Unidad de Fomento

Unidad de Fomento

The Central Bank of Chile translates the “Unidad de Fomento” on their website to An Inflation–Indexed Accounting Unit and CPI–Indexed Unit of Account (UF).

      The UF´s value in Chilean escudos was originally (1967) updated every quarter which would be the official rate for the following quarter. The UF´s original value of 100 has never been rebased like most CPIs. It was updated monthly from October 1975, with the currency changeover to pesos, till 1977. Since July 1977 it was calculated daily by interpolation between the 10th of each month and the 9th of the following month, according to the monthly variation of the Indice de Precios al Consumidor (IPC), the Chilean Consumer Price Index. The Banco Central de Chile has calculated and published the UF´s value daily since 1990. The UF is a lagged daily interpolation of the Chilean CPI. The IPC is independently calculated and published monthly by the Chilean National Statistical Institute.

      The UF daily rate is available on the Chilean Central Bank´s website.

      Most bank deposits in Chile are 30–day non–indexed deposits or 90–day indexed deposits whose rates are expressed in terms of the UFs. Interest rates on the indexed deposits are expressed as a premium over the UFs. On maturity, the deposits are converted back to pesos at the current UF rate. Shiller, 1998, p3.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Differences between CIPPA and CPPA

Differences between CIPPA and CPPA

"Constant Purchasing Power Accounting (CPP) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money.  It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the value of the currency. It attempts to deal with this problem by converting all of the currency unit measurement in accounts into units at a common date by means of the index." Geoffrey Whittington, Inflation Accounting – An Introduction to the Debate, 1983. (My bold text).

          It is very clear from the above quote that Prof Whittington also considered – at that time – that “indexing accounts by means of a general index” would “deal with the inflation problem” and not the stable measuring unit assumption problem.

         CPPA is dealt with in this book as it is implemented in terms of IAS 29 Financial Reporting in Hyperinflationary Economies.

        CIPPA automatically maintains the constant purchasing power of shareholders´ equity constant for an indefinite period of time in entities that at least break even in real value during low inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not, by measuring financial capital maintenance in units of constant purchasing power in terms of a Daily CPI. The net monetary loss or gain and the net constant item loss or gain are calculated and accounted in the income statement. CIPPA is not an inflation accounting model. CIPPA is a price–level basic accounting alternative to HCA authorized in IFRS during low inflation and deflation. The stable measuring unit assumption is rejected under CIPPA.

            Differences

                                                                          

1.  When implemented

 CIPPA

Implemented during low inflation and deflation.

CPPA  
Only implemented during very high and hyperinflation as required by IAS 29.

2. Stable measuring unit assumption

          CIPPA

No stable measuring unit assumption.
 
CPPA
The stable measuring unit assumption is implemented in the preparation of Historical Cost or Current Cost financial reports which are then restated in terms of the period-end monthly CPI during hyperinflation. 

          3. Capital concept

           CIPPA

Constant purchasing power financial capital concept implemented. 

CPPA
Nominal financial capital concept  implemented in HC or CC financial reports then restated in terms of the period-end monthly CPI.

4. Capital maintenance concept

             CIPPA

Financial capital maintenance in units of constant purchasing power concept
implemented; e.g. shareholders´ equity is measured in units of constant
purchasing power daily in terms of a Daily Consumer Price Index.
                                                                                                           

           CPPA
          Financial captial maintenance in nominal monetary units concept implemen-
          ted; shareholders´ equity is measured in nominal monetary untis in HC or CC fin-
           ancial reports and restated at the period-end monthly CPI.

         5. Inflation accounting model

            CIPPA

Not an inflation accounting model.
         
CPPA
An inflation accounting model only implemented during very high and hyperinflationn.

6. IFRS authorization

            CIPPA

Originally authorized in IFRS in the Framework (1989), Par 104 (a). 

CPPA
Authorized in IFRS in IAS 29.          

7. Daily or period-end measurement

            CIPPA

 All historic and current items are measured daily in terms of a DCPI as detailed below.
                                                             
CPPA
Only non-monetary items are restated (not measured daily in units of constant purchasing power at the time of a transaction or event) at the end of the financial period in terms of the period-end monthly CPI.

                                                                     
8. Measurement of monetary items

CIPPA

Historic and current period monetary items are inflation-adjusted daily in     

terms of the DCPI. When not inflation-adjusted daily during the current period, the net monetary loss or gain is calculated and accounted. 
        

              CPPA
              Monetary items are measured in nominal monetary units. They are not inflation -adjusted or restated. The net monetary loss or gain is calculated and accounted.

             9. Measurement of variable items

                  CIPPA

      Variable items are measured in terms of IFRS and updated daily in terms of the Daily CPI.
                                              

CPPANo split of non-monetary items  in variable and constant items. All non-monetary items in  period-end HC or CC financial reports are restated in terms of the period-end monthly CPI.

