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Small savings, big headache

P Vaidyanathan Iyer | June 08, 2004

Finance Minister P Chidambaram has a tough task on hand -- re-setting the interest rate on small savings, on the Employees Provident Fund and other instruments like the Government of India Savings Bonds, better known as relief bonds. And given the Left's stance, there is a risk that he may buckle under pressure.

Certainly, Chidambaram knows the perils of higher administered interest rates. And luckily, he does not have to look far for solutions. He has the Y V Reddy report on small savings as a ready reckoner.

The committee, headed by the current Governor of the Reserve Bank of India, had linked the administered rate to the yield on government securities of similar tenure in the secondary market.

Chidambaram's predecessor, Jaswant Singh, boldly cut the rate on small savings by 50 basis points last fiscal to an average of 8 per cent across all instruments like the post office monthly income scheme, National Savings Certificate, Indira Vikas Patra and the provident fund.

The interest rate on the relief bonds was also reset to 6.5 per cent (tax-free) still yielding post-tax returns of almost 9.5 per cent in the highest tax bracket.

This year, Chidambaram also has the report of the Rakesh Mohan committee on small savings. Though the report has not been made public, committee members say that the new formula is a modification of the Reddy formula.

Whatever the formula, it is clear that the small savings interest rates, at 8 per cent with tax rebates, create quite a distortion. With yields on five- and 10-year paper as low as 4.95 per cent and 5.25 per cent, respectively, the Centre is shelling out an unstated interest subsidy of almost 3 to 5 per cent a year.

The logic is that the Centre would be far better off borrowing from the primary market than relying on the money raised through small savings and relief bonds. Yes, interest rates may go up slightly, but they will still be at least 200 basis points cheaper.

It is not for the savings in interest cost for the Centre that Chidambaram must cut the rates. Foremost among the reasons that he should take the plunge in slashing the rate is to stop doling out benefits to people who do not require it.

Although the profile of the investors is not officially available, any investment consultant will tell you that senior citizens and middle-income people hardly account for any significant amount of the funds raised through these bonds.

Much of the investment is made by high net worth individuals. Since there is no upper limit on the amount of funds that one can invest in the 6.5 per cent tax-free relief bonds and the 8 per cent taxable bonds, businessmen and high net worth individuals invest crores of rupees every year.

In a falling interest rate regime, locking in funds for five years and earning an annual tax-free interest of 6.5 per cent, definitely makes immense sense.

The government would have raised nothing less than Rs 30,000 crore (Rs 300 billion) through relief bonds last fiscal, thus doling out an interest subsidy of almost 3 per cent, or about Rs 4,500 crore (Rs 45 billion) over the next five years.

Similarly, at 9.5 per cent now, the interest rate on the Employees Provident Fund Organisation is unjustified. Do the leaders in the Left realise that in demanding a 12 per cent return on the EPF they are only pushing the case of better-paid employees? There is already a distortion, with small savings rates at 8 per cent and the EPFO offering returns of 9.5 per cent.

Moreover, the EPF is for the salaried people, who earn a monthly income. Besides, with inflexible investment norms, the EPFO runs a real risk of dipping into the capital to honour the high returns promised. Already, the EPF, a part of the EPFO, has an unfunded gap of Rs 1,700 crore (Rs 17 billion).

Almost three-fourth of the EPFO corpus remains invested in the Government of India's Special Deposit Scheme, which earns the organisation an interest rate of 8 per cent.

So, the EPFO can ill-afford to offer more than 8 per cent returns to its members. But, last fiscal, the former labour minister announced a 0.5 per cent bonus in addition to the 9 per cent, by drawing from the surplus in the suspense account.

Technically, the finance ministry can do little to force a cut in the EPF rate. It has to act upon the recommendations of the Central Board of Trustees chaired by the labour minister. It tried in vain last year to convince the labour ministry to cut the rate.

If the ministry decides to cut the interest rate on the SDS, the labour ministry will have little choice but to prune the returns offered by the fund because, much of the EPF corpus continues to remain invested in the SDS.

Unless, yes, Chidambaram takes a political decision to provide interest subsidy to the EPFO to fund the gap between what the EPF earns and what it proposes to offer to its members!

The Left, in fact, would be wise to push for a higher interest rate for retirees and senior citizens who are the worst affected in a falling interest rate regime.

Unlike today's white-collar workers who are reaping the benefits of consumerism and low rates on home and car loans, employees of yesteryear were saddled with life-long high interest costs. And now, when it's time to sit and relax, they are being faced with a soft interest rate regime with low returns on deposits.

Chidambaram would do well to devise schemes for senior citizens and explicitly provide for the interest subsidy. The Varishta Bima Yojana is one such scheme offering 9 per cent annual returns.

The Dada-Dadi bonds, promised by Jaswant Singh, could be another. Some more attractive fixed deposit schemes with some flexibility on withdrawal for emergencies would do senior citizens a lot of good.

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Sub: small savings intt. rates

Success of VRS is depend on reasonable higher intt. earnings.

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most of us who opted for VRS did so at a time when interest rates on savings was high and we could make a decent ...

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