Why Did Small Savings Rates Not Drop During COVID the Way FD Rates Did?

Why Small Savings Rates Held Firm When Bank FDs Fell

Many people believe that all interest rates move together. So, during the COVID-19 pandemic, it was confusing for savers. Bank Fixed Deposit (FD) rates dropped quickly and sharply. But interest rates on small savings schemes in India, like the Public Provident Fund (PPF) and Senior Citizen Savings Scheme (SCSS), did not fall as much. This left many wondering why there was such a big difference.

This situation highlights a common misconception. While both types of rates are influenced by the country's economy, they are set through very different processes. One is driven almost purely by the market, while the other has a strong element of government policy mixed in. Understanding this difference is key to making smart saving decisions.

How Banks Decide Your FD Interest Rate

Bank Fixed Deposit rates are closely tied to the actions of the Reserve Bank of India (RBI). The most important factor here is the repo rate. The repo rate is the interest rate at which the RBI lends money to commercial banks.

Think of it like this:

• When the economy is slow, the RBI cuts the repo rate. This makes it cheaper for banks to borrow money.
• To encourage borrowing and spending, banks then lower the interest rates on their loans, like home loans and car loans.
• To protect their profit margins, banks must also lower the amount they pay out on deposits. This is why your FD rates fall.

During the COVID-19 crisis, the RBI made aggressive cuts to the repo rate to support the economy. Banks responded almost immediately. They passed on the lower costs to borrowers and, in turn, offered lower returns to depositors. This process is fast, direct, and driven by market conditions and central bank policy.

The Formula Behind Small Savings Scheme Rates

Interest rates for small savings schemes in India are not set by banks or the RBI. Instead, they are decided by the Ministry of Finance, a department of the central government. These rates are announced every three months for the upcoming quarter.

There is a specific formula for this, based on the recommendations of the Shyamala Gopinath Committee. The goal was to connect these rates to the market and remove political influence. The formula links the interest rate of each scheme to the yield on government securities (G-Secs) of a similar maturity.

A G-Sec yield is the return an investor gets on a bond issued by the government. The formula works like this:

Small Savings Rate = Average G-Sec Yield of Previous Quarter + Spread

The 'spread' is a small extra percentage added on top of the G-Sec yield. This spread varies by scheme. For example, the Senior Citizen Savings Scheme has a spread of 100 basis points (or 1%) over the 5-year G-Sec yield. This is to offer senior citizens a higher, more secure return. The PPF rate is linked to the 10-year G-Sec yield.

The Built-in Delay

One crucial part of the formula is timing. The rate for the upcoming quarter (e.g., July-September) is based on the average G-Sec yields from the previous quarter (April-June). This creates a natural lag. Even if G-Sec yields fall sharply today, the small savings rates will only reflect that change three months later. This is one reason why the rates did not drop instantly as FD rates did.

The Real Reason Rates Didn't Drop: A Government Choice

The formula and the time lag only tell part of the story. During 2020, G-Sec yields fell significantly. If the government had followed the formula strictly, the rates on schemes like PPF and Sukanya Samriddhi Yojana should have been cut much more than they were.

So, why didn't they? The government made a deliberate choice to not pass on the full cut to the public.

Here are the primary reasons for this decision:

1. Protecting Savers: The pandemic caused widespread job losses and income uncertainty. Small savings schemes are the financial backbone for millions of middle-class families, retirees, and farmers. A sharp cut in interest rates would have added to their financial hardship during a national crisis. The government chose to provide a safety net.
2. Social Goals: Schemes like the Sukanya Samriddhi Yojana are designed to encourage saving for a girl child's education and marriage. The Senior Citizen Savings Scheme provides a regular income for the elderly. Maintaining attractive rates on these schemes ensures that these important social objectives continue to be met.
3. Funding Government Spending: The money collected from all small savings schemes goes into a large pool called the National Small Savings Fund (NSSF). This fund is used by the central and state governments to help finance their budget deficits. During the pandemic, government spending on healthcare and welfare schemes increased massively. By keeping the interest rates attractive, the government ensured a steady flow of money into the NSSF, which it could then use for its own expenses.

Example in Action: A Tale of Two Rates in 2020

Bank FD Rate: In May 2020, the RBI cuts the repo rate by 0.40%. Within two weeks, a large public bank cuts its one-year FD rate from 5.5% to 5.1%. The action is swift and directly linked to the RBI's move.

PPF Rate: G-Sec yields dropped sharply in the first quarter of 2020. Based on the formula, the PPF rate for April-June should have fallen below 7%. However, the government only made a partial cut, bringing it down from 7.9% to 7.1%, and then held it there for many subsequent quarters despite falling yields. This was a policy decision to cushion the blow for savers.

What This Means For Your Investment Strategy

The difference in how these rates are set has important implications for you as an investor. The rates on small savings schemes in India offer a degree of stability that bank FDs may not, especially in a falling rate environment. They are shielded from immediate market volatility by the government's policy decisions.

However, the reverse can also be true. When market interest rates start to rise, bank FD rates will likely increase much faster. Small savings scheme rates might be slower to catch up, as the government may choose to raise them more gradually.

The verdict is clear: the stability of small savings rates during COVID was not an accident. It was a combination of a formula with a built-in time lag and, more importantly, a conscious government decision to prioritize the financial security of its citizens and its own funding needs during an unprecedented crisis. A smart financial plan often includes a mix of both FDs for liquidity and faster rate transmission, and small savings schemes for stability, tax benefits, and long-term goal planning.