Dogma plays an important role in both politics and economics. After all both are inexact sciences (latter more than the former), hence value of data is always secondary to the primacy of dogma.
Even granting for that though, the decision by the Modi government yesterday to reduce administered interest rates on small savings defies all logic. One, it alienates a core constituency of the BJP, the urban middle class, that was already chaffing at the margins for the Union Budget gaffe on EPF taxation (hastily rescinded). Two, it doesnt even make sense from a purist, macroeconomic standpoint!
Lets go through the market fundamentalist view of why small savings rates needed to come down. The view is simple - as long as households (in other words middle class folks with some disposable income) have alternative savings instruments in the form of PPF/NSC (and other small savings products) with high tax-free interest rates, banks would not be able reduce interest rates on their deposits. So while RBI could cut policy rates, the ability of banks to pass those rates on to borrowers would be circumscribed by the fact that they face unfair competition for deposits in the form of small savings with high interest rates.
Like most market fundamentalist dogmas, the hypothesis doesnt stand basic empirical scrutiny. Lets look at the data on household financial savings in India. Over the last few years, household financial savings have been hovering around the 10% of GDP mark. And they get deployed in a variety of instruments - Bank deposits, shares, Life Insurance, PF, and Small Savings. Look at the composition below.
The numbers are self explanatory. Bank deposits account for a massive 48% of all savings deployed by households in financial assets. Where is that big "transmission roadblock" culprit, Small Savings? Well, its consolidated in the section Claims on Government. And its marketshare? 5.6%! ALL the other components of household financial savings - deposits, insurance, pensions, shares, UTI - are subject to market determined interest rates.
In other words, a small implicit subsidy in 5% of the flows prevents rate cut transmission in 95% of the flows!
This is a classic example of tilting at windmills and brandishing a reformist sword - unfortunately, the financial Don Quixotes have impact far exceeding the spanish dilettante!
Lets also go further and examine the other point - what about the cost to the government of such largesse (towards small savings scheme). The latest Economic Survey has the data.
As can be seen, interest rate subsidy on PPF (the largest, and ostensibly the "unfairest" component of small savings), is ~12000 crores. The other small savings products (PO savings, KVC etc) are used to fund state government deficits, and hence the interest is serviced by state governments. Lets say that the subsidy on account of all other small savings product is a similar amount. So the total subsidy on account of administered interest rates is ~24000 crores.
For a country with zero social security, is that a big number for rudimentary safety net? In terms of fiscal impact, the notional loss to the government on account of corporate tax exemptions add up to nearly 6 lac crores.
Its clear therefore that purely from an economics standpoint, the reduction of rates on small savings doesnt stand up to basic scrutiny. It seems to be a case of the government giving in to a "financial market populist" demand. However, the political cost of this far outstrips any benefit on the monetary side. For a government that has been so cautious about anything radical, this is a classical "penny wise pound foolish".
Even granting for that though, the decision by the Modi government yesterday to reduce administered interest rates on small savings defies all logic. One, it alienates a core constituency of the BJP, the urban middle class, that was already chaffing at the margins for the Union Budget gaffe on EPF taxation (hastily rescinded). Two, it doesnt even make sense from a purist, macroeconomic standpoint!
Lets go through the market fundamentalist view of why small savings rates needed to come down. The view is simple - as long as households (in other words middle class folks with some disposable income) have alternative savings instruments in the form of PPF/NSC (and other small savings products) with high tax-free interest rates, banks would not be able reduce interest rates on their deposits. So while RBI could cut policy rates, the ability of banks to pass those rates on to borrowers would be circumscribed by the fact that they face unfair competition for deposits in the form of small savings with high interest rates.
Like most market fundamentalist dogmas, the hypothesis doesnt stand basic empirical scrutiny. Lets look at the data on household financial savings in India. Over the last few years, household financial savings have been hovering around the 10% of GDP mark. And they get deployed in a variety of instruments - Bank deposits, shares, Life Insurance, PF, and Small Savings. Look at the composition below.
The numbers are self explanatory. Bank deposits account for a massive 48% of all savings deployed by households in financial assets. Where is that big "transmission roadblock" culprit, Small Savings? Well, its consolidated in the section Claims on Government. And its marketshare? 5.6%! ALL the other components of household financial savings - deposits, insurance, pensions, shares, UTI - are subject to market determined interest rates.
In other words, a small implicit subsidy in 5% of the flows prevents rate cut transmission in 95% of the flows!
This is a classic example of tilting at windmills and brandishing a reformist sword - unfortunately, the financial Don Quixotes have impact far exceeding the spanish dilettante!
Lets also go further and examine the other point - what about the cost to the government of such largesse (towards small savings scheme). The latest Economic Survey has the data.
As can be seen, interest rate subsidy on PPF (the largest, and ostensibly the "unfairest" component of small savings), is ~12000 crores. The other small savings products (PO savings, KVC etc) are used to fund state government deficits, and hence the interest is serviced by state governments. Lets say that the subsidy on account of all other small savings product is a similar amount. So the total subsidy on account of administered interest rates is ~24000 crores.
For a country with zero social security, is that a big number for rudimentary safety net? In terms of fiscal impact, the notional loss to the government on account of corporate tax exemptions add up to nearly 6 lac crores.
Its clear therefore that purely from an economics standpoint, the reduction of rates on small savings doesnt stand up to basic scrutiny. It seems to be a case of the government giving in to a "financial market populist" demand. However, the political cost of this far outstrips any benefit on the monetary side. For a government that has been so cautious about anything radical, this is a classical "penny wise pound foolish".
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