report on currency and finance 2005-06...ever since the introduction of theme based report on...

REPORT ONCURRENCY AND FINANCE

2005-06

RESERVE BANK OF INDIA

DEVELOPMENT OF FINANCIAL MARKETS ANDROLE OF THE CENTRAL BANK

“The findings, views, and conclusions expressed in this Report are entirely thoseof the contributing staff of the Department of Economic Analysis and Policy(DEAP) and should not necessarily be interpreted as the official views of theReserve Bank of India”.

In India - Rs. 280 (Normal)

- Rs. 300 (Inclusive of Postal Charges)

- Rs. 210 (Concessional)

- Rs. 235 (Concessional Inclusive of Postage)

Abroad - US $ 35 (Inclusive of Air Mail Courier Charges)

Published by A. Karunagaran for the Reserve Bank of India, Mumbai-400 001and designed and printed by him at Alco Corporation, A-2/72, Shah & Nahar Industrial Estate, Lower Parel, Mumbai-400 013

© Reserve Bank of India 2006All rights reserved. Reproduction is permitted provided an acknowledgement of the source is made.

ISSN 0972-8759

FOREWORD

Over the last 10 years, many emerging market economies have made significant efforts to strengthentheir domestic financial systems, including various segments of the financial market. A well-functioningfinancial market is a key to sustained economic growth. Financial markets also facilitate effectiveimplementation of monetary policy by serving as a link in the transmission mechanism between monetarypolicy and the real economy. In India, although financial markets have existed for a long time, they remainedrelatively underdeveloped vis-a-vis some emerging market economies for a variety of reasons. Concertedefforts to develop the financial markets towards global standards began in the early 1990s as a part ofbroader financial sector reforms.

Reforms in the financial markets encompassed all segments - the money market, the credit market,the government securities market, the foreign exchange market, the equity market and the private corporatedebt market. The development of financial markets has been pursued for bringing about a transformationin the structure, efficiency and stability of markets. Some of the major measures that have been initiatedto develop the financial markets include market determined pricing of various financial assets, removal ofrestrictions on participants, introduction of electronic trading platforms and introduction of new instruments.All these measures have had a significant impact on the structure and efficiency of financial markets.However, financial markets in India are not yet fully developed. There are several issues that remain to beaddressed. The need for developed financial markets has never been felt so strong as at this point of timefor several reasons such as sustaining the present high rate of economic growth; improving transmissionmechanism of monetary policy; developing a diversified financial system and maximising gains fromglobalisation while minimising its costs.

Ever since the introduction of theme based Report on Currency and Finance in 1998-99, theDepartment of Economic Analysis and Policy has released seven Reports encompassing several importantcontemporary issues concerning central banking and macroeconomic issues relating to India. The currentReport is in continuation of the themes addressed in the previous Reports and attempts to address theissue of financial market development. An effort has been made in this Report to cover the vast canvasof financial market operations as they have emerged in India. The thrust of the Report is to considerapproaches for making financial markets in India more developed, efficient and integrated in the light ofour own experience gained so far and keeping in view the international best practices, while recognisingcountry context, especially that India is an emerging market economy. The pace of change in financialmarket development will necessarily have to be guided by the predominant imperative of maintainingmacroeconomic and financial stability, while enabling growth inclusive.

The Report has been prepared in the Department of Economic Analysis and Policy with the activeinvolvement of operational departments. The Report has been prepared under the guidance and supervisionof Janak Raj, Adviser. R.K.Pattnaik, Adviser was also involved.

The core team involved in the drafting of the Report comprised Rajiv Ranjan, Dhritidyuti Bose, R.KJain, Rajan Goyal, Muneesh Kapur, A.Karunagaran, Kumudini Hajra, M.Ramaiah, Sharat Dhal, Deepa SRaj, Indranil Bhattacharyya, Binod B Bhoi, Satyananda Sahoo, Siddhartha Sanyal, Atri Mukherjee, S.Suraj,S.M.Lokare, Sangita Misra, Jai Chander, Raj Rajesh, V.Dhanya, Harendra Behera, Amar Nath Yadav,A.K.Shukla, Pallavi Chavan, Samir Behera, Rajeev Jain, B.S.Misra, Sunil Kumar and Indrani Manna.

Dr. P.D.Jeromi, who unfortunately passed away while the work of preparing the Report was inprogress, made a valuable contribution.

The team benefited from the significant suggestions from V. Leeladhar, Shyamala Gopinath,Usha Thorat, V.K. Sharma, K.Kanagasabapathy and G.S.Bhati.

Notable contributions were made at various stages of preparation of the Report by officers fromthe operational departments, viz., Himadri Bhattacharya, Prasant Saran, Salim Gangadharan, MichaelD. Patra, Chandan Sinha, G. Mahalingam, Mridul Saggar, Himanshu Joshi, Partha Ray, T. Rabishankar,T.B.B. Verma, Deepak Kumar and Mohua Roy.

These apart, impressive contributions by operational departments, viz., Monetary Policy Department,Department of Banking Operations and Development, Financial Markets Department, Foreign ExchangeDepartment, Department of External Investments and Operations are highly appreciated. Almost everyDivision in the Department of Economic Analysis and Policy contributed in the preparation of the chapteron ‘Recent Economic Developments’ (Chapter II).

I hope that the analysis presented and suggestions made in the Report would guide us in ourendeavour to further develop the financial markets.

I take this opportunity to place on record my deep appreciation of the professional skills and utmostdedication of the officials of the Department of Economic Analysis and Policy, without which it would nothave been possible to bring out this Report.

Rakesh MohanMay 24, 2007 Deputy Governor

I

CONTENTS

Page No.

FOREWORD

I. THEME OF THE REPORT ......................................................................................... 1 to 8

Mobilising Resources for Sustaining Higher Growth .................................................. 2

Financial Markets and Monetary Policy ..................................................................... 3

Diversified Financial System ...................................................................................... 4

Financial Integration and Financial Markets ............................................................... 5

II. RECENT ECONOMIC DEVELOPMENTS ................................................................. 9-66

Real Sector ................................................................................................................. 10

Fiscal Situation ........................................................................................................... 21

Monetary and Credit Situation .................................................................................... 30

Financial Markets ....................................................................................................... 41

Banks and Financial Institutions ................................................................................. 52

External Sector ........................................................................................................... 55

Overall Assessment .................................................................................................... 64

III. MONEY MARKET ...................................................................................................... 67-118

Role of the Money Market – Theoretical Underpinnings ............................................ 69

Operating Procedures and Money Market – International Experience ...................... 73

Money Market in India – Up to the Mid-1980s ........................................................... 80

Evolution of Reserve Bank’s Liquidity Management .................................................. 81

Money Market Developments – Mid-1980s Onwards ................................................ 91

The Way Forward ....................................................................................................... 106

Summing Up ............................................................................................................... 108

Exhibit III.1 : Monetary Policy Transmission through Interest Rate Channel ............. 70

Annex III.1 : Operating Procedures of Liquidity Management in Developed Countries ................................................................................................ 110

Annex III.2 : Operating Procedures of Liquidity Management in Emerging Market Economies ................................................................................. 111

Annex III.3 : Structure of Money Markets ................................................................... 112

(Contd...)

II

IV. CREDIT MARKET ...................................................................................................... 119-163

Significance of the Credit Market ............................................................................... 120

Institutional Structure of the Credit Market in India .................................................... 121

Policy Developments in the Credit Market in India ..................................................... 124

Trends in Credit – The 1990s and Onwards ............................................................... 129

The Way Forward ....................................................................................................... 157

Summing Up ............................................................................................................... 160

Exhibit IV. I : Credit Market Structure .......................................................................... 123

Annex IV.1 : Menu of Policy Options in Responding to Rapid Credit Growth ............ 162

Annex IV.2 : Supervisory Measures to Manage Key Risks of Rapid Credit Growth .. 163

V. GOVERNMENT SECURITIES MARKET .................................................................. 164-210

Role of the Government Securities Market ................................................................ 165

International Experience ............................................................................................ 169

Government Securities Market in India – Policy Developments ................................ 179

Government Securities Market in India: Analysis and Assessment ........................... 193

The Way Forward ....................................................................................................... 202

Summing Up ............................................................................................................... 207

Annex V.1 : Reforms in the Government Securities Market ....................................... 209

VI. FOREIGN EXCHANGE MARKET ............................................................................. 211-257

Exchange Rate Regimes in Emerging Markets ......................................................... 212

Indian Foreign Exchange Market: A Historical Perspective ....................................... 216

Foreign Exchange Market Structure .......................................................................... 220

Foreign Exchange Market: An Assessment ............................................................... 228

Behaviour of the Foreign Exchange Market in the Post-Unification Period ............... 236

Issues Relating to Central Bank Intervention in the Foreign Exchange Market ........ 248

The Way Forward ....................................................................................................... 253

Summing Up ............................................................................................................... 256

Exhibit VI.1 : De Facto Exchange Rate Regime of Fund Members ........................... 214

Page No.

(Contd...)

III

VII. EQUITY AND CORPORATE DEBT MARKET .......................................................... 258-284

Equity Market .............................................................................................................. 258

Private Corporate Debt Market .................................................................................. 271

The Way Forward ....................................................................................................... 279

Summing Up ............................................................................................................... 282

Annex VII.1 : Characteristics of Trading Frameworks for Corporate Bonds ............... 284

VIII. FINANCIAL MARKET INTEGRATION ...................................................................... 285-312

Concept and Dimensions of Financial Market Integration ......................................... 286

Policy Measures Enabling Market Integration in India ............................................... 289

Domestic Financial Markets Integration in India ........................................................ 289

India’s International Financial Integration ................................................................... 301

The Way Forward ....................................................................................................... 308

Summing Up ............................................................................................................... 312

IX. OVERALL ASSESSMENT......................................................................................... 313-322

Money Market ............................................................................................................. 314

Credit Market .............................................................................................................. 315

Government Securities Market ................................................................................... 317

Foreign Exchange Market .......................................................................................... 318

Equity and Corporate Debt Market ............................................................................. 319

Summing Up ............................................................................................................... 320

SELECT REFERENCES............................................................................................ I to XVIII

Page No.

IV

LIST OF BOX ITEMS

Box No. Title Page No.

III.1 Role of the Money Market in the Monetary Transmission Mechanism ............... 72

III.2 Liquidity Adjustment Facility ................................................................................ 85

III.3 The Interface between Monetary Policy Announcements andFinancial Market Behaviour ................................................................................. 89

III.4 Market Microstructure: Issues in Money Market Liquidity ................................... 90

III.5 Development of a Short-Term Yield Curve – Some Issues ................................. 94

IV.1 The Credit Channel of Monetary Policy .............................................................. 122

IV.2 Credit Market Reforms ........................................................................................ 126

IV.3 Asset Securitisation ............................................................................................. 127

IV.4 Credit Information Bureaus ................................................................................. 127

IV.5 Credit Derivatives ................................................................................................ 128

IV.6 Policies Relating to the Priority Sector, Micro-finance andCredit Cards in Rural Areas ................................................................................ 133

IV.7 Credit Flow to Small Scale and Medium Industries – Recent Measures ............ 140

IV.8 Household Credit Market – International Experience ......................................... 144

IV.9 Rapid Increase in Credit – Prudential Measures ................................................ 145

IV.10 Determinants of Bank Credit ............................................................................... 149

IV.11 Credit Boom: Analytical Issues ........................................................................... 151

IV.12 Credit Boom and Monetary Policy....................................................................... 152

V.1 Role of Government Securities Yield Curve as a Public Good ........................... 166

V.2 Government Debt Structure and Monetary Conditions ....................................... 168

V.3 Principles of a Deep and Liquid Government Securities Market ........................ 169

V.4 Auction Pricing – Uniform versus Multiple ......................................................... 173

V.5 Reserve Bank and the Government Securities Market – Legal Framework ....... 180

V.6 Mandated Investment in Government Securities ................................................ 182

V.7 Revised Guidelines for Primary Dealers ............................................................. 184

V.8 Risk Management Practices adopted by the CCIL ............................................. 191

V.9 Separate Trading of Registered Interest and Principal of Securities (STRIPS) .. 205

VI.1 Exchange Rate Regimes and Monetary Policy in EMEs .................................... 213

VI.2 Recommendations of the Expert Group onForeign Exchange Markets in India ..................................................................... 219

(Contd...)

V

Box No. Title Page No.

VI.3 Measures Initiated to Develop the Foreign Exchange Market in India ............... 220

VI.4 Foreign Exchange Derivative Instruments in India ............................................. 223

VI.5 Derivatives Market: Comprehensive Guidelines ................................................. 224

VI.6 Policy Measures Undertaken in the Wake of Asian Crisis .................................. 239

VI.7 Invoicing Pattern of Trade and Exchange Rate Pass-Through ........................... 245

VII.1 Does Stock Market Promote Economic Growth in India? ................................... 260

VII.2 Private Placement Market in India ...................................................................... 273

VII.3 Recommendations of the High Level Expert Committee onCorporate Debt and Securitisation ...................................................................... 276

VII.4 Development of Corporate Bond Market– Experiences of Select Economies ................................................................... 278

VIII.1 Theory of Financial Market Integration ............................................................... 287

VIII.2 Benefits and Risks of Financial Integration ......................................................... 288

VIII.3 Measures Enabling Financial Market Integration in India ................................... 290

VIII.4 Foreign Exchange Market Efficiency................................................................... 298

VIII.5 Initiatives on Regional Integration in Asia ........................................................... 305

VI

LIST OF CHARTS

Chart No. Title Page No.

II.1 Annual Growth Rate of GDP at Factor Cost (At 1999-2000 Prices) ................... 10

II.2 Saving by Institutional Sources (At 1999-2000 Prices) ....................................... 13

II.3 Gross Capital Formation by Institutional Sources (At 1999-2000 Prices) .......... 13

II.4 Weighted Average Interest Rate on State Governments’ Market Borrowing ...... 29

II.5 Utilisation of WMA and Overdraft by States (Weekly Average) .......................... 29

II.6 Investment in 14-day Intermediate Treasury Bills by the State Governments .... 30

II.7 Broad Money Growth (y-o-y) ............................................................................... 33

II.8 Non-food Credit ................................................................................................... 34

II.9 Consumer Price Inflation ..................................................................................... 37

II.10 International Commodity Prices .......................................................................... 37

II.11 Wholesale Price Inflation ..................................................................................... 39

II.12 Movement in Key Market Rates .......................................................................... 43

II.13 Movement of Primary Yields of Treasury Bills ..................................................... 46

II.14 Government Securities Turnover and Yield Curve .............................................. 47

II.15 Rupee vis-a-vis Major Currencies ....................................................................... 49

II.16 Movement in Forward Premia ............................................................................. 49

II.17 Trends in Sectoral Stock Indices ......................................................................... 51

II.18 World Output Growth........................................................................................... 55

II.19 Growth in World Trade Volume and Prices .......................................................... 56

II.20 Movement of Invisibles Surplus .......................................................................... 60

II.21 Current Account Balance .................................................................................... 61

II.22 Net Inflows/Outflows by Foreign Institutional Investors ...................................... 62

II.23 NRI Deposits – Outstanding ............................................................................... 62

II.24 Accretion to Foreign Exchange Reserves ........................................................... 63

II.25 Currency Composition of External Debt ............................................................. 64

III.1 LAF Corridor and the Call Rate ........................................................................... 86

III.2 Reserve Bank’s Open Market Operations........................................................... 86

III.3 Liquidity Adjustment Facility and the Call Rate ................................................... 88

(Contd...)

VII


(Contd...)

III.4 Overnight Interest Rates ..................................................................................... 91

III.5 Call Money Rate .................................................................................................. 95

III.6 Yields on Treasury Bills ....................................................................................... 98

III.7 Commercial Paper ............................................................................................... 100

III.8 Certificates of Deposit ......................................................................................... 101

III.9 OIS and G-Sec Yields ......................................................................................... 103

III.10 MIFOR SWAP and G-Sec Yields ........................................................................ 104

III.11 Monetary Policy and Swap Rates ....................................................................... 104

III.12 Money Market Rates ........................................................................................... 105

IV.1 Total Assets of Financial Intermediaries-Relative Shares .................................. 124

IV.2 Bank Credit and Non-food Credit Growth ........................................................... 130

IV.3 Sectoral GDP and Credit ..................................................................................... 132

IV.4 Short-term Credit Intensity of the Industrial Sector ............................................ 138

IV.5 Types of Borrowings by the Private Corporate Sector ....................................... 138

IV.6 Trends in Credit to the SSI Sector ....................................................................... 139

IV.7 Credit Intensity of the SSI Sector ........................................................................ 140

IV.8 Share of Personal Loans Accounts/Amount in TotalAccounts/Amounts of Scheduled Commercial Banks......................................... 141

IV.9 Trends in Housing Loans ..................................................................................... 142

IV.10 Share of Personal Loans in Total Credit .............................................................. 142

IV.11 Share of Medium and Long-term Loans in Total Credit ...................................... 145

IV.12 Incremental Credit-Deposit Ratio ........................................................................ 145

IV.13 Credit and Investment ......................................................................................... 146

IV.14 SLR Investments by Scheduled Commercial Banks ........................................... 147

IV.15 Credit-GDP Ratio ................................................................................................ 147

IV.16 Non-performing Assets of Scheduled Commercial Banks .................................. 147

IV.17 Incremental Accretion to NPAs............................................................................ 147

IV.18 Cyclical Component as Percentage of Actual ..................................................... 150

IV.19 Policy Rates and Lending Rates of Banks .......................................................... 154

IV.20 Lending Rate and Yield on Government Securities ............................................ 155

VIII

V.1 Size of Government Securities Market – Select Countries ................................. 170

V.2 Weighted Average Maturity of Central Government Securities .......................... 195

V.3 Yield and Maturity of Central Government Dated Securities .............................. 196

V.4 Share of Re-issues in the Total Issuance of Central Government Securities ..... 197

V.5 Yield and Annual Turnover (market value) .......................................................... 197

V.6 Secondary Market Outright Transactions – Central Government Securities ...... 198

V.7 Holding Pattern of Central and State Governments Securities .......................... 198

V.8 Investment in SLR Securities by Scheduled Commercial Banks........................ 199

V.9 Yield Curve Movement – SGL Transactions........................................................ 199

V.10 Movements in Yield Spread ................................................................................. 200

V.11 Yield and Maturity of Central Government Dated Securities – Primary Auctions ....... 200

V.12 Monthly Yields and Turnover in Central Government Securities ......................... 201

V.13 Trading Volumes in When Issued Market ............................................................ 201

V.14 Yields on Various Government Securities Market Instruments ........................... 201

VI.1 Trends in Rupee-Dollar Exchange Rate .............................................................. 217

VI.2 Turnover in Indian Foreign Exchange Market ..................................................... 229

VI.3 Scheduled Commercial Banks-Profit from Foreign Exchange Transactionsas a Proportion of Total Profit .............................................................................. 230

VI.4 Foreign Exchange Turnover - Segment-wise ...................................................... 230

VI.5 Inter-bank and Merchant Transactions in Foreign Exchange Market ................. 231

VI.6 Bid-Ask Spread (Re-USD) in the Spot Foreign Exchange Market ..................... 232

VI.7 Movement of Forward Premia and Rupee-Dollar Exchange Rate ...................... 233

VI.8 Transmission from the Call Money Market to the Forward Market ..................... 233

VI.9 Movement of Indian Rupee in the Spot, Forward and NDF Markets .................. 235

VI.10 The Relationship between Demand-Supply Mismatch and RBI Intervention ..... 251

VI.11 Sterilisation Operations of the Reserve Bank ..................................................... 252

VII.1 Investor Protection Index in Select Economies ................................................... 261

VII.2 Market Capitalisation as per cent of GDP in India .............................................. 262

VII.3 Market Capitalisation as per cent of GDP inSelect Economies................................................................................................ 263

VII.4 The Turnover Ratio in Select Countries .............................................................. 263

(Contd...)


IX


VII.5 Impact Cost in the Equity Market (Spot) ............................................................. 264

VII.6 Turnover in the Equity Derivatives Market at NSE .............................................. 264

VII.7 Quarterly Coefficient of Variation of BSE Sensex ............................................... 265

VII.8 Net Fund Mobilisation by Mutual Funds – Scheme-wise .................................... 266

VII.9 Scheme-wise Net Assets under Management by Mutual Funds ........................ 267

VII.10 Total Assets held by Mutual Funds ..................................................................... 267

VII.11 Number of Capital Issues and Resources Raised through Public Issues .......... 267

VII.12 Ratio of New Capital Issues (NCI) to GDP and GDCF ....................................... 267

VII.13 New Capital Issues in Select Economies ............................................................ 268

VII.14 Resource Mobilisation through Euro Issues ....................................................... 269

VII.15 Gross International Equity Issuances by Select Countries ................................. 269

VII.16 Resources Raised by Indian Corporates – Domestic andInternational Capital Markets .............................................................................. 269

VII.17 Shareholding Pattern of Companies Listed at NSE ............................................ 270

VII.18 Resource Mobilisation through Debt Issues ....................................................... 272

VII.19 Composition of Bond Market in the US ............................................................... 277

VIII.1 Interest Rates and Exchange Rate in India ........................................................ 291

VIII.2 Implied Interest Rate ........................................................................................... 294

VIII.3 91-day Treasury Bills Rate and 10-year G-Sec Yield .......................................... 294

VIII.4 Turnover in Secondary Market for Government Securities ................................. 294

VIII.5 Bond Yields .......................................................................................................... 295

VIII.6 36-Currency Trade Weighted Real Effective Exchange Rate (REER) ................ 296

VIII.7 Covered Interest Parity ........................................................................................ 296

VIII.8 Short-term Money Market Rates ......................................................................... 299

VIII.9 Aggregate Net Resource Flows to Developing and Emerging Countries ........... 303

VIII.10 Net Portfolio Flows to India ................................................................................. 306

X

LIST OF TABLES

Table No. Title Page No.

