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Recently RBI announced it would conduct a simultaneous purchase and sell of Government securities under Open Market Operations (OMO) of Rs.10000 crore each on Aug 27 and Sept 3, 2020. This is being called a local version of ‘Operation Twist’ by our mainstream media.
The History:
‘Operation Twist’ was first used by U.S. Federal Reserve in 1961 to recover the economy slumped by the Korean War under the administration of the John F. Kennedy government. It was again used in 2011 by the U.S. Fed. It’s a monetary policy tool that aims at reducing long term borrowing interest rates.
How it works out?
RBI will purchase the long term government bonds, and at the same time, it will sell the short term bonds. As RBI will buy long term bonds heavily, there will be more demand for those bonds, causing the bond price to rise and thus making effective bond yield lower.
Let’s take an example. There is a GOI Bond 2026 at Rs.100, each with a yield of 8.15%, i.e., you will get Rs.8.15 interest per Rs.100 bond. Now RBI comes into the picture, and it starts buying these bonds. Let’s say because of high demand by RBI, prices of these bonds increase from Rs.100 to Rs.110. But interest remains the same, i.e., Rs.8.15 per bond held, thus making effective yield down at 7.4%. So, it will be a less attractive yield for new investors.
As an effective yield of Government bonds come down, corporates can also raise money by issuing bonds with lower results to the public. Even our borrowing rates from the bank are directly linked with these long term bond yields, making loans cheaper. As money is available at a lower interest rate, businesses tend to make new investments and start new production units, expand themselves, etc. causing more employment. As market interest rates come down, the government can also raise the fresh capital at lower interest rates for starting new infrastructure projects to revive the economy.
So, ‘Operation Twist’ literally twists the current bond yield scenario, by lowering significant long term yields and increasing the short term yields.
Why ‘Operation Twist’ Now?
Despite several cuts in the repo rate by RBI, banks didn’t cut the loan interest rates up to that mark. As inflation rose to 6.93% in July, it will be difficult for RBI to cut the repo rate further. Hence, RBI using this off-the-beat monetary policy tool to reduce the long term borrowing rates to boost the economy.