Thursday, February 18, 2010

Go for inflation-indexed bonds

Go for inflation-indexed bonds


The elderly need to be protected from inflation through instruments that promise a real rate of return of, say, 2 per cent over the rise in consumer prices. Inflation will not spin out of control, as is feared. The move will, in fact, signal the government's intent to contain inflation, says S. S. TARAPORE.

If the governmentis serious about the welfare of the disadvantaged sections and the elderly, it should be willing to float inflation indexed bonds.

All governments claim that they are committed to inflation control, but at some stage or the other they fail to achieve this objective. The segments most affected by inflation are fixed income earners who have no indexation facilities, the retired population and the deprived.

The devastation caused by inflation is best illustrated by a simple arithmetical calculation. A small saver invests Rs 100 in the present Post Office Senior Citizen Scheme for five years at a rate of interest of 9 per cent per annum. If the inflation rate is 5 per cent, the real rate of interest is only 4 per cent; moreover, at the end of the five year maturity period the real value of the capital is Rs 78.4 and at the end of 10 years Rs 61.4.

The authorities, continue to swear by the Wholesale Price Index (WPI), which does not reflect consumer prices. The world over, the Consumer Price Index (CPI) is used as an indicator of inflation. In India we have four sets of CPI and it should be possible to work out a weighted average CPI, based on the four CPIs. The latest year-on-year (unweighted) average of the four CPIs is around 14 per cent.


.Using this indicator the 9 per cent Senior Citizen Scheme yields a negative real rate of interest of 5 per cent per annum. In real terms, a savings of Rs 100 is worth only Rs 51.9 and at the end of five years and Rs 27 at the end of 10 years.

In India, governments, from time to time, have toyed with the idea of introducing inflation-indexed bonds, but on each occasion the authorities have backed off. The ostensible reason is that such bonds would serve as a signal for indexation of the entire economy, and the authorities fear that they would lose control over inflation.

Imprudent macroeconomic policies, and not indexation, are a cause of inflation. The real reason for rejecting the indexation idea is that governments do not trust their ability to control inflation.

If the government is serious about the welfare of the disadvantaged segments of society and the elderly, it should be willing to float inflation indexed bonds for senior citizens with a maturity of, say, five years. The scheme should offer a real rate of interest of only 2 per cent per annum; if the CPI at the end of the year shows an increase of 14 per cent, the saver should be paid a nominal rate of interest of 16 per cent for that year.

If the government vows to bring down the CPI inflation to, say, 4 per cent, the saver would be paid a nominal rate of interest of only 6 per cent per annum. Each year's interest can be paid at the end of the year, based on the CPI inflation rate.

The real value of the capital should be protected and if, over the five-year period, the CPI inflation rate averages 14 per cent, on an initial investment of Rs 100, on maturity the saver should be paid back an amount of Rs 192. But if the inflation rate averages only 4 per cent, the amount returned on maturity would be only Rs 122.

Instead of being apprehensive about floating an inflation-indexed bond when the CPI inflation rate is high, as at present, the government should launch the scheme at precisely such a time. It would act as a signal that the government is determined to bring down the inflation rate to very low levels. A determined move by the government can alter inflationary expectations.


The bond should protect both interest as well as capital. The scheme could be open only to citizens above the age of 60 years and subject to an overall ceiling of Rs 5 lakh which should be applied jointly to a husband and wife. The bond should be kept open each year only from April 1-15 so as to avoid complex calculations.

The nominal rate of interest on the bond should be subject to income tax and there should be no Section 80C deduction at the time of investment. Therefore, there should be no tax on the maturity corpus. The nominal capital appreciation should not be subject to capital gains tax.

To the extent that inflation is moderated there would be an inflation control dividend for the government. The Finance Minister could announce the scheme on February 28, 2010, and the scheme should be put into operation on April 1, 2010.

The Hindu Business Line : Go for inflation-indexed bonds (18 February 2010)

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