During the last week, the government hiked EPF rates from 8.50% to 8.65%. As a pre-election move, it is surely going to impress the vast middle class population in India. But the hike in EPF rates could have larger macroeconomic import which India cannot ignore. Here are 3 important things that the Indian people must understand before celebrating the hike in EPF rates.
It will hike borrowing cost
EPF rates are, in a way, a major signal of interest rate direction in the economy. Being government sponsored, the EPF rates set the benchmark for risk free rates in the economy. The government has already projected the fiscal deficit to go beyond the FRBM commitments in the next two years. That means; the government will have to borrow more aggressively to bridge that gap. In the last few weeks we saw that government paper is not really getting a good response from the bond investors due to the low yield levels. By hiking the EPF rates to 8.65%, the government has indirectly done two things. Firstly, it has created an anomalous interest rate situation that is at cross purposes with the dovish monetary policy that the MPC outlined in its minutes. If the EPF rates are hiked then it is unlikely that rate cuts can be passed on to the ban borrowers as it will make debt expensive in the first place. Banks will be unwilling to pass on rate cut, so credit off-take suffers.
Distorts the yield curve
This is a much bigger problem and economists have time and again spoken about the same. EPF is a totally safe form of investment, albeit with a lock in period. But that is not the point. The interest rate of 8.65% is just one of the benefits. The investment in EPF entitles the individual to get 30% (peak rate) tax exemption under Section 80C of the Income Tax Act. That raises the effective yields on the EPF investment. Secondly, interest earned on the EPF is fully tax exempt in the hands of the investor. While the government pays just 8.65% to the investor, if you add up the Section 80C benefit and the interest exemption, the actual yield is much higher and government is actually paying a steep cost for the EPF monies. That is what distorts the yield curve.
Pressure on EPF fund managers
Most savers erroneously assume that the returns on EPF will continue to be assured. But, recently the EPF has been forced to take a hit on its investments in IL&FS bonds. One does not really know the shortfall that EPF has but that will be known sooner rather than later. At some point, the government is going to be able to ill-afford these giveaways. Either the government reduces the rates sharply or it will be forced to take on greater risks (as in the case of IL&FS). One only hopes that the EPF does not end up becoming another US-64! ©