Things to know about Inflation Indexed Bond

Benjamin Franklin once said that the only things certain in life are death and taxes. While taxes may not be true for many people, death is. After all, we have just 42,000 people who earn more than a crore. Poor souls, they must be regretting after declaring their income. The bad news, however, is that you cannot save yourself from inflation, a form of indirect tax on your earning. Especially, in a country like India where average spend on food and basic necessities form the bulk of expenditure, inflation is killing. This possibly explains Indians’ penchant for gold because it has proved its worth time and again.

 

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But the problem is…

She take my money when I'm in need, Yeah she's a trifling friend indeed

Oh she's a gold digger way over town, That dig's on me (lines from Gold Digger)

The finance minister doesn’t call the citizens trifling but he does get weary of our appetite for Gold. India doesn’t produce enough gold to satisfy the insatiable Indian gold diggers. The only way to get more gold is to import it. The finance ministry is facing huge current account deficit (CAD) owing to the high gold import and other things. The only way to handle the large CAD is to reduce import or improve export. Both of them look difficult in current economic scenario.

Countries like United States can afford to have higher CAD because it can attract foreign capital. The same is not true for India. In the long run, higher CAD can wreak havoc in the economy.

The name is Bond, Inflation Indexed Bond

So to bridge the current account deficit, Mr Chidambaram in his budget speech 2013 proposed to reduce the import of gold and thus reduce CAD. Now Mr Chidambaram is smart guy. He knows the only reason Indians buy Gold is that they have lost the faith in bank deposits and Government securities. Today, bank deposits and Government securities provide a return which is lower than the inflation. Essentially, my dear investor, you lose money when you keep money in bank or in Government bonds. Equity market and mutual funds may sound alien to many people despite the fact that they usually beat inflation by a big margin.

The panacea for the complex riddle of inflation is inflation indexed bonds or IIB. This is already launched in developed countries like USA long back. This bond is expected to be launched in the next year. The returns on IIB will depend on the inflation. Hence investors will get marginally better return than the inflation rate. This will help them achieve real positive return on their investment.

But there is a glitch…

The IIB will track wholesale price index (WPI) numbers and not consumer price index (CPI). Since most of the consumers do not buy at wholesale level, they may find the returns unpalatable. Consumers are more concerned about the CPI numbers and this is what impacts their purchasing power. Using WPI is not incentive enough to attract investors put money in IIB. As per last data, the WPI inflation was about 7% while the CPI was about 10%. You can see the difference.

The way forward

While the idea has been praised widely, the use of WPI numbers hasn’t gone well with the investing community. Hopefully, Government will consider benchmarking returns against the CPI and not WPI when they eventually launch it next year. Unless that happens, IIB is not a good idea for investors. Moreover, it will not serve the purpose of Finance Minister of luring away investors from Gold. Keep an eye on this space. We will cover the scheme when it comes to the market.

You can find more details about inflation indexed bonds at http://www.rbi.org.in/scripts/FAQView.aspx?Id=91 

 

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