2.1 Real Gross Domestic Product ............................................................................. 10

2.2 Quarterly Growth Rates of Gross Domestic Product .......................................... 11

2.3 Growth in Real Gross Domestic Product, 2007-08 – Forecasts for India ........... 11

2.4 Output Growth: Cross-Country Comparison ....................................................... 12

2.5 Gross Domestic Saving and Investment ............................................................. 12

2.6 Saving – Investment Balance .............................................................................. 13

2.7 Cumulative Rainfall .............................................................................................. 14

2.8 Crop-wise Targets/Achievements ........................................................................ 15

2.9 Season-wise Agricultural Production .................................................................. 15

2.10 Management of Foodstocks ................................................................................ 16

2.11 Monthly Growth of IIP .......................................................................................... 18

2.12 Growth of Manufacturing Industries (2-digit level classification) ......................... 18

2.13 Sectoral Contribution to IIP Growth .................................................................... 19

2.14 Growth Rate of Infrastructure Industries ............................................................. 19

2.15 Quarterly Growth Performance of Sub-Sectors of Services ............................... 20

2.16 Key Deficit Indicators of the Central Government ............................................... 22

2.17 Receipts of the Centre ........................................................................................ 23

2.18 Expenditure Pattern of the Centre ...................................................................... 24

2.19 Financing Pattern of Gross Fiscal Deficit ............................................................ 25

2.20 Major Deficit Indicators of the State Governments ............................................. 25

2.21 Aggregate Receipts of the State Governments .................................................. 26

2.22 Expenditure Pattern of the State Governments .................................................. 27

2.23 Decomposition and Financing Pattern of Gross Fiscal Deficit of the States ...... 28

2.24 Market Borrowings of the State Governments .................................................... 29

2.25 Combined Liabilities and Debt-GDP Ratio .......................................................... 30

2.26 Reserve Money ................................................................................................... 32

2.27 Monetary Indicators ............................................................................................. 33

2.28 Scheduled Commercial Banks Survey ................................................................ 34

2.29 Deployment of Non-food Bank Credit ................................................................. 35

(Contd...)

XI

(Contd...)


2.30 Select Sources of Funds to Industry ................................................................... 36

2.31 Annual Consumer Price Inflation ........................................................................ 36

2.32 Global Inflation Indicators .................................................................................... 38

2.33 Wholesale Price Inflation in India ........................................................................ 40

2.34 Consumer Price Inflation (CPI) in India .............................................................. 41

2.35 Domestic Financial Markets – Select Indicators ................................................. 42

2.36 Commercial Paper – Major Issuers ..................................................................... 45

2.37 Mobilisation of Resources through the Primary Market ...................................... 50

2.38 Net Resource Mobilisation by Mutual Funds ...................................................... 50

2.39 Trends in Stock Markets ...................................................................................... 51

2.40 Institutional Investments in the Stock Market ...................................................... 52

2.41 Turnover in Derivatives Market vis-à-vis Cash Market in NSE ........................... 52

2.42 Important Parameters of Select Bank Groups .................................................... 53

2.43 Urban Co-operative Banks – Select Financial Indicators ................................... 54

2.44 Financial Institutions – Select Performance Indicators ....................................... 54

2.45 Consolidated Balance Sheets of NBFCs ............................................................ 54

2.46 Profile of Residuary Non-Banking Companies (RNBCs) .................................... 55

2.47 Country-wise Growth Rates ................................................................................ 56

2.48 Global Merchandise Export Growth .................................................................... 57

2.49 India’s Foreign Trade ........................................................................................... 58

2.50 India’s Principal Exports ...................................................................................... 58

2.51 Major Destinations of India’s Exports .................................................................. 59

2.52 India’s Principal Imports ...................................................................................... 59

2.53 India’s Current Account ....................................................................................... 60

2.54 Capital Flows (Net) .............................................................................................. 61

2.55 Foreign Investment Flows by Category ............................................................... 61

2.56 Inflows under NRI Deposit Schemes .................................................................. 62

2.57 Components of External Debt ............................................................................. 63

2.58 Debt Indicators .................................................................................................... 64

XII

(Contd...)

3.1 Liquidity Absorptions ........................................................................................... 87

3.2 First and Second LAF ......................................................................................... 88

3.3 Activity in Money Market Segments .................................................................... 92

3.4 Treasury Bills – Primary Market .......................................................................... 99

3.5 Volatility in Money Market Rates ......................................................................... 101

4.1 Total Outstanding Credit by all Credit Institutions ............................................... 129

4.2 Institution-wise Growth of Outstanding Credit .................................................... 129

4.3 Distribution of Credit – Category-wise Share...................................................... 130

4.4 Sector-wise Credit of Commercial Banks – Compound Annual Growth Rate .... 131

4.5 Distribution of Outstanding Credit of Scheduled Commercial Banks ................. 132

4.6 Trends in Outstanding Priority Sector Advances ................................................ 134

4.7 Progress of SHG-Bank Linkage Programme ...................................................... 135

4.8 Progress of Kisan Credit Cards Scheme ............................................................ 136

4.9 Non-SLR Investments of Scheduled Commercial Banks ................................... 136

4.10 Non-Bank Sources of Funds for Industry ............................................................ 137

4.11 Type of Credit to Industry by Banks .................................................................... 137

4.12 Bank Credit to the Infrastructure Sector ............................................................. 138

4.13 Performance of the SSI Sector – Major Parameters ........................................... 139

4.14 Gross NPAs of Scheduled Commercial Banks in the SSI Sector ....................... 140

4.15 Growth and Share of Personal Loans in Total Bank Credit ................................. 141

4.16 Composition of Household Credit Provided by Commercial Banks .................... 142

4.17 Trends in Housing Loans Provided by Commercial Banks ................................. 142

4.18 Non-Deposit Sources of Funds ........................................................................... 146

4.19 Trends in Credit Growth ...................................................................................... 148

4.20 Credit to the Private Sector ................................................................................. 152

4.21 Number of Loan Accounts – Select Countries .................................................... 153

4.22 Commercial Bank Credit Penetration in India ..................................................... 153

4.23 Region-wise Number of Credit Accounts per 100 persons –Scheduled Commercial Banks in India ............................................................... 153

4.24 Incidence of Indebtedness of Households in India ............................................. 153

4.25 Debt-Asset Ratio of Households ......................................................................... 154


XIII

(Contd...)

4.26 Stress Tests: Capital Adequacy Ratio under Various Scenarios ......................... 154

4.27 Shares of Loans Extended at Sub-BPLR Rates by ScheduledCommercial Banks ............................................................................................. 154

4.28 Changes in the Repo Rate and Advance Rate of Scheduled Commercial Banks 155

4.29 Intermediation Cost of Banks of Major Asian Countries ..................................... 155

5.1 Indicators of Liquidity in Domestic Currency Government Bond Markets –Select Countries .................................................................................................. 171

5.2 Government Securities Market in India ............................................................... 194

5.3 Outstanding Stock of Central and State Government Securities ........................ 194

5.4 Maturity Profile of Central Government Securities Issued during the Year ......... 195

5.5 Maturity Profile of Outstanding Stock of Central Government Securities ........... 195

5.6 Weighted Average Interest Rate on Government Securities .............................. 196

5.7 Role of Primary Dealers in the Government Securities Market .......................... 196

5.8 Annual Turnover in the Government Securities Market ...................................... 197

5.9 Correlation of Yield on 10-year Government Securitieswith Other Instruments ........................................................................................ 202

6.1 Evolution of Exchange Rate Regimes, 1996 - April 2006 ................................... 214

6.2 Emerging Market Countries: Transition to More FlexibleExchange Rate Regimes .................................................................................... 215

6.3 Authorised Dealers (Category-I) in the Foreign Exchange Market ..................... 222

6.4 Global Foreign Exchange Market Turnover ......................................................... 228

6.5 Traditional Foreign Exchange Market Turnover in EM Currencies - April 2004 .. 229

6.6 Indicators of Indian Foreign Exchange Market Activity ....................................... 229

6.7 Relative Size of the Foreign Exchange Market in India ...................................... 229

6.8 Foreign Exchange Turnover – Bank Group-wise Share ...................................... 230

6.9 Derivatives Turnover in India ............................................................................... 230

6.10 REER and NEER of Select Asian Countries ...................................................... 238

6.11 Reserve Bank’s Intervention in the Foreign Exchange Market ........................... 238

6.12 India’s Sovereign Credit Rating by S&P, Moody’s and Fitch Ratings .................. 241

6.13 Daily Exchange Rate Volatility in Select Emerging Economies .......................... 242

6.14 Movements of Indian Rupee - US dollar Exchange Rates ................................. 243

6.15 Trends in External Value of Indian Rupee ........................................................... 244

6.16 Volatility of Exchange Rates in the Global Foreign Exchange Market ................ 244


XIV

6.17 Currency-wise Invoicing of India’s Exports and Imports ..................................... 246

6.18 Cross Currency Correlation................................................................................. 246

6.19 Macroeconomic Parameters of the United States .............................................. 247

6.20 Savings-Investment Gap in Emerging Economies .............................................. 247

6.21 Effects of Foreign Exchange Intervention ........................................................... 249

6.22 Major Findings of Recent Studies on Central Bank Intervention ........................ 250

6.23 India’s Capital Flows: Composition ..................................................................... 251

6.24 Extent of RBI Intervention in the Foreign Exchange Market ............................... 252

7.1 Liquidity in the Stock Market in India .................................................................. 263

7.2 Top Five Equity Derivative Exchanges in the World ............................................ 265

7.3 Volatility in Select World Stock Markets .............................................................. 265

7.4 Share of Various Instruments in Gross Financial Savings ofthe Household Sector in India ............................................................................. 266

7.5 Pattern of Sources of Funds for Indian Corporates ............................................ 268

7.6 Size of Domestic Corporate Debt Market and other Sources ofLocal Currency Funding ...................................................................................... 274

7.7 Turnover of Debt Securities ................................................................................. 274

8.1 Depth of Financial Markets in India - Average Daily Turnover ............................ 291

8.2 Correlation Among Major Financial Markets ....................................................... 293

8.3 Financial Market Volatility .................................................................................... 299

8.4 Interest Rate Spread over the Reverse Repo Rate ............................................ 299

8.5 Global Trade Openness ....................................................................................... 301

8.6 Intra-regional Trade Share in Asia ....................................................................... 302

8.7 Global Current Account Balance ......................................................................... 302

8.8 Gross Foreign Assets and Liabilities ................................................................... 302

8.9 Capital Flows to Developing and Emerging Economies ..................................... 303

8.10 Volatility of Capital Flows..................................................................................... 304

8.11 Select Indicators of India’s Openness ................................................................. 304

8.12 India’s Trade and Capital Accounts ..................................................................... 306

8.13 FDI Openness : Select Countries ........................................................................ 306

8.14 Regional Stock Market Return Correlation ......................................................... 307

8.15 Regional Money Market Correlation ................................................................... 307

8.16 Regional Bond Market Correlation ...................................................................... 308


XV

ABF – Asian Bond Fund

ABS – Asset-Backed Security

ACD – Asia Cooperation Dialogue

ACU – Additional CompetitiveUnderwriting

ADR – American Depository Receipt

ADs – Authorised Dealers

AFS – Available for Sale

AGL – Aggregate Gap Limit

AIBP – Accelerated Irrigation BenefitProgramme

AIFI – All-India Financial Institution

ALD – Aggregate Liability toDepositors

ALM – Asset-Liability Management

AMC – Asset Management Company

AML – Anti-Money Laundering

ARC – Asset Reconstruction Company

ASEAN – Association of South EastAsian Nations

ATM – Automated Teller Machine

BAHTNET – Bank of Thailand AutomatedHigh Value Transfer Network

BCD – Bond, Currency andDerivatives

BCR – Bank Credit

BE – Bills of Exchange

BEX – Bond Electronic Exchange

BFS – Board for Financial Supervision

BIDS – Bond Information andDissemination System

BIS – Bank for InternationalSettlements

BITs – Bilateral Investment Treaties

BOJ NET – Bank of Japan NET

BPLR – Benchmark Prime LendingRate

BPO – Business Process Outsourcing

BSE – The Bombay Stock ExchangeLimited

CAD – Current Account Deficit

CAPM – Capital Assets Pricing Model

CAS – Credit Authorisation Scheme

CBLOs – Collateralised Borrowing andLending Obligations

CBO – Collateralised Bond Obligation

CCC – Credit Counseling Canada

CCDM – Credit Counseling and DebtManagement

CCIL – Clearing Corporation of IndiaLtd.

CCP – Central Counter Party

CCS – Credit Counseling of Singapore

CDO – Collateralised Debt Obligation

CDR – Corporate Debt Restructuring

CDs – Certificates of Deposits

CDS – Credit Default Swaps

CENVAT – Central Value Added Tax

CFMS – Centralised FundsManagement System

CGS – Commonwealth GovernmentSecurities

CIB – Capital Indexed Bond

CIBIL – Credit Information Bureau(India) Limited

CIP – Covered Interest Parity

CLF – Collateralised Lending Facility

CLN – Credit Linked Notes

CLO – Collateralised Loan Obligations

CP – Commercial Paper

ABBREVIATIONS

XVI

CPI – Consumer Price Index

CPI-IW – Consumer Price Index for(Industrial Workers)

CPSS – Committee on Payment andSettlement Systems

CPSUs – Central Public SectorUndertakings

CRAR – Capital to Risk-WeightedAssets Ratio

CRR – Cash Reserve Ratio

CRT – Credit Risk Transfer

CDSL – Central Depository Services(India) Limited

CSGL – Constituents’ SubsidiaryGeneral Ledger

CSO – Central Statistical Organisation

CSRC – Chinese Securities RegulatoryCommission

CV – Coefficient of Variation

DAD – Deposit Accounts Department

DCCB – District Central CooperativeBank

DFHI – Discount and Finance House ofIndia

DFI – Development Finance Institution

DMO – Debt Management Office

DRT – Debt Recovery Tribunal

DTL – Demand and Time Liabilities

DTTs – Double Taxation Treaties

DvP – Delivery versus Payment

ECB – European Central Bank

ECBs – External Commercial Borrowings

ECS – Electronic Clearing Service

EEFC – Exchange Earners’ ForeignCurrency

EFP – External Finance Premium

EFT – Electronic Fund Transfer

EMEAP – Executives’ Meeting of EastAsia Pacific Central Banks

EMEs – Emerging Market Economies

EMU – European Monetary Union

ET – Exchange Traded

FAST – Fully Automated System forIssuing /Tendering

FCA – Foreign Cureency Assets

FCAC – Fuller Capital AccountConvertibility

FCCBs – Foreign Currency ConvertibleBonds

FCNR (A) – Foreign Currency Non-Resident(Accounts)

FCNR (B) – Foreign Currency Non-Resident(Banks)

FDI – Foreign Direct Investment

FEDAI – Foreign Exchange Dealers’Association of India

FEMA – Foreign ExchangeManagement Act

FERA – Foreign Exchange RegulationsAct

FESFBs – Foreign Exchange StabilisationFund Bonds

FFMCs – Full Fledged Money Changers

FIDF – Financial InstitutionsDevelopment Fund

FIIs – Foreign Institutional Investors

FIMMDA – Fixed Income Money Marketand Derivatives Association ofIndia

FMCG – Fast Moving Consumer Goods

FIs – Financial Institutions

FOMC – Federal Open Market Committee

FRAs – Forward Rate Agreements

FRBM Act – Fiscal Responsibility andBudget Management Act

XVII

FRBs – Floating Rate Bonds

FRL – Full Reservoir Level

FRLs – Fiscal ResponsibilityLegislations

GATS – General Agreement on Tradeand Services

GCC – General Credit Card

GDCF – Gross Domestic CapitalFormation

GDP – Gross Domestic Product

GDR – Global Depository Receipt

GDS – Gross Domestic Saving

GEMM – Gilt-Edged Market Makers

GFD – Gross Fiscal Deficit

HFT – Held for Trading

HPEC – High Powered ExpertCommittee

HTM – Held to Maturity

IAS – Integrated Accounting System

IBA – Indian Banks’ Association

IBPCs – Inter-Bank ParticipationCertificates

ICDs – Inter Corporate Deposits

IDBI – Industrial Development Bank ofIndia

IDR – Indian Depository Receipt

IFC – International FinanceCorporation

IFCI – Industrial Finance Corporationof India

IIAs – International InvestmentAgreements

IIBI – Industrial Investment Bank ofIndia

IIP – Index of Industrial Production

ILAF – Interim Liquidity AdjustmentFacility

IMD – India Meteorological Department

IMDs – India Millennium Deposits

IMF – International Monetary Fund

INFINET – Indian Financial Network

INR – Indian Rupees

IOC – Indian Oil Corporation

IOMA – International Options MarketsAssociation

IOSCO – International Organisation ofSecurities Commissions

IPAs – Issuing and Paying Agents

IPF – Investor Protection Fund

IPO – Initial Public Offer

IRDA – Insurance Regulatory andDevelopment Authority ofIndia

IRFs – Interest Rate Futures

IRS – Interest Rate Swap

ISMA – International Securities MarketAssociation

IT – Information Technology

ITES – Information TechnologyEnabled Services

JGBs – Japanese Government Bonds

JLG – Joint Liability Group

JSDA – Japanese Securities DealersAssociation

KCC – Kisan Credit Card

KTBs – Korean Treasury Bonds

KYC – Know Your Customer

LAF – Liquidity Adjustment Facility

LERMS – Liberalised Exchange RateManagement System

LIBOR – London Inter-Bank OfferedRate

LIC – Life Insurance Corporation

LOLR – Lender of Last Resort

XVIII

LOOP – Law of One Price

LPA – Long Period Average

LPG – Liquefied Petroleum Gas

LTCCS – Long Term Cooperative CreditStructure

LTO – Long-Term Operations

M3

– Broad Money

MAS – Monetary Authority ofSingapore

MBS – Mortgage Backed Securities

MCAP – Market Capitalisation

MCI – Monetary Conditions Index

MFI – Micro Finance Institution

MGSs – Malaysian GovernmentSecurities

MIBOR – Mumbai Inter-Bank Offered Rate

MIFOR – Mumbai Inter-bank ForwardOffered Rate

MME – Mature Market Economies

MMIs – Money Market Instruments

MMMFs – Money Market Mutual Funds

MNSB – Multilateral Net Settlement Batch

MoU – Memorandum of Understanding

MPBF – Maximum Permissible BankFinance

MSS – Market Stabilisation Scheme

MTM – Mark to Market

MUC – Minimum UnderwritingCommitment

NABARD – National Bank for Agricultureand Rural Development

NASDAQ – National Association ofSecurities Dealers AutomatedQuotation System

NASSCOM – National Association of Softwareand Services

NASSD – National Association ofSoftware and ServicesDepartment

NBC – Net Bank Credit

NBFCs – Non-Banking FinancialCompanies

NCAER – National Council for AppliedEconomic Research

NCCF – National Calamity ContingencyFund

NCDs – Negotiable Certificates ofDeposits

NDA – Net Domestic Assets

NDF – Non Deliverable Forward

NDS – Negotiated Dealing System

NDS-OM – Negotiated Dealing System-Order Matching

NDTL – Net Demand and TimeLiabilities

NEAT – National Exchange forAutomated Trading

NEER – Nominal Effective ExchangeRate

NFA – Net Foreign Assets

NFC – Non-Food Credit

NGO – Non-Government Organisation

NOF – Net Owned Funds

NPAs – Non-Performing Assets

NPL – Non-Performing Loan

NRE – Non-Resident External

NRIs – Non-Resident Indians

NSDL – National Securities DepositoryLimited

NSE – National Stock Exchange ofIndia Limited

NSS – National Settlement System

NSSF – National Small Savings Fund

XIX

NSSO – National Sample SurveyOrganisation

NTR – Non-tax Revenues

OD – Overdrafts

ODA – Official DevelopmentAssistance

OECD – Organisation for EconomicCooperation and Development

OIS – Overnight Index Swap

OLS – Ordinary Least Square

OMOs – Open Market Operations

OPEC – Organisation of the PetroleumExporting Countries

OTC – Over-the-Counter

OTCEI – Over-the-Counter Exchange ofIndia

OWS – Other Welfare Schemes

P&L – Profit & Loss

PACS – Primary Agricultural CreditSociety

PCARDB – Primary Cooperative andAgriculture Rural DevelopmentBank

PCs – Participation Certificates

PD – Primary Deficit

PDAI – Primary Dealers’ Association ofIndia

PDO – Public Debt Office

PDs – Primary Dealers

PIO – Persons of Indian Origin

PLF – Plant Load Factor

PLR – Prime Lending Rate

PPP – Purchasing Power Parity

PSCFC – Post Shipment Creditdenominated in Foreign Currency

PSU – Public Sector Undertaking

PTC – Pass-Through Certificate

RD – Revenue Deficit

REER – Real Effective Exchange Rate

RIBs – Resurgent India Bonds

RIDF – Rural InfrastructureDevelopment Fund

RIP – Real Interest Parity

RITS – Reserve Bank Information andTransfer Systems

RMDS – Reuters Markets Data System

RNBCs – Residuary Non-BankingCompanies

RRBs – Regional Rural Banks

RTGS – Real Time Gross Settlement

RTP – Reserve Tranche Position

SAARC – South Asian Association forRegional Cooperation

SACP – Special Agricultural Credit Plan

SARFAESI – Securitisation and Reconstructionof Financial Assets andEnforcement of Security Interest

SC(R)A – Securities Contract (Regulations)Act, 1956

SCARDB – State Co-operative Agriculturaland Rural Development Bank

SCB – State Co-operative Bank

SCBs – Scheduled Commercial Banks

SDDS – Special Data DisseminationStandards

SDLs – State Development Loans

SDs – Satellite Dealers

SEACEN – South East Asian Central Banks

SEANZA – South East Asia, New Zealandand Australia

SEBI – Securities and Exchange Boardof India

SFC – State Financial Corporation

SGF – Settlement Guarantee Fund

XX

SGL – Subsidiary General Ledger

SHCIL – Stock Holding Corporation ofIndia Limited

SHG – Self Help Group

SIDBI – Small Industries DevelopmentBank of India

SLR – Statutory Liquidity Ratio

SME – Small and MediumEnterprises

SPV – Special Purpose Vehicle

SR – Security Receipt

SROs – Self Regulatory Organisations

SRS – System Requirement Study

SSI – Small Scale Industries

STCCS – Short-Term Co-operativeCredit Structure

STCI – Securities Trading Corporationof India

STP – Straight Through Processing

STRIPS – Separate Trading of RegisteredInterest and Pr incipal ofSecurities

STT – Securities Transactions Tax

TAC – Technical Advisory Committee

TDS – Tax Deducted at Source

TFC – Twelfth Finance Commission

TIPS – Treasury Inflation ProtectedSecurities

TOR – Turnover Ratio

TPDS – Targeted Public DistributionSystem

TRS – Total Return Swap

UCBs – Urban Co-operative Banks

UIP – Uncovered Interest Parity

UK – United Kingdom

US – United States

USAID – United States Agency forInternational Development

UTI – Unit Trust of India

VAR – Vector Auto Regression

VaR – Value at Risk

VCF – Venture Capital Fund

VSAT – Very Small Aperture Terminal

VTR – Value Traded Ratio

WADR – Weighted Average DiscountRate

WDM – Wholesale Debt Market

WI – When Issued

WMA – Ways and Means Advances

WOS – Wholly Owned Subsidiaries

WPI – Wholesale Price Index

WSS – Weekly Statistical Supplement

WTO – World Trade Organisation

YTM – Yield to Maturity

ZCBs – Zero Coupon Bonds

This Report can also be accessed on InternetURL : www.rbi.org.in

1.1 A well-functioning financial system is a sinequa non for the pursuit of economic growth withstability. The core function of a well-developedfinancial system is to facilitate smooth and efficientallocation of resources from savers to the ultimateusers. That an efficient financial system is a key todevelopment is not new in the economic literature. Infact, in his classic, Lombard Street : A Description ofthe Money Market (1873), Walter Bagehot had arguedthat it was England’s efficient capital market that madethe industrial revolution possible. Bagehot was the firstto define the two primary roles of financial markets.One, they facilitate the accumulation of capital. Two,they manage risk inherent in particular investmentprojects and industries.

