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Suresh Krishnamurthy

THE opposition of the central board of trustees of employees provident fund to the interest rate cut on provident funds appears to have assumed ritualistic proportions. Ever since the Finance Minister, Mr Yashwant Sinha, brought down the interest rate on public and general provident funds, the central board of trustees has always recommended to the Finance Minister that interest rates on employee provident funds be maintained.

Last year, bowing to the pressure from the board, the rates remained 11 per cent for three months before settling down lower at 9.5 per cent. What will happen this year remains unclear.

The SDS linkage: The thrust of the Board's argument is that there is surplus generated from investing on behalf of the investors and the surplus must be returned to the investors.

The Finance Ministry seems to be arguing that since the fund earns from investing in the special deposit securities of the Central government, it would be better to link the rate offered on PPF to the rate offered on special deposit securities. Both approaches, however, appear to be only partially correct.

The board's argument that the surplus belongs to the investors is not debatable. However, keeping the rate at a level higher than the rate earned by the funds is not the way to go about returning the surplus to the investors.

If the rate is kept at a higher level, fresh inflows not involved in the creation of the surplus will also earn the higher interest undeservedly.

The Finance Ministry's contention that the rate on PPF should be linked to the rate offered on special deposit securities is quite correct.

Dealing with surpluses: However, it does not suggest any solution for dealing with the surplus. It is not fair to just let the surplus persist year after year.

What can be done is to proportionately share the surplus among the various constituents of the fund, based on the amount outstanding to the credit of each investor at the end of March 31 each year.

The rate on special deposit securities will then be the rate offered from April 1 of each year.

This way, surpluses will not persist and the rate offered on EPF will be linked to the rate on special deposit securities. The rate offered on EPF will, thus, be a guaranteed rate for all practical purposes with the prospect of some surplus as well.

Needed portfolio diversification: Other larger issues concerning the fund's investments also remain, such as the need for investing in corporate securities. The rate on public provident fund has now been linked to the average yield on government securities.

It is quite possible that the rate will come down to 8 per cent from 9 per cent this year. This will then set the stage for a reduction in the rate offered on employees provident fund. Overall, there is the danger of a significant reduction in yields on the provident funds.

In this backdrop, it is, perhaps, time for diversification into top-rated corporate securities.

Some of the top rated corporate securities offer better protection than many of the State government securities. At the same time, the returns from such securities would also be higher.

Prudential norms: It is true that we have to deal with default risk in the case of corporate securities and not every investor will be willing to under take that risk.

As such, diversification into corporate securities should be after taking the consent of the investors. Strict prudential rules relating to investment strategy and limits have to be imposed on the funds to protect the investor who chooses diversification as an option.

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