The inflation is pulling us back
The biggest problem RBI is facing today is to keep a close watch on inflation and keep it under reasonable limit. People with slightest knowledge of money matters are well aware that investment, savings and returns on different kind of our investments depend entirely on inflation rate and people with slightest knowledge of economics invest their hard-earned money where they get best return on their investments. Recently the increasing loss in current account has increased the concerns of reserve bank of India because such a loss puts more pressure on value of rupee and increase rate of inflation and invariably affects the credibility of economical valuation on international level.
The import of gold plays a major role on inflation in current account where the role of our government seems to be ineffective as all efforts in respect of import of gold are misfiring badly. The increasing inflation is making a bad impact on our savings and returns on savings to nullify the benefits of savings in different accounts to make things even worse. There is a simple formula to calculate investor’s interest. If the inflation rate is higher than interest paid on savings or the yield rate is lower than inflation rate that is obvious indication that the investor is in loss. The inflation rate is increasing at such a rapid rate, which is making all savings worthless of what we are getting in return in form of interest and that is what driving consumer to a comparatively safer investment-the gold. The average inflation rate according to government sources has been limited to 7% in last couple of years while the rates of gold have gone up at the rate of 25% within the same period making it an obvious choice for investment purpose.
To reduce demand of gold
The government has taken some steps to curve the import of gold and divert savings toward government bonds the reserve bank has introduced Inflation Index Bond (IIB) the latest formula to curve the increasing demand and import of gold. The economist had been planning it seeing the increasing demand of gold for last couple of years. They plan to introduce IIB on June 4, available in the market for investors as a better alternative for investment.
Price index plays a major role
Price index is a major factor with investors, now the question arises that what index is going to be applicable with IIB. As per policies of Indian government the wholesale price index is associated with monitory policies where as in countries like the US, UK, Canada etc they take consumer price index, this could make a big difference as both these indexes have a difference of almost 5% in India and that may make a major difference on the success of IIB.
Although the government has given IIB, a green signal but they still have their reservations about the issue. They are afraid of a major setback on other government bonds/securities, once they introduce IIB. G-sec being the government’s backbone for credit purpose from the banks and ones the IIB introduced all major investors would go for them, which may create problems for government as the value of government securities is bound to go down. Although, if the problems will increase for government at one hand the investors would have a wider choice, including global investors as these carry almost no risk having guarantee of government of India.
IIB at a glance
A- Reserve bank of India plans to issue IIB worth Rs. 12,000 Crore to Rs15,000 Crore in 2013-14
B- Initially, the first installment of IIB will be limited to Rs 1000 Crore to Rs 2000 Crore released on 4th June 2013
C- IIB will carry a combined interest on principal amount based on inflation
D- The bonds will be auctioned on last Tuesday of every month
E- The maturity of IIB will be for 10 years duration and their base of inflation will be governed on the basis of wholesale price index.
Basics of IIB
We all are aware that the power of money lies in its purchasing value and the value of money is going down too rapidly for the comfort of public lately. Especially the returns on long-term investment are proving to decrease the value of your money on maturity. In simple words, if inflation rate is higher than your interest rate you ultimately are a looser. Here the IIB come into play because it guarantees you a better return than the inflation rate and that is the basic of IIB, if the inflation rate is 10% for a particular year you will get 10% or if you have a bond worth Rs 1000, it will have its value converted to Rs 1100.
The guarantee provided by government to give you actual inflation based returns although the wholesale price index makes it bit susceptible, as I mentioned earlier - consumer price index would have made it a better deal. However, the IIB is better compared to other securities as it covers your investment from current inflation rate. The only possible risk factor as our government may find is a possible effect of other securities issued by different governmental agencies.
Eligibility criteria
Reserve bank of India intends to issue IIB to all organized/institutional/financial sectors like insurance companies, pension funds, etc and 20% for small investors in place of conventional 5% reserved for small investors. Later, they have plans to launch second phase in October this year especially for small investors depending upon the demand of the bond after the launch on 4th June this year. This date probably would have more answers of the matter since institutional and small investor would be waiting to see the result. Probably the coupon return has its answer hidden in its figures. Normally fixed investment yield 8-11% returns. Therefore, the answer is hidden in inflation rate and coupon return (read fixed interest) for the success of this issue.
