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Winning the battle against inflation

Winning the battle against inflation
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First Published: Sun, May 23 2010. 01 15 AM IST
Updated: Mon, May 24 2010. 12 47 PM IST
The recent bout of high inflation may have heightened one’s perception of the risk to the real value of one’s retirement income. How many more rupees will one need to beat inflation—that’s the concern. Savers will have to cautiously over-engineer retirement planning.
The average inflation rate from March 1984 to March 2010 was 7.6% (as calculated by the year-on-year increase in the all-India average of the Consumer Price Index, or CPI, for industrial workers). If one knew that inflation would be constant at 7.6% per annum in the future, one—or one’s pension scheme—could plan accordingly. The trouble is that our inflation rate is far from stable. And one’s retirement plan (unless it is already indexed to inflation) could mean a lot less in real terms if one faces high inflation immediately on retirement. One way to address this problem is to build an investment corpus bigger by, say, 30-40% than what it could have been if inflation was stable. But that means saving that much more.
Alternatively, and more easily, one’s pension scheme needs to invest at least some money in inflation-indexed bonds. These bonds guarantee an inflation-adjusted positive return. This would make it possible for pension schemes to offer a post-retirement inflation-adjusted annuity. This may also be helpful for the few among us who might want to directly invest in inflation-indexed bonds and manage one’s own investment income during retirement. Even in the UK, the US and France—countries with relatively more stable inflation—10-25% of their outstanding government debt is in the form of inflation-indexed bonds.
In the US, the inflation-indexed debt is linked to the CPI for all urban consumers. France and Germany issue inflation-indexed debt linked to the euro zone’s CPI (excluding tobacco). Like India, the US and the euro zone too lack a uniform inflation rate.
But why would governments want to issue inflation-indexed debt? Usually, there are four reasons. First, the country’s growth rate and its inflation rate generally are positively associated. Thus, in high growth years, on the back of a higher growth in tax collections, the government is likely to be in a better position to service a higher interest cost. And in low growth years, because of a slower growth in tax collections, the government would prefer to service a lower interest cost. In other words, the government is well placed to bear the risks associated with inflation-indexed debt. Second, retired persons are not in a position to bear the risk of unstable inflation. Third, this kind of debt creates an incentive for the government to reduce the average inflation rate, since a lower inflation rate would translate into a lower interest cost. Fourth, in contrast to long-term nominal bonds where governments traditionally pay higher yields, one study undertaken by the Netherlands government expects that government could save interest costs up to 0.35% through an inflation-indexed bond.
But the fourth reason may not hold the same way in India. In recent years, the average yield on even our longest-tenor bond issuances has been close to 7.6%—the annual inflation rate of the last 25 years. This means inflation-indexed debt won’t offer any positive spread over these long-term bonds. But this only shows that with such high inflation—even if it were stable—the long-term debt pension funds usually invest in barely offer a good return.
That makes it all the more imperative to get hold of an instrument that can help beat inflation. Unless our government begins issuing inflation-indexed bond (preferably interest income tax-exempt) and continues to do so regularly, our pension plans are fighting a losing battle against inflation.
AM Godbole is an adviser with AV Rajwade & Co. Pvt. Ltd, a risk management consulting firm
Comments are welcome at otherviews@livemint.com
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First Published: Sun, May 23 2010. 01 15 AM IST