RBI Tries to Pass Benefit of Lowered Interest Rates to Common Man

Reserve Bank of India (RBI) conducted ‘Operation Twist’ to pass down the benefit of the repo-rate cut. In this Open Market Operation (OMO), it bought back Rs. 10,000 crore worth long-term securities and auctioned short-term securities of the same amount.

Crux of the Matter

What is RBI Trying to Do?
RBI has reduced it repo-rate. This is the rate used by banks to determine lending rates. However, bank lending rates are not reflective of this rate cut. Long-term Government Security yield (return) is related to the long-term lending rate (Interest rate on loans). Therefore, RBI is bringing down long-term yields – which is a benchmark rate for banks – to bring down long-term lending rates.

What did RBI do?
RBI bought back the 6.45% Government Security (GS) 2029, which is a 10-year benchmark security for banks. Of the Rs 25,698 crore bids% received, RBI accepted bids worth Rs. 10,000 crore. Only 151 bids were accepted. The cut-off yield, 6.4874%, was higher than the coupon rate, 6.45%, reducing the weighted average price each bidder received to Rs. 99.66 instead of the face value of Rs. 100.

To escalate this Open Market Operation to Operation Twist, RBI offered four short term Government Securities,
1. 6.65% GS maturing in 2020.
2. 7.80% GS maturing in 2020.
3. 8.12% GS maturing in 2020.
4. 8.27% GS maturing in 2020.

RBI sold Rs. 6,825 crore worth of short-term securities. Of the offered short-term securities, bids for 6.65% GS, 7.80% GS, and 8.27% GS, were only accepted, and the weighted average yield was 5.3134%, 5.4537% and 5.4320%, respectively.

What Does this Mean?
Comparing the yield of short term securities (approx 5.4% as seen above) with the yield offered by the 6.45% GS 2029, the lower yield of the long-term GS will flatten the yield curve to reflect the current economic situation. The flat curve is representative of lower interest rates in the economy. Between February and October this year, RBI had cut down the repo-rate by 135 basis points or 1.35%.

We must note that RBI has mandated banks to link their lending rates with External Benchmark Rate (EBR). State Bank of India recently announced a cut of 25 basis points in lending rates. Similarly, banks are required to pass on the benefit of lower benchmark rates to borrowers. However, in a scenario when that does not happen, as right now, RBI has to lower long-term yield rates because higher long-term yields lead to higher long-term lending rate. That, coupled with the sluggish economic environment, required RBI to lower yields and enhance the flow of benefits.

Curiopedia

India’s Open Market Operation is much influenced by the fact that it is a developing country and that the capital flows are very different from those in developed countries. Thus India’s central bank, the Reserve Bank of India (RBI), has to make policies and use instruments accordingly. Prior to the 1991 financial reforms, RBI’s major source of funding and control over credit and interest rates was the cash reserve ratio (CRR) and the SLR (Statutory Liquidity Ratio). But after the reforms, the use of CRR as an effective tool was deemphasized and the use of open market operations increased. OMOs are more effective in adjusting market liquidity. The two type of OMOs used by RBI:
1. Outright purchase (PEMO) is outright buying or selling of government securities. (Permanent).
2. Repurchase agreement (REPO) is short term, and are subject to repurchase. More Info

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