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Why raising EPFO interest rates makes no sense

By Business Standard
January 29, 2016 10:23 IST
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High rates of such schemes deter banks from dropping borrowing rates - and thus lending rates

It has been reported that the government is considering a significant increase in the rate of interest associated with deposits in the Employees’ Provident Fund Organisation, or EPFO.

It is said that the EPFO has recommended that the interest rate on provident funds, which is 8.75 per cent at present, be raised to 8.95 per cent for 2015-16. The current interest rate on fixed deposits in the State Bank of India is 8.5 per cent. The differential is much greater when tax savings associated with provident fund deposits are considered.

The EPFO interest rate is just one of the many complex and strikingly persistent administered rates for various state small savings schemes. Banks have to compete for depositors with these tax-saving schemes.

The high rates that such schemes offer their depositors are often cited by banks as one reason why they cannot easily drop borrowing rates – and thus lending rates – in spite of repeated cuts in the repo rate by the Reserve Bank of India.

It is important, therefore, from the point of view of strengthening the monetary transmission mechanism, that such rates be more explicitly linked to the market. Recent committee reports, including from committees chaired by Shyamala Gopinath and Y V Reddy, have strongly recommended as much.

But the government has been reluctant, for political reasons, to cede control. In fact, the last major alteration to administered rates in the small-savings system was in 2002. A recent research report from the State Bank of India suggested that the small savings rate should be uniform and linked to the average of deposit rates with the top five banks.

The RBI has also indicated that the government must take action to correct problems in monetary policy transmission – indeed, in September 2015, when the RBI cut repo rates by 50 basis points to 6.75 per cent, the finance ministry had explicitly said that the Centre would review and rationalise small savings schemes. Even subsequently, the finance ministry has indicated that a plan to liberalise the interest rate regime for small savings schemes is under consideration.

It is to be hoped, therefore, that the suggestion that the EPFO interest rate be increased is viewed in the light of the larger project of reforming small savings and cleaning up the transmission of monetary policy. The interest rate on provident funds must be depoliticised, which would require it to be linked to some market-based formulae instead of the current, essentially arbitrary system where a government-influenced board of trustees makes recommendations about the rate and the government chooses to notify it.

Certainly, given low inflation at the moment and the fact that most other rates are lower, it is difficult to argue that the EPFO rates should be increased—especially at the cost of maintaining stable reserves of cash.

The EPFO has cautiously begun to invest in equities – it put Rs 5,000 crore into SBI Mutual Fund-managed instruments last August – and maintaining stable reserves is even more important under such circumstances. If the government is concerned about protecting the common man, it should note that an increase in interest rates of provident funds is more beneficial to those who have larger PF accounts.

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