A case for indexed bonds

Suresh Krishnamurthy

WE are fast approaching the date for the announcement of the monetary policy proposals, and as the fund-manager for the Union Government, it may be time for RBI to revisit the issue of the indexed-bonds with interest payments are linked to inflation.

Consider the prevailing situation. Growth in money- supply over the past few years, has been consistently above the growth in gross domestic prices. If the status quo persists, then sooner or later, inflation or interest rates are likely to rise from current levels. In fact, according to ICICI Securities, both inflation and interest rates may be headed upwards. There may not be any major problems on the inflation front since it is expected to move up to only around 6 per cent. However, interest rate increases may impact investors who have had to park their investments in low-interest bearing investments, over the past couple of years. Even banks may find the present situation, of investing now in government securities at lower yields, knowing fully well that interest rates may rise.

Of course, interest rates normally rise and fall in tune with business cycles and investors should not be voicing any complaints. However, it is only unexpected twists that pose problems. Inflation at times comes in handy to meet revenue targets and the temptation might be too overwhelming for governments. In this context, inflation indexed bonds could be really useful. When inflation-indexed bonds are used, inflation as a tool to meet short-term revenue targets lose their potency. Any increase in revenues due to inflation would be compensated by the increase in interest payments. In a country such as India where vested interests operate and short-term political considerations dominate, policy prescriptional tools such as inflation-indexed bonds may be indispensable.

An experiment was indeed made in 1997 with inflation-indexed bonds. However, given that inflation was at its peak then, there may not have been any takers for such bonds then. Now, inflation is threatening to move up and banks may only be too willing to subscribe to such issues.