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Is The Cut On Interest Rates In Small Savings Schemes Justified? - Outside View by PersonalFN
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Is The Cut On Interest Rates In Small Savings Schemes Justified?
Mar 30, 2016

"You can please some of the people all of the time, you can please all of the people some of the time, but you can't please all of the people all of the time"-John Lydgate

What John Lydgate, an English monk and a poet, said about 6 centuries ago still holds true. You can't favour all people at the same time. In India, for the ruling Government to take politically unfavorable decisions, especially when the elections are around the corner in 5 states, is a rare sight. However, the Modi Government has decided to bite the bullet this time by lowering the interest rates on Small Savings Schemes (SSS).

Interest Rates Reshuffled...

Instrument Interest rates (in %) FY 2015-16* Interest Rates (in %) Q1, FY 2016-17**
Savings Deposits 4 4
1-Year Time Deposit 8.4 7.1
2-Year Time Deposit 8.4 7.2
3-Year Time Deposit 8.4 7.4
5-Year Time Deposit 8.5 7.9
5-Year Recurring Deposit 8.4 7.4
5-Year Senior Citizens Savings Scheme 9.3 8.6
5-Year Monthly Income Account Scheme 8.4 7.8
5-year National Savings Certificate 8.5 8.1
Public Provident Fund Scheme 8.7 8.1
Kisan Vikas Patra 8.7 7.8
Sukanya Samriddhi Account Scheme 9.2 8.6

Note: * For the period between April 01, 2015 and March 31, 2016; ** for the quarter of FY 2016-17 ending on
June 30, 2016
(Source: Finance Ministry)

Background to the Government's action

Reserve Bank of India (RBI) has been insisting for banks to pass on the benefits of policy rate cuts to borrowers announced in January 2015. The median reduction in lending rates by banks has been around 60-70 basis points (bps)-about half of the total 125 bps reduction in policy rates. One basis point equals to 100th of 1.0%.

The counter argument is that Banks were offering higher interest rates on deposits. Banks pointed out that the higher interest rates paid by the Government on SSS made their deposits unattractive to investors. They requested the Government to cut interest rates on SSS, before they could cut lending rates more aggressively. Since September 2015, the RBI has maintained status quo on policy rates, owing to the lack of transparency observed by banks in monetary transmissions. The other reasons were clarity on fiscal prudence, infusion of capital in Public Sector banks, and supply side constraints to name a few. Breaking the deadlock, the Government has now placed the ball in the banks' court. Moreover, adhering to the fiscal deficit target of 3.9% for the current fiscal and 3.5% set for FY 2016-17, the Government has lived up to the RBI's expectations.

What the Government has to say about its decision?

Unlike earlier, when interest rates were adjusted only once a year, now the Government will re-set interest rates on SSS every quarter i.e. 4 times a year based on the G-Sec yields of the previous three months. Every category of savings instruments within SSS would earn you additional interest, over and above the g-sec yields. As clarified by the Government ,The additional spread for these Schemes are 25 basis points for PPF, 100 basis points for Senior Citizen Savings Scheme, 75 basis points for Sukanya Samridhi Scheme, 25 basis points for five year time deposit, 25 basis points for National Savings Certificate and 25 basis points for Monthly Income Scheme."

The Finance Ministry is of the view that, the interest rates shall fall in India. Defending the decision of his ministry, the Finance Minister said that, "Interest rates had risen a lot earlier but now they have come down. The way economy is moving today, we cannot have a situation where lending rates are going down but deposit rates remain high. Both are linked. To make economy more efficient rather than sluggish, the country has to move towards lower interest rates in both."

Should investors be worried about falling interest rates?

Beyond a doubt, higher interest rates on SSS do make bank FDs unattractive. Now that the Government has lowered interest rates, banks will be under pressure to cut their lending rates, and their deposits will now be at par with other products on offer. As far as its impact on investors goes, lower interest rates don't automatically translate into wealth erosion. When the inflation adjusted interest rate is negative, your deposits become unproductive for you. The average retail inflation measured by the movement of Consumer Price Index (CPI) has been 5.0% over the last one year. This suggests that, even after the recent alterations made by the Government on interest rates in SSS, they continue to remain positive on inflation adjusted basis. Since the rate of interest earned will be reset quarterly; the returns earned would be susceptible to various market forces driving the direction of rates. This could have an impact on those planning for important life goals viz. retirement using SSS.

How the middle class may react?

Whenever interest rates on popular SSS deposits are slashed, the Government comes under heavy criticism. This time it's been nothing different. While prudent people may understand the economics behind the falling interest rates; they will question the Government about what stopped it from applying the similar logic while choosing NOT to pass on the benefits of falling crude oil prices.

What to expect on borrowing rates?

The pressure on the RBI to lower rates may mount with this, as well as on banks to lower their lending rates. The markets have already started factoring in a 25bps rate cut. Although there are questions we still don't have answers to, these developments clearly indicate brighter days for borrowers.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


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