Finance

Even as evidence mounts of the government’s fiscal position in the current year slipping out of control, the fiscal responsibility bill has been in the news, thanks to the recommendations on the bill of parliament’s standing committee on finance. The government’s initial reaction to the committee’s recommendations was that they virtually dispensed with the notion of fiscal responsibility. This would appear to be a rather extreme view. The notable feature of the debate on fiscal responsibility has been the widespread appreciation that it has revealed of the importance of fiscal prudence. The government should build on this broad consensus rather than press for passage of the original bill without any modifications.

The arguments for linking interest rates on small saving (SS) schemes to market rates and rationalising the tax benefits available to them rest on removing the government's arbitrary powers in a liberalised interest rate environment. If as a result of the suggested measures SS schemes become relatively unattractive, the government would need to borrow more from alternative sources. If total government borrowing is not kept in check, yields on government securities would go up and with it the interest rates on SS schemes would also warrant upward revision.

There have been significant financial sector reforms through the 1990s. One of the major policy changes affecting the financial markets has been reduction in government's recourse to claims on loanable funds through statutory liquidity ratio as well as high levels of Cash Reserve Ratios. The central government has switched to market borrowing to finance its fiscal deficit on a larger scale than before. There is a general move towards market determined rates and flows in the financial sector. One area where administered rates are still important is the small saving instruments. The government sets these interest rates and mobilises funds for meeting the fiscal deficits at the centre and more so at the state level. If these rates were to be determined by the markets, what would happen to the interest rates in general. One argument is that the small saving rates act as a floor to the deposit rates of the banking sector and hence also determine the lending rates. If the overall balance of demand and supply of loanable funds is such that interest rates can be lower, the small saving rates do not let that emerge. Further, as interest rates decline, there would be significant gains in economic growth. This paper is an attempt to examine this viewpoint. We develop a monetarist model of the economy and assess the implications of alternative methods of financing the fiscal deficit of the government, central and states combined. The results support the view that overall interest rates would decline if the small saving rates were to be liberalised but the gains in economic growth would not be dramatic.

This paper recommends an inflation adjustment formula for setting the interest rate on all Small Savings and Provident Funds and discusses the rationale for the suggested formula.