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Concepts & Tutorials

The Original Operation Twist and Why India’s Version Will Fail

In 1961, when Kennedy became President, the US was going through a recession. The answer was to lower interest rates, but since rates were higher in Europe (and money was backed by gold), the fear was that people would just take their money and gold from the US and put it elsewhere. The yield curve was normal – that is, short term rates were lower than longer term ones.

(Source: Eric T. Swanson, HT @anandhsub)

Since businesses borrow longer term, and arbitrageurs play in the short term, one idea was to keep short term rates high (so arbs will bring money to the US) and long term rates low (so businesses can borrow at better rates). This could have been achieved with the Fed buying the longer term securities, while the treasury (the government) issued more short term and less long term securities. Effectively the yield curve was being moved from an upward sloping one to a flat one, which explains the “twist”.

Note that a few factors helped:

  • Arbitrageurs weren’t stopped from taking out or bringing in money
  • Inflation wasn’t bad. A recession kind of ensured that.
  • There was a normal yield curve to begin with
  • The size of the operation was HUGE – about 1.7% of GDP. ($8.8 bn of long term securities bought)
  • Issuance of longer term securities was replaced by the shorter term ones.
  • The program lasted four years for an impact.
  • I don’t know if foreign investors could hedge the currency but in all likelihood the US would not have prevented a hedge.

The impact: There was no major impact for about six months. While the program was launched in Feb 1961, by October, short term yields had fallen (from 2.42% to 2.3%) and long term yields had risen (3.84% to 4.01%). However, slowly over four years, the yield curve flattened out as we see here:

Yields during Operation Twist 1

(Source: Amol Agarwal’s paper at STCI)

Why will Operation Knicker-Twist (India) Fail?

The RBI is trying something that sounds dangerously like Operation Twist of the US. It’s being called Operation Knicker-Twist, because we at Capital Mind know what is getting twisted. The concept is the same – reduce long term bond yields but maintain high short term rates.

It will fail.

The conditions in India are not conducive for such an action. (That is the PR version. The real sentence is: Have we gone batshit insane? But I digress.)

  • India has an inverted or flat yield curve already. (See this post) We have had an inverted curve for the last few years. But right now, before this madness, we are at short term yields of 10% and long term yields of 9%.
  • India has high inflation. Adding net money to the system (RBI must print money to buy bonds, but it can only temporarily take out money by selling fresh short term bonds, which mature quickly and the money goes back in) will cause even more inflation. We have directly caused inflation by inflating money supply in the last decade, largely printing to buy dollars, and more printing now will be fatal to our children.
  • Foreigners and Indians both find it difficult to arbitrage debt. To buy debt a foreigner (and only specific approved ones called FIIs) has to bid for it once a month. They have to pay for the privilege. The SGL system is a pain and makes things extremely difficult. Indians find it difficult to get foreign exchange to buy foreign debt (which is the other part of the arbitrage).
  • Hedging is a pain and sometimes impossible. If you’re betting one interest rate against the other, you want to get the currency out of the equation. Hedging the rupee is difficult because the RBI makes it so. Limits on trading, limits on who can trade how much, limits on where the rupee can be traded, limits on authorised dealers – these hamper the ability to hedge.
  • There is no slowing down of longer term issuance. Without that a Twist of any sort will fail, like it did in the US in 2012.
  • We don’t have that kind of size. If we tried a 1.7% of GDP program, this would mean printing around 200,000 cr., which would expand the RBI balance sheet by 10% and cause huge inflation. Then, like someone said, it will be million, billion and then onion.
  • We don’t have that kind of time. The RBI expects this to steady the markets in the short term – otherwise it would be a well thought out plan. They can’t handle a longer term bond going even higher for six months before the program takes its impact. In a longer time frame inflation would have kicked in and they will have to raise rates – note that when the yield curve was flat in the graph above, the rates were substantially higher, and the RBI has no appetite for double digit long term yields.

Why it will fail is that this is not well thought through or designed. Doing something like this a month before a new governor comes in, if it meant to be a longer term measure, is a little weird – I hope that Mr. Rajan is not involved in its construction. If it is not meant to be long term then it will fail before you can say “twist”.

What is my solution? I’m suddenly not sure of the problem in the first place. The liquidity tightening will work in about a year, if you just give it time and stick with the program. Let the dollar go where it has to, control inflation (pretty much all that the RBI can impact right now) and don’t create panic by knee-jerk reactions. There will be defaults, and there will have to be bank mergers or rescues, so prepare for that anyhow. Cursing gold imports, reducing trading and doing the wrong thing with a good market will only hurt us and create fear in the minds of outsiders who want to invest. We’re a darn big economy, now let’s behave like one.

  • Ngm says:

    If possible can you comment about your views on this Krugman piece:
    He states it is that headlines about the rupee’s fall are mostly overdone and has mostly resulted because of withdrawal by FIIs. Also he notes that external debt is around 20% of GDP.
    I noted that around 56% of this debt is in USD and 23% is INR. Now that the INR is falling it should be easy to serve this 23% of debt? ( page 6)

  • Ngm says:

    IMO I find MMS and Chidu panicking as well (slew of recent measures), so Krugman is missing something. I think Panic is because of Oil imports stand at around 6% of GDP (Now that they are put in measures to curb Gold imports)
    Your thoughts? What is Krugman missing?

  • Jose says:

    Brilliant Deepak, perfectly analysed. Your recommendation is bang on..but do they hv the balls in their Knicker ? to bite the bullet and take on the Political class ? Todays market gave a Thumbs down to it by ramming the Rupee ! So much for RBI’s policy…..Fire in the mountain run run run 🙂

  • mangoman says:

    RBI and government are working in tandem to rape the real savers of economy. To help a handful of people who get benefited from the banking system, they keep the entire Indian population to ransom by resorting to keep the interest rate artificially low for extended period for may be about 5 years now.
    The system is screaming for rate hike but RBI is resisting the temptation to support the people who are in power. Also the government is successful in creating a section in media and as well as general public who can support rate cut. Most of them are idiots and few of them are interested parties who think that their real estate ‘investment’ will not lose value if the rates are cut. How pity?
    Now yesterday RBI tried something and Mangoman thought that markets may rally for 1-3 days. But markets ( how cunning this animal is..) gave it right back at RBI and fell for about 2%. so now what?
    Rupee is touching new low everyday. This is kind of record of sorts.
    You have to read foreign media about the real damage to Indian economy.
    wall street journal, economist, reuters etc are rapping india down. And many of them in the opinion that India deserve a downgrade. So what? WE WANT TO SAVE OUR REAL ESTATE GOONS. LET COUNTRY GOES TO HELL. am I right?

  • mangoman says:

    I read a interesting piece of view in Economic Times editorial few days back.After shedding crocodile tears about the fall in Indian currency in few sentences the newspapers says that
    ‘ we knew about this (collapse of rupee and markets) much earlier. But not to make people panic we did not write this in our newspaper. we have ethics blah..blah..blah..’
    My comments
    Most idiotic statement has come from times. We know times is interested party in propping up the bubble . The own artha property and are neck deep into real estate business also. Be informed that this newspaper always paints a rosy picture about the economy and had a huge role in propping up the real estate bubble in the country. Many insuspecting news readers would have fell for the advertisements and recommendations given by the paper.
    Remember with every monetary easing, this newspaper is used to write ‘your home loan rate is coming down’ even though the benefits are not passed on by banks. Now they are taking credit on both sides. There is a saying in tamil.
    பேய் ஆட்சி செய்தால் பிணந்தின்னும் சாத்திரங்கள்…