January 5, 2015
The Prime Minister echoed past finance ministers and other economists by asking banks to coax people to invest less in gold and more in financial instruments.
At the 60th anniversary celebrations of ICICI Bank on the 2nd of January, Narendra Modi said, as quoted by The Indian Express, “People buy gold and they have the psychological feeling that gold is safe, secure and good for the future.” He presented this as a challenge to banks, “The challenge for the banking sector is to convince the people that a bank is as safe and reliable as they perceive gold.”
Wish it were that simple. It is not the safety of money in banks that worries people, for bank fixed deposits (FDs) are simply the largest form of financial savings in India. Rather, people buy gold for other reasons – one, as a long-term hedge against inflation, and two for use as jewellery.
If the prime minister’s intention is to lure people away from buying gold, he has to address at least one side of the demand equation – its use as an inflation hedge. The demand for jewellery cannot be curbed in the foreseeable future for cultural reasons.
Gold buyers do not fret about temporary decreases in the value of gold, for they do not buy the metal only as investment. For them gold has use value, store value and exchange value. It is currency that they can also use for jewellery.
The problem is neither the government, nor the Reserve Bank of India (RBI) has yet offered any product that is easy to understand by the ordinary saver and also offer inflation protection. Hence gold really has no competitor beyond real estate, but gold is more fungible than property.
Sometime in 2013, the previous RBI governor, D Subbarao, offered a Wholesale Prices Index-linked inflation-indexed bond. A while later, his successor Raghuram Rajan also offered Consumer Price Index-based bonds.
We haven’t seen a stampede of investors rushing to buy either bond. Rather, a few of the bonds were taken up by some financial institutions and mutual funds, and even they may be regretting their choice. As for the audience that believes in gold, it has barely noticed the instrument.
According to The Economic Times today (3 January), the WPI-linked inflation-indexed bonds have been huge value-destroyers, with their prices being quoted at a 20 percent discount to face value. A part of the reason is the sharp fall in WPI this year, with the November index coming in at zero, but a Rs 100 bond trading at Rs 80 is no advertisement for inflation-indexing. Far from weaning people away from gold, it will drive them faster towards gold.
As for the CPI-linked bond, it’s not hot property for the ordinary saver for the simple reason that it is too complex – and hedged with too many a conditionality to be useful to her.
The bonds have a 10-year tenure, with a lock-in of one year for senior citizens (65+) and three years for the rest. If you exit early, you lose 50 percent of the interest earned in the year before.
The coupon rate is 1.5 percent above CPI inflation – but the interest, both the fixed part and the inflation-linked part, will be cumulated and compounded every six months and paid only when the bonds mature. The ceiling on investment is Rs 5 lakh.
How will this help ordinary citizens earn a regular inflation-indexed income when all of it is going to come back only after 10 years? Exiting early means kissing goodbye to half the indexation benefit.
To make matters worse, with average CPI inflation trending down, this bond does not currently beat even the ordinary FD. The average CPI for the last six months was around 6.5 percent, which means even with the 1.5 percent coupon added, the return is 8 percent. Bank FDs offer anything from 8.5-9 percent.
If Modi wants to wean savers away, he (and his central banker) will have to forget about complicated bonds and offer them a product they can understand easily. And the product they understand easily is the bank FD.
He should ask Arun Jaitley and Raghuram Rajan to work out an inflation-indexed FD sold through banks. Banks may not mind it even though it would compete with their normal deposits since they can earn commissions from maintaining such FDs. After all, they are eager sellers of fixed-maturity schemes that also compete with deposits and get long-term tax breaks. Savers would certainly keep at least a portion of their funds in inflation-indexed FDs as a hedge against inflation.
If they will buy FDs, why not inflation-indexed bonds? The reason is fear of principal erosion. Bonds appreciate and depreciate depending on current interest rates. If rates fall, their value would crash – and no investor wants to lose a part of his core principal. This is why the WPI-linked inflation bond is wholly unappetising right now.
It will remain so. The way to go is inflation-indexed FD.