Two per cent rate cut -- An unfair exercise

Suresh Krishnamurthy

IT IS well understood that small savings schemes provide returns that are superior on a risk-adjusted scale to almost any comparable investment options.

It is also true that the Government borrows from the government securities market at a rate lower than what it pays to investors in small savings schemes. In this backdrop, there is more than a reasonable basis for an interest rate cut on small savings.

However, a two percentage point cut appears quite unfair. In fact at 9 per cent, the Government would be borrowing at a rate much lower than what is paying in the government securities market now. If it is argued that the tax benefits enhance the effective yield on these instruments then the government can reduce the yield by 1 per cent and simultaneously reduce the tax benefits on these instruments.

Also, options such as post office monthly income schemes and the Kisan Vikas Patra do not offer any tax rebates and a two percentage point rate cut may make these instruments unattractive, even from a risk-adjusted perspective.

In fact, the objective of the exercise appears to be to cut down the interest burden of the government rather than rationalise the yields on government borrowings in tune with the risk involved in the investment. A two percentage point cut in the overall interest rate regime would lead to a substantial decline in interest costs.

At a time when expenditure compression has assumed importance, no other factor appears to have entered the calculation when the Economic Advisors of the Government suggested a 2 percentage cut. It is not even clear if factors such as the increasing burden imposed on the retail investor, the complete delink between inflation and interest rate movements figured in any discussion on reducing the coupon rates on small savings schemes.

Meanwhile, it would be better if investors opt for NSCs rather than the public provident fund. In the case of PPF, any reduction in the interest rate would also apply to balances existing as on the date on which interest rates are changed. However, in the case of NSCs it would apply only prospectively. Also, over the medium-term, because interest rates are being pushed down deliberately, there is the possibility of fluctuation in interest rates. In such a backdrop, it is quite important that investors have a portfolio properly diversified between fixed maturity options such as fixed deposits and floating maturity schemes such as mutual fund debt schemes.