1.2 The most important and thorough recognitionof the role of financial development in economicdevelopment came in 1912 when JosephSchumpeter contended that financial developmentpromotes economic growth by improving productivity.However, this view had fallen out of mainstreamthinking for quite a long time as several prominenteconomists subsequently acknowledged that thefinancial systems were an essential feature of anadvanced economy, but argued that they did notthemselves contribute to growth. For instance, JoanRobinson (1952) argued that financial systemsemerge in a passive way to respond to the needs ofthe real economy. In fact, early empirical workappeared to suggest that although economic growthand financial development occurred in tandem, therewas no evidence of a causal relationship. This viewwas generally accepted over the 1950s through theearly 1970s. Academics and policy makers duringthis period believed that finance emerges in aneconomy only after a certain stage of development.To the extent f inance appeared in the ear lydevelopment literature, it was only to advocate thatthe financial system could be managed to achievecertain societal goals. In fact, many developingcountries were encouraged to favour the flow ofcredit to certain preferred sectors through creditrationing or interest rate ceilings. However, theobserved failure of these strategies - dubbed as‘financial repression’ by McKinnon-Shaw (1973) - ledto the realisation of the central role played by thefinancial system.

1.3 There has also been a better understandingof the role of financial systems in advanced economiesthrough endogenous growth theory. The key to growthin this model is continuous productivity advances thattake place through technological advancement. Thismakes productivity the main engine of growth. Oneof the crucial structural factors that affects productivityis the financial system (King and Levine, 1993). Thisview was in line with the view earlier suggested bySchumpeter. According to Levine (1997), financialservices affect economic growth through five mainchannels, viz., saving mobilisation, resource allocation,risk management, management monitoring and tradefacilitation. Each of the five main channels contributesto both capital accumulation and the process oftechnological innovation. These, in turn, feed directlyto economic growth by the Solow growth model.

1.4 Financial reforms and liberalisation that havetaken place in emerging economies in the 1980s andthe 1990s have been largely inspired by the Mckinnon-Shaw thesis (1973). However, financial crises of thelast decade vividly established that a weak financialsystem not only makes a country, open to internationalcapital flows, more vulnerable to crises, but alsoexacerbates the costs of any financial crisis that doesoccur. Over the past decade, many emerging marketeconomies have, therefore, made significant effortsto strengthen their domestic financial systems,including financial markets – the money market, thegovernment securities market, the foreign exchangemarket and the equity market. Local bond markets arenow the dominant source of funding for theGovernments in several countries. There has beensome improvement in the domestic corporate bondmarket as well in some countries, although the progresshas been slow in this segment of the market.

1.5 What are then the key objectives of financialmarket development? From the viewpoint of anemerging economy like India, the basic aim offinancial market development must be to aid economicgrowth and development. The primary role of financialmarkets, broadly interpreted, is to intermediateresources from savers to investors, and allocate themin an efficient manner among competing uses in theeconomy, thereby contributing to growth, both throughincreased investment and through enhancedefficiency in resource use (Mohan, 2007).

THEME OF THE REPORTI

2

REPORT ON CURRENCY AND FINANCE

1.6 Financial markets in India have existed for along t ime. However, they remained relativelyunderdeveloped for a variety of reasons. Indiaintroduced financial sector reforms as a part ofstructural reforms in the early 1990s. Since then,momentous changes have taken place in the Indianfinancial sector, including financial markets. Reformsin the financial markets encompassed all segments -the money market, the credit market, the governmentsecurities market, the foreign exchange market, theequity market and the private corporate debt market.The development of financial markets in India hasbeen pursued to bring about a transformation in thestructure, efficiency and stability of markets as alsoto facilitate integration of markets. The emphasis hasbeen on strengthening price discovery, easing ofrestrictions on flows or transactions, lowering oftransaction costs, and enhancing liquidity. During thepost-reform period, the structure of financial marketshas witnessed a remarkable change in terms offinancial instruments traded in various segments ofthe f inancial market and market par ticipants.Development of these markets has been done in acalibrated, sequenced and careful manner in step withthose in other markets in the real economy. Thesequencing has also been informed by the need todevelop market infrastructure, technology andcapabilities of market participants and financialinstitutions in a consistent manner. In a low incomeeconomy like India, the cost of downside risk is veryhigh, so the objective of maintaining financial stabilityhas to be constantly kept in view while developingfinancial markets (Mohan, 2007).

1.7 Financial sector reforms have had a profoundeffect in terms of aiding growth, while at the sametime avoiding crises, enhancing efficiency of financialintermediaries and imparting resilience to the system(Reddy, 2000). Although various segments of thefinancial market, in general, have certainly becomedeeper and more liquid, there is still some way to gobefore all the segments of the financial market arefully developed. Whereas it has always been theendeavour of the authorities to develop financialmarkets, the need for developed financial markets hasnever been so strongly felt as at this point of time.The need for sustaining higher economic growth,improving the transmission mechanism of monetarypolicy, developing a diversified financial system,maximising the gains from financial integration andminimising its costs, and preparing for smooth capitalaccount conver tibility, all point to the need forcontinuing sustained and perhaps accelerated effortsat developing financial markets in India.

MOBILISING RESOURCES FOR SUSTAININGHIGHER GROWTH

1.8 The primary role of the financial system inany economy is to mobilise resources for productiveinvestment and thereby enhance productive capacityof the economy. A developed financial systembroadens access to funds; conversely, in anunderdeveloped financial system, access to funds islimited and people are constrained by the availabilityof their own funds and have to resort to high costinformal sources such as money lenders (Mohan,2006c). Domestic financial markets are a critical pillarof a market based economy. The vital role of financialmarkets emanates from the fact that the needs ofsavers and investors, in general, are not homogenousin nature. Financial markets also facilitate trading ofinstruments and thus allow speedy exit. Savingessential ly involves future consumption, thepreference for which would vary depending on therequirements of liquidity, time (or maturity), safety andrisk, and expected returns. Similarly, investment needsare different across enterprises. Financial marketsthus play an important role in providing an array ofinstruments of various maturities and other featuresto satisfy various needs of savers and investors. Inthe absence of such instruments, capital mobilisationwill be less than adequate. A shallow financial system,characterised by a limited number of instruments,cannot mobil ise potential savings and meetinvestment requirements for several productivesectors with the attendant implications for theeconomic performance.

1.9 Realising the importance of financial sectordevelopment for high and steady growth anddevelopment, policy makers in emerging marketeconomies (EMEs) and developing countries havebeen making efforts to provide appropriate regulatoryenvironments for financial markets that (i) encouragecompetitive forces; (ii) facilitate the use of a variety ofinstruments; (iii) promote the growth of different kindsof institutions offering a wide range of financialinstruments and services to potential savers andinvestors; (iv) protect the interests of savers byreducing their risks; and (v) promote the developmentof instruments that help in risk management. Forregulating financial markets, regulators are guided byvarious considerations in the larger interest of society.Broadly, the objective of regulation is to protectdepositors’ and investors’ interests (safety andconduct of business), promote financial inclusion,ensure monetary and financial stability and achievesustained economic progress.

3

THEME OF THE REPORT

1.10 The Indian economy grew by 9 per cent during2005-06 and it is estimated by the Central StatisticalOrganisation that it would grow by 9.2 per cent in2006-07. The average annual growth rate in the lastfour years has been over 8 per cent. The grossdomestic investment rate increased significantly from23.0 per cent of GDP in 2001-02 to 33.8 per cent in2005-06. The gross domestic saving rate alsoimproved from 23.6 per cent to 32.4 per cent over thesame period, underpinned by a significant turnaroundin public sector saving and increase in privatecorporate sector saving. There has been optimismabout the growing potential of economic growth inIndia. The Approach Paper to the Eleventh Five YearPlan (2007-08 to 2011-12) aims at putting theeconomy on a sustainable growth trajectory with agrowth rate of approximately 10 per cent in theterminal year, which would yield an average growthrate of about 9 per cent in the Plan period. However,a set of issues relating to investments has beenidentified by the Planning Commission. An averagegrowth of 9 per cent during the 11th Plan periodrequires an increase in domestic investment rate from27.8 per cent in the 10th Plan to 35.1 per cent in the11th Plan. While half of this increase in investment isexpected to come from private investment in farms,small and medium enterprises and in the corporatesector, the rest is estimated to emanate from publicinvestment with a focus on the infrastructure sector.

1.11 In order to achieve the desired savings andinvestment rates, there would be need to raise largeresources domestically. India has a reasonably highand growing savings rate. However, for meeting thefinancing requirements of a growing economy whatis important is mobilisation of financial savings. In thiscontext, it may be noted that physical savings havebeen growing at a rate higher than the financialsavings in recent years. Although this trend wasreversed in 2005-06, physical savings still continueto be large. In order to facilitate substitution of physicalsavings in favour of financial savings, there would beneed for innovative and attractive f inancialinstruments. Appropriate instruments should also beavailable for the generation of longer term savingsthat are needed for financing infrastructure. Financialmarkets, therefore, would have a crucial role to playin mobilising resources of the required nature.

FINANCIAL MARKETS AND MONETARY POLICY

1.12 From the point of view of the central bank,developed financial markets are critical for effectivetransmission of monetary policy impulses to the rest

of the economy. Monetary transmission cannot takeplace without efficient price discovery, particularly withrespect to interest rates and exchange rates (Mohan,2007). The transmission process for policy actions bycentral banks involves two stages. In the first stage,policy actions are transmitted to financial markets. Thesecond stage of the transmission mechanism involvesthe propagation of monetary policy impulses from thefinancial system to the real economy and aggregateprices. A successful implementation of policy requiresa reasonably accurate assessment of how rapidly theeffects of policy actions are transmitted through thefinancial system, via financial prices and quantities,to the real economy, affecting aggregate spendingdecisions of households and firms, and from there toaggregate demand and inflation.

1.13 The first stage of the transmission mechanismdepends on how changes in the market operations ofcentral banks get transmitted through the moneymarket to other markets, i.e., the bond market andthe bank loan market, which directly affect spendingdecisions of individuals and firms. This involves theterm structure, through which short-term moneymarket rates affect longer-term bond rates, and themarginal cost of loan funding, through which bankloan rates are affected. Since the first stage involvesthe propagation of changes in policy instrumentsthrough the financial system, the state of financialmarket development, the efficiency of institutions orintermediaries and the institutional and structuralcharacteristics of the financial system are critical forthe effectiveness of monetary policy.

1.14 Developed financial markets enable centralbanks to use market-based instruments of monetarypolicy to target monetary variables more effectively.Developed financial markets also enable monetaryauthorities to extract forward-looking informationabout certain macroeconomic variables, such as theexpected future path of economic growth, inflation andfinancial conditions, which are important in formulatingeffective monetary policy.

1.15 Recent developments in the global economyhave accentuated the challenges that monetaryauthorities face. An important challenge faced bymonetary authorities in the conduct of monetary policyhas been brought by the new environment characterisedby increased financial globalisation in recent years. Inparticular, it renders economies vulnerable to changesin external demand, volatility in capital flows andexchange rate shocks. Monetary policy formulation thusbecomes much more inter-dependent than before acrosseconomies and has to factor in developments in the

4


global economic situation, the international inflationarysituation, interest rates, exchange rate movements andcapital flows. As a result, while domestic developmentscontinue to dominate, global factors are increasinglygaining more importance. Massive cross-border capitalflows, globalisation of financial markets and advancesin information technology have combined to altersignificantly the choice of instruments of monetary policy,operational settings, lag structures and transmissionmechanism (Mohan, 2004). The heightened uncertaintysurrounding the conduct of monetary policy hasobscured a proper assessment of the nature of shocksimpacting the economy and the resulting risks to pricestability. It has also made the interpretation ofmacroeconomic and financial data difficult.

1.16 With the gradual liberalisation of the Indianeconomy, there has been substantial inflow of foreigncapital into India, much in excess of the prevailingcurrent account deficit. Whereas the opening of theeconomy has brought about gains in terms of inflowsof foreign investments with positive implications foroutput and employment, it has also posed newchallenges for managing the macroeconomy amidstlarge and volati le capital f lows. The marketstabilisation scheme (MSS) was introduced to absorbinflows of the more enduring part of the liquidityoverhang induced by excess capital flows. Suitablechanges were also made in the liquidity adjustmentfacility (LAF) scheme. However, going forward, therewill be a continuous need to adopt an appropriatestrategy of active liquidity management and short-terminterest rate smoothening for effective monetarymanagement and financial stability. This issue becomeseven more relevant under a freer regime of capital flows(Mohan, 2006b).

1.17 The Reserve Bank’s approach has been tofoster balanced development of various segments of themoney market to improve the transmission mechanismof monetary policy. However, certain segments of themoney market have yet to develop. As a debt managerto the Government, the development of a deep and liquidmarket for government securities is of critical importanceto the Reserve Bank as it results in better price discoveryand cost effective Government borrowing. Thegovernment securities market also provides an effectivetransmission mechanism for monetary policy, facilitatesthe introduction and pricing of hedging products andserves as a benchmark for pricing other debtinstruments. Although the government securities markethas developed considerably over the years, more needsto be done for it to become fully developed. A liquid andreliable yield curve, especially at the longer-end of the

maturity needs to be developed further. The absence ofa developed private corporate debt market also hampersthe smooth transmission of monetary policy impulses.With the financial markets in India acquiring greaterdepth and maturity in recent years, the issue of greaterintegration of various financial market segments has alsocome to the forefront, particularly in the context ofmonetary policy transmission. The significance ofdeveloped and well-integrated financial markets from amonetary policy perspective thus can hardly beoveremphasised.

DIVERSIFIED FINANCIAL SYSTEM

1.18 While the importance of finance is now widelyrecognised, it was less clear, until recently, as to whatwere the main features of a successful financial system.Financial institutions and financial markets are twogeneric mechanisms for transferring resources fromsurplus spending units to deficit spending units. Whilethe financial systems in the US, the UK and other Anglo-Saxon countries relied more on capital markets, inJapan and Germany, banks dominated their financialsystems. Both bank-based and market-based systemshave their unique advantages and disadvantages.Banks are generally in a better position to collect andinterpret information about investment opportunitiesand monitor projects. Banks are also better equippedto operate in a system where the legal framework isnot adequately developed as they are able to makeborrowers disclose the information needed by them andto repay. However, intermediaries tend to favour low-risk projects. On the other hand, capital markets mayhave an advantage in dealing with uncertainty and newideas and make funding of riskier projects possible. Inpractice, both types of mechanisms co-exist andsupplement each other, though one system may havepredominance over the other.

1.19 Some argue that differences in the financialstructure do matter. For instance, financial systemsdominated by arm’s-length transactions (markets withlower bank density and greater disintermediation)have been found to better accommodate resourcereallocations from declining to expanding sectors thansystems dominated by relationship-basedtransactions. As arm’s-length transactions tend to bemore characteristic of capital markets than of banks,this would suggest that economies with moredeveloped capital markets may be more flexible anddynamic, and, therefore, more likely to experiencehigher productivity and growth, than those with bank-based financial systems (Rato, 2006). However,histor ical exper ience suggests that both the

5

THEME OF THE REPORT

mechanisms have worked well. If market-basedsystems were successful in the UK and the US, bank-based systems were successful in Germany andJapan. After the East Asian crisis, however, it has beenwidely recognised that there should be a balancedfinancial system wherein both financial institutions andfinancial markets play important roles.

1.20 Historically, financial systems in emergingmarket and developing economies have beendominated by their banking systems. Excessivereliance on the banking system, however, makes thefinancial system vulnerable to shocks andexacerbates the crises, as was observed during theEast Asian crisis. Developed capital markets alsoenable countries to reduce their reliance on foreignborrowing. This is particularly important for emergingmarket countries. Since external debt has been amajor source of vulnerability in EMEs, capital marketdevelopment could potentially exercise a stabilisinginfluence (Rato, 2006). Similarly, complementary orsupporting infrastructure such as the repo market,margin trading and derivatives, if developed within anappropriate framework in EMEs, can be importantmeans of reducing the transaction cost further. It alsoallows market participants to manage and transferrisks to those who are able and willing to bear them,which helps in developing a robust financial system.

1.21 Historically, the financial system in India hasalso been dominated by financial intermediaries, ingeneral, and banking institutions, in particular. Thispattern has remained more or less unaltered overthe years. Households invest only a small portion oftheir savings in the securities market directly orindirectly through mutual funds. The need, therefore,is felt to develop a diversified financial system overa period of time in which both financial institutionsand financial markets play important roles.

1.22 Developed financial markets are required notonly to enable corporates to raise resources from themarket, but also to enable banks to raise resourcesto sustain their growth. Banks need to raise capitalfrom the market on an ongoing basis in order tosustain their operations. Their requirements of capitalare also expected to increase on implementation ofBasel II. Thus, banks’ inability to raise resources fromthe capital market could stunt their growth withattendant implications for economic growth. In India,pension and provident funds hold a large corpus offunds. These funds, however, generate low returnsas they have limited avenues to deploy their funds inhighly rated corporate bonds. Developed privatecorporate debt market may enable these pension and

provident funds to deploy their funds in corporatebonds and generate higher returns.

FINANCIAL INTEGRATION AND FINANCIALMARKETS

1.23 The need for developed financial marketsalso arises in the context of increasing integrationof domestic financial markets with internationalfinancial markets. The concept of globalisation todayis no longer restricted to its traditional sense, i.e.,variety of cross-border transactions in goods andservices, but also extends to international capitalflows, driven by rapid and widespread diffusion oftechnology. In fact, most of the literature in recentyears on globalisation has centred around financialintegration due to the emergence of worldwidefinancial markets and the possibility of better accessto external financing for a variety of domestic entities.Integration of the domestic economy with the globaleconomy can also provide the benef i ts ofdiversification to the residents. During the 1980s,capital account liberalisation came to be seen as anessential, and even inevitable step on the path toeconomic development, analogous to the earlierreductions in barriers to international trade in goodsand services. However, capital account liberalisationalso exposes the domestic economy to certain risks.Large capital flows cause volatility, i.e., tendency offinancial markets to go through boom and bust cyclesin which capital flows grow and then contract.Another risk is contagion, that is inability of themarket to distinguish between one type of borrowerand another. These risks, if not managed well, couldhave serious implications as was observed in thecase of East Asian cr is is in the mid-1990s.Inadequate or mismanaged domestic financial sectorliberalisation has been a major contributor to crisesthat may be associated with financial integration(Mishkin, 2006). Thus, with greater f inancialintegration, a developed, vibrant, effective and stablefinancial system assumes considerable significance.

