Quantitative Easing, RBI Style

Is it a bird? Is it a plane? No, that's Jonty Rhodes!

That is how the commentators reacted to South African cricketer Rhodes’ flash fielding as he sent Pakistan's Inzamam-ul-Haq back to the pavilion at a 1992 World Cup match at the Gabba.

Market commentators are looking at the Reserve Bank of India’s (RBI’s) latest action in the same way. The central bank is going for simultaneous purchase and sale of government securities under the so-called open market operations (OMO) today. It will sell four short-term treasury bills maturing between June 2020 and April 2021 and buy four dated securities, of six, eight, nine and 10 years, for a similar amount.

Is it a switch? Or a twist? Is it monetisation in spirit but not in letter? 

Let’s call it the Indian version of quantitative easing.

What purpose does it serve? Why can’t the RBI buy the dated securities directly instead of going for this two-step operation – first buy the short-term treasury bills and, in the next stage, exchange them with dated securities?

Theoretically, quantitative easing is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market to increase money supply and encourage lending and investment.

This is the fourth round of special OMO -- or simultaneous sale and purchase of securities -- that the RBI had launched on December 23, 2019. At that time, the media had dubbed it "Operation Twist".

That term was first used on a dance floor. Chubby Checker, an American rock 'n roll singer, popularised it in the early 1960s by twisting his feet while dancing. In fact, in September 2008, "The Twist" topped Billboard’s list of the most popular singles to have appeared among the Hot 100 since its debut in 1958.

The US Federal Reserve resorted to "Operation Twist" between 2011 and 2012 to bring down long-term interest rates. The Fed first sold short-term securities and in the second stage, bought long-term bonds.

The first round of such an OMO in December 2019 saw the RBI selling short-term treasury bills up to one year worth Rs10,000 crore and buying long-term securities, up to 10 years, of the same value.

What is the logic behind this move?

By resorting to the two-step OMOs, the RBI is managing the yield at both the shorter end as well as the longer end. While it buys the treasury bills, the short-term yield drops. Similarly, the buying of dated securities influences the long-term yields. Immediately after it announced this special OMO last Friday, the yield of 10-year paper dropped around 15 basis points (or bps; one bps is a hundredth of a percentage point).

By bringing down the yield, the RBI helps pare the cost of government borrowing. The government’s gross market borrowing in the current financial year is pegged at Rs7.8 trillion; of this, Rs4.88 trillion or close 63 per cent, is slated to be raised in the first half of the year, between April and September.

As the fiscal deficit is set to go up because of the impact of Covid-19 on the economy, the borrowing will be higher for sure.

But it is not the government alone that gains from RBI's move. Banks too will reap the benefit. As the bond yield goes down, they make profits trading in government papers. The yields and prices of bonds move in opposite directions.

Besides, the southward move of the yield shields the banks’ bond portfolio from the so-called mark to market or MTM losses. MTM is an accounting practice of valuing an asset (in this case, the bonds) at the prevalent market price and not the price at which it is bought. So, if the bond yield rises (and prices go down), the banks are required to book MTM losses.

I would imagine such OMOs – the Indian version of quantitative easing – are here to stay. The RBI might continue to buy treasury bills first and then exchange part of them with dated securities. It has probably bought around Rs50,000 crore worth of treasury bills so far.

Every round of buying will release money to the banking system (as the banks are selling securities) and the banks will use that money to buy new securities to see through the government borrowing programme. This will continue till the banks get their risk appetite back and return to the credit market. At some point, this will happen. Till such time, the RBI will continue to rotate its treasury bill and bond buying.

The management of the yield of government securities this way is not new. Other central banks too have been doing this to manage yield and create liquidity. The Australian central bank does this for securities up to three-year maturity and the Bank of Japan manages the yield of bonds of up to 10-year maturity.

However, there is one difference between the RBI and other central banks. Most central banks globally announce the quantum of such operations upfront, preparing the market for it with their forward guidance. The RBI has refrained from doing so.

While the market keeps on guessing the time and quantum of the OMOs, the central bank enjoys the flexibility. It can always plan its next move looking at the bond yields, the liquidity in the system and the banks’ risk aversion.

Since he took over as RBI governor, Shaktikanta Das has been experimenting with different instruments. He broke away from the convention of sticking to the metric of 25 bps for a rate cut and then followed it up with “switches”, “twists” and even a smart rate cut without involving the Monetary Policy Committee.

The biggest challenge before him is bringing banks back to the credit market. Last Thursday, the banking system parked Rs7.21 trillion at the RBI’s reverse repo window. As the banks have cut their deposit rates drastically, they are fine with a risk-free 3.75 per cent return from the central bank.

Whether we accept it or not, most Indian banks have become “narrow” banks at this point – happy buying government securities. They do not have the appetite for credit. Das needs to find ways to excite them to lend.

The writer, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd.

Twitter: TamalBandyo  

This column first appeared in Business Standard

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