Towards an appropriate interest rate regime

INTEREST RATES in the financial sector were substantially regulated in India until the late 1980s. Following the recommendations of the Chakravarty Committee (1985), a gradual process of deregulation was initiated. This process gained momentum in the 1990s with the suggestions of the Narasimham Committee (1991). At present, the structure of interest rates in India has become reasonably flexible, as most of the interest rates relating to banks and financial institutions and debt market have been deregulated. The remaining rates are few which are under constant review.

The interest rates relating to small savings and provident fund continue to be administered by the Government under various Acts of Parliament. Regulation of interest rates in this segment has not only created distortions in the interest rate structure but has also adversely affected the allocative efficiency of resources.

There is a policy dilemma with regard to maximisation of receipts through small saving schemes and minimisation of debt service burden to the Central and State governments.

In April, the Government constituted an expert committee under the chairmanship of the Deputy Governor of the Reserve Bank of India, Dr. Y. V. Reddy, to review the system of administered interest rates and other related issues. Last week the committee submitted its report suggesting some changes in the small savings rates. The following are the summary of recommendations.

The Committee's recommendations are unanimous and to the extent feasible, explicit and firm. However, since the issues relating to small savings are complex and involve a wide range of stakeholders, the Committee would suggest a wider debate on various issues involving all stakeholders. Wider consultations (particularly with the States) in respect of the Committee's recommendations regarding small savings would be desirable.

Although the Committee has deliberated on the entire structure of administered interest rates, its recommendations relate mainly to the small saving schemes including PPF (Public Provident Fund). The underlying principles pertaining to these recommendations are, however, extendable and equally applicable to similar administered interest rates in the system.

Financial savings in general and long-term and contractual savings in particular, should be encouraged keeping in view the long-term investment requirements of the economy. Small saving schemes are essentially a basket of diversified and heterogeneous products and therefore there is a need to distinguish the various schemes in terms of their purpose and whether they cater to the needs of small savers / investors as they are purported to be. In principle, small savings should inculcate the habit of thrift among the people and therefore, be restricted to individuals.

The Committee observed that the present system of direct management of long-term funds by the public sector and fixing administered rates of interest with all tax advantages would not be sustainable in the medium-term. Most of these funds, in future, are expected to be privately managed with larger and diversified investment portfolios. The medium-term objective of the Central Government should be to spell out a well conceived investment policy to facilitate switching over to fully funded long-term saving schemes managed independently and professionally and aimed at promoting growth and meeting genuine investment demands in the economy.

The PPF may be integrated into the Pension Funds system that emerges along the lines of action taken towards the reform of GPF, EPF and other old age security schemes. The continuation of administered regime of interest rates on small saving schemes should, therefore, remain temporary and any benchmarking of these rates should also be treated as an interim measure.

Benchmarking

In order to prescribe a suitable benchmark, the options before the Committee were: (a) real return based on inflation rate/real growth rate of the economy; (b) bank deposit rates corresponding to different maturities; (c) Bank Rate; and (d) average secondary market yield on Government securities. After considering all feasible options, the Committee recommends the following benchmarking with regard to alternative instruments:

(i) Post Office Savings Bank (POSB) account has similarities with current account in a commercial bank and therefore, such account- holders may not earn interest on it. In order to promote rural savings, Government is currently giving an interest rate of 3.5 per cent. This is a facility available only to small savers. Keeping in view that even commercial banks are offering interest at 4 per cent on such accounts, the Committee recommends that the present rate of 3.5 per cent on POSB accounts may continue so long as the inflation rate rules above 3.5 per cent or the savings bank deposit rate of commercial banks is not below 3.5 per cent.

(ii) Interest rate on One Year Postal Deposit may be benchmarked to the average yield of 364 Days Treasury Bills traded in the secondary market during the previous year.

(iii) Interest rate on 5-Year Postal Deposit/Post Office Monthly Income Scheme/Post Office Recurring Deposit may be benchmarked to the average secondary market yield on Government securities having a residual maturity of around five years.

(iv) Interest rates on 2 and 3-Year Postal Deposits may be calibrated between one and five-year Postal Deposit rates.

(v) Interest rates on all non-bearer certificates should be marginally higher (lower) than the 5-Year Postal Deposit rate, depending upon the maturity of the instruments.(vi) Interest rate on present bearer instruments like Kisan Vikas Patra should also be on par with non-bearer certificates after removing the transferability feature of this instrument.

(vii) As regards interest rate on relief bonds, the same principles should apply. However, it should be terminated at an early date to avoid distortions.

(viii) Interest rates on PPF may be benchmarked to average secondary market yield on Government securities having a residual maturity of around ten years.

(ix) Interest rates on other administered schemes like GPF and EPF may follow the principle applicable to PPF.

(x) The spread over the benchmark yields for fixing the interest rates on the small saving schemes may have to be suitably calibrated subject to a maximum of 50 basis points depending upon the maturity and liquidity of the instrument, keeping in view the savers' interest, particularly for long term instruments. The objective should be to reduce the spread over the benchmark rate over a period.

