The RBI’s ‘operation twist’ – A sign of bigger measures to come, or a tweak to bandage the fiscal deficit?

If you’ve read financial dailies lately, it’s unlikely you’ve missed the term ’operation twist’, describing the RBI’s recent announcement that it will buy long-term Indian government bonds while selling short-term Indian government bonds through special open-market operations.

A little trivia

While the RBI didn’t officially come up with this name, the move reminded market observers of a similar policy move adopted by the US Fed back in 1961 (and later in 2011, under Fed Chair Ben Bernanke),  dubbed ‘operation twist’, apparently inspired by American songwriter Chubby Checker’s popular number, ‘The twist’. In the context, it may be tempting to imagine RBI Chairman Shaktikanta Das grooving to yesteryear-actor Mehmood’s ‘Aoo twist karein’ from the 1960s, but this ‘twist’ isn’t probably quite as entertaining.

What this is all about and the story so far

On 19 December 2019, the RBI announced that it would conduct special open-market operations, buying long-term government securities (G-Secs or government bonds) worth INR 10,000 crores while selling short-term G-Secs worth the same amount.

In essence, the RBI did not intend to infuse liquidity into the bond market, instead reallocating money from one part of the yield curve (absorbing liquidity at the shorter end by selling short-term bonds) to the other (adding liquidity at the longer end by buying long-term bonds). Effectively, it seemingly wanted to flatten the yield curve (reduce the gap between short-term and long-term yields), among other things. Not surprisingly, the RBI announced another round of the same a week later, on 26 December 2019, and yet another on 2 January 2020 (see details at the end of the post).

Interestingly, though, the RBI did infuse some liquidity into the system – in contrast with its original plan – buying INR 10,000 crores worth of long-term bonds in all three tranches but selling only INR 6,825 crores worth of short-term bonds in the first tranche and INR 8,501 crores worth in the second, while selling bonds worth the entire planned quantum of INR 10,000 crores only in the third tranche. What’s even more interesting is that while this seemed to be turning into a weekly trend, there has been no such announcement by the RBI in the week gone by (since 2 January, to be precise).

Why twist at all?

The policy-rate transmission angle:

The RBI has a rather unenviable job on its hands – balancing growth and inflation while managing the government’s borrowing operations and the cost of funding its budget deficit (revenue minus spending). On the growth front, things haven’t been hunky dory, to say the least (growth for the second quarter of FY 2019 came in at 4.5%, the slowest since March 2012-13), with the RBI recently slashing its estimate of India’s FY 2020 GDP growth from 6.1% to 5% after multiple rating agencies did so earlier in the year. This, even as the RBI cut its benchmark repo rate five times in 2019 by a cumulative 135 basis points (bps) to 5.15% from 6.5%.

One of the RBI’s bigger headaches has probably been the fact that its rate cuts haven’t reflected in G-Sec yields at the longer end of the curve. India’s 10-year benchmark bond yield had moved from ~7.5% – where it stood the day before the RBI cut rates for the first time (on 7 February 2019) after raising rates twice in 2018 – to 6.8%, a mere 70 bps reduction, less than a week before the RBI announced its own ‘operation twist’. In fact, this is only point-to-point transmission. A recent report suggests the RBI’s 135 bps cut has only resulted in a 44bps transmission.

By flattening the yield curve, the RBI may have wanted to ensure better monetary policy transmission, and drive credit offtake and, by consequence, growth. Earlier this year, the RBI asked banks to link their lending rates to external benchmarks, specifically to the repo rate or benchmark interest rates published by the Financial Benchmarks India Private Ltd (FBIL), to promote transparency and improve policy transmission. The RBI’s ‘twist’ seemed to plausibly be another step in the same direction, more so because it extended buying support to bonds other than the 10-year G-Sec in round three (see details at the end of this post).

However, this now seems less likely to have been the reason behind the RBI’s move, for multiple reasons, especially given the absence of any news on round four of the twist.

Inflation dynamics and government borrowing:

Meanwhile, things haven’t panned out too well on the inflation front either, albeit due to short-term transitory issues (primarily food inflation) – as some have argued. While inflation rose to 5.54% in November 2019 from 4.62% in October, reaching its peak since 2016, the RBI raised its inflation forecast for the second half of FY 2020 from 3.5-3.7% to 5.1-4.7% and to 4.0-3.8% for the entire first half of FY 2021 from its previous forecast of 3.6% for the first quarter of FY 2021. Most of these figures stand taller than the RBI’s inflation target of 4%, which has left the RBI with its hands tied behind its back. The result? The RBI decided against cutting rates on 6 December 2019, surprising the market, which appeared to have factored in a cut.

Yet, the RBI can’t turn a blind eye to the government’s borrowing costs – 10-year G-Sec yields jumped 15 bps higher to 6.613% on 6 December 2019 after the RBI refused to cut rates, reaching 6.80% a week prior to ‘the twist’. This, at a time when the government looks set to overshoot its fiscal deficit target, especially after it cut corporate tax rates to shore up private sector investment and, as a result, growth, leaving it with no option but to borrow more, which would further suppress bond prices (due to excess supply) and raise bond yields (prices and yields are inversely related).

