Take a longer view on Inflation-indexed bonds

Prasanna A

The Government of India has decided to issue inflation-indexed bonds (IIB), starting from June, in an effort to broaden the menu of investment choices available for investors.

Although the bonds will be issued primarily for institutional investors, the government is making efforts to woo small investors by allocating a higher portion for non-competitive bidders. Further, the success of this bond and the pricing would have a bearing on a separate series of inflation-linked bonds that may be issued to retail investors, sometime later this year.

A lot of views have been aired about the potential success of IIBs and their likely pricing. In the context of declining WPI inflation, there seems to be an apprehension that IIBs may not receive an enthusiastic response. While it is difficult to hazard a guess before the first auction, participants should take a longer view on IIBs. A cursory glance at the benefits of IIBs for various stakeholders tells us that this instrument will be a net positive for the financial system.

For investors, IIBs represent the truest inflation hedge possible. Years of false marketing may have convinced some investors of the superiority of equity returns but neither equities nor physical assets can offer an effective and stable hedge against inflation. By their very design, IIBs are geared to provide such a hedge. IIBs have also known to provide diversification benefits and thus have emerged as a separate asset class, distinct from nominal bonds in many countries.

In advanced countries, IIBs have helped lower the cost of borrowing for the government, as nominal bonds contain an inflation risk premium; further, in periods when investors over-estimate inflation, IIBs could result in cost savings compared to nominal bonds. In some emerging economies, governments have been forced to issue IIBs as there were few takers for nominal bonds during periods of high inflation. None of these constraints hold in India.

Thanks to captive buying from banks and insurance firms and regular intervention by the RBI, the government is able to borrow as much as it pleases through nominal bonds. Further, the yields on nominal bonds continue to be extremely favourable to the government considering India's potential growth, inflation behaviour and chronic fiscal deficits. Thus, there is little conventional incentive for the government to issue IIBs.

Rather, the government's thinking seems to be to improve the choices available to investors and to wean away households from the gold obsession. One of the criticisms against IIBs in other countries is that such bonds lead to the spread of indexation i.e. the linking of wages and other prices in the economy to inflation. Studies have shown that such concerns are overblown. In India, indexation is already excessive. Public sector wages are linked to inflation and, more damagingly, the wages paid out in the rural job schemes are also linked to inflation.

What about the use of WPI instead of CPI for IIBs? It is a dampener when it comes to marketing the instrument to households; however, since the RBI has been basing its policy on WPI, the decision seems logical. Once India works out how to construct a representative and robust consumer price basket, then bonds linked to CPI can be issued.