The Mutual Fund Association of Pakistan has developed a policy paper on the implications of National Savings Schemes (NSS) on economy and the financial sector. It says: National Savings Schemes play an important role in mobilisation of savings for meeting the Government of Pakistan's (GoP) financing needs. However, pricing and tax anomalies in NSS need to be addressed.
Addressing these anomalies can save the G o P up to Rs 100 billion per annum through reduction in debt servicing costs and increase in taxes and penalties on early withdrawal from NSS. This will also reduce the interest rate risk for the G o P and help in bringing the interest rates down in the country which will help in promoting economic growth while continuing to meet the financing needs of the G o P through the NSS.
NSS STRUCTURE AND RATE OF RETURNS The total size of NSS was Rs 1,411 billion in December 2010, excluding Rs 250 billion of prize bonds. The Special Savings Certificates of 3-year maturity and Behbood Savings Certificate of 10-year maturity combined accounted for over Rs 1 trillion out of this total NSS savings (see Annexure A). Our analysis indicates that there is very substantial mis-pricing in these two schemes. Behbood presently offers a rate of 15.4% p.a.with zero percent tax on it. Over 90% of Pakistani retirees do not have the savings to invest in the Behbood Scheme.
The investors who invest in the Behbood Scheme are rich and it is not right that they should be provided subsidy. It is also widely believed that individuals open multiple Behbood Deposit Accounts at different NSS Centers. There is a need to investigate this fraudulent availing of Behbood subsidy beyond the set limit of Rs 3 million if it exists and to impose penal tax on the concerned individuals.
There may be some justification for Income Subsidy for the very poor such as through the Benazir Income Support Program, provided it can remain targeted for the benefit of the genuinely very poor and needy. On the other hand , there would appear to be no justification for providing subsidy to the very rich through payment of very high interest rates and also making the rate of return paid (15.36 % per annum) on the Behbood deposits free of tax.
RATE OF RETURN ANOMALY ON NSS We have compared the NSS rates in Pakistan with similar Small Savers Scheme in India (see Annexure B & C). In India the average bank deposit rate is about 7.5% p.a. and the average return on Savings Schemes is about 8% p.a. In Pakistan the average bank deposit rate is around 6% p.a. and the average return on NSS is about 14% p.a. (calculated based on the prevailing rates of returns). It will be seen that as compared to India the average rates of return on NSS in comparison to bank deposits is too high at twice the average bank deposit rates.
NSS with GoP as issuer is rated AAA while the weighted average rating of the banking sector in Pakistan is AA. The weighted average rate of return on all bank deposits is around 6% p.a., whereas the rate of return on NSS is around 14% p.a. This is as major anomaly which is against the basic principles of Investments. Lower risk investment should earn a lower return and higher risk investment a higher return. The G o P can save Rs 50 billion per annum by removing this anomaly and most savers will still invest in NSS because of the lower risk and higher comfort level in these schemes as compared to banks & mutual funds.
THE PENALTY STRUCTURE ANOMALIES ON NSS The penalty structure on NSS is also inconsistent (see Annexure D). The penalty on 10-year Defence Saving Certificate for redemption in the first year is 5.6% and the penalty on 10-year Behbood Savings Certificate in the first year is only 1%. Not only are there inconsistencies in the penalty structure of different schemes, the penalties are very low on Special Savings Scheme, Regular Income Certificate and Behbood Scheme.
On the 3-year Special Savings Certificate there is almost no penalty if a saver redeems after completion of 6-months period. Thus in reality this is a 6-month instrument providing a 3-year instrument. Return. Low penalties on withdrawal from NSS exposes the GoP to interest rate risk. If interest rates go up, benefiting from very low or no penalties, savers quickly move to other avenues forcing G o P to increase the rates on NSS for existing savers as well. On the other hand, if interest rates go down, savers remain locked-in at higher rates, thus the G o P cannot benefit from the lower interest rate environment.