Demand of Gold
Reserve bank of India and our financial experts think that this issue should reduce the demand of gold by attracting investors toward IIB because gold seems be the safest investment to date for Indians. The increased duty on gold has not brought any visible change in the investment trend of gold in Indians, on the contrary the demand has gone up despite the big fluctuation in metal market but if the rate of gold goes further down in the global market, there will be no direct link with increased demand of gold and IIB. According to world gold council India registered a decrease in demand of gold to the tune of 5-6% but the demand rose again from 215 tones to 255 tones recently and most of it was for investment purpose (50%) and the demand for jewelry also increased by 15%.
How the experts think
As per the big financial experts sitting in RBI and finance ministry the inflection index bond (IIB) must solve all possible inflation problems in this country but we have yet to make a formula as how the system would work. In most other developed countries, the use of Fisher’s equations technique, a complicated but very accurate on to calculate interest based on inflation but we have to depend on wholesale price index plus a fixed interest. I must add here that in case of price index going down the capital may go down as well. Then there are big financial institutes who certainly would take maximum benefit of these bonds. Answers are hidden in future when the public especially the small investor will know how to invest in these bonds. If the process would be complicated then the contribution of common person may not be worthwhile. If the need of the bond demands multiple accounts etc, that certainly would turn the small investor away from but it certainly would be a safe heaven for big players. For the time being no one is sure about IIB as no one knows the rules exactly.
You should know
If you invest in market for earning money by taking risks you should know about bonds market as well. You purchase partnership in a company while you invest in shares but you lend money while you invest in form of bonds and the one who sells you bonds pays you interest known as coupon also, for you money. Whenever a company or government needs money, they issue bonds on fixed terms. For example if you have purchased bonds worth Rs 1000/ for an interest rate of 8% per annum you shall get 80/ as long as the terms of bonds allows you to stay there. It is kind of fixed income security where you get your interest and principal amount back intact after completion of period of the bonds. You may ask a simple question at this point – is your money blocked for a long period if invested in bonds? The answer is yes and no. You have the facility of trading your bonds in the market on profit and loss basis. These brands can be sold in open market depending upon company’s position, on premium or at discounted price. Ratings of bonds depend on interest rates, if the rates on interests in the market increase there are few takers otherwise your bonds may sell like hot cakes. Therefore, you must stay prepared for the risk factor in the market even on bonds, especially if you are selling them mid-term. You must have a demat account for trading in bonds or you can invest through mutual funds in bonds. Few simple terms-
A- Coupon- The interest rate you get on bonds is better known as coupon. The coupon rate is mostly fixed but in some cases, it can be associated with any particular index to make it flexible.
B- The yield- The amount you receive at the time of maturity is known as ‘yield to maturity’ your yield may vary depending whether you bought it from source or open market.
C- Maturity period – The time it takes to mature is known as maturity period. It could be any time starting from few months to fifty years depending on source you bought it.
D- Issue size – same as the trend of share market, if a company comes out with a million shares of thousand Rupees each the value of the issue is as good as one hundred crore.
Coupon rate of IIB
The RBI has not yet declared coupon rate of coming issue of IIB but according to information through different domains and experts it is likely to start with 2%. However, whatever the coupon rate, it would be inclusive of amount due to inflation in the principal amount. The basic of the interest would be based on capital indexation bond wherein the amount of inflation is compounded and then the coupon is calculated.
The way the things are moving in Indian capital market, there are remote chances that the inflation would go down in near future but you must not take it for granted. It has happened in June 2009 when the inflation rate had gone down in minus -1.61 to be exact, in such case the rate of your bond may go down and coupon rate too would be down accordingly. As the reserve bank of India has decided to link the valuation of profit or loss to markets, it is wiser to invest in IIB.
Conclusion
All said and done, to fight with inflation and to bring down demand of gold we shall have to take some bold steps and IIB seems to be a right step in this direction provided we do not make the procedure too complicated. We should not let technical aspects take over the benefit intended to reach to the common public of this country or the big fish eating small fish. The authorities must keep a close watch on the issue to see that benefit going to common man to fight with the inflation and financial institutes etc take the back seat. India is in need of such schemes, which can bring down inflation by focusing on economical reforms and make new products like Inflation Index Bonds popular among common persons.