The Hindu Business Line : For inflation-adjusted FDs

INVESTORS are likely to take higher exposure in fixed-income investments what with stock prices declining sharply in recent times. But fixed-income investments run a high inflation risk because of cost-push factors. That inflation can hurt returns is clearly visible from the fact that real interest rate is currently negative. This may not, however, act as a disincentive for investors. Given the savings-consumption pattern in India, there is a strong likelihood that people will cut their current consumption to maintain the savings rate. This may have a direct impact on economic growth. To prevent such a cascading effect, banks could introduce inflation-adjusted fixeddeposits _ the most popular fixed-income product.

Negative real rates: Inflation has risen to a near-term high of 5.89 per cent. With the average one-year bank fixed-deposit rate at 5 per cent, investors earn a negative real rate of 0.89 per cent. For this purpose, inflation expectation is taken to be the same as current inflation. At present, investors do not have an investment avenue to hedge their inflation risk. Typically, the increase in price is higher for goods that are part of the monthly household budget. The problem is that salaries are not inflation-adjusted. People have to, hence, make a trade-off between consumption and investment.

Typically, people choose to cut their non-essential current consumption to protect their savings rate. RBI statistics show that the savings rate has been stable over the last ten years despite varying price levels. Besides, household savings rose at a compounded annual growth rate of 13 per cent since 1990-91 while GDP rose 12 per cent during the period. This suggests there is some bias towards savings.

Given this, negative real rates could prompt people to save more to maintain the savingsconsumption trade-off. And this may have a negative effect on the economic growth. A cut in nonessential consumption would lead to lower demand for such goods, which could affect the employment level in those sectors. This may have an adverse impact on economic growth.

Note that this argument prima facie turns the traditional economics on its head. Economic textbooks forcefully argue that higher inflation rate will lead to more current consumption because people will be apprehensive of the future price levels. But that is mostly true for economies facing runaway inflation and not for countries such as India.

Inflation indexing: The country needs an instrument to strike a balance between savings and consumption. Such an instrument should be, therefore, styled to protect the household purchasing power. The easiest way to design such a product is to inflation-adjust investment.

The RBI should, hence, construct a model that would enable commercial banks to inflation-adjust fixed-deposits. The central bank proposes to re-introduce the capital-indexed bonds, which are essentially inflation-protection securities.

An inflation-adjusted fixed-deposit is only a logically extension of this concept. Of course, the commercial banks will have to bear a higher cost to protect the purchasing power of the people, as inflation-protected fixed-deposits mean higher nominal interest rates. But banks would also gain from the positive secondary effects of such deposits.

Secondary effects: Demand for non-essential goods may, perhaps, increase if purchasing power is protected. The reason is this: People will be aware that money in fixed-deposits will fetch them return to neutralise the increase in price level of goods needed for future consumption. The current surplus would then be used to splurge on non-essential goods, which are comfort and luxury goods. If demand for such goods is strong, there will be a positive effect on other sectors as well. The banking sector will benefit from the increased business, which may offset their burden due on higher interest outgo on inflation-adjusted deposits.

(Feedback can be sent to bvenky@thehindu.co.in)

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