The rising rate of inflation has put some restraint on the central bank in using its interest rate mechanism. And the focus has now shifted to other monetary policy instruments, especially Open Market Operations (OMOs).
OMO refers to buying and selling of government securities by RBI to regulate the liquidity in the market. If RBI wants to inject liquidity in the market, it would buy government securities. On the other hand, if it wants to curb liquidity, it would sell government securities.
From last December onwards, RBI has been conducting a special tranche of OMOs, whereby the central bank is simultaneously selling short-term securities and buying long-term securities. Here, the objective of OMO was not to regulate liquidity, but to manage the yield curve, and it came to be known as the Indian version of ‘Operation Twist‘.
‘Operation Twist’ was first used by the US Federal Reserve in 1961, and then in 2011, to lift the US economy out of recession. Through ‘Operation twist’, RBI aims to bring down long-term bond yields.
There exists an inverse relationship between bond prices and yields. In the current scenario, as RBI purchases long-term bonds, its demand pushes bond prices upwards. With an increase in the price of long-term bonds, yields would come down. The fall in long-term bond yield will benefit long-term borrowers, as it would bring down the cost of borrowing.
The government has raised its gross borrowing for FY21 to Rs 12 lakh crore. And, the excess supply of government bonds in the market, especially long-term bonds, has put upward pressure on bond yields. Even in an environment of low interest rates and surplus liquidity, there has not been a commensurate decline in long-term bond yield.
Similarly, a hint of prolonged pause on rate cut has pushed bond yields upward. It is in this background that RBI has decided to conduct simultaneous purchase and sale of government securities under OMO for an aggregate amount of Rs 20,000 crore in two tranches of Rs 10,000 crore each on August 27 and September 03, 2020.
With long-term bond yields coming down, the government would be able to borrow money at a cheaper rate from the market. Similarly, the corporate sector would benefit as yields of corporate bonds would follow a similar line. For instance, if yields on government bonds keep on rising, investors would demand a higher rate on corporate bonds, making them costlier for the corporate sector to borrow.
The OMO by RBI would help reduce the spread between long-term G-sec bonds and corporate bonds. Yet, the widening of fiscal deficit and increased market borrowing by the government could reverse the trend in the bond market. In such a scenario, there is a need for RBI to actively participate in the bond market through OMOs to cool off bond yields.
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)