1.24 Global developments, particularly those ininternational financial markets, have the most directand serious impact on the financing conditions inemerging markets. Volatility in financial markets couldadversely affect the EMEs in many ways, and also ina complex and interrelated fashion. For convenienceof analysis, the impact may be classified broadly into:(i) the impact on the financing conditions in whichEMEs operate; (ii) impairment of the balance sheetsof the banking sector; and (iii) hampering of thegrowth prospects in the real sector (Reddy, 2005).

6


1.25 India has been gradually and cautiouslyliberalising its capital account since the early 1990s.However, in several areas capital account is stillmanaged by the Reserve Bank. Given the largeinvestment needs of the country, domestic savingsmay need to be supplemented by foreign capital,although the absorption of foreign capital is limitedon a macroeconomic basis by the magnitude of asustainable current account deficit.

1.26 With the greater globalisation of trade andrelatively free movement of financial assets, riskmanagement through derivative products has alsoassumed significance in India. With the Indiancorporates getting increasingly integrated with overseasmarkets and accessing international capital markets,there is need to develop a broad-based, active andliquid foreign exchange derivatives market whichprovides them with a spectrum of hedging products foreffectively managing their foreign exchange exposures.Derivative markets reallocate risk among financialmarket participants and reduce information asymmetryamong investors. Derivative markets also facilitateefficient price discovery and make unbundling of riskeasier (Gambhir and Goel, 2003).

1.27 Thus, if benefits from financial integration areto be maximised, it is imperative to pursue effortstowards a greater sophistication of financial marketsand develop instruments that allow appropriatepricing, sharing and transfer of risks.

1.28 The need to develop financial markets hasalso been underlined by the two high-poweredcommittees, viz.; Committee on Fuller Capital AccountConvertibility (FCAC) and the High Powered ExpertCommittee on Making Mumbai an InternationalFinancial Centre. The Committee on Fuller CapitalAccount Convertibility in its Report submitted in July2006 indicated that in order to make a move towardsfuller capital account convertibility, it needs to beensured that different financial market segments arenot only well-developed but also that they are well-integrated. Otherwise, shocks to one or more marketsegments would not get transmitted to other segmentsefficiently so that the entire financial system is ableto absorb the shocks with minimal damage.

1.29 Developed and well-integrated financialmarkets are critical for sustaining high growth, for theeffective conduct of monetary policy, for developing adiversified financial system, financial integration andensuring financial stability. The question thus is notwhether we need developed financial markets, buthow we should go about in developing them fully.

Financial markets today deal with complex andsophisticated products. Introduction of such productswould require clear regulatory frameworks,appropriate institutions and development of humanresource skills. The speed for further changes in thefinancial markets would thus depend on how quicklyare we able to meet these requirements.

1.30 Deregulation, liberalisation, and globalisationof financial markets pose several risks to financialstability. Financial markets are often governed by herdbehaviour and contagion and excessive competitionamong financial institutions can also lead to a race tothe bottom. The East Asian crisis of the 1990ssuggested that global f inancial markets canexacerbate domestic vulnerabilities. Notwithstandingthe conventional wisdom that financial markets punishdeviations from prudent policies, financial markets,at times, seem to tolerate imprudent behaviour for aremarkable stretch of time, while reacting pre-maturely at other t imes (Lipschitz, 2007). Inrecognition of these possible destabilising factors,while liberalising domestic financial markets in India,appropriate prudential safeguards have also been putin place. Excessive fluctuations and volatility infinancial markets can mask the underlying value andgive rise to confusing signals, thereby hinderingefficient price discovery. Accordingly, policy effortshave also aimed at ensuring orderly conditions infinancial markets (Mohan, 2006a). Enhancingefficiency, while at the same time avoiding instabilityin the system, has been the challenge for theregulators in India (Reddy, 2004). This approach todevelopment and regulation of financial markets hasimparted resilience to the financial markets.

1.31 From the point of view of the economy as awhole, while developing financial markets it isessential to keep in view how such developmenthelps overall growth and development. The pricediscovery of interest rates and exchange rates, andintegration of such prices across markets helps inthe efficient allocation of resources in the real sectorsof the economy. Financial intermediaries like banksalso gain from better determination of interest ratesin financial markets so that they can price their ownproducts better. Moreover, their own r iskmanagement can also improve through theavai labi l i ty of di f ferent var iet ies of f inancialinstruments. The access of real sector entities tof inance is also assisted by the appropr iatedevelopment of the financial markets and theavailability of transparent information on benchmarkinterest rates and prevailing exchange rates. The

7

THEME OF THE REPORT

approach of the Reserve Bank in the developmentof financial markets has been guided by theseconsiderations, while also keeping in view theavailability of appropriate skills and capacities forpar ticipation in financial markets, both amongfinancial market participants and real sector entitiesand individuals (Mohan, 2007). The Reserve Bank’sapproach has, therefore, been one of consistentdevelopment of markets while exercising caution infavour of maintaining financial stability in the system.

1.32 In the last 15 years, several reform measureshave been initiated to develop the financial markets inIndia. As a result, various segments of the financialmarket are now better developed and integrated.Despite considerable progress made so far, financialmarkets need to develop further in line with the evolvingconditions. In order to strengthen the understanding ofthe structure of the Indian financial markets and toidentify the substantive issues that need to be addressedtowards meeting this objective, the theme of this Reportfor 2005-06 has been selected as “Development ofFinancial Markets and Role of the Central Bank”. TheReport undertakes an in-depth analysis of varioussegments of the financial market in India in terms ofinter-temporal development, cross-country comparison,highlighting the current major issues and the policyinitiatives. An attempt is also made to outline the wayforward for each segment of the financial market. Thethrust of the Report is to assess the impact of variouspolicy measures and to look ahead as to what furtherneeds to be done to develop financial markets in India.Various measures suggested in this Report set outonly the broad direction in which reforms in the financialmarkets could move in future. Their implementationwould need careful sequencing in tune with the evolvingdomestic and global developments. The implementationof measures suggested would also be contingent uponthe development of appropriate market infrastructureand market players. Participants in financial marketsare exposed to various risks. These risks, therefore,need to be managed carefully. In view of this, it wouldbe necessary to develop market players whounderstand the risks and have the wherewithal tomanage them. The transferring of risks to those marketparticipants who do not understand them and do nothave the capacity to manage them could have seriousimplications for the financial system. The pace andsequencing of measures could, therefore, be calibratedkeeping in view the degree of comfort in moving forwardin a credible way.

1.33 The Repor t, including this chapter, isorganised into nine chapters. As a prelude to the

substantive theme based discussion, Chapter II of theRepor t titled “Recent Economic Developments”presents an analytical account of macroeconomicdevelopments in the Indian Economy during 2005-06and 2006-07 (up to the period for which data wereavailable). Besides, latest macroeconomicdevelopments for 2007-08, wherever available, arealso covered. The chapter covers six broad sections,viz., the real sector, fiscal situation, monetary andcredit situation, financial markets, financial institutionsand the external sector.

1.34 The theme based Repor t begins withChapter III on “Money Market”. The money market isa key segment of the financial market as it providesthe fulcrum of monetary operations conducted by thecentral bank in its pursuit of monetary policyobjectives. Besides providing an equil ibratingmechanism for demand and supply of short-termfunds for banks and other entities, it ensures anefficient market clearing price, while enabliing thecentral bank to intervene for influencing both thequantum and cost of liquidity in the financial system,thereby transmitting monetary policy impulses to thereal economy. After delineating internationalexperience on money market operating procedures,instruments, objectives, the evolving practices inliquidity management operations as well as thestructures of money markets, the chapter deals withvarious aspects of the money market in India. Thechapter focuses on the changing role of the ReserveBank’s liquidity management operations, in line withthe shifts in the operating procedures, that shapedthe development of the money market. It also spells outthe role of risk management and the Reserve Bank’sproactive role in mitigating various risks in the moneymarket. Emerging issues in monetary and liquiditymanagement in India and the need for addressing theseissues in future for the smooth functioning of the moneymarket and the efficient conduct of monetary policy havealso been highlighted in the chapter.

1.35 Chapter IV titled as “Credit Market” deals withvarious aspects of the credit market in India. After abrief outline of the theoretical underpinnings on thesignificance of the credit market in economic growth,the chapter sets out the structure of the credit marketin India and policy measures initiated to develop italong sound lines since the early 1990s. The focus ofthe chapter is on trends in credit growth in India sincethe early 1990s with a special emphasis on rapidcredit growth in recent years. Aspects relating to thecredit channel of monetary policy, analytical issuesrelating to credit boom and monetary policy and the

8


relationship between bank credit and asset priceshave been addressed comprehensively. The wayforward for further strengthening the role of the creditmarket has been outlined.

1.36 Chapter V titled as “Government SecuritiesMarket” covers various aspects of the governmentsecurities market in India since the early 1990s andattempts to identify the key issues that need to beaddressed to meet the emerging challenges. Thechapter begins with the theoretical underpinnings andprinciples and policy strategy for developing a deepand liquid government securities market, both primaryand secondary, based on the international experience.While outlining the developments in the governmentsecurities market in India, the chapter underscoresthe role played by the Reserve Bank in developingthis market segment since the early 1990s. Finally,the chapter raises some issues that need to beaddressed for enabling the government securitiesmarket to play a more vibrant role in the emergingscenario, especially in the context of the FiscalResponsibility and Budget Management (FRBM) Actand move towards fuller capital account convertibility.

1.37 Chapter VI titled as “Foreign ExchangeMarket” attempts to analyse the role of the centralbank in developing the foreign exchange market. Aftera brief overview of different exchange rate regimesbeing followed in EMEs, it traces the evolution of theforeign exchange market in India along with the shiftsin exchange rate regime in the post-independenceperiod. Regulatory and policy initiatives by theReserve Bank and the Government of India fordeveloping a vibrant foreign exchange market havebeen covered in the chapter. It also spells out thecurrent foreign exchange market structure and marketinfrastructure in terms of market players, tradingplatform, instruments and settlement mechanisms.This is followed by an assessment of the performanceof the Indian foreign exchange market in terms ofmarket liquidity and efficiency. Empirical exerciseshave also been carried out relating to the behaviourof forward premia, bid-offer spreads and determinantsof market turnover. It also traces the journey of theIndian foreign exchange market since the early 1990s,especially through periods of volatil ity and itsmanagement by the authorities. Further measuresneeded for deepening the foreign exchange marketto meet the emerging challenges of f inancialintegration have been outlined.

1.38 Chapter VII titled as “Equity and Corporate DebtMarket” is broadly divided into two sections, viz., the

equity market and the corporate debt market. Adiscussion on theoretical underpinnings of the role ofthe stock market in financing economic growth is followedby an overview of the measures initiated to reform thecapital market in India since the early 1990s. It thenassesses the impact of various reform measures on size,liquidity, transaction cost and volatility in the stock marketin India. The performance of the equity market in Indiahas been compared with select international markets,wherever possible. A brief account of the asset pricesalong with the wealth effect and its impact on aggregatedemand is also presented. In the section on thecorporate debt market, the need for developing theprivate corporate bond market for promoting growth andcreating multiple financing channels, especially for anemerging country like India, has been spelt out. This isfollowed by a description of the evolution of the debtmarket in India from the mid-1980s onwards, theemergence and the predominance of the privateplacement market, and the factors that are hamperinga healthy and vibrant growth of this segment of themarket. The chapter draws attention to the path forwardfor enhancing the role of the primary equity market andfor developing the private corporate debt market in Indiain the light of select cross-country experiences.

1.39 Chapter VIII of the Report titled as “FinancialMarket Integration” begins with the conceptualframework of financial market integration. This isfollowed by a discussion on different dimensions andbenefits and risks of financial market integration. Itthen outlines the various policy measures undertakenin India, which have facilitated the integration ofvarious financial market segments. After delineatingbriefly the phases of domestic market integration inIndia, the chapter presents a detailed empiricalanalysis on the integration of various segments of thefinancial market in India, viz., the governmentsecurities market, the credit market, the foreignexchange market and the capital market. Issuesrelating to market integration and monetary policyhave also been highlighted. Various aspects of globaland regional integration and India’s internationalfinancial integration have also been covered. As a wayforward, the chapter suggests certain measures tofurther strengthen the process of financial marketintegration in India.

1.40 Chapter IX titled as “Overall Assessment” setsout some final reflections for further developing andintegrating the various segments of the financialmarket in India.

RECENT ECONOMICDEVELOPMENTSII

2.1 The Indian economy continued to exhibit robustmacroeconomic performance during 2006-07.Industrial production maintained its momentum withgrowth accelerating to double digit during 2006-07,propelled by strong growth in manufacturing. Asignificant feature of the industrial sector performancehas been the continued high growth rate of the capitalgoods sector. The performance of the private corporatesector has improved, after a brief moderation duringthe second half of 2005-06, underpinned by buoyantdomestic and export demand. Investment climatecontinues to be encouraging. The growth in the servicessector accelerated during the first three quarters of2006-07 mainly led by the sub-sectors ‘trade, hotel,transport and communication’ and ‘financing, insurance,real estate and business services’. The onset of theSouth-West Monsoon 2006 was delayed by over aweek. Although the overall performance of the Monsoonwas close to normal, the temporal and spatialdistribution was uneven. However, on the whole, theIndian Economy is expected to grow at a robust pace.

2.2 Headline inflation remained at an elevatedlevel from November 2006, driven mainly by primaryfood articles and manufactured products. Consumerpr ice inf lat ion remained above WPI inf lat ionthroughout the year, mainly reflecting the impact ofhigher food prices. The Mid-term Review of the AnnualPolicy Statement of the Reserve Bank in October 2006observed that the combination of high growth andconsumer inflation coupled with escalating assetprices and tightening infrastructural bottlenecksunderscored the need to reckon with dangers ofoverheating and implications for the timing anddirection of monetary policy setting. It, however, alsoemphasised that it was important to recognise thatthe apprehension of overheating could at best betransitional in nature as there was evidence ofsubstantial investment taking place, accompanied byoverall productivity increases which should augmentpotential output. The Reserve Bank continued toemphasise the criticality of monitoring all availableindicators that point to excess aggregate demand.

2.3 During 2006-07, the Reserve Bank managedliquidity with a judicious mix of the available tools, viz.,liquidity adjustment facility (LAF) and issuance ofsecurities under the market stabilisation scheme(MSS). In order to ensure an effective liquidity

management, the Reserve Bank in March 2007modified and put in place an augmented programmeof issuance under the MSS with a mix of treasury billsand dated securities in a more flexible manner.Accordingly, the daily reverse repo absorption waslimited to a maximum of Rs.3,000 crore. In view ofunderlying inflationary pressures, the Reserve Bankhas resorted to a series of pre-emptive monetary policymeasures, viz., increase in the Cash Reserve Ratio(CRR) by 150 basis points and the repo/reverse reporate by 125/50 basis points in phases since June 2006.These measures combined with supply side fiscalmeasures and moderation in fuel prices helped inkeeping inflationary expectations well-anchored. Theapproach to liquidity management, however, continuedto ensure that appropriate liquidity is maintained in thesystem to meet all the legitimate requirements of creditfor the productive purposes, consistent with theobjective of price and financial stability, as emphasisedby the Third Quarter Review in January 2007.

2.4 Financial markets remained orderly, barringbrief spells in November and mid-December 2006 andin mid-March 2007, when call money rates moved upto high levels due to liquidity frictions. The equitymarket also encountered brief spells of volatility duringMay-June 2006 and February/March 2007. Barringthese episodes, financial markets were stable.

2.5 Financial institutions, especially scheduledcommercial banks, witnessed improved business andfinancial performance during 2005-06, underpinnedby robust macroeconomic fundamentals. Publicfinances of both the Centre and the States as perrevised estimates showed improvement on the backof buoyancy in both tax and non-tax revenue, whichmore than offset the higher expenditure.

2.6 The external sector continues to reflectdynamism with strong growth in merchandise exportsof goods and services. The balance of paymentsposition has remained comfortable, despite high andvolatile international crude oil prices during the mostpart of the year. Large capital flows continued much inexcess of the current account deficit, resulting insubstantial net accretion to foreign exchange reserves.

2.7 Against the above backdrop, this chapterpresents a detailed account of macroeconomicdevelopments during 2005-06 and 2006-07 (up to the

10


Table 2.1: Real Gross Domestic Product(At 1999-2000 Prices)

(Per cent)

Sector 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07(QE) (AE)

1 2 3 4 5 6 7 8

Growth Rate

1. Agriculture and Allied Activities -0.2 6.3 -7.2 10.0 0.0 6.0 2.7a) Agriculture -0.6 6.5 -8.1 10.9 -0.2 6.3 ..

2. Industry 6.4 2.4 6.8 6.0 8.4 8.0 10.2a) Manufacturing 7.7 2.5 6.8 6.6 8.7 9.1 11.3b) Mining and Quarrying 2.4 1.8 8.8 3.1 7.5 3.6 4.5c) Electricity, Gas and Water Supply 2.1 1.7 4.7 4.8 7.5 5.3 7.7

3. Services 5.7 6.8 7.4 8.9 10.0 10.3 11.0a) Trade, Hotels and Restaurants 5.2 9.6 6.9 10.3 8.4 8.2 13.0 $b) Transport, Storage and Communication 11.2 8.2 13.6 15.1 15.2 13.9 c) Financing, Insurance, Real Estate and Business Services 4.1 7.3 8.0 5.6 8.7 10.9 11.1d) Community, Social and Personal Services 4.8 4.1 3.9 5.4 7.9 7.7 7.8e) Construction 6.2 4.0 7.9 12.0 14.1 14.2 9.4

4. Gross Domestic Product at Factor Cost 4.4 5.8 3.8 8.5 7.5 9.0 9.2

Sectoral Composition

1. Agriculture and Allied Activities 23.9 24.0 21.5 21.7 20.2 19.7 18.52. Industry 20.0 19.3 19.9 19.5 19.6 19.4 19.63. Services 56.1 56.7 58.7 58.8 60.2 60.9 61.94. Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Memo:

Real GDP at Factor Cost at 1999-2000 Prices (Rupees crore) 18,64,773 19,72,912 20,47,733 22,22,591 23,89,660 26,04,532 28,44,022

.. : Not available. QE: Quick Estimates. AE: Advance Estimates. $ : Includes ‘trade, hotels and restaurants’ and ‘transport, storage and communication’.Source: Central Statistical Organisation.

growth, albeit somewhat lower than in 2004-05(Table 2.1 and Chart II.1). Growth in agriculture and

period for which latest data are available). Latestmacroeconomic developments for 2007-08, whereveravailable, are also covered. While section I presentsdevelopments in the real sector, section II presents adetailed account of Central and State Governmentfinances. Section III dwells on monetary and creditdevelopments along with the inflation trends. SectionIV outlines developments in the financial markets.Business operations of financial institutions arecovered in Section V. Section VI sets out externalsector developments. Overall assessment ispresented in Section VII.

I. REAL SECTOR

National Income

2.8 The Indian economy exhibited robust growthperformance during 2005-06 with real GDP growthaccelerating to 9.0 per cent from 7.5 per cent in 2004-05. The improved performance during 2005-06 wasunderpinned by a turnaround in the growth ofagriculture and allied activities and sustained growthof the services. The industrial sector maintained high

Chart II.1: Annual Growth Rate of GDP at Factor Cost(At 1999-2000 Prices)

Per

cen

t

Range: 3.8 per cent to 9.2 per cent

(PE

)

(QE

)

(AE

)

11

RECENT ECONOMIC DEVELOPMENTS

Table 2.2: Quarterly Growth Rates of Gross Domestic Product(At 1999-2000 prices)

(Per cent)

2001-02 2005-06 2006-07 April-December

Sectorto 2006-07 2005-06* 2006-07#

Q1 Q2 Q3 Q4 Q1 Q2 Q3 2005-06 2006-07

(Average)

allied activities was enabled by both foodgrains andnon-foodgrains production and improvement inrespect of hor ticulture, livestock, fisheries andplantation crops. Real GDP growth originating fromthe industrial sector was driven mainly by strongmanufacturing activity. Sustained expansion indomestic as well as exports demand, increasedcapacity utilisation, augmentation of capacities andposit ive business and consumer confidenceunderpinned the growth of the manufacturing sector.Continuing the double digit growth of the previousyear, real GDP originating in the services sectorrecorded a growth of 10.3 per cent during 2005-06.The services sector remained the key driver of growthduring 2005-06, contributing three-fifth to the overallreal GDP. The robust performance of the servicessector was led mainly by the sub-sectors ‘trade, hotels,transpor t and communication’ and ‘f inancing,insurance, real estate and business services’.

2.9 The Advance Estimates by the CentralStatistical Organisation (CSO) have placed the GDPgrowth for 2006-07 at 9.2 per cent, which points tocontinuing buoyancy in domestic economic activity.Real GDP growth for the first three quarters of 2006-07 (April-December) was placed higher at 8.9 per centas against 8.6 per cent in the corresponding period ayear ago (Table 2.2). Overall industrial productionincreased sharply by 10.1 per cent in the three

quarters of 2006-07 (April-December) from 7.8 percent in the corresponding period of 2005-06. Theservices sector growth is estimated to be higher at10.8 per cent in the first three quar ters (April-December) of 2006-07 as against 9.8 per cent duringthe same period in 2005-06.

