Worry-Free Inflation-Indexing for Sovereigns - How Governments Can Effectively Deliver Inflation-Indexed Returns to Their Citizens and Retirees

Abstract

In this paper we explore how small countries such as Malaysia, Singapore, and Taiwan, can offer their aging populations the means to protect their retirement income against inflation without the governments directly issuing inflation-protected bonds. While inflation swaps are a well-known means by which to attain this, we show how an inflation index-replication strategy is also feasible. With this ability to provide inflation-adjusted returns, governments, pension funds, and other institutions can begin to offer a broad suite of inflation-indexed products, ranging from retirement annuities to inflation-linked insurance policies. This will improve the functioning of national pension systems, and hence the welfare of retirees. The added benefit of such structures is that they allow governments to broadly replicate their local Consumer Price Index (CPI) returns without disrupting their traditional financing structures. Given the potential of reinsuring national default risks across borders via currency and credit default swap facilities at the federal level, there is a unique role for the government in this process as the reinsurer of last resort.

Keywords: inflation indexing, inflation-protected bonds, inflation-indexed annuities, pension plans, inflation swaps, inflation index replication

JEL Classification: G11, G15, G18, G23, J26