Operation Twist hasn’t quite produced expected outcomes but will RBI’s latest attempt buck previous trend?

  • By buying long-term bonds, the RBI increases the demand for them, which raises bond prices but lowers the yield or interest rate

  • Liquidity is not an issue, there is plenty of it. But policy rate cuts haven’t improved transmission or lowered interest rates on loans

  • In the first two operations, the RBI bought Rs 20,000 crore of long-dated securities, but sold only Rs 15,391 crore of short-dated ones

The Reserve Bank of India’s (RBI) ‘Operation Twist’ does not, in fact, draw its name from the Chubby Checker cover that was the craze in 1960, but from a card game called pontoon: the UK version of a game we all know as ‘Twenty One’, and very similar to blackjack.

You can ‘stand’ – keep the cards you are holding – or ‘twist’ – draw another card to get as close to 21 as possible. The RBI is dealing and the market is playing to change the portfolio composition of government securities (G-Secs) that banks hold.

Until recently, the central bank believed it held a ‘strong’ hand. But five successive policy rate cuts totalling 135 basis points (a basis point is one-hundredth of a percentage point) weren’t able to appreciably reduce interest rates, increase demand for loans, or encourage and incentivise bank lending. Thus ‘Operation Twist’, to try and achieve that objective.

 Operation Twist hasn’t quite produced expected outcomes but will RBI’s latest attempt buck previous trend?

File image of RBI. AFP

The central bank is buying long-dated securities – 10-year G-Secs or bonds – and selling the same amount in 1 to 5-year G-Secs from its portfolio. In other words, the RBI is trying to flatten the yield curve. The first two ‘operations’ succeeded, lowering the 10-year yield (yield = return) to 6.45 from 6.8 percent, and raising the short-end from 5.2 to 5.35 percent. But there’s more to it than that.

Before we go there, a brief review of the RBI’s logic, for context. The difference or spread between the short-term or one-year yield (for the 364-day Treasury bill, or T-bill) and the 10-year G-Sec rate is almost 1.5 percent or over. That’s too much.

(The yield-curve [yield is the market price of a bond divided by the face value, which is usually Rs 1,000, multiplied by the interest rate on the bond] from 1-year to 10-year G-Secs is upwardly sloping; in the current state of the economy that curve is steeper than it should be.)

By buying long-term bonds, the RBI increases the demand for them, which raises bond prices but lowers the yield or interest rate. Lower interest rates mean lower cost of long-term borrowing for most, including the government. By selling shorter-term securities, the RBI reduces their prices but increases the yield or interest rate for buyers (mostly banks).

Operation Twist has a range of consequences, though. Banks benefit, too. By lowering long-term interest rates, the banks’ return on their government bonds portfolios will go up; unanticipated increases in market interest rates will not lead to higher provisions for losses when bond investments are marked to market.

Second, the banks’ non-performing assets (NPAs) continue to grow and dent incomes. The divergence between the RBI’s asset quality review (AQR) and banks’ own assessments indicates that additional provisioning may be necessary; perhaps additional capital – which is scarce – may be needed. A successful ‘Operation Twist’ could mitigate that additional need. Past experience, however, shows that success can be a mixed blessing.

The lessons of history

Operation Twist was first tried in 1961; newly elected US President John F Kennedy asked the then Federal Reserve Board (the Fed) Chairman, William McChesney Martin, for monetary policy action that would pull the US out of a recession it had been in since 1959. Martin raised short-term rates, and brought the recession to an end.

But the yield curve did not flatten, or bring long-term rates down for four years. Even then, some economists argued that the flatter yield curve was the result of a growing economy, rather than the Fed’s policy action.

Eric Swanson, an economist at the Federal Reserve Bank of San Francisco, found that the interest rates on 10-year Treasury bonds fell by just 15 basis points; the impact on mortgages was smaller, and that on corporate debt, negligible. Operation Twist officially ended in 1965.

In September 2011, the Fed tried Operation Twist again (also known as QE3, the third round of quantitative easing) as the continuing monetary policy to mitigate the effects of the 2009 global financial crisis. Fed Chairman Ben Bernanke announced that Operation Twist would use $400 billion.

QE3 shifted that focus of the Fed’s policy actions from repairing the damage of the sub-prime mortgage crisis to supporting lending in general. It sought to move lenders and investors away from very safe Treasuries towards higher-return, higher risk loans.

In June 2012 – nine months after the announcement – the yield on 10-year Treasury bonds fell to their lowest level in 200 years (the Fed funds rate, the equivalent of India’s repo rate, was zero percent). So yes, it acted faster than in 1961. But it did not revive the economy adequately; unemployment did not come down, and business confidence did not rise. This version of Operation Twist ended in December 2012.

Will it work now for India?

In August 2013, India tried a variation of Operation Twist too. The objective was the same: lowering long-term rates while keeping short-term rates high enough. It sold Rs 22,000 crore of short-term cash-management bills (CMBs) on 19-20 August (Monday/Tuesday), and bought back Rs 8,000 crore of long-dated securities on 23 August (Friday), for example.

Yes, long-term rates did decline, but the overall rate conditions were complicated at that time; the yield curve was inverted, liquidity was tight, and many rates were higher than 10-year bond rates (CMBs, for example, were at 12.25 percent!). Whether it was a success is kind of unclear. But it raises several questions.

First, what will the latest version, currently underway, deliver? Liquidity is not an issue, there is plenty of it. But policy rate cuts haven’t improved transmission or lowered interest rates on loans. The transmission has always been slower than expected; the financial system’s structure and efficiency may be the problem.

Second, how much borrowing is priced on the basis of the 10-year bond, really? Most retail lending – even mortgages – is priced by rough estimation, rather than a matter of finely tuned formulae. Divergence on NPAs clearly shows that the banks’ internal credit ratings methods that pricing is mostly herd behaviour; differentials for similar loans between two banks are virtually non-existent.

Third, how big will Operation Twist be? Recall that the US Fed operation was $400 billion, or 1.7 percent of Gross Domestic Product (GDP). For India, that scale is unimaginable. It means selling Rs 2,50,000 crore of short-dated G-Secs, which the RBI may not have.

Here’s an informed guesstimate. Consider that of the Rs 58.88 lakh crore of outstanding government debt in dated securities at end-September 2019, the RBI holds 15 percent. Of the total outstanding of Rs 13.92 lakh crore of 1 to 5-year maturity, the RBI probably holds about Rs 2.08 lakh crore; how much of that can the RBI put out? Not enough. In the first two ‘operations’ the RBI bought Rs 20,000 crore of long-dated securities, but sold only Rs 15,391 crore of short-dated ones.

Fourth, does the RBI have the luxury of time? Perceptible impact may take a long time; waiting for three or four years for the economy to react is unaffordable. Operation Twist then becomes ineffective.

Thus far, we don’t know enough. Maybe, as a money market analyst and economist suggested, the RBI knows more than it’s telling: the government could breach the fiscal deficit target, and the RBI is acting pre-emptively to bring rates. Or maybe there’s a twist in the tale that we don’t know anything about yet.

(The writer is a former journalist and communications consultant)

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Updated Date: Jan 06, 2020 12:12:24 IST