2.10 Various national and international organisationshave placed the real GDP growth rate for 2007-08 inthe range of 7.9-8.5 per cent (Table 2.3). At this rate,India would continue to be one of the fastest growing

1 2 3 4 5 6 7 8 9 10 11 12 13

1. Agriculture and Allied Activities 3.0 6.0 2.7 4.0 4.0 8.7 5.5 3.4 1.7 1.5 6.0 2.2(20.9) (19.7) (18.5)

1.1 Agriculture .. 6.3 ..

2. Industry 7.0 8.0 10.2 9.8 6.6 7.2 7.9 9.7 10.5 10.0 7.8 10.1(19.5) (19.4) (19.6)

2.1 Mining and Quarrying 4.9 3.6 4.5 6.0 0.1 2.7 3.0 3.4 3.1 5.7 3.0 4.1 2.2 Manufacturing 7.5 9.1 11.3 10.7 8.1 8.2 8.9 11.3 11.9 10.7 9.0 11.3 2.3 Electricity, Gas and Water Supply 5.3 5.3 7.7 7.4 2.6 5.0 6.1 5.4 7.7 9.3 5.0 7.5

3. Services 9.1 10.3 11.0 9.5 9.5 10.3 11.0 10.4 10.7 11.1 9.8 10.8(59.5) (60.9) (61.9)

3.1 Trade, Hotels, Transport & Communication 10.8 10.4 13.0 10.2 9.5 10.0 12.9 13.1 13.8 13.0 9.9 13.3 3.2 Financing, Insurance, Real

Estate and Business Services 8.6 10.9 11.1 8.9 10.6 9.8 10.5 9.0 9.5 11.6 9.8 10.1 3.3 Community, Social and Personal Services 6.2 7.7 7.8 7.5 7.9 8.3 7.6 7.4 6.9 7.5 7.9 7.2 3.4 Construction 10.3 14.2 9.4 12.7 11.3 16.6 12.0 9.5 9.8 9.9 13.6 9.7

4. Real GDP at Factor Cost 7.3 9.0 9.2 8.4 8.0 9.3 9.3 8.9 9.2 8.6 8.6 8.9(100.0) (100.0) (100.0)

* : Quick Estimates. # : Advanced Estimates. .. : Not Available.Note : Figures in parentheses denote share in real GDP.Source : Central Statistical Organisation.

Table 2.3: Growth in Real Gross DomesticProduct, 2007-08 – Forecasts for India

(Per cent)

Institution Latest Month ofProjection

1 2 3

Asian Development Bank 8.0 (March 2007)

Centre for Monitoring Indian Economy 8.5 (May 2007)

Confederation of Indian Industry 8.5 (April 2007)

Credit Rating InformationServices of India Limited 7.9-8.4 (March 2007)

National Council of AppliedEconomic Research 8.3 (April 2007)

International Monetary Fund 8.4 (April 2007)

Reserve Bank of India Around 8.5 (April 2007)

Memo: Range 7.9-8.5

12


Table 2.5: Gross Domestic Saving and Investment

(Per cent of GDP at current market prices)

Sector 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05P 2005-06 QE

1 2 3 4 5 6 7 8

1. Gross Domestic Saving (GDS) (1.1+1.2+1.3) 24.8 23.4 23.5 26.4 29.7 31.1 32.4

1.1 Household Saving 21.1 21.0 21.8 22.7 23.8 21.6 22.3 a) Financial assets 10.6 10.2 10.8 10.3 11.3 10.2 11.7 b) Physical assets 10.5 10.8 10.9 12.4 12.4 11.4 10.7

1.2 Private corporate sector 4.5 4.3 3.7 4.2 4.7 7.1 8.1

1.3 Public sector -0.8 -1.9 -2.0 -0.6 1.2 2.4 2.0

2. Gross Domestic Capital Formation (GDCF)# 25.9 24.0 22.9 25.2 28.0 31.5 33.8

3. Saving-Investment Balance (1-2) -1.1 -0.6 0.6 1.2 1.7 -0.4 -1.3

4. Gross Capital Formation (4.1+4.2+4.3+4.4) 26.1 24.1 23.8 25.0 26.6 29.7 32.2

4.1 Household sector 10.5 10.8 10.9 12.4 12.4 11.4 10.7

4.2 Private corporate sector 7.4 5.7 5.4 5.9 6.9 9.9 12.9

4.3 Public sector 7.4 6.9 6.9 6.1 6.3 7.1 7.4

4.4 Valuables@ 0.8 0.7 0.6 0.6 0.9 1.3 1.2

P : Provisional. QE : Quick Estimates.# : Adjusted for errors and omission. @ : Valuables covers the expenditure made on acquisition of valuables included in the Gross Capital Formation.Note : Figures may not add up to the totals due to rounding off.Source : Central Statistical Organisation.

Table 2.4: Output Growth: Cross-Country Comparison(Per cent)

Country Average 1999 2000 2001 2002 2003 2004 2005 2006 2007P 2008P 1999-2008

1 2 3 4 5 6 7 8 9 10 11 12

World 4.4 3.7 4.8 2.5 3.1 4.0 5.3 4.9 5.4 4.9 4.9Advanced Economies 2.6 3.5 4.0 1.2 1.6 1.9 3.3 2.5 3.1 2.5 2.7Other Emerging Markets and Developing Countries 6.4 4.1 6.0 4.3 5.0 6.7 7.7 7.5 7.9 7.5 7.1Argentina 2.9 -3.4 -0.8 -4.4 -10.9 8.8 9.0 9.2 8.5 7.5 5.5Bangladesh 5.9 5.4 5.6 4.8 4.8 5.8 6.1 6.3 6.7 6.6 6.5Brazil 3.1 0.3 4.3 1.3 2.7 1.1 5.7 2.9 3.7 4.4 4.2Chile 4.0 -0.4 4.5 3.5 2.2 4.0 6.0 5.7 4.0 5.2 5.1China 9.4 7.6 8.4 8.3 9.1 10.0 10.1 10.4 10.7 10.0 9.5India 7.0 6.7 5.3 4.1 4.3 7.3 7.8 9.2 9.2 8.4 7.8Indonesia 4.8 0.8 5.4 3.6 4.5 4.8 5.0 5.7 5.5 6.0 6.3Malaysia 5.5 6.1 8.9 0.3 4.4 5.5 7.2 5.2 5.9 5.5 5.8Mexico 3.1 3.8 6.6 – 0.8 1.4 4.2 2.8 4.8 3.4 3.5Pakistan 5.3 3.7 4.3 2.0 3.2 4.9 7.4 8.0 6.2 6.5 6.5Philippines 4.9 3.4 6.0 1.8 4.4 4.9 6.2 5.0 5.4 5.8 5.8Sri Lanka 5.2 4.3 6.0 -1.5 4.0 6.0 5.4 6.0 7.5 7.0 7.0Thailand 4.9 4.4 4.8 2.2 5.3 7.1 6.3 4.5 5.0 4.5 4.8

P : IMF Projections.Source: World Economic Outlook, April 2007.

economies among the emerging market economiesin the world (Table 2.4).

Saving and Investment

2.11 The rate of gross domestic saving (GDS), asa proportion to GDP at current market prices, which

has been continuously increasing since 2000-01, wasplaced at 32.4 per cent in 2005-06 (Table 2.5 andChart II.2).The rate of GDS at 32.4 per cent was thehighest ever achieved since 1950-51. The householdsector continued to be the major contributor to GDSwith its saving rate placed at 22.3 per cent in 2005-06as compared with 21.6 per cent in 2004-05. Savings

13


by households in the form of physical assets during2000-01 to 2004-05 exceeded those in financialassets. This trend, however, was reversed in 2005-06.Private corporate saving, which has been increasingsteadily since 2001-02, grew by 8.1 per cent in 2005-06,reflecting a significant growth in profit. The publicsector, which started posting positive saving ratebeginning 2003-04, recorded a saving rate of 2.0 percent in 2005-06, on account of continuing fiscalimprovement.

2.12 The rate of gross domestic capital formation(GDCF), as a proportion to GDP at current marketprices, increased sharply to 33.8 per cent in 2005-06from 31.5 per cent in 2004-05 due to improvement inpublic investment as well as private corporate

Household Private Corporate Public Sector

Chart II.2: Saving by Institutional Sources(At 1999-2000 Prices)

Per

cen

t to

GD

P

investment. The higher increase in the investment ratethan the saving rate is reflected in a deficit of 1.3per cent in the overall saving-investment balance in2005-06 as compared with a deficit of 0.4 per cent in2004-05 (Table 2.6 and Chart II.3).

Agriculture

2.13 After witnessing a marked recovery during2005-06, agricultural growth is expected to remainsubdued during 2006-07, mainly on account ofexpected lower growth in foodgrains production.According to the Third Advance Estimates, the totalfoodgrains production during 2006-07 has beenestimated at 211.8 million tonnes, indicating an increaseof 1.5 per cent over the previous year (5.2 per cent).

Table 2.6: Saving-Investment Balance(At 1999-2000 prices)

(Per cent of GDP at current market prices)

Item 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05P 2005-06 QE

1 2 3 4 5 6 7 8

Saving-Investment Balance (GDS-GDCF) -1.1 -0.6 0.6 1.2 1.6 -0.4 -1.3Private Sector* 7.7 8.8 9.2 8.6 9.2 7.4 6.9Public Sector* -8.2 -8.8 -8.9 -6.6 -5.2 -4.7 -5.4Current Account Balance -1.0 -0.6 0.7 1.2 2.3 -0.8 -1.3

Memo:Valuables@ 0.8 0.7 0.6 0.6 0.9 1.3 1.2

P : Provisional. QE : Quick Estimates. GDS : Gross Domestic Saving. GDCF : Gross Domestic Capital Formation.* : Private and Public Investments refer to gross capital formation (GCF), unadjusted for errors and omissions.@ : Valuables covers the expenditure made on acquisition of valuables included in the GCF.Note: Derived from CSO and Reserve Bank of India data. Components may not add up to totals due to errors and omissions.

Chart II.3: Gross Capital Formation by Institutional Sources(At 1999-2000 Prices)

Public Sector Private Corporate Household Valuables

2004-0

5(P

E)

2005-0

6(Q

E)

Per

cen

t to

GD

P

14


1 According to IMD, the departure of aridity index from the normal value is expressed in percentage and accordingly drought is categorised assevere (more than 50 per cent), moderate (26-50 per cent) and mild (up to 25 per cent).

South-West Monsoon 2006

2.14 The vagaries of the South-West monsoon withregard to the time of onset as also its temporal andspatial distribution have a profound impact on theperformance of the agriculture sector. As two-thirdsof the cultivated area is still unirrigated, agronomicpotential is largely determined by the progress andperformance of the South-West monsoon. Accordingto the long range forecast of India MeteorologicalDepartment (IMD) issued on June 30, 2006, theSouth-West monsoon rainfall for the country as awhole was expected to be around 92 per cent of theLong Period Average (LPA) with a model error of +/-4 per cent. However, the actual rainfall during theSouth-West monsoon was 99 per cent of the normal,resulting in replenishment of the moisture content ofthe soil as well as that of the reservoirs.

2.15 Although overall performance of the South-West monsoon 2006 turned out to be of the sameorder as that of the previous year, its spatialdistr ibution was more uneven compared to theprevious year. Of the 36 meteorological sub-divisions, cumulative rainfall was excess/normal in26 sub-divisions (32 sub-divisions during last year)and deficient/scanty/no rain in 10 sub-divisions (4sub-divisions during last year) (Table 2.7). Duringthe season, rainfall was also not well distributed overtime. Large rainfall deficiency was observed from thesecond to the fourth week of June and July, last weekof August and during the middle of September 2006.The excess rainfall during the first three weeks ofAugust, especial ly over Central India, wasresponsible for the revival of the rainfall scenario inthe country.

2.16 The rainfall over the country as a whole wasbelow normal in June (13 per cent below LPA) andnear normal in July (2 per cent below LPA) andSeptember (1 per cent below LPA). However, themonsoon was active in August with excess rainfall(5 per cent above LPA). Thus, the South-Westmonsoon rainfall witnessed deficiency only duringthe month of June and remained close to normal inthe subsequent months. Among the fourhomogenous regions, the South-West monsoonrainfall was deficient in North-East India, North-WestIndia and Southern Peninsula, which recordedrainfall of 83 per cent, 94 per cent and 95 per centof LPA, respectively. The near normal performanceof the South-West monsoon rainfall over the countrywas contributed mainly by the excess rainfall overCentral India (116 per cent of LPA). At the sub-division level, five sub-divisions (Andaman andNicobar Islands, Arunachal Pradesh, Assam andMeghalaya, Western Uttar Pradesh and Haryana)experienced moderate drought1 conditions at theend of the season. Of the 533 meteorologicaldistricts, 130 districts (25 per cent) experiencedmoderate drought, while 30 districts (6 per cent)experienced severe drought conditions at the endof the season.

Reservoir Status

2.17 The Central Water Commission monitors thetotal live water storage in 76 major reservoirsaccounting for around 63 per cent of the totalreservoir capacity of the country. At the end of theSouth-West monsoon season (as on September 28,2006), the reservoir position with total live waterstorage at 91 per cent of the Full Reservoir Level(FRL) was higher than the previous year’s position(81 per cent) and the last ten year’s average (71per cent). The comfortable reservoir position is likelyto augur well for the rabi crop production as wellas hydroelectricity generation during 2006-07. Ason April 12, 2007, the total live water storage was35 per cent (32 per cent as on March 29, 2006) ofthe FRL. In view of the near normal performanceof the South-West monsoon and improvement inthe water storage levels, the Ministry of Agricultureset the target for the total foodgrains productionduring 2006-07 at 220 million tonnes, higher thanthe target of 215 million tonnes during the previousyear (Table 2.8).

Table 2.7: Cumulative Rainfall

Number of Sub-Divisions

Category South-West Monsoon North-East Monsoon

2004 2005 2006 2004 2005 2006

(Jun. 1 to Sep. 30) (Oct. 1 to Dec. 31)

1 2 3 4 5 6 7

Excess 0 9 6 8 11 3Normal 23 23 20 10 6 6Deficient 13 4 10 17 5 14Scanty/No Rain 0 0 0 1 14 13

Source : India Meteorological Department.

15


North-East Monsoon 2006

2.18 Cumulative rainfall recorded during the North-East monsoon (October 1, 2006 to December 31,2006) was 21 per cent below normal as comparedwith 10 per cent above normal dur ing thecorresponding period of the previous year. Of the 36meteorological sub-divisions, cumulative rainfall wasexcess/normal in 9 sub-divisions (17 sub-divisionsduring last year) and deficient/scanty/no rainfall in27 sub-divisions (19 sub-divisions during last year)(Table 2.7).

Kharif 2006

2.19 Against the backdrop of a normal monsoon,production of foodgrains during kharif 2005 (109.9million tonnes) registered a growth of 6.3 per centover that in the previous year. According to the ThirdAdvance Estimates, the kharif foodgrains productionduring 2006-07 has been estimated at 108.4 milliontonnes, a decline of 1.4 per cent over the previousyear (Table 2.9). Among kharif foodgrains, while theproduction of coarse cereals (6.5 per cent) and pulses(0.8 per cent) witnessed a decline, that of rice (0.3per cent) registered a marginal improvement over theprevious year. After witnessing a sharp recoveryduring 2005-06, production of kharif oilseeds isexpected to witness a sharp decline during 2006-07.However, with the continued growth momentum since2003-04, sugarcane and cotton are expected to scalenew peaks during 2006-07.

Rabi 2006-07

2.20 Total foodgrains production during rabi 2005-06 increased by 3.7 million tonnes to 98.7 milliontonnes (Table 2.9). Consequently, the overallfoodgrains production for 2005-06 at 208.6 milliontonnes registered a growth of 5.2 per cent over theprevious year. Favourable soil moisture conditionsalong with remunerative open market and supportprices led to improved sowing position during rabi2006-07. Area sown under rabi crops so far (up toApril 27, 2007) has been about 2.2 per cent higherthan that a year ago. Barring oilseeds and rice, allmajor crop groups have witnessed improvement in

Table 2.8: Crop-wise Targets/Achievements(Million tonnes)

Crops 2004-05 2005-06 2006-07

T A T A T AE

1 2 3 4 5 6 7

Rice 93.5 83.1 87.8 91.8 92.8 91.1

Wheat 79.5 68.6 75.5 69.4 75.5 73.7

Coarse cereals 36.8 33.5 36.5 34.1 36.5 32.9

Pulses 15.3 13.1 15.2 13.4 15.2 14.1

Total Foodgrains 225.1 198.4 215.0 208.6 220.0 211.8Oilseeds 26.2 24.4 26.6 28.0 29.4 23.3

Sugarcane 270.0 237.1 237.5 281.2 270.0 322.9

Cotton* 15.0 16.4 16.5 18.5 18.5 21.0

Jute & Mesta** 11.8 10.3 11.3 10.8 11.3 11.3

T : Target. A : Achievement.AE : Third Advance Estimates as on April 4, 2007.* : In million bales of 170 kilograms each.** : In million bales of 180 kilograms each.Source : Ministry of Agriculture, Government of India.

Table 2.9: Season-wise Agricultural Production(Million tonnes)

Kharif Rabi

Crop 2004-05 2005-06 2006-07 2004-05 2005-06 2006-07 A A AE A A AE

1 2 3 4 5 6 7

Rice 72.2 78.3 78.5 10.9 13.5 12.5Wheat .. .. .. 68.6 69.4 73.7Coarse Cereals 26.4 26.7 25.0 7.1 7.3 7.9Pulses 4.7 4.9 4.8 8.4 8.5 9.3Total Foodgrains 103.3 109.9 108.4 95.1 98.7 103.4Oilseeds 14.1 16.8 13.9 10.2 11.2 9.4Sugarcane 237.1 281.2 322.9 .. .. ..Cotton* 16.4 18.5 21.0 .. .. ..Jute & Mesta** 10.3 10.8 11.3 .. .. ..

A : Achievement. AE : Third Advance Estimates (2006-07) as on April 4, 2007... : Not Available. * : In million bales of 170 kilograms each. ** : In million bales of 180 kilograms each.Source: Ministry of Agriculture, Government of India.

16


Table 2.10: Management of Foodstocks (Million Tonnes)

Year/ Month Opening Stock Foodgrains Foodgrains offtake Closing Buffer Stockof Foodgrains Procurement

PDS OWS OMS - Domestic ExportsStock Norms $

1 2 3 4 5 6 7 8 9

2005April 18.0 14.2 2.4 1.0 0.0 0.0 28.5 16.2May 28.5 3.0 2.5 0.8 0.0 0.0 27.9 June 27.9 0.9 2.5 1.7 0.0 0.0 25.1 July 25.1 0.8 2.8 0.8 0.1 0.0 21.4 26.9August 21.4 0.4 2.6 0.8 0.1 0.0 18.4 September 18.4 0.4 2.7 0.7 0.1 0.0 15.5 October 15.5 7.5 2.7 0.5 0.0 0.0 19.8 16.2November 19.8 2.7 2.3 0.5 0.1 0.0 19.0 December 19.0 2.9 2.7 0.7 0.2 0.0 19.3

2006 January 19.3 4.0 2.7 0.8 0.1 0.0 19.5 20.0February 19.5 2.9 2.7 0.6 0.3 0.0 18.3 March 18.3 1.9 2.5 0.9 0.2 0.0 16.6 April 16.6 10.3 2.5 0.3 0.0 0.0 22.8 16.2May 22.8 2.2 2.9 0.4 0.0 0.0 22.3 June 22.3 1.5 2.6 0.6 0.0 0.0 20.5 July 20.5 0.8 2.7 0.4 0.0 0.0 17.1 26.9August 17.1 0.5 2.7 0.4 0.0 0.0 15.5 September 15.5 0.2 2.6 0.5 0.0 0.0 12.6 October 12.6 8.0 2.5 0.3 0.0 0.0 18.6 16.2November 18.6 2.0 2.5 0.4 0.0 0.0 17.8 December 17.8 2.6 2.6 0.3 0.0 0.0 17.5

2007January 17.5 4.3 2.7 0.4 0.0 0.0 18.1 20.0February 18.1 2.4 2.7 0.5 0.0 0.0 19.1March 19.1 1.2 .. .. .. .. .. April .. 8.7 .. .. .. .. .. 16.2May* .. 1.4 .. .. .. .. ..

Memo :

2005-06 @ 18.0 41.4 28.6 8.9 0.9 0.0 18.3 2006-07 @ 16.6 35.9 28.9 4.6 0.0 0.0 19.1 2007-08 * .. 10.1 .. .. .. .. ..

PDS : Public Distribution System. OWS : Other Welfare Schemes. OMS : Open Market Sales.$ : Minimum Buffer Stock norms to be maintained, as on 1st April, 1st July, 1st October and 1st January, revised under New Buffer Stocking Policy with

effect from March 29, 2005. * : Procurement up to May 8, 2007.@: Offtake up to end-February and closing stock as on March 1. .. : Not Available.Note : Closing Stock figures may differ from those arrived at by adding the opening stocks and procurement and deducting, offtake as stocks include

coarse grains also.Source : Ministry of Consumer Affairs, Food and Public Distribution, Government of India.

the area sown. According to the Ministry ofAgriculture, Government of India, the less coverageunder oilseeds was mainly due to diversion of areafrom rapeseed and mustard to bengal gram in MadhyaPradesh and to wheat in Haryana, Rajasthan andUttar Pradesh.

2.21 Timely sowing of the rabi crops along withimprovement in area sown have brightened theprospects of rabi crops during 2006-07. Accordingly,the Third Advance Estimates have placed the rabifoodgrains production at 103.4 million tonnes, an

increase of 4.8 per cent over the previous year. Totalproduction of wheat is expected at 73.7 million tonnes,an increase of 6.3 per cent over the previous year.

