Six Months After Demonetisation Cash is King Again and Questions Still Remain

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On November 8, 2016, the prime minister Narendra Modi announced his government’s decision to demonetise Rs 500 and Rs 1,000 notes, to an unsuspecting nation. The decision came into effect from the midnight between November 8 and November 9, 2016, and suddenly rendered 86.4 per cent of the nation’s currency in circulation, useless.

It’s been six months since then and more than four months since December 30, 2016, the last date for depositing the demonetised Rs 500 an Rs 1,000 notes, into bank accounts. But even after this period as far as the government is concerned, a few basic points remain.

a) How much demonetised money finally made it into bank accounts? When demonetisation was first announced, this number was shared regularly. Nevertheless, the last announcement on this front from the Reserve Bank of India(RBI) came on December 13, 2016. As of December 10, 2016, Rs 12.44 lakh crore of demonetised currency had made it back into the banks.
Given that Rs 15.44 lakh crore worth of currency notes had been demonetised, nearly 80.6 per cent of the currency had found its way back into banks, nearly three weeks before the last date to deposit demonetised notes into bank accounts.
Neither the Reserve Bank nor the government has told the nation how much money eventually made it back into the banks. This is an important question and needs to be answered.

b) The initial idea behind demonetisation was to curb fake currency notes and eliminate black money.
As far as fake currency goes the minister of state for finance Arjun Ram Meghwal told the Lok Sabha in early February 2017 that the total number of fake notes deducted in the currency deposited into banks after demonetisation stood at 2.46 lakhs. This amounted to a total value of Rs 19.5 crore.
As mentioned earlier, the total value of demonetised notes had stood at Rs 15.44 lakh crore. Given this, the proportion of fake notes deducted is almost zero and can be ignored. Hence, as far as detecting and eliminating fake notes was concerned, demonetisation was a total flop.
How did it do as far as eliminating black money is concerned? The hope was that the black money held in the form of cash will not make it back into the banks, as people wouldn’t want to get caught by declaring it. But by December 10, 2016, more than four-fifth of the demonetised notes had already made it back into the banks. Since then the government and the RBI have not given out any fresh numbers. It’s surprising that it has been more than four months since December 30, 2016, and this number is still not out in the public domain.
Also, it is important to point out here: “High denomination notes are known to facilitate generation of black money. In this connection, it may be noted that while the total number of bank notes in circulation rose by 40% between 2011 and 2016, the increase in number of notes of Rs.500/- denomination was 76% and for Rs.1,000/- denomination was 109% during this period.”
If high denomination notes facilitate generation of black money, then why replace Rs 1,000 notes with Rs 2,000 notes. Given that a Rs 2,000 note is twice the value of a Rs 1,000 note, it makes black market transactions even more easier. It also makes storage of black money in the form of cash easier, given that it takes less space to hide the same amount of money.
Again, this is a basic disconnect in what the government planned to achieve through demonetisation and what it eventually did. No effort has been made to correct this disconnect.

c) The government has still not offered a good explanation of what prompted it to demonetise. There has been no similar decision taken by any other country in a stable financial situation like India currently is, in the modern era. The best that the government has done is blamed it on the RBI. As Meghwal told the Lok Sabha in early February 2017: “RBI held a meeting of its Central Board on November 8, 2016. The agenda of the meeting, inter-alia, included the item: “Memorandum on existing banknotes in the denomination of Rs 500 and Rs 1000 – Legal Tender Status.””
Anybody who has studied the history of the RBI would know that the RBI would never take such an extreme step without extreme pressure from the government.

d) Other than eliminating black money and fake currency notes through demonetisation, in the aftermath of demonetisation, the government wanted to promote cashless transactions. As Modi said in the November 2016 edition of themann ki baat radio programme: “The great task that the country wants to accomplish today is the realisation of our dream of a ‘Cashless Society’. It is true that a hundred percent cashless society is not possible. But why should India not make a beginning in creating a ‘less-cash society’? Once we embark on our journey to create a ‘less-cash society’, the goal of ‘cashless society’ will not remain very far.”

