The Reserve Bank of India’s plan to launch inflation-indexed bonds (IIB) linked to the consumer price index (CPI) by end-December is in line with the increased policy focus on retail inflation under the new Governor Raghuram Rajan. The current 10-year IIBs offer returns over inflation, based on the wholesale price index (WPI). Given that WPI inflation, at 7 per cent in October, is ruling significantly below the corresponding CPI rate of 10.1 per cent, the IIBs are unattractive for retail investors. They provide no protection against price rise experienced at the consumer end; for retail investors, WPI inflation has only a theoretical relevance. Also, IIBs that don’t provide returns over actual retail inflation fail to meet a key objective behind floating these instruments: weaning Indian households away from gold.
Proof of the small appetite for the IIBs in their present WPI-linked form is the declining cut-off prices at auctions. The first sale of a 10-year bond on June 4 was made at a coupon of 1.44 per cent. But subsequent re-issues of the same 1.44 per cent paper have seen yields rise to almost 3.7 per cent. Even this has not prevented a part of the auctioned amounts from devolving on primary dealers underwriting these issues. It only means that even a 3.5 per cent interest, which is on a principal value that supposedly adjusts for inflation from year to year, isn’t good enough to attract investors. The only reason for this is the wrong measure of inflation being used. A ‘real’ return of 3.5 per cent is more than decent if it is based on an accurately determined inflation rate — and not on an unreal, low inflation rate, which is what the WPI effectively yields. The real returns here can never compete with those from investing the same money in gold, real estate or even onions!
Offering IIBs linked to CPI can be a real game changer, given that there isn’t a single financial instrument in India now that insures against inflation risk. Having such a product would force banks to be more sensitive to depositors’ interests, creating a climate in which it will no longer suffice to mobilise savings simply on the assurance of safety. The public is equally bothered about erosion in the value of their savings from unrelenting price rise. This is the primary reason for money increasingly finding its way into gold and land at the expense of bank deposits. IIBs, provided they reflect actual inflation, can also serve an additional useful purpose in terms of disciplining the entity issuing them: the Centre. To the extent high inflation rates lead to increased interest outgo, the latter will be compelled to increase its commitment to fighting rising prices through fiscal consolidation.