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Bonds vs. Gold. Which will beat inflation?

Mar 4, 2013

In this issue:
» Will Rs 10,000 make youths 'job ready'?
» NREGA resulted in real unemployment
» Buffett sees opportunity in the global doom
» Budget to help India Inc save Rs 250 bn in two years
» and more....

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For quite some time now the Finance Minister (FM) has been worried about the Indians' obsession for gold. In his opinion, the love for gold has led to an increase in imports of the yellow metal. This in turn has contributed towards the higher current account deficit that has plagued the country's finances. As a result he has decided to address one big reason as to why Indians prefer gold as an investment. And this reason is that it provides a hedge against inflation. To address this concern, the FM has introduced the inflation indexed bonds or IIBs. So will this induce investors to shift focus towards bonds instead of gold? We don't think so.

There are several reasons why we don't think this would succeed. The first is the structure of the bonds. The principal as well as the interest payments on the bonds would be indexed to inflation. Let us assume that the bond's principal value is Rs 100, it pays a coupon rate of 10% and the rate of inflation is 10%. The indexed values paid to the investor would be Rs 110 as principal and 11% as coupon rate. But the big problem in India is what the rate of inflation would be used for this? As per the guidelines, the bonds are linked to the WPI (wholesale price index). It is a known fact that the consumer inflation is much higher. Therefore the investor is not really protected against inflation if the IIB is linked to WPI.

In addition to this, the bond markets in India are still at a nascent stage. Though institutional investors do participate in the market, retail investors have pretty much stayed away. They need quite a bit of pushing to enter this space and this may prove to be an expensive deal for the dealers. Moreover due to the underdeveloped market condition, the liquidity in the markets is very low too. Something that makes it too risky for the retail investor.

On the other side is gold. It not only provides a hedge against inflation but also enjoys a safe haven status. In recent times, the prices of the yellow metal have corrected quite a bit. A large part of this correction is attributable to the sense that the global economy is on a recovery mode. Let us face it that the truth is far from this. Governments have applied a temporary balm through quantitative easing programs. But things are still not on the path of recovery. Emerging economies are slowing down. Developed economies are in recession. Sooner or later investors around the world will wake up and realize that the clouds of doom have not yet passed. During such times gold would be back in vogue.

In a nutshell, the FM wants investors to turn to IIBs. But these bonds are linked to WPI and not to the CPI which is inflation that bites into the investors' pockets. Therefore they offer very little by way of relief to the investors. Given this and the fact that gold has more long term benefits, investors are more likely to continue holding gold in the portfolios. It therefore pays to remain invested in the yellow metal through a reasonable allocation in your overall portfolio.

Do you think the inflation indexed bonds will kill Indians' love for gold? Please share your comments or post them on our Facebook page / Google+ page

 Chart of the day
The real estate developers may be having difficulties in the country, but the prices of real estate continue to soar. As per The Reserve Bank of India (RBI), the house price index for nearly all metros was higher the 2nd quarter (Q2) as compared to the 1st quarter (Q1) of 2012. As shown in the chart, barring Chennai, the index was higher for each of the metros and for the country as a whole. One major reason for this increase in prices is speculation. Particularly in the higher price brackets.

The Union Budget 2013 has introduced some benefits for housing. Most of these benefits are limited for the first time owners in the small to middle priced housing categories. By introducing taxes on higher priced housing, the government hopes to reduce the speculation in real estate markets. But will these measures help to curb the increase in pricing? We hope so.

Souce: Financial Express, Reserve Bank of India

One of the main factors driving India's economic growth is the demographic dividend. India has the highest youth population in the world and the number is steadily growing. But is having a huge labour force alone good enough? Not at all! In fact, if the youth are not productively channelised, the economic growth may get stagnated. There can be a worrying situation where high unemployment is accompanied by shortage of skilled labour. This can further have adverse socio-political consequences.

One must remember that the next general elections are just a year away. And the incumbent government certainly does not want to fare poorly with the youth. So in the Union Budget 2013-14, the Finance Minister proposed an ambitious scheme. The Government would give Rs 10,000 to every youth for skill training. If things go as per plan, this would create 150 million job-ready youths by 2022. At the face of it, it may sound like a game-changer for India. But the most critical aspect is implementation. This is where the government has not much to boast about. Also, such big schemes are often the breeding grounds for corruption. So yes, there are positives. There will be more skilled youths in the labour force. This will improve productivity. But it would be too early to cheer the move. We'd like to wait and see if this plan is going to be something more than just another carrot to grab votes.

The UPA government may consider National Rural Employment Guarantee Act (NREGA) its biggest achievement. After all, the scheme has boosted income levels in the hinterlands. However the many ill effects of the scheme have also come to the fore in recent months. Fall in farm employment for women is one of the most inconspicuous effects. The women, it seems, have been moving out of farm labour that offers premium wages to men labourers. The women have preferred to work under NREGS that offers them relatively better pay. As a result the share of women farm labourers dropped from 33% to 27% over the last three years. With shortage of farm labourers the gap between men and women's wages also narrowed. One may ask what is the negative in this. Well as hiring women labourers got more expensive, farm owners chose to use mechanized equipments rather than hiring them. This meant not just less employment opportunities for rural women but also expensive farm output. Thus food inflation and lower rural employment also need to be reckoned amongst the downsides of NREGA.

