How to avoid RGESS fate for inflation-indexed bonds

R Jagannathan
Firstpost.com

Former Finance Minister Pranab Mukherjee, now safely out of the finance ministry, blamed financial illiteracy for the Indian infatuation with gold.

He had said: "Quantum of import of gold … is a clear indication (that) a large section of the community…want investment in dead asset only with expectation that value would appreciate. My request to financial analysts and other experts and leaders in this field is to ensure than we can create confidence in (the) market, spread financial literacy, and merit of investment could be widely spread."

To entice Indians to invest in something other than gold he launched the Rajiv Gandhi Equity Savings Scheme (RGESS) – but like Rajiv Gandhi, the scheme promised much and failed to deliver. As predicted by Firstpost as early as mid-2012, the scheme has now become a resounding flop.

According to a report in Business Standard today, the scheme managed to snare all of 20,000 investor in a nation of 1.2 billion, And the total investments were around Rs 34 crore – which yields an average investment of Rs 17,000 per demat account.

His successor, P Chidambaram, also railed against gold and raised import duties on the metal to 6 percent. But he is exhibiting a greater sense of financial literacy than his predecessor.

In an interview to Reuters, Chidambaram said raising duties would merely help gold smugglers. Instead, the idea should be to give investors alternatives. “Creating inflation-hedged financial instruments is a way out to reduce dependence on imports of gold. RBI and the government are working on inflation-proof, inflation-indexed instruments,” he said.

But if the RGESS scheme is any guide, even inflation-indexed bonds have to be designed right.

The RGESS failed because it created too much complexity for a product that is supposed to entice first-time investors into equity (read why here). Moreover, when retail investors in general are not investing in equity, to get them to invest in RGESS purely for tax-benefit reasons, and with a lock-in, was impossible.

This is why Chidambaram had to backtrack in this budget and promise an easier scheme. He said in his speech: “The Rajiv Gandhi Equity Savings Scheme will be liberalised to enable the first time investor to invest in mutual funds as well as listed shares and she can do so, not in one year alone, but in three successive years.  The income limit will be raised from Rs 10,00,000 to Rs12,00,000.”.

However, we don’t know if RGESS will work better this year than it did the last time.

As for the inflation-indexed bonds issue, once again the issue is structuring. In two earlier avatars, in 1997 and 2004, the bonds did not fly because of poor structuring, and the lack of a secondary market.

To succeed this time, Chidambaram needs to ensure three things.

First, both the principal and the interest rates must be indexed to inflation. The choice of inflation index should be the consumer price index.

Second, the bonds must be liquid, or tradeable. Tax-free bonds work because there seems to be a fairly liquid secondary market in many of them.

Third, for small investors, there must be a buyback plan so that the money is not locked. If inflation-indexed bonds can be bought back by banks at a small discount to market prices, retail investors will lap it up.

The bottomline is Indian investors are cannier than what finance ministers think they are. Evidence: as soon as they got a whiff of a potential increase in gold tariffs, they tanked up on the metal in advance. Thus, in the quarter ended December 2012, the World Gold Council reported that Indians bought gold worth $14.5 billion, 44 percent more than in the previous year.

Indian investors know which side of their bread is buttered. Finance ministers should not take them for fools.

The writer is editor-in-chief, digital and publishing, Network18 Group