INDIA: Inflation bonds for seniors shelved

MUMBAI (The Economic Times), June 10, 2005:

The proposal to issue inflation-linked bonds to help investors hedge against the risk of inflation has been shelved.

The government has rejected the recommendations of an expert committee to issue such bonds to protect investors in terms of real returns. A real return is the return on investment after adjusting for inflation. According to officials, neither the issuer — the government — nor the RBI was comfortable with the proposal on a few counts. The committee had suggested to the government that a reasonable spread over the inflation rate be offered to senior citizens, through a new scheme.

Apart from administrative hassles, it has been pointed out that there have been problems in many countries which have issued similar bonds, although volumes have been high. Among the negatives cited are the choice of index, the lag in indexation and the relative illiquidity in the market for index-linked bonds, compared to conventional bonds.

From the government’s standpoint as well, the issuance of these bonds could pose a degree of uncertainty on cash flows, although some countries have touted the virtues of low-cost borrowing for the sovereign thanks to this product.

The UK has been one of the most prominent issuers of inflation linked bonds, popularly known as linkers.

The US Treasury also has the Treasury Inflation Protected Securities knows as TIPS issued for tenors ranging from 5 to 20 years. Several other countries, led by Canada, Germany, Sweden, Italy, France and Greece have also embraced this bond. The bonds are linked to the retail price index there.

Last year, the RBI said it would look at issuing bonds, in consultation with the government, featuring a product in which both the principal and interest payments would be protected against inflation. In such bonds, the amount of interest payments and the principal change with the inflation rate. The benchmark would be the consumer price index.

In other words, if the inflation rate rises, the principal amount and the interest amount will also rise.

The RBI proposal envisaged that the returns be linked to the monthly average of the wholesale price index (WPI) for all commodities.

However, the experience in India with such capital-indexed bonds in 1997 was not successful. The lack of investor response to these bonds was attributed to the fact that they offered protection only on the principal amount, while the interest was left unhedged.

The complex issues involved in pricing the bonds were also cited as a reason for the lukewarm response.

The RBI had proposed issuance of capital-indexed bonds as part of its efforts to widen the market for government securities.

By Shaji Vikraman