Madan Sabnavis: Time to think of inflation derivatives

They may provide a useful hedge against abnormal price increases

The world of derivatives is truly amazing. From esoteric terminology for common sense transactions, it has evolved into a tool that has helped elevate markets to a different level.

Today, we are faced with an issue of rising inflation and considering that we were at the pinnacle of glory with high growth numbers, inflation has come as a dampener.

It is not surprising that the inflation numbers released on Fridays have become as exciting as the outcome of cricket matches because they affect all markets.

It is also true that nobody can bring down prices with the wave of a wand. But if these two seemingly unrelated concepts of "derivatives" and "inflation" are juxtaposed, we could just be releasing the genie from the bottle.

Inflation is not something that can be forecast with a great accuracy, and what we hear are really projections based on the heroic assumption of "normal conditions".

After all, it is difficult to conjecture the level of turmoil in the Gulf or the severity of the monsoon. At best we have conjectures based on logical premises.

We already have some inflation cover provided on indexed bonds. This is so because if we are not to suffer from the classical "Keynesian money illusion", we should be looking at "real returns". So any monetary return has to be adjusted for inflation to arrive at a "real return", which is what economic theory is all about.

One way to buffer oneself against inflation and the resulting uncertainties is to have a product or scheme that protects us from abnormal price increases. There are two ways of going about it.

One is to get the government in and play a major role in inflation protection, while the other is in the realm of commodity exchanges where the market mechanism determines the terms of trade. Prima facie, it appears that the latter could be more efficient.

Let us look at the scenario where the government decides to drive such initiatives. The government could be the counter party to such transactions wherein it announces an inflation rate for the year at, say, 5 per cent.

This would be the benchmark rate for the public to start with. People can buy the inflation index at 5 per cent for a premium just like we buy insurance. If inflation goes beyond 5 per cent, you can get a compensation for the increase depending on the amount you would like to insure.

So if you go in for a policy for Rs 1,00,000, you pay, say, 1 per cent premium, which is Rs 1,000. If inflation goes to 8 per cent, you get Rs 3,000. The scheme would work just like our senior citizen scheme, where individuals can invest up to a fixed maximum amount, except that the government would gain in case inflation falls below the benchmarked rate and, hence, it would not necessarily be a subsidy that strains the coffers.

Hence, it is more analogous to the weather insurance being provided where if rainfall for the four-month period falls below a certain level, the insured can claim compensation.

The issue now is whether the government would be encouraged to announce a higher inflation rate to begin with. Quite unlikely, because a responsible government would never like to show that the country is afflicted with inflation.

Besides, if it is not a credible benchmark, there will be little enthusiasm for the scheme. The budgetary impact over a period of time would be neutral and in case inflation is controlled, the government could actually earn a surplus on this score.

Alternatively, if the government is kept out of the picture, commodity exchanges can design various products for different inflation targets. Therefore, for a rate of 5 per cent the premium would be Rs x while for 6 per cent it will be Rs x+y.

There would always be counterparties that are willing to take the opposite position in case the government is not involved and we could see volumes building on the exchanges. This derivative product could come as a future or an option where the latter would give you the right but not the obligation to exercise the option.

So, if inflation is below 5 per cent, then you could simply move away by not exercising the right but paying only an option premium at the beginning.

Such a contract will be very liquid and provide volumes for exchanges, since every Friday will bring with it expectations and announcement effects. This way, the government is out of the picture, but the public at large gets a useful cover nevertheless.

Commodity exchanges have the potential to transform the landscape of commodity trading and introducing an inflation index, be it the wholesale price index or the consumer price index, will widen the canvas.

Single commodities are providing price risk cover, but such a concept would actually span the macro horizon and cover the entire price risk of all commodities.

(The writer is chief economist, NCDEX Limited. The views expressed are personal)