Cutting interest rates on Small Savings Schemes is the right move...

The government announced cuts in interest rates offered on Small Savings Schemes a couple of days ago.

What are small savings schemes? Why has the government decided to cut the interest rates it offers on these schemes? Is this the right move? How will it impact the transmission of rate (Repo rate) cuts by the RBI to the lending rates offered by banks to their customers?

These are the type of questions I will answer in this post.

What are Small Savings Schemes?

“Small Savings Schemes” is an umbrella term used to refer to a number of schemes/savings instruments offered by the GOI to small investors/savers in order to mobilize savings from citizens across the country. The National Savings Institute (NSI), Department of Economic Affairs (DoEA), Ministry of Finance (MoF), is responsible for the design and administration of these schemes.

Table 1: National Small Savings Schemes currently on offer

As shown in the chart above, aggregate Gross Collections (“gross” implies without netting out redemptions/ withdrawals) under all the Small Savings Schemes offered by the government were Rs. 2,88,748 Crore in FY15 (Apr 14-Mar 15). Net Collections (after netting out withdrawals) in FY15 were much smaller at Rs. 40,080 Crore. This rather wide gap between “Gross” and “Net” Collections was due to heavy withdrawals especially from the POSA, PORD, MIS, POTD and KVP schemes (as evident in the chart).

These schemes are operated mainly using the network of post offices spread across the country. Some of the schemes (PPF, KVP, SCSC, SSA) are also operated through designated branches of nationalized and a few private banks.

Small Savings Schemes offer certain tax benefits that make them more attractive vis-a-vis regular bank FDs/other investments:

• Deposits under PPF, NSC, Senior Citizen’s Savings Scheme (SCSC), Sukanya Samriddhi Account (SSA) and 5-year Post Office Time Deposits enjoy income tax deduction under Section 80C of the Income-tax Act. This means that the principal you invest in these schemes is exempt from taxes and can be claimed as a deduction under Section 80C while filing returns. This benefit is not available for a bank deposit, unless it is a tax-saver fixed deposit. The interest paid/payable on all POTDs (all maturities), PORD, MIS, KVP and SCSC is taxed per the income tax slab of the investor.

• The interest on PPF and SSA is fully tax-exempt. This is in addition to the original principal being invested in these schemes also enjoying tax deduction (as mentioned above). Such instruments are said to be “EEE tax exempt”.

• Interest accrued on NSCs every year is deemed to have been reinvested under the scheme and enjoys rebate under Section 80C. Hence, you don’t pay any tax on this interest. However, at the 
  time of maturity, you do pay taxes on the interest for the final year (as this not re-invested).

Small Savings Schemes have always competed with bank deposits 

There have obviously been fluctuations in the interest rate differential between Small Savings Schemes and bank term deposits over time, but usually (on an average), small savings schemes (esp. the PPF and SCSC) have offered higher interest rates vs. bank term deposits. Even when they haven’t, given the deep access of the post office network especially in rural areas and the safety (government’s guarantee) offered by these schemes, they have always presented a reliable and convenient investment option for small savers across the country.

Table 2: Interest rates offered by Small Savings Schemes vs. rates on SBI Term Deposits during the quarter, Jan-Mar 2016

In the first calendar quarter of 2016, all Post Office Term Deposits, the 5-year Recurring Deposit, and the Monthly Income Scheme offered interest rates 1.0-1.5% higher than SBI term deposits of the same maturity. The SCSC offered 2% higher interest vs. a 5-year SBI deposit, while the PPF and SSA offered pre-tax interest rates that were 5.0-5.5% higher vs. the highest yielding term deposits offered by the SBI! Given a choice, investment in these schemes was a no brainer!!

Banks have complained that the high interest rates offered by Small Savings Schemes limit their ability to transmit rate cuts made by the RBI

Banks have cited the high interest rates offered by Small Savings Schemes as one of the reasons for their not being able to “transmit” RBI’s cuts in Repo rate to lending rates offered to customers. With small savings schemes offering interest rates significantly higher vis-à-vis rates on fixed deposits, they’ve argued that there wasn’t much leeway for them to cut deposit rates without losing customers.

