The India Street opinion on how to combat inflation

By Vipin Agnihotri

In my opinion, a penny saved does not necessarily mean penny earned. This is because of the simple reason that inflation eats away the value of every rupee earned. Even worse, it is quite tough to forecast inflation.

No one will argue with the fact that the bull run on the bourses has been unprecedented, yet there exists a vast majority of risk averse investors who are interested in playing safe and opt for assured return schemes. This very class of investors is more exposed to the menace of inflation.

Taking this into account, bulletproofing one’s portfolio against the threat of inflation necessitates the need to come up with a portfolio that includes some inflation hedged investments. This in turn will make sure that you get sufficient returns even after factoring in high rates of inflation.

It is worth mentioning in this regard that inflation indexed bonds give you return at a fixed rate, and yet incorporate the ability to combat inflation. Interestingly, such kinds of bonds were allowed by Reserve Bank of India way back in 2004.

According to experts, Reserve Bank of India’s proposal in 2004 would have benefited investors who desire predictable real cash flows despite inflationary pressures, but such instruments never caught on. There is a buzz in the market regarding the possibility of similar capital indexed bonds being reintroduced.

Initial signs are that even infrastructure companies are looking at the bond route to meet their big financing requirements. On the other hand, for households and individuals such bonds hold the key to bridging the gap between risk and return over the long term.

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Inflation and innovations in the financial markets of India

By Vipin Agnihotri

Inflation reduces the purchasing power of money. For example, if the rate of inflation is say 10 percent per annum, the purchasing power of money declines by 10 percent per annum. In such a situation, an income increase of 10 percent per annum is needed to protect investors real income.

Likewise, if the rate of inflation is 10 percent per annum, the rate of return on investment must be at least 10 percent per year to avoid erosion in real wealth. To earn a positive real rate of return in a situation like this, the nominal rate of return must be greater than the inflation rate, namely 10 percent.

The question now arises: What innovations have occurred in financial markets in response to inflation? The following have been the important inflation-induced innovations in financial markets:

• Flexible interest rates

• Lender’s participation in equity

• Financial futures

Traditionally, lenders have offered fixed-interest loans to investors. Under this arrangement, when unanticipated inflation occurs and interest rates increase in response to it, lenders suffers and investors gain. To cope with this, lenders can opt for flexible interest rate home mortgages with interest rates based on some index of cost of funds. In addition, adjustable interest rates are also found in many kinds of debt contracts.

As compensation for bearing inflation risk, lenders may seek participation in equity. This essentially implies that lenders partake in increases (or decreases) in the value of assets financed by them. The most common type of such participation is the Shared Appreciation Mortgage (SAM) found in real estate financing.

In a typical SAM the interest rate is one-third lower than the prevailing standard mortgage loan. In return for this sacrifice, the lender gets one-third of the appreciation in the real estate when it is sold-in some arrangements, the lender can collect its share of appreciation after a certain period, even though the property may not be sold.

An agreement between two parties to exchange an asset for cash at a pre-determined future date for a price that is specified today is referred to as a futures contract. A financial futures contract represents a futures contract for financial assets like currencies, treasury bills, bonds and commercial papers. Financial futures may be used to speculate on changes in security prices caused largely by changes in interest rates.

Inflation has been a persistent feature of the Indian economy. Hence, it should be properly considered in capital investment appraisal. In practice, however, adjustment for inflation is rarely, if ever, made. The use of current price structure is deemed satisfactory and the reasoning offered runs as follows:

Inflation is expected to raise the revenues and costs of the project in a similar fashion. Hence, net revenues after adjustment for inflation would be equal to net revenues in current terms. The above argument, however, overlooks the following considerations, which cause distortion:

• The depreciation charge is based on historical costs and hence the tax advantage arising from depreciation charge does not keep pace with inflation.

• The cost of capital used for investment appraisal contains a premium for anticipated inflation.

Finally, inflation below 5 percent

By Dr Suvrokamal Dutta

Good news for India, inflation fell below the psychologically worrisome 5 per cent for the first time in 10 months. According to experts, this will provide the Indian government higher fiscal and monetary maneuverability to sustain India’s high growth rate.

It is worth mentioning in this regard that inflation based on wholesale prices fell to 4.85 for the week ended May 26, and the latest price data came barely a week after India galloped into the league of high- growth economies with the gross domestic product (GDP) swelling 9.4 per cent in 2006-07. Inflation was 5.06 in the previous week.

“The fall in inflation, driven by cheaper food prices, might take the pressure off the Reserve Bank of India to execute further monetary tightening to control the runaway price line,” pointed out Pooran Singh, noted economist based at India.

The pivotal factor here is that in its slack season credit policy in April, the Reserve Bank of India had pegged the average annual inflation rate for 2007-08 at 5 per cent and said it would be in the range of 4.0-4.5 per cent over the medium term. There is no doubt that with a series of interest rates hikes in quick succession the Reserve Bank of India has aggressively tightened the monetary screws.

It has come into the notice of The India Street that while the government has cut duties on number of products, including cement and edible oils, the Reserve Bank of India has hiked the cash reserve ratio (CRR) and the repo rate to contain inflation.

“The decline in food prices was significant, with prices of fruits dropping 2.8 per cent. Vegetables also became cheaper by 1.1 per cent, and prices of pulses fell by 0.8 per cent. The arrival of the first few consignments of imported pulses might have eased prices,” pointed out a government official in the finance ministry.

Furthermore, Indian government had decided to import 1.5 million tonnes through public sector trading agencies and 115,000 tonnes have arrived on Indian shores.

While inflation rate is expected to hover around 4.85% level for the next few weeks because of the high base in the corresponding period last year, economists believe that the monsoon and international oil prices held the key to a further decrease.

"A bad monsoon could put pressure on food stocks and prices. It is very important that the rains are good and the crop is healthy," pointed out PV Kamath, business journalist based at India.