FE Editorial : Bonding with inflation

Written by The Financial Express | Updated: Feb 14 2013, 02:16am hrs
Though the finance ministry has not been too keen on inflation-indexed bonds in the past, it is an idea whose time has cometo that extent, the fact that the budget may make an announcement in this regard is a good thing. While household savings fell from 25.2% of GDP in FY10 to 22.3% in FY12, the proportion being saved in financial savings fell from 12% of GDP to just 8%though there is no concrete evidence as to what caused the move towards saving more in physical assets like land and gold, the most accepted theory is that these are hedges against inflation. So, while investing in gold would give a handsome post-inflation return, investments in fixed deposits would yield a negative real rate of return given the way inflation has behaved over the last few years. This is what inflation-indexed bonds hope to try to fix since, at all points in time, investors in this class of assets will always be guaranteed a positive, even if small, rate of return.

Its not clear how much of the $10.5 billion of gold imports in Q2FY13 was made by households looking for an inflation hedge, but keep in mind this comprised around 50% of that quarters current account deficit. So if, for the sake of argument, a fifth of gold imports were on account for those looking for an inflation hedge, this can potentially reduce the current account deficit by a tenth. Nor is the cost that large. Assuming the government issues Rs 1 lakh crore worth of such bonds, or around a sixth of its borrowings, and it has to pay an interest rate of 3 percentage points more, this adds up to annual costs of Rs 3,000 croresmall change compared to the relief this gives on the current account. And given that, once such bonds are traded, their yields will give a 24x7 view of what the markets inflationary expectations are, this is an important additional tool in the policymakers armoury.

There is a fear such bonds will cut into the attractiveness of fixed deposits or provident fund investments where, in real terms, the earnings are negative, more so if you keep the CPI instead of the WPI in mind. While driving savings into fixed deposits can hardly be the governments objective, the amounts invested by households alone in fixed deposits (R4-5 lakh crore in FY12) are so large, inflation-indexed bonds are unlikely to kill the marketnor is it clear if there will be a quota for small investors. And, if households get a better deal, thats to be welcomed. Theres no earthly reason why households should be continuously be forced to invest in, for instance, the inefficient EPFO if inflation-indexed bonds offer a better dealif anything, such bonds will force banks and others to get more competitive. To the extent inflation-indexed bonds help get household savings back to financial products, this will be a cheaper solution than the other alternative being talked ofof raising 80C limits.