Column

Mukul G Asher & Deepa Vasudevan

Small savings schemes came into being in the years following Independence with the aim of providing simple and reliable savings avenues to lower and middle income groups.

These schemes were administered by public sector institutions such as the Post Office Savings Bank and subsequently, the nationalised banks.

The Public Provident Fund (PPF) was established in 1968 to encourage individuals to save for retirement.

The ultimate responsibility for mobilising small savings is vested with the National Savings Institute (NSI), a division of the ministry of finance. It markets small savings schemes nationally, provides policy-relevant feedback to the ministry, and addresses customer queries.

The primary objective of the small savings program was to promote the savings habit, especially among those with limited incomes and savings potential.

Over time, the original purpose was lost, largely because of a failure to calibrate scheme design and administration with changing economic structures. For example, the PPF was initially conceptualised as a flexible savings scheme for non-salaried workers.

By March 2001, the effective tax-adjusted return on the PPF had risen to 16.9%, which was far higher than the maximum yield on bank deposits (10%) or the redemption yield on government securities (up to 12%).

There is still considerable mismatch between the term structure and yield across small savings schemes. For instance, the 6-year RBI taxable savings bond and the 15-year PPF (with some withdrawals permitted after 5 years) both offer 8% return, whereas the 5-year Senior Citizens Scheme offers 9%.

Consistent with the principle of substitution — which states that economic agents shift from instruments with relatively low risk-adjusted returns to those with higher returns — upper income groups began to take advantage of small savings instruments.

Thus, rather than facilitate savings for those with modest incomes, small savings investments have been used for tax planning by higher income groups, and for channeling unaccounted and tax-evaded incomes.

Between 2000-01 and 2006-07, receipts on account of small savings schemes grew at 11.8% compounded annually. The collective outstanding amount under these schemes was approximately Rs5,64,300 crore in 2006-07, equivalent to 15.1% of nominal GDP, 21.6% of aggregate bank deposits and 9.4% of BSE’s market capitalisation on January 25, 2008.

As the bulk of net small savings (gross collections less repayments) has historically been transferred to state governments, they began to consider these flows as guaranteed receipts, in the process loosening fiscal discipline and setting up a Ponzi scheme.

In 2007, over half of state government deficits were being financed by small savings — a proportion that is inconsistent with sound public finance principles, or with efficient intermediation.

As the Indian economy liberalised in the 1990s, capital markets evolved both in scope and regulation. On January 25, 2008, market capitalisation on the Bombay Stock Exchange was Rs60,30,000 crore ($1.5 trillion).

Debt, commodity and derivatives markets are also beginning to acquire critical scale for risk management. The stock market is professionally and competently regulated; and financial literacy of investors has improved moderately.

The Centre passed the Fiscal Responsibility and Budget Management Act in 2003, and several states have enacted similar legislations. Adopting more prudent debt management practices will reduce the dependence on small savings to finance state government deficits. Small savings must now be integrated with financial and capital markets.

Appropriately, the government has initiated the task of rationalising small savings schemes. The bonus offered on maturity in the Monthly Income Scheme was recently reduced from 10% to 5%. Five-year post office deposits and the Senior Citizen’s Savings Scheme have recently been made eligible for an income tax exemption of Rs1 lakh.

Even this modest alignment of small savings interest rates with the market has had the desired impact. Between April and September 2007, the total stock of small savings shrunk by about 1% to Rs5,57,000 crore.

Market developments were conducive to this trend: buoyant capital markets triggered a sharp growth in investment in equity linked insurance schemes; and rising interest rates in mid-2007 diverted some funds into bank deposits.

The time is appropriate for further rationalisation of small savings schemes.

On the demand side, substitution opportunities must be minimised by linking interest rates with market rates. As the New Pension Scheme will soon be available to all citizens on a voluntary basis, there is less need to provide special advantages to retirement savings.

The requirement of permanent account number should also be extended to small savings. This may help reduce use of unaccounted money in these schemes.

The task of collecting funds for small savings schemes is carried out by about half a million licensed agents, who are appointed by state government small savings organisations.

This agency-based distribution channel should be strengthened by promoting financial literacy among the agents through more frequent and up-to-date training programs.

The NSI must also give greater impetus to market research to better understand the dynamics of preferences of small savers. This, in turn, should be incorporated in the design of small savings schemes.

Organisational and individual incentives of the post office divisions offering financial services need to be restructured. Recently, the Central government appointed public sector mutual funds to manage the corpus of Post Office Life Insurance Fund and Rural Post Office Life Insurance Fund.

A similar arrangement for small savings balances, thereby bringing them under Sebi’s regulation, merits serious consideration.

The appointment of fund managers and investment policies must follow best governance practices involving professionalism, transparency and accountability.

The investment guidelines should permit a mix of debt and equity, including government securities, and corporate bonds. Gradually, returns on these schemes should be linked to the returns obtained on these funds.

The finance minister is strongly urged to use the opportunity provided by the 2008-09 Budget to further rationalise small savings schemes. The objective should be to reduce overall transaction costs, improve professionalism and governance; and integrate them with broader financial and capital markets.

Mukul Asher is professor of public policy, National University of Singapore (sppasher@nus.edu.sg). Deepa Vasudevan is a freelance researcher (deepavasu@hotmail.com)