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Forex accumulation by the RBI has tended to move in tandem with net capital inflows into the Indian economy. Photo: Aniruddha Chowdhury/Mint
Forex accumulation by the RBI has tended to move in tandem with net capital inflows into the Indian economy. Photo: Aniruddha Chowdhury/Mint

Decoding Operation Twist – the act of RBI during covid-19

  • Whether it's the pandemic induced global crisis, the fiscal cliff, or regulations, businesses are not willing to hire until they are sure the demand will be there

The Reserve Bank of India conducted several simultaneous sales and purchases of government securities under open market operations since March. The actions were taken following a review of current and evolving liquidity and market conditions induced by covid-19 pandemic. RBI’s simultaneous sales and purchases of government securities, termed 'Operation Twist’ is a way to manage yields in the market. Operation Twist is a program of quantitative easing used by the RBI that was first introduced by the Federal Reserves in US in 1961.

Why Twist?

The idea is that by purchasing longer-term bonds, the RBI can help drive the bond prices up and yields down (since prices and yields move in opposite directions). At the same time, selling shorter-term bonds should cause their yields to go up (since their prices would fall). In combination, these two actions twist the shape of the yield curve.

Operation Twist is designed to induce downward pressure on longer-term interest rates by lowering long-term Treasury yields. The central bank buys long-term notes with the proceeds from short-term bills. This increases demand for Treasury notes. Just like any other assets, as demand rises, so does the price. But higher bond prices are offset by a lower yield for investors.

Why Does the RBI Want Lower Long-Term Interest Rates?

Lower longer-term yields help boost the economy by making loans less expensive for those looking to buy homes, purchase cars, and finance projects, while saving becomes less desirable because it doesn't pay as much interest.

Rationale behind Operation Twist

With the declining economic conditions in India, the RBI wants to lower the long-term interest rates to stimulate the weak economy. However, the present, short-term rates are very low (in some cases it had moved below RBI’s reverse repo rate of 3.5%, which the market considers as an operative policy rate) as a surplus of liquidity has been chasing shorter-dated assets. Thus, the prevailing uncertainty and cross-border yield differentials increases the likelihood of arbitrageurs to convert domestic currency to gold and/or invest in high-yield and lucrative assets outside India. This results in outflow of gold and domestic currency from India to other attractive global markets. A proposed solution to check the outflow of Indian currency is to try to increase the short-term yields, while lowering the longer-term interest rates. The reason being that business investment and housing demand are primarily determined by longer-term interest rates, while cross-currency arbitrage is primarily determined by short-term interest rate differentials across countries. Therefore, if longer-term interest rates could be lowered without affecting short-term yields, the declining economy can be stimulated without worsening the outflow of gold and domestic currency. This justifies the motive behind the RBI’s worthwhile use of ‘Operation Twist’ mechanism to push up shorter-term interest rates, while pushing down long-term rates. Under Operation Twist, RBI conducted a bond-swapping programme under open market operations (OMOs). The central bank engaged in OMO sales to drain liquidity in the financial system and OMO purchases to infuse liquidity.

Estimating the long term effects of Operation Twist

The RBI has so far carried out three rounds of simultaneous bond buy-and-sell via open market operations. The two key concerns of the present economy are inflation and employment.

Inflation: The upside risk of inflation is largely contained by monetary policy permit. More concerning will be falling prices that would lead to a period of debt deflation. As opposed to this, we do see that the inflation is expected to remain constant or marginally rise over the forecasted months.

Employment: The worrying unemployment rates are due to two factors--cyclical unemployment and structural unemployment. Cyclical unemployment is caused by the covid-19 induced uncertainty, triggering a recessionary phase of the business cycle. Structural unemployment is what happens when the long-term unemployed lose the skills needed to compete in the job market. However, we see that the unemployment rates will fall as the central and the state governments relax the lockdown terms and with adequate medical interventions setting in the coming months. Further, declining covid-19 related death rates will add to the recovery of the economic downturn.

Operation Twist, or any other RBI program, can't do much to reduce unemployment because liquidity is not the problem. In other words, there is little that expansionary monetary policy can do to spur the economy. The problem is low confidence among business leaders. Whether it's the pandemic induced global crisis, the fiscal cliff, or regulations, businesses are not willing to hire until they are sure the demand will be there. The solution must come from joint efforts of the central government and the state policies, rather than any individual industry segment or a concern.

(Anandadeep Mandal is assistant professor, University of Birmingham, UK, and Neelam Rani associate professor, Indian Institute of Management Shillong, India. Views are personal and do not reflect Mints' editors)

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