(xi) Investors should have the option to choose between the fixed rates or floating rates at the time of entry, excepting investors in provident funds (PPF, GPF and EPF) who would have the option of floating rates only.

(xii) The Committee feels that the periodicity of revision in interest rates should be annual, at the beginning of the financial year which may be reviewed at a later date.

Transfer of proceeds to States

Historically, the Central Government played the role of financial intermediary in collection of small savings and their sharing with the State governments. The amount mobilised through the small saving schemes is accounted under the Public Account of the Central Government. The net amount (gross collections minus repayments) is shared between the Centre and the States and forms part of the borrowed funds for financing the fiscal deficit of both Centre and States. One of the terms of reference before the Committee was to explore the feasibility of transferring the entire net proceeds of small saving to States. The Committee also felt the need to simultaneously address the 'overhang' problem created historically due to maturity mismatches between small saving deposits and loans extended to States by the Centre against small saving collections.

Rationalisation of taxation

For the purpose of tax treatment, financial instruments could be categorised into: (a) short and medium-term financial savings (maturity up to 6 years) and (b) long-term saving (maturity more than six years). Although this Committee has broadly agreed with the recommendations of the Shome Advisory Group on Tax Policy and Tax Administration, following modifications are suggested for the short and medium-term instruments.

(i) All tax incentives on short and medium-term financial assets as provided under Section 80L, Section 88 and Section 10 of Income-tax Act may be withdrawn.

(ii) With a view to checking tax evasion, the capital income on financial assets with short and medium-term maturity could be subjected to tax deduction at source. The applicable tax rate for this purpose could be the minimum income tax rate, which is currently 10 per cent. A certificate to this effect could be provided to the holder of that financial instrument for the purposes of filing income tax return to the Income Tax Department. The income tax authority, on the basis of this certificate could realise the unpaid part of tax revenue, if any, from the holder of such financial asset and refund the amount to those who have no income tax liability. Investors not liable to pay income tax may submit Form 15H to avoid tax deduction at source.

(iii) The tax incidence should be on total return, irrespective of whether it is from dividend/interest or capital gain.

With regard to long-term savings, the Committee recommends the following:

(i) The tax concession at the time of accrual may be provided under Section 88 of IT Act, providing tax rebate at a rate of 20 per cent on investment up to Rs.60, 000.

(ii) Considering the social structure of the Indian economy and inadequate social safety provisions, it is proposed that the rate of income tax at the time of withdrawal may be kept lower than the rate at which the tax concession was conferred on contribution. It is accordingly proposed that all withdrawals at the time of maturity could be uniformly taxed at a rate of 10 per cent.

(iii) In order to facilitate financial accumulations and also eliminate the misuse of premature withdrawals for the purpose of tax avoidance; all premature withdrawals except in the case of death of the beneficiary, should be subjected to a uniform income tax at a rate of 20 per cent - the rate at which the tax concession was obtained at the time of making contribution in the long-term financial assets. Premature withdrawals, in the event of premature death of the beneficiary, should, however, be subjected to fixed rate of income tax at 10 per cent - at par with tax treatment for withdrawal on maturity.

(iv) The introduction of EET system, with immediate effect, will make all the existing long-term savings taxable. The incidence of tax on existing long-term savings would fall with retrospective effect. With a view to correcting this situation, all the existing long-term saving schemes may be categorized into 'old' and 'new' schemes. While the fresh accretions Into 'old' scheme would stop with immediate effect, the existing tax benefits exempting withdrawals from taxation may continue till the redemption of that scheme. The 'new' schemes for long-term savings should be subjected to proposed tax regime with immediate effect.

(v) The income of the Trust managing the long-term financial savings should be fully exempted from corporate tax.

Design of instruments

Although existing instruments of small savings would continue, the Committee preferred a wider menu to the investors. Those who are completely risk-averse, may like to invest in all short and medium-term instruments at a fixed rate at the time of entry while risk-neutral investors may join these schemes on a floating rate basis. As it is difficult to take a long-term view on interest rates, investment in PPF would be on a floating rate basis.

Rules governing deposits and withdrawals

As tax incentives are thus to be withdrawn from short and medium- term instruments, conversion of these savings into long-term savings may be allowed at the option of the investors without any penalty within a stipulated time, say, six months or at the most one year.

Institutional arrangements

A National Small Savings Authority (NSSA) may be constituted at the Centre to administer the NSSF with regard to all fresh flows.

To formulate policy in respect of small saving schemes, the NSSA would have an Executive Committee consisting of representatives of the Ministry of Finance, Government of India, some State Governments and a permanent invitee from the RBI in advisory capacity.

A nominee of the Controller General of Accounts may also be included in the Executive Committee. The NSSA may compile data on small savings on a monthly basis and disseminate them regularly.

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