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In the latest announcement by the RBI, it will be executing Operation Twist, a maneuver borrowed from the Federal Reserve. Via this move, it will buy 10,000cr (US$1.4bn) of long tenor bonds (10-year government bonds), and sell an equivalent amount of short duration government -bills in an attempt to bring down long term interest rates. [ Buying 6.45% 2029 GSecs and selling four short duration t-bills]. In today's piece, we will try to understand why the RBI had to resort to the move, the possibility and impact of more such moves in the future, and the options available now with both the RBI and the government to revive the dangerously poised economy.
Displeasure over lack of rate transmission
The RBI has been trying hard to bring down rates though its policies, slashing the repo rate (rate at which the RBI lends to banks) by 135bps this year (1.35%). The intent behind these rate cuts is that the banks will pass on these lower rates to their customers (think cheaper car and home loans to consumers or cheaper corporate debt for factory expansions and lesser incentive to deposit your money leading to higher spending and more growth in the economy), but that hasn't worked. In an environment where private banks are increasingly taking share from the public banks, PSBs are reluctant to drop rates from a fear of alienating the treasured retail depositor. The RBI's repeated cuts and thinly veiled suggestions to the banks to pass on the rates continued to go unheeded. With Operation Twist what the RBI attempts to do is a renewed attempt to change this for good. It also gains a modicum of control over the long end of the yield curve, something it had historically little direct control over.
Shrinking traditional policy options
Another potential impact from the move is that the probability of a significant rate cut in the future goes down quite a bit. Inflation in India has been creeping up quite steadily limiting the impact of the RBI to cut rates. What the RBI resorting to such unconventional methods implies is that in addition to the lack of effectiveness of the traditional rate cut, there is also now significantly less room to pursue that measure going forward. In a scenario where growth is slowing down and inflation is creeping up, the RBI's traditional policy options are fast shrinking.
Can there be twists?
Which begs the question, can the RBI double down on operational twist? The long term rates fell quite sharply on the announcement of the RBI move. If they see the move as successful in reaching their wanted objective there could be a temptation to introduce more such structured twists, giving the markets a calender of said moves perhaps to better moderate rates to the levels they want. And while forced meddling with the yield curve might be frowned upon by few, in a world where options are fast running out, it will certainly have its allure.
Is fiscal support off the table?
This brings us to the last piece of the puzzle, the government. When all else fails on the monetary side, the government can step in with fiscal support to give the economy a fillip. However, with shrinking direct and indirect tax revenues, the ability of the government to extend that support without significantly denting fiscal deficit seems unlikely. Numerous international agencies including the IMF have repeatedly warned against this move as well. But with growth hitting sub 5%, and popular sentiment against the government dwindling fast, it seems like the tradeoff with the deficit number is one we might have to make.
In the end, we will have to wait and watch how this plays out. If it succeeds, economists might look back at the moment and praise it as a brilliantly unconventional move needed to get out of a tricky spot. If it fails, they will comment on how the meddling of an entity running out of options made a bad situation worse. In the moment though it does seem like the RBI making the best of a bad situation, and while that is certainly encouraging, the implications especially if it fails are quite scary.
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Zapp 5: (Day's 5 top stories in 3 lines or less)
1. Sensex fell 181 points after a steady rise the previous week. Markets will be closed for trade tomorrow on account of Christmas. Experts were expecting a correction in the shortened holiday week.
2. The RBI executed Operation Twist in an attempt to reduce long term rates and revive a slowing economy.
3. Cooperative Bank distress: CoBanks went from being 19.4% of assets of commercial banks to 10.6%. Gross NPAs rose to 7.1 per cent from 6.7 per cent but the net NPA ratio improved to 2.6 from 2.8
4. Coal Secretary Anil Jain asks Coal India's exploration arm to increase pace of discovery of proven reserves, emphasizing on a shift in exploration methods.
5. HK police fired tear gas to disperse Christmas eve protestors. The Hong Kong protests are now in their seventh month and have still retained a lot of the initial energy.