Operation Twist is the new buzz word in the money market ever since the Reserve Bank of India (RBI) made an announcement for the simultaneous purchase and sale of government securities on 19 December of a similar amount of Rs 10,000 crore. The same has been replicated on 26 December and 2 January with the auctions to take place on the following Monday. What exactly is the game plan here?
An open market operation (OMO) is where the RBI buys and sells securities to infuse or absorb liquidity in the system. But when the RBI does the same on both sides, it is different when the amounts are the same which means that overall liquidity does not get influenced at all. But what is done is that the RBI is buying the benchmark 6.45 percent 2029 paper which is the 10 year one. On the other hand, it sells various papers in the 2020 bracket which is less than one year. Now what happens is that when the RBI buys 10 years paper, the demand for the same goes up leading to an increase in price or decline in yields. The same happens when it sells short-term paper which banks buy that, in turn, increases the yield as supply increases reducing thus the prices (in the fixed income market the yield moves in the opposite direction of prices).
Why is this being done? The idea is to lower the long-term yields to something more tuned to the RBI. At the time of the first simultaneous OMO announced, the 10-year yield was 6.75 percent and after the two rounds of Operation Twist has come down to 6.51 percent. Clearly the RBI is not satisfied and is going in for the third round too. It is also possible that this operation can continue until such time the yields come down to the level with which the RBI is satisfied. While the 2020 paper yields have not quite increased to the same extent, the overall differential has come down. The latest auction announced also involves 4 and 6 years paper purchase along with the 10 years paper.
At the theoretical level, such operations are influencing the yield curve which should reflect the differential in the tenures as well as move all rates down as the repo rate has been reduced by the RBI by 135 bps last year.
As the transmission to the market did not take place in the last policy when the repo rate was reduced in October, Operation Twist has been used to guide rates. It may be recollected that when the repo rate was reduced in the October policy, the 10-year yield was in the range of 6.70 percent; and the introduction of the new benchmark security of 6.45 percent 2029 paper did bring down the yields for a couple of weeks before they rose once again towards the 6.70 percent mark. This is why the RBI felt there was a requirement to do something different.
The first question is why were the yields behaving the way they did and not respond to the repo rate? The ‘market’ is the best judge of the state of the ‘financial markets’ and there is a feeling that the government will not be able to meet its fiscal target and that this would lead to higher market borrowings. Therefore, the 10-year yield which is the indicator of the entire market moved up even as the RBI lowered the interest rate at the repo window. A consequence of this intransigence in the market is that other interest rates tend to be sticky too and do not move down – which includes bank lending rates. Therefore, to simultaneously also improve the transmission of the repo rate changes to the marginal cost of funds based lending rate (MCLRs), it was necessary to do something different.
Will this work? So far Rs 20,000 crore of OMO twists have brought down the yield to 6.51 percent and the third announcement of Rs 10,000 crore on Thursday has moved the rate marginally down to 6.49 percent at 10.30 am on Friday, which gives an indication that there may not be too much of a variation till the auction day. In fact, when the first announcement was made on 19 December, the yield came down by 10 bps on Friday even before the auction.
Hence this third auction will hold the clue to whether the decline in 10 years yield has hit the right mark and will no more go down or whether there is any further scope for the RBI to continue with such operations.
The interesting thing about the Operation Twist is that the RBI becomes a decisive player in the market and moves rates without changing the overall liquidity in the system but altering the liquidity in specific securities. Last time, it must be pointed out that the sale transaction did not lead to all of them being accepted while the purchase was successful. This time the clue will be whether there is enough interest in the series of securities that are being used in this operation.
Last, why is the RBI interested in such an operation? As mentioned earlier, it appears to be aimed at flattening out the yield curve and reducing the spreads between different maturities. In the process, there will be gains for the government in case the market borrowing programme is increased as the cost will come down, which has been witnessed in its borrowing programme so far. And slippage in the fiscal deficit is given though the amount is uncertain. The choice for finance is the use of cash balances (zero cost), NSSF (higher cost) or market borrowings (hopefully at a lower cost).
(The writer is Chief Economist, CARE Ratings)
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Updated Date: Jan 03, 2020 12:09:21 IST