Another round of RBI’s Operation twist!
Last updated: 02 Sep, 2020 | 01:02 pm
- The Reserve Bank of India recently announced that it will conduct open market operations (OMOs) for ₹10,000 crores each on 27 August and 3 September.
- The central bank added that it will buy government securities including 6.18%, 8.24%, 5.79% and 7.95% maturing on November 4, 2024, February 15, 2027, May 11, 2030, and August 28, 2032, respectively.
- At the other end of the yield curve, it will sell securities that mature between October 2020 and November 2020.
What are Open Market Operations?
- Open market operations refer to the sale and purchase of government securities and treasury bills by RBI or the central bank of the country.
- The objective of OMO is to regulate the money supply in the economy. When the RBI wants to increase the money supply in the economy, it purchases the government securities from the market and it sells government securities to suck out liquidity from the system.
How are Open Market Operations used in Operation Twist?
- From December 2019 onwards, RBI has been conducting OMOs in which it is simultaneously selling short-term securities and buying long-term securities.
- Here, the objective of OMO has been to manage the yield curve (reduce the difference in short term and long term rates) rather than managing liquidity.
- By purchasing long term bonds, the RBI increases the demand for these and thus pushing up the prices which leads to a fall in yields and by selling short term securities, their prices fall, consequently raising their yields.
- This helps to flatten the curve by reducing the spread between long term and short term yields.
- 'This simultaneous selling of short term securities and buying of long term securities is known as ‘Operation Twist.’ It was first used by the US Federal Reserve in 1961 and then in the year 2011.'
What is the RBI trying to do?
- RBI has chosen to use Operation twist instead of direct OMO purchases to avoid adding more liquidity to the system, as the system is already flux with excess liquidity
- Inflation has been on a rise lately and is expected to shoot up over the next 2-3 years, thus limiting the RBI’s scope for further rate cuts. With less flexibility to use the interest rate mechanism RBI had to shift its focus on OMOs.
- Flattening of the yield curve: 'Recent rate cuts have reduced the short term yields thus steepening the curve. A steep yield curve is not a good sign for the economy.' The following chart shows how India’s yield curve has steepened over the last year.
- Induce long term borrowing: The RBI is suffering from the problem of transmission. Despite the moves by RBI, banks have not been extending credit to the cash strapped economy. Bank credit (non-food) is down ₹1.6 Lk Cr in this Financial year alone. This includes loans, cash credits (against pledged assets) and overdrafts extended to companies.
- This is because of the heightened credit risk in lending currently caused by a widespread disruption in the economy. Banks have preferred to park their money in safer Government securities instead- investments by banks in government securities is up over ₹4 Lk Cr this FY (Since Apr 1).
- RBI is trying to make lending easier via OMOs.Long-term Government bond yields act as an interest-rate benchmark for auto loans, home loans, or for that matter any long-term investments or borrowing.
- So, by bringing down long-term bond yields, loans will become cheaper. With long-term bond yields coming down, not only the government would be able to borrow money at a cheaper rate from the market, but the corporate sector would also benefit as yields of corporate bonds would follow suit.
'India’s 10Y G-sec yield has risen to 6.221% from 5.83% in the past 20 days. The primary reason for this is the higher inflation expectation. However, after RBI’s recent leg of OMO, the yields have cooled off a bit.'
- The RBI remains constrained in its possible actions as rate cuts are having low impact on stimulating the economy while risk on impact to our currency remains high (lower interest rates lead to outflows from the country).
- Shooting fiscal deficit and increased market borrowing coupled with high inflation expectations will put upward pressure on the bond yields. Thus RBI may have to aggressively use operation twists in the coming sessions to manage yields.
- Monetary policy changes and fiscal measures are good measures to promote growth in the short term. However, in the long term, fundamental factors of the economy guide real growth and sustainability.
- We expect the interest rates to increase and yield spread to decrease in the next 2-3 years.
- In an increasing interest rate environment, high duration funds, and long-maturity bonds tend to underperform compared to low duration funds and bonds.
- Stick to AAA-rated low duration funds and bonds over high duration funds, and long-maturity bonds as yields will remain volatile in the near future but in the medium term (2-3 years) the rate cycle is expected to bottom out and move up