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Thinning small savings cushion, coming of EMIs

NDA government recently lowered rates for PPF and other products.

Written by Shaji Vikraman |
Updated: April 5, 2017 6:07:55 pm

In May 2004, while campaigning in his Lok Sabha constituency Hazaribagh in Jharkhand, sitting MP Yashwant Sinha experienced firsthand the political impact of a decision taken by the NDA government four years earlier. Many voters, including employees of the state-owned giant monopoly Coal India, had spread the word that Sinha as Finance Minister had been primarily responsible for their savings being hit.

In January 2000, the Finance Ministry had cut administered interest rates across the board — all post office schemes, PPF and General Provident Fund — from 12% to 11%, leaving small savers like the coal mine workers unhappy. A year later, in the 2001 Budget, Sinha had gone a step further — sharply lowering the rate from 11% to 9.5% — convinced that once administered rates were cut, average interest rates would move south, and provide a boost to the economy and to investment.

Indeed, by 2004, the economy had rebounded — but Sinha’s voters were not impressed. The Hazaribagh Lok Sabha seat went to the CPI that year.

The P V Narasimha Rao government, and Finance Minister Manmohan Singh, had set the ball rolling on interest rate de-regulation back in 1991, but administered rates were left unchanged for years. It was only in 1998-99, after the Finance Ministry under Sinha realised that 50% of revenues raised by the government went only towards paying interest on borrowings, that it decided to look at hard policy options. Average interest rates in 1999-2000, and up to August 2000, were 14.5% — while state governments borrowed from the central government at over 13%. A committee headed by RBI Deputy Governor R V Gupta recommended linking rates on small savings and other government schemes to similar products offered by banks and financial institutions, with a positive spread of 50 basis points, or half a per cent.

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Once the Finance Ministry was clear that rates had to be brought down, Sinha went to the Prime Minister for support. He told Atal Bihari Vajpayee that by early 2000, inflation had been around 4% for 42 weeks consecutively, while the government was paying 12% on small savings schemes — a huge real interest rate (nominal interest rate minus inflation) of 8%. This kept the burden of interest payments and the government’s debt high, and left little for productive investment. The PM was told that unless the cost of doing business came down, the government’s aim of building infrastructure would be difficult to achieve. To encourage investment, interest rates must be lowered, Sinha and team argued.

Vajpayee was convinced — and thus began in January 2000 a secular trend in lowering interest rates that continued until average rates had fallen to 8% by 2003-04. Even post office savings scheme rates were reduced — but it took the government significant effort to persuade RBI Governor Bimal Jalan to cut provident fund rates for the central bank’s own staffers!

Once interest rates were aligned, the Ministry told Governor Jalan to get on board his deputy, Y V Reddy, to head a committee to review administered interest rates in 2001. In its report submitted that May, the committee made out a case for linking rates on small savings to the yields or rates on bonds in the secondary market, transfer of the full proceeds collected by states through small savings back to the states, and a National Small Savings Authority. Later, as Governor, Reddy was to tell the government that any risk-free instrument issued by the sovereign should offer a rate of only 3% or 4%.

With the government leading the way, the RBI had to follow — it began cutting the bank rate and Cash Reserve Ratio starting 1998, forcing banks to reduce their lending rates. Much like the scenario now, all this was done in the shadow of a local banking crisis. India’s mainly state-owned banks had piled up bad loans after a lending binge in the mid-1990s, as business groups, following rosy projections of growth, built excess capacities. By 1998-99, gross non-performing assets of banks had risen to 14.6% of the total advances or loans compared to 14.4% the previous year, hitting their balance sheets and impairing their ability to lend. But as interest rates came down over the next few years, banks which had excess stocks of bonds with high interest rates, were able to make gains to help cushion their capital and profits and ultimately claw back by 2003-04, ready for the upturn, and to fund projects a year later.

Other complementary reforms or policies went hand-in-hand. Asset Reconstruction Companies, or RCs, which buy out bad loans from banks at a discount and sell them when there is a turnaround, and a stronger law for taking possession of assets by lenders and debt recovery tribunals, came into vogue.

When Sinha was in Washington for the spring meeting of the International Monetary Fund in 1998, his elder son, Jayant — now junior Minister in the Ministry of Finance — who was then working in the US, introduced the Minister to his classmate from IIT Delhi, Raghuram Rajan, who was then teaching at Chicago University. Rajan suggested to Sinha that housing could be an economic multiplier, and a boost to this sector could have a broader impact on the economy. The NDA government took the cue and started offering tax incentives to homebuyers, allowing for a deduction on interest paid, and raising the threshold progressively. It worked well because interest rates came down sharply, marking the beginning of the culture of equated monthly instalments or EMIs — pushed hard first by state-owned Hudco, which had no link to individual customers, and by ICICI, and soon afterward by other banks.

Although two other committees — headed by two Deputy Governors of the RBI, Rakesh Mohan (2004) and Shyamala Gopinath (2011) — were also to later review small savings schemes and submit recommendations, gradualism remained the preferred road until 2012. With double-digit inflation for a long time, rates were negative for savers.

But with inflation now trending down, the NDA government recently lowered rates for PPF and other products. The political test for the Narendra Modi government — at the hands of middle class voters who may not be able to see the big picture — may come in the coming Assembly elections. Even in distant Hazaribagh, where no elections are due, there are undercurrents. Last heard, trade union leaders were telling people that the son — MoS, Finance Jayant Sinha — was following in the footsteps of the father!

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