PPF rate cut: Less dismay if inflation is kept low, stable

Ever since the financial crisis of 2008, most of the Western economies, including Japan, have had very low interest rates. The United States kept interest rates near zero for almost a decade before tentatively beginning to raise rates this year. Even that is likely to be paused. Japan’s ultra low rates have been around for more than two decades.

The world has now entered the phase of negative interest rate policy (NIRP). The central banks of Japan, Eurozone, Switzerland, Sweden and Denmark have all negative policy rates. What this means is that in those regimes, you have to pay the bank to accept your deposit.

Such an NIRP scenario is unthinkable in India, where the official policy rate, called the repo rate, is at 6.75%. This is not the highest in the world, but certainly looks high compared to negative numbers. And mind you, the policy rate was cut several times by the Reserve Bank of India (RBI), with a total cut of 1.25% in the past one year. Even then, the borrowing rate for home loans or working capital is still more than 10-11%. It seems that the banks are unable to pass on the benefit of lower repo rate to their borrowers.

This is because the banks are already under stress due to soaring loans and increasing defaults. So, they need to make profits from the rest of the still-healthy loans. Good borrowers suffer because bad loans increase. India’s economic growth needs big investments, which in turn needs much lower interest rates. Lower rates will also benefit the biggest borrower in the system, which is the Government of India.

The Centre’s annual interest burden is close to Rs 5 trillion. The average interest paid by the Union government (which is the best among all long term borrowers) is about 7.8%. So, if that rate goes down by 1%, it will save the government more than Rs 50,000 crore annually. Imagine if all that money is deployed towards health or education expenditure. Lowering interest rates will also make many more businesses viable.

The housing industry will get a boost, so will the auto industry, since most purchases are done with loans and paid in installments. Although the RBI decreased policy rates by 1.25%, further rate cuts will depend on the inflation outlook.

Another stumbling block to lower rates are the high rates administered by the government. These are rates paid out on “small savings schemes,” which include instruments like Kisan Vikas Patra, National Savings Certificates and also the Public Provident Fund. Most of these schemes pay out rates which are much higher than the current policy rate of the RBI, and much higher than those paid out by banks on their fixed deposits.

Tax-free schemes
Further, unlike bank deposits, the interest earned on small savings in general, but PPF in particular, is tax-free. Indeed, the PPF is the queen of all investments. It enjoys tax exemption at the time of investing, during accumulation and at the time of withdrawal. This triple exemption is called EEE. You can accumulate PPF investments for 15 years, extendable by another five, with a cap of Rs 1.5 lakh per annum. 

The Economic Survey of 2016 shows that on a post-tax basis, PPF investors earn an extra 6% interest compared to bank depositors. And because the PPF rate is administered by the government, it amounts to a subsidy. The Survey points out that 62% of the people who use these tax savings (filed under section 80C) report an annual income of at least Rs 4 lakh. This places them in the top 3-percentile proportion of income earners in India.

The more money you invest in tax-free schemes paying high interest, the more subsidy you earn. The total annual subsidy paid out thus in tax-free high interest schemes, including tax-free bonds, is about Rs 1 lakh crore. Most of these subsidies go to high income individuals, not really “small savers”.

It is these high-administered interest rates which are an impediment to lowering interest rates all over the economy. That is why the reduction in administered rates was much overdue. This will make it easier for the RBI to cut rates further. It is high time that administered rates are linked to the market-determined rates, such as those paid on government bonds.

Home loan borrowers, industry chambers and the financial sector led by banks, always call for a rate cut by the RBI. A former RBI governor once said that the lobby for rate cuts is very strong, but nobody calls for a rate hike on behalf of depositors.

Those people who depend on “fixed income products” like bank FDs, or pension trusts, for their income, are deeply dismayed when rates are cut. If inflation is pinching your pocket already, a further cut in interest paid on your FD makes you worse off. So, depositors are justified in being miffed by rate cuts.

That explains the negative reaction to the PPF rate cut from some quarters. But if inflation is kept in check, then the real rate of return is protected. Thus, a 9% nominal rate with a 6% inflation is the same as 7% nominal with 4% inflation. Indeed, the Western world is grappling with nearly zero inflation, or even deflation. Which explains their low rates.

Therefore, a sure way to keep both depositors and borrowers happy is to keep inflation low and stable. That calls for not just a vigilant RBI but also a fiscally prudent government that can keep a check on its ballooning expenses.  In other words, inflation control calls for cooperation between monetary and fiscal authorities.
Let’s hope that the PPF rate cut kicks off a virtuous cycle of lower borrowing rates, stable rupee, strong inflows, cheering markets and higher economic growth.

(The writer is a senior economist based in Mumbai)

(The Billion Press)