Heavy hand on savings

A significant reform measure in the financial sector was the reduction of the interest rate on small savings (post office savings, public provident fund accounts, National Savings Certificates and other instruments) from 12 per cent to 8 per cent in stages over three years.

This change contributed in a major way to the overall reduction of interest rates in the economy, which in turn has fuelled the housing and retail finance boom of the last three years and also brought down the government's cost of borrowing, which, of course, has helped manage the fiscal deficit.

The logical extension of this reform would be to allow the interest rate on small savings itself to be market-determined. Although this was recommended by a committee set up by the Reserve Bank of India some time ago, it has not been acted upon.

As the price of mobilising savings under these schemes fell, so did the price at which they were lent onwards. The entire amount raised is available for borrowing by state governments at 9.5 per cent interest. Further, each state is entitled to borrow the amount that was mobilised by post offices and bank branches within its territory.

In an environment in which states are generally resource-constrained and other sources of funds are difficult to tap, this may sound like a boon.

However, this is not, in general, the case today. Some states find themselves able to borrow directly from the market at better rates. This channel has been facilitated by the recommendations of the Twelfth Finance Commission.

However, as reported by this newspaper, the ministry of finance may put a spoke into this wheel. It believes that states should approach the market only after they have fully exhausted their quota of small savings.

This goes against the logic of reforms. Forcing a state government to borrow at a higher rate of interest than investors believe it should pay, is tantamount to imposing a tax on credit-worthiness. It creates a disincentive to implement measures which improve credit-worthiness, which essentially comes from fiscal discipline and efficient management of the state's economy.

States that are being rewarded by the market for their achievements on these fronts are fully entitled to take advantage of lower interest rates. The central government has no business coming in the way; if anything, it should be facilitating the process.

There are more efficient and market-friendly ways to deal with unwanted small savings. The best way to do this is to allow for a secondary market to emerge. States with large entitlements and good borrower ratings should be allowed to lend their unutilised quotas to states on the other side of the divide, for whom small savings are a low-cost source of funds.

This mechanism will ensure that aggregate borrowings by state governments take place at the lowest possible cost. It will also determine the correct spread between borrowing and lending rates that these resources can command. A fixed spread of 1.5 per cent is entirely arbitrary. Let the market decide what it should be.