On Wednesday evening, the government announced a significant reduction in interest rates on small savings schemes for three months from June.
Interest rates on the Senior Citizen Savings Scheme and the National Savings Certificate were reduced by 90 basis points to 6.5% and 5.9%, respectively. A basis point is 0.01 percent point.
In the case of the Public Provident Fund (PPF), India’s most popular middle-class investment and tax saver, the interest rate has been slashed by 70 basis points to 6.4 per cent. This is the lowest interest rate on PPF, which has been at 5.8% since July 1974.
In a tweet on Thursday morning, Finance Minister Nirmala Sitharaman overturned the decision, saying: “Interest rates on small savings schemes will remain at the same rates as in the last quarter of 2020-2021.”
Many explanations for this are that assembly elections are currently taking place in many states, and this will alienate voters from the Bharatiya Janata Party.
However, the reduction in interest rates on small savings schemes was in line with the overall fall in interest rates across the economy, including bank deposits. In February 2021, the average interest rates on domestic term deposits of banks stood at 5.39%. The deposit rate has fallen by 113 basis points since the beginning of 2020. Banks’ weight-to-average lending rate fell 85 basis points to 9.29 per cent.
Low interest rates are expected to help individuals and corporate borrowers, leaving more cash for other financial activities than repaying the loan. Also, at lower interest rates, individuals are expected to borrow and spend more, and corporates are expected to expand by borrowing, which will help the economy thrive in the process.
This is something that corporate leaders, economists, analysts and fund managers have repeatedly pointed out over the past few years.
By February 2021, total lending to corporates had shrunk by 0.24%, making it clear to us that borrowing is not just about low interest rates. When it comes to retail lending, growth slowed to 9.55% in single digits.
There is a third beneficiary of low interest rates, and that is the government. In 2020-21, the government has a plan to take out total loans ₹12.8 trillion. In 2021-22, it plans to borrow more ₹12.06 trillion. In this scenario, lower interest rates will help the government.
The trouble is, borrowers, everyone is talking, and wanting lower interest rates, are only one side of the equation. There are also savers on the other hand and low interest rates are already hurting them. The lower interest rates on small savings plans make them more vulnerable.
Now the interest rates on the offer are very close to inflation, or the price increase rate is at 5.03% in January. In fact, excluding food, fuel and light goods, the core inflation rate was close to 6% in January.
Core inflation is more relevant to the middle class. Once we take into account core inflation, the real interest rate on deposits (interest rate minus core inflation) is in negative territory. This is done without even considering the income tax payable on interest on deposits.
Clearly, there is a problem here. The irony is that none of the economists, analysts and fund managers are talking about this. Although it is difficult to quantify, a section of the population, especially senior citizens, rely on interest income to meet their regular expenses. They have already suffered from lower interest rates, and lowering interest rates on smaller savings plans would have made them even more vulnerable.
From the beginning of 2020 when interest rates are low and there is no inflation, senior citizens get into trouble. The only way is to reduce their costs. It affects consumption and promotes economic growth.
Also, keep in mind that most Indians save by investing in fixed deposits, small savings schemes, provident and pension funds and life insurance. In 2019-20, 84.24% of household financial savings was made in these financial instruments. Investments in shares and debentures (which include mutual funds), despite all the hype, were down 3.39% of total savings. The fall in interest rates will adversely affect the majority of Indian savers, reducing the return on their investments. This clearly has an impact on consumption. This is something that neither the Reserve Bank (RBI) nor the government has considered.
Of course, these things cannot be measured easily. It doesn’t make an impact because something is measurable or at least not important enough to talk about.
Furthermore, due to low interest rates, a small segment of savers moved their money into the stock market for higher returns. They have been successful over the past year. However, it is safe to say that current values are high and stock prices have been in bubble territory for some time, with more money chasing stocks over the past year.
Cutting interest rates on small savings plans will push more investors into stocks and increase the overall risk of the system. As has happened many times in the past, when stock bubbles (or other bubbles such as real estate) burst, the real economy is in trouble.
This is not to say that interest rates should remain high. Between March 27, 2020 and March 12, 2021, banks increased valuable deposits ₹13.55 trillion. During the same period, they gave only valuable loans ₹4.27 trillion, which is less than a third of the deposits.
In an environment where banks cannot lend the bulk of their deposits, it is natural for interest rates to fall. The RBI has printed and pumped money into the economy, further lowering interest rates and helping the government borrow money at a lower rate.
In all of this, the savers are hurting. It is also hurting the economy. While there is not much that can be done about it, all we can do is at least talk about it. Trying to show low interest rates as a ruin for everything is not the right way to go about it.
Vivek Kaul is the author of Bad Money.