Why choose WPI for inflation indexed bonds?

Finally, after many years of deliberation Govt/RBI have decided to launch inflation indexed bonds (IIBs). It was announced in the budget 2013-14 but has been under consultation for a very long time. The launch is based on this technical paper. I will try and release a simplified version if possible.

The choice of index for inflation remains WPI despite having a new CPI. What is the purpose of new CPI then? Yes it does not have a time-series as old as WPI but we are not really talking about using CPI from a historic perspective. If the bond is issued today we are going to use CPI series from hereon.

The technical paper says:

IIBs by definition mean providing protection to investors against inflation. But it is difficult to ascertain the price index that would provide complete protection against inflation. The consumer price index (CPI) is supposed to represent level of inflation that the public at large face and thus, the CPI is widely used index for adjusting the cash flows for the indexed bonds in many countries. However, unavailability of a single CPI representing the consumption basket of all sections of society in India renders it impractical to be used in indexation of IIBs. Therefore, under given circumstances, wholesale price index (WPI) for all commodities may be used for linking IIBs. In the past also, WPI was used for indexing the capital indexed bonds (CIB) wherein principal was indexed at the time of redemption.

We now have a single CPI. There is CPI-Rural, CPI-Urban and CPI-Composite. The third one stands for India. Moreover, WPI does not represent the consumption basket as well. Yes, earlier there was no choice and WPI was the only index. Now, we have the new series of CPI which should be tried as it represents the consumption basket better than WPI which does not have any services in the index.

This ignorance to CPI is not understood. Rajiv Malik of CLSA wrote a scathing criticism over this ignorance of CPI.

One macro issue in India that deserves renewed attention is the preference for the wholesale price index (WPI) over the consumer price index (CPI) for tracking inflation. Indeed, the WPI is given much greater importance than the CPI by the Reserve Bank of India (RBI) for calibrating its monetary policy. This is a serious policy faux pas.

 India’s use of WPI inflation for monetary policy is in contrast to the reliance on CPI inflation by central banks and governments in other countries. This idiosyncrasy causes a bizarre contradiction: policy makers, businesses and their lobby groups, and the business media are celebrating the significant decline in inflation, relying on WPI inflation. This contrasts with retail inflation, which better represents the inflationary pressures experienced by households, being off the charts.

t’ll come as a rude shock to many that India’s retail inflation is the sixth highest in a ranking of 100 countries. This is both embarrassing and worrying. Indeed, India is the only country where policy makers and most investors have been celebrating the “collapse” in inflation, even though consumer inflation remains worryingly high.

I was curious to figure what would happen if Govt. was to choose CPI? Before the new CPI series, we had old one. So I just averaged WPI and CPI (old-series) inflation levels :

 (in %) CPI-IW CPI-UNME CPI-AL WPI
1980s 8.3 8.2 6.8 6.5
1990s 9.5 9.3 9.3 8.1
2000-08 4.6 4.9 3.7 5.2
2008-13 10.1 11.0 10.5 7.6
All Period 8.2 7.9 7.6 6.9

There you go. CPI inflation across all series has averaged much higher in most periods except 2000-08. So any bond indexing on CPI basis will cost the govt. much more. CPI-new series average in 2012-13 is 10.2 much higher than WPI average of 7.35. Whichever way you look at it, indexing via CPI would have clearly cost more.

It is even better this time as timing for IIBs is near perfect. With WPI inflation headed south thanks to huge base for several years, government would save many a dozens compared to if it was done via CPI.

A clever choice I must say!

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