Photo: Alamy
Photo: Alamy

Opinion | Is it time for India’s own version of the US Fed’s Operation Twist?

Since longer-maturity yields are proving hard to keep down, RBI could sell short-term bonds and buy long-range securities

The synchronized global economic revival that began in 2017 now seems to be gasping for air. There are indications of a slowdown in almost every major economic area—the US, China, Europe, Asia, Japan. The Indian economy is also losing momentum. Indian economic growth in the fourth quarter of the fiscal year that ends on 31 March is likely to be around 1.7 percentage points lower than in the first quarter.

It will be worth seeing whether the International Monetary Fund reduces its forecast for global growth this year in its new report on the global economy due to be released in April. In the January update of its flagship World Economic Outlook, the multilateral lender had forecast global growth at 3.5% in 2019 and 3.6% in 2020.

In India, the slowdown in consumer spending that was perhaps sparked off by tighter liquidity during the Non Banking Financial Company (NBFC) scare seems to have deepened. The recent revival in portfolio flows into Indian equities plus the prospect of lower commodity prices because of the tepid global economy will act as buffers.

Financial markets are betting on a rate cut in April to follow the one in February. The market for overnight indexed swaps (OIS) is pricing in three interest rate reductions over the next 12 months. Most of the economists who met Reserve Bank of India Governor Shaktikanta Das earlier this month spoke about the weakness in aggregate demand.

There are three complications. First, the February rate cut call was a close one, with two out of the six Monetary Policy Committee members voting against it. Second, core inflation has been persistently high despite the economic slowdown, and some economists argue that the headline will eventually rise to meet the core rather than the other way around. Third, there are limits to monetary easing when fiscal policy is already in expansionary mode.

The RBI governor has some other concerns besides the level of policy interest rates.

Actual bank lending rates have not responded to the February rate cut. Some bankers even predict, in private, that lending rates will go up rather than down in the coming months. Why? The record fiscal borrowing programme of the government, combined with a revival in bank lending will put upward pressure on interest rates given the financial resources available in the system. Bank credit growth is running ahead of bank deposit growth.

The Indian central bank has been expanding its balance sheet to create durable liquidity in the money market. The initial focus was on bond buying through open market operations, since foreign exchange inflows were weak till recently. The revival of foreign exchange inflows over the past few weeks gives RBI space to also buy dollars to create domestic liquidity. The $5 billion swap—where the central bank will give banks rupees in exchange for the dollars they bring in—is nothing but an attempt to boost domestic liquidity. This swap is similar to the one announced in 2013 to defend the rupee. The difference this time is that there is no macro stress on the horizon.

Much of the action has till now been restricted to the short end of the money market. The Indian central bank has been less successful in dealing with yields on bonds with longer maturity. The problem is that the heavy borrowing by the government, combined with a revival in bank credit growth, is putting upward pressure on interest rates despite the anticipated reductions in policy rates. The domestic yield curve has been steepening because of what one economist described to me as “fiscal fatigue" in the markets.

One option right now is to borrow a trick from the US Federal Reserve—Operation Twist, named after the dancing style that was all the rage in the years after World War II. There have been two famous instances when the US central bank “twisted" a steep yield curve through clever money market operations, first in 1961 and then in 2011. In each case, the Fed changed the relative amounts of short-term and long-term securities in the market. How? It sold the short-term treasuries it had and used the proceeds to buy long-term securities. The result was that short-term interest rates went up while long-term interest rates came down. The yield curve flattened.

Economists have been torn between two camps over the success of the first Operation Twist. In a paper published in February 2011, Eric Swanson of the Federal Reserve Bank of San Francisco argued that the 1961 operation had a statistically significant effect on long-term bond yields once high frequency rather than quarterly data was used. His delightfully titled paper, Let’s Twist Again: A High-Frequency Event-Study Analysis Of Operation Twist And Its ImplicationsFor QE2 (https://bit.ly/2UVs74T), was one piece of empirical evidence used to justify the second Operation Twist launched six months later. The RBI is doing a form of quantitative easing by expanding its balance sheet. The yield curve remains steep. Is it time for its own version of Operation Twist?

Niranjan Rajadhyaksha is research director and senior fellow at IDFC institute. Read Niranjan’s previous Mint columns

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