Investment: Why 'small' is safe

Years of strong equity markets and the promise of good rates on fixed deposits have pushed the small savings option into the backdrop. Today, as we stare at the possibility of falling fixed deposit rates and volatile markets, it may be time to reconsider the trusty old option of small savings.

The gamut of small savings instruments is a wide one. Instruments such as the Public Provident Fund, the Post Office Monthly Income Scheme and the National Savings Certificate are among the popular ones.

These instruments offer a fixed rate of return determined periodically by the government. The interest rate on small savings was 12 per cent a decade ago, and was last cut in Budget 2003. Today the tax-free rate of return on PPF and NSC is fixed at 8 per cent.

The small savings rate has held steady despite a sharp drop in interest rates over the past year. The country's top bankers have argued that the interest rate of small savings deposits must be cut to avoid an outflow from bank FDs. Bankers and economists also agree that the small savings interest rate is acting as a floor on deposit rates and preventing interest rates from falling sharply despite the RBI's rate cuts.

While the arguments are strong, they may not find favor with a government that has just returned to power on a popular vote. With the government's focus on the 'aam adami', a sharp cut in the small savings rate seems unlikely. Even if the Budget delivers a 50-75 basis point cut in the small savings rate as rumored, small savings may still make sense for your portfolio.

With the Reserve Bank of India expected to keep interest rates low at least till the year's end and inflation at a record low, fixed deposit rates will remain under pressure.Besides, a flush of liquidity in the system has meant that the days of high yielding special fixed deposit schemes designed to lure depositors like you and me, have come to an end.

Over the past few weeks, most banks have cut their deposit rates for shorter duration deposits. They now offer rates in the range of 7-8 per cent for medium term deposits. Shorter term deposits are attracting very low rates. Compare that to the risk-free 8 per cent return offered by many small savings instruments and it may make sense for you to put away some of your spare cash in one of these.

Small savings may have many advantages in the current interest rate environment, but before you decide to park your money, you must consider some inherent disadvantages of small savings schemes as well.

For starters, most of these schemes have relatively long lock-in periods of up to five years. While some schemes will allow for early withdrawals, not all do.

At the same time, the tax benefits are also not substantial. Small savings schemes are eligible for Section 80C exemption on investments up to Rs 1 lakh, but the returns are not tax exempt, except for PPFs. Interest earned on other instruments is no longer exempt from tax.

Despite the drawbacks, small savings continue to draw a large number of Indians, mainly due to the safe and steady returns that they offer. While it has mostly been senior citizens who have been attracted to these instruments, the latest RBI data reflects a change in preferences. After falling for two consecutive years in 2006-07 and 2007-08, small savings collections have risen by 16 per cent in 2008-09 as more and more investors seek safer and less volatile investment options.

So, if you are looking for a safe way to invest some of your cash, you may want to stash away some of it in small savings.

The author is associate editor, banking, NDTV Profit