The first issuance of an indexed financial instrument was in 1742 when the State of Massachusetts issued bills linked to the cost of silver. The market has traversed a long way since, with economists such as Keynes, Musgrave, Friedman, Barro, among others, supporting the issuance of indexed bonds.
In India, the first indexed bond was issued in December 1997, in which the capital was indexed. Currently, the Government plans to issue Inflation Indexed Bonds (IIBs) where both principal and interest are to be protected from inflation.
Concern has been expressed over the usage of Wholesale Price Index (WPI) as the reference, instead of Consumer Price Index (CPI). The former, it is felt, would not give complete inflation protection to the retail investor. Moreover, WPI tends to fluctuate more than CPI.
Globally, too the evidence is tilted towards usage of CPI. However, one of the pioneers of IIBs, Argentina (1972-1989), had referenced their first issue to non-agricultural wholesale prices and later graduated to a combination of consumer, construction and wholesale price indices.
Similarly Brazil from 1964-1990, Columbia in 1967, Finland from 1945-1967, Turkey 1994-1997 had issued IIBs linked to wholesale prices. The UK continues to issue gilt linkers with the reference index being Retail Price Index, which happens to be more volatile than the CPI. This is despite the fact that its monetary policy is focused on CPI.
Domestically, the choice of WPI instead of CPI as a reference index for pricing IIBs has been made more out of necessity rather than preference. For an index to serve as true reference it needs to meet certain criteria, such as easy accessibility, wide acceptance and regularity in periodic updates. The WPI meets these requirements. It has been in existence for a much longer period than the national CPI (which came into being two years back) with revisions to its base at regular intervals. WPI is also the most important gauge of price movements, as far as monetary policy is concerned.
Our markets would require any new product to be well accepted initially by wholesale investors and market intermediaries, resulting in liquidity for the instrument.
As the coverage of WPI is wider than the CPI, any financial instrument indexed to WPI can cater to a wider investor base.
Once the wholesale market develops a level of comfort regarding IIBs, we could move on to meet the needs of retail investors through CPI. This is already being looked at by the regulator; once the CPI matures to become the focus of monetary policy, the reference index for IIBs could be shifted to CPI.
While a retail investor may assume a basis risk when he takes a bond linked to WPI rather than CPI, IIBs in their current avatar will still offer a high degree of protection compared with the nominal yield bond.
The author is Chief General Manager, Treasury & International Banking, IDBI Bank.