<b>Subir Roy:</b> Inflation-indexed imperfections

The Union Budget in February 2013 had promised an instrument for protecting the savings of the poor and the middle class from raging inflation. Something needed to be done to wean ordinary people from investing in gold, which was seen as the only reliable store of value at a time when banks were offering negative returns.

In May, the Reserve Bank of India (RBI) introduced inflation-indexed bonds - which was quite inexplicable, given the stated purpose such bonds were supposed to serve. Nothing could be further removed from instruments that were simple and easy for ordinary people to buy, hold and sell when necessary. The bonds were no different from regular government securities, which are the stock-in-trade of professional wholesale money market players. True, a portion of the offerings was reserved for individual investors. All that they needed to do to lay their hands on them was to open an account with a primary dealer and get the bonds at the cut-off price!

Indications were given that there was a method in this. The index-linked bonds, pegged to the wholesale price index, would be used by the RBI as a price discovery mechanism; after the market had yielded its secret, inflation-indexed certificates would be issued. That has now happened. The RBI has announced the introduction of "inflation-indexed national savings securities-cumulative", linked not to the wholesale price index but to the consumer price index - and, would you believe it, these will be available at banks.

Nobody can accuse the RBI and the government of failing to follow textbook procedures. However, between February and now, the massive Saradha Ponzi scheme has unravelled in which thousands of ordinary people in eastern India have lost more than Rs 2,000 crore of their meagre and critical savings. Moreover, though regulators are slowly closing some of the routes used till now by the perpetrators of typical Ponzi schemes, many continue to operate through "nidhis", or mutual benefit societies without any legal limit on the number of members. As surely as night follows day, innumerable poor people will lose thousands of crores more as they remain intimidated by banks and their procedures, and turn to the agents of Ponzi schemes to park their savings.

There is little hope for an economy that fails to tame persistently high inflation. Inflation-linked instruments can, however, be used to give some relief to the public so as to tide it over a high-inflationary episode. But to do so it is important not to lose sight of fundamentals - for whom an instrument is meant and what purpose it is meant to serve.    

The Budget speech identified two distinctly separate groups - the poor and the middle class - that need to be protected from the ravages of inflation. Distinctly separate instruments are needed to serve the two groups. The instrument that has now been announced goes some way towards meeting the needs of the middle class - though it has minuses, mainly concerning the issue of liquidity. It brings up the age of senior citizens who can prematurely encash such certificates to 65, contrary to the general movement towards settling on 60 as the legal cut-off for old age. If you cannot encash in the case of, say, a medical emergency, then what good is such an instrument? Even when you can encash, there is the question of what a reasonable penalty is. There is a case for levying only a token penalty for premature encashment. If an instrument is well designed, there will be an incentive to hold till maturity, with encashment taking place only in case of a genuine emergency.

However, the instrument seemed designed by people who were unfamiliar with what mattered to the poor, and hence it is wholly inadequate in terms of keeping them away from Ponzi schemes. Chandra Shekhar Ghosh, chairman and managing director of the leading microfinance organisation Bandhan, says that "liquidity of savings is of the utmost importance to poor people" who can very easily fall into destitution. If the "lock-in" is too long, they lose interest. This has become clear in trying to sell the new pension scheme to them. "Continuation is a problem" for poor people since they do not like to wait for long for the payback.

The poor are also "mistrustful of fluctuating rates and prefer a fixed rate of return" that they can understand and absorb. In order to overcome all this, it is not enough to devise a good instrument; it is critical to carry out a long continuing financial literacy programme. Of course, attractive returns are important. But that's just the beginning.   

subirkroy@gmail.com