Government's small savings U-turn puts spotlight on calculation of interest rate

Finance Minister Nirmala Sitharaman. (File Image)

The announcement could easily have been taken for an ‘April fool’ joke, had it not come from the official Twitter handle of finance minister Nirmala Sitharaman on Thursday morning. Hours after the government announced a sharp reduction in the interest rate of small savings schemes across different instruments, it abruptly reversed the move.

The reversal overnight adds to a long list of U-turns on key policy decisions, including on issues such as land acquisition, farm laws, PSU privatisation and so on. In the case of withdrawal of the small savings scheme rate cut, the minister said the announcement happened due to an ‘oversight’.

The announcement of small savings rate is a routine affair. It happens periodically, and is calculated on a set formula based on government security (G-Sec) rates and other parameters, said people familiar with the process. An oversight on such a key data release is unusual, they said, asking not to be named.

“Purely on market determined interest rates, the rate of interest on government savings scheme is high and a roadblock in lowering the overall interest rates, a necessity to spur the growth,” said Rajnish Kumar, former chairman of State Bank of India, the country’s largest lender.

So then, could the government have avoided the U-turn?

Yes, said experts. The government could have avoided this flip-flop on a socially and politically sensitive subject by cutting small savings rate in small doses instead of a sharp up to 110 basis points, even if it had to do it, they said. One basis point is one-hundredth of a percentage point.

Despite the onus on growth, in the absence of social security, a large section of senior citizens depends on interest income from various deposit schemes of the government, according to Kumar. “It's difficult for the government to ignore this reality when trying to align the interest rates to the market,” he said.

Instead, the government could have treaded carefully, not because of political reasons but considering that inflation is inching up and millions of small savers will be impacted by the sharp rate cut.

According to a 2017-18 report on small savings collections, the highest share in overall net collections during the year under report have been recorded in PPF (43.87 percent), followed by Senior Citizens’ Savings Scheme Account (SCSSA) at 19.73 percent, Kisan Vikas Patra (KVP) at 15.56 percent and NS Time Deposits Account at 12.42 percent.

A key saving avenue for retirees

Small savings schemes are widely used by savers, particularly retired citizens to park their life savings. Announcing the rate cut, the government cut small savings deposit rate from 4 percent to 3.5 percent for the first quarter of the financial year starting April 1, 2021. Besides this, rates of other small saving schemes were also cut.

The government cut interest rates of the Senior Citizen Savings Schemes to 6.5 percent from 7.4 percent; of the Public Provident Fund Scheme to 6.4 percent from 7.1 percent; of the Kisan Vikas Patra scheme to 6.2 percent from 6.9 percent; and of the Sukanya Samriddhi Account Scheme to 6.9 percent from 7.6 percent.

Also, the government cut one-year time deposit rates to 4.4 percent from 5.5 percent, and two-year, three-year, four-year and five-year recurring deposit rates to 5 percent, 5.1 percent, 5.8 percent and 5.3 percent from 5.5 percent, 5. 5 percent, 6.7 percent and 5.8 percent, respectively.

Is there a problem in the way small savings rates are calculated?

That brings us to another problem.

Madan Sabnavis, chief economist of CARE rating agency, questioned the methodology of calculation. “There is a lack of transparency in the way small savings rates are calculated presently. The G-sec rates have been going up since March which doesn’t justify such a sharp cut in small savings rate. The question is: can we really link the small savings rate to G-Sec rates?” said Sabnavis.

The finance ministry decides the rates on small savings rates on a quarterly basis based on the weighted average of the G-Sec yields. But this methodology is flawed and do not take into account the realistic scenario, Sabnavis said. The G-Sec rates have gone up sharply by 30 bps since January from 5.865 percent to 6.166 per cent.

Economists said there is a distortion in interest rates in the financial system but the government could have taken a gradual approach instead of cutting the rates sharply in one go. “There is a distortion in interest rate structure in the economy. But rates should have been aligned in a gradual manner. Such a sharp rate cut in small savings rate was not warranted,” said D K Joshi, chief economist, Crisil Ratings.

A veteran banker who has headed a large financial services company for nearly three decades said the government did a mistake by cutting small savings rates sharply. “Globally, rates are going up and in India too that is the trend. How can they cut rates now?” asked the banker requesting anonymity.

The Reserve Bank of India (RBI) has been striving to keep the government’s borrowing cost low around 6 percent by announcing OMOs (open market operations) back-to-back. “So when the RBI is artificially controlling the rates and don’t let demand-supply decide the pricing, we have a problem,” said an economist with a private firm who didn’t want to be named.

What is the way ahead?

The rate cut came at a time when inflation is inching up. There are no second thoughts on the fact that small savings rates are critical for senior citizens. The government should have a mechanism to link the small savings rate to inflation, considering that India doesn’t have a social security system, unlike in the West.
Small savers are hit hard by the low returns on their life savings. “Inflation is inching up and this is hurting the common man. There should be a mechanism to ensure citizens have safety net,” said a senior banker who too declined to be named.