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RBI mulls inflation-linked instrument to blunt the bite from price hikes

RBI mulls inflation-linked instrument to blunt the bite from price hikes, but uncertainties remain.

What's proposed? The Reserve Bank of India, or RBI, is planning to re-introduce inflation-linked bonds to offer investors a hedge against price rise. With inflation showing no sign of abating, the bank is keen on providing new instruments to investors to fight it. India's Wholesale Price Index, or WPI, accelerated to 9.78 per cent in August. It has stayed persistently high for more than a year despite RBI's repeated rate hikes. Details such as the tenor of these bonds as well as the choice of the inflation benchmark have yet to be announced.

How it works: The bond is tied to inflation, which could be headline inflation in our case. In other countries, it is linked to the consumer price index, as in the United States and Japan, or the retail price index, as in the UK. The link could be either between inflation and coupon rate, or the interest rate promised, or between inflation and the principal amount. In any case, the return on the instrument increases if inflation increases.

What it will achieve: Investors are already interested. Prashant Sharma, Chief Investment Officer at Max New York Life, believes there will be a significant appetite for such products. "Not only will they offer a natural hedge against inflation, but such instruments can also help us design products which have purchasing power protection built into them," he says. Firms such as his will be interested in inflation-linked bonds of 10-15 year tenure. D.V.S.S.V. Prasad, MD, PNB Gilts, a primary dealer in government securities, anticipates high interest in these bonds. Had inflation been in the four to seven per cent range, interest would have been muted, he says.

"If the coupon is high, many investors, including pension funds and hedge funds, will be interested. It can also be a platform to attract the retail investor," says Prasad. Joydeep Sen, Senior Vice President, Advisory Desk, Fixed Income, BNP Paribas Wealth Management, believes that even high net worth individuals will be interested. "Inflation is top of the mind for everyone. The only concern may be liquidity of the instrument," says Sen.

Uncertainties: Vikas Gupta, Executive Director, Global Emerging Markets, JP Morgan, is not sure how the market will price these bonds given the uncertainties around the key variable - the inflation index, which impacts the economics of the instrument. In India so far, the WPI is the measure of inflation, though there are measures of consumer inflation as well. Besides, the tenor of these bonds must cover a complete inflation cycle to allow for a medium-term call by investors. BNP's Sen believes a reasonable reset period for the coupon and the extent of inflation considered for indexation will be other key ingredients for its success.

Past experience: The only other time capital-indexed bonds were issued in India was in December 1997. They generated lukewarm interest in the primary and secondary market due to pricing complexities and the coupon being exposed to inflation.