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Foundations

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.

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