Why Inflation Indexed Bonds is Necessary?

By | March 1, 2013

The Reserve Bank of India (RBI) lauded the government’s decision to introduce inflation-indexed bonds or IIBs and said that the new investment instrument may be launched as early as the first quarter of next fiscal (April-June of 2014).

“The Budget has taken some important steps for boosting domestic savings and reversing the declining savings-to-GDP (gross domestic product) ratio. One of the innovative schemes in the Budget is the proposed introduction of inflation-indexed bonds,” said Urjit Patel, deputy governor of the RBI.

What is Inflation Indexed Bonds ?

These bonds will be linked to the inflation index of the country (Wholesale Price Index or WPI) and serve as a better investment option as compared to physical assets like real estate and gold. Higher the inflation, higher your returns.

The WPI has largely been in the range of about 6-8% so far this fiscal. However, inflation is expected to ease further.

While investors may not be happy about it, this would be the apt timing for the government to issue IIBs. The RBI pointed out that the government’s intent to launch IIBs signals a credible commitment to lowering inflation.

The central bank said that IIBs are good hedging instruments against inflation. They should encourage household savings to shift away from gold that is largely unproductive for the economy, said the RBI.

Why is it necessary?

If inflation is higher then the interest rates in the economy the real rate of returns turn negative, which is why investor prefer to invest in gold and real estate.

By launching the inflation indexed bonds, P Chidambaram plans to wean away investors from gold and real estate.

Chidambaram said that consultations will be held with the Reserve Bank of India and details of the instruments will be announced in due course. “The private sector, comprising households and corporates, remains the main contributor to saving. The household sector must be incentivised to save in financial instruments rather, than buy gold,” he said.

Inflation indexed bonds are a perfect hedge against gold, since gold has served as a hedge against inflation. But, the question is given India’s penchant for gold, will the index inflation bonds work? It’s difficult to say unless details of the scheme are announced. If the government provides some kind of incentive like a tax rebate, it could very well work or else individuals would prefer gold.

In any case, one will have to wait for the details of the scheme before one can draw a conclusion.

Read: Detail about How to Diversify Your Risk with IIBs

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