UPSC Prelims 2022 Q5: Indian Economy – Financial Markets & Capital Markets
With reference to the Indian economy, what are the advantages of "Inflation - Indexed Bonds
(IIBs)"?
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
- (c) 1 and 3 only
- (d) 1, 2 and 3
Answer: (a) 1 and 2 only
Explanation
Inflation-Indexed Bonds (IIBs)
IIBs adjust the principal and/or interest in line with an inflation index (in India, the CPI; earlier issues used WPI).
| Statement | Verdict | Reason |
|---|---|---|
| 1. Government can reduce coupon rates | Correct | Investors accept a lower real coupon because they are protected from inflation |
| 2. Protect investors from inflation uncertainty | Correct | Returns rise with inflation, so real value is protected |
| 3. Interest and capital gains are tax-free | Wrong | Interest and gains are taxable under normal Income-tax rules |
India's experience:
| Issue | Detail |
|---|---|
| Capital Indexed Bonds | 1997 — principal indexed |
| WPI-linked IIBs | June 2013 |
| CPI-linked IINS for retail | December 2013 |
Answer: (a) 1 and 2 only.
Why each option is right or wrong
- (a) CORRECT. IIBs let the government pay lower coupons and protect investors from inflation.
- (b) Incorrect. Statement 3 is false; IIB income is taxable.
- (c) Incorrect. Statement 3 is false, and it leaves out the true Statement 2.
- (d) Incorrect. Statement 3 is false, so 'all three' fails.
Key point
IIBs: coupon linked to inflation, lower real coupon for the government, inflation protection for investors; income is taxable.
Remember
IIBs protect investors from inflation and lower the government's coupon, but they are taxable.
Common mistakes
- Assuming government bonds are always tax-free; IIB income is taxable.
- Not seeing why the government saves: investors accept a lower coupon in return for protection.
- Confusing IIBs with Sovereign Gold Bonds, whose capital gains on redemption are tax-free.
Exam tip
Inflation protection is the investor's gain; lower coupon is the government's gain. Tax-free status is not part of IIBs.
Sources
- RBI — Inflation Indexed Bonds FAQs (2013)
- NCERT Class XII — Introductory Macroeconomics (Government Budget)