Consequences of reducing interest
It appears that rollbacks are becoming common in economic policy these days. The latest in the list of withdrawals—either due to public disapproval, market backlash or political pressure—includes the reduction of interest rates on small savings schemes. The circular issued after sunset was reversed soon after sunrise citing ‘oversight’, but the actual reason behind the scurryfunging, critics believe, is the forthcoming Assembly elections. The Ministry of Finance, armed with the blessings of the Election Commission, passed the order, only to take a raincheck belatedly. That there’s a need to align these rates with others like bank deposits is often debated but rarely deployed. In that context, the government may have set out with good intentions, but in the end embarrassed itself and sacrificed its own credibility in lieu of anticipated political mileage.
Currently, bank deposit rates are a little over 5% or just above the inflation rate. As a result, real return on deposits is effectively negative. As if poking on a sore spot, even this income gets taxed! Now, at this juncture, lower rates on small savings schemes, which are typically 100 bps above bank deposit rates, will devastate savers, particularly senior citizens depending on interest income. Moreover, the real return on these schemes will run the risk of turning negative and completely avoidable. Perhaps, this is one reason why successive governments refuse to tinker with rates despite overwhelming evidence against the need for interest rate parity.
But giving in to demands of the RBI, which has been batting for interest rates alignment to help improve monetary policy transmission, the government seems to have bit the bullet, only to reverse its decision. Any rate reduction will force households to explore alternatives like mutual funds or even equities, where the risk is high. Until transparency and awareness of riskier financial products is improved, the least the government should do is to protect the interest of households by keeping inflation under check and ensuring that conventional financial products like deposits deliver decent return on investment.