Unlike G o P's Bonds such as PIBs, where the interest rate risk is borne by the saver, in NSS due to the absence of similar penalties, the interest rate risk is borne by the G o P. This is reason why the rates offered on NSS schemes can be lowered as compared to the G o P Bonds in view of G o P taking higher interest rate risk on NSS versus G o P Bonds. Annexure E compares the Effective Penalty rates for saving schemes in Pakistan with India. Effective penalties are much lower in Pakistan as compared to India. Also, Senior Citizens Savings Scheme in India has a 5-year maturity versus a 10-year maturity of Behbood Scheme in Pakistan. The longer maturity exposes the G o P to much higher interest rate risk specially with the penalty on Behbood Savings Certificate averaging only 0.625% in the first 4 years and 0% in the last four years.
THE TAX STRUCTURE ANOMALIES ON NSS Annexure F compares the tax structure on savings schemes for India and Pakistan. For all schemes excluding Behbood Savings certificate there is a flat 10% full and final tax rate on income irrespective of the income level of the saver. In India, by contrast, the tax rate is 10% on Income level of upto INR 500,000, which rises to 20% for income levels between INR 500,001 and INR 800,000, and 30% for income levels above INR 800,000. Behbood Savings Certificates are completely tax exempt in Pakistan whereas in India for Senior Citizens Savings Scheme the tax rate rises with the income levels of the savers and reaches 30% for savers with income levels above INR 800,000.
We recommend that (i) there should be a 10% withholding tax on all savings schemes including Behbood Savings Certificates; (ii) the withholding tax rate should not be full and final, and all savers in all schemes should be required to pay the remaining tax based on their individual tax rates at the time of filing of tax returns. The same policy should apply to all bank deposit holders as well and the 10% withholding tax should not be full and final settlement. The G o P will collect well above Rs 30 billion in taxes from NSS alone if the above recommendations are implemented.
IMPACT OF HIGH RATES OF NSS ON THE PRIVATE SECTOR, FINANCIAL SECTOR, DEBT AND STOCK MARKETS, AND OVERALL ECONOMIC GROWTH Very high rates of NSS have a strong negative effect on the Private Sector and on the economy. With NSS offering returns of 12%-15% per annum, the Private Sector is forced to borrow at an even higher rate. Recent example is that of a premier company.
Engro offering a 14.5% per annum return to savers for its Commercial Paper. Average companies needing to borrow on similar lines will need to pay even more - 15% - 20% p.a. This is an illustration of the negative results from the very high rates on NSS are slowing down the private sectors borrowings as the rates for them become prohibitively high and become a barrier for business and industrial investment and expansion which can provide growth.
The wide spread of over 8% between NSS rates and bank deposits also has a negative impact for the banking system as well. SBP has stated in its Financial Stability Review 2009-10: "more net flow towards NSS tend to shift medium term fund or fixed deposits away from the banking system that limits the banks' ability to invest in the medium term projects". High NSS rates are also a major impediment in the growth and development of the savings sector in Pakistan which provides financing to the productive sector such as through the mutual fund industry in Pakistan.
The Debt Capital Market Committee (DCMC) set up by SECP in 2006 concluded that NSS posed a major challenge in reforming debt capital markets and reported that NSS has: "historically been a costly source of funding for the government due to the inefficient pricing structure and the free embedded put option.
The built-in option allows investors to redeem the investment at any point in time without any redemption charges. Subsequently, comparable market based instruments, in contrast, seem unattractive and non-competitive to the retail investor base". The Committee recommended that the Government should fulfil its long-term needs through PIBs instead of NSS.
The SBP in its Financial Stability Review 2009-10 reported that the reason for the degree of substitution between NSS rates and bank deposits is the early encashment facility in NSS which can be utilised without incurring any penalty. It concluded that NSS instruments need to be integrated into mainstream capital markets by making them tradable and by withdrawing the implicit put option, which is a potential source of liquidity problems for the Government.
