RBI’s latest announcement on fifth round of Operation twist to
“flatten” the yield curve may ensure better monetary transmission; however, on
the flip side it may actually hurt corporate investor’s sentiment.
The Central banks across the world
have a long history of experimenting with unconventional monetary policy tools
and strategies for liquidity and interest rate management in the economy. One
such example is of “Operation twist” which was first exercised by US Federal
Reserve way back in 1961 and later in 2011 where it twisted its steep yield
curve using clever money market operations. Taking a leaf out of Federal
Reserve’s book, RBI introduced its own Indian version of this quantitative
easing programme in late 2019 as conventional tools of policy rate reduction
seemed ineffective.
Operation twist (simultaneous
buying of long term securities and selling short term securities under Open
market operation) was first introduced on 23 December 2019, with the objective
of correcting weak monetary transmission observed in FY20. Despite RBI’s
reduction in repo rates by 135 bps since Jan 2019 to revive the slowing
economy, banks hardly lowered their lending rates by 50bps; thereby destroying
the basic motive behind stimulus. Thus, monetary policy tool of “Operation
twist” was announced to aid RBI to bring down the elevated long term interest
rates (and raise short term rates) and subsequently “flatten” the yield curve
without having to depend on banks.
The slope of the yield curve
generally hinges on aggregate perception of financial stakeholders towards
future “expectations” of interest rates, inflation rate and risks to those
expectations. Amid heavy liquidity infusion and exceptionally dovish monetary
policy stance by the central bank in recent quarters to revive the slowing
economy, the yields on the short term government bonds have slumped; while
yields on long term bonds remained quite high as investors are hesitant to make
long term investment in Indian economy owing to economic slump and uncertain
growth & recovery outlook for future, thereby leading to “steepening” of
the yield curve, which needs to be flattened. Currently in India the spread
between three-month Treasury bill and the 10-year Government bond is close to
3% (300 bps), which is quite high and unhealthy for an economy especially at a
time when it is heading towards recession.
By bringing down the long term
yields, RBI is actually targeting at better monetary transmission in the
system. Since the lockdown itself, the central bank has brought down the policy
repo rate by 115 basis points; however, on account of rising NPAs, the banks
have largely remained risk averse and have failed to pass on the benefit to
consumers; thereby adversely affecting the credit demand creation. In addition,
amid rising loan defaults, banks are so scared of lending that they are opting
to park their surplus money with the RBI, even when they don’t need to. To
discourage such practise, RBI has massively slashed “reverse repo” rate in
recent policy reviews. Between April 2019 and February 2020, the reverse repo
rate was slashed by 85 bps to encourage banks to push their loan advancements
to revive the sinking economy. It was further reduced by 155 bps to a historic
low of 3.35% after the Covid-19 outbreak began hurting the demand very badly.
However, even reduction in reverse repo rate by RBI hasn’t incentivised the
banks to lend. This indicates towards bank’s highly risk averse attitude as
they favour low-interest-rate deposits with RBI rather than lending the money
to customers, which could give them higher returns. Going ahead, the economic
slump due to Covid-19 is likely to spook banks further and discourage them from
lending.
In this light, the sole purpose
of operation twist is to moderate high long term interest rates and bring them
closer to repo rate, thus ensuring better monetary transmission. For instance,
presently, the spread between the 10-year benchmark bond yield and the repo
rate remains close to 200 basis points, with the 10-year government bond yield
trading at approximately 6% compared to the existing repo rate of 4%.
To correct above mentioned
divergence, recently in the month of July, the Reserve Bank of India conducted
“fifth round” of Operation twist to buy long-dated government bonds worth Rs.
10,000 crore and sell shorter-tenure ones of the “same value”( so that amount
of liquidity remains constant in system) under its under Open Market Operations
(OMO). The Central bank stated that it would buy bonds maturing between 2027
and 2033, and sell those maturing between 2020 and 2021. The mere announcement
by the Central bank led the yields on the benchmark 10-year government security
falling 12 basis points to 5.90% from 6%.
Reduction in long term yields can
have overall positive impact in economy and can benefit in several ways.
Firstly, the rates on the 10-year bonds serve as a benchmark for lending rates
for retail housing, vehicle, and other long-term loans. With lower long term
yields, borrowing rates for corporate borrowers seeking long-term funds for
infrastructure building and deleveraging will also come down, thus helping in
credit creation and subsequent demand revival. In the present covid 19 pandemic
and lockdown scenario, where construction and real estate sector are so adversely
affected, lowering the long term cost of capital is inevitable. Secondly, RBI
by bringing down the long term yield will also benefit Central government by
lowering its borrowing cost which is likely to experience rising fiscal
deficit(~7% against BE of 3.5%) amid pandemic situation. Due to increase in
expenditure on account of the COVID-19, government has already raised its
estimated gross market borrowing target by 50% from initial budget estimate of
Rs7.8 trillion to Rs 12 trillion in the financial year 2020-21.
To this end, it’s also important
to analyse the effectiveness of Operation twist in the long run. In the short
run, ‘Operation Twist’ indeed has helped the RBI achieve its objective of
better monetary policy transmission. Since its announcement in December, with
five rounds of Operation twist, the yield on the benchmark 10-year government
security has dipped from a high of 6.8% in December to less than 6% presently.
Despite these comforting effects,
Central bank’s over interference with the money market can have inadvertent
consequences that can backfire in future. In its effort to flatten the yield
curve, RBI will end up escalating the short-term rates, thereby hurting
corporate borrowers and NBFCs who tap the markets for 1- to 5-year government bonds(short
term bonds) for their working capital needs. Further, occasional tinkering with
market yields by RBI may lead to reduction in interest rate spreads between
emerging economies and developed world; thus impeding foreign investors from
investing in India’s sovereign debt.
Anyhow such operations can only
have a temporary effect on the slope of yield curve. In medium term,
fundamental factors such as inflation trends, risk expectations and the size of
borrowing may bring the yield curve back to its original shape. Moving ahead,
widening fiscal deficits of the government (thereby issuing more long term
bonds) should be kept in check for the efficacy of long-term interest rate cuts
to be sustained. Otherwise the trend in the bond market would be reversed with
yet again rising long term rates.
Going forward, more long-lasting
methods needs to be innovated to ensure sustainable monetary transmission.
Firstly, banks should maintain individual credit scores of borrowers and peg
loan interest rates to these scores. The process of credit scoring itself will
ensure more standardisation and transparency in retail lending to customers.
Secondly, competition among the domestic banks should be encouraged so that
banks are stimulated to innovate and compete on loan interest rates.
Moving ahead, rigorous efforts to
bring down the long term rates are not suffice. Unless, there is a revival in
demand, mere reduction in cost of capital is not going to help much.
Nevertheless, RBI must resort to every possible tool it has in its kit.
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