How are things looking on that front? Look at the following table. It shows the volume of digital transactions over the last few months.

Month Volume of digital transactions (in million)
Nov-16 671.5
Dec-16 957.5
Jan-17 870.4
Feb-17 763.0
Mar-17 893.9
Apr-17 843.5

Source: Reserve Bank of India

While digital transactions picked up in December, they have fallen since then. The total number of digital transactions in April 2017 is higher than it was in November 2016. Nevertheless, it is worth asking, whether this jump of 25 per cent was really worth the trouble of demonetisation.

e) Falling digital transactions since December 2016 tell us that cash as a mode of payment is back in the system. There is another way this can be shown. Between November 2016 and February 2017, banks barely gave out any home loans. During the period, the banks gave out home loans worth Rs 8,851 crore. In March 2017, they gave out total home loans of Rs 39,952 crore, which was 4.5 times the home loans given out in the previous four months. It also amounted to 35 per cent of the home loans given out during the course of 2016-2017.

A major reason why people weren’t taking on home loans between November 2016 and February 2017 was demonetisation. There simply wasn’t enough currency going around. With this, the real estate transactions came to a standstill because without currency it wasn’t possible to fulfil the black part of the real estate transaction. Those who owned homes (builders and investors) were not ready to sell homes, without being paid for a certain part of the price, in black.

By March 2017, nearly three-fourths of the demonetised currency was replaced. This basically means that by March 2017, there was enough currency in the financial system for the black part of the real estate transactions to start happening all over again. Also, the Rs 2,000 note makes this even more convenient.

To conclude, six months after the declaration of demonetisation it is safe to say that demonetisation has failed to achieve what it set out to achieve i.e. if it set out to achieve anything on the economic front.

The column originally appeared on Firstpost on May 9, 2017

RERA: With state govts diluting key provisions, can the Act protect buyers at all?

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The Real Estate (Regulation and Development) Act, 2016, or RERA for short, has come into effect from May 1, 2017.

In large sections of the media, the RERA is being projected as a saviour for the home buyers. But will it turn out to be like that?

Will builders stop taking home buyers for a ride?

Will home buyers get the same home and facilities, which had been advertised, and which had been paid for?

Will the home buyers ever come to know what is the exact size of the home that they are paying for?

Will a builder still manage to not finish the project and disappear with the money he had taken from home buyers?

Will builders stop demanding black money?

The RERA is expected to make things better for the prospective home buyer, at least in theory. But in practice it’s off to a bad start.

While RERA is a central Act, land is a state subject. The Indian constitution divides legislative actions into three lists: a) union list b) state list c) concurrent list, on which both the state governments and the union government can legislate. Land is a state subject. Construction of homes requires land. And given this, the different state governments need to come up with the operational rules to implement RERA.

And this is where the entire idea of RERA protecting the interest of the home buyers seems to be going for a toss. First and foremost, even though the Act has come into effect from May 1, 2017, many state governments are yet to notify the operational rules in order to implement RERA.

A Crisil Research note titled Most states miss RERA deadline and dated May 2, 2017, points out: “Despite continuous monitoring and follow up by the Ministry of Urban Development and Housing, Government of India, only nine states (Andhra Pradesh, Bihar, Gujarat, Kerala, Madhya Pradesh, Maharashtra, Odisha, Rajasthan, and Uttar Pradesh) and six union territories (Andaman and Nicobar Islands, Chandigarh, Dadra and Nagar Haveli, Daman and Diu, Lakshadweep, and National Capital Territory of Delhi) have notified their respective Real Estate (Regulation and Development) Rules, 2017.”

Given that Union Territories are largely in control of the union government, it isn’t surprising that the operational rules are in place. But only around one-third of the states have notified the operational rules of RERA. And this in itself shows how serious state governments are about implementing RERA.

Further, even those states which have passed operational guidelines have diluted the Act in the process. As per the RERA, an ongoing project  is basically a project “for which the completion certificate has not been issued” on the date of commencement of the Act. This basically makes sure that many home projects which are work-in-process come under the Act.

