RBI Announces Its Own ‘Operation Twist’ – Is It Time For Sarkari Dollar Bonds?

Recently, the Reserve Bank of India (RBI) announced its own ‘operation twist’ (a tool used to influence the prevailing interest rate in markets) where it will buy long-term bonds and sell short-dated securities with the intention to bring down the steep yield curve.

This is a big development considering that the yield on 10-year G Sec was higher than the nominal growth rate for the second quarter.

The December meeting of the Monetary Policy Committee (MPC) where it held rates constant did lead to speculation that perhaps something else is likely to be announced – however, the anticipation was for an announcement of expansion in money supply.

Many commentators have gradually asked for an operation twist to reduce the spread between short and long-term bonds.

However, operation twist does not imply an expansion in money supply as the RBI will simultaneously sell and purchase bonds worth Rs 10,000 crore. This will have some impact on the yield and the RBI can gradually increase the amount over the next couple of months.

But there remains a significant amount of pressure from government borrowings on the interest rates, and despite reduction in policy rates, transmission will remain a challenge until small savings rates are reduced. Massive open market operations (OMOs) will help provided the RBI is willing to be bold enough.

The significance of operation twist is such that it will reduce the cost of borrowing for the government which will help it find additional fiscal space. As is the case, a bulk of our fiscal deficit goes in interest payments, and there is a definite case for an expansion in our primary deficit which is only possible if interest burden is reduced.

The low levels of inflation present this opportunity to reduce the nominal (and the real) cost of borrowings which can have a significant impact on the fiscal condition of the government.

Of course, we could have used a similar strategy to restore the balance sheet of our corporates. However, government borrowings did have an adverse impact on bond yields while the reluctance to cut small savings rate has further added to the transmission problem.

The complex problem and India’s recent experience makes me revisit the Budget presented in July by the Finance Minister which had indicated the possibility of issuing sovereign bonds. That was by far one of the most important parts of the Budget which had the potential to address a lot of the problems discussed here. Unfortunately, there is no clarity on whether sovereign bonds will be issued or not.

Though people talk about a dollar-denominated bond when they talk about a sovereign bond. However, it is possible to diversify the issuance into three separate currencies such as the Japanese yen, the US dollar and the euro. This would ensure to some extent that we are insulated from any unilateral strengthening of any currency.

One advantage of the sovereign bond was that it reduced the cost of borrowing for the government thereby giving it a much-needed fiscal breather. This would have enabled it to initiate fresh investments in human capital, which is required to augment our productivity.

However, the biggest advantage would have been in terms of its impact on availability of domestic savings, which would be now utilised for private investment. This increased availability of domestic savings would also result in reduction of prime lending rates (provided we stop interfering with our small savings rates etc).

For a capital starved country like India, getting cheap debt for government borrowings would allow private firms to access domestic savings at a cheap rate while also allowing some of them to raise debt in foreign countries through the ECB (external commercial borrowings) route.

The biggest beneficiary of this exercise would have been small and medium firms who will now have adequate credit available to finance their expansion. Combined with the corporate tax cut, this would unleash the animal spirits and result in a period of prudent, sustained high economic growth.

The idea was indeed a bold one and could have resolved some of the issues that our public finances face – yet it was opposed on ideological grounds rather than its merits. While the RBI initiates operation twist, it is important to revisit the idea of a sovereign bond. As Harsh Gupta mentioned in his articles and tweets over the last couple of months – what is the point of autonomy if you are not going to use it?

The case for a sovereign bond has only grown stronger over the last couple of months and therefore, one hopes that there is a detailed discussion within the government regarding the same so that it could be issued in the coming financial year. India has strong economic fundamentals and now would be the time to leverage it in order to unshackle capacity constraints that bind the Indian economy.