For context, the RBI cut the Repo rate by 125 bps in 2015. The banks’ base rate declined by ~60bps (on an average) in the same period. So, only ~50% of the RBI’s cuts were transmitted to lending rates.

Read my posts, “Why should a cut in Repo rate transmit to bank lending rates?” is NOT a stupid question and How bank deposit composition complicates transmission of Repo rate cuts in India to understand the oft-mentioned issue of “transmission” better.

Now, there are many reasons that banks have had trouble with “transmission”:

• Repo funds form a very small percentage (less than or =1%) of the total deposits of banks – so there’s little direct impact on cost of funds from a cut in Repo rate.

• Even if banks lower interest rates on new deposits, since most existing deposits are contracted at fixed rates, banks have to continue to pay these rates till maturity. As a result, their average cost of funds doesn’t move much in the near term. Lowering lending rates in this scenario impact margins.

• Lower Repo rate means lower yield on government securities which means lower treasury income from banks’ SLR securities. This actually puts pressure on banks to not cut lending rates. (Opposite of the desired impact).

• Small Saving Schemes offer higher interest rates, making it hard for banks to cut deposit rates as they risk losing customers.

As you can see, higher rates on Small Savings Schemes are just one of the many factors behind the transmission problem.

That said, how big of a factor (contributor) are they?

Let’s run some numbers....

Let’s run through the numbers to get some context.

Table 3: The Outstanding Balance in Small Savings Schemes was 8.5% of the outstanding balance in Savings deposits and Term deposits offered by SCBs as on Mar 31, 2014.

Table 4: We estimate that Gross Collections in Small Savings Schemes in FY15 (Apr 14-Mar 15) were ~10% of the Gross Increase in Savings Deposits and Term Deposits at Scheduled Commercial Banks during the same period.

From the calculations above, we can safely say that for Small Savings Schemes, the Outstanding Balance as well as Gross Collections are 8-10% of the O/T Balance and Gross Collections for competing deposits (Savings + Term deposits) at SCBs.

8-10% is a significant number. Thus, Small Savings Schemes are certainly a source of competition for banks as far as garnering deposits is concerned. 

That said, it’s important to note that investment in these schemes is particularly strong in rural areas where the post office network is three times as large as the bank branch network. It’s estimated that ~30% of the total collections in small saving schemes are drawn from the rural population. In these rural areas, the accessibility, convenience and safety offered by these schemes is as important as the interest rates offered by them. Thus, the complaint of banks that the higher interest rates offered by Small Savings Schemes is the primary reason for the competition presented by these schemes is over-stated in my view. There are other fundamental factors at play as well. 

Cutting Rates on Small Savings Schemes the right move

1. Regardless of the competition that Small Savings Schemes offer bank deposits, cutting rates on them is the right move. When rates are falling (as they are now), it doesn’t make fiscal sense for the government to offer interest rates on these schemes that are much higher than those offered by the government bonds in which proceeds from these schemes are invested. It adds to the government’s deficit.

2. It’s important to keep in mind the concept of “Money illusion” (a term coined by Irving Fisher in his book “Stabilising the Dollar”). “Money illusion” refers to the tendency of most people to think of currency in nominal, rather than real, terms. This means that they confuse the nominal value of money with its purchasing power, without taking inflation into account.

Back in 2013, the average inflation (simple average of CPI inflation numbers for the year) was 10.92%. The PPF interest rate was 8.7%. This means that the real rate of interest earnt by investors was -2.2%. So in real terms, PPF investors actually lost money in 2013. The purchasing power of their investment fell. Despite this phenomenon, we did not hear any noise about low interest rates on the PPF!

Today, the PPF rate (after being cut) is 8.1%. Inflation for June stood at 5.77%. This gives us a real rate of interest of +2.33%. Yet, there is a lot of concern amongst small savers about the rate cuts, even though they are in much better position vs. 2013.

Bottom-line: it’s OK to cut rates. Investors are making higher real returns than they have in many years.

3. Finally, as we discussed above, cutting rates on Small Savings Schemes will lead to better transmission of RBI rate cuts. Not to the extent that the bank project (in my view), but they certain will help. 

