits and available tax exemptions," it said.

The economic advisory council recommended pension and provident fund interest rates be lowered to a maximum of two percentage points above the inflation rate for the preceding six months.

Wholesale price inflation now stands at a five-year high of 8.5 per cent, but core inflation -- which excludes volatile fuel and food prices -- is running at about half that rate.

LOW RETURNS ON FORCED CONTRIBUTIONS

Labour unions oppose the rate cuts, and not just because contributions to provident fund schemes are compulsory.

"Wage earners have relied solely on these investments. Other instruments do not offer the same safety," said L R Parab, general secretary of All India Reserve Bank Officers' Association.

The fact workers cannot withdraw funds for a decade or more is another reason analysts feel higher rates are warranted.

And while rate cuts may be needed to channel savings into more productive investments than merely funding burgeoning state government deficits, analysts say alternative investment opportunities are seriously lacking.

"A rate cut is a simplistic logic. Unless accompanied by alternate investment plans, savings will go to the wrong instruments," said an economist with a European investment firm.

Private pension funds are still not common and insurance policies, only recently freed from state control, are purchased for security or as collateral for housing loans, not as investments, he said.

Analysts are quick to warn that if authorities are not watchful, savers could be hurt like happened four years ago when finance firms offering outrageous returns collapsed.

Economic Survey 2000-2001
Budget 2001
Money

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