Several states have diluted this definition. Crisil Research points out: “Andhra Pradesh, Kerala and Uttar Pradesh have altered this definition in their notified rules.” In case of Gujarat, the operational rules do not mention any definition of an ongoing project.

The operational rules of the Haryana government also dilute the definition by stating that projects which have applied for a part completion certificate or an occupancy certificate will not come under the RERA, if the certificate is granted. This has led to many builders rushing to get an occupancy certificate to ensure that their project does not come under the Act.

As a newsreport in The Economic Times points out: “Developers in Haryana are making use of the window provided by the draft state RERA rule, published on Friday [April 28, 2017], to get out of the ambit of the regulatory authority. On the first working day after the draft rule was announced, over 50 applications were submitted with the department of town and country planning (DTCP), seeking occupation certificates (OC).” In the days to come, many more applications are expected to be submitted. This has basically made a mockery of what RERA was trying to achieve.

There are other dilutions that have been made as well. As Crisil Research points out: “According to the central legislation, the model sale agreement is required to specify 10% advance payment, or charge an application fee from buyers, while entering into a written agreement for sale. In addition, in case of any structural defects arising within five years of handing over the possession of project to buyers, developers will be liable to rectify such defects without further charge. However, there is no clarity on these clauses in most states’ RERA notifications.”

Another important clause in RERA is the escrow account clause. As the Act states: “seventy per cent of the amounts realised for the real estate project from the allottees, from time to time, shall be deposited in a separate account to be maintained in a scheduled bank to cover the cost of construction and the land cost and shall be used only for that purpose.”

Hence, 70 per cent of the money taken from the home buyers by the builder needs to be maintained in a separate escrow account and needs to be used only for the purpose of building the homes. Also, this money needs to withdrawn in proportion to the percentage of completion of the project.

This is a key clause in RERA and was put in to stop the builders from raising money for a project and then using it for other things like completing an earlier project or paying off debt that was due.

The operational guidelines of many states are not clear on this. Like the operational guidelines of Gujarat, do not mention the norms for withdrawal of money from the escrow account of the project. The operational guidelines of Kerala state that “70% (or less, as notified by the government) of the amount realised by developers to be deposited in a separate account.” There is no clarity on withdrawal of money from the escrow account. This is true even for the guidelines issued by Madhya Pradesh.

Over and above this, RERA recommends imprisonment and fines for non-compliance with the Act. Several states have diluted this as well. Long story short—while the idea behind the RERA might have been noble to protect the buyers from the builders, but the state governments have managed to dilute that core purpose to a large extent.

The column originally appeared on Firstpost on May 3, 2017.

 

 

Will RBI’s Latest Rescue Act Clean the Mess in Public Sector Banks?

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Late last week, the Reserve Bank of India(RBI) unleashed yet another weapon to clean up the mess that India’s public sector banks are in. The RBI reviewed and revised the preventive corrective action (PCA) framework for banks.

At a very simplistic level, the PCA framework essentially will restrict the ability of any bank to go about their normal business, in case they don’t meet certain performance parameters. The idea is to ensure that banks do not get into a further mess.

The RBI has basically set three risk levels for the PCA framework to kick-in. Take the case of bad loans or net non-performing assets(NPAs) of banks. (NPAs are essentially loans which borrowers have defaulted on and are no longer repaying. These NPAs are referred to as gross NPAs. Against, the gross NPAs, the banks set aside a sum of money referred to as provisions. Once these provisions are subtracted from gross NPAs what remains are net NPAs).

Let’s say the net NPA of a bank is greater than or equal to 6 per cent but less than 9 per cent. In this case, the bank will face a restriction on dividend distribution. This is the first risk level of the PCA framework. In case, the net NPA is greater than or equal to 9 per cent and less than 12 per cent, along with dividend restrictions the bank will also face a restriction on branch expansion and at the same time will have to increase its provisions or the money it sets asides against gross NPAs. This is the second risk level of the PCA framework.

If the net NPA is greater than or equal to 12 per cent, then along with the dividend restrictions, restrictions on bank expansion, greater provisioning, the banks will have to limit the management compensation and directors’ fees. This is the third risk level of the PCA framework.

