It pays to be irrational. Or so it seems. Whether you are the government or an investor, the result is the same. It pays, and pays very well. So, should one jump on the bandwagon of irrationality? Or should one forgo near term 'irrational' returns for long term surety.
If you have not guessed by now, we are referring to the government savings schemes like the Public Provident Fund, Employee Provident Fund and Post Office Savings Scheme. To this list one can also add the latest government dole out -- the pension plan for senior citizens to be offered by the Life Insurance Corporation of India.
And how does this irrationality 'pay'?
From the government's perspective it is simple -- they use our money (taxes) to fund assured return schemes that are offering returns which are much higher than what these schemes actually earn. In effect we get our money (taxes) back in the form of higher interest. And for some reason we feel that the government is doing a great job whenever they launch such a scheme. With our money they win our votes. This surely pays well for the incumbent government.
From the investor's perspective too these schemes 'pay' very well. Such schemes, which are the safest in the market, offer assured returns which are much higher than what one would otherwise earn by investing in other comparable investment avenues. So rather than invest in a 15 year government security which yields about 5.75% pa (market determined), one would rather put the money in a PPF account and earn 8.00% pa assured compounded return. The PPF by the way also offers tax benefits under Section 88 and maturity proceeds are tax free. Other such schemes offer equally, if not more, attractive assured returns (the EPF offers 9.5% pa till very recently!).
Where does the question of irrationality come in?
Let's take the government first. The thinking it seems in India as far as the government is concerned is to implement fresh initiatives and not worry about consequences (by when probably a new government will be formed). So while they can benefit from the launch of such schemes, when the time to set things right comes, the blame can be easily passed on the government which launched the scheme.
However, one cannot go on hiding these liabilities for long. Sooner or later these will be too big to ignore. The government will have to, to use a cliché, bite the bullet -- like in the case of the Unit Trust of India, which was perceived to be government backed.
As far as investors are concerned, there seems to be no desire to learn from past experiences. The most recent being the Unit Trust of India episode where investors took a hit on their investments, despite the 'apparent' government guarantees. Today, money is pouring into government saving schemes, once again, on the premise that the return is being guaranteed by the Government of India. But is the chance of default really zero?
Technically yes. The reason is that the borrower, i.e. the government, has the power to print money. So whenever it runs short of money, it can simply print the deficit. But is the government likely to keep printing its way out of this 'deficit'?
The answer, expectedly, is a little blurred. Let's take the case of UTI, where the 'hit' was shared both by the government and the investors (the irrational ones who continued to stay invested despite early warning signals). The government on its part provided funds to the UTI to meet redemption pressures. It also guaranteed the bonds issued in lieu of cash that was to be paid on redemption. And what about the investors?
First, of course, investors found that the value of their holding eroded from Rs 14.55 to Rs 10.00 (the administered price) overnight, as the NAV was 'corrected' to less than Rs 6.
Second, units of large investors were locked in, and redemption was only allowed in phases.
Third, even the final redemption (beyond 5,000 units), which got over only recently, was in the form of bonds, and not money. Investors will need to wait for the bonds to get listed before cashing in their bonds. Then too there are risks about liquidity and pricing.
It is only fair to say that investors did take a hit. The government ensured that it was not saddled with all the liabilities. Irrationality does not always pay. And going forward this is one example one must remember.
Now let's take the case of an assured return life insurance policy. You may have invested in an insurance policy, which guarantees you 12% pa for 30 years. You probably feel great that you managed to beat the deadline when the policy was going to be closed to fresh applicants. But, are you sure that the insurance company will meet its obligation? Do you really believe that the government will meet the entire deficit in case of a default?
Today, state government backed securities, which offered high rates of interest are seemingly in default with interest payments and redemptions being delayed (Gujarat Lease and Finance Company). The central government too has set a precedent of sorts in the UTI case.
It is time for investors to take note of the risk involved in investing in government savings schemes.