Small savings rates finally come down to more rational levels

Let us understand why the big cut in small savings rate on March 31, 2020 is significant.

April 01, 2020 1:44 IST | India Infoline News Service
For a long time, the rates of interest on small savings like PPF, NSC, SCSS and post office deposits were largely out of sync with yields in the market. Small savings products were not just about higher yields but also tax benefits. For example, products like NSC are eligible for exemptions under Section 80C. PPF not only offers exemptions under Section 80C but even the interest is tax free. These distortions made small savings artificially attractive. That is why the big cut in small savings rate on March 31, 2020 becomes significant.

Small savings rate cut and after
Small Savings Product Old Rate (till 31st Mar) New Rate (from 01st Apr) Cut in rates (in bps)
Savings Deposit 4.0% 4.0% No Change
1-Year Time Deposit 6.9% 5.5% -140 
2-Year Time Deposit 6.9% 5.5% -140 
3-Year Time Deposit 6.9% 5.5% -140 
5-Year Time Deposit 7.7% 6.7% -100 
5-Year Recurring Deposit 7.2% 5.8% -140 
SCSS 8.6% 7.4% -120 
POMIS 7.6% 6.6% -100
NSC 7.9% 6.8% -110 
PPF 7.9% 7.1% -80
Kissan Vikas Patra 7.6% 6.9% -70 
Sukanya Samriddhi 8.4% 7.6% -80

Data Source: Ministry of Finance

The  rate cuts have ranged from 70 bps at the lower end to 140 bps at the upper end. These rate cuts were long called for and put small savings products at par with other debt instruments. This rate cut could have 3 implications; planning for senior citizens, debt funds and bank borrowings.

How this rate cut will impact senior citizens?
In India senior citizens make extensive use of two products viz. Post Office Monthly Income Scheme (POMIS) and the Senior Citizens Savings Scheme (SCSS). The interest rates on these two products have been cut by 100 basis points and 120 basis points respectively. This is likely to adversely impact the monthly earnings of senior citizens and make them reconsider their decision to continue in these products when they come up for renewal. The solace of being backed by the government will continue to work in favour of these small savings products. But the government has surely made an aggressive move which makes the rates on small savings more competitive with less artificial advantage. Going ahead, asset allocation becomes more critical for senior citizens.

Will this move be a boost for debt funds?
How will debt funds now rank vis-à-vis PPF after these rate cuts. One can argue that they are strictly not comparable, but they do present two interesting options for conservative investors. Let us assume that the investment is Rs100,000, the person is in 20% tax bracket and average returns on debt funds are at 9%.

Old Taxation Formula New Taxation Formula
Details PPF Debt Funds PPF Debt Funds
Investment Rs100,000 Rs100,000 Rs100,000 Rs100,000
Return (%) 7.1% 9.0% 7.1% 9.0%
Section 80C Rs20,000 Nil Nil Nil
Effective Invest Rs80,000 Rs100,000 Rs100,000 Rs100,000
Annual Earnings Rs7,100 Rs9,000 Rs7,100 Rs9,000
Tax (20%) Nil Rs1,800 Nil Rs1,800
Post Tax earnings Rs7,100 Rs7,200 Rs7,100 Rs7,200
Effective Yield 8.875% 7.20% 7.10% 7.20%
PPF continues to be attractive vis-à-vis debt funds if you continue with the old taxation formula. However, if you opt for the new tax formula and forgo exemptions, the average yield on debt funds is slightly better than PPF. That is why, this sharp cut could be a game changer for debt funds. RBI has already committed to keep rates low and liquidity abundant.

Now banks can ensure better transmission of rate cuts
The biggest take away from the cut in small savings rates is that it would result in better transmission of rate cuts to end borrowers. For example,  prior to October 2019, the transmission used to be extremely poor at just about 30%, making rate cuts ineffective. Post October 2019, the RBI shifted all floating rate loans to external benchmarking. This led to an improvement in the transmission ratio to above 50%. However, this cut in small savings rates could be the real kicker for transmission of rate cuts. Here is why.

Most banks could transmit rate cuts only if they reduced the rates paid on deposits also. That was not possible due to the artificially high rates offered by the government on small savings. That acted as a floor below which banks could not drop rates of interest. With the sharp cut in small savings, that floor becomes a lot more reasonable and it could mean that banks can drop deposit rates more freely now. The onus is now on banks to ensure that any rate cuts by the RBI are seamlessly transmitted to the borrower making the relationship between lower repo rates and higher industrial growth more significant.

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