The imminent launch of a new series of inflation indexed bonds (IIBs) that will give investors a measure of protection from the consequences of rampant inflation fulfils a key announcement made in the Union budget. The government’s hope is that the bonds will wean away domestic households from their craze for gold and induce them to invest their savings in financial instruments. That, in turn, would reduce the quantum of gold imports, which, despite some duty hikes and administrative measures, shows no signs of abating. Last year (2012-13), India imported 1017 tonnes of gold at a value of $54 billion, only marginally lower than in the previous year. The consequences of the steep gold import bill on the trade balance and hence on the current account deficit is well known and does not bear repetition. The Finance Ministry and Reserve Bank of India are only too aware of the problem but appear to have run out of meaningful options to curb the apparently insatiable demand for gold.
A major reason for this lies in the fact that a substantial portion of gold imports — estimates speak of almost two thirds — is used by the jewelry industry, with only a portion of the balance meeting investment demand. Even within the narrower category of gold investors, motivations for holding the metal vary. Some want to beat inflation, others to get a real return, or earn handsome capital gains. Gold scores for other reasons as well. It is liquid, there is no documentation, no capital gains tax or TDS, and, more importantly, gold confers anonymity on the buyer. The realisation that no financial product, however well designed, can wean away a significant portion of gold demand should moderate the expectations from the upcoming issue of inflation indexed bonds. However, the IIBs are certainly worth a try. Care should be taken to simplify the terms of their issue, especially in the ways principal and interest will be aligned periodically with the chosen inflation indices. As with all new financial products, investor education is a must. Inevitably, the IIBs have to make a mark across the financial sector where, apart from banks, mutual funds and many other intermediaries are well entrenched. The IIBs’ selling point as an inflation-beater might not be sufficient if the bonds are deficient in other attributes such as accessibility and convenience. Finally, the IIBs might well demonstrate their ability to beat inflation. But it is going to be a different ball game to douse inflation expectations, conditioned as they are to a high price regime in recent times.