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B. Venkatesh

THE Budget has cut the interest rate on small savings by 50 basis points (bps). Besides, the tax rebate allowed for investing in such small savings products and life insurance contracts has been reduced from 20 per cent to 10 per cent, for those whose taxable income does not exceed Rs 5 lakh; those with incomes higher than Rs 5 lakh will no longer enjoy this rebate.

This move by the Finance Minister, Mr Yashwant Sinha, has prompted many to conclude that the Government is consciously lowering incentives to save. The reason is simple. The income equation is a combination of consumption and savings. If you save less, you will be left with more money in hand, assuming that your income level does not change. And that means more money to consume.

Now, many contend that the Government is actually directing people to consume more to push the economy upwards; at present, the economy is cantering at a growth rate of just 4.5 per cent. The reason the Government should be stressing consumption is that we need to improve demand for goods and services to achieve a higher sustainable economic growth rate. After all, mere output of goods and services does not help improve growth rates; consumption, the other side of the equation, has to keep pace as well. And what better way to increase demand than by encouraging people to spend (by lowering the incentive to save)?

Lowering borrowing cost

While the above explanation is plausible, this article argues that the reason for lowering incentives to save is more mundane — to lower the government's borrowing cost. Consider this. The government has been running up a huge fiscal deficit for a long time now; the current fiscal deficit stacks up to 4.7 per cent of GDP. It has been borrowing primarily to pay its past borrowings. The latest Economic Survey states that the government makes interest payments of Rs 69 for every Rs 100 collected as taxes.

Now, the government has been very fortunate in lowering its interest cost in the last two years, as the banking system has been flush with funds. The excess liquidity in the system has been a function of the increase in bank deposits and poor credit offtake. With no better investment avenues, banks have been forced to deploy their incremental deposits in building their trading books (bond holdings other than for SLR requirement).

As more money poured into the bond market, bond prices rose and yields crashed, due to the inverse price-yield relationship. The benchmark ten-year bond, for instance, has fallen from 11 per cent in January 2000 to 7.3 per cent this year. This means the government can now raise 10-year money at 7.3 per cent.

Contrast this with the small savings products. The Public Provident Fund (PPF) fetches 9.5 per cent for 15 years; that is a good 200 bps higher than what the government pays on its 15-year bonds. Agreed, the higher return on PPF may be due to the higher liquidity risk; this is the risk of having to hold the investment till maturity, unlike government bonds, which can be sold in the secondary market.

Even if the higher return is taken as a compensation for the liquidity premium, there is still the 20 per cent tax rebate on the amount invested in small savings. This takes the effective return for the investors to around 11.5 per cent, which is essentially the cost to the government. And then there are other costs. The cost of collecting and maintaining PPF accounts is very high. This is not the case with bonds, which are electronically held and can be transferred through the Subsidiary General Ledger (SGL) maintained by the Reserve Bank of India (RBI). Another factor to be considered is that 75 per cent of the small savings amount collected in a year are anyway distributed by the Centre to the States.

In other words, the interest cost on small savings is still high for the government. This, coupled with higher market borrowings, has actually increased interest payments for fiscal 2002, despite the sharp fall in rates; the increase in interest payments is Rs 10,133 crore. There is, thus, the overwhelming need to reduce interest cost to lower the fiscal deficit.

In short, the high cost of borrowing and the fact that the monies are transferred to the States could have prompted the government to dissuade people from investing in small savings. This seems a more logical reason for the Finance Minister's decision to lower incentives in the small savings scheme.

Shift in consumption

Lowering incentives to save will weigh on the minds of the savers. The question is whether the savers will cut their future consumption and consume more now (remember, cutting current consumption to save actually means that you prefer to consume sometime in the future).

No doubt, there will be some increase in current consumption. After all, the people who contribute to small savings comprise rural and middle-class urban population, whose marginal propensity to consume is high. But the likelihood of the income equation becoming overweight on current consumption seems unlikely.

Consider this. We have a job market that is no longer "sticky". That is, the possibility of a person losing his or her job is higher than ever before. This lack of job insurance will prevent people from shifting a substantial proportion of their savings to current consumption. The desire to keep money for the future seems more overwhelming than the substantial reduction in returns on savings.

Having said that, the composition of savings is likely to change. People may prefer to deposit all or a substantial proportion of their financial savings into banks. The primary reason is that bank deposits protect the nominal value of the principal, which is not the case if you invest in mutual funds or take direct exposure in the equity market.

The nominal value is referred to in the sense that the principal is not at risk in a bank deposit, due to deposit insurance, whereas the same may be lost due to market risk if invested in equity or mutual funds. This does not, however, take into account any loss due to inflation. If inflation (not the figures the government declares) is higher than the interest earned on the deposits, investors will lose even by investing in bank deposits.

This is not to say that money will not flow into other areas. There could be some surge in investment in physical assets — housing, for instance. This is more so because housing still appears an attractive investment, due to sizable tax breaks.

But the point is that not many people who invest in small savings can really afford to invest in houses. A large proportion of the reverse flow of money from small savings could, therefore, move into banks. And that may cause more problems for investors!

Implications of rise in bank deposits

Inflow of deposits could place a considerable strain on the banks. Here is why. Assuming deposits are cut by around 50 bps (deposit rates are somewhat sticky, and banks may not be able to cut rates very sharply), a one-year deposit will cost the banks around 6.5 per cent. If banks want to match their asset-liability and therefore invest in a 364-day Treasury Bill (T-bill), they will generate a negative spread (or cost of carry) even without accounting for overheads and other costs.

Banks will, therefore, be forced to increase the duration of their trading books (bonds that are held for trading rather to satisfy the SLR requirement) to gain on spreads. For instance, banks will prefer to invest in 10-year bonds to gain more on spreads. If the one-year deposit rate is 6.5 per cent, borrowing for one-year and investing in 10-year bonds will earn the bank 80 bps, assuming that the 10-year yields are 7.3 per cent.

As more banks resort to duration extension, the demand-supply principle will take over. Higher demand for long-term bonds will push up prices. And as the price-yield relationship in bonds is inverse, higher prices mean lower yields. Suppose the 10-year bond yields touch 6.8 per cent. This will have a circular effect, as banks will be forced to again cut the deposit rates.

In other words, more bank deposits will only cause the bond yields to drop further, and this could mean further reduction in the return on savings. But the circular effect will not reduce the savings rate (the percentage of income saved) given the non-sticky labour market, at least in the private sector.

Of course, the circular effect can be reduced if the demand for credit from the private sector improves. In that case, banks can create loan-assets or invest in corporate bonds, and not pour the incremental deposits into the government bond market. The lack of more money flowing into the government bond market may at least arrest the fall in yields. And that may prevent banks from effecting further cut in deposit rates.

One positive factor for the banks from the likely higher flow in deposits is that the core time and demand deposit base is likely to increase. This is because investors may invest in bank deposits for a longer time, and even roll over matured deposits, given the unattractiveness of other investment avenues. A higher core deposit base translates into a more stable source of funds for the banks, helping them better manage their asset-liability position.

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