In today's newsletter we will try and attempt to do what no publication has successfully managed to do. Simplify the complicated mechanics of RBI's Operation Twist.

So hold on to your repo rates. Things are going to get bumpy.

Policy

The Story

It was supposed to be simple. The Reserve Bank of India cuts interest rates. Banks, in turn, borrow at cheaper rates. The intense competition that propels all banking activity forces incumbents to start offering cheaper loans. Once borrowing becomes attractive, consumers and corporates will use this money to spend, invest and boost economic activity. They call this monetary transmission.

Unfortunately, we seem to have a problem here.

So let's begin with the first variable in the equation - RBI's interest rate. When you borrow from the Reserve Bank you are expected to meet your repayment obligation in less than 24 hours. In fact, the interest rate is often referred to as the “overnight rate” because come morning, you will have to pay up. Granted they can reborrow the next day and continue doing so until the RBI decides to tweak rates once again. But it does tell us something very important — transmission is always very effective on the shorter end of the spectrum, not so much on the long end. Meaning bankers will gladly cut interest rates on loans so long as the repayment periods remain short and comfy. But when they have to dole out loans that mature in 10, 20, 30 years they’ll be more prudent irrespective of what RBI does with the overnight rates. And you can’t blame them, especially considering most of them have their finances in such terrible shape.

Unfortunately, RBI couldn’t care less about loans with short maturities right now. For a while now they’ve been trying to stimulate the economy by getting people to spend and invest and do all sorts of things that could theoretically propel demand. But since most consumer loans have long repayment periods, banks simply haven’t been cutting interest rates here. So despite repeated rate cuts by the RBI, things haven’t improved on this front. And this is a problem.

Now readers must bear in mind that banks mobilize funds from many places and not just the RBI. For instance, they borrow money from you. When you go to a bank and tie your money up in a 10 year FD (Fixed Deposit), that’s you lending money to the bank. And unlike RBI’s overnight loans, banks will only have to pay you at the end of 10 years. So if you were a banker and you were offering a 10-year consumer loan to a prospective customer, you would probably be very willing to cut interest on this loan if you could get people to tie up their money on a 10-year FD at a cheaper rate as well. And that means if there was some way for the RBI to yank back those FD rates or even interest rates on other sources of long term funding, maybe banks would be more willing to cut rates on consumer loans.

Enter Operation Twist

The objective is now clear. RBI has to find a way to influence Deposit rates or other sources of long term funding. One way they can do this is by influencing the yield on 10-year G-Sec’s. If you haven’t heard of Government Securities, know this much. When you go out there and lend money to the government, the government, in turn, will offer you a piece of paper (G-Sec) guaranteeing your principal and some extra money on top. The yield on the G-Sec is the extra money you’ll make at the end of 10 years. And since most people believe that a government is never going to default on its payment, the return on a G-Sec is often called the risk free rate of return. You are now an expert on G-Sec’s and we can move on with the story.

So the RBI goes out there and buys a truckload of 10-year G-Sec’s (worth about 10,000 crores) and since it can print as much money as it wants, the buying bit isn’t a problem. But it does set in motion the most amazing sequence of events. When RBI does so much of the buying there is very little need for the government to borrow from anyone else. So if you are still looking to invest in a G-Sec, the only way you can entice the government into taking your money is if you are willing to take a hit on your return i.e. the extra money that you were expected to make. The yield, remember? Therefore, the RBI with its massive buying exercise can bring down yields on 10-year G-Secs and this is where things get very interesting.

Now that investors figure they are going to make less money by investing in a G-Sec, some will inevitably turn elsewhere. Maybe 10-year fixed deposits? As more money keeps flowing into fixed deposits, banks will soon realise they won’t have to lure in customers by offering exorbitant returns. So they’ll cut FD rates in tandem until the money eventually stops flowing. And soon enough some of the benefits of this low-cost funding will eventually trickle down to consumers by way of cheaper home, auto, and personal loans.

But there is one other problem. To buy G-Secs, the RBI had to print a lot of money. Money that will eventually enter the financial ecosystem. And if you know anything about printing money, it’s that there is always a very real risk of stoking inflation on the side. Considering we are already seeing inflationary tendencies flare-up, this perhaps isn’t an ideal move. So in an attempt to mop up the extra money, the RBI is simultaneously selling 10,000 crores worth of G-Secs that are maturing next year. Buying long term G-Secs and selling short term ones. So theoretically, the yields on the 10 years G-Secs will tumble and the yield on the short term G-Secs will rise. In effect twisting the equilibrium that once prevailed.

And hence the name.

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