- Nominal vs Real interest rate
- Inflation index bonds: Salient Features
- IIB: How do they protect against inflation?
- IIB: principal also protected
Economic Survey Chapter 4: Prices and Monetary Management. FIVE subparts
- Inflation indexed bonds
- measures of money supply: M0, M1, M2, M3, M4, Broad-narrow money
- Monetary policy trends, RBI restructuring
- Indexes’ Theory: WPI, CPI, IIP, Services index and others
- Indexes’ Current: Survey observations on WPI, CPI & IIP, How to combat inflation
- Real = nominal minus inflation.
- Suppose SBI offering 4% on savings account (SA) and 9% on fixed deposit (FD). These are called “NOMINAL” interest rates.
- But will they protect my savings against inflation?
- I can find out via “real interest rate”
|Nominal||CPI (Inflation)||Real interest rate
=Nominal MINUS inflation
- Observe that real interest rate is “NEGATIVE number”. Meaning, inflation will ERODE my purchasing POWER, IF I invest in savings or fixed deposit.
- Therefore, during high inflation, juntaa prefers to invest money in physical assets like gold, real estate than in financial assets like bank deposits or mutual funds.
- Consequences: higher gold import => CAD increased => Rupee weakens => crude oil import expensive=> petrol diesel expensive => milk, veggies everything expensive due to higher transport cost.=> more inflation
- Thus, a vicious cycle created: more inflation => more gold import.
To break this cycle, what should we do?
- Ans. Provide an investment option where Juntaa gets POSITIVE real interest.
- And thus, we come to our topic of discussion: inflation indexed bonds.
- Decode the words: Bonds=> you are giving money to someone, he gives you a piece of paper, he’ll repay interest and principal.
- But there is a caveat: this “RETURN” will be linked to inflation so if more inflation then he’ll pay you MORE.
- 1997: Capital index Bond (CIB) had similar features.
- Budget 2013: announced inflation indexed bonds (IIB)
- RBI launches two type of IIB
|Fullname||Inflation indexed bonds||Inflation Indexed National Savings Securities-Cumulative|
|Born||Jun 2013. then more launched in Aug, Sep, Nov…||Dec. 2013. Stopped after March 2014.|
|Whocan invest?||Anyone can file application BUT the allottment is made in such manner that
||ONLY retail investors can apply. Meaning
||RBI “outsourced” the selling work to
||Same. But senior citizens given some relief. They can pullout money after a few years.|
|Trading||CANNOT be traded in secondary market (BSE, NSE etc.) so once you buy, you’ve to keep it to yourself. until the maturity period (10 years).|
So far we learned the salient features of two types of inflation indexed bonds. BUT, HOW do they protect your investment against inflation?
Return (interest rate) on these bonds
- 1st Jan 2014: You’ve invested Rs.10,000 on IINSS-C.
- On June 2014, Rajan will count the interest rate to be paid to you. Using CPI data of four month earlier i.e. Feb.2014
- In Feb 2014, CPI was 8.03
- Therefore you’ll earn 1.5+8.03=9.53% interest
So, is your “investment” protected against inflation? Well we can simply cross check by finding “REAL INTEREST RATE”.
|nominal||MINUS Inflation||=REAL interest rate|
- This time, real interest rate is a POSITIVE number. So, yes, Inflation indexed bonds protect your savings against inflation.
- In the above example, you’ve invested Rs.10000 in IINSS-C.
- You redeem after ten years, IF CPI inflation is 60% that time, you’ll get 16,000 rupees. (This is only for illustration, real calculation has more caveats.)
- 1997: RBI had launched CIB (Capital indexed bonds). They only protected the interest from inflation but did not protect principal from inflation.
- But both of these new bonds protect your (principal + interest) from inflation.