What is LTRO? Know The "Operation Twist" by the RBI

The Reserve Bank of India has been in news lately for the implementation of the Operation Twist and/or LTRO(Long Term Repo Operations) in order to boost and infuse liquidity into the economy. The RBI did this so to recover from the economic downturn caused by COVID pandemic. However, they have been doing something similar since November 2019, when COVID was not even around. The liquidity crunch made RBI undertake multiple Open Market Operations(OMO) and Repo rate cuts. Let's find out the story behind this.

Where It All Started...

The story goes back to when the IL&FS fraud and credit default which shook the country's vigilance and credit system. The rising number of loan defaults caused the banks to restrict the supply of cash into the economy, that is, the banks became more cautious and vigilant while giving out credit. When the supply of money stopped in the economy so did economic progress. This caused RBI to undertake multiple repo rate cuts and Open Market Operations. To find out more about how repo rate works, click here.

Essentially, before implementing LTRO, the Reserve Bank implemented two liquidity tools namely LAF(Liquidity Adjustment Facility) and MSF(Marginal Standing Facility). So what do these terms mean exactly?

LAF or Liquidity Adjustment Facility is a monetary policy tool used to induce liquidity in the market wherein the RBI lends money to all banks(Private and Otherwise) at the repo rate for a short period( Overnight upto 7 days) depending on the situation in exchange for government securities or bonds.

MSF or Marginal Standing Facility is the rate at which scheduled banks can borrow funds from Reserve Bank of India (RBI) overnight at repo rate + 3%(300 basis points).

However, neither MSF nor LAF did any good. The RBI's intention was to put money into the system, and the money did reach the banks. However, it failed to reach the market. People refused to borrow money. The rate cuts only reduced the interest received on bonds, whereas the banks couldn't reduce their interest rates. This failed to drive up investments. The problems of LAF and MSF were:

1. Lack of Policy Transmission. Even though RBI had rate cuts, this didn't reflect in the banking system which failed to deploy the funds into the market.
2. Credit Flow was inadequate, the market's borrowing didn't increase substantially.
3. Liquidity Issues.

Coming to LTRO or Long Term Repo Operations

After the LAF and MSF failed to boost the economy. The RBI decided to come up with LTRO or Long Term Repo Operations and the Operation Twist.

Fun Fact: Operation "Twist" was implemented for the first time in the USA by the Kennedy Administration in the mid-1960s. It was named after a dance form which was a craze back in the day.

LTRO is a tool that lets banks borrow funds for one to three years from the central bank at a fixed repo rate, by providing government securities with similar or higher tenure as collateral. Essentially, instead of a repo operation for a short term, RBI is lending money to the banks for a longer-term (greater than 1 year).

The government implemented the LTRO in three stages:

1. LTRO. Notified on Feb 07. Read Here.
2. TLTRO I (Targeted Long Term Repo Operation).
3. TLTRO II.

In the first LTRO, RBI had deployed ₹50,000 crores worth of funds. By 18th March, RBI had lent out ₹1.5 Lakh crores worth of funds banks for a period of one to three years. To RBI's dismay, the COVID-19 pandemic forced the entire nation to go under a lockdown. This meant banks had no reason to deploy funds. Banks held on the funds instead of deploying them.

The RBI had to figure out a way to ensure that the banks deployed the funds in the market instead of holding on to them. Therefore, RBI came up with Targeted LTRO (TLTRO).

Under TLTROs the banks had to invest the amount received in TLTROs in primary and secondary markets. This involved corporate bonds, commercial paper, debentures, NBFCS, MFIs and other securities. Thereafter, In TLTRO 2.0 banks had to :

1. Invest at least 50% of the total funds in bonds issued by small NBFCs of asset size of Rs 500 crore and below
2. Invest in Mid-sized NBFCs of asset size between Rs 500 crore and Rs 5,000 crore
3. Invest in MFIs or Micro Finance Institution
   
   However, TLRTO was a no show with very few bidders participating in it. Essentially, it wasn't a success as well.

Operation Twist

There were certain pre-conditions set by banks to avail TLTROs by banks. It involved banks requiring to invest a certain amount of borrowed amount in the primary and secondary markets. On 25th August 2020, the RBI announced that it was going to conduct the second stage of Operation Twist to induce liquidity into the market.

Let's understand a few terms before understanding Operation Twist.

• Operation Twist- Operation Twist is an Open Market Operation(OMO) by the central bank where it sells short term bonds and buys more long term bonds. These are mostly government securities(G-Sec)

• Long Term Bonds- These bonds are redeemable in the far future or are far from maturity.

• Short Term Bonds- These bonds are redeemable in the near future or closer to maturity.

• Liquidity- Money supply for an individual or a group of individuals or the market.

• Yield - A bond yield is the return an investor realizes on a bond.

What goes on in Operation Twist

In Operation Twist, the central bank sells short term bonds. The proceeds received from selling short term bonds are used to buy more of long term bonds.

What this does is that it creates a shortage of long term bonds, which in turn increases its price. This brings down its yield or interest rate. Likewise, the opposite holds true for short term bonds.

Note: Price and Yield of a bond are inversely proportional.

When the RBI sells the short term bonds, the supply of it increases, which in turn decreases the price of the bond, which in turn increases yield, which then drives up short term interest rates.

When the short term bonds mature and its payout time, the ones who own the bonds will get a higher payout than usual. This increases the 'supply of money' in the system. Which brings down overall interest rates. The lower interest rates encourage the market to borrow more and invest in market activity. This way the economy starts to prosper.

Summing it up

The Operation Twist in recent times was first adopted post the 2008 economic crisis to lift the country out of recession. The RBI had been trying its best to revive the Indian money market after the IL&FS fraud and default case. It had tried various different monetary policy tools, LAFs, MSFs, OMOs and LTROs all to its dismay. This move has been praised by many as a masterstroke. Well, many such operations were in the past. Whether or not the Operation Twist turns out to be a masterstroke, only time can tell.