For over a century Governments have been raising money from individuals for meeting their budgetary requirements through institutions like the Central Directorate of National Savings (CDNS). And if truth were told they should continue doing so for the simple reason to add another channel of distribution to reach out directly to the investors.

The CDNS is seen by some as being the savior of the less fortunate by paying a return incommensurate to the level of return prevailing in the economy to keep them from being poverty stricken. While as noble the objectives of the CDNS may seem to be, we could try to find an alternative that would try to capitalize on the positive aspects of the scheme.

The CDNS, seems to have taken on an adversarial role to the banks, in order to restrain their monopolistic position to generate perceived excessive profits from their financial intermediation activities. In fact, CDNS has gone above and beyond their role, as just another channel of distribution of long term paper to retail investors, to being the sole provider. This by itself would not be an impediment in the development of capital markets had the returns been market driven. The truth is that the CDNS, rather the Government, in the guise of raising long term funds in reality has only raised short term funds. This I say because CDNS uses the following tools to structure its instruments:

1) The instruments should provide the investors with short-term liquidity without loss of capital;
2) The instruments should also have a tax advantage over other investment opportunities in the economy;
3) The interest or principal should be automatically reinvested;
4) The return should be higher than those determined by market forces to provide income supplements to not only widowed or retired persons who can afford to invest in their schemes but also to those that may not fall within the purview of poverty stricken individuals; and
5) The higher return should also be made available to non-resident investors who are being offered a higher rate just to get them to bring foreign currency to Pakistan on a repatriable basis.

The core objectives of the government for its CDNS obviously would be as follows:

1) To raise funds to meet budget deficit in the most effective long-term cost basis;
2) To provide a risk free term structure of rates to serve as a beacon for financial transaction;
3) To provide to the government, markets perception about inflationary or deflationary risks to the economy; and
4) To be flexible to meet the needs of its investor community without sacrificing key fundamentals of debt management.

In the words of Dr. Ishrat Husain, “if these (NSS) rates are kept at the same level as in the past, the debt servicing costs will, at once stage, consume all the tax revenues leaving nothing for other expenditures, including running of government, defense and development.”

Dr. Husain’s apprehension about the future is based on the fact that the only source available to the government to service the debt is from tax revenues. The growth in tax revenues are highly correlated with the growth in the nominal income of taxpayers which is brought together by inflation and real growth in the economy, ceteris paribus. The rates cannot be set on an exogenous basis but should have a sound rationale of rate setting.

Unlike what most people think about the use of the funds borrowed by the government, it is not used in projects where the marginal return on capital is the highest. In fact most of the project the government if forced to invest in are the ones that the private sector has generally shunned.

In reality, the government runs a budget deficit because of private sectors inability to:

1) minimize cyclical nature of economic activity (leading to a drop in tax revenues); and
2) Investment in projects of public interest (due to the return not being above the cost of capital).

Now there would be a lot of examples given as to the number of government projects earning a handsome return but these would fail on three accounts:

1) The private sectors were not willing to take the risk initially;
2) These were originally private sector projects nationalized by the government; or
3) These are exceptions to the rule; that is, on a portfolio basis the risk-adjusted return would be insignificant.

It should be noted that with the Government Revenue Receipts of about PKR 644 billion and National Savings Schemes debts of PKR 793 billion, any return administratively set at a level beyond the nominal growth of the economy would be unsustainable. In such a situation, a 15-18% return would lead us to an internal debt crisis similar to that of an external debt crisis of 1998.

Inflation is a favorite defense of individuals bent on retaining the current systems or proponents of increasing its return. This would be based on the assumption that when they originally invested the money in the CDNS schemes the inflation was zero. The constantly quote that why is the government reducing the rates of return on the scheme because inflation has not been eliminated.

It should be understood that at a time when CDNS was in 1996-97 offering 16.27% p.a. on Special Savings Certificates and 18.04% p.a. on Defense Savings Certificates, the “official” inflation rate was 11.80%. Today, the “official” inflation rate stands at 3.80%. The question that the investors should ask is whether the inflation has receded and not whether it has been eliminated.

“Official” inflation measurement is not only a bane of the statistical collection body in Pakistan but these problems have also been highlighted by the Commissioner of the US Bureau of Labor Statistics. It should be noted that the CPI of any country is for the purposes to measure the price movement in the economy. It is not the measure to reflect the inflation of any specific household or investor. This is because CPI measurements have biases due to substitution, outlet selection, quality consumed or new products added to consumption pattern.
It is interesting to see that the CDNS has failed to maintain the investor flexibility posture. This is not to say that the government should give in all that the investor demands that may be in conflict with core government objectives. We see that CDNS certificate issuance which should be relatively constant shows wild swings quarter over quarter. This means that the administered rates are unable to meet the objective of meeting the government’s demand and the investor’s supply objectives seamlessly. We have also seen that in times of major rates increase long-term certificates are encashed soon after their issuance.

This proves a point that the early encashment feature of the CDNS schemes are not merely for non-economic reasons but the investors are clearly aware of its economic benefits to the detriment of the government and taxpayers.

This feature, together with the tax advantage and automatic reinvestment, has been costing the government about PKR 3.5 billion p.a. based only on new issuance or about 2.5% p.a. for each PKR borrowed directly. This is without the advantage of being able to manage its cash flows for proper debt management.

It would be more efficient to unbundle the inefficient features into the following:

1) An opportunity to invest in government securities at market driven interest rates for each tenor. This would enable a proper term structure of interest rates to be established in the economy. This would enable policy makers to get an indication of what the market thinks the monetary policy is expected to be in the future without the Government or the Central Bank causing undue influence.
2) Encourage savings for retirement on a temporary tax-deferred basis. Historically, the incentives were permanent tax-deference of income tax on the contribution, if held for three years. In addition, the income on the contribution was also exempt permanently. The tax advantage on contribution should be reinstated but on a temporary tax-deferred basis which would enable those employees not having the facility of tax-exempt provident funds and pension plans to build for their retirements.

3) Provide an “Income Supplement” support to citizens on income eligibility basis from the savings generated from making the CDNS schemes market driven. This would go a long way for the 4.5 million people who are not investors but would qualify for support on income assessed basis.
4) Provide access to savers from professional guidance from “Wealth Management Companies” or “Mutual Funds”, as they would be able to provide competitive investment products. The Income Tax laws should provide tax shelters for retirement, education and first home ownership savings incentives.

The fall out benefit from these changes would be to improve the depth and breadth of the secondary market of government securities which till now has been the domain of only buy and hold institutional investors. The liquidity needs of the retail investors would increase the secondary market trading of government securities.

It is hoped that the skin-deep popularity of the CDNS schemes would be substituted by an institution of more substance that would provide value added services to the retail investors.