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RBI Launches Operation Knicker-Twist

(The name credit is to @eyeofsiva who will probably disagree with my opinion on it!)

RBI has decided to panic as the 10 year bond went to 9.24%. In an announcement today, it decided to take four steps. Three are benign:

Banks were earlier told to bring down their “Held to Maturity” (HTM) holdings down to 23% of assets, from 25%. Such bonds are not impacted by mark-to-market changes – so if their prices fall, banks don’t have to book  a loss. With lesser HTM bonds, banks will have more bonds that they have to mark losses on when prices go down. And prices are down about 8-10% in a month or so.

One change is that this “bringing down HTM” has been halted at 24.5% (it was supposed to be 24% in end Sep, and then 23% in March 2014).

Another thing is that a move from other categories to HTM (of bonds held) was done just once a year. Now, they’ve allowed it once more as a one-time measure, marking any HTM’ed bonds to the July 15 prices. July 15 was when yields were around 7.3%, and prices much higher.

The third is to allow the “depreciation” (that is, the 8-10% loss mentioned above) to be spread over the next seven months.

These should help; the impact otherwise was about 40,000 cr. losses to bank capital – they hold about 22 lakh cr. of govt bonds, and 24% would have meant they could HTM just 18 lakh crore. So losses on 4 lakh cr worth bonds at 10% deprectiation = Rs. 40,000 cr. That would have hit 4% of bank capital.

Now, the impact will be on about 3.6 lakh cr. worth securities, so about 36,000 cr. spread over 7 months. Much less a problem and built on a hope that the long term yield will either recover or remain flat.

Operation Knicker-Twist

The fourth step is very strange economics. Remember that the RBI is actually selling Rs. 22,000 cr. of short term cash management bills (the latest one, today, was sold at 12.27%). This takes away that much cash out of the system, and keeps cash tight.

However, RBI has announced Open Market Operations (OMO) to buy Rs. 8,000 cr. worth of Long Term securities on Friday. This is to “twist” the yield curve, like Operation Twist in the US, where long term bonds are bought and short term ones sold so that the economy can recover.

But this is insane in India, because the US had no need to squeeze liquidity, we do. Because the US has no inflation problem, we do. If you take out Rs. 22,000 cr. from the system on Monday and Tuesday, and then promptly introduce Rs. 8,000 cr. back INTO the system on Friday, you are basically like a hamster running around just to be in the same place.

Squeezing of liquidity will eventually hurt long term rates. That’s how it has to work, if it has to help bring the dollar-rupee equation to a more favourable level. It’s the relative lack of free rupees that will help, and if you give 8,000 cr. of rupees just like that (The RBI has to print money to buy bonds), it will not help at all.

This is going to again increase the size of the RBI balance sheet, and create even more inflation going forward. Remember, India has had a ridiculous amount of quantitative easing in the last 16 years, which is the cause for inflation now. The RBI have their economic fundas completely wrong, in my opinion, and that’s why: Operation Knicker-Twist.

In reaction, the 10 year bond fell to about 8.9%, which is a big jump in prices. However, every other bond is around 9.25% or higher.

Effectively we are giving free money to the banks. They borrow at 10.25% (MSF) to invest in cash management bills at 12.25%. They get to sell their long term bonds to the RBI at a higher rate (the RBI will try to “signal” a lower yield by buying high). We have become an oligarchy run by the banks, because you and I, the taxpayers, are paying that 12.25%. Giving free money to the banks will never help the economy, and the US will find that out in the next couple years; we, with the kind of inflation we already have, won’t have to wait that long.

What’s coming next is more capital controls. We are reacting in a panic. It’s okay to let long term rates rise. It’s okay to have the dollar fall. I’m not scared of that. I’m very scared of the knee-jerk reactions of the government and the RBI.

For the time being we will get an illusion of being nice and happy people, till suddenly it will strike that this doesn’t help at all, it just delays the problem for a few months, and it takes away from our children’s future to help our present. But that is pretty much the story of India of the last five years.

  • Kaka says:

    Also, the US yield curve is steep and so the operation isn’t risky. But, in India, we have an inverted yield curve which by itself usually foretells bad economic conditions. Why would the bank invert even more (by raising the short end and bringing the long end down)? It seems very weird.

    • Yes, plus there is hardly a way to do short end arb. FIIs have to bid for limits. Then they can’t easily participate in forex hedging. Who will bother at the short end?
      The original Operation Twist in the 60s in the US, when the USD was freely convertible, and short term arbitrage was welcome. India has none of those conditions either (plus high inflation plus an already inverted curve like you said)

  • Inder says:

    Why didn’t US suffer from high inflation with the amount of QE Fed has done ?

  • Balaji says:

    Hi Deepak,
    Why are the FIIs not selling heavily in debt and equity markets ? Will we see capitulation ?
    As you said (train wreck in slow motion), it is pretty painful to follow the news daily !!

  • mangoman says:

    They say Raghuram Rajan is appointed as officer special duty to RBI. But the effects are not visible or shall I say it is working contrary to our belief?
    RBI apparently expecting short term results decided to inject money again into the system (yes, the same Indian banking system which they think are punting in Dollar and thus eroding Rupee value) to the tune of 8000 crores. They panicked by seeing the short term bond yields going up. These guys will never learn the lessons.
    They say Raghuram Rajan is inteligent and will do the necessary for the economy. But it seems he is panicking more than others.
    Equity markets are shaky
    Bonds markets are shaky
    Commodity markets , the less said it is better
    Raghuram Rajan should know one thing. He should not try to emulate Chidambaram’s method of talking up the market on day to day basis.
    As mango rightly predicted 2 days back, RBI allowed our banks to make adjustments in their bond portfolio so that they need not make provisions for 40000 crores loss they made in 1 month. long live Indian Banking System and RBI.
    Now what next?
    RBI, Can you save markets for 2-3 days due to this measure? Do you know, by this measures you are still accentuating the issues?
    I wonder still nobody in this government is talking about over priced real estate which is the root cause of all the evils. But I salute the real estate brokers for the influence they have in the current establishment.

  • Vivek says:

    People invest in real estate to save taxes plus they don’t show rent earned, they save more tax. Housing deductions reduce tax inflow of government. even capital gains are exempt if you buy another real estate. This all is eating into govt’s revenues and hence they have to borrow more from outside. Limit the exemptions first, then fall in price will happen.
    Cutting down Mutual fund NFO’s was the moment when people stopped investing into stock market and then it went into hands of FII’s.
    Nothing can stop flow of money to gold. more it rise more people will buy, more it falls more people will buy.
    Best remedy for real black money is issue Rs10k/5k denomination note and then systimatically cancel it in 5 years.