Along with net NPAs, the other performance parameters that the RBI plans to take a look at as a part of the PCA framework are the capital adequacy ratio, return on assets and the leverage of the bank. If the bank does not meet the RBI set levels of these parameters, the actions highlighted above will kick-in.

Over and above this, there are other actions that can kick-in. These include:

  1. Special audit of the bank
  2. A detailed review of business model in terms of sustainability of the business model of the bank.
  3. RBI to actively engage with the bank’s Board on various aspects as considered appropriate.
  4. RBI to recommend to owners (Government/ promoters/ parent of foreign bank branch) to bring in new management/ Board.
  5. RBI to supersede the Board.
  6. Reduction in exposure to high risk sectors to conserve capital.
  7. Preparation of time bound plan and commitment for reduction of stock of NPAs.
  8. Preparation of and commitment to plan for containing generation of fresh NPAs.
  9. Strengthening of loan review mechanism.
  10. Restriction of staff expansion.
  11. Restrictions on entering into new lines of business.
  12. Restrictions on accessing/ renewing wholesale deposits/ costly deposits/ certificates of deposits.
  13. Reduction in loan concentrations; in identified sectors, industries or borrowers.

If you look at the above actions, other than the RBI superseding the board of the bank, the other steps are more or less what any bank which is in trouble would undertake. The question is will the PCA unravel the mess that the Indian banks, in particular the government owned public sector banks, are currently in.

The biggest problem for the public sector banks has been the fact that their gross NPAs have been increasing at a very rapid rate. Between December 2014 and December 2016, the gross NPAs of public sector banks increased by 137 per cent to Rs 6.46 lakh crore.

What is the reason for this huge and sudden increase in gross NPAs? A major reason lies in the fact that banks have been recognising their bad loans as bad loans at a very slow speed. The question is the recognition of bad loans as bad loans over? Have all bad loans been recognised as bad loans? Or are banks still resorting to accounting gimmicks and postponing the recognition of bad loans? This is a question which only the banks or the RBI can answer.

The most important step in cleaning up the balance sheets of Indian banks is ensuring that all the bad loans have been recognised as bad loans. A problem can be solved only after it’s properly identified. The tendency not recognise bad loans as bad loans and project a financial picture which is incorrect needs to end.

The second biggest problem for Indian banks has been the poor recovery rate of bad loans (i.e. net NPAs in this case). Data from RBI shows that in 2015-2016, the recovery rate fell to 10.3 per cent of the net NPAs. In 2014-2015, it was at 12.4 per cent. In 2013-2014 and 2012-2013, the recovery rates were even better at 18.4 per cent and 22 per cent, respectively.

This basically means that the ability of banks to recover bad loans has gone down over the years. Will the PCA framework be able to help on this count? It doesn’t seem so. A greater portion of the bad loans need to be recovered from corporate India. As the Economic Survey points out: “The stressed debt is heavily concentrated in large companies.” Hence, any major recovery from large companies will need a lot of political will something, which is something the RBI cannot do anything about.

The PCA framework will kick-in depending on the performance of banks as on March 31, 2017. But taking the net NPA numbers as on December 31, 2016, how does the scene look like for public sector banks? There are 21 public sector banks which currently have a net NPA ratio of greater than 6 per cent. Hence, the PCA framework will apply to all of these banks. The first risk level of the PCA framework will apply to all these banks.

Of these ten banks have an NPA of greater than 9 per cent. The second risk level of the PCA framework will apply to these banks. Two banks have an NPA of greater than 12 per cent. The Indian Overseas Bank is the worst of the lot at 14.3 per cent. The State Bank of Patiala came in next as of December 2016. This bank has since been merged with the State Bank of India.

The PCA framework will essentially limit the ability of these banks to carry out business and hence, limit further damage to the bank and the financial system.

Nevertheless, there is no way the framework will clear up the mess that these banks are in. For that what is needed is a lot of political will to go after corporates and recover the bad loans that are outstanding. The question is do we have that kind of political will?

