Small savings rates could be cut to boost bank rate transmission

The problem for RBI is that the rates on small savings are substantially higher than bank deposits and that prevents banks from cutting deposit rates for fear of losing deposits. But are small savings rates really higher?

Dec 26, 2019 10:12 IST India Infoline News Service

On December 11, 2019, the RBI advised the government of India to cut rates on small savings instruments like PPF, post office deposits, NSC, SCSS, Sukanya Samriddhi, etc. Small savings are guaranteed by the government and are considered to be risk-free in terms of timely payment of interest and principal. The problem for RBI is that the rates on small savings are substantially higher than bank deposits and that prevents banks from cutting deposit rates for fear of losing deposits. But are small savings rates really higher?
 
Are small savings rates really higher; yes they are!
To get a relative perspective of rates we have compared small savings rates announced by the government with the benchmark rate paid by SBI on its 5 year deposits. The graph gives a comparative view of rates on small savings vis-à-vis the SBI 5 year bank deposits.
Data Source: RBI & SBI
 
The chart underlines that, the average rate of interest payable on small saving instruments (shaded in blue) is sharply higher than the rate of interest payable on SBI 5-year FD (shaded in red). What does this mean?
 
This kind of a difference in rates puts bank FDs at a clear disadvantage vis-à-vis other small savings instruments. SBI has expressed concerns that any sharp cut in FD rates by SBI could lead to a migration of funds to post offices. Small savings already have the advantage of being government backed.
 
In the post October 2019 scenario, floating rate loans offered by banks are linked to an external benchmark. The most important factor determining the MCLR is the cost of deposits. To cut lending rates in tandem with the cut in repo rates, banks need to cut their deposit rates too. That is not practical considering that the rates on bank FDs are sharply lower than the rate on small savings.
 
Tax benefits are another distorter of interest rates
One of the advantages that small savings have is that they are tax exempt at multiple levels. For example, in case of PPF, the contribution has an exemption up to Rs150,000 per year under Section 80C. In addition, interest received on the PPF investment is also tax-free in the hands of the investor. In the case of bank deposits, Section 80C benefit is available on long term deposits of 5 years and above. However, even in that case, the interest on the bank FD continues to be taxable. Here is how the comparison works out for an individual in the 30% tax bracket.
Particulars PPF Investment 5-Year PO Deposit 5-Year SBI Deposit
Total Investment Rs100,000 Rs100,000 Rs100,000
Interest rate 7.90% 7.70% 6.25%
Section 80C Available Yes Yes Yes
Interest tax status Tax Free Taxable Taxable
Comparison of Effective returns on the 3 instruments
Section 80C benefit-30% Rs30,000 Rs30,000 Rs30,000
Effective Investment (A) Rs70,000 Rs70,000 Rs70,000
Interest received Rs7,900 Rs7,700 Rs6250
Post Tax Interest (B) Rs7,900 Rs5,390 Rs4,375
Effective Post Tax yield (%) – B/A 11.29% 7.70% 6.25%
Notes: (1). Effective investment is reduced by tax exemption (2). Cess and surcharge are ignored for simplicity
 
In the above case, the SBI FD continues to be at a similar disadvantage to a PO deposit. However, the disadvantage vis-à-vis PPF gets widened because interest on PPF is tax-free. This tax benefit under Section 80C is only available for 5 year bank deposits. If it is a 4-year deposit, then the effective post tax yield would only be 4.38%. That is why banks are facing really serious problems with reference to small savings rates in India.
 
A cut in small savings rates is inevitable
The gap in interest rates between banks and small savings is currently more than 140 basis points and it will not be possible for the banks to cut their deposit rates further from these levels. Unless the banks cut their deposit rates, loan rates cannot be cut. That possibly explains why the actual loan costs have gone down by less than 50 bps, although the RBI has cut repo rates by 135 basis points since January 2019. Till the small savings rate anomaly is resolved, it will be hard to expect any worthwhile transmission by the banks to borrowers.
 
RBI is right in asking for lower small savings rates. Government will have to bite the bullet, although the issue can be sensitive. That will be the first step needed to align rates better. Initial calculations are that the government will have to look at a substantial cut in small savings rates to make repo rate cuts meaningful. Whether the economic imperative is backed by political will; remains to be seen.

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