10. Measurement of constant items

                  CIPPA

     Constant items are measured in units of constant purchasing power on a daily basis in terms of the DCPI.

     CPPA
No split of non-monetary items in variable and constant items. All non-monetary items in period-end HC or CC financial reports are restated in terms of the period-end CPI.

                                             
11. Net constant item loss or gain

                  CIPPA

    Net constant item loss or gain calculated and accounted. This is a new accounting concept.

      CPPA
A net constant item loss or gain concept does not exist under HCA, CPPA or IFRS (IAS 29).

                12. Measurement of trade debtors and trade creditors

                 
                  CIPPA

          Constant real value non-monetary payables and receivables (e.g. trade debtors and trade creditors) are measured in units of constant purchasing power daily in terms of a DCPI.

                CPPA                                                                   

                Trade debtors and trade creditors and other payables and receivables are treated as monetary items and measured in nominal monetary units in HC or CC financial reports. They are not restated.

            13. Consumer Price Index 

               CIPPA

  Daily Consumer Price Index used during low inflation and deflation.  
        

            CPPA
            Monthly consumer price index used during hyperinflation.
Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

TIPS are nominal bonds during deflation: better investments than during inflation

TIPS are nominal bonds during deflation: better investments than during inflation

      The 6-monthly TIPS coupon payments are inflation- and deflation-adjusted; i.e., they are maintained at their real interest rates during inflation and deflation.

      The principal is repaid at maturity. If the nominal value of the principal is lower than the issuance value due to deflation, then the nominal issuance value will be repaid. The principal is thus inflation-indexed during inflation, but, it is a nominal bond during deflation; i.e., it is not deflation-adjusted for repayment purposes, only in order to calculate the constant real interest rate during inflation and deflation. The TIPS principal will gain real value during deflation since it will be repaid at its nominal issuance value.

     True to its name, the Treasury Inflation-Protected Security´s principal or capital amount is protected against the risk of losing real value during inflation. Additionally, the principal also gains in real value during deflation. TIPS are nominal bonds with a constant real interest rate or coupon payments during deflation.

     The TIPS principal gains in nominal value during inflation (its real value stays the same) while it gains in real value (its nominal value stays the same) during deflation. TIPS coupon payments stay the same in real value during inflation and deflation. TIPS are thus worth more in real value during deflation than inflation. TIPS are better investments during deflation than inflation. TIPS are inflation-protected and deflation-enriched with constant coupon payments.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Treasury Inflation-Protected Securities - TIPS

         Treasury Inflation-Protected Securities - TIPS

      Treasury Inflation–Protected Securities are inflation–adjusted money loans to the US government. They are inflation-indexed on a daily basis since they trade daily. The U.S. Treasury started issuing TIPS in January 1997. The United Kingdom has been issuing inflation-indexed bonds since 1981 and Canada since 1991. The United States of America was thus a relatively late starter in the inflation-indexed government bond market. Unlike normal nominal Treasury Bonds, these TIPS offer investors protection against inflation.

Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. Treasury Direct http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm

TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

       If at maturity the inflation-indexed capital amount is less than the par amount of the security due to deflation, the final payment of the principal will not be less than the par amount of the security at issuance. In such a circumstance, the US Treasury will pay an additional amount at maturity so that the additional amount plus the deflation-indexed capital amount will equal the par amount of the security on the date of issue.

       Nominal Treasury Bonds would gain from the fact that deflation creates real value in nominal monetary items in both the principal and in interest payments.

      TIPS are inflation-indexed daily in terms of a Daily CPI based on the US non-seasonally adjusted Consumer Price Index for All Urban Consumers (NSA CPI-U). The CPI-U for a particular calendar month is published during the following calendar month. The inflation-indexed coupon and capital repayments are thus paid in terms of a TIPS Daily Consumer Price Index which is a lagged daily interpolation of the CPI-U with a two month lag. The CPI-U index value used for the calculation of the DCPI on the first day of a calendar month is the CPI-U of three months before.

       The TIPS DCPI value calculated for any given day in a calendar month is the daily interpolation of the CPI-U index value (of three months before) used at the beginning of the calendar month and the CPI-U index value (of three months before) used at the beginning of the following calendar month.

       A country which issues inflation-indexed government bonds and uses a one or two month lagged interpolated Daily Consumer Price Index to determine the daily price of these bonds can use the DCPI for the implementation of financial capital maintenance in units of constant purchasing power during inflation and deflation (CIPPA).

       A DCPI is not automatically a monetized daily indexed unit of account like the Unidad de Fomento in Chile. A DCPI is a lagged daily interpolation of the monthly CPI. The monthly CPI is generally published several days after the close of the calendar month to which it refers. That is why the Daily CPI has to be lagged and interpolated.

