Thursday, March 24, 2016

Small Savings Smaller return-Slashing of interest rates on small savings

Hindustan times decodes the reasons
The average return on small savings schemes (SSS) has been reduced by an average of 0.8% for the April-June period of 2016. The finance ministry said that the revision will enable banks “to move their rates in line with current money market rates”.
The resetting of rates is now done on a quarterly basis, which means these rates will change again for the July-September period. SSS include savings deposits, fixed and recurring deposits, monthly income schemes and public provident fund etc.
Why do interest rates have to be changed?
Interest rates offered on financial products are dependent on factors such as inflation, the cost at which banks can borrow money and the interest rates on government securities etc.
The Shyamala Gopinath Committee that reviewed the small savings schemes in 2011 recommended that interest rate on such schemes should be linked to the interest on government securities (G-Sec). For example, the interest you earn on your 5-year FD is linked to the 5-year G-Sec.
At present, the interest on G-Secs with maturities ranging from less than a year to 10 years is in the range of 7-7.9%. The yields on small savings for a quarter will vary according to the average three-month yield on the linked G-Sec. The interest rates on G-Secs vary according to the demand and supply in the market. These are in turn dependent on inflation.
High inflation leads to higher yields as bond-owners would want the interest rate to compensate for inflation — to be precise retail or CPI inflation. Also, high inflation expectations will mean that buyers will want to pay less for a bond that gives a certain return. Bond returns or yields rise when their prices fall and vice-versa.
A return higher than inflation would mean that the bond earns a positive real return.
Linking small savings to G-Secs effectively links them to the market so that they change according to prevalent economic conditions.
How does this move help the banks?
Banks invest much of the deposits in G-Secs as they are risk-free and the Reserve Bank of India mandates them to do so. As of December 2015, commercial banks owned 44% of all government securities.
However, yields on government bonds decreased in 2015 shrinking the banks returns. As government bond yields also figure in base rate calculation, a drop in yield causes banks to show reluctance in passing on RBI’s rate cuts to customers — called monetary policy transmission in economic jargon.
How are G-Secs related to interest rates on loans?
The base rate for loans as calculated by banks in India takes into account the cost of deposits, which is the interest that the banks have to pay to borrowers.
Deposits including small savings account for over 90% of the banks’ total deposits, therefore a cut in the interest rate of small savings will put more money in the banks’ kitty. Small savings stood at ` 6.4 lakh crore as on August 31, 2015. The present interest rate cut (of 0.8% on average) can therefore reduce the deposit cost and give banks room to cut lending rates.
Is that it?
Japanese financial major Nomura in a report (as quoted in PTI) said that the “move to deregulate small savings rates should be a win-win for both the government and the banks. It will give banks greater flexibility to lower deposit rates in sync with falling inflation, while lowering the interest burden for the government.”
The interest burden arises as the government borrows money from people through post-office accounts and schemes such as National Savings Certificate.
But what about the people who have invested in small savings?
With CPI inflation remaining low, owners of small savings will still earn a positive real interest. For example, if inflation stays at 5% for 2016-17, at an interest rate of 7.1% a 1-year FD will yield a real return of 2.1% (excluding taxes).
Therefore, you will feel your interest income drop from small savings but the EMIs on your loan will also dip — if the banks reduce their lending rates.
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