BackRBI’s 'Operation Twist' to play with yields
The central bank’s planned special open market operation involving the simultaneous purchase and sale of securities seems largely aimed at lowering borrowing costs for the government, but the question is whether it is worth distorting market interest rates.
PremiumThe Reserve Bank of India (RBI) is set to conduct the simultaneous sale and purchase of government securities for the second time in two months. In the first week of July, it conducted special open market operations (OMO) by purchasing ₹10,000cr worth of long-term government bonds and selling equivalent amount of short-term bonds (182 days). Now, it proposes to conduct a similar operation, only twice the earlier size, over the next couple of weeks. It will purchase securities with tenures between 4 and 12 years, and sell short-term securities maturing in October and November.
The rationale behind these open market operations is to boost the short-term rates of return and lower the long-term rates of return to essentially flatten the yield curve. RBI succeeded in achieving its objective last time and most probably will succeed again. The last such operation also led to new bond issues from corporates as borrowing costs had fallen. Despite these effects, the important question is: are such interventions in the financial markets desirable?
The yield curve for government debt represents the valuation by investors of securities with different maturities. It reflects their valuation of income streams at different points of time after factoring in inflation expectations and the time path of government spending. If investors expect higher inflation in the future or increased government spending over time or both, then long-term rates will be higher than short-term rates. The higher long-term rates become essential to compensate for the expected loss of purchasing power on account of a rise in prices and to finance increased borrowing from the government. Given this, the current higher rates of return on long-term bonds seem to be in line with the economic fundamentals. The recently released consumer expectations survey by RBI suggests that consumers expect an increase in inflation over a one-year period. Government spending is definitely expected to increase substantially to counter the effects of the pandemic and the lockdown on economic activity. Therefore, even if RBI succeeds in flattening the yield curve, it will do so by ignoring the underlying factors driving the time value of money and distorting financial decisions.
In the first place, why is there a need to engage in such special OMOs? Primarily to soak up the surplus liquidity created by an accommodative monetary policy on the one hand and weak demand for borrowings on the other. In addition to subsequent cuts to the policy rate—the repo rate—there was a further reduction in the reverse repo rate, making the policy interest rate corridor asymmetric. The reverse repo rate represents the rate at which banks can park their funds with RBI. A reduction in this rate while keeping the policy rate and the penalty rate constant has incentivized banks to move their funds out of RBI and lend in the short-term market. This reduced the rates of return on various short-term securities, making the overall yield curve steeper. Operation twist seems to be aimed at reversing this situation and making long-term borrowing relatively cheaper primarily for the government.
The evidence of the real effects of such quantitative easing exercises is mixed at best. Such policies were followed by central banks in many developed countries in the aftermath of the 2007 financial crisis and ended up changing the slopes of their respective yield curves, but their success in terms of stimulating the real economy has been limited and circumspect. On the contrary, the tremendous liquidity injections in the post-financial crisis period saw the cheaply available money being used for speculation in oil markets. Some economists argued that the resulting oil price shock may have actually prolonged the Great Recession.
Another reason suggested for such open market operations is to improve the transmission of monetary policy. However, the limited transmission highlights the underlying economic constraints that prevent banks from reducing their lending rates following a repo rate cut. Unless those conditions change, any effort at boosting liquidity might have more unintended consequences. Perhaps it might be better to increase the reverse repo rate back to its pre-pandemic level, putting back the control of monetary policy more firmly in the hands of the monetary policy committee. Otherwise, the only thing that operation twist might end up doing is soaking up short-term liquidity that it unleashed in the first place, but it will do so by distorting interest rates and hence intertemporal incentives.
The author is associate professor of economics, School of Liberal Studies, Ambedkar University Delhi
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