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RBI Expands its Monetary Policy Toolkit



The Reserve Bank of India last week announced that it would conduct the simultaneous purchase and sale of short term and long-term government securities under Open Market Operations (OMO). It cited the evolving financial conditions in the economy, in addition to current liquidity, as its motivation to sell one long term bond while simultaneously buying four short-term bonds of the same value (worth INR 10,000 crore / $1.4 bn each). This kind of OMO is an unconventional, not to mention novel, monetary policy move for the RBI.  So why has it been used now?

While there is surplus liquidity in the financial system, the cost of borrowing or the interest rate has remained high. After five successive rate cuts in 2019 amounting to 135 bps under an accommodative monetary policy, the RBI’s Monetary Policy Committee (MPC) in early December decided to continue to hold off on further rate cuts. This left the market surprised and the repo rate steady at 5.15%. The MPC cited inflationary pressures in the economy as to why it held rates steady, but also needed to address the high cost of credit in a contracting economy.

This monetary policy mechanism has been used by the central banks around the world, such as in Japan and the US, to tackle similar issues of yields curves and interest rates. Famously used for the first time by the Federal Reserve of the United States, it is commonly referred to as an Operational Twist.

The MPC’s significant repo rate cuts should, in theory, have led to a fall in the interest rate through the transmission of such rate cuts to the government securities market. However, the government securities yield curve indicates otherwise. A yield curve, essentially, plots the interest rate (yield) associated with the maturity length (term in years) of government securities. It is indicative of the market’s expectations about the economy’s performance and the cost of borrowing in the short and long-term future.

The yields for the short-term one-year government bonds had fallen below even the repo rate to 5.10% in the first week of December, while that for the benchmark 10-year security was 117 bps higher at 6.86% (1% = 100 bps). The steeply upward-sloping yield curve that resulted was a sign that the market expected the cost of borrowing to rise sharply in the short term, while expecting it to fall in the long-term. This presented a problem that the RBI needed to tackle amid a global and domestic economic slowdown.

The RBI is, thus, now testing this new OMO as an alternative policy tool to bring down the interest rates in the economy to stimulate private sector borrowings while also making the government’s borrowings cheaper.

As announced, the RBI recently purchased INR 10,000 crore worth of long-term government bonds and sold INR 6,825 crore worth of short-term bonds maturing in 2020. As it buys long term securities, it expects their rise in demand to lower the long-term yields, while expects the short-term yields to be pushed up due to their sale. The yield on the long-term security is reported to have fallen by 3 bps after its recent OMO. The RBI may continue to undertake such OMOs until the yields on India’s government benchmark securities are within its targets, thereby supporting its consistent efforts to revive the economy.