It was the 1960s, a period of a plethora of complex cultural and political evolutions, including the recovery during the recession from the post-Korean war in the United States of America, when it witnessed a new dance trend, called ‘twist’, sparked by singer Chubby Checker. Probably taking inspiration for a name from this new dance craze, the US Federal Reserve announced an ‘Operation Twist’. Years later in 2011, it implemented the same monetary policing exercise in light of the financial crisis the country was facing. Now, the Reserve Bank of India seems to have followed in the footsteps of the US Central Bank, to deal with our own dooming economy.
Now, what is ‘Operation Twist’ you ask? It’s the practice of buying and selling of short-term and long-term government securities (G-secs) through Open Market Operations (OMOs) by the Central Bank to lower or raise the yields on such securities. To really understand what this ‘twist’ is all about, learning about the basics is of paramount importance. In a layman’s language, government securities are nothing but the money the government pays to the lenders as a guarantee of repayment of the principal amount with an interest on the same. This interest is ‘yield’ on that particular security. This practice basically aims to change the shape of the yield curve, from steeper to flatter. How it does that is essential but knowing the backstory is even more essential.
The Backstory: Let’s rewind a bit. The Indian economy has been going through a rough phase for most of this financial year and I am sure this is not a new piece of news to anybody anymore. With the huge NBFC crisis leading to a shocking decline in auto sales, real estate halt in growth and infrastructural revenue fall, the demand in the economy has been stagnated to an indefinite extent. A fall in aggregate demand is disastrous for any economy because that means people are not demanding and investing, which means a fall in the overall economic growth of the country. The Central Bank has tried to do all sorts of things to get people to invest and demand, however, there hasn’t been much improvement. The reason behind this is that most consumer loans have longer repayment periods, for instance, loans for cars, houses and the like, and thus banks have not been willing to lower the interest rates while they’re more than happy to lower the interest rates on short-term loans owing to the feeling of security they would feel. According to a report, yields in the short term fell below the benchmark repo rate of 5.15% and those in long term touched 150 base points. The yield curve had, as a result, turned way steeper, and hence the RBI decided to ‘twist’ in order to correct it. This corrective action brought the yields and the repo rate closer to each other.
The Mechanism: Now that we’ve understood where the problem was, let’s understand how ‘Operation Twist’ works. On 23rd December 2019, the RBI purchased long-term G-secs worth 10,000 crore rupees and sold short-term securities of 6,825 crore rupees. Selling short-term securities will raise the yield on them as now there’s less money in the hands of investors whereas buying of long-term securities will lower the yield on them. Now when investors will get a lower yield on these securities, why wouldn’t they go ahead and look for other alternatives? Why wouldn’t they probably approach banks and invest their money there? As a result, banks now will feel no need to lure customers in and hence would lower the interest rates. This will spur the economy again owing to an increase in aggregate demand and investment and a rise in the money supply.
Furthermore, lower long-term rates will bring down the Government’s cost of borrowing. All of this is precisely what the RBI achieves to do- stimulate demand to wake the economy up.
The Result: Ever since the RBI implemented this, good results have been pouring in. Already reports tell that the yield on long-term G-secs has fallen by 15 base points, to 6.16% and that on short-term ones has risen by 5 base points. On 30th December 2019, just a week after the first round, the RBI implemented the second round of OMOs, again purchasing more than it sold. The idea behind this must be to not suck the liquidity out of an already suffering economy.
These certainly might not be the last rounds of OMOs the RBI undertakes. Just like every good thing has latent defects, this monetary tool might be having some of its own too. Some argue that the month of November saw inflationary tendencies rise up, with the rate of inflation sliding up from 4.62% to 5.26%. For buying these securities, the RBI had to print a lot of money, money that will eventually end up in the market, leading to even more inflation.
However, I personally believe that the RBI ended up taking this crucial step after much deliberation and as a last resort. When nothing works, you have to take huge and difficult steps to get things going. Everything has its pros and cons and Operation Twist, doubtlessly, will help in ‘twisting’ the yield curve and save the economy. While up until now only 2 rounds of this tool have been completed, there’s no guarantee that the RBI won’t announce more of these and thus only time can tell accurately the fruits these decisions will bear.