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Will inflation-indexed bonds check rising gold demand?

To curb the appetite for gold, Finance Minister P Chidambaram in Budget 2013 has proposed the introduction of inflation-indexed bonds or national security certificates.

twitter-logo Anand Adhikari        Last Updated: February 28, 2013  | 18:35 IST

Finance Minister P. Chidambaram said on Thursday that the current account deficit, the broadest measure of trade, is a bigger worry than the fiscal deficit. But the budget for 2013/14 does not have enough measures to check the current account gap that stands close to $75 billion for this financial year.

One of the main reasons for India's ballooning current account deficit is growing imports of gold. The country is the world's largest buyer of the yellow metal, and the appetite for gold has remained high even after the government increased import duty. It is this demand that the finance minister aims to curb with his proposal to introduce inflation-indexed bonds or national security certificates in the budget.

How will these products help? Savers prefer to buy gold as the yellow metal acts as a hedge against inflation, which eats away a major part of household income. There is no financial instrument today that protects savers from inflation. Even bank saving deposits give a negative return since inflation is higher than interest rates. For the past two years, inflation based on the wholesale price index has been hovering above 7.5 per cent while bank saving schemes fetch four to six per cent.

This isn't the first time that the country is experimenting with indexed bonds. A variant of indexed bonds, capital index bonds, was first issued way back in 1997. The product didn't succeed because only principal repayment at the time of redemption was indexed to inflation.

In a recent interview with Business Today, Reserve Bank of India Governor Duvvuri Subbarao had said that there was a strong case for inflation-indexed bonds. "That (inflation-indexed bonds) is good for investors, savers, the RBI and everybody watching the inflation numbers... because you have a better assessment of inflation expectations."

Chidambaram didn't give any details on the structure and tenor of the proposed instruments. These details, he said, will be announced later in consultation with the RBI.

A recent RBI report gives an indication to the structure of the proposed instruments. The product, says the report, should protect both interest payments and principal repayments against inflation. The principal would be indexed and the coupon would be calculated on the indexed principal. Inflation based on the wholesale price index will be used for indexation.

The introduction of inflation-indexed paper is a long-term measure to control rising demand for gold. In a scenario where inflation is high, say above 10 per cent, the government would have to pay more from its pocket. But inflation has been cooling for the past few months. The timing is just right.

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