Inflation index bonds

In this year budget the government had mooted a plan to introduce inflation indexed bonds. The first question that comes to mind is why? Let us assume you have invested 100000 Rs in an fixed deposit of 8% in some public sector bank for 1 year .The real rate of interest you are getting should be calculated considering the inflation in that year .Let the inflation rate be 7 % (as was in India in the last one year) then we have a real interest rate of 0.9 % (((1.08/1.07)-1)%).This is just an example of how inflation eats into investments and makes inflation risk a serious concern especially in developing countries.

Why inflation is necessary?

Many economists will tell you that inflation has a direct relation with growth, and India being a developing nation needing growth requires inflation too. Inflation allows for people to produce more, a factory owner is incentivize to spend on expansion if he feel the demand for his good will increase. The economic cycle wants inflation and growth to be together but the Indian case is strange to say the least, inflation has remained high despite growth slowing down to 5% of GDP in 2012-13.This has called for major structural reforms in Indian economy as a whole.

India has been a moderate inflation country controlled by government pricing policies which have worked well to control inflation but induced scarcity of products, the so called quote license raj of the 1970s. In the 62 years since 1950-51 average annual inflation rate as measured by changes in the wholesale price index (WPI) increased at a rate of 6.7 per cent per annum according to the RBI. This is not very high considering nations across the world have seen inflation levels of 17% per annum as recently as the 1990s.

Table 1: In recent years India’s inflation rate has been  higher than world average
(Year-on-year in per cent)
	2000-07	2008	2009	2010	2011	2012	2008-12
	Average	Annual					Average
Global Inflation
World	3.9	6.0	2.4	3.7	4.9	4.0	4.2
EDEs	6.7	9.3	5.1	6.1	7.2	6.1	6.8
Inflation in India
WPI	5.2	8.1	3.8	9.6	8.9	7.6	7.6
WPI-Food	3.8	8.9	14.6	11.1	7.2	9.1	10.2
WPI-NFMP	4.3	5.7	0.2	6.1	7.3	5.2	4.9
CPI-IW	4.6	9.1	12.2	10.5	8.4	9.9	10.0
Indian inflation data pertains to financial year,          DEs: Emerging and Developing Economies,  WPI: Wholesale Price Index,                                  NFMP: Non-food manufactured products,  CPI-IW: Consumer Price Index for Industrial Workers.

Source: RBI

The table above compares the world inflation with the economically developing EDE (emerging developing economies) we see that the emerging economies have had an inflation rate more than the world. Inflation in India in the years 2000-07 was better than the average of the EDEs but in the post crisis period India after the sharp V of the post crisis period in 2009, inflation in India has remained sticky with an average of 7.6 percent higher than the other EDEs.

This has eaten away into the savings rate of India which has come down from an average of around 34 % in FY11 to 30.8% in FY12 according to the Economic Survey. Inflation has become the biggest enemy of the India public.

The India Government decided to introduce inflation indexed bonds to make sure the savings rate doesn’t go down due to inflation. The official government statement reads 

“Pursuant to the announcement in the Union Budget 2013-14, the Government of India in consultation with Reserve Bank of India (RBI) has decided to launch Inflation Index Bonds (IIBs), as instruments that will protect savings of poor and middle classes from inflation and incentivise household sector to save in financial instruments rather than buy gold.”

The Indian Government has woken up to the problem of gold imports and gold as an investment which doesn’t add anything to the economy except to the coffers of the already strong gold selling community of India(the author acknowledges the limited employment opportunities created by the industry).High inflation encourages speculative tendencies and money get diverted from productive activities to speculative activities as the rate of return in the standard assets is not longer enough to survive the hit by inflation. Hence we see the rise in prices of commodities and the increase in trading in derivatives.

To control inflation the Reserve Bank raised its policy repo rate 13 times between March 2010 and October 2011 by a cumulative 375 basis points. The policy repo rate rose from a low of 4.75 per cent to 8.5 per cent. Still it did not help contain inflation. The critics of the Reserve Bank have argued that monetary tightening rather than lowering inflation has slowed down growth. Interest rate is a weak instrument. It first slows growth and then inflation which in a country hungry for growth is a recipe for disaster as the growth slowdown has been much more than inflation control.

The inflation index bonds are a method to return India towards investment in the productive sector and increasing our savings rate again to 35% levels at least if not the Chinese savings rate of nearly 50%.

The details of the first series of bonds which are to be issued on 4^th of June is

Capital Indexed Bonds (CIBs) have a fixed real coupon rate and a nominal principal value that is adjusted against inflation.  Periodic coupon payments are paid on adjusted principal.  Thus, CIBs provide inflation protection to both principal and coupon payment.  At maturity, the adjusted principal or the face value, whichever is higher, will be paid.

·         Index ratio (IR) will be computed by dividing ref. index for the settlement date by ref. index for issue date (i.e. IR set date = Ref. Inflation Index Set Date / Ref Inflation Index Issue Date).

·         Final Wholesale Price Inflation (WPI) will be used for providing inflation protection in this product.  In case of revision in the base year for WPI series, base splicing method would be used to construct a consistent series for indexation. 

·         Indexation Lag:  Final WPI with four months lag will be used, i.e. Sept 2012 and Oct 2012 final WPI will be used as reference WPI for 1st Feb 2013 and 1st March 2013, respectively.  The reference WPI for dates between 1st Feb and 1st March 2013 will be computed through interpolation.

·         Issuance method:  CIBs will be issued by auction method.

·         Retail Participation:  Non-competitive portion will be increased from extant 5 per cent to upto 20 per cent of the notified amount in order to encourage retail investors’ participation.

·         Maturity:  Issuance would target various points of the maturity curve in order to have benchmarks. To begin with, these bonds will be issued for tenor of 10 years.

·         Issuance Size:  Each tranche of CIBs will be for Rs. 1,000 - 2000 crore and total issuance would be for about Rs. 12,000-15,000 crore in 2013-14

·         Issuance Date:  First such tranche will be issued on June 4th 2013 and the same would be issued regularly through auctions on the last Tuesday of each subsequent month during 2013-14.

The criticism of the bonds are that they are linked to the WPI which is hardly seen as a yardstick of inflation unlike the CPI which is real representation of inflationary pressure on the households, the WPI is now at an 41 month low of 4.89%(April 2013) and the CPI which is still at 9.39%.The CPI should be used as the benchmark index for inflation index bond if the government is really targeting the retail sector. The use of the 'auction method' for determining the coupon rate for the inflation-indexed bonds has been mentioned above , so the first tranche of Rs 1,000-2,000 crore bonds slated for June 4 is not for retail investors.  They will have to wait till October this year to apply for the inflation index bonds by that time inflation levels are expected to moderate even further.

Inflation index bonds does provide cover from the WPI but it would be better if it provided protection from CPI or food inflation which has remained high and is the real cause of decrease in saving rate in India and the protection that the India householder needs urgently.