Operation Twist’s success may only be temporary

Taking a leaf out of the US Federal Reserve’s playbook, the Reserve Bank of India on Monday experimented with an unconventional policy tool to coerce the yield curve to do its bidding. It put through open market operations that entailed buying 10-year government bonds worth ₹10,000 crore while auctioning off up to one-year treasuries of the same value. In the short run, ‘Operation Twist’ has certainly helped the RBI achieve its objective. Since the RBI’s announcement last week, the yield on the benchmark 10-year government security has dipped from a high of 6.8 per cent on December 16 to 6.57 per cent. One hopes though, that the success of this edition of Operation Twist doesn’t prompt the RBI to resort to such interventionist measures too often in future.

Officially, Operation Twist is motivated by the objective of driving better monetary transmission. Despite the Monetary Policy Committee effecting a 135-basis cut in rates since January this year to rev up a slowing economy, banks have barely lowered lending rates, effectively scuttling this stimulus. The special open market operations allowed the RBI to launch a frontal attack on long-term borrowing costs in the market without having to rely on banks. Lower yields on the 10-year government security, it is hoped, will automatically force lenders to re-evaluate their rates for retail housing, vehicle and other long-term loans. Rates are also expected to moderate for corporate borrowers seeking long-term funds for infrastructure building and deleveraging. Unofficially, this operation also has the happy effect of lowering interest costs for the Centre, which is likely to overshoot its borrowing target this year on the back of a widening fiscal gap. Despite these palliative effects, messing with the market can have unintended consequences that can come back to bite the RBI. In trying to flatten the yield curve by driving up short-term rates, the RBI can end up hurting corporate borrowers and NBFCs who tap the markets for 1- to 5-year money for their working capital needs. Presently, such borrowers vastly outnumber those seeking project loans. Ad-hoc fiddling with market yields, especially if it leads to shrinking rate differentials between India and the developed world, can also deter foreign investors from betting on India’s sovereign debt. In any case, such operations can have only a temporary effect on the yield curve. Fundamental factors such as inflation trends and the size of the borrowing programme are bound to re-assert their influence over the medium term.

In the long run, there are far more durable methods to ensure monetary transmission that the RBI should consider. One, it must insist on more transparent retail loan products from banks that clearly peg their spreads to the individual credit scores of borrowers. The process of credit scoring itself can do with more standardisation and transparency. Two, the RBI must introduce more competition into domestic banking, so that banks are forced to innovate and compete on loan pricing instead of offering cookie-cutter loan and deposit products.

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