Inflation-protected bonds provide protection against inflation; the government will be able to partly fight inflation by issuing these types of bonds.
This was stated by Mehdi Nosrati, an economic analyst, in a write-up for the Persian daily Donya-e-Eqtesad. A translation of the text follows:
“Next Iranian year [2022-23] will see a much lower inflation rate,” Minister of Economic Affairs and Finance Ehsan Khandouzi made this old, undelivered promise last week.
You can believe such promises only on condition that the government issues inflation-protected bonds. In general, policymakers’ promises should not be made at no cost; conversely, politicians must pay the price of their failure to deliver on their promises. The main function of inflation-protected bonds in Iran will be to make promises costly.
These bonds have become prevalent in the world for years now. In the US, they are known as Treasury Inflation-Protected Securities or TIPS. The Central Bank of Iran issues the likes of such bonds under different names like deposit bonds every once in a while but then forgets the whole thing.
One of the advantages of inflation-protected securities over conventional bonds is that they give the government real motivation to reduce inflation, whereas conventional bonds entice the government into increasing inflation to negate real interest rate
TIPS are indexed to inflation to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value. For example, if the economy registers a 50% inflation rate in a year, the owners of TIPS will receive the interest payment of 50%.
These bonds have good features. To begin with, they ensure people that the value of their money will be protected, such that they won’t need to shuttle among markets to protect their money on a daily basis. The second and most important characteristics of these bonds is that they put a damper on the government’s craving for inflation; the higher the inflation rate, the heavier the burden that future interest payment will place on government finances.
However, some might argue that these types of bonds impose high costs on the government. Why should the government opt for bonds at 30-40% interest rate when it can sell debts at the rate of 25%?
First, in a country like Iran, conventional debt bonds (fixed-rate bonds) alone cannot solve the problem of inflation and interestingly, governments are advised to create inflation to devalue their debts. In fact, one of the advantages of inflation-protected securities over conventional bonds is that they give the government real motivation to reduce inflation, whereas conventional bonds entice the government into increasing inflation to negate real interest rate.
Secondly, inflation-protected securities do not necessarily impose higher costs on the government. Thanks to their lure for buyers, these bonds are usually facing excess demand. If the government sells them through an auction mechanism, the market price will be higher than the base price, so that the rate of return for the buyer and consequently their cost for the government will not be too high. As a result, the attractiveness of these bonds renders them less costly for the government.
Imagine that the nominal and base price of these securities (face value) stands at 1,000 rials. As a buyer, if you expect the inflation rate to hover around 40% and you trust the government to announce the real inflation, then you expect the government to pay you a 40% interest rate next year on bonds you’ll purchase.
On the other hand, parallel markets such as the stock market, gold, forex and cars are firstly risky and secondly already affected by future inflation. Therefore, it is sensible to expect you won’t gain a 40% interest upon entry to those markets. Here, it is conceivable that the demand for these bonds will increase and during their initial supply, they will be priced at higher prices such as 1,200 rials (market value). In other words, the market value of these securities is pegged to inflation.
Notably, the policymakers are required to buttress their reputation first if they intend to issue inflation-protected securities. Otherwise, economic players won’t be incentivized to buy these bonds due to the lack of trust in the government.
It should also be noted that the problem with Iran’s economy, including its inflation, is structural and cannot be solved radically simply by tweaking a few nominal variables or even with wielding tools such as inflation-protected securities.
But in short, the monetary policymakers’ failure to issue such bonds suggests that they themselves do not believe in their promises; that’s what people call “empty talk”.
