RBI's Operation Twist: How is it reviving the Indian Economy?

18 Jan 2020 Read 278 Views

When 'Operation Twist' started trending on social media one fine evening, people were somewhat confused if it is some covert operation by armed forces. There was incomplete information and misinformation doing rounds until financial news handles came up and explained.

Reserve Bank of India announced the 'Operation Twist.' The plan seemed simple at press conferences but much complicated when one tries to understand this. This piece is to make this understanding simpler.

The Economic Scenario

The current times are not cheering. There is a slowdown, unemployment at 45 years high, GDP at 13-year low and so on. The growth and hopes seem to fade. Demonetization hit badly on consumer demand and a shoddy GST system has aggravated the supply-side woes.

To boost the economic activities in such time, RBI lowered the repo rate. Repo rate is the rate at which banks can borrow from RBI. RBI assumed that with reduced repo rate, banks would borrow more.

Since borrowing is cheap, banks would lend this money to consumers at a cheaper rate. Ultimately, the retail and commercial loans would get cheaper and people would start buying more goods.

However, rising bad loans, high credit-to-deposit ratio failed this idea. Due to reduced economic activity, savings have fallen and hence, the deposits are falling. Consequently, banks are in the lurch.

Despite RBI reducing the repo rate of about 1.55 percentage points, banks did not reduce the interest rate. Even mandatory linking to an external benchmark, like government security, was in vain.

The Bonds

Before we head further to Operation Twist, it is important to understand the basics of the bond market. When the government or corporation wants to borrow money, they issue bonds. These bonds have some interest rate called a coupon rate. The return one gets on holding the bond is called as ‘Yield’ of the bond. Yield is defined as:

Since the coupon rate is predefined, an increase in bond prices reduces the yield, while a decrease in bond prices improves the yield.

Now, another relation is between the Yield and Interest rate. Suppose you have a bond of ₹100. This bond has a coupon rate of 8%, meaning that you get ₹8 every year as a coupon. Now, what would happen if banks increase the interest rates to 10%? In that case, you would want to get rid of the bond; and make a Fixed Deposit in the bank because it offers a higher interest rate than your bond coupon rate.

 Even people might not be very willing to buy the bond you have. This means the demand for your bond will go down. It means that the bond prices would fall. It also means that the Yield of your bond would go up.

In another scenario, if the interest rate falls down to 6%, people would want to have the bond that you possess, because it offers higher returns. The demand for your bond would increase. The price would increase. This means that the Yield of the bond would go low.

Concluding this, we should boil down to the following correlations.

The Time to Maturity

Any investment held for the long term needs to have better returns than the short-term. This is because it might be certain of what is going to happen in 2 weeks, but no certainty about conditions in the next 10 years. 

Why would one invest at the same rate in the longer-term, if he gets the same returns in the short term? Hence, long-term earnings returns should always be more than the short term.

However, in an economic environment of despair, people start losing hope. Consequently, people are less attracted to long-term investments. Banks also charge high interest, seeing that long-term loans might be risky. 

For example, a builder will have to pay high interest on long-term loans because banks do not think many people are interested in buying homes in current times. They might lose their money.

High long-term interest rates are detrimental because they push up the cost of projects, making them expensive for (already unwilling) consumers. Long-term bonds are also not attractive at this time. Their prices are low. We have also seen that the high-interest rate pushes bond prices low.

When the economic environment is not hopeful of the future, just like the current Indian market, some efforts have to be made to cheer up spending and push economic activities. The only way to ensure is more money availability to people, like cheap loans.

When other plans of RBI fell flat, they planned to 'twist.'

The Twist Mechanism

US Federal Reserves coined ‘Operation Twist’ in 1961 in post-Korean war slowdown. Let us see what India did in the first week of January 2020, the fourth round of Operation Twist.

RBI sold short-term government bonds and it bought long-term bonds from the market. There is no significant difference in the value of bonds sold and bought. In the fourth round, it was targeted as ₹10000 crores, for both sale and purchase.

RBI sold short-term government bonds maturing in 2020, and it has bought government long-term (10-year) securities maturing in 2029.

The Twisting Effect

What would happen if the government buys long-term bonds worth ₹10000 crores? Since the demand for long-term bonds has pushed up, the bond price would start increasing (they were low until now).

Higher bond price means the 'Yield' on the bond starts falling. Falling 'Yield' implies that the incentive of holding the long-term bond is falling.

Who owns the biggest chunk of Government long-term bonds?’

The Banks! Due to CRR and SLR norms, they are bound to keep some amount as Government securities. Banks would sell their long-term bonds to the government since they would lose on yield if they held it for more time.

Instead, this money meant for the long term is now available to them. The way to earn better from this money is to lend it for the long term. Though no one was taking loans because rates are high, now banks have more capital to lend. They would reduce interest rates to attract long-term investors. This would not only boost earnings of the banks, cheaper long-term loans mean a boost in economic activity across infrastructure, construction and automobile-like long term sectors.

If you are worried about what will happen to short-term loans, here is the additional information. Theoretically, selling more short-term bonds indeed mean to fall in its price.

This means the 'yield' would increase and instead of lending, banks might buy the bonds and push the short-term interest rates further. However, we must understand that short-term loans are governed by RBI repo rates.

RBI has already made this capital available at cheaper rates. Therefore, market rates would be much in line with RBI repo rates.

Moreover, these bonds are supposed to mature in just 2020, so not much time left, and hence fluctuations will be minimal. (Explaining the Time effect on bonds is beyond the scope of this article)

Did it twist?

Absolutely. Although it is an early judgment effect that was visible the same day. In fact, the day RBI started the third round of 'Operation Twist,' the yield on 10-year Government Bond fell by 0.2 percentage points the same day! Its effect on interest rate is much awaited.

Unwinding the Twist

RBI has helped banks free up their long-term capital for boosting long-term investments. In a way, it asked banks to replace its long-term securities with short-term securities. RBI has enough money, and banks have enough means to continue facilitating short-term loans. Freeing up long-term loans was necessary so that banks may take up lending opportunities. Operation Twist has definitely been a ray of hope for the country on the verge of stagflation.

About the Author: Vivek Tiwari | 46 Posts

Vivek Tiwari is a Software Engineer and a Data Scientist who hopelessly fell for Economics. His plans to move to Finance might now save mankind from his IITJEE selection story.

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