I’m ending this post with a snapshot of what Small Savings Schemes interest rates will look like vs. bank deposits post the announced cuts.

Table 5: Interest rates to be offered by Small Savings Schemes (post announced cuts) vs. rates on comparable SBI term deposits, starting Apr 1, 2016. 

Saving = Investment, the Classical Equilibrium Condition: A Clarification

This quick post is a follow-up from my previous post, Basic Classical Model. Those of you who’ve read that post, will recall that the Classical Model of macroeconomic theory asserts that an economy tends to move towards “full employment” on its own (Full employment refers to the situation when the labour market is in equilibrium i.e. demand for labour = supply of labour at the existing wage).

At the full employment level, output will be = spending for the economy as a whole. This belief is rooted in Say’s law, which asserts that supply creates its own demand. 

Here’s the basic National Income Accounting (NIA) identity that we’ve all learnt at school, which is based on the same general idea. 

Y (output) = C + G + I (total spending) 

where Y = output, C = consumption spending, G = government spending and I = investment 

But what really ensures that this identity holds? (I’ve discussed this in my post: Basic Classical Model) 

According to the Classical model, the flexible interest rate in the loanable funds market adjusts to ensure that the demand for funds is equal to the supply of funds, so that Output = Spending for the economy as a whole. 

Different textbooks lay down this condition in slightly different ways, which can cause confusion. I hope to erase that confusion in this post. 

Let’s define a few terms first

Y = C + I + G

Y - C - G = I (re-arranging the NIA identity)

Now, Y - C - G = S (National Saving)            (1)

This makes sense. From total output (Y), if we subtract total consumption expenditure, both private (C) and government (G), we’re left with savings for the whole economy.

Subtracting and adding T (net taxes) on the LHS of eq. (1) gives us:

(Y - T - C) + (T - G) = S 

Where (Y - T - C) = Private Saving and (T - G) = Public Saving            (2) 

Private Savings are the savings of households. From total income (Y), once we subtract taxes (T), we get the disposable income of households. This disposable income (Y - T) is either consumed or saved. Hence, Y - T - C = the savings of households. 

Public Savings (the savings of the government) are = government revenues - government spending = T - G. 

With that background, let’s derive the condition for equilibrium in the loanable funds market.

How Mankiw (Macroeconomics, 5th edition) describes the condition for equilibrium in the loanable funds market

Mankiw assumes that the supply of funds = National Savings (S) 

and the demand for funds = Investment (I). 

The loanable funds market is in equilibrium when National Savings are = Investment (S = I). 

This condition is easily derived from the NIA identity. 

Y = C + I + G

Y - C - G = I

The LHS of the above equation = National Savings (refer to eq. 1), which implies that S = I.

This manipulation of the NIA identity shows us that when National Savings = Investment spending, the loanable funds market is in equilibrium, and output = spending. 

How Hall and Lieberman (Macroeconomics: Principles and Applications) describe the condition for equilibrium in the loanable funds market

They assume that the supply of funds = Private Savings (PS)
and the demand for funds = Investment (I) + budget deficit (G -T)

When the interest rate adjusts so that PS = I + G - T, the loanable funds market is in equilibrium, and output is = Spending.

Let’s prove this. We start with the NIA identity. 

Y = C + I + G

Subtracting T from both sides of the eq. and moving C over to the LHS gives us:

Y - T - C = I + G - T 

Remember, Private Saving = Y - T - C (see (2) above) 

So, the eq. above implies that PS = I + (G - T)

Hence proved. Simple, isn't it?

Conclusion

Both S (National Savings) = I, and PS (Private Savings) = I + G - T, are the same condition. Both are a manipulation of the National Income Identity (output = spending).

Basic Classical Model

Following up from my previous post, The Main Cause of Disagreement between Economists: Long Run vs. Short Run, I’m going to talk about the key assumptions of the basic “Classical Model” of Macroeconomic theory in this post. Understanding the fundamental assumptions of this model in a robust fashion will make all future discussions much easier. 

Like I mentioned in the previous post, I’m using Chapter 8, 'The Classical Long-Run Model' of 'Macroeconomics: Principles and Applications' (5th edition; Robert Hall and Marc Lieberman) as a base for this exercise. 