COMPARISON OF SAVINGS SCHEMES IN INDIA AND PAKISTAN
--- In India institutional investment is not allowed in savings schemes except one. In Pakistan institutions are allowed unrestricted investment in all savings schemes (excluding Behbood Savings Certificates).
--- Interest rate on Savings Schemes are determined administratively by the Government of India and are not linked to Sovereign bond rates as in Pakistan
--- Tax slabs rise to 30% in India as against 10% in Pakistan
--- The rates on Savings Schemes in India are about the same as the average bank deposit rate. In Pakistan the NSS rates are about twice that of the average bank deposit rate.
--- Most Saving Schemes in India have a 5 year maturity as against 10 years in Pakistan exposing G o P to more expose to interest rate risk.
RECOMMENDATIONS FOR THE GOVERNMENT OF PAKISTAN
--- The NSS should be targeted towards small savers and as in India institutions should not be allowed to invest in NSS
--- As in India rates should be linked to bank deposit rates and not to sovereign bond yields.
--- Penalties on NSS for premature redemptions should be raised substantially to reduce interest rate risk for G o P
--- Higher tax rates slabs should be applicable on all NSS and bank deposits based on the income levels and tax bracket rates of the investors.
--- Investment limits for Behbood Saving Certificates should be reduced to PKR 1 million and manipulation of multiple investment, if it exists, should be stopped by developing a centralised database system and properly verifying the identity of the saver.
--- Rate of Return on Behbood Saving Certificates and Defence Saving Certificates, both having a 10-year maturity, should be in line with 10-year bank deposit rate, which is presently about 11% p.a.
--- The above measures will help G o P save about Rs 100 billion per annum on account of reduced debt servicing costs and higher taxes and penalties receipts.
--- Know Your Client (KYC) requirements should be made applicable to NSS as well as they are applicable to bank and mutual funds. This will help reduce money laundering and improve transparency and documentation of the economy.
--- Even if G o P gradually reduces NSS rates and raises penalties, it will still be able to attract the target amounts as banks / mutual funds returns are substantially lower than NSS rates.
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Annexure A: NSS - Asset Size
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Name of Scheme Asset Size-Dec 2010 Present
(in Billions Rs) Rate of Return
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Defence Savings Certificate (10 yrs) 227 13.55%
Special Saving Certificate (SSC) (3 yrs) 489 13.33%
Regular Income Certificate (5 yrs) 158 13.44%
Behbood Savings Certificate / PBA (10 yrs) 520 15.36%
Savings Account (perpetual) 17 9.00%
Total* / Weighted Average Rate of Return** 1,411* 14.10%
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Does not include prize bonds worth about Rs 250 billion
The maximum amount is in SSC and Behbood as they are the most mis-priced. In Behbood the richest Pakistanis are being subsidized by the Government in the name of "pensioners". This is based on the assumption that all investments are enjoying the prevailing rate of return.
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Annexure B: Comparison of Savings Schemes Rates with Bank Deposits
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India Pakistan
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Returns Average Returns Average
Scheme Years on Bank Difference Scheme Years on Bank Difference
Name Saving Deposit Name Saving Deposit
Schemes Rate Schemes Rate
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Time Deposits 3 7.30% 7.50% -0.30% SSC 3 13.30% 6.00% 7.30%
Time Deposits 5 7.50% 7.50% 0.00% RIC 5 13.40% 6.00% 7.40%
Senior Citizens 5 9.00% 7.50% 1.50% Behbood 10 15.40% 6.00% 9.40%
KisanVikas 8 8.40% 7.50% 0.90% DSC 10 13.60% 6.00% 7.60%
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The Government of Pakistan (GoP) is paying much higher rates, than what it should, to attract the same amount of money.
GoP can save about Rs 50 billion p.a, in interest payments on NSS by pricing the instruments properly, ie 4% - 5% p.a. higher than average bank deposits rather than 7% - 9% p.a. higher than average bank deposit rate.
