Operation Twist

The Central Bank announced that it will conduct simultaneous sale and purchase of ?10,000 crore of government securities of varying tenor. This move is on the lines of US Federal Reserve’s Operation Twist

• The Reserve Bank of India (RBI) announced simultaneous sale and purchase of government bonds. RBI will sell short-term bonds of ?10,000 crore, it will also purchase long-term securities of the same value.
• Operation Twist of United States: RBI’s move resembles the 2011 Operation Twist of the US Federal Reserve Bank. It was intended to make long-term borrowing cheaper and spur bank lending. The Fed had swapped short-term bonds for longer-term debt.
• Difference with the US version: US version of the Operation Twist had started mid-2011 and lasted till late-2012. In case of RBI it is not clear if this is a one-time exercise or part of continuing operations.
• Aim: The hope is that with yields coming down, banks will cut lending rates given that lending to the government is deemed to be the safest, and if that comes down, so should the remaining rates as well.

How does Operation Twist get its name?

• The US Federal Reserve was the first central bank that attempted such an exercise of buying and selling government securities at the same time. This happened in 1961.
• At that time, the “twist" was a new dance craze sparked by singer Chubby Checker. Since then the name for such an exercise carried out by a central bank has stuck.
• Used as a measure in the financial crisis: Much later, Operation Twist was tried in the US in the aftermath of the financial crisis. In this case, the Federal Reserve purchased government securities with maturities varying from six years to 30 years and sold government securities with maturities of three years or less.
• The idea is to twist the yield curve: The yield curve is a graph that plots the yields of government securities (or other financial securities) of different maturities.
  • The yield is the per-year return an investor can earn on a financial security by staying invested in it till maturity.
  • When a central bank buys government securities, the prices go up. At a higher price, the yields or the returns come down as the interest paid on the securities stays the same.
  • Vice versa, when the bank sells government securities, the prices fall and the return or the yield on the security goes up.
  • This creates a visual effect of a twist in the yield curve.

Why did long term yields increase?

• No response to monetary easing: Over the past few months, long-term bonds failed to respond to RBI monetary easing. In fact, the long term 10-year premium widened against the repo rate to 140-150 basis points (bps).
• Widening yield gap: While the term premium for long term bonds touched around 150 bps, the short term yields had fallen below RBI’s benchmark repo rate of 5.15%, making the yield curve steeper.
• Fears of fiscal slippage: There have been fears of fiscal slippage. There are concerns that the government’s borrowing programme will be exceeded because there are problems on the fiscal side; i.e. it might borrow more to meet its fiscal deficit target.
• Pause on rate cuts: After lowering its repo rate by 135bps in five consecutive rate cuts in 2019, the central bank’s monetary policy committee (MPC) decided to keep rates on hold for the meanwhile.
  • The MPC wants to wait for further government measures in the forthcoming budget and take a note of the effects of future policy actions before taking a decision to cut rates.

Benefits of RBI’s Operation Twist

• Yield anomaly corrected: With RBI’s Operation Twist the net liquidity in the system will remain unchanged, but the anomaly between the yields of short and long-term bonds will be corrected.
  • As RBI will buy long-term bonds, its demand will go up and yields will go down and the opposite will happen when it sells bonds.
  • Through this, the central bank is narrowing out the differential between the short- and long-term yields, and will flatten the yield curve.
• Spur private borrowing: The simultaneous sale and purchase of government bonds may aid governments borrowing plan by making it cheaper. It is expected to dampen term premium to stimulate private sector borrowing.
  • With the long-term yields coming down, government will be able to borrow money cheaper against its bonds, as well as induce demand for private sector loans.

Will money supply increase because of RBI’s move?

• If the central bank buys government securities a few times, it will increase the money supply in the economy, which is likely to lead to higher inflation, with a greater amount of money chasing the same amount of goods and services.
• But by selling securities worth a similar amount, RBI will not end up increasing the money supply because of this operation.

How can this be made to have an effective impact?

• A one-off operation will not help: The idea is to drive down the yields on 10-year government securities. This can happen if the government continues with Operation Twist. A one-off operation will not help and yields will climb back soon.