In an important policy statement, the Reserve Bank of India (RBI) recently announced that it will issue Rs.12,000-15,000 crore of 10-year maturity inflation-indexed bonds (IIBs) in 2013-14 in line with a budget announcement in February.
These bonds will have their coupon rate and the principal value linked to the wholesale price index (WPI). The bonds, according to RBI, were being issued with an aim to protect savings of poor and middle classes from inflation and incentivize the household sector to save in financial instruments rather than buy gold. The issuance would be done through the primary auction route initially for institutional investors and will be extended to the retail investor segment by October.
While there is a general euphoria about the introduction of these instruments, it is important to understand why the option of issuing inflation-indexed bonds was not availed in the past few years when inflation levels and uncertainty were significantly greater. By all measures, inflation appears more under control today—annualized WPI inflation for the month of April is below 5.55% with every component of core inflation also significantly falling.
So, why issue inflation-indexed bonds now?
Let us begin with a few initial remarks about IIBs. They are one of the earliest financial innovations with their initial trading going back to 1780, the first issuance being by the Massachusetts Bay Company. However, most of the observed growth in the market for IIBs happened in the last two decades, with outstanding debt increasing from over $200 in late 1990s to $2 trillion in 2011. Most of the instruments are issued in the long-term maturity category and they remained a relatively smaller proportion of the nominal debt.
In terms of issuers, there are broadly three categories of countries that issued such bonds. The first group includes the Latin American countries experiencing high and volatile inflation, which made IIBs their best available option to raise long-term capital in the bond market. The second group of countries, such as the UK, Australia, Sweden and New Zealand, issued IIBs in the 1980s and early 1990s not out of necessity but as the result of a deliberate policy choice. The issuance of IIBs served both to add credibility to the government’s commitment to these policies and to reduce its cost of borrowing, by capitalizing on excessive inflation expectations in the market. Finally, a third group of industrialized countries, including the US, developed an IIB programme in more recent years, in the context of fairly low and stable inflation and inflation expectations, with a view to improve the investor welfare.
By choosing to issue IIBs now rather than two or three years back, India has chosen to be in the second and third category of issuing governments rather than the first.
Over the past few years, excessive reliance on gold purchases as hedging against inflation has caused Indian gold imports to surge and led to significant current account deficit for the economy. Gold imports constituted almost 30% of the current account deficit, estimated to be above 5% for FY13. Issuing IIBs few years back would have appeared tempting for the government as they could potentially act as substitutes to gold in inflation hedging as well bring down the inflation risk premium in the cost of public debt.
However, issuing IIBs in times of significant inflation uncertainty carries even more significant risks. An analogy can help understand the issue. Many firms, notably in the European telecom sector, have issued credit-sensitive notes, whose coupons rise if their credit ratings decline in future. Such notes are a way for management to signal their credibility in maintaining adequate credit standards. However, if the credit ratings indeed decline, then the debt payments will automatically rise even further, potentially serving a death knell for the firms.
Similarly, if a government issues IIBs but is unable to rein in inflation, then the debt burden for the government increases at precisely the worst macroeconomic time, inducing a possible death spiral for the economy.
Thus, inflation-indexed bonds are an important innovation for governments to reduce their debt issuance costs and provide a hedge to retail and institutional investors against inflation in the economy, provided a credible anti-inflationary monetary and fiscal policy framework is in place.
While RBI has maintained a clearer anti-inflationary stand in the last few years, thereby, making the timing of introduction of IIBs right, the government of India needs to build on its recent efforts to lay a credible fiscal policy framework to rein in long-term inflationary expectations.
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Viral V. Acharya and Gangadhar Darbha are, respectively, C.V. Starr Professor of Economics at the Stern School of Business, New York University, and an investment banker based in Mumbai. Views are personal.