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Annexure C: Comparison of Savings Schemes Rates with Bank Deposits and Govt. Securities
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India Pakistan India Pakistan India Pakistan India Pakistan
1 Year 1 Year 3 Year 3 Year 5 Year 5 Year 10 Year 10 Year
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Govt Sec minus Bank Deposits 0.70% 6.54% 1.00% 5.33% 1.20% 5.04% 1.00% 5.18%
NSS minus Bank Deposits -0.50% 1.79% 0.50% 4.62% 0.50% 4.39% 1.15% 6.46%
NSS minus Gov Sec -1.20% n.a -0.50% -0.71% -0.70% -0.65% 0.15% 1.28%
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Both Savings Schemes rates relative to bank deposit rates and Government Securities rates relative to bank deposit rates are much higher in Pakistan relative to India.
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Annexure D: Inconsistent Penalty Structure on NSS at Present
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Years
Scheme Name Tenor 1 2 3 4 5 6 7 8 9 10
(Years)
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Special Saving Certificate/Account* 3 0.13% 0.13% 0.13%
Regular Income Certificate 5 2.00% 1.50% 1.00% 0.50%
Behbood Savings Certificate / PBA 10 1.00% 0.75% 0.50% 0.25% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Defence Saving Certificates (DSC) 10 5.60% 5.40% 5.00% 4.40% 3.70% 3.00% 2.20% 1.40% 0.70% 0.00%
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No interest payment if encashment before completion of half early period Penalties on SSC (3 years), RIC (5 years) and Behbood (10 years) are very low, which exposes GoP to interest rate risk. If interest rate goes up, due to the very low penalties investors can quickly move to other avenues forcing GoP to borrow at higher rates or increase the rates on NSS.
If interest rate goes down, investors are locked in at higher rates for long periods thus GOP cannot benefit from the lower interest rate environment. Thus, unlike Government Bonds, for example PIBs, where the interest rate risk is borne by the investors, in NSS in the absence of substantial penalties, the interest rate risk is borne by the GoP.
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Annexure E: Comparative Effective Penalties Structure - Saving Schemes
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Scheme Pakistan India
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3 Years Tenor 6 months = 100% Year 1 = 100%
Year 1 = 0.1% Year 2 = Significant Penalties onwards*
Year 2 = 0.1%
5 Years Tenor Year 1 = 14.9% Year 1 = 100%
Year 2 = 11.2% Year 2 = Significant Penalties onwards*
Year 3 = 7.5%
Year 4 = 3.7%
Behbood / Senior Citizens Year 1 = 6.5% Year 1 = 16.7%
Year 2 = 4.9% Year 2 = 11.1%
Year 3 = 3.3% Year 3-5 = 0%
Year 4 = 1.63%
Year 5-10 = 0%
(Maturity 10 years)(Maturity 5 Years)
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Effective penalty is calculated by dividing the actual penalty percentage with the coupon rate on the saving scheme. Penalties need to be increased on SSC and Behbood.
Maximum maturity for Behbood should be reduced to 5 years from 10 years to reduce GoP interest rate risk. This is the case in India on its Senior Citizens Scheme.
We have not been able to obtain the exact rate of penalties for India.
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Annexure F: Comparison of Tax Benefits
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Pakistan India
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Following tax rates apply for the given income levels:
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There is a flat 10% full and final tax up to INR 500,000 : 10%
rate on income from saving schemes INR 500,000 - 800,000 : 20%
irrespective of the investment amount Above INR 800,000 : 30%
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Senior Citizens Savings Scheme
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Tax Rate
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Behbood Saving Schemes: up to INR 100,000 : 0%
Tax Rate = 0% INR 100,000 to INR 500,000 : 10%
INR 500,000 - 800,000 : 20%
Above INR 800,000 : 30%
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There should be a 10% withholding tax on all savings schemes including Behbood.
The withholding tax should not be full & final and all investors in the scheme should be required to pay the remaining tax at their individual tax rates at the time of filing returns.
About Rs 30 billion can be collected in taxes by following the above steps.