- What is the issue?
- How RBI took this decision?
- What prompted the RBI to take this move?
- Liquidity Surplus in the Banks
- Is RBI thinking out of the box?
- Operation twist of US Federal Reserve
- Is this move related to budget?
- Best Way Forward
RBI’s Operation Twist
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It is the first time the RBI has conducted special Open Market Operation (OMOs) of this kind, similar to the ‘Operation Twist’ carried out in the United States in 2011.
What is the issue?
- Bond yields have been rising since the RBI unexpectedly left its key repo rate unchanged earlier this month, even as it slashed its forecast for economic growth to its lowest in over a decade.
- The RBI said it will buy 100 billion rupees’ worth of the current benchmark 10-year bond while selling four bonds maturing in 2020 for an equivalent amount.
- The central bank said it had decided to conduct the special OMO after reviewing the liquidity & market situation and assessing financial conditions.
How RBI took this decision?
- This is an unusual step from the RBI. It hasn’t taken such move so far.
- The decision has been prompted by a desire to flatten the yield curve.
- Currently, in the short term securities, the yield is lower than the overnight repo rate. Whereas, in the long term securities, the yield is 150 basis points higher than overnight repo rate.
- Since the RBI’s last monetary policy review, the yield on the long term repo rate has moved up by 36 basis points. In these kind of situation, RBI realized that there is a need to flatten the yield curve from short term to long term.
- RBI is flooding the long term bonds in the market and with the money they are receiving, they sucking out short term bonds from the market. So that the supply of those short term bonds comes down. Therefore, the yield on short term bond goes up and long term debt yield comes down.
- In the last monetary policy review, the RBI talked about a coordinated monetary policy and a fiscal policy plans. The lasts attempt to sell short term and buy long term is aimed at helping the government to meet borrowing requirements, slightly at lower costs.
What prompted the RBI to take this move?
- The move to sell short term bonds and buying long term bonds with the proceeds started by US Federal Reserve in 2011 worth $400 bn to revive the economy hit by global financial crisis.
- The reason behind taking such step by the Fed was twofold. Firstly, the bank became risk averse, they hesitated in buying long debt securities and loans.
- Secondly, the $400 bn was substantial i.e. 14% of the total balance sheet of the Federal Reserve and many of the fixed rate loans are benchmarked to the 10 years yield. 10 years is the most liquid security period abroad as well as in India.
- India is trying to do the same in current sluggish economic situation because, RBI wants to bring down the long term interest rate. But, the similar kind of effect in India is unlikely as the 10,000 crores yield gained from the sale of bonds is only 0.4% of RBI’s balance sheets.
Liquidity Surplus in the Banks
- This operation is going to be liquidity neutral because there is simultaneous sale and purchase of 10,000 crores bonds.
- The market scenario is that there is market demand for short term securities which is pushing the price high, lowering the yield and the opposite is happening in long term security bonds.
- To correct this imbalance, it is in RBI and government’s interest that there should be a bigger market for long term debt securities.
- It will reduce the cost of borrowing for government and it will deepen the long term debt market. Rs. 10,000 crore yield is not very substantial amount. Therefore, it can be said that the government is taking these steps on pilot basis and if the operation succeeds, RBI can launch bigger such operation.
- In terms of assessing the quantum of gaps between short term and long term securities, it is about 120-130 basis points for two to ten years.
- That gap is very wide and the current attempt is to reduce that gap. This is called ‘Term Premium’ and which is very high. Despite reduction in repo rate from 6.5%, the to 5.15 %, that will be 135 basis points reduction, the repo rate need to be seen for bringing the desired impact in the market.
- RBI has said, it is the assessment of the liquidity in the system.
Is RBI thinking out of the box?
- The RBI is trying to flatten the yield curve and at the same time it is conscious of government’s fiscal needs.
- The government’s need for some extra borrowing is now well recognized, the fiscal deficit may not be contained at 3.3% of GDP in current financial year and hence, government will have to borrow from the market. For that the RBI has to facilitate that move of the government. The operation twist will certainly address that economy concern so that government’s borrowing programme goes smoothly without any undue extra costs.
- This will, to some extent, address the worry of lack of transmission of the repo rate cut to the larger money market in a sense that in the credit market, the transmission has not been to the desired level. In money market, the transmission has been descent.
- Probably, the foreign players may be interested in Indian bond market by seeing the RBI’s current move which is based on Federal Reserve’s previous move and steps. The foreign players hesitate to invest in Indian bond market instead of obvious advantage of high rate of return in India in comparison to their rate of interest.
- All these issues can be tackled by the RBI current operation twist.
Operation twist of US Federal Reserve
- Operation Twist was created by the Federal Reserve for the US market. That time the credit course was not taking place due to people’s risk aversion to the lending agencies.
- In India, whatever RBI does through monetary policy, two things will happen, either positive impact on banks’ balance sheet because of lot of SLR security present in the higher end. If the price goes down, they can be treated as profit and that profit helps the RBI to create a positive impact.
- Transmission only doesn’t flow due to no repo rate cut but because of low demand also. Whatever the monetary policy does, it won’t push the current economy to growth trajectory unless there is a fiscal policy changes.
- If the government sticks to the Fiscal deficit target of 3.5%, the problem won’t be solved. There is a need to create a demand in the market which will only revive the economy.
Is this move related to budget?
- Yes, particularly to the response of the market as the buying of long term security debts will likely to bring fiscal slippage. If the market feels that the market will see the more supply of government bonds, the prices will remain low but if the supply remains low then the prices will be high and attractive.
- Success or failure of this RBI move will be an indication of the market assessment of the government’s decision. If it succeeds, certainly it will smoothen the way for government in bonds mobilization and the RBI has been doing a lot of heavy lifting in terms of reducing as much as 135 basis points.
- The government on its part has done massive corporate tax reduction and the grounds are being prepared for further tax reduction.
- The government consumption has its own limitation as our economy is largely private consumption driven and that has to be spurred. For that necessary changes are required in tax and regulatory environment.
Best Way Forward
- The Operation twist is a pilot exercise and important fallout of this exercise is for those banks who may see the price of long term debts may go up and the end balance sheet may improve.
- The big question is to what extent; the government manages its fiscal deficit more responsibly. If the government would be able to manage it properly, the chances of such experiments succeeding with greater result will get bigger.
- The monetary policy can only function in coordination with the fiscal policy. This experiment will start a new cycle which if properly exploited in coordination with fiscal policy, it will be a good news for the Indian economy.
- The government has to create more liquidity in the market by doing higher deficit financing to create more demand. The government can borrow in low cost of rate but it will crowd in the market if the demand is being not created.
RBI has done a lot to improve the situation on cost and access to credit but there are many things which are beyond credit. On its part, the government has its own limitation in spending. We have to look for private consumption investment and the measures to boost it.