A TIPS Valuation Framework, Lehman Brothers, Fixed Income Research, US Interest Rate Strategy, 2006.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Major Inflation-Linked Bond Markets

Major Inflation-Linked Bond Markets by Estimated Market Value ($bn) as at 31 December, 2009

                        $bn

US                   550

UK                 300    

Turkey           240      GDP $735  billion  (2010 estimate)

Chile               210     GDP $243  billion  (2011 estimate)

France           200      GDP $2808 billion  (2011 estimate)

Mexico            200

Poland            200

Colombia       160

South Korea  160

Brazil             150   GDP $2090 billion  (2011 estimate)

Italy               130

Japan               70

Germany          40

Canada             40

Sweden             30

Global estimated index-linked bond market: 2 680 $bn

Standard Life Investements, An Investor´s Guide to Inflation-Linked Bonds,

http://uk.standardlifeinvestments.com/O_FG_Inflation_Linked_Bonds/getLatest.pdf

Chile, with less than one tenth of France´s GDP, has a bigger government inflation-indexed bond market. Chile´s 44-year history of inflation-indexing monetary items in terms of the Unidad de Fomento, which is a monetized daily indexed unit of account, most probably had a strong influence on this state of affairs. Chile was not plagued by hyperinflation and did not have to resort to Dollarization during that period while some of their regional neighbours had to.

Both Turkey´s and Brazil´s relatively big sovereign inflation-indexed bond markets may be a result of their recent experiences with hyperinflation. Brazil did not inflation-index a significant portion of their broad money supply - like Chile currently does – during their 30 years of very high and high inflation from 1964 to 1994, but, they measured most non-monetary items in their non-monetary or real economy daily in terms of a daily government supplied non-monetary index.

Both Brazil and Turkey have first-hand experience of how rapidly hyperinflation can destroy the purchasing power of money and other monetary items.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Inflation-indexed bonds

Inflation-indexed bonds

Inflation-indexed bonds also known as inflation-linked bonds are government and commercial bonds indexed to inflation. The first known inflation-indexed bond was issued by The Massachusetts Bay Company in 1780.

The capital amount or principal of the bond is indexed to inflation. Inflation-indexed bonds are thus money loans to governments and companies designed to eliminate the risk of inflation eroding the real value of the principle and interest payments. The corporate inflation-indexed bond market is quite small compared to the sovereign market. The British government began issuing inflation-linked Gilts in 1981. The market for inflation-linked bonds has grown rapidly since then. Sovereign inflation-indexed bonds comprised over $2.68 trillion of the international debt market at the end of 2009. Private sector issued inflation-linked bonds make up a small portion of the international inflation-indexed bond market.

Interest is paid my means of coupon payments. A coupon payment on a bond is a periodic interest payment to the bondholder during the period between the bond issue date and when the bond matures. The coupon is equal to the product of the nominal coupon rate and the inflation index for the period involved. The Fisher equation presents the relationship between real interest rates, coupon payments and breakeven inflation. An increase in real rates, inflation expectations, or both, results in a rise in coupon payments.

The underlying principal of the bond is inflation-indexed for most bonds, such as in the case of Treasury Inflation-Protected Securities (TIPS), which results in a higher interest payment when multiplied by the same rate. The interest rate is adjusted according to inflation for some bonds, such as the Series I Savings Bonds in the US.

The most liquid markets are US TIPS, the UK Index-linked Gilts and the French OATi/OAT€I market. Japan, Germany, Italy, Canada, Australia, Sweden, Iceland, Portugal, Greece, Finland, Netherlands, Spain, Saudi Arabia, Qatar, Kuwait, UAE, South Korea New Zealand and Hong Kong also issue inflation-indexed bonds, as well as a number of Emerging Markets such as Brazil, Turkey, Chile, Mexico, Colombia, Argentina and South Africa.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Daily Consumer Price Index (DCPI) - Part 1

The Daily Consumer Price Index – DCPI

(i)          Introduction

      Unstable money is the unstable medium of exchange, unstable store of value and unstable unit of account in the economy. Pre–monetary economies had units of account without money being available in the economy. (See Robert J. Shiller, Indexed Units of Account: Theory and Assessment of Historical Experience, Cowles Foundation Discussion Paper No 1171, 1998, p4).

      Today the economic values of all economic items are stated in terms of unstable money. Prices are expressed in unstable monetary units. Unstable money is the generally accepted unstable monetary unit of account used to value and account all economic activity by entities applying the stable measuring unit assumption as part of the traditional Historical Cost Accounting model under which they implement financial capital maintenance in fixed nominal monetary units with unstable real values in the world economy during inflation, deflation and hyperinflation.

