Which of the following best explains “Operation Twist” by RBI?
(A) It increases CRR while decreasing SLR
(B) It simultaneously buys long-term and sells short-term government securities
(C) It raises repo rate but reduces reverse repo
(D) It involves swapping forex reserves for rupee bonds
The correct answer is (B) It simultaneously buys long-term and sells short-term government securities.
What is Operation Twist? 🔄
Operation Twist is a special type of open market operation where the central bank (RBI) tries to change the shape of the yield curve. A yield curve is a graph that plots the interest rates (yields) of bonds with equal credit quality but different maturity dates.
The RBI’s goal with Operation Twist is to lower long-term interest rates to make borrowing cheaper for companies and individuals, thus boosting investment and consumption, without injecting new money into the economy.
It works like this:
- RBI Buys Long-Term Government Securities (G-Secs): This increases the demand for these bonds, causing their prices to rise. When a bond’s price goes up, its yield (the return you get) goes down.
- RBI Sells Short-Term Government Securities: This increases the supply of short-term bonds, causing their prices to fall and their yields to rise.
The net effect is a “twist” – long-term rates fall while short-term rates rise, flattening the yield curve. The operation is liquidity-neutral because the money raised from selling short-term securities is used to buy the long-term ones.
Definitions of Key Terms in All Options
To fully understand why the other options are incorrect, here are the definitions of the key monetary policy tools mentioned.
From Option (A): CRR and SLR
- Cash Reserve Ratio (CRR): This is the percentage of a commercial bank’s total deposits that it must hold as a cash reserve with the RBI. Banks do not earn any interest on this money. A higher CRR means banks have less money available to lend, which reduces liquidity in the system.
- Statutory Liquidity Ratio (SLR): This is the percentage of a bank’s deposits that it must maintain in the form of safe, liquid assets like cash, gold, or government securities. A higher SLR restricts a bank’s lending capacity.
These are tools to manage the quantity of money, not to specifically structure long-term and short-term interest rates.
From Option (C): Repo and Reverse Repo Rate
- Repo Rate: This is the interest rate at which the RBI lends money to commercial banks, typically for a short period, against government securities as collateral. It is a key tool to control inflation. When the RBI raises the repo rate, borrowing becomes more expensive for banks, which in turn raises interest rates for the public.
- Reverse Repo Rate: This is the interest rate at which commercial banks can park their excess funds with the RBI. It’s the rate at which the RBI borrows from banks. It’s used to absorb excess liquidity from the financial system.
These are the main policy rates that influence the overall cost of money in the economy, but they don’t perform the specific “twisting” action on the yield curve.
From Option (D): Forex Swap
- Forex Swap: This is an agreement between two parties (like the RBI and a commercial bank) to exchange currencies for a certain period. For example, the RBI might sell US dollars to a bank in exchange for Indian rupees and simultaneously agree to reverse the transaction at a specified future date and rate.
This tool is primarily used to manage the country’s foreign exchange market and the liquidity of the domestic currency.