Hold your fire! Govt cutting rates on PPF, small savings schemes is a good move; here’s why

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The Narendra Modi government has cut the interest rates on offer on the public provident fund(PPF) and other small savings schemes run by the post office.

The new interest rates will come into play from April 1, 2016 and will be in effect until June 30, 2016. The interest rate on PPF has been cut from 8.7% to 8.1%. The interest on the Senior Citizens Savings Scheme has been cut from 9.3% to 8.6%.

Instrument Rate of interest w.e.f. 01.04.2015 to 31.3.2016 Rate of interest w.e.f. 01.04.2016 to 30.6.2016
Savings Deposit 4.0 4.0
1 Year Time Deposit 8.4 7.1
2 Year Time Deposit 8.4 7.2
3 Year Time Deposit 8.4 7.4
5 Year Time Deposit 8.5 7.9
5 Year Recurring Deposit 8.4 7.4
5 Year Senior Citizens Savings Scheme 9.3 8.6
5 Year Monthly Income Account Scheme 8.4 7.8
5 Year National Savings Certificate 8.5 8.1
Public Provident Fund Scheme 8.7 8.1
Kisan Vikas Patra 8.7 7.8 (will mature in 110 months)
Sukanya Samriddhi Account Scheme 9.2 8.6

 

This decision to cut down interest rates hasn’t gone down well with the middle class. This has come soon after the Employees’ Provident Fund(EPF) fiasco where the government tried to tax the accumulated corpus of the private sector employees on contributions made after April 1, 2016.

While trying to tax EPF was incorrect, the hue and cry being made out on interest rates on PPF and small savings schemes being cut, is uncalled for. This is happening primarily because most people have become victims of what economists call the money illusion.

What is money illusion? As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes: “[Money illusion] involves a confusion between ‘”nominal” changes in money and “real” changes that reflect inflation…Accounting for inflation requires the application of a little arithmetic, which…is often an annoyance and downright impossible for many people…Most people we know routinely fail to consider the effects of inflation in their finance decision making.”

Hence, money illusion is essentially a situation where people don’t take inflation into account while calculating their return on an investment.

How does this apply to the current context? Let’s consider the Senior Citizens Savings Scheme. The interest rate on offer on the scheme was 9.3%. The rate of inflation that prevailed between 2008 and 2013 was 10% or more. Hence, the real rate of return on the scheme was negative. This was the case with other small savings schemes as well as bank fixed deposits.

In fact, the real rate of return was well into the negative territory. The real rate of return for a senior citizen who did not have to pay income tax on the earnings from the Senior Citizens Savings Scheme stood at minus 0.7% (9.3% minus 10%).

For those who had to pay income tax, the real rate of return was even lower. For those in the 10% tax bracket the real rate of return was minus 1.63% per year. For those in the tax 20% and 30% tax brackets, the real rate of return was minus 2.56% and minus 3.49%.

But back then no one complained about the interest rate being low, even though almost everyone who invested in PPF and other small savings, was losing money. The purchasing power of their investment was coming down.

The situation is totally different now. Inflation as measured by the consumer price index stood at 5.2% in February 2016. Given this, the real rate of return is now in positive territory. Let’s repeat the Senior Citizens Savings Scheme example and see how the real returns stack up.

The interest rate on offer on the Senior Citizens Savings Scheme from April 1, 2016, is 8.6%. For those who do not have to pay any income tax, the real rate of return is 3.4% (8.6% minus 5.2%). For those in the 10%, 20% and 30% tax brackets, the real rate of return works out to 2.54%, 1.68% and 0.82% respectively.

Hence, the situation is substantially better than it was in the past. Investor are actually making a real rate of return on their investments. Also, for savings instrument like PPF, where no tax needs to be paid on accumulated interest, the real returns are higher.

But given that the nominal interest rate has been cut, people have an issue and a lot of noise is being made.

Given these reasons, the government was right in cutting the interest rates on offer on PPF and other small savings schemes. Also, it is important to understand that the high rates of interest on offer on these schemes has been preventing the banks from cutting their deposit as well as lending rates at the speed at which the Reserve Bank of India wants them to.

As RBI governor Raghuram Rajan had said in December 2015 Since the rate reduction cycle that commenced in January [2015], less than half of the cumulative policy repo rate reduction of 125 basis points [one basis point is one hundredth of a percentage] has been transmitted by banks. The median base lending rate has declined only by 60 basis points.” Repo rate is the rate at which RBI lends to banks.

While RBI cut the repo rate by 125 basis points in 2015, the banks only managed to pass on less than half of that cut to their end consumers. One reason for this is that many public sector banks have had a huge problem with their corporate loans. Another reason has been the high interest rates on offer on small savings schemes.

The banks compete with these schemes for deposits and given the high interest on offer on post office savings schemes, banks could not cut interest rates beyond a point without losing out on deposits.

The hope now is that the RBI will cut the repo rate further, banks will cut the interest rates on their loans and deposits, and people will borrow and spend. Whether that happens remains to be seen.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on March 19, 2016

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About vivekkaul
Vivek Kaul is a writer who has worked at senior positions with the Daily News and Analysis(DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System , the latest book in the trilogy has just been published. The first two books in the trilogy were published in November 2013 and July 2014 respectively. Both the books were bestsellers on Amazon.com and Amazon.in. Currently he works as an economic commentator and writes regular columns for www.firstpost.com. He is also the India editor of The Daily Reckoning newsletter published by www.equitymaster.com. His writing has appeared across various other publications in India. These include The Times of India, Business Standard,Business Today, Business World, The Hindu, The Hindu Business Line, Indian Management, The Asian Age, Deccan Chronicle, Forbes India, Mutual Fund Insight, The Free Press Journal, Quartz.com, DailyO.in, Business World, Huffington Post and Wealth Insight. In the past he has also been a regular columnist for www.rediff.com. He has lectured at IIM Bangalore, IIM Indore, TA PAI Institute of Management and the Alliance University (Bangalore). He has also taught a course titled Indian Economy to the PGPMX batch of IIM Indore. His areas of interest are the intersection between politics and economics, the international financial crisis, personal finance, marketing and branding, and anything to do with cinema and music. He can be reached at vivek.kaul@gmail.com

5 Responses to Hold your fire! Govt cutting rates on PPF, small savings schemes is a good move; here’s why

  1. Srihari says:

    The inflation might be low but for an average person there’s no change in retail prices of goods. I’m not paying anywhere less !!! 😦

  2. raj says:

    Dear Vivek,

    When the inflation was high, people like you never argued for interest rate hike, but when inflation is low you start complaining how middle class is not under standing. End of the day I need my hard earned money after paying taxes should retain its value. During high inflation period my savings eroded, why not i earn high interest now so that my eroded savings regain certain value which has been lost. Average inflation should be equivalent to average interest rate, else it is unfair. We cannot consider just one year inflation rate and reduce interest rate.

    • vivekkaul says:

      Hello

      Actually I did…And more than a few times…But you have already formed your opinion before looking…

      Vivek

      • raj says:

        Dear vivek,

        Yes you argued, that people should shift to volatile asset class to save capital erosion like MF. Not for increasing the interest rate of ppf, PF or small savings. This move by government is anti middle class, people like you create false impression that since inflation gas come down it is right to reduce interest rate. What about the erosion of capital due inflation rate, when is government going to take steps to regain the eroded capital because of high inflation regime. Government should allow people to regain their eroded capital before make such dumb and stupid moves. The government will move like a turtle to catch hold of mallya, control inflation and bring back black money, but acts very swift in reducing interest rate or bringing new taxes.

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