Procurement, Offtake and Stocks of Foodgrains

2.22 The procurement of foodgrains (rice andwheat) during 2006-07 at 35.9 million tonnes waslower by 13.2 per cent over the corresponding periodof the preceding year (Table 2.10). This was mainlyon account of a significantly lower procurement ofwheat at 9.2 million tonnes during 2006-07 as against

17


14.8 million tonnes during the corresponding periodof the previous year. Similarly, the offtake of rice andwheat during 2006-07 (April 1 to February 28, 2007)was lower by 12.7 per cent over the comparable periodof the previous year. The decline in offtake was mainlydue to a sharp fall in the offtake under Other WelfareSchemes (OWS). Furthermore, the offtake of wheatunder the Targeted Public Distribution System (TPDS)also declined by 14.5 per cent. Total stocks offoodgrains with Food Corporation of India and otherGovernment agencies at 19.1 million tonnes as onMarch 1, 2007 were 4.3 per cent higher as comparedwith 18.3 million tonnes in the corresponding periodof last year. During 2007-08 so far (up to May 8, 2007),total procurement of wheat and rice at 10.1 milliontonnes was 7.5 per cent lower than 11.0 million tonnesprocured during the corresponding period of theprevious financial year.

Recent Policy Initiatives

2.23 With a view to achieving the target of around4.0 per cent agricultural growth as envisaged in theApproach Paper to the Eleventh Plan, a number ofnew initiatives were undertaken by the Governmentduring last year for redressing the problems afflictingthe agriculture sector. These, inter alia , were(i) creation of a National Rain-fed Area Authority inNovember 2006 to suppor t upgradation andmanagement of dry-land and rain-fed agriculture;(i i) formulation of a model law on agriculturalmarketing in consultation with the State Governments/UTs to bring about marketing reforms; (iii) packagefor revival of Short-term Rural Co-operative CreditStructure in January 2006; (iv) interest subvention toenable lending for crop loans up to a principal amountof Rs.3 lakh at 7.0 per cent rate of interest beginningKharif 2006-07; (v) special relief package for farmersin 31 high incidence districts of farmers’ suicides inAndhra Pradesh, Maharashtra, Karnataka and Kerala;and (vi) launch of National Agricultural InnovationProject in July 2006 aimed at enhancing livelihoodsecurity by involving farmer groups, Panchayati Rajinstitutions and the private sector.

2.24 To promote more broad-based and inclusivegrowth, the Union Budget, 2007-08 has placed theacceleration of agricultural growth at the top of theGovernment’s agenda. The Budget has fixed a farmcredit target of Rs.2,25,000 crore for the ensuingfinancial year with an objective of bringing 5 millionnew farmers into the fold of the banking system. Inorder to augment resources to refinance rural creditco-operatives, NABARD has been permitted to issue

rural bonds of Rs.5,000 crore and RRBs have beenasked to undertake a significant branch expansionprogramme. Further, the Budget has proposed toextend the Securitisation and Reconstruction ofFinancial Assets and Enforcement of Security Interest(SARFAESI) Act to loans advanced by RRBs; permitRRBs to accept NRE/FCNR deposits; andrecapitalise, in a phased programme, the RRBs whichhave a negative net worth. A Fund with NABARD formeeting the cost of developmental and promotionalinterventions and a Technology Fund to meet the costsof technology adoption has been proposed in theBudget for promoting financial inclusion.

2.25 The National Commission on Farmers haddrawn attention to the knowledge deficit, whichconstrains agricultural productivity. Farming practicesin large parts of the country are sub-optimal. TheUnion Budget, 2007-08 has highlighted the need forestablishing a good extension system to make full useof the existing technology in the agriculture sector.The Budget has also proposed to (i) expand theIntegrated Oilseeds, Oil palm, Pulses and MaizeDevelopment Programme; (ii) enhance outlay underAccelerated Irrigation Benefit Programme (AIBP); and(iii) restore water bodies and groundwater rechargefor improving the productivity of crops.

Industry

2.26 The industrial sector expanded at a robustpace for the fifth year in succession during 2006-07.The upswing in the industrial sector was drivenmainly by manufacturing activity, which contributesmore than 90 per cent to the industrial growth.During 2006-07, the IIP registered an accelerateddouble digit growth of 11.3 per cent – the highest since1995-96 (13.1 per cent) (Table 2.11). Strongconsumption demand, expansion in investment andcapacity additions were the main factors thatcontributed to the accelerated growth. The growthwas well-diversif ied across al l the sectors. Asignificant pick-up in the intermediate goods sectorin recent months underlines the new acquireddynamism and competit iveness of the Indianindustry. The continued buoyant performance of thebasic and the capital goods sectors provides a basisfor sustained high industrial growth.

2.27 During 2006-07, the manufacturing sectorrecorded a growth of 12.3 per cent, which has beenthe highest since 1995-96, when it recorded a growthof 14.1 per cent. The mining sector recorded a highergrowth of 5.1 per cent, benefiting from higherproduction of crude oil. Higher output of crude oil

18


1. Wood and wood products,furniture and fixtures (29.1)

2. Basic metal and alloy(22.8)

Note : Figures in parentheses are growth rates.Source : Central Statistical Organisation.

1. Chemicals and chemicalproducts except products ofpetroleum and coal (9.2)

2. Paper and paper products(8.3)

3. Wool, silk and man-madefibre textiles (8.2)

4. Food products (8.2)

5. Other manufacturingindustries (6.5)

6. Leather and leather & furproducts (0.3)

1. Jute and other vegetablefibre textiles (-17.2)

Table 2.12: Growth of Manufacturing Industries (2-digit level Classification) (April-March 2006-07)

Above 15 per cent 10-15 per cent 0-10 per cent Negative

1 2 3 4

1. Transport equipment andparts (14.9)

2. Cotton textiles (14.8)

3. Machinery and equipment otherthan transport equipment (14.0)

4. Non-metallic mineral products(12.8)

5. Rubber, plastic, petroleum andcoal products (12.7)

6. Metal products and parts (11.4)

7. Beverages, tobacco andrelated products (11.3)

8. Textiles products (includingapparels) (11.2)

Table 2.11: Monthly Growth of IIP(Per cent)

General Electricity Mining & Quarrying Manufacturing

Month/Weight (100.00) (10.17) (10.47) (79.36)

2005-06 2006-07 2005-06 2006-07 2005-06 2006-07 2005-06 2006-07

1 2 3 4 5 6 7 8 9

April 8.1 9.9 3.1 5.9 2.8 3.4 9.2 11.0

May 10.8 11.7 10.5 5.0 5.2 2.9 11.3 13.3

June 12.2 9.7 9.6 4.9 4.8 4.7 13.2 10.7

July 4.7 13.2 -0.9 8.9 -1.9 5.1 6.0 14.3

August 7.6 10.3 7.9 4.1 -2.5 -1.7 8.5 11.9

September 7.2 12.0 -0.8 11.3 -1.9 4.3 8.9 12.7

October 9.8 4.5 7.7 9.7 -0.1 5.9 10.9 3.8

November 6.0 15.8 3.4 8.7 -2.1 8.8 7.0 17.2

December 5.7 13.4 3.4 9.1 -0.1 6.1 6.4 14.5

January 8.5 11.4 6.4 8.3 2.0 7.2 9.4 12.1

February 8.8 10.8 9.1 3.3 3.8 7.1 9.2 11.9

March 8.9 12.9 3.4 7.9 2.0 6.2 10.1 14.1

April-March 8.2 11.3 5.2 7.2 1.0 5.1 9.1 12.3

Source: Central Statistical Organisation.

reflected the recovery from the setback to production,following the outbreak of fire at Mumbai High in July2005. The electricity sector recorded a higher growthof 7.2 per cent during the period, reflecting mainlythe higher plant load factor (PLF) in thermal powerplants and double-digit growth in hydro-powergeneration.

2.28 A notable feature of industrial growth inrecent years has been the continued buoyancy ofthe manufactur ing sector. Dur ing 2006-07, 16manufacturing industry groups (in terms of 2-digitlevel classification) recorded a positive growth(Table 2.12). Significantly, two industries constitutingaround 24 per cent weight in IIP, viz., machinery and

19


equipments, and chemicals and chemical productscontributed 32.9 per cent to the manufacturing sectorgrowth during 2006-07. ‘Metal products and parts’,‘wood and wood products’, ‘leather and leather andfur products’, ‘paper and paper products’ and ‘wool,silk and man-made fibre textiles’ made a turnaround,while ‘jute and other vegetable fibre textiles’ recordednegative growth during the year.

2.29 The performance of industry in terms of use-based classification was equally impressive during2006-07. The basic goods sector recorded a growthof 10.2 per cent – the highest growth since 1995-96(Table 2.13). The accelerated growth of cement, highspeed diesel and various other iron and steelproducts such as carbon steel, bars and rods, pipesand tubes, structurals, etc., contributed to highergrowth of the basic goods sector. Growth of theintermediate goods sector at 11.7 per cent has alsobeen the highest since 1995-96 (19.3 per cent). Thegrowth was driven largely by the higher growth ofsome yarns, polyester fibre, viscose staple fibre,

PVC pipes and tubes and glazed tiles/ceramic tiles.The capital goods sector also recorded a high growthof 17.7 per cent during 2006-07 as compared with15.8 per cent during 2005-06 and was sustained bycomplete tractors, boilers, diesel engines, textilemachinery, material handling equipment, protectionsystem/switch board, and process-controlinstruments. The consumer goods sector recordeda moderately lower growth of 10.0 per cent during2006-07 as compared with 12.0 per cent during thecorresponding period of the previous year. This wason account of the decelerated growth of bothconsumer durables and non-durables mainly due tonegative performance of some of the food productsand edible oils and some drugs.

Infrastructure

2.30 During 2006-07, the overall growth of coreinfrastructure industries at 8.6 per cent (as comparedwith 6.2 per cent during 2005-06) was the highestsince 1999-00 (Table 2.14). The higher growth was

Table 2.13: Sectoral Contribution to IIP Growth(April-March)

(Per cent)

Industry Group Weight Growth Relative Contribution

in IIP 2004-05 2005-06 2006-07 P 2004-05 2005-06 2006-07 P

1 2 3 4 5 6 7 8

Basic Goods 35.57 5.5 6.7 10.2 20.9 25.4 27.5

Capital Goods 9.26 13.9 15.8 17.7 16.4 20.0 17.4

Intermediate Goods 26.51 6.1 2.5 11.7 20.3 8.4 26.7

Consumer Goods (a+b) 28.66 11.7 12.0 10.0 42.6 46.3 28.7

a) Consumer Durables 5.36 14.3 15.3 9.0 12.9 14.9 6.7

b) Consumer Non-durables 23.3 10.8 11.0 10.3 29.6 31.4 22.0

IIP 100.0 8.4 8.2 11.3 100.0 100.0 100.0

P : Provisional.Source : Central Statistical Organisation.

Table 2.14: Growth Rate of Infrastructure Industries(Per cent)

Sector Weight in IIP 2002-03 2003-04 2004-05 2005-06 2006-07 (P)

1 2 3 4 5 7 8

1. Electricity 10.17 3.2 5.1 5.2 5.2 7.22. Coal 3.22 4.5 5.1 6.2 6.6 5.93. Finished Steel 5.13 7.3 9.8 8.4 11.2 10.94. Cement 1.99 8.8 6.1 6.6 12.4 9.15. Crude Petroleum 4.17 3.4 0.7 1.8 -5.3 5.66. Petroleum Refinery Products 2.00 4.9 8.2 4.3 2.4 12.6Composite Index 26.68 5.0 6.1 5.8 6.2 8.6

Source: Office of the Economic Adviser, Ministry of Commerce and Industry, Government of India.

20


Table 2.15: Quarterly Growth Performance of Sub-Sectors of Services(Base: 1999-2000)

(Per cent)

Sub-sector 2004-05 2005-06 2006-07

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

1 2 3 4 5 6 7 8 9 10 11 12

Construction 12.4 8.5 14.5 13.5 12.7 11.3 16.6 12.0 9.5 9.8 9.8Trade, hotels, transport & communication 11.7 12.2 10.2 11.0 10.2 9.5 10.0 12.9 13.1 13.8 13.0Financing, insurance, real estate &business services 9.7 8.4 10.6 10.7 8.9 10.6 9.8 10.5 9.0 9.5 11.6Community, social & personal services 11.2 5.1 8.9 12.7 7.5 7.9 8.3 7.6 7.4 6.9 7.5Services 11.2 9.1 10.4 11.6 9.5 9.5 10.3 11.0 10.4 10.7 11.1GDP at factor cost 8.1 6.9 5.5 8.6 8.4 8.0 9.3 9.3 8.9 9.2 8.6

Source: Central Statistical Organisation.

mainly a reflection of strong growth of electricity andpetroleum refinery products and turnaround in thegrowth of crude petroleum during the period. Amongstthe core sector groups, petroleum refinery productsrecorded the highest growth of 12.6 per cent duringthe period.

2.31 Despite strong domestic demand, a high basecontributed to a double-digit but moderate growth insteel output. Rising domestic and external demandcontinued to underpin the growth of the cement sector,notwithstanding some moderation on account of thebase effect. Negative growth in coal production inSeptember resulted in a lower growth in the coal sectorduring the year. Crude petroleum recorded a turnarounddue to restoration of production of crude oil in ONGCplant at Mumbai High and rise in crude oil production inprivate and joint-venture companies. Higher capacityutilisation in various refineries across the country andhigher exports of petroleum refinery products enabledthe petroleum refinery products sector to register animpressive growth.

Services Sector

2.32 India’s growth over the past few years hasbeen driven primarily by the services sector. Theservices sector continued to grow at a robust pace of10.3 per cent during 2005-06 on top of 10.0 per centgrowth in 2004-05. The services sector maintainedthe growth momentum and recorded an impressivedouble-digit growth (10.7) during April-December2006, despite a higher base (9.8 per cent during thesame period in 2005). The acceleration in the growthwas led by ‘trade, hotels, transpor t andcommunication’, which recorded the highest growthof 13.3 per cent among the sub-sectors during theperiod (Table 2.15).

2.33 Enhanced synergy with the industrial sectoras well as the robust economic condition have spurredthe strong growth of trade, transpor tation,communication, construction and financial services.The trade sector recorded a double-digit growth asboth exports and imports grew at a strong pace. Rapidgrowth in domestic and international tourism, bothbusiness and leisure, aided the growth of the hotelindustry. Burgeoning revenue earning freight trafficof railways and robust growth of aviation sectorpropped up the transport sector. Strong growth in thecellular subscr iber base and steady growth inbroadband connections underpinned the stronggrowth in the communication sector. The ‘financing,insurance, real estate and business services’ sub-sector benefited from the healthy growth in bankdeposits and non-food credit, surge in insurancebusiness of both public and pr ivate insurancecompanies, and increased business processoutsourcing-information technology enabled servicesexports. ‘Community, social and personal services’sub-sector recorded a higher growth due to increasein both plan and non-plan expenditure.

Information Technology Enabled Services andBusiness Process Outsourcing

2.34 The export-oriented information technology(IT) and business process outsourcing (BPO) sectorscontinued to perform well due to growing internationaldemand for skilled, low-cost English-speaking Indianworkers. The Information Technology EnabledServices (ITES) and BPO segments have contributedsignificantly in sustaining the growth of the servicessector. According to the National Association ofSoftware and Services Companies (NASSCOM),ITES-BPO revenue increased significantly in 2005-06to US$ 29.6 billion on account of a rapid growth in

21


demand from overseas and domestic consumers. Theexports of Indian IT-ITES industry increased by 33per cent, generating revenues of US$ 23.6 billion in2005-06 as compared with US$ 17.7 billion in 2004-05.Factors such as evolution of global delivery modeland unbundling of large IT outsourcing deals withlarge companies based in India contributed to thebuoyant export performance. India’s strength in theIT enabled and BPO segments has increased inrecent years through large client wins, cross-bordermergers and acquisitions, and movement of theindustry towards a stable pricing model.

Industrial Outlook

2.35 The Industr ial sector, which performedconsistently well in recent years remained buoyantduring 2006-07, underpinned by strong consumptiondemand, expansion in investment and capacityadditions. The performance of the mining sectorimproved in 2006-07. It is expected to put up a modestgrowth as the recent de-blocking of coal reserves forcaptive consumption by steel and power companieswould push up the coal production activity in thecountry. The power sector continues to suffer fromgas supply shortages, which has forced gas-basedplants to operate at lower capacity. Growth of themanufacturing sector is well-diversified. Consideringthe buoyant industrial climate in the country, growthin the manufactur ing sector is expected to besustained at a double-digit level.

II. FISCAL SITUATION

Central Government Finances

2.36 The Union Budget, 2007-08 was presentedagainst the backdrop of strong macroeconomicfundamentals, albeit with some concerns on theinflation front. The Budget commits to fur therstrengthen the fiscal correction as stipulated in theFiscal Responsibility and Budget Management(FRBM) Rules, 2004 with the proposed reductions inthe revenue deficit and fiscal deficit, while at the sametime allocating higher funds for social sectorexpenditure.

2.37 The major thrust of the Budget, 2007-08 wason attaining faster and more inclusive growth. In orderto achieve the objective of inclusive growth, bulk ofthe budgetary resources have been allocated to eightflagship programmes of the Government covering the

areas of education, health and rural employment. Inorder to sustain the growth momentum, the budgethas proposed policies aimed at tapping extrabudgetary resources and leveraging them forinvestment, especially the infrastructure.

2.38 The budget seeks to continue the impressiveperformance on the tax front through a strategy ofmoderate and stable tax rates and administering thetax laws in a tax payer-friendly manner. In the case ofdirect taxes the strategy is to (a) minimise thedistortions within the tax structure by rationalising thetax structure and expanding the tax base andmaintaining moderate tax rates; and (b) improve theefficiency and effectiveness of the tax administrationso as to enhance voluntary compliance through ahigher deterrence level. The strategy of indirect taxesis to bring down the customs tariff to the comparablelevels of East Asian countries, widen the tax baseand converge the excise duty to the CENVAT rate. Inthe case of service tax, the strategy is to expand thetax base, while at the same time provide exemptionto small service providers. In the case of indirect taxes,tax policy was aimed at containing the inflationarypressures in the economy and taking steps forintroducing the fully integrated goods and servicestax by April 1, 2010.

Revised Estimates 2006-07 2

2.39 The revised estimates for 2006-07 showedimprovement in all the key deficit indicators, viz.,revenue deficit (RD), gross fiscal deficit (GFD) andprimary deficit (PD) relative to GDP over theirbudgeted levels. Reduction in deficit indicators wasmainly on account of improved revenue receipts, bothtax and non-tax, which more than offset the higherexpenditure. Aggregate expenditure was higher thanthe budget estimates on account of revenueexpenditure, par ticularly on interest payments,fertilizer and interest subsidies, and non-plan non-defence capital outlay. Plan expenditure was in linewith the budget estimates.

2.40 The revenue deficit in the revised estimatesconstituted 2.0 per cent of the GDP in 2006-07 asagainst the budgeted level of 2.1 per cent. The declinein revenue deficit was on account of a markedimprovement in revenue receipts by Rs.19,866 crore(4.9 per cent) which offset the increase in revenueexpenditure. Notwithstanding the fall in revenuedeficit, the GFD was higher by Rs.3,642 crore (2.4

2 All comparisons of 2006-07 in this Section are with budget estimates, unless stated otherwise.

22


Table 2.16: Key Deficit Indicators of the Central Government(Amount in Rupees crore)

Item 2005-06 2006-07 2006-07 2007-08 Variation (Per cent)

(Accounts) (BE) (RE) (BE)

col.4 over 3 col. 5 over 4

1 2 3 4 5 6 7

Gross Fiscal Deficit 1,46,435 1,48,686 1,52,328 1,50,948 2.4 -0.9(4.1) (3.8) (3.7) (3.3)

Revenue Deficit 92,299 84,727 83,436 71,478 -1.5 -14.3(2.6) (2.1) (2.0) (1.5)

Gross Primary Deficit 13,805 8,863 6,136 -8,047 -30.8 -231.1 (0.4) (0.2) (0.1) (-0.2)

BE : Budget Estimates. RE : Revised Estimates.Note: Figures in parentheses are percentages to GDP.

3 All comparisons of 2007-08 in this Section are with revised estimates for 2006-07, unless stated otherwise.

per cent) than the budgeted level on account of a fallin non-debt capital receipts as well as higher non-plan non-defence capital outlay. In relation to GDP,however, it was lower at 3.7 per cent than the budgetestimates of 3.8 per cent. Primary deficit at 0.1 percent of GDP was lower by 30.8 per cent in the revisedestimates for 2006-07 than the budget estimates(Table 2.16).

2.41 Revenue receipts in the revised estimates for2006-07 increased by 4.9 per cent over the budgetedlevel. The gross tax revenue in the revised estimatesfor 2006-07 was higher by Rs.25,695 crore than thebudget estimates. Collections under all the taxes areset to be higher than the budgeted level. Among therecently introduced taxes, fr inge benefit tax isestimated to yield Rs.5,500 crore, Secur it iesTransactions Tax (STT) Rs.3,750 crore and bankingcash transaction tax Rs.550 crore in 2006-07. Thenet tax revenue [gross tax revenue less States sharein Central taxes and amount transferred to NationalCalamity Contingency Fund (NCCF)] increased by 5.7per cent and constituted 8.4 per cent of the GDP(Table 2.17).

2.42 Under non-debt capital receipts, recoveriesof loans and advances declined by 31.9 per cent overthe budget estimates (Table 2.17). Recoveries ofloans to the State Governments are estimated todecline by Rs.4,102 crore in the revised estimates for2006-07 due to the impact of the debt waiver underthe Twelfth Finance Commission (TFC) award.Recoveries from Public Sector Enterprises, statutorybodies, etc., are, however, estimated to increase byRs.1,596 crore.