      Unstable money is not fixed in constant real value. Unstable money is fixed in nominal value in economies subject to inflation, deflation and hyperinflation. Unstable money is a fixed nominal unit of account with a daily changing real value (purchasing power).  Financial capital maintenance in nominal monetary units, although approved in IFRS and by the United States Financial Accounting Standards Board (FASB) and implemented worldwide, is a very popular accounting fallacy not yet extinct because it is impossible to maintain the real value of capital in nominal monetary units per se during inflation and hyperinflation.

      Bank notes and bank coins cannot currently be inflation–indexed or deflation-indexed which makes it impossible for money or the monetary unit of account to be a perfectly stable unit of constant real value during inflation, deflation and hyperinflation.

(ii)        Unidad de Fomento

      Notwithstanding or despite the above, monetary items in the form of certain time deposits  – not the actual bank notes and coins – and other monetary items, e.g. government and commercial capital market bonds, have been inflation–indexed in Chile since 1967 by means of the Unidad de Fomento which is now a monetized daily indexed unit of account.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

IAS 29 needs to be totally reviewed by the IASB

IAS 29 needs to be totally reviewed by the IASB

This CIPPA project is about financial capital maintenance in units of constant purchasing power during low inflation and deflation.

As a secondary issue, the project also clearly demonstrates the futility of implementing IAS 29 during hyperinflation as required by IFRS and describes the solution: daily updating of all non-monetary items in terms of the daily US Dollar parallel rate or a Brazilian style Unidade de Valor Real index as was done in Brazil during 30 years from 1964 to 1994.  

This supports the current request by many accounting authorities for a total review of IAS 29 by the International Accounting Standards Board.

CIPPA clearly demonstrates that simple restatement of Historical Cost and Current Cost financial statements in terms of the period-end monthly Consumer Price Index during hyperinflation as required by IAS 29 makes absolutely no difference to the destruction of a country´s constant item economy, not by hyperinflation, but, by the stable measuring unit assumption as it forms part of the HCA model as it happened in Zimbabwe over the 14 years of hyperinflation in that country till final monetary meltdown in 2008. IAS 29 was implemented in Zimbabwe since 2002 and made absolutely no difference.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Problems CIPPA can help solve

Problems CIPPA can help solve

1.    It would automatically solve the problem of the erosion of companies´ capital and profits by the stable measuring unit assumption (the HCA model) during low inflation amounting to hundreds of billions of USD p.a. on a worldwide basis and instead would automatically maintain that amount p.a. for and unlimited period of time in all entities that at least break even in real value during low inflation – ceteris paribus – whether they own any revaluable fixed assets or not.

2.    It would solve the problem of the very rapid destruction a country´s non-monetary economy by the implementation of the stable measuring unit assumption (HCA) during hyperinflation by means of daily measurement of all non-monetary items in units of constant purchasing power in terms of the daily US Dollar parallel rate or a Brazilian style daily index.

3.    It would solve the problem of economic instability caused by the implementation of the stable measuring unit assumption (HCA) during deflation.

4.    It corrects the fallacy that the erosion of companies´ capital and profits is caused by inflation: it is caused by the stable measuring unit assumption during inflation.

5.    It corrects the fallacy that financial capital can be measured in nominal monetary units per se as stated in IFRS: it is impossible to maintain the real value of financial capital in nominal monetary units per se during inflation.

6.    It corrects the fallacy that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation. The implementation of the stable measuring unit assumption causes the erosion of hundreds of billions of US Dollars in real value p.a. worldwide in that portion of entities´ shareholders´ equity not backed by sufficient revaluable fixed assets (revalued or not) during low inflation.

7.    It corrects the generally accepted belief that there are only two concepts of capital and capital maintenance authorized in IFRS; there are three concepts of capital authorized in IFRS: (i) physical capital (ii) financial capital measured in units of constant purchasing power (CIPPA) and (iii) financial capital measured in nominal monetary units (HCA).

8.    It corrects the generally accepted belief that there are only two basic economic items in the economy; there are three: monetary, variable and constant items.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

The value of CIPPA

The value of CIPPA

a.)  The principle treated in the topic, namely, financial capital maintenance in units of constant purchasing power, was originally authorized in IFRS in the Framework, Par 104 (a) in 1989.

b.)  In developing the topic, CIPPA introduces several new accounting concepts and terms for the first time, e.g.:

(i)           Financial capital maintenance in units of constant purchasing power during LOW inflation and deflation – not only during very high and hyperinflation.

(ii)          The split of non-monetary items in variable and constant items making this model possible during low inflation and deflation.

(iii)        Not just 2 but three basic economic items.

(iv)        Variable item economy.

(v)          Constant item economy.

(vi)        Net Constant Item Loss.

(vii)       Net Constant Item Gain.

(viii)     Daily Consumer Price Index.

(ix)        Inflation Illusion.

(x)          Accounting-Dollarization.

c.)   The fact that IFRS authorize three instead of the generally accepted two concepts of capital and capital maintenance was first published on this blog.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.