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.