In a bid to soften yield on the 10-year G-Sec and reduce cost of funds for banks, the RBI had announced a series of measures last month.

Aside from announcing two additional tranches of ‘Operation Twist’ (OT) and easing held-to-maturity (HTM) limits for bond holdings by banks, the RBI had also allowed banks to retire higher cost borrowings availed by them under previous long-term repo operations.

Banks that had borrowed funds under LTRO (Long Term Repo Operations) in February and March, at the then repo rate of 5.15 per cent, have made a beeline to retire these borrowings to lower their cost of funds.

The repayment of these borrowings were slated to happen over five tranches. In the first four tranches, banks have returned ₹98,854 crore so far. The last repayment of funds is scheduled for today. Banks can in turn avail funds at the current repo rate of 4 per cent.

Also read: RBI plans G-Secs switch for ₹24,000 cr

While one hand this will help lower banks’ cost of funds, it will also lead to increase in liquidity in the banking system that is already flush with funds. Over the past two to three months, there has been close to ₹6-7 lakh crore of surplus liquidity in the system. Banks returning over ₹1-lakh crore of funds will in turn create more headroom for the RBI to do outright open market operations (OMOs) — purchase of government bonds.

Also read: How RBI moves have led to a rise in short tenure bond yields, impeding transmission

The RBI recently announced OMOs of ₹10,000 crore to be conducted on September 24. Banks returning funds borrowed earlier under LTRO opens up scope for further OMOs of ₹1-1.1 lakh crore (if liquidity is to be maintained at current levels), which can help in softening the yield on G-Secs.

First OMO this fiscal

In a bid to ease the interest rates on long-term government bonds, the RBI began announcing operation twist (OT) in December 2019 — using proceeds from the sale of short-term securities to buy long-term government debt papers. These are essentially liquidity-neutral, but help in easing yield on long-term bonds.

On the other hand, an outright purchase of bonds (OMOs) infuses liquidity into the system, while also aiding yields to cool off. So far this fiscal (April 2020 onwards), the RBI has only undertaken OT to ease bond yields and did not resort to OMOs. The recently announced OMOs is the first so far this fiscal.

Also read: What does the Fed meeting signal for India’s bond market, rupee

Scope for more OMOs

Banks returning a tidy sum borrowed earlier under LTROs, has opened up scope for further OMOs in the coming months. This will help anchor long-term bond yields, critical given the Centre’s large borrowings expected in the second half of the fiscal.

When banks borrow funds under LTRO, it has the effect of increasing their funding base and also increasing RBI’s balance sheet. A reversal of this (on banks returning the funds), leads to shrinkage of RBI’s balance sheet, which can again be offset by the OMO activity.