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    Explained: OMO and other tools in the RBI kit for cooling bond yields

    Explained: OMO and other tools in the RBI kit for cooling bond yields

    Explained: OMO and other tools in the RBI kit for cooling bond yields
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    By Ritu Singh   IST (Updated)

    Bond yields have been inching up over the last one week, following the government’s announcing a bigger borrowing plan for this fiscal and later the RBI raising the consumer price inflation forecast slightly for the first half of FY22. Also, the bond market was disappointed by the RBI not mentioning any schedule for open market operations in its monetary policy.
    Rising yields signal that interest rates are set to climb, and this is viewed negatively by financial markets as well as companies.
    In this explainer, we look at the various tools in RBI’s arsenal through which it can cool down bond yields.
    What in open market operation and how does it help bring down yields?
    An open market operation (OMO) is simply an activity where the central bank injects or drains liquidity into/from banks by buying or selling government bonds. This is RBI's primary liquidity management tool.
    When the RBI buys bonds from the open market, it effectively increases the demand for bonds. These are typically large operations which are enough to raise bond prices. Why? Because those holding the bonds bought them at existing rates for various reasons, and so the RBI would have to pay a higher price to convince them to sell. Given the inverse relationship between bond prices and yields, higher bond prices mean lower yields and vice-versa.
    What are the other mechanisms through with RBI can reduce yields?
    1. Communication or Open Mouth Operation
    The easiest and by far the cheapest mode of managing yields is good old communication, often referred to as "open mouth operation". By simply communicating where the preferred interest rates should be, that current yields are "too high" or "too low" or at "undesirable levels", the central banks are able to influence markets to adjust rates.
    2. Hiking liquidity coverage ratio, or statutory liquidity ratio
    Liquidity Coverage Ratio or LCR is a measure of highly liquid assets banks are required to hold which can easily be converted into cash so that they can easily meet any short-term obligations.
    SLR, or statutory liquidity ratio, is a measure of the reserves that banks are required to hold in the form of government bonds, gold, and similar liquid assets.
    By hiking LCR or SLR requirements, RBI can effectively mandate more bond buying which can drive yields down. But this method is not effective when there's already excess bond holding.
    3. Increasing the HTM limit of bonds for banks
    In the held to maturity (HTM) category, banks don't have to mark-to-market their investments to the current market rates. This helps banks avoid nominal losses that may arise because of the periodic fluctuation in bond prices. Increasing HTM limit would mean more demand for bonds, which would then help cool yields. However, RBI did not announce this in the 5 Feb policy; they just extended the HTM period by one more year.
    4. Introducing more floating-rate bonds
    Floating rate bonds have a coupon reset every six months- which addresses the duration risk of bonds. This also means the mark to the market problem doesn't arise. As risk goes down, so do bond yields. However, this is not commonly used as govt would also have to pay a higher coupon in case of an adverse yield movement.
    Can the interest rate go up in the short term?
    After a recessionary year, India is set to see much better growth in FY22, helped by the statistically low base and improving economic prospects. Add to this, RBI has hiked its inflation forecast slightly to 5-5.2 percent for the first half of FY22. Both of these mean that the rate cut cycle may be over after the aggressive cuts by RBI to spur growth last year which saw repo rate being brought down to a historic low of 4 percent. With normalisation beginning to happen, the justification of keeping market rates at the same level as last year may not hold. Hence, rates are bound to rise sooner or later.
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