What is the Classical Model?

In simplistic terms, the Classical model asserts that markets/economies function best when there is minimal interference from the government. The Classical model was developed in the late 18th, 19th and early 20th centuries. Adam Smith’s seminal work “The Wealth of Nations”, published in 1776 birthed the Classical school of thought. 

While there is a distinction between Classical and Neoclassical economics (build on the Classical tradition) that I will cover in a subsequent post, for now, I’m going to club these two together. 

The Classical model attempts to explain the observation that economies perform rather well over the long run (multiple years, decades). While there may be business cycles in the short run, over the long term, economies tend to operate at "full employment" or at "potential output". There are strong forces that push economies towards full employment. Lets see what these are.....

1. All Markets Clear - the fundamental Classical assumption 

A critical assumption of the Classical model is “market clearing”. This means that in every market, price adjusts till market demand is = market supply.

This is why the Classical model is a much better predictor of the long run rather than the short run. While in the long run, the forces of demand and supply will tend to force markets to clear, in the short run there are rigidities like minimum wage, government imposed price-floors, reluctance of firms to cut product prices etc. that may not allow markets to clear. 

2. The Economy achieves “Full Employment” on its own

2 (a). In the Classical Model, determining how much Output an economy will produce starts with the Labour market.

Let’s start with a very simple economy. Let’s assume Output (Y) in this economy is a function of Labour (L) and Capital (K). Let's also assume that the amount of K and the production technology are fixed. Y= f (L, K) represents the aggregate Production Function for this economy. The aggregate production function shows us the total amount of output that this economy can produce with different quantities of labour, given the fixed amount of capital and constant production technology. 

In the Classical model, the process of determining how much output this economy will produce begins in the labour market. Note: we assume that all markets (markets for products and factors of production) are perfectly competitively. 

Per the market clearing assumption, the real wage in the labour market adjusts to equilibrate labour demand (DL) and labour supply (SL). The labour market clears at point E, with equilibrium level of employment determined at L0 (see the top graph in Chart 1 below). 

Chart 1: Output Determination in the Classical Model

2 (b). The Equilibrium level of Employment in the Labour market is the “Full Employment” level. 

By “Full Employment” Classicals mean that all those people who are willing to work at the prevailing wage (w0) are able to find employment. Those workers who are not willing to work at the existing wage are voluntarily unemployed. Consequently, in the chart above, at point ‘E’, the labour market is at full employment.

Since prices are flexible and markets always clear (in the Classical model), the economy automatically moves towards full employment and no government action is needed to achieve this. 

Per Classicals, wide spread unemployment should not occur. The only type of unemployment witnessed is frictional unemployment (that happens when workers are in-between jobs) or sectoral unemployment. This type of unemployment happens when demand for the products of a sector goes down and workers lose jobs. When this happens, wage rates in the affected sector fall and workers move to other sectors where wage rates are higher i.e. there is higher demand for that sector’s end product. This leads to a rebalancing of the labour force, so that again, price flexibility causes the labour market to come back to full employment. 

If extensive unemployment is witnessed, Classicals would tend to blame this on “sticky” prices (prices that don’t adjust downward easily) due to unions, government intervention etc. 

2 (c). Once the Equilibrium level of Employment (Full Employment) is determined in the Labour market, the aggregate Production Function determines the Equilibrium level of output (or Potential output).

As I mentioned above, the aggregate production function shows us the total output an economy can produce when we vary the amount of labour (capital and technology are fixed). Once the full employment level (L0) is achieved in the labour market, the production function gives us the total amount of output (Q0) that the economy will produce with L0 amount of labour (See chart 1 above). 

So (again), in the Classical model, the economy achieves its “Potential Output” where labour is at “Full Employment” on its own, without the need for any government intervention. 

3. Spending is always equal to Equilibrium Output (Say’s Law)

This follows from the Classical assumption of full employment. If the economy has to remain at the full employment, spending has to be = output. If this is not the case and businesses are not able to sell what they produce (i.e. spending < output), inventories will pile up and businesses will lay off workers which means that the economy will no longer be at full employment. 

