By Ruma Dubey

Chidambaram wants to do everything possible to control the out-of-control Current Account Deficit and he thinks the best possible way to do that is by curbing the fetish which Indians have for gold. This yellow metal is being blamed for the entire financial mess we are in today.

Apart from hikes in duties, our honorable Finance Minister has proposed the introduction of Inflation-Indexed Bonds or IIBs. The idea is indeed in the right direction – when investors are given an alternate investment option, which helps you hedge against rising inflation, the FM hopes that IIB will do the trick. Real estate and gold, move with costs and these avenues are today beyond the reach of most and to some extent, have themselves become inflationary; adding on to the rising costs.

Ironically, today, RBI Governor while speaking at a convocation ceremony at Pune said that high inflation was forcing people to indulge in buying gold rather than depositing funds with banks. And to think that under these circumstances, we can change a mind-set, urge people to stop buying gold and instead invest in IIB seems too far-fetched.  

Before we assess whether IIBs will meet the objective of bringing down gold consumption or not, let us first try and understand what this actually means.  RBI has already floated a technical paper on the same and in the paper it has stated that IIBs will provide insurance to investors from inflation and cost savings for the Govt on account of reduction in coupon payments with lowering inflation rate, elimination of uncertainty risk premium, and containing inflationary expectations. In IIBs, the principal is indexed to the Wholesale Price Index (WPI) periodically while the coupon would be paid on this inflation-adjusted principal.

How this works is something like this. Suppose you buy bonds at par, which could be Rs.1000 and assume the interest rate is at 9%. This means at the end of the year, you will get an interest of Rs.90. Now let us assume inflation rises to 8%. So this inflation index bond will adjust the principal at Rs.1080 and the interest rate of 9% will be paid on Rs.1080 and not Rs.1000. This means, when adjusted to inflation, you will Rs.97.20 and not Rs.90.

And what happens when inflation comes down? Suppose inflation falls to 7% then principal will be adjusted at Rs.1070 and you will earn Rs.96.30. And in case of deflation, of say, 5%? The principal will get reduced to Rs.950 and interest earned will come down to Rs.85.50. Well, deflation and that too in India? Seems highly impossible so one need not worry about earning less!

At the time of redemption, if the option chosen is not cumulative, then the principal repaid would be equivalent to its par value. It will never be less than Rs.1000.

Actually, we should say that RBI is ‘reintroducing’ these IIBs as it had previously, rather half-heartedly, launched IIBs. First time was way back in 1997 where only the principal was indexed and not the interest rate. This was withdrawn and a new version was once again launched in 2004 and this time, both principal as well as interest rate were indexed. The IIBs failed because there was no faith in the benchmark and there was no real depth in the bond market. But this time around, the benchmark, the way WPI is calculated and the depth in the bond market, all have improved.

Economically, IIBs now makes more sense. More importantly, there is mindless investment in gold and realty at illogically high prices. Gold especially, wherein gold imports are going up and this is leading to a skewed fall in rupee. As we pay for the gold imports in dollars, buying more and more gold is not good for the Indian economy. The Govt has tried its best to curb gold buying but that will not help as long as there is no alternative.   IIBs make perfect sense as it is the perfect hedge against inflation. It will help investors have a more diversified asset portfolio and give them more productive assets. But no way will it be able to curb gold buying. Imagine a housewife being asked to choose between buying gold and IIB; it will be a no brainer – obviously she will choose gold!

So IIB is a very good idea but if the aim it to curb gold buying, it will not be able to achieve the objective.