OPERATION TWIST

Since the last couple of weeks, a seemingly clandestine code name
“Operation Twist” has been trending everywhere, from the Internet to the
business pages of newspapers and magazines. Well, this is no covert mission
of the Indian Army, but a tool being used by the Reserve Bank of India to
stimulate the bond market.
Originally, Operation Twist was the name given to a monetary policy
tool by the US Federal Reserve which involves simultaneous buying and
selling of government securities through open market operations (OMOs). It
was first used in 1961 in the US, when the economy was recovering from
recession post the Korean War, to strengthen the US dollar and hike liquidity
in the economy. In order to boost spending, the Federal Open Market
Committee (FOMC) tried to flatten the yield curve, which would reduce the
excess compensation that bondholders would earn for the added risk of
holding bonds for a longer tenure. Another instance of Operation Twist was
seen in 2012 when it was used by the US Fed to revive the weak economy.
The policy was so effective that it reduced the yield on a 10-year treasury to
a 200 year low.
The term yield is used to describe the amount of interest or dividend
earned on a particular investment over a particular period of time. Another
pertinent term is the Yield Curve. It is the graphical representation of
interest rates on debt instruments of different maturities. It shows the yield
that the investor can expect to earn by lending money for different periods
of time. Traditionally, yield curves have been upward sloping, indicating
higher return on longer term securities, due to the higher risk involved, by
locking in the investment for a longer period of time.
Operation Twist basically targets changing the shape of the yield curve by
synchronous buying and selling of Government bonds. The policy has got its name from the way it twists the upward sloping yield curve i.e. short term
yield rises, while long term yield falls simultaneously.
On the same lines, recently the Reserve Bank of India bought 10-year
government securities worth Rs.10000 crores and sold four shorter-term
government bonds worth Rs.6825 crores in the first tranche. In the second
tranche, it bought Rs. 10000 crores of G-Secs and sold Rs. 8501 crores of
shorter-term bonds. The RBI has once again decided to undertake the third
tranche of the operation on January 6th, 2020. However, one question is
pertinent here. Why did the RBI have to undertake such a step?
Well, this measure was taken in the wake of the inability of the RBI to
revive the economy by reducing the Repo Rate. Although the Repo Rate has
been reduced by 135 basis points till now since February 2019, the
transmission has been dismal and banks have reported a decline of just
40-45 basis points in their weighted average lending rates. The reduced repo
rate is not translating into reduced lending rates by banks because the Repo
Rate is the rate at which banks receive short term funds from the RBI. Thus a
reduction in the Repo Rate might lead to a fall in the interest rates on the
short term loans, but when the banks need to lend money for long periods
like 10, 20 years, they will be more prudent and unwilling to reduce interest
rates, especially considering the increasing NPA problem with the Indian
banks.
Even the compulsory linking of bank lending rates to an External
Benchmark, like the Repo Rate did not lead to the furtherance of the RBI’s
objectives. Moreover, a reduction in the Repo Rate will only reduce short
term interest rates. However, to boost the economy, investments in long
term, fixed assets need to be increased. Another reason was the increasing
public concern over fiscal slippages and rising inflation, which lead to an
increase in the 10-year G-Sec yields to a high of 6.8%. This has an impact on
bank lending rates as well. If the 10-year G-Sec yield rises, the banks
increase their lending rates, which hurts retail borrowers.
A cumulative effect of all these reasons was the recent measure taken
by the RBI, due to which the long term interest rate fell from 6.8% to 6.57%.
This leads to flattening of the yield curve and induces people to buy more
and more fixed assets such as houses, automobiles etc.
One might argue that with the already increasing inflation, the RBI buying
Rs. 10,000 crores of Government Bonds would further lead to increased
inflation, as it would print money to buy these bonds. This is where another
‘twist’ in the tale comes up! In an attempt to reduce the inflationary
tendency of the action and to remove extra liquidity from the system, the
RBI sold short term G-Secs.
However, according to some economists, the measure is not free from
its loopholes. It could demotivate foreign investment. It may increase the
interest rates for short term loans that hurts the profitability of financial
institutions that want to make short term investment of one to five years.
The alternative to this measure could be that RBI must promote banks
to find out methods to reduce interest rates. It should strive to increase
competition among banks to promote financial inclusion and will help boost
the economy, by offering competitive lending rates to the retail borrowers.

By Shreya Raj