Inflation-Indexed Bonds (IIBs) and Positive real Interest rate UPSC pre 2022

The question on Inflation Indexed bonds was Medium level question because it can be done using the elimination method.

With reference to the Indian economy, what are the advantages of

“Inflation-Indexed Bonds (IIBs)”? [2022]

1. Government can reduce the coupon rates on its borrowing by way of IIBs.

2. IIBs provide protection to the investors from uncertainty regarding inflation.

3. The interest received as well as capital gains on IIBs are not taxable.

Which of the statements given above are correct?

(a) 1 and 2 only

(b) 2 and 3 only

(d) 1, 2 and 3

TIP

No tax exemptions given on “Inflation-Indexed Bonds (IIBs)”

Solution - A

What is Inflation-Indexed Bond [IIB] ?

A bond is a type of security.

Inflation Indexed bonds interest rates are linked to the Inflation rate.

For e.g. -

Inflation Indexed National Savings Securities-Cumulative (IINSS-C) with Interest

Rate = CPI + 1.5%

Why do we need IIB?

RBI Launched IIB in 1997, 2013, and 2018 to provide positive Real interest rates to households.

What is a Positive real Interest rate?

Real Interest Rate = Nominal Interest rate - Inflation.

For E.g. If your bank is giving 5% interest on your deposit and the inflation rate is 7% then the real interest rate is -2% i.e in Negative.

When the Interest rate is negative then purchasing power is reduced despite the increase in money quantity in the bank account.

In this case, people prefer to park money in gold/real estate- which is not very beneficial to the economy.

So, to decrease Gold consumption RBI launched these bonds.

It helps in reducing the Current account deficit and weakening the rupee against the dollar.

Else expensive crude oil will further increase inflation and as we know keeping inflation under control is one of the responsibilities of RBI.

Statement 1

Since these bonds provide no risk of capital loss,

it can offer a lesser rate of interest [coupon rates] as we know interest on bonds is directly proportional to risk.

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