The RBI’s announcement of something akin to the Fed’s operation twist brought 10-year G-Sec yields back down to 6.50% temporarily before they climbed back up to 6.59% as of 10 January 2020, possibly due to the absence of round four of the twist, among other things.

That said, yields are still lower than they were prior to the announcement, and meanwhile, in what comes across as a well-coordinated move, reportedly, the government now plans to cut its spending by INR 2 lakh crores, somewhat offsetting its reported revenue shortfall of INR 2.5 lakh crores. Of course, it may still need to borrow more than it planned to at the beginning of the fiscal year, unless it manages to pull money out of a hat, and one would imagine it would welcome the RBI’s ‘twist’.

What next?

Now that the RBI hasn’t announced round four of the ‘twist’, it seems as if this was either a short-term test of how a ramped-up operation will play out, given the rather modest scale of the operation, or a temporary reprieve for the government by curbing the cost at which it funds its fiscal deficit for FY 2020. Either way, the ‘twist’ looks poised to have a short-lived impact on yields and the economy as a whole, if the past is anything to go by.

The numbers

For starters, the scale suggests that the RBI is either testing the waters for a larger-scale move or facilitating lower borrowing rates for the government in the near term.

If you compare the US Fed’s operation twist back in 2011-2012 with that of the RBI, the scale stands as the starkest difference. The Fed’s first round of the twist, which lasted from September 2011 to June 2012, had USD 400 billion worth of firepower. The second round, which lasted from July 2012 to December 2012, had an outlay of USD 267 billion, translating to a total of USD 0.667 trillion or 4.5% of the US’ public debt (total bonds outstanding) of USD 14.79 trillion in 2011.

That completely dwarfs the RBI’s cumulative purchases so far, worth INR 30,000 crores or ~0.5% of India’s public debt of INR 60.36 lakh crores as of 6 January 2020, with no further action on the horizon.

What history suggests

If the past is anything to go by, the impact of this operation is likely to be temporary, even if the RBI ramps up this operation. Interestingly, in 2011, even after the Fed announced its operation twist in September, US 10-year Treasury yields remained rather flat for the first few months.

Data source: macrotrends; chart source: Vikram Nagarkar (blog: The Coin)

And while US 10-year Treasury yields did dive to their 200-year low of 1.43% in July 2012 as the Fed commenced round two of its operation twist, they more than doubled just a year after the Fed ended the operation in December 2012.

Data source: macrotrends; chart source and presentation: Vikram Nagarkar (blog: The Coin)

Amid slowing GDP growth (since May 2012), spending cuts by the US government, uncertainty around tax rates and a government shutdown at the time, the US was also grappling with concerns about unemployment and the need to avert the fiscal cliff.

It’s almost uncanny how many of those elements overlap with the Indian narrative today – slowing growth, looming spending cuts for this fiscal (at least), unemployment and a swelling budget deficit. Then there’s also higher-than-expected inflation forecasts and the somewhat crippled state of the banking and shadow banking sectors, which are in some disarray, with the RBI forecasting further deterioration in the NPA (bad loans) scenario. Given this backdrop, it’s unlikely that operation twist alone will be able to keep the yield curve in check for too long or even boost growth, for that matter.

On the growth front, US GDP growth did see a revival in the years that followed, with the exception of 2016.

Data source: macrotrends; chart source: Vikram Nagarkar (blog: The Coin)

That said, it’s worth noting that there were other factors at play, such as quantitative easing (QE; the Fed buying government bonds from the market to infuse liquidity into the financial system), which continued until 2014 and was aimed specifically at adding liquidity to the system and boosting/protecting growth.

Final thoughts

All considered, even a ramped-up operation twist is unlikely to fix the Indian economy. And with the government reportedly looking to cut spending for this fiscal year, growth could take a further hit.

As the RBI governor pointed out himself, the need of the hour is for the government to take up counter-cyclical and structural reforms, because there is only so much a central bank’s monetary policy can do to fight structural and cyclical slowdowns, more so in the current yawn-inducing (and sometimes scary) global economic environment. Lower medium-term or long-term rates alone may not translate to credit offtake if reforms don’t come through.

Now that the RBI has tossed the ball back into the government’s court by pausing its series of rate cuts, it appears as if the RBI is only buying the government some time, primarily to help cap its borrowing costs, while mildly reiterating that it still has an eye on monetary policy transmission. In other words, the RBI seems to be doing its best to offer a temporary fix for the more stubborn, less temporary issues that plague the Indian economy today, in the hope that the government’s economic strategies will soon come of age.

Annexures (from the RBI website) – The RBI’s proposed plan for the three special open-market operations so far

The RBI’s proposed first and second rounds of special open-market operations

The RBI’s third round of special open-market operations