Vivek Kaul
Before taking over as the governor of the Reserve Bank of India(RBI), Raghuram Rajan was the Chief Economic Advisor to the Ministry of Finance. As the Chief Economic Advisor, Rajan authored the Economic Survey, which was released before the budget presented in February 2013.
In this survey there was a detailed discussion on the fascination Indians have for gold. The survey came to the conclusion that Indians were buying gold to protect themselves against the high consumer price inflation prevailing for the last few years. It also said that there were no financial instruments in which Indians could invest ]in order to protect their purchasing power. Hence, they ended up buying gold.
“The overarching motive underlying the gold rush is high inflation and the lack of financial instruments available to the average citizen, especially in the rural areas,” wrote Rajan. “The rising demand for gold is only a “symptom” of more fundamental problems in the economy. Curbing inflation, expanding financial inclusion, offering new products such as inflation indexed bonds, and improving saver access to financial products are all of paramount importance,” he added.
The survey was released in February 2013. At that point of time India was dealing with high gold imports which were putting pressure on the rupee. India produces almost no gold of its own. Hence, all the gold that is consumed in this country needs to be imported. Every time, gold is imported, the importer needs to sell rupees in order to buy dollars, which he uses to pay for gold. As more gold is bought more rupees are sold to buy dollars to pay for gold. This puts pressure on the value of the rupee against the dollar.
In fact, on April 30, 2013, one dollar was worth Rs 53.81. By August 28, 2013, one dollar was worth Rs 68.83. The rupee rapidly lost value against the dollar.
Raghuram Rajan took over as the governor of the RBI on September 4, 2013, and very soon inflation indexed bonds for retail investors were launched. This was in line with what Rajan had written in the Economic Survey released in February 2013.
These bonds offer an interest rate of 1.5% over and above the rate of inflation measured through the consumer price index. So, if the inflation measured through the consumer price index is 10%, like it currently is, then the rate of interest offered on these bonds would be 11.5%.
This is higher than what any bank fixed deposit is offering at this point of time. But the trouble with these bonds is that the rate of interest will keep varying with the rate of inflation. And if the rate of inflation falls then the rate of interest on offer will fall as well.
In case of fixed deposits that is not the case. If an individual puts money in a five year fixed deposit
offering an interest of 9% right now, he will continue to get an interest of 9%, even if the inflation falls from the current 10% to let us say around 6%. In that case, the interest on the inflation indexed bonds will fall to 7.5% (6% inflation + 1.5%).
This uncertainty has been one of the reasons why these bonds haven’t really taken off among investors. As a report in the Daily News and Analysis(DNA) points out “A check at few private and public sector banks revealed that they haven’t seen a significant interest from consumers for this product.” In fact, in a bid to ensure that more people invest in these bonds, the RBI recently extended the deadline to invest in these bonds to March 31, 2014, from an earlier date of December 31, 2013.
These bonds are being sold through banks. For a bank, inflation indexed bonds are a direct competition with fixed deposits and, hence, any bank is unlikely to encourage people to invest in inflation indexed bonds on its own.
Unless, the bank is offered a high commission to do so. Insurance companies offer banks high commissions to sell investment plans masquerading as insurance. And that is what most banks are interested in selling these days. As the report in the DNA referred to earlier points out “Bankers also agreed that they are not marketing the products aggressively. This is not surprising considering that they have not been incentivised enough. RBI pays a nominal amount to banks for the sale of IIBs, this is way lower than the 1-5% that is paid by insurance companies as commission, explain bankers. Not surprisingly then, Ulips[unit linked insurance plans] and other life insurance products are offered as the top investment options by relationship managers in all banks.”
Given this lack of commission on inflation indexed bonds, it is unlikely that banks will ever get around to selling them to their customers. The new pension scheme(NPS) is an example of another excellent product which is there in the market, but practically no bank pushes it because they barely make any commission on it.
Hence, if the inflation indexed bonds are to take off, then the commissions that are offered by insurance companies on investment plans masquerading as insurance, need to be brought down further. The question is whether the government will get around to doing this?
While commissions offered by insurance companies have fallen over the years, but they still remain higher than the commissions offered on almost all other financial products. This ensures that banks and other financial firms are interested in only selling insurance.
The government is unlikely to cut commissions any further given that it needs the Life Insurance Corporation(LIC) of India to help finance its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. . A large portion of the money raised by LIC is used to buy government bonds. This helps the government finance its fiscal deficit easily.
The government also uses LIC to bailout its disinvestment programme. The government sells shares in public sector enterprises to help finance the fiscal deficit. On several occasions, stock market investors do not want to invest in these shares. On such occasions, LIC is directed to pick up these shares.
Hence, the government needs LIC to finance its fiscal deficit. The LIC needs to keep selling more and more insurance policies. And for that to happen, it needs to keep offering a high rate of commission to its agents all over the country.
This is the major reason why Raghuram Rajan’s grand plan of getting Indians to invest in inflation indexed bonds instead of gold, will not take off. It will take off only when insurance commissions are brought in line with commissions on offer on other financial products, so that banks and investment advisers are interested in selling a product that is best for their customer rather than the product which offers the highest commission. And that will happen only when the fiscal deficit is under some sort of control.
The article was published on www.firstpost.com on January 6, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)