The column originally appeared on Firstpost on April 19, 2017 

EPF issue: Why protests against rate cut show cussedness of trade unions

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The interest on the Employees’ Provident Fund(EPF) for the year 2015-2016 has been set at 8.7%.

The Central Board of Trustees(CBT) of the Employees’ Provident Fund Organisation(EPFO) had proposed an interest of 8.8%, when they had met in February earlier this year. The ministry of finance finally decided on an interest rate which is 10 basis points lower at 8.7%, than what the Trustees of EPFO had proposed. One basis point is one hundredth of a percentage.

This hasn’t gone down well with the trade unions and they have decided to protest. Bhartiya Mazdoor Sangh (BMS), the trade union closest to the ruling Bhartiya Janata Party, given its affiliation to the Rashtriya Swayamsevak Sangh(RSS), has decided to hold protests across the country.

As its general secretary Virjesh Upadhyay told PTI: “BMS strongly condemns the cut in EPF interest rates and will hold demonstrations at EPF offices on April 27,” Sangh general secretary said, adding, the Fund is managed by the Central Board of Trustees (CBT), an independent and autonomous body.”

Other trade unions have also come out strongly against the move. But the entire thing is quite bizarre. The question is what are they protesting about? It seems the ministry of finance’s decision of cutting down the interest rate offered by 10 basis points to 8.7%, from the 8.8% proposed by the CBT of EPFO, hasn’t gone down well with the unions.

As AK Padmanabhan, board member of the CBT of EPFO and the president of Centre for Trade Union Congress told The Indian Express: “It’s unusual that after the CBT recommendation, the finance ministry has decided to cut interest rate.”

Maybe, the move is unusual, but are the trade unions also totally jobless? Allow me to explain. How much difference does the 10 basis point cut actually make? On a corpus of Rs 1 lakh, it makes a difference of Rs 100.

Also, the interest rate paid on EPF in 2014-2015 and 2013-2014 was 8.75%. In comparison to that, the interest for 2015-2016 will be lower by Rs 50 per lakh.

Is it worth protesting on something like this? What are the trade unions actually trying to achieve by doing this? Or since they are trade unions, they need to protest against everything?

Also, don’t the trade unions know that 8.7% interest being paid on EPFO, is the highest interest rate being offered by the government across all its schemes? It is sixty basis points more than the 8.1% per year interest currently being offered on the Public Provident Fund and the National Savings Certificate(NSC).

It is ten basis points more than the 8.6% on offer on the Senior Citizens’ Savings Scheme and Sukanya Samriddhi Account Scheme. Even the senior citizens who typically get paid more otherwise, are being paid lower than the interest being paid on EPF. So what are the trade unions protesting about?

The government is trying to move the country towards a lower interest rate regime. Fixed deposit rates are down by more than 100 basis points in the last one year. In comparison, the EPF interest rate has been slashed by just 5 basis points. Further, interest earned on fixed deposits is taxable. Interest earned on EPF is not.

If all these reasons are taken into account, the planned protests of the trade unions essentially look very hollow.

Also, what is the government trying to achieve by cutting the EPF interest rate by 10 basis points? In an ideal world, the government would have wanted to cut the EPF interest rate much more, to bring it in line with the other prevailing interest rates. But given all the hungama that has recently happened whenever the government has tried to bring any change to the EPF, it basically wasn’t in the mood to take on any more risk.

Having said that a 10 basis point cut in the EPF interest rate essentially achieves nothing.

Further, it needs to be asked, why a provident fund as big as EPF is, is not professionally managed? As on March 31, 2015, the EPFO managed funds worth Rs 6.34 lakh crore in total. Provisional estimates suggest that in 2015-2016, the EPFO saw Rs 1.02 lakh crore being invested in the three schemes that it runs. Of this around Rs 71,400 crore was invested in the EPF. This means as on March 31, 2016, the EPFO managed funds worth Rs 7.36 lakh crore in total.

This is a huge amount of money. The question is why is this money not being professionally managed. The CBT of EPFO essentially comprises of the labour minister, a few IAS officers, a few businessmen and a bunch of trade union representatives. Which one of these categories of people has some the expertise to manage investments?

