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The big deal about small savings schemes

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Last week’s interest rate cut on small savings schemes—which was later revoked—wasn’t the first cut. It won’t be the last.

For the past two decades, successive governments have been trying to walk the tightrope between financial inclusion and fiscal prudence. Government-backed small savings schemes offer a safe and attractive investment avenue for small investors and a capital pool for governments to tap into. But it is an expensive capital pool given the wide difference between market rates and the rates offered in many of these schemes.

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These schemes are typically offered by post offices (and occasionally, banks). They come with a central government guarantee and the money raised via them goes to the centre. In pre-liberalisation days, when investment options were scarce, small savings schemes were the trusted options of households, especially in rural India. Post-liberalisation, their relative importance has reduced in monetary terms. But given their demographic (small investors) and historical benefits (high returns and tax breaks), any attempt to make their interest rates market-linked becomes a talking point.

Under Pressure

Interest rates on small savings have been on a downward trend for nearly two decades now. Post-2015, cuts in interest rates have been larger and more frequent, with the government moving to a quarterly review system in 2017 to align them with market rates. Post-2015, every small savings instrument has seen a rate cut, barring one. The extent of cuts has ranged from 1.6 percentage points to 2.9 percentage points.

The latest central government circular would have lowered rates further by up to 0.9 percentage points. A lower interest rate was also proposed for the one instrument that had been largely spared thus far: the post office savings account, from 4% to 3.5%.

Mass Appeal

The revocation came during state elections, underscoring the political sensitivity of small savings. This is despite the fact that small saving schemes occupy a small part in the overall financial assets of Indian households. According to the central bank, of every 100 of new investments in 2019-20 by Indian households in financial assets, only 12 went into small savings (excluding the Public Provident Fund, or PPF). Even if one includes PPF, that number increases only marginally, given that PPF accounts for 9% of total small savings.

However, more than the amount invested, a greater consideration is how many small investors invested. Data from India Post shows 367.5 million individual accounts across small savings instruments. This is a significant share of the population, even if one accounts for multiple accounts for the same individual. About 52% of accounts are in basic savings accounts, used to access payments from various welfare schemes.

Above Market

Interest rates on post office (PO) savings accounts are market-linked. It’s on long-tenure PO schemes that rates are above market. The premium over market rates are higher in schemes that give a tax break on entry and are not taxed during tenure or on exit, such as PPF. The 2015-16 Economic Survey showed that a significant part of such tax benefits went to individuals who didn’t need it. In 2013-14, 62% of Section 80C tax deductions—for which select small savings schemes qualify—were availed by those with a gross taxable income of above 4 lakh a year.

Lowering rates has disincentivised investments in small savings schemes. Growth in the small savings corpus has dropped from a compounded annual rate of 12.3% in the first decade of this century to 5.2% in the second decade. Yet, at present, only the savings account (15% of the overall portfolio) is market-linked.

Political Ramifications

Everything else remains a work in progress, with political implications. Had the recent rate cut gone through, the most affected would have been individuals in West Bengal, a poll-bound state. According to the National Savings Institute, West Bengal accounted for 15% of gross inflows into small savings schemes in 2017-18, the latest period for which state-wise data is available. The state’s population share in India is 7.3%. Other key states with a similar differential are Delhi, Gujarat and Punjab.

For the government, small savings remain a balancing act. It relies on them to finance its fiscal deficit. Small savings funded 26% of the Centre’s fiscal deficit in 2020-21, against 10% in 2015-16, according to a recent research report from the i-bank, Barclays. Thus, there is an imperative to keep interest rates aligned to market rates. Doing it is not easy, especially in election season.

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