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RBI’s recent monetary policy can extricate Indian economy in short term



Recent surge in Indian equity market might have brought cheer to the jittered investors, but credit should be given to the RBI Governor ‘Urjit Patel’ for his austere move of buying back govt securities to infuse capital into parched Indian market, especially at the time when the sanctity of the central bank is being questioned by the government. Government has always been at loggerheads with central bank over economic policies, even pointed out by the last RBI Governor ‘Raghuram Rajan’. It might have turned severe this time with government threatening the autonomy of central bank leading RBI deputy governor coming forward quoting “Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire and come to rue the day they undermine an important regulatory institution.” However, the tensions seem to have eased off with markets finally gaining momentum, US waiving Iran’s sanctions and record GST collection ahead of festive season. In this article, I am going to talk about how an open market operation works and what effects government buy backs will have on Indian market.
Open market operations can be of two types and are usually exercised by government to provide stability to financial markets, control inflation and bolster economy by managing interest rates.
In expansionary open market operation, central bank tries to stimulate the economy by providing liquidity to banks so that they have enough cash to lend. They do it by buying back government securities and injecting capital into the market. This results in banks having sufficient reserves to lend.
In contractionary monetary policy, central bank sells government bonds/ securities to put brakes on an overheating economy and rising inflation. By executing contractionary open market operations they reduce funds in banks which results in increase in short term interest rates since there is less money in circulation for borrowers. This makes it expensive for people to borrow resulting in controlling inflation.
Announcement of consecutive buying back operations by RBI is expected to provide much needed liquidity in the underconfident market. Indian markets had been on a downward spiral since the revelation of defaults by the largest Non banking financial company ‘ILFS’ where government had to bail it out in order to avoid the contagion effect. Strictness of law by RBI and lending restrictions on state owned banks to control non controlling assets have resulted in liquidity crunch for businesses looking to get credits to expand. Not only it has shaken the market, loss of confidence could also be seen by net outflow by FII in recent months. By deciding to buy government securities, RBI is trying to bring that confidence back.
Buying back securities would be like a knight in shining armor for the bond holders. Effect of expansionary monetary policy can be seen by the decrease in an all time high short term yields, sloping up an almost flattened yield curve, another issue that RBI had to deal with. Yield on short term bonds has decreased from 8.14% to 7.75%. Prices and yields move in opposite direction. Decrease in yield would make the existing bonds more valuable, making it less costly to raise debt, thereby, bringing confidence into sluggish debt market. 
High bond yields also put pressure on stock markets making current valuation expensive, which leads to cash flow from equity to bond markets in a rising interest rates environment. For example, present value of a stock can be found out by discounting projected cash flows at WACC. If yield/discount is high, present value of the stock would end up being low making their previous valuation look expensive. Investors demand high yield for taking additional risks and thus switching to high yielding bond market is not surprising. By reducing yield on short term securities RBI is trying to revive the stock market that has seen some outlandish outflow in recent times.
The move, coming at a time did bring some cheer to Indian investors but at the core, Indian market is still struggling to find stability. GNPA has increased to 12.3%. Foreign fund net outflow in 2018 touched Rs 1 lakh Crore and is expected to stay like this on account of shrinking interest rates difference between US and India.  Most of the recent surge in market is due to confidence shown by domestic investors which could just be a result of short term momentum. 
I would suggest be cautious in the current market especially during the time of approaching elections as market is still fundamentally weak and there could be further depreciation in rupee on account of increased pressure on current account by hefty government's electoral spending.
Author: Mohit Tuteja | MS Finance, University at Buffalo, State University of New York | Master of Management, University of Sydney | CFA Level 1 candidate

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