Further, why does a committee need to meet to decide on an interest rate for EPF? Why can’t it simply be declared on the basis of returns on the investments made? Why can’t returns on EPF investments be declared on a regular basis? Why is there so much opaqueness in the entire process?

The only possible explanation is that if things do become transparent, then the trade unions controlling the CBT of EPFO, will essentially become useless. When it comes to transparency, it’s the same story everywhere.

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

The column originally appeared on Firstpost on April 26, 2016

Janet Yellen’s tourist dollars are driving up the Sensex

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Central bankers drive stock markets. At least, that is the way things have been since the current financial crisis started in September 2008, when Lehman Brothers, the fourth largest investment bank on Wall Street went bust.

On March 30, 2016, the BSE Sensex rallied by 438 points or 1.8% to close at 25,338.6 points. What or rather “who” was responsible for this rally? Janet Yellen, the chairperson of the Federal Reserve of the United States, the American central bank.

Yellen gave a speech on March 29. In this speech she said: “I consider it appropriate for the committee to proceed cautiously in adjusting policy.” The committee Yellen was referring to is the Federal Open Market Committee or the FOMC.

The FOMC decides on the federal funds rate. The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

In December 2015, the FOMC had raised the federal funds rate for the first time since 2006. The FOMC raised the federal funds rate by 25 basis points (one basis point is one hundredth of a percentage) to be in the range of 0.25-0.5%. Earlier, the federal funds rate had moved in the range of 0-0.25%, for close to a decade. FOMC is a committee within the Federal Reserve which runs the monetary policy of the United States.

The question that everybody in the global financial markets is asking is when will the FOMC raise the federal funds rate, again? It did not do so when it met on March 15-16, earlier this month. The next meeting of the FOMC is scheduled for April 26-27, next month.

By saying what Yellen did in her speech she has essentially ruled out any chances of the FOMC hiking the federal funds rate in April 2016. This is the closest a central bank head can come to saying that she will not raise interest rates any time soon.

This was cheered by the stock markets all over the world. Yellen basically announced that the era of “easy money” was likely to continue, at least for some time more.

This means that financial institutions can continue to borrow money in dollars at low interest rates and invest this money in stock markets and financial markets all around the world, in the hope of earning a higher return.

This means that the “tourist dollars” are likely to continue to be invested into the Indian stock market. Mohamed A El-Erian defines the term tourist dollar in his new book The Only Game in Town. As he writes: “During periods of large capital flows induced by a combination of sluggish advances economies, robust risk appetites, and highly stimulative central bank policies, emerging markets serve as destination for a huge pool of crossover funds, or what I refer to as tourist dollars.

As Erian further writes: “Rather than “pulled” by a relatively deep understanding of country fundamentals, this type of capital is typically “pushed” there by prospects of low returns in their more traditional habitats in the advanced world.”

The federal funds rate in the United States is in the range of 0.25-0.5%. In large parts of Europe as well as in Japan, interest rates are in negative territory. In this scenario, the returns available in these countries are very low. At the same time, it makes tremendous sense for financial institutions to borrow money at low interest rates from large parts of the developed world and invest it in stock markets, where they expect to make some money.

And India is one such market, where these “tourist dollars” are coming in and will continue to come in, if the central banks of the developed world continue running an easy money policy.

What got the stock market wallahs all over the world further excited was something else that Yellen said during the course of her speech. As she said: “Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long term interest rates and so support the economy.”

What does this mean? This basically means that, if required, the Federal Reserve will print money and pump it into the financial system to drive down long-term interest rates in the United States, so that people will borrow and spend more. This was the strategy that the Federal Reserve used when the financial crisis started in September 2008. This basically means that the era of easy money unleashed by the Federal Reserve is likely to continue in the days to come.

Now only if the Modi government could get its act right on the economic front., the tourist dollars would just flood in.

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

The column originally appeared on Firstpost on March 30, 2016

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

#EPFnotax: Six reasons why taxing EPF was a stupid idea in the first place

 

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010

The Narendra Modi government has decided to withdraw their plan to tax the corpus accumulated by investing in the Employees’ Provident Fund(EPF). As the finance minister Arun Jaitley said in the Lok Sabha today: “In view of representations received, the government would like to do a comprehensive review of this proposal and therefore I withdraw the proposal.”

