Small Savings Rates: How Much Does The Government Need To Lower Them?

A struggle to improve the pass-through of easier monetary policy to the broader economy has prompted a number of changes. The central bank has flooded the system with liquidity, initiated purchase of long-term bonds and asked banks to link their lending rates to an external benchmark.

However, one piece in the interest rate transmission process that remains missing is a cut in small savings rates. Interest rates on small savings instruments, ranging from post office deposits to National Savings Certificates, among others, remain administered with rates decided by the government. While these rates were linked to government bond yields in 2016, following recommendations of the Shymala Gopinath committee, the government has not strictly adhered to the formulas suggested.

The result is that small savings interest rates offered currently remain much higher than rates offered by banks on instruments such as fixed deposits.

The gap is wide.

While benchmark bond yields had fallen to 6.5 percent in November from 7.4 percent in February in response to 135 basis points in policy rate cuts, rates on key small savings instruments have moved by just about 10 basis points. If the government had followed the formulas adopted strictly, rates on different small savings instruments would have been lower by 80-160 basis points.

For example, if the prescribed formulas were to be strictly followed:

• The interest rate on public provident fund should have been 7.04 percent as opposed to 7.90 percent announced in the third quarter.
• The rate on one-year post office deposits should have been at 5.30 percent compared to 6.90 percent offered.
• The rate on the National Savings Certificate should be at 6.81 percent compared to 7.90 percent now.

Higher interest rates on small savings instruments is a historic problem, said Devendra Pant, chief economist and head of public finance at India Ratings and Research. The reset in interest rates has not been in line with the movement in government securities, he said.

Why It Matters?

Small savings instruments compete with banks for deposits. As such, a wide differential in rates can lead to a flow of deposits away from banks and, in turn, bring down deposit growth. In situations, where credit demand is strong, weaker deposit growth can delay a fall in lending rates despite monetary policy easing.

Commenting on the slow pace of adjustment in small savings rates, India’s Monetary Policy Committee called for greater flexibility at its last meeting in December. “The introduction of external benchmarks is expected to strengthen monetary transmission. In this context, there is also a need for greater flexibility in the adjustment in interest rates on small saving schemes,” the committee had said.

While noting the need for small savings rates to fall, Pant said these small financial instruments were often targeted at people at the bottom of the pyramid, to bring them into the folds of formal savings. As such a sharp fall in rates or sudden volatility may hurt the most vulnerable.

Meanwhile, the high rates offered by small savings instruments have kept collections in these schemes high. This pool of savings is now used by the government for its financing needs.

As interest rates in small savings instruments remained high, investments in these instruments rose by 30 percent to Rs 94,659 crore between April 2018 and February 2019, according to data released by the RBI as part of its monthly bulletins.