Prof. Acharya on Inflation-indexed Bonds

The following is an Live Mint/Wall Street Journal op-ed written by Professor Viral Acharya.

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. Read the entire op-ed.

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