This Classical belief is rooted in Say’s Law. In essence, Say’s law states that “supply creates its own demand” i.e. by the very act of producing goods and services, a firm creates a demand (for goods/services) equal to what it has produced. 

So, per Say’s law, Y = C + I + G 

where Y = output, C = consumption spending, I = investment, G = government spending, and C + I + G = total spending. 

This is the basic national income identity. We haven’t included net exports in here because we are using the example of a simple, closed economy. 

Subtracting T (net taxes) from both sides of this identity gives us:

Y - T = C + I + (G - T)                      where G - T = the Budget Deficit

Y - C - T = I + (G - T)          

Now, total output/income (Y) for a household = consumption + savings + taxes i.e. Y = C + S + T, which means that Y - C - T = S (Private Savings i.e. savings of households). 

Putting this in the equation above gives us:

S = I + (G - T) 

So, for Say’s law to hold i.e. for Output to be = Spending, Savings must be = Investment + Government deficit spending. What this means is that whatever households save must be channeled into private investment spending (I) and government deficit spending (G - T), so that there are no leakages and the total income earnt (from producing the output) is fully spent on buying it. 

Per Classicals, the flexible interest rate in the loanable funds market adjusts to ensure that the supply of funds (S) = the demand for funds (I + G - T), so that Say’s law holds and the economy remains at full employment. 

Chart 2: Loanable Funds Market Equilibrium in the Classical Model 

4. Fiscal Policy is ineffective in the Classical Model

In the Classical Model, Fiscal policy does not change total output, it only changes its composition. Let me explain with an example.

Let’s assume government spending is initially = G, and then increases to G1. To finance this increased spending (G1-G), the government will have to borrow funds from the loanable funds market. 

The total demand for funds will now increase by G1 - G (or S2 -S0 in chart 3) at every interest rate i.e. the demand for funds curve will move to the right by this amount. 

As a result, the equilibrium in the loanable funds markets will move from point ‘A’ to ‘B’. At B, the interest rate (r1) will be higher and Investment spending (I) will be lower by S2 - S1 (vs. what it would have been at r0). 

Additionally at B, Savings (S) will be higher which means that Consumption (C) will lower by S1 - S0 (vs. what it was at r0). 

This implies that total spending will remain the same. The increase in government spending (S2 - S0) will be exactly offset by the decrease in Investment (S2 - S1) and Consumption (S1 - S0) Spending. 

In other words, in the Classical model, an increase in government spending (G) completely “crowds out” private sector spending (I + C), leaving total spending unchanged. 

As a result, fiscal policy has no impact on the level of output or employment in the economy. All it does is change the composition of output. 

Chart 3: In the Classical Model, an increase in Government spending completely crowds  out private sector spending (Investment + Consumption)

This is enough to absorb and mull over for now. Ciao.

The Main Cause of Disagreement between Economists: Long Run vs. Short Run

In this post, I’m going to address the mystery of the ages aka why economists never seem to agree on anything. They argue not only with each other, but also with themselves a disturbing majority of the time. Why else would American President Harry Truman (famously) say, “Give me a one-handed economist. All my economists say, ‘on the one hand… on the other hand.’” 

Hall and Lieberman ("Macroeconomics: Principles and Applications") answer this question with the help of an illustration. I’m going to “indian-ize” the illustration. 

Curtailing the Indian Fiscal Deficit 

India's Modi-led government was able to reign in the Fiscal Deficit (FD) to 3.9% of GDP in FY16 (vs. 4.1% in FY15 and 4.7% in FY14). Low oil prices obviously played an important role. While  disinvestment proceeds were lowered than planned, the government chose to boost revenues with excise duty hikes rather than cut Plan spending in order meet the FD target. 

Reducing the FD to 3.5% of GDP in FY17, as the government had initially planned, will be hard now given the implementation of the 7th Pay Commission. However, the government remains optimistic about achieving its FD target of 3% by March 2018. 

Why this is the right move

Now, most economists agree that curtailing the Fiscal Deficit is the right policy move. A lower deficit (G-T) where G = government spending and T = net taxes, requires the government to borrow less in the loanable funds market. When the government’s demand for funds is lower, the interest rate tends to be lower, which encourages private Investment spending (I). Strong investment spend is a prerequisite for GDP growth. 

