Interest rate cuts by the Reserve Bank of India (RBI) are usually good for the economy. It reduces the borrowing costs of business, which in turn leads to incremental economic activity, higher employment rates and higher GDP growth. The stock and bond markets react favourably to rate cuts by the RBI. On April 5, 2016 the RBI cut the repo rate by 25 basis points and on the same day the Sensex fell by more than 500 points, because the market was expecting a bigger cut. Whether there is room for RBI to reduce rates further in the coming quarters is a topic of debate amongst economists, bankers and policy makers. While lower interest rates are good for the stock and bond markets, as a society we should also recognize that there are millions of Indians who depend on the interest income of small savings schemes.
Small savings schemes formed 35% of the financial savings of average Indian households from FY 2000 – 2014. In the month of February 2016, the Government announced new small savings scheme rules, which has come into effect from April 1, 2016. Under the new rules, investors in small savings schemes like Public Provident Fund, National Savings Certificates, Senior Citizens Savings Scheme, Post Office Monthly Income Scheme, etc will earn considerably lower income than before. Further, under the new rules, the interest is likely to fall further in the future. What should investors who depend on these schemes do? In Advisorkhoj, we believe in the old adage, “Knowledge is power”. While situations in life change, your knowledge remains with you. Knowledge does not only help you understand the current situation but, more importantly, it arms you with the power of foresight, which helps you to make better financial decisions. In this blog post, we will discuss what has changed in the small savings schemes, why has it changed, what may happen with interest rates in the future and finally, how can you increase your income?
From April 1, 2016 the interest rates of small savings schemes have been revised downwards. The table below shows the revised interest rates, with effect from April 1, 2016.
Source: New interest rates as per India Post website
While the lower interest rates will certainly hurt the income of investors in these schemes, this is not the only change in small savings schemes. Earlier, the interest rates were set for one year. Under the new rules, the interest rates will be revised every quarter, based on the previous 3 month yields of the benchmark Government Bonds with a small mark up. Under the new rules, even the quantum of mark up has been reduced. So if Government Bond yields fall by 20 basis points in the first quarter of this year, the interest rates of small savings schemes can go down further by 0.2% in the next quarter. This is an important point that you should remember for your financial planning.
While most of these changes were expected over the last few months, there were expectations in some quarters that the Government would leave the Senior Citizen Savings Scheme and Sukanya Samriddhi Scheme interest rates unchanged, since senior citizens and girl children are two important demographic constituencies in India. However, you can see that, the interest rates of even these two schemes were slashed. Let us understand why the interest rates of small savings schemes were reduced by the Government. Since 2015, the RBI has reduced repo rates by 1.25%. However, reduction in policy rates did not translate into an equal reduction of actual lending rates by the banks. While the RBI cut interest rates by 1.25%, only about 60% of the rate cut was passed on to the borrowers by the banks. As such, the RBI rate cuts did not have the desired effect on credit off-take and economic growth in India.
The banks cited multiple reasons as to why they were not able to reduce their lending rates by the same quantum as the RBI rate cut. The reasons why banks were not able to cut lending rates by as much as the repo rate reduction are not part of our discussion today. The RBI has already taken steps to ensure better transmission of monetary policy actions, e.g. new method of calculating base lending rates, lowering cash reserve ratio (CRR) requirements etc. Relevant to today’s topic, is one of the reasons, the banks cited for the transmission gap with respect to monetary policy actions of the RBI. The banks said that they were not able to reduce their deposit rates, because they were facing unfair competition from the small savings schemes of the Government. Since the interest rates of the Government small savings schemes were high and some of these schemes also enjoyed favourable tax treatment, the banks were not able to bring down their deposit rates to the desired extent because they were losing their share of Indian household savings to the Government small savings schemes.
The high percentage of house financial savings in small savings schemes over the last 15 years, as discussed in the first paragraph of this post, lends credence to the bank’s argument. Since the banks were not able to reduce their deposit rates to the desired extent, they were also not able to reduce the lending rate. On this premise, the RBI has been asking the Government to reduce the interest rates in the small savings scheme so that the banks can reduce their fixed deposit interest rates, which will result in lower cost of funds for the banks, which in turn will enable them to reduce lending rates. The Government saw merit in RBI’s position and reduced the interest rates of the small savings schemes. Further, the Government felt that the interest rates of small savings schemes were not linked to yields of Government bonds to the extent they should be. Investors should understand that, the collections in the small savings schemes are invested in Government bonds of different maturities. While the yields of the Government bonds are market driven, the interest rates of small savings schemes were set for a year and sometimes remained unchanged for years together. The quarterly reset of interest rates of these small savings is a measure to bring about a greater alignment between market yields and small savings interest rates.
Under the new rules, interest rates of small savings schemes in the next quarter and beyond will depend on the benchmark Government bond yields. On April 5, the RBI reduced repo rates by 25 bps. We had discussed earlier that the RBI was also taking steps to improve the transmission of rate cuts in the banking system. In their April 5 monetary policy announcement, the RBI announced significant measures to improve the liquidity situation in the banking system of India. You should also remember that from April 1 2016, the banks have adopted a new method, prescribed by the RBI, for calculating base lending rates, which will be based on marginal cost of funds of the banks. SBI and ICICI Bank have already come out with revised lending rates, based on the new method. The effect of all the measures taken by the RBI, as per bankers and economists, will result in lower actual interest rates in the economy and lower Government bond yields by 20 to 25 basis points further. If the benchmark Government bond yields fall by 20 to 25 basis points, the interest rates of small savings schemes will fall by a similar amount. What is the longer term outlook of Government Bond yields? The chart below shows the historical 10 year Government bond yields.
You can see in the chart above that, 10 year Government Bond yield has been declining from its high of around 9% over the last 2 years. The 10 year Government Bond yield is now well below 8%. In fact, if you carefully observe the last part of the chart, you will see that the 10 year yield has come down in the last one month. The Government is targeting a lower year on year fiscal deficit in FY 2017. CPI inflation is in control aided by lower global commodity prices. We had two consecutive bad monsoons in India. Very early meteorological forecasts indicate good monsoon this year; better meteorological forecasts will be available in the next few weeks. Our point is that, if we have good monsoon, the food price inflation will be lower. The RBI has reiterated its accommodative monetary policy stance in each of its policy announcements over the last few quarters. Therefore, one can expect the Government bond yields to go down further in the coming quarters, barring unexpected economic shocks. As a result, the interest rates of small savings schemes are likely to go down further, in the near to medium term with reduction in Government Bond yields.
Though the reduction in small savings scheme’s interest rates will hurt many Indian households who depend on these schemes, investors simply have no choice but to accept the new reality. As discussed in the previous paragraph, the interest rates of small savings schemes are likely to go down further over the coming quarters and also years. About 4 months back, a relative from my wife’s side, who will retire in April 2017, told me that he would invest a substantial portion of his Provident Fund and Life Insurance policies maturity proceeds in the post office MIS and earn 8.5% interest, payable monthly, for a significant part of his post retirement monthly income needs. Naturally, he is worried after the MIS interest rates were slashed by 0.7%. Worrying will not help you; you have to invest wisely to get the best possible income from your investment. Here are some of the options that you can consider to get a higher income.
In this post, we have discussed that, the interest rates of small savings schemes have been slashed, starting April 1, 2016. It is very likely that, the interest rates will be reduced further in the coming quarters. Investors have no choice but to accept the new reality with respect to these schemes. On the other hand, if investors educate themselves about different products available, especially in the mutual fund space (please see our article, Demystifying debt mutual funds), they can get good tax efficient returns which will meet their financial goals.
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