Last week, we discussed Warren Buffett's take on dividends that he so brilliantly described in his latest letter to shareholders. However, this was not the only piece of wisdom on offer. The letter also gave a glimpse of what makes Buffett so successful at his craft. A lot of credit, we believe, goes to this rare ability of his to spot opportunity in every adversity. 'America has faced the unknown since 1776', he thundered. But America's destiny has always been clear as per him and it is nothing but ever increasing abundance.

Thus, while people focus on myriad of uncertainties that have always existed, Buffett is clear that the long term game is very favorable. He therefore is not averse to making big acquisitions in the current environment. Well, it will take a brave soul to bet against him, isn't it? In fact, what Warren Buffett observed can be applicable to India as well. Here too there seems to be a fair bit of uncertainty clouding people's minds. But the economy does seem to be pretty well positioned from a long term perspective. Thus, investors would be better off taking advantage of the valuations that the uncertainty is creating and in the process, enhance their long term investing track record.

In an aim to spurt investments in India, the FM proposed to introduce an investment allowance of 15% for large scale investments (those exceeding Rs 1 bn) by each company. The proposal has naturally been welcomed by industry leaders. According to the Centre for Monitoring Indian Economy, India Inc. capex plans are expected to stand at a massive Rs 5 trillion over the next two years. It has estimated the savings - due to this scheme - to stand at Rs 250 bn. And since these savings would directly add to the profits of companies, there is logically no reason for India Inc. not to take advantage of the scheme. This does raise one question in our mind. Is this scheme the much needed fillip that the capital goods and construction companies require? While it may be too soon to say, we believe the possibility is high.

In the meanwhile after opening the day on a weak note, Indian equity markets continued their journey in the negative zone. At the time of writing, the Sensex was down by 86 points (0.5%). Barring Japan, the other major Asian stock markets have closed the day in the red as well. Europe too has opened the day on a subdued note.

 Today's investing mantra
"As in roulette, same is true of the stock trader, who will find that the expense of trading weights the dice heavily against him." - Benjamin Graham

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7 Responses to "Bonds vs. Gold. Which will beat inflation?"

Sajan Kumar

Mar 4, 2013

The days of love for Gold is over. Due to various factors the downward trend of gold has started. In such scenario the bond is more likely to beat inflation as compared to gold


Gangadharan Nair

Mar 4, 2013

Never, nothing can beat the Gold. In India we never had INFLATION. What we had per annumwas DEVALUATION of our currency. Our currency was loosing its value at the rate of 15% and the cost of material, or the price index was increasing at the rate of less than 10% per annum. In such a condition there won't be any INFLATION. And there will be only DEVALUATION. A Government which spends 80% of their revenue only on Salary , Pension and related miscellaneous expenditure CANNOT control the deficit. Only remedy, is print more currency and distribute and create an atmosphere of INFLATION. If you closely analyse the financial conditions in the country, you will be astonished to see that in the past 48 years the price of agricultural products has gone up only by 20 to 30 times and minimum wage of the workmen has gone up only by 35 times but the value of our currency has gone DOWN to 1/500. This is very very bad condition of the nation. The Sovereignty of any nation depends on the STRENGTH of the VALUE of that nation's official currency. Some of the countries have introduced even ATMs for Gold Coins, and that shows the strength of those nation. The CURRENCY is not only the INSTRUMENT of media for negciations it is the nation's powerful WEAPON too. Since our Finance Minister is struggling to penalize the Gold purchases, it shows our nation is very very weak.



Mar 4, 2013

Authors argument that IIB is not good as it will be linked to CPI makes sense, but I am not sure how investment in gold will provide a permanent solution for the indian inflation. Please note gold is a commodity hence will come under pricing cycle, albeit from a much longer cycle though. Please do not put an arugment for the sake of it.


Mukesh Gupta

Mar 4, 2013

Now a days Indian Govt. is controlling its deficits. And in long term perspective Indian Govt. again will be controlling its deficit due to this reason(Bonds) also. Indian govt. is also trying to get rid of paying pensions. How it will succeed in provisioning of Indexed Bonds.



Mar 4, 2013

I would never trust the inflation and GDP numbers. If you all have noticed these figures are revised after two months by govt. How can the inflation be @6.5% when our household expenses have gone up from Rs.8000 to Rs.22000 per month.



Mar 4, 2013

In accord with rationale given by you IIB would be nothing but a miss as CPI is main culprit and how easy its to buy GOLD is far complicated with bonds for us Indians even we should take it as surprising approach by a scholar FM who chose this step to curve the interest in yellow metal.



Mar 4, 2013

The Indian economists as well as govt are acting like mad people with high level of inconsistencies. Even the proven constitutional obligation are given twist to suit their political egoism. No other choice for the common man to have some hedge against these mad people as such he prefers GOLD.

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