Indian two thousand and five hundred rupee banknotes are arranged for a photograph in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

RBI MPC Meet: Does India Need Its Own Version Of ‘Operation Twist’ To Protect The Rupee?


The abrupt pressure on currencies and the delicate policy balance needed to stave off that pressure remains the most critical conundrum for emerging market central banks.

Over the past few months, as currency weakness has persisted, monetary policy strategies have evolved and communication has changed. In recent instances, the Bank of Indonesia has resorted to a series of rate hikes and, in its accompanying statement, said that the need to “maintain the attractiveness of domestic financial markets” and “maintain external resilience” amidst global uncertainty were among the reasons for the rate action. This is an explicit guidance with embedded assurance for the future too.

India, too, has continued to see a depreciation in its currency. On Oct. 3, the rupee fell to a record low of 73.35 against the dollar.

So far, the Reserve Bank of India has allowed the market to adjust to global forces and used foreign exchange reserves to smoothen out market moves. In addition, policy rates have been raised by 50 basis points this year to defend against inflation pressures, including those emanating from a weaker currency.

The current debate in India is centered around two questions:

  • Should the central bank try and prevent depreciation beyond a point or let markets find their own level?
  • And if the central bank should intervene, should it consider the use of interest rates via another round of 25-50 basis point in rate hikes?

Let us focus on the second question. If the level of the rupee is to be protected, then what is the way to go?

In the current environment of rising adversities, the MPC may choose to stay away from a series of policy rate hikes in a short span of time as these could take heavy toll on the economy in the medium term, even though a weaker rupee is no lesser evil.

Credit Markets And Currency Markets

To understand why, you need to look away from the currency markets and towards the credit markets.

The ongoing strain in the credit markets, particularly for non-bank lenders, could have a bearing on growth in the economy if it persists. Non banking financial companies have shown strong growth in their loan books over the last few years driven by access of abundant and reasonably priced capital from the bond markets and from banks. This, in turn, has helped keep consumption spending strong amidst subdued capital expenditure from corporates.

Should growth in NBFC credit slow down, it will shave off consumption spending directly or indirectly. This slowdown could rein in consumer imports to an extent and prove to be a blessing in disguise for rupee.

In essence, the strain in the credit markets could, inadvertently help the currency markets. Thus, another hike in the policy rates may not be appropriate.

India’s Own Operation Twist

Instead of using a blunt instrument like a policy rate hike, the RBI could consider a more delicate maneuver by influencing the shape of the yield curve.

Changing the shape of yield curve, aka Operation Twist, was a mechanism used during the quantitative easing period. The key objective of QE, unveiled after the collapse of Lehman Brothers, was to bring down long-term yields and push real interest rates into negative territory, to protect against recessionary impulses in the economy. While pumping money into the system on the one hand, the Federal Reserve also made it more lucrative for banks to park money with the central bank. They did the latter by taking a decision to start paying interest on required and excess reserves parked with the Fed.

By doing that, the net system liquidity was contained to guard against short term asset price bubbles. Thus, the common myth that QE was only designed to pump in a deluge of money into the system is largely unjustified.

The chart below shows that the money parked with the Fed went up to as high as 22 times the required holding of reserves. It currently stands at 10 times the minimum requirement.

RBI MPC Meet: Does India Need Its Own Version Of ‘Operation Twist’ To Protect The Rupee?

Also read: India Fights Rupee Drop, Cash Crunch in Coordinated Policy Moves

Coming back to India, the economy is no where close to recession, but managing the yield curve could be an effective tool to guard against a weakening currency in a manner that doesn’t hurt the broader economy.

This could be done in a way to keep the long-term yield at a level, which is conducive for capital creation. At the same time, the short-term yield could be nudged higher to ensure the attractiveness of Indian financial assets to the rest of the world given the flattening of the U.S. yield curve.

Most of the portfolio flows that come to India come into shorter tenure securities. With U.S. short term rates rising, higher rates in India would help maintain the interest rate differential alive and keep foreign investor interests in these securities alive.

How Can This Be Achieved?

So, how can the RBI go about this ‘Operation Twist’?

The RBI could buy more long-term government bonds under its open market operations to pull down yields. This would be consistent with the needs of the domestic market as well since portfolio flows (net foreign assets) have been feeble. Considering the required base money expansion, it is legitimate to expect more open market operation bond purchases to ensure a level of liquidity that is not disruptive to the economy. At the same time, the government could issue more shorter tenure bonds in sync with the borrowing targets in the second half of the year.

Together, this could mean adequate availability of short-term liquidity through the money market segment, albeit at higher cost. Moreover, at the system level, the duration of bonds will come down amid hardening interest rates - a nuanced step towards ensuring stability in the system.

Anecdotal evidence suggests that a weak domestic currency acts as a disincentive to exporters and other entities to bring back their foreign currency receivables. This happens when exporters expect the currency to weaken further and see opportunity to borrow at reasonable rates in the domestic market. To break this arbitrage, it is necessary to disincentivise unnecessary short-term borrowings. Elevated short-term domestic rates could do this job.

This operation would also need to go together which some appropriate communication, which would have the desired impact on the Rupee and credit flows. The communication should aim to encourage credit creation for long-term growth and the RBI’s signalling should be clear enough to avoid any ‘signal extraction’ problems.

The strategy is not without risk. It is possible that the liquidity infusion leads to a fall in short-term yields, which, in an environment of credit risk aversion, could lead to currency weakness. This could eventually become an adverse feedback loop. To prevent that, the RBI could consider a purchase of long-term government bonds which runs parallel to the sale of short-term bonds. Both can be done under the central bank’s open market operations.

To be sure, the effectiveness of yield curve dynamics and its impact on credit is not easy to gauge completely. Nonetheless, it may be worth considering this as an option to policy rate hikes, which could prove to be a blunt instrument to deal with a complex domestic environment.

Also read: Rupee Fall: India’s Not The Weakest Emerging Market, Why Is Its Currency So?

Soumyajit Niyogi is Associate Director at India Ratings & Research - a Fitch Group Company. The views expressed here are his own and do not reflect those of his organization.