New Delhi, Feb. 16: Millions of small savers have reason to groan.

The Narendra Modi government has decided to link the rates on the several small savings schemes to the market-determined yields on government securities from April 1.

Effectively, small savings rates on some of the most popular schemes could tumble by half a percentage point given current gilt yields that have retreated sharply since April 2015 when the rates were last set.

The schemes that will be hardest hit are the one-year, two-year, three-year term deposits, five-year recurring deposit schemes - all of which currently offer an interest rate of 8.4 per cent - and Kisan Vikas Patra that pays 8.7 per cent.

All these schemes had enjoyed a spread of 25 basis points above the yields of gilts with a comparable tenure last year.

The government has now decided to remove the spread for these schemes altogether "to make them closer in interest rates to the similar instruments in the banking sector", said a press note issued late tonight.

"This is expected to help the economy move to a lower overall interest rate regime eventually and thereby help all, particularly low-income and salaried classes," the note added. It did not seek to explain how a lower interest rate regime would "help" savers who will clearly be incensed by the move.

The note suggested that the relatively high small savings interest rates were limiting the banks' ability to lower their deposit rates in response to the monetary policy impulses of the Reserve Bank of India which has cut the repo - the policy rate - by 125 basis points since January last year. Banks, in contrast, have trimmed lending rates by just 70 basis points.

The government said it would retain the spread of 25 basis points above the relevant gilt in the case of the popular monthly income scheme (MIS), five-year time deposit, five-year National Savings Certificate (NSC) and the Public Provident Fund (PPF).

Sukanya Samriddhi Yojana, Senior Citizen Savings Scheme and the Monthly Income Scheme (MIS) - which command interest rates that are 0.75 per cent, 1 per cent and 0.25 per cent higher than G-secs respectively - will remain untouched as they are linked to social security goals.

But the rates on these schemes will also fall - though less sharply - because the gilt yields have fallen across all tenures.

The five-year small savings schemes have traditionally been set on the basis of the five-year government securities yield. The one-year deposit has been benchmarked to the 364-day treasury bill while the two-year deposit is calculated on the basis of a formula that incorporates the 364-day T-bill yield and the 5-year G-Sec yield. The government has not said whether it will change the benchmarks when it re-sets the small savings rates.

What's worse is that the interest rates for all schemes will be recalibrated every quarter, bobbing in tandem with the gilt yields. In a falling interest rate scenario, the yields are expected to continue to head southwards.

Kisan Vikas Patra (KVP), which was re-launched soon after the Modi government was formed, currently provides for doubling of principle in 100 months (8 years and 4 months).

Meanwhile, the Employees' Provident Fund Organisation (EPFO) today announced a higher interest rate of 8.8 per cent for this fiscal (2015-16), marginally up from 8.75 per cent in the previous fiscal (2014-15).

Over Rs 9 lakh crore are currently tied up in small savings schemes. Linking the small savings rates to market rates is estimated to save the government roughly Rs 4,500 crore per year.

The move, it said, would help the economy move to "a lower overall interest rate regime eventually, and thereby help all, particularly low-income and salaried classes".

The finance ministry said the compounding of interest, which is bi-annual in the case of 10 year National Saving Certificate (discontinued since December 20 last year), 5-year National Saving Certificate and Kisan Vikas Patra, shall be done on an annual basis from April 1.

The government has also permitted premature closure of PPF accounts "in genuine cases" arising from serious ailment or higher education for children. "This shall be permitted with a penalty of 1 per cent reduction in interest payable on the whole deposit and only for the accounts having completed five years from the date of opening," it added.

"Broadly the underlying philosophy of small savings rate changes is to make the rate more frequently market aligned, make it as closely market aligned as possible," economic affairs secretary Shaktikanta Das has said.

Small savings schemes earn higher interest rates compared with bank rates and are more attractive. This has been adversely affecting banks' deposit collection. The difference between the interest rates on small savings schemes and banks is between 1-2 per cent, which makes it difficult for the banks to transmit the policy rate cut.

Das said the small savings rate would move in line with the policy rate. "But at the long end of the curve, the spread will be protected. The government has taken into consideration the interest of small savers and the need to also encourage long term savers."

The RBI and banks have been pressing for a reduction in small savings rates and bring them in line with market rate for effective transmission of monetary policy. Governor Raghuram Rajan has said the rate reduction on small savings and post office deposit is going to bring down the cost of fund for banks.