2.43 Revenue expenditure in the revised estimatesfor 2006-07 was higher by 3.8 per cent than the budgetestimates, while capital expenditure declined by 1.2per cent over the budget estimates (Table 2.18).Revenue expenditure was higher on account ofinterest payments, fertiliser and interest subsidies,grants to the States and pensions. In the capitalexpenditure, non-defence capital outlay and loans andadvances were higher than the budget estimates.

Budget Estimates 2007-08 3

2.44 After achieving the targets in the precedingyear, the Union Budget for 2007-08 proposes tofurther strengthen the fiscal correction as stipulatedin FRBM Rules, 2004. Accordingly, key deficitindicators, viz., revenue deficit (RD), gross fiscaldeficit (GFD) and primary deficit (PD), as per cent ofGDP, are budgeted lower at 1.5 per cent, 3.3 per centand -0.2 per cent in 2007-08 than 2.0 per cent, 3.7per cent and 0.1 per cent, respectively, in thepreceding year (Table 2.16). The Union Budget, 2007-08 proposes to acquire the Reserve Bank’s equityholding in State Bank of India, for which it provided asum of Rs.40,000 crore. This transaction, however,being shown as a non-debt capital receipt matchedby capital expenditure, would not have an impact onthe deficit indicators.

2.45 The revenue receipts in 2007-08 are budgetedto increase by 14.9 per cent on top of a high growthof 21.8 per cent recorded in 2006-07, primarilyreflecting a growth of 17.2 per cent in gross taxcollections as compared with an increase of 27.8 percent in 2006-07. Among the direct taxes, corporation

23


Table 2.17: Receipts of the Centre(Amount in Rupees crore)

Item 2005-06 2006-07 2006-07 2007-08 Variation (per cent)(Accounts) (BE) (RE) (BE) Col.4 Col.5

over 3 over 4

1 2 3 4 5 6 7

Total Receipts (1+2) 5,06,123 5,63,991 5,81,637 6,40,521 * 3.1 10.1(14.2) (14.3) (14.2) (13.8)

1. Revenue Receipts 3,47,462 4,03,465 4,23,331 4,86,422 4.9 14.9(9.7) (10.2) (10.3) (10.5)

i) Tax Revenue (Net) 2,70,264 3,27,205 3,45,971 4,03,872 5.7 16.7(7.6) (8.3) (8.4) (8.7)

ii) Non-Tax Revenue 77,198 76,260 77,360 82,550 1.4 6.7(2.2) (1.9) (1.9) (1.8)

2. Capital Receipts 1,58,661 1,60,526 1,58,306 1,54,099 * -1.4 -2.7(4.4) (4.1) (3.9) (3.3)

of which:Market Borrowings 1,06,241 1,13,778 1,10,500 1,10,827 -2.9 0.3

(3.0) (2.9) (2.7) (2.4)

Recoveries of Loans 10,645 8,000 5,450 1,500 -31.9 -72.5(0.3) (0.2) (0.1) (0.0)

Disinvestment of Equity of Public Sector Undertakings 1,581 3,840 528 1,651 * -86.3 212.7(0.0) (0.1) (0.0) (0.0)

Memo Items:

Gross Tax Revenue 3,66,152 4,42,153 4,67,848 5,48,122 5.8 17.2(10.3) (11.2) (11.4) (11.8)

of which:i) Corporation Tax 1,01,277 1,33,010 1,46,497 1,68,401 10.1 15.0

(2.8) (3.4) (3.6) (3.6)

ii) Taxes on Income other than Corporation Tax # 60,749 73,409 78,210 93,629 6.5 19.7(1.7) (1.9) (1.9) (2.0)

iii) Customs Duty 65,067 77,066 81,800 98,770 6.1 20.7(1.8) (1.9) (2.0) (2.1)

iv) Union Excise Duty 1,11,226 1,19,000 1,17,266 1,30,220 -1.5 11.0(3.1) (3.0) (2.9) (2.8)

v) Service Tax 23,055 34,500 38,169 50,200 10.6 31.5(0.6) (0.9) (0.9) (1.1)

vi) Securities Transaction Tax 2,559 3,500 3,750 4,500 7.1 20.0(0.1) (0.1) (0.1) (0.1)

vii) Banking Cash Transaction Tax 321 500 550 645 10.0 17.3(0.0) (0.0) (0.0) (0.0)

viii) Taxes of UTs (Net of Assignments to Local Bodies) 1,125 903 1,341 1,442 48.5 7.5(0.0) (0.0) (0.0) (0.0)

ix) Other Taxes 773 265 265 315 0.0 18.9(0.0) (0.0) (0.0) (0.0)

BE : Budget Estimates. RE : Revised Estimates.* : Adjusted for an amount of Rs.40,000 crore on account of transactions relating to transfer of Reserve Bank’s stake in SBI to the Government.# : Includes Fringe Benefit Tax.Note: Figures in parentheses are percentages to GDP.

tax collections are expected to increase by 15.0 percent in 2007-08 as compared with an increase of 44.6per cent in 2006-07. Revenue from the personalincome tax is estimated to grow by 19.4 per cent ascompared with an increase of 29.9 per cent in 2006-07.In the case of indirect taxes, the collections under

customs duty are budgeted to increase by 20.7 percent as compared with 25.7 per cent, a year ago.Excise duty collections are, however, budgeted toshow a higher growth of 11.0 per cent from 5.4 percent. Non-tax revenues (NTR) are budgeted toincrease to Rs.82,550 crore in 2007-08 from

24


Table 2.18: Expenditure Pattern of the Centre(Amount in Rupees crore)

Item 2005-06 2006-07 2006-07 2007-08 Variation (per cent)(Accounts) (BE) (RE) (BE) Col.4 Col.5

over 3 over 4

1 2 3 4 5 6 7

Aggregate Expenditure (1+2) 5,06,123 5,63,991 5,81,637 6,40,521 * 3.1 10.1(14.2) (14.3) (14.2) (13.8)

1. Revenue Expenditure 4,39,761 4,88,192 5,06,767 5,57,900 3.8 10.1(12.3) (12.4) (12.4) (12.0)

Interest Payments 1,32,630 1,39,823 1,46,192 1,58,995 4.6 8.8(3.7) (3.5) (3.6) (3.4)

Subsidies 47,520 46,213 53,463 54,330 15.7 1.6(1.3) (1.2) (1.3) (1.2)

Grants to States 30,475 35,361 36,152 38,403 2.2 6.2(0.9) (0.9) (0.9) (0.8)

Defence Revenue 48,211 51,542 51,542 54,078 0.0 4.9(1.4) (1.3) (1.3) (1.2)

2. Capital Expenditure 66,362 75,799 74,870 82,621 * -1.2 10.4(1.9) (1.9) (1.8) (1.8)

Loans and Advances 11,337 8,861 9,706 7,498 9.5 -22.7(0.3) (0.2) (0.2) (0.2)

Defence Capital 32,338 37,458 34,458 41,922 -8.0 21.7(0.9) (0.9) (0.8) (0.9)

Non-defence Capital Outlay 22,687 29,480 30,706 33,201 * 4.2 8.1(0.6) (0.7) (0.7) (0.7)

BE : Budget Estimates. RE : Revised Estimates.* : Adjusted for an amount of Rs.40,000 crore on account of transactions relating to transfer of Reserve Bank’s stake in SBI to the Government.Note : Figures in parentheses are percentages to GDP.

Rs.77,360 crore in 2006-07, reflecting higherrevenues from dividends and profits (Table 2.17).Interest receipts, on the other hand, declined primarilyon account of Centre’s disengagement from lendingto the States, except for loans under externally aidedprojects in pursuance of the recommendation ofTwelfth Finance Commission (TFC). The other factorsbehind lower interest receipts include reduced lendingrate on loans to the States, operation of incentivelinked debt restructuring of the States that enact fiscalresponsibility legislation, the debt swap scheme whichoperated from 2002-03 to 2004-05 that allowed theStates to pre-pay high cost debt and prepayments ofloans by Central Public Sector Undertakings(CPSUs).

2.46 A salient feature of the fiscal consolidationprocess in recent years has been the Government’scontinued effort to control revenue expenditure. Therevenue expenditure in 2007-08 is budgeted to showa growth of 10.1 per cent, lower than 15.2 per cent in2006-07. Total subsidies are budgeted to increase by1.6 per cent as against an increase of 12.5 per centin 2006-07. Adjusting for Rs.40,000 crore proposedto be incurred on account of transactions relating tothe transfer of Reserve Bank’s stake in State Bank of

India to the Government, the capital expenditure isbudgeted to increase by 10.4 per cent in 2007-08 asagainst an increase of 12.8 per cent in 2006-07.Adjusted for transactions for purchasing the stake inthe State Bank of India, the capital outlay is budgetedto increase by Rs.9,959 crore (15.3 per cent) asagainst an increase of Rs.10,139 crore (18.4 per cent)in 2006-07. The defence capital outlay is estimatedto increase by Rs.7,464 crore and the non-defencecapital outlay by Rs.2,495 crore (Table 2.18).

2.47 The net market borrowings (excludingenabling allocations budgeted under MSS) wouldfinance 73.4 per cent of the GFD in 2007-08 ascompared with 72.5 per cent in the previous year. Thebudget estimates did not make any provision fordrawdown of cash balances. Securities against smallsavings, which financed only 2.0 per cent of the GFDin 2006-07, are expected to finance 7.0 per cent in2007-08 (Table 2.19). This increase reflects thereinvestment of redemptions proceeds as well asinvestment from small savings collections followingthe decision to reduce the minimum obligation of theStates to borrow from NSSF to 80 per cent of netcollections. External assistance is budgeted to finance

25


6.0 per cent of GFD compared with 5.2 per cent inthe previous year.

Table 2.19: Financing Pattern of Gross Fiscal Deficit (Amount in Rupees crore)

Item 2006-07(RE) 2007-08 (BE)

1 2 3

Gross Fiscal Deficit 1,52,328 1,50,948

Financed by :

Market Borrowings 1,10,500 1,10,827(72.5) (73.4)

NSSF investments in Securities 3,010 10,510against Small Savings (2.0) (7.0)

External Assistance 7,892 9,111(5.2) (6.0)

State Provident Fund 5,000 5,000(3.3) (3.3)

NSSF -3,128 17,850(-2.1) (11.8)

Reserve Funds 4,265 738(2.8) (0.5)

Deposit and Advances 11,647 -2,411(7.6) (-1.6)

Postal Insurance and Life Annuity Funds 1,237 1,261(0.8) (0.8)

Draw down of Cash Balances 10,926 0 (7.2) (0.0)

Others # 979 -1,938(0.6) (-1.3)

RE : Revised Estimates. BE : Budget Estimates.# : Includes savings (taxable) bonds 2003 and Deposits Scheme for

Retiring Employees.Note : Figures in parentheses are percentages to GFD.

State Finances

2.48 The State Governments continued to pursuefiscal correction and consolidation programmesdur ing 2006-07. As per the latest informationavailable, Fiscal Responsibility Legislations (FRLs)have been enacted by 25 State Governments. By April5, 2007 all States, barring Uttar Pradesh, implementedValue Added Tax (VAT) in lieu of sales tax.

2.49 The State Governments in their budgets for2006-07 proposed various policy initiatives to carryforward the process of f iscal correction andconsolidation. The States have emphasised fiscalempowerment through broadening and rationalisationof the tax system. Simultaneously, they have laidstress on improvement in tax administration,streamlining and strengthening of the existing tax andnon-tax collections, plugging of revenue leakages andloopholes and effective expenditure management.

Budget Estimates – 2006-07 4

2.50 The consolidated position indicates that theState Governments have budgeted to achieve nearrevenue balance during 2006-07, notwithstandingsome variation across the States. The budgetedreduction in revenue deficit will facilitate a declineof 0.5 percentage point in the GFD-GDP ratio from3.2 per cent in 2005-06 (RE) to 2.7 per cent in 2006-07(BE). Primary deficit is also budgeted to declinesharply to 0.2 per cent of GDP in 2006-07 from 0.7per cent in the previous year (Table 2.20). Theimprovement in the fiscal position of the Statesduring 2006-07 was facilitated by the larger grants

4 The analysis of State Finances for 2006-07 (Budget Estimates) is based on the budgets of 29 State Governments (including NCT Delhi).

Table 2.20: Major Deficit Indicators of the State Governments (Amount in Rupees crore)

Item 1990-95 1995-00 2000-04 2004-05 2005-06 2005-06 2006-07 Percentage variations(Avg.) (Avg.) (Avg.) (BE) (RE) (BE)

Col.7/5 Col.7/6 Col.8/7

1 2 3 4 5 6 7 8 9 10 11

Gross Fiscal Deficit 1,09,257 1,10,050 1,13,888 1,09,610 4.2 3.0 -3.8(2.8) (3.4) (4.3) (3.5) (3.1) (3.2) (2.7)

Revenue Deficit 36,423 24,913 17,178 4,511 -52.8 -31.0 -73.7(0.7) (1.6) (2.4) (1.2) (0.7) (0.5) (0.1)

Primary Deficit 21,268 17,252 24,894 10,185 17.0 44.3 -59.1(1.1) (1.4) (1.5) (0.7) (0.5) (0.7) (0.2)

BE : Budget Estimates. RE : Revised Estimates. Avg. : Average.Note : 1. Figures in parentheses are percentages to GDP.

2. GDP from 1990-91 to 1998-99 are on old base (1993-94) and from 1999-2000 onwards on new base (1999-2000).3. Data on GDP for 2006-07 are based on CSO’s Advanced Estimates while for 2005-06 are based on Quick Estimates.

Source : 1. Data on fiscal variables have been compiled from budget documents of State Governments.2. Data for GDP have been obtained from the website of Central Statistical Organisation (CSO).

26


5 The Union Budget 2007-08 indicates an increase in transfers from the Central Government to the State Governments by Rs.10,391 crore(0.3 per cent of GDP) in 2006-07 (RE) over 2006-07(BE).

Table 2.21: Aggregate Receipts of the State Governments(Amount in Rupees crore)

Item 1990-95 1995-00 2000-04 2004-05 2005-06 2005-06 2006-07 Percentage variations

(Avg.) (Avg.) (Avg.) (BE) (RE) (BE) col.7/5 col.7/6 col.8/7

1 2 3 4 5 6 7 8 9 10 11

Aggregate Receipts (1+2) 5,76,762 5,80,092 6,13,379 6,72,116 6.3 5.7 9.6(16.1) (15.1) (17.4) (18.4) (16.3) (17.2) (16.4)

1. Total revenue receipts (a+b) 3,72,075 4,30,679 4,54,243 5,20,148 22.1 5.5 14.5 (12.1) (10.9) (11.3) (11.9) (12.1) (12.7) (12.7)

(a) States own Revenue 2,36,668 2,61,796 2,71,518 3,10,540 14.7 3.7 14.4(7.3) (6.9) (7.1) (7.6) (7.3) (7.6) (7.6)

States own tax 1,89,133 2,15,246 2,24,817 2,57,203 18.9 4.4 14.4(5.4) (5.3) (5.7) (6.0) (6.0) (6.3) (6.3)

States own non tax 47,535 46,550 46,702 53,337 -1.8 0.3 14.2(1.8) (1.6) (1.4) (1.5) (1.3) (1.3) (1.3)

(b) Central Transfers 1,35,406 1,68,883 1,82,725 2,09,608 34.9 8.2 14.7(4.9) (4.0) (4.2) (4.3) (4.7) (5.1) (5.1)

Shareable taxes 78,550 90,002 92,723 1,09,419 18.0 3.0 18.0(2.6) (2.4) (2.4) (2.5) (2.5) (2.6) (2.7)

Central Grants 56,857 78,882 90,002 1,00,188 58.3 14.1 11.3 (2.3) (1.6) (1.9) (1.8) (2.2) (2.5) (2.4)

2. Capital Receipts (a+b) 2,04,687 1,49,413 1,59,136 1,51,969 -22.3 6.5 -4.5 (4.0) (4.2) (6.0) (6.5) (4.2) (4.5) (3.7)

(a) Loans from Centre @ 26,157 31,216 10,911 13,525 -58.3 -65.0 24.0 (1.2) (1.0) (1.0) (0.8) (0.9) (0.3) (0.3)

(b) Others Capital Receipts 1,78,529 1,18,197 1,48,224 1,38,443 -17.0 25.4 -6.6 (2.9) (3.2) (5.0) (5.7) (3.3) (4.2) (3.4)

BE : Budget Estimates. RE : Revised Estimates. Avg. : Average.

@ : With the change in the system of accounting with effect from 1999-2000, States’ share in small savings which was included earlier underloans from Centre is included under internal debt and shown as special securities issued to National Small Saving Fund (NSSF) of theCentral Government. The data for the years prior to 1999-2000 as reported in this Table, however, exclude loans against small savings, forthe purpose of comparability.

Note : 1. Figures in parentheses are percentages to GDP.2. GDP from 1990-91 to 1998-99 are on old base (1993-94) while the same is on new base (1999-2000) from 1999-2000 onwards.3. Data on GDP for 2006-07 are based on CSO’s Advanced Estimates while for 2005-06 are based on Quick Estimates.4. Capital receipts include public accounts on a net basis.5. Figures for 2005-06 (BE) and 2006-07 (BE) for revenue receipts are adjusted for Rs.742 crore and Rs.273 crore respectively

towardsAdditional Resource Mobilisation measures proposed by the States.


and increase in shareable Central taxes, asrecommended by the TFC. The sharp correction inrevenue deficit during 2006-07 would emanate mainlyfrom higher transfers from the Centre, especially theshareable Central taxes5 (Table 2.21). Correction inrevenue deficit during 2006-07 will also be facilitated

by a deceleration in revenue expenditure, partly onaccount of decelerat ion in expenditure onadministrative services and pensions. Capital outlayis budgeted to decelerate during 2006-07, though,as a ratio to GDP, it would be maintained at 2.4 percent. Developmental expenditure will decelerate

27


Table 2.22: Expenditure Pattern of the State Governments(Amount in Rupees crore)

Item 1990-95 1995-00 2000-04 2004-05 2005-06 2005-06 2006-07 Percentage variations(Avg.) (Avg.) (Avg.) BE RE BE

Col.7/5 Col.7/6 Col.8/7

1 2 3 4 5 6 7 8 9 10 11

Aggregate Expenditure 5,66,303 5,78,891 6,07,753 6,68,129 7.3 5.0 9.9(1+2 =3+4+5) (16.0) (15.2) (17.3) (18.1) (16.2) (17.0) (16.3)

1. Revenue Expenditure 4,08,497 4,55,593 4,71,421 5,24,658 15.4 3.5 11.3

of which: (12.8) (12.6) (13.7) (13.1) (12.8) (13.2) (12.8)

Interest payments 87,989 93,298 88,994 99,425 1.1 -4.6 11.7(1.7) (2.0) (2.8) (2.8) (2.6) (2.5) (2.4)

2. Capital Expenditure 1,57,805 1,23,299 1,36,332 1,43,471 -13.6 10.6 5.2

of which: (3.2) (2.7) (3.6) (5.0) (3.5) (3.8) (3.5)

Capital outlay 61,559 77,048 85,350 96,506 38.6 10.8 13.1(1.6) (1.4) (1.6) (2.0) (2.2) (2.4) (2.4)

3. Developmental Expenditure 2,93,538 3,26,482 3,62,300 3,92,926 23.4 11.0 8.5(10.8) (9.6) (9.7) (9.4) (9.2) (10.2) (9.6)

4. Non-Developmental Expenditure 1,88,298 2,11,447 2,03,189 2,30,225 7.9 -3.9 13.3(4.3) (4.9) (6.0) (6.0) (5.9) (5.7) (5.6)

5. Others* 84,467 40,962 42,265 44,978 -50.0 3.2 6.4(0.9) (0.8) (1.6) (2.7) (1.1) (1.2) (1.1)

BE : Budget Estimates. RE : Revised Estimates. Avg : Average.

* : Comprises Compensation and Assignments to local bodies, Grants-in-Aid and Contributions, Reserve with Finance Department, Dischargeof Internal Debt, Repayment of loans to the Centre till 2002-03. Since 2003-04, it also includes Inter-State Settlement, Contingency Fund,Small Savings, Provident Fund, etc., Reserve Funds, Deposit & Advances, Suspense & Miscellaneous, Appropriation to Contingency Fundand Remittances.

Note : 1. Figures in parentheses are percentages to GDP.2. GDP from 1990-91 to 1998-99 are on old base (1993-94) while the same is on new base (1999-2000) from 1999-2000

onwards.3. Data on GDP for 2006-07 are based on CSO’s Advanced Estimates while for 2005-06 are based on Quick Estimates.4. Capital expenditure excludes public accounts.


during 2006-07 as against a sharp increase in theprevious year (Table 2.22).

2.51 Decomposition of GFD indicates that fiscaldeficit during 2006-07 was mainly on account ofcapital outlay as RD declined sharply. Small savings(NSSF) remained the major source of financing of theGFD, followed by market borrowings (Table 2.23).

2.52 The net allocation of market borrowings for allStates during 2006-07 amounted to Rs.17,242 crore.The gross allocation of market borrowing wasRs.26,597 crore, including the additional allocationof Rs.2,803 crore. During 2006-07, total marketborrowing raised by all States was Rs.20,825 crore.All the State Governments resorted to the auction

route for raising the market loans during 2006-07(Table 2.24).

2.53 The weighted average interest rate of marketloans of State Governments during 2006-07 was at8.10 per cent as compared with 7.63 per cent duringthe previous year (Chart II.4).

2.54 The weekly average utilisation of ways andmeans advances (WMA) and overdrafts (OD) by theState Governments during 2006-07 was at Rs.234crore as compared with the average utilisation ofRs.482 crore during the previous year, reflecting thecomfortable liquidity position of the States. During2006-07, only eight States resorted to normal WMAand two States resorted to OD (Chart II.5).

