The slowdown in the Indian economy has forced the Government and the Central Bank to resort to various measures to revive the economy. For instance, RBI has cut the rates five times in a row to a cumulative 135 bps, with a view to stimulate the economy. However, the effect of monetary stimulus on the economy was rather limited. Similarly, it could be seen that the rate cuts by the Central Bank has not been effectively transmitted to the consumers. And with the rising inflation in the economy, RBI was forced to strike the pause button for rate cuts.
Rising inflation has put some restraint on the Central Bank to use ‘repo rate’ tool to attain its objectives. In this scenario, RBI resorted to use the instrument of Open Market Operations (OMOs). OMO refers to buying and selling of government securities by RBI to regulate the liquidity in the market. If RBI wants to inject liquidity in the market, it would buy government securities. On the other hand, if the Central Bank wants to curb liquidity, it would sell government securities.
RBI has conducted OMOs on 23rd December, 2019 by purchasing Rs 10,000 cr worth of long-term government securities, and by selling Rs 10,000 cr worth of short-term securities. Here, the objective of OMOs was not to regulate the liquidity, but to bring down the long-term yields, and it came to known as the Indian version of ‘Operation Twist’.
‘Operation Twist’ was first used by the Federal Reserve in 1961, and then in 2011 to lift the US economy from recession. ‘Operation twist’ aims at lowering the long-term yield by keeping the short-term yield unchanged.
There exists an inverse relationship between bond prices and yields. In the current scenario, as the RBI purchases long-term bonds, its demand increases pushing bond prices upwards. With an increase in the price of long-term bonds, its yield would come down. A fall in the long-term yield will benefit the long-term borrowers as it would bring down the cost of borrowing. It would exert a positive impact on consumer spending, and a revival of consumption demand.
Similarly, investors in long-term bonds will also benefit as increase in bond prices lead to better returns. However, the interest rates on small saving schemes such as National Savings Certificate (NSC) and Public Provident Fund (PPF) could register a decline as the rates are linked to government bonds with similar maturities.
With the long-term yield coming down, government will be able to borrow money at a cheaper rate from the market. However, the widening of fiscal deficit and additional market borrowing by the government could reverse the trend in the bond market.