Why this is the wrong move 

That said, there are others who believe that an acute focus on curtailing the deficit is not a good idea, and infact harmful for growth. They encourage government spending in order to accelerate economic growth. 

Both views are correct. One focuses on the Long run (Classical view). The other focuses on the Short run (Keynesian view). 

Let me explain. 

The first school of thought (curtailing FD is the right move) is based on Classical macroeconomic theory, which provides a good description of the Long run (multiple years). Classicals believe that wages and prices are flexible and that markets always clear, so that demand is = supply. 

As a result, they believe the economy is always at “full employment” (i.e. those willing to work at the equilibrium wage always find work). Since the economy is always at “full employment” and producing its “potential output”, an increase in government spending instead of increasing total spending and output, causes an equivalent fall in investment and consumption spend, leaving total output unchanged. Thus, per the Classical school, Fiscal policy is ineffective (does not change total output). All higher government spending does is “crowd out” investment spending. 

Since private Investment spend is crucial for long-term growth, based on the classical school of thought, curtailing the deficit is the right move. 

Bottom-line: Economists encouraging the curtailing of the Indian FD are taking a long-term view (several years) of the economy. 

The second school of thought (focus on cutting FD is the wrong move) draws from Keynesian macroeconomic theory, which is good at describing the economy in the short run (next few quarters, a year). Keynesians believe that an increase in government spending has a “multiplier effect” and increases output/income. There’s some crowding out of investment, but this is only partial. Output rises in response to expansionary fiscal policy (i.e. increased government spending).

This is an apt description of how the economy behaves in the short run i.e. over the next year or the next few quarters. Thus, economists criticizing the curtailing of the Indian FD are focusing on the short-term. 

(Note: For the uninitiated, we’ll cover the basic theory behind Classical and Keynesian macroeconomic theory in subsequent posts. So, don’t bother about terms you don’t fully understand at this point)

So, the main bone of contention between economists is the time horizon. When talking about the same time horizon (long run for instance), most are likely to give the same policy prescription. 

If two economist with the above-mentioned opposing views are asked if cutting the FD is a good thing long term, they will most likely agree that this would lead to more investment by private firms and faster economic growth. (Per the Classical view) 

If these same economists are asked if cutting FD is a good thing short term, they will likely agree that this will mean slower growth over the next few quarters. (Per the Keynesian view)

And this in a nutshell, is the reason why economists disagree so much. They focus on different time horizons. “Once the distinction between the long run and the short run becomes clear, many apparent disagreements among macroeconomists dissolve.” (Macroeconomics: Principles and Applications, Hall & Lieberman) 

Finally, what is the right policy prescription for India? 

The right move for India (vis-à-vis the Fiscal Deficit) is a nuanced combination of both schools of thoughts. 

The right policy mix involves: 

1) Raising tax revenue: This involves expanding the tax base (there are only 5.43 crore tax payers in India currently which is just 4% of the population), rationalizing and lowering tax rates (corporate tax rate is being lowered to 25% over the next few years), checking evasion (the passage of the GST bill is a step in the right direction) etc. Meeting FD goals by raising revenue rather than cutting expenditure would the ideal outcome. 

2) Tightening wasteful revenue expenditure/ subsidy spend: The reduction in FD achieved in FY16 was in large part due to the fall in crude prices which allowed the government to reduce its petroleum subsidy burden substantially. However, such a situation may not exist in the future, which is why it is important to expedite reforms in petroleum and other subsidy areas. 

3) Enhance capital spending on infrastructure, health and education: It is important for the government to enhance capital spending. India needs to invest heavily in infrastructure (roadways, power, water) for Prime Minister Modi’s “Make in India” campaign to turn from a marketing blitzkrieg to reality. Solid investment is also required in health and education if India is to develop a work force that is readily employable.

While adhering to broad fiscal deficit targets (Classical school), it is important to not get overly obsessive and make sure that government capital spending on the right priority areas does not suffer (Keynesian school). If this means a slightly slower pace of Deficit reduction, so be it.