Savings scheme

Why Small Savings Plan Interest Rates Matter

Last week’s interest rate cut on small savings plans – which was later revoked – was not the first cut. It won’t be the last.

Over the past two decades, successive governments have tried to walk a tightrope between financial inclusion and fiscal prudence. Government-backed small savings programs provide a safe and attractive investment avenue for small investors and a pool of capital that governments can tap into. But this is costly pooled capital given the large difference between market rates and the rates offered in many of these plans.

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These programs are usually offered by post offices (and sometimes banks). They come with a guarantee from the central government and the money collected through them goes to the center. In the days of pre-liberalization, when investment options were scarce, small savings programs were the trusted options of households, especially in rural India. After liberalization, their relative importance declined in monetary terms. But given their demographic (small investors) and historical (high yields and tax breaks) advantages, any attempt to align their interest rates with the market becomes a matter of discussion.

Under pressure

Interest rates on small savings have been trending downward for nearly two decades now. After 2015, interest rate cuts were larger and more frequent, with the government moving to a quarterly review system in 2017 to bring them in line with market rates. After 2015, all small savings instruments saw their rates fall, except one. The magnitude of the cuts ranged from 1.6 percentage points to 2.9 percentage points.

The latest central government circular is said to have lowered rates further to 0.9 percentage points. A lower interest rate was also proposed for the only instrument which had been largely spared so far: the post office savings account, from 4% to 3.5%.

Mass call

The dismissal came during state elections, underlining the political sensitivity of small savings. This despite the fact that small savings plans occupy a small portion of the overall financial assets of Indian households. According to the central bank, of each ??100 of new investments in 2019-20 by Indian households in financial assets, only ??12 went into small savings (excluding the Public Provident Fund, or PPF). Even if the PPF is included, this number increases only slightly, as the PPF accounts for 9% of total small savings.

However, more than the amount invested, a more important consideration is the number of small investors invested. India Post data shows 367.5 million individual accounts in small savings instruments. This is a significant portion of the population, even if there are multiple accounts for the same individual. About 52% of the accounts are basic savings accounts, used to access payments from various social protection schemes.

Above the market

Interest rates on post office (PO) savings accounts are market linked. It is on long-term PO plans that the rates are above the market. The premium over market rates is higher in regimes that provide tax relief on entry and are not taxed during tenure or exit, such as the PPF. The 2015-2016 Economic Survey showed that a significant portion of these tax benefits were intended for people who did not need them. In 2013-2014, 62% of Article 80C tax deductions, for which some small savings plans are eligible, were used by those with gross taxable income greater than ??4 lakh per year.

The fall in rates has discouraged investment in small savings plans. The growth of the small savings body went from a compound annual rate of 12.3% in the first decade of this century to 5.2% in the second decade. However, at present, only the savings account (15% of the overall portfolio) is linked to the market.

Political ramifications

Everything else is a work in progress, with political implications. If the recent rate cut had been implemented, those most affected would have been individuals in West Bengal, a state linked to the polls. According to the National Savings Institute, West Bengal accounted for 15% of gross inflows into small savings plans in 2017-18, the latest period for which state data is available. The share of the state’s population in India is 7.3%. Other key states with a similar differential are Delhi, Gujarat and Punjab.

For the government, small economies remain a balancing act. He is counting on them to finance his public deficit. Small savings financed 26% of the Centre’s budget deficit in 2020-2021, up from 10% in 2015-16, according to a recent research report from i-bank, Barclays. It is therefore imperative to keep interest rates aligned with market rates. It is not easy, especially during an election period.

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