This is a sensible decision to withdraw what was basically a very stupid idea at multiple levels.

a) The finance minister Arun Jaitley in his budget speech had said that only 40% of the corpus accumulated by investing in EPF would be tax free. This would apply on investments made after April 1, 2016.

The entire 100% accumulated corpus could be made tax free by investing 60% of the corpus in annuities. Annuities are essentially policies sold by insurance companies which can be used to generate a regular income.

The trouble is that most annuities in India give a return of around 5-7%. Given this, they remain a bad way to invest a large corpus. Even investing in a long term fixed deposit can give you a better return.

Some savings bank accounts also pay more than the returns that can be generated by investing in annuities. The annuities in their current are essentially nothing but a rip-off and anyone in their right mind would stay away from investing in them.

Then there is the Senior Citizens Savings Scheme, which allows a senior citizen to invest up to Rs 15 lakh. The scheme pays an interest of 9.3%per year. Given that better returns are available elsewhere, why force people to invest 60% of their provident fund corpus into annuities paying 5-7% per year.

b) Also, the change applied only to private sector employees with a salary of greater than Rs 15,000. This meant that the government employees investing in the General Provident Fund (GPF) or employees of public sector companies investing in other recognised provident funds, could withdraw 100% of their accumulated corpus and need not have paid any income tax on it.

Why was the change proposed only for private sector employees? Why was this distinction made on the basis of the employer? If the idea was to tax, the tax should have applied to everyone and not just the private sector employees.

In the way things had been proposed, a private sector employee making Rs 16,000 per month would have had to pay a tax on the accumulated corpus. A government employee need not have done anything like that. How is that fair and equitable?

c) The government has defended this move on the logic of moving towards a “pensioned society”. As the clarification issued by the ministry of finance a few days back pointed out: “The purpose of this reform of making the change in tax regime is to encourage more number of private sector employees to go for pension security after retirement instead of withdrawing the entire money from the Provident Fund Account.”

Why was only the private sector encouraged to move towards a pensioned society? Also, what about those people who are earning less than Rs 15,000 per month. Their need for a regular income after retirement is even greater than those making more money.

d) Also, why make only EPF and other recognised provident funds taxable at maturity. Why leave out the Public Provident Fund? Shouldn’t self-employed professionals who invest in PPF to possibly accumulate a retirement corpus, also be encouraged to become a part of the pensioned society?

e) The government also planned to tax the principal amount invested in the EPF. How fair is this? While calculating capital gains for investments made in stocks or real estate, the principal amount is not included. Also, investments made in real estate and debt mutual funds get indexation benefits, where the impact of inflation is taken into account while calculating the cost of purchasing the asset. This brings down the capital gains on which income tax is paid.

Further, there is no tax on long-term capital gains made on stocks and equity mutual funds. Taking all this into account, how fair was it to decide to tax EPF? Why leave out the investing modes of the rich and decide to tax the middle class EPF?

f) Further, it needs to be realised that different people have different needs. As Jaitley said in the Lok Sabha today: “”Employees should have the choice of where to invest. Theoretically such freedom is desirable, but it is important the government to achieve policy objective by instrumentality of taxation. In the present form, the policy objective is not to get more revenue but to encourage people to join the pension scheme.”

For that to happen there are so many other things that need to be set right. People use their retirement corpus for various things. They use the money to get their children married, educated and so on. While the government may look at this as something that shouldn’t be done but at times there is no option.

Sometimes emergency medical costs are also met out of withdrawing out of the corpus accumulated by investing in the EPF. In a country where there is almost no insurance for the old, how fair is to deny them access to the EPF corpus by deciding to tax it?

What all these points clearly tell us is that the Modi government clearly introduced the idea of taxing the EPF corpus in a hurry. There is clearly more thinking needed on it. Also, several things need to change before such a tax is introduced. And these changes are not going to happen any time soon.

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

The column originally appeared on Firstpost on March 8, 2016