Since the time Reserve Bank of India Governor Shaktikanta Das assumed office, his approaches towards policy have been dynamic in nature. From forex swaps instead of its traditional bond purchases to embracing an ‘Operation Twist’, Das is pushing the boundaries of conventional central bank policy to improve rate transmission, spur credit to the economy and keeping rupee stable.
Spot and forward intervention
Spot intervention also persists as the RBI is constantly buying dollars to support the export competitiveness in the background of falling export growth. It has also been seen by rising premiums which have shot up to 4.30 percent from 3.70 percent in November end. This indicates the RBI has switched its intervention in forwards too where it is buying in spot and selling in forward as liquidity is excess in the short run.
What is a bond intervention ?
Last week, the RBI announced ‘Operation Twist’, different from traditional open market operations (OMO). Here, the RBI purchased Rs 10,000 crore worth of long-term government securities and sold Rs 6,825 crore of four short-term. The tool essentially aims at changing the shape of the yield curve from steep to flat. A flatter yield curve reduces the spread (Long term bond rates – repo rate) that bondholders earn for the added risk of holding bonds for a longer tenure. The intent is to moderate high long-term interest rates in the market and bring them closer to the repo rate.
The high spread gives banks ample opportunity to a safe arbitrage, in which they can borrow short and invest in longer-dated bonds at a risk spread of nearly two percentage points. If the longer-term yields come down, that arbitrage opportunity minimises significantly. However, the short-term yields are determined by liquidity and repo rate. While the liquidity is abundant in the system, and repo rate is low, the short-term yields can't remain high for long.
Lower long-term interest rates would provide more liquidity to the market. Anything that increases the demand for long-term government bonds, puts downward pressure on the interest rate and less demand for bonds tends to put upward pressure on interest rates. By buying long-term bonds, the RBI wants to significantly increase their demand, thereby lowering interest rates. Likewise, by selling short-term bonds, the RBI wants to reduce their demand and drive up their yields and interest rates.
Why did RBI switched from traditional OMOs to Operation Twist?
Despite a cumulative reduction of 135 basis points in policy repo rate, banks have declined and transmitted only 40-47 basis points in their average lending rates. Even the mandatory linking of bank lending rates to an external benchmark (including the repo rate) has not helped. With growing concerns over fiscal slippage and rising inflation, the key market interest rate i.e. the 10-year G-sec yield rallied to 6.8 percent especially after the MPC kept the rate unchanged on December 5 meeting.
High market yields on the 10-year G-sec influence bank lending rates on vehicles, housing and other long-term loans, hurting retail borrowers. This seems to have prompted the RBI with the surprise announcement of Operation Twist. Post the announcement, the 10-year G-sec yield dropped by almost 20 basis points to 6.6 percent while the yields on shorter tenure bond (five years) rose 16 basis points to 6.67 percent making for a flatter yield curve. That also helps bring down borrowing costs for the government.
How does it affect the economy?
The high yields on long-term government borrowings had led to banks pricing their retail loans at high rates. These loans can now be expected to get slightly cheaper with Operation Twist. Cheaper retail loans can boost consumer spending which can eventually boost the GDP.
Effect on rupee Fundamental aspect:
Fall in the yields has somewhat contributed to the outflows of about $654.35 million from the bond market till last week. This might have weighed on the rupee as during the same period, the pair depreciated from 70.85-71.25 levels. Nonetheless, going ahead we expect the pair to range between 70.50-71.50 in absence of volumes due to holiday week.
Technically, after 4-5 attempts, the rupee has broken its resistance of 71.20 in a successful way. The next resistance for the pair is near 71.50 levels and the support will now be at 71.00 levels. As the resistance of 71.20 is broken, there is a 60-70 percent possibility that pair will move close to 71.40-50 levels. However, till the time pair is in a range of 70.50-71.50 levels, buying on dips close to 70.50-70.70 and selling on spikes close to 71.20-71.50 levels are decent levels to hedge for immediate exposures.
Amit Pabari is MD at CR Forex Advisors.