28


Table 2.23: Decomposition and Financing Pattern of Gross Fiscal Deficit of the States(per cent)

Item 1990-95 1995-00 2000-04 2004-05 2005-06 2005-06 2006-07(Avg.) (Avg.) (Avg.) BE RE BE

1 2 3 4 5 6 7 8

Decomposition (1 to 4) 100 100 100 100 100 100 1001. Revenue Deficit 24.7 44.8 56.3 33.3 22.5 15.1 4.12. Capital Outlay 55.3 43.3 36.7 56.3 69.7 74.9 88.03. Net Lending 20.0 12.2 7.0 10.3 7.8 10.0 8.84. Disinvestments .. -0.2 .. .. .. .. -0.9

Financing (1 to 11) 100 100 100 100 100 100 1001. Market Borrowings 16.0 16.1 24.6 31.6 16.2 16.4 20.82. Loans from Centre 49.0 40.6 7.8 -10.8 15.7 1.9 4.43. Loans against Securities Issued to NSSF – 28.9 * 35.4 62.2 50.0 65.4 53.14. Loans from LIC, NABARD, NCDC, SBI and Other Banks 1.8 2.8 4.9 – ** 7.7 4.9 6.95. State Provident Fund 14.3 13.4 8.3 7.2 7.2 7.9 8.06. Reserve Funds 6.8 5.5 4.5 6.5 3.8 2.9 4.07. Deposits & Advances 9.8 9.8 3.4 7.4 -2.5 -0.6 -1.18. Suspense & Miscellaneous 4.3 2.7 -0.4 -2.4 -1.4 3.3 3.39. Remittances -1.4 -3.6 0.6 1.1 1.5 0.8 1.810. Overall Surplus (+)/Deficit (-) 4.4 -2.6 1.1 9.6 0.4 4.9 3.611. Others -5.0 9.5 9.8 -12.4 $ 1.2 -7.9 -4.7

BE : Budget Estimates. RE : Revised Estimates. Avg. : Average. .. : Nil. – : Not Applicable. * : Pertains to 1999-2000 as it was introduced from that year only. The sum of items will not be equal to 100 for 1995-2000 (Avg.).** : Tamil Nadu has taken into their budget the bonds issued by Tamil Nadu Industrial Development Corporation (TIDCO) and Power Bonds of

Tamil Nadu State Electricity Board showing negative figures for Loans from NCDC and Loans from Other Institutions. The consolidatedpicture has, therefore, undergone a change.

$ : On account of Land Compensation and other Bonds (Rs.1,962 crore) issued by Government of Tamil Nadu during 2004-05.Note : 1. Due to the change in the accounting procedure from 1999-2000, Loans from the Centre excludes States’ share in small savings

collections which is shown under Securities issued to the NSSF under Internal Debt. Accordingly, repayments of small savingcollections included under repayments of Loans to Centre is now shown under discharge of Internal Debt to have consistentaccounting for receipts and expenditure.

2. Figures for 2004-05 (Accounts) in respect of Jammu & Kashmir and Jharkhand relate to Revised Estimates.3. Financing Items are on a net basis.4. ‘Others’ is a residual and includes, inter alia, Contingency Funds, Appropriation to Contingency Funds, Miscellaneous Capital

Receipts, Inter-State Settlement, Land Compensation and Other Bonds and Loans from Financial Institutions other than mentionedin the Table.

Source : Budget Documents of State Governments.

2.55 The weekly average investment by the Statesin the 14-day Intermediate Treasury Bills during 2006-07 amounted to Rs.43,075 crore as compared withthe weekly average investment of Rs.35,278 croreduring the corresponding period of the previous year(Chart II.6). The surge in surplus cash balances maypose challenges to cash and financial managementby the State Governments.

Outlook

2.56 With a view to improving transparency andefficiency in transactions of the Governments, manyStates have proposed to complete computerisationof their treasuries and also to introduce e-transfer for

the transactions. For improving accountability ofbudget proposals, some States have proposed tointroduce ‘Outcome Budgets’. Furthermore, manyState Governments have proposed to introduce‘Gender Budgeting’. Some States have proposedcomprehensive restructuring of State public sectorundertakings, including closure of chronically loss-making units for reducing budgetary support for them.Some States have announced introduction of newpension scheme based on defined contribution toarrest their rising pension obligations. Some Stateshave also proposed curtailment of non-developmentalexpenditure by doing away with vacated posts,adoption of austerity measures and reduction of non-plan expenditure.

29


Table 2.24: Market Borrowings of the StateGovernments – 2006-07

(Amount in Rupees crore)

Items Date Cut-off Tenor AmountRate (years) Raised(%)

1 2 3 4 5

(A) Tap Issues – – – –

(B) Auctionsi. First April 27, 2006 7.65 10 300ii. Second May 11, 2006 7.87 10 400iii. Second May 11, 2006 7.89 10 500iv. Second May 11, 2006 7.91 10 500v. Second May 11, 2006 7.93 10 1,307vi. Second May 11, 2006 7.95 10 881vii. Second May 11, 2006 7.96 10 130viii. Second May 11, 2006 7.98 10 57ix. Second May 11, 2006 8.00 10 1,646x. Second May 11, 2006 8.04 10 150xi. Second May 11, 2006 8.05 10 15xii. Third July 13, 2006 8.62 10 225xiii. Third July 13, 2006 8.65 10 933xiv. Third July 13, 2006 8.66 10 300xv. Fourth August 25, 2006 8.11 10 1,050xvi. Fifth October 17, 2006 7.99 10 153xvii. Fifth October 17, 2006 8.04 10 48xviii. Sixth November 16, 2006 7.74 10 2,184xix. Sixth November 16, 2006 7.80 10 91xx. Sixth November 16, 2006 7.82 10 156xxi. Seventh December 14, 2006 7.81 10 340xxii. Seventh December 14, 2006 7.89 10 166xxiii. Seventh December 14, 2006 7.93 10 809xxiv. Seventh December 14, 2006 7.94 10 455xxv. Seventh December 14, 2006 7.99 10 193xxvi. Eighth January 18, 2007 7.96 10 500xxvii. Eighth January 18, 2007 7.99 10 715xxviii. Ninth February 2, 2007 7.95 10 200xxix. Tenth February 22, 2007 8.10 10 47xxx. Tenth February 22, 2007 8.17 10 375xxxi. Tenth February 22, 2007 8.19 10 800xxxii. Tenth February 22, 2007 8.20 10 563xxxiii. Tenth February 22, 2007 8.45 10 1,615xxxiv. Eleventh March 13, 2007 8.38 10 212xxxv. Eleventh March 13, 2007 8.45 10 250xxxvi. Eleventh March 13, 2007 8.40 10 470xxxvii. Eleventh March 13, 2007 8.39 10 67xxxviii.Eleventh March 13, 2007 8.39 10 70xxxix. Eleventh March 13, 2007 8.39 10 90xxxx. Eleventh March 13, 2007 8.32 10 300xxxxi. Eleventh March 13, 2007 8.25 10 200xxxxii. Eleventh March 13, 2007 8.32 10 414xxxxiii.Eleventh March 13, 2007 8.38 10 211xxxxiv.Twelfth March 23, 2007 8.35 10 738

Total - B (i to xxxxiv) 20,825

Grand Total (A+B) 20,825

a major responsibility with regard to provision of socialand economic services such as education and healthand economic infrastructure such as roads,waterworks and power. In order to make the processof fiscal consolidation durable and sustainable,adequate investment in economic infrastructure andspending on social services would be essential.Against this backdrop, a desirable path to fiscalcorrection lies through fiscal empowerment, i.e., byexpanding the scope and size of revenue flows intobudget, rather than fiscal enfeeblement. Augmenting

Per

cen

t

Chart II.4: Weighted Average Interest Rate onState Governments' Market Borrowing

Ap

ril

May

Ju

ne

Ju

ly

Au

gust

Sep

tem

ber

Oct

ober

Nov

emb

er

Dec

emb

er

Jan

uar

y

Feb

ruar

y

Mar

ch

Chart II.5: Utilisation of WMA and Overdraft by States(Weekly Average)

Rs.

cro

re

2.57 Notwithstanding the progress in f iscalconsolidation since 2004-05, structural rigiditiespersist as manifested in sluggish non-tax revenue,downwardly rigid non-development expenditure andlow allocation in respect of social sectors such ashealth and education. The State Governments have

30


Table 2.25: Combined Liabilities and Debt-GDP Ratio

Year (end -March) Outstanding Liabilities (Rupees crore) Debt-GDP Ratio (per cent)

Centre States Combined Centre States Combined

1 2 3 4 5 6 7

1990-91 3,14,558 1,28,155 3,68,824 55.3 22.5 64.91995-96 6,06,232 2,50,889 7,28,208 51.0 21.1 61.32002-03 15,59,201 7,98,921 19,83,298 63.4 32.5 80.72003-04 17,36,678 9,23,500 22,52,074 62.8 33.4 81.42004-05 19,94,422 10,42,305 25,75,146 63.8 33.3 82.42005-06 RE 21,95,387 11,52,652 28,01,050 61.5 32.3 78.52006-07 BE 24,73,562 12,58,672 31,04,262 60.3 30.7 75.7

RE: Revised Estimates. BE: Budget Estimates.

Note : Ratios to GDP for the years 2002-03 onwards are based on the new series of National Accounts Statistics with the base year 1999-2000.The debt-GDP ratio for 2006-07 BE is based on CSO’s Advance Estimates of GDP.

Source : Budget documents of the Central Government; and State Finances - A Study of Budgets of 2006-07, Reserve Bank of India, December 2006.

resource mobilisation from non-tax revenue throughappropriate user charges and restructuring of Statepublic sector undertakings continue to be of criticalimportance.

Public Debt

2.58 The combined outstanding liabilities of theCentral and State Governments, as a proportion toGDP, is budgeted to decline to 75.7 per cent by end-March 2007 from 78.5 per cent as at end-March 2006.The fiscal consolidation process underway at the Centreand States as well as the strong macroeconomicperformance have led to the budgeted decline incombined Government liabilities (Table 2.25).

III. MONETARY AND CREDIT SITUATION

Monetary Conditions

2.59 This section makes an assessment of theconduct of monetary policy during 2006-07 andoutlines the developments relating to the monetaryand credit situation, followed by a discussion onliquidity management operations of the ReserveBank. In line with the Annual Policy Statement ofthe Reserve Bank announced in April 2006, the FirstQuarter Review (July 2006), the Mid-term Review(October 2006) and the Third Quar ter Review(January 2007) of the Annual Policy Statementindicated that it would continue to ensure thatappropriate liquidity is maintained in the system sothat all legitimate requirements of credit are met,particularly for productive purposes, consistent withthe objective of price and financial stability. Towardsthis end, it was indicated that it would continue withits policy of active demand management of liquiditythrough open market operations (OMOs), includingMSS, LAF and CRR, and use al l the pol icyinstruments at its disposal flexibly, as and when thesituation warrants.

2.60 The Mid-term Review of Annual PolicyStatement for 2006-07 (October 31, 2006) of theReserve Bank noted that barring the emergence ofany adverse and unexpected developments in varioussectors of the economy and keeping in view theassessment of the economy including the outlook forinflation, the overall stance of monetary policy wouldbe to ensure a monetary and interest rate environmentthat supports export and investment demand in theeconomy so as to enable continuation of the growthmomentum while reinforcing price stability with a view

Ap

ril

May

Ju

ne

Ju

ly

Au

gust

Sep

tem

ber

Oct

ober

Nov

emb

er

Dec

emb

er

Jan

uar

y

Feb

ruar

y

Mar

ch

Chart II.6: Investment in 14-day Intermediate TreasuryBills by the State Governments (Weekly Average)

Rs.

cror

e

31


to anchor inflation expectations with an emphasis tomaintain macroeconomic and, in particular, financialstability by promptly considering all possible measuresas appropriate to the evolving global and domesticcircumstances.

2.61 The Third Quarter Review of the AnnualStatement on Monetary Policy for the year 2006-07also emphasised that the outlook for inflation assumescriticality in terms of policy monitoring and action andaccordingly management of liquidity would receivepriority in policy hierarchy over the remaining part ofthe year. Furthermore, a judicious balancing ofweights has been assigned to monetary policyobjectives to accord priority to stability in order tosuppor t growth on a sustainable basis and todemonstrate that inflation beyond the tolerancethreshold of the Reserve Bank is unacceptable andthat the resolve to ensure price stability is alwaysbacked by timely and appropriate policy responses.

2.62 In the Third Quar ter Review of AnnualStatement on Monetary Policy for the Year 2006-07 inJanuary 2007, the Reserve Bank indicated that barringthe emergence of any adverse and unexpecteddevelopments in various sectors of the economy andkeeping in view the then assessment of the economyincluding the outlook for inflation, the overall stance ofmonetary policy in the period ahead would be:

• To reinforce the emphasis on price stability andwell-anchored inflation expectations, whileensur ing a monetary and interest rateenvironment that supports export and investmentdemand in the economy so as to enablecontinuation of the growth momentum.

• To re-emphasise credit quality and orderlyconditions in financial markets for securingmacroeconomic and, in par ticular, financialstability while simultaneously pursuing greatercredit penetration and financial inclusion.

• To respond swiftly with all possible measures asappropriate to the evolving global and domesticsituation impinging on inflation expectations andthe growth momentum.

2.63 In recognition of the cumulative and laggedeffects of monetary policy, the Reserve Bank begana gradual withdrawal of accommodation in mid-2004in spite of inflation being within tolerance limits at thattime. Since September 2004, repo/reverse repo rateshave been increased by 175/150 basis points and theCRR by 200 basis points. General provisioningrequirements for standard advances and risk weights

have also been raised in the case of banks’ exposuresto specific sectors. The stance of monetary policy hasprogressively shifted from an equal emphasis on pricestability along with growth to one of reinforcing pricestability with immediate monetary measures and totake recourse to all possible measures promptly inresponse to the evolving circumstances.

2.64 In pursuance of the stance of monetary policy,liquidity management was modified on March 2, 2007to put in place an augmented programme of issuanceunder the MSS with a mix of Treasury Bills and datedsecurities in a more flexible manner. In view of theenhanced MSS programme and the need to conductLAF as a facility for equilibrating very short-termmismatches, daily reverse repo absorptions werelimited to a maximum of Rs.3,000 crore, effective March5, 2007. In the light of the prevailing macroeconomic,monetary and anticipated liquidity conditions, and witha view to containing inflation expectations, the ReserveBank increased the fixed repo rate under LAF by 25basis points from March 30, 2007 and the CRR by 50basis points in two stages from April 14, 2007 and April28, 2007. Globally, the process of withdrawal ofaccommodation in monetary policy is being vigorouslypursued. Since mid-February, 2007 among the leadingcentral banks, the European Central Bank and the Bankof Japan have raised the key policy rates by 25 basispoints each, while the People’s Bank of China hasraised the one year benchmark lending rate by 45 basispoints (27 basis points in March 2007 and 18 basispoints in May 2007) and the reserve requirements by150 basis points (including the hike of 50 basis pointsto be effective from June 5, 2007). There has been nochange in the policy rates of the US Federal Reserve,the Bank of England, the Bank of Canada, and theReserve Bank of Australia, all of which had undertakenprior policy action.

Reserve Money Survey

2.65 Growth in reserve money at 23.7 per cent,year-on-year (y-o-y), as on March 31, 2007 was higherthan that of 17.2 per cent a year ago. Adjusted for theimpact of the hike in the CRR, reserve moneyexpansion was 18.9 per cent as on March 31, 2007.Expansion in reserve money was mainly led by foreigncurrency assets of the Reserve Bank which increased(net of revaluation) by Rs.1,64,601 crore during 2006-07 as compared with an increase of Rs.68,834 crorein the previous year. On the other hand, the ReserveBank’s net credit to the Centre declined by Rs.1,042crore during 2006-07 as against an increase ofRs.28,417 crore during the previous year (Table 2.26).

32


Table 2.26: Reserve Money(Amount in Rupees crore)

Variation during

Item 2005-06 2006-07 2006-07

Q1 Q2 Q3 Q4

1 2 3 4 5 6 7 8

Reserve Money 7,08,950 83,922 1,35,892 13,470 18,666 14,210 89,546(17.2) (23.7)

Components (1+2+3)1. Currency in Circulation 5,04,167 62,015 73,491 22,283 -2,011 26,871 26,348

(16.8) (17.1)2. Bankers’ Deposits with RBI 1,97,295 21,515 61,784 -7,204 20,224 -12,165 60,929

(18.9) (45.6)3. ‘Other’ Deposits with the RBI 7,487 393 617 -1,610 453 -495 2,269

(6.1) (9.0)Sources (1+2+3+4-5)1. RBI’s net credit to Government 4,362 26,111 -3,775 53 2,826 -12,754 6,100

of which: to Centre (i+ii+iii+iv-v) 4,118 28,417 -1,042 3,071 2,584 -12,568 5,871i. Loans and Advances 0 0 0 0 0 0 0ii. Treasury Bills held by the RBI 0 0 0 0 0 0 0iii. RBI’s Holdings of Dated Securities 97,172 13,869 26,763 -27,610 24,944 22,733 6,696iv. RBI’s Holdings of Rupee coins 12 7 -143 9 -107 97 -142v. Central Government Deposits 93,066 -14,541 27,662 -30,672 22,253 35,398 683

2. RBI’s credit to banks andcommercial sector 9,173 535 1,990 -3,135 3,107 2,065 -47

3. NFEA of RBI 8,66,153 60,193 1,93,170 71,845 11,392 27,250 82,682(9.8) (28.7)

of which: FCA, adjusted for revaluation – 68,834 1,64,601 28,107 10,948 31,634 93,913

4. Government’s CurrencyLiabilities to the Public 8,229 1,306 -525 -920 155 166 75

5. Net Non-Monetary liabilities of RBI 1,78,967 4,222 54,968 54,373 -1,186 2,517 -736

Memo:

Net Domestic Assets -1,57,203 23,729 -57,277 -58,376 7,274 -13,040 6,864

Reserve Bank’s Primary Subscriptionto Dated Securities 0 10,000 0 0 0 0 0

LAF, Repos (+)/Reverse Repos (-) 29,185 12,080 36,435 -23,060 28,395 22,195 8,905

Net Open Market Sales # * – 3,913 5,125 1,536 1,176 389 2,024

Mobilisation under MSS * 62,974 -35,149 33912 4,062 8,940 -3,315 24,225

Net Purchases(+)/Sales(-) fromAuthorised Dealers – 32,884 1,18,994 21,545 0 19,776 77,673

NFEA/Reserve Money £ 122.2 117.4 122.2 127.0 125.0 126.5 122.2

NFEA/Currency £ 171.8 156.3 171.8 164.4 167.7 164.0 171.8

NFEA : Net Foreign Exchange Assets. FCA : Foreign Currency Assets. LAF : Liquidity Adjustment Facility.* : At face value. # : Excludes Treasury Bills. £ : Per cent, end of period.Note : 1. Data are based on March 31 for Q4 and last reporting Friday for all other quarters.

2. Figures in parentheses are percentage variations during the fiscal year. 3. Government balances as on March 31, 2007 are before closure of accounts.

Outstandingas on

March 31,2007

The decline in net RBI credit to the Centre during2006-07 could be attributed to higher deposits of theCentre, which, in turn, reflected fresh issuance ofsecurities under the MSS. Bankers’ deposits with theReserve Bank expanded partly on account of the hikein the CRR.

2.66 The year-on-year (y-o-y) reserve moneyexpansion was 23.6 per cent (16.3 per cent adjusted

for increase in the CRR) as on May 18, 2007 ascompared with 17.1 per cent a year ago. The ReserveBank's foreign currency assets (adjusted forrevaluation), on a y-o-y basis, increased byRs.1,55,105 crore as on May 18, 2007 as comparedwith an increase of Rs. 90,841 crore a year ago. TheReserve Bank's net credit to the Centre increased byRs. 4,414 crore as compared with an increase of Rs.8,458 crore a year ago.

33


Table 2.27: Monetary Indicators (Amount in Rupees crore)

Outstanding as on VariationItem March 31, 2007

2005-06 2006-07

Amount Per cent Amount Per cent

1 2 3 4 5 6

I. Reserve Money 7,08,950 83,922 17.2 1,35,892 23.7II. Narrow Money (M1) 9,59,875 1,43,825 21.1 1,33,497 16.2III. Broad Money (M3) 32,96,919 3,96,881 17.0 5,67,372 20.8

a) Currency with the Public 4,84,171 58,248 16.4 71,052 17.2 b) Aggregate Deposits 28,05,261 3,38,081 17.1 4,95,704 21.5

i) Demand Deposits 4,68,216 85,025 26.5 61,829 15.2ii) Time Deposits 23,37,045 2,53,056 15.3 4,33,875 22.8

of which: Non-Resident Foreign Currency Deposits 66,242 -16,876 -22.2 6,967 11.8IV. NM3 33,06,958 4,21,126 18.1 5,59,370 20.4

of which: Call Term Funding from Financial Institutions 86,151 11,224 15.6 3,007 3.6V. a) L1 34,21,762 4,36,397 18.1 5,70,256 20.0

of which: Postal Deposits 1,14,804 15,271 17.2 10,886 10.5 b) L2 34,24,694 4,37,206 18.1 5,70,256 20.0 c) L3 34,50,758 4,41,207 18.1 5,72,479 19.9

VI. Major Sources of Broad Moneya) Net Bank Credit to the Government (i+ii) 8,32,867 17,888 2.4 66,272 8.6

i) Net Reserve Bank Credit to Government 4,362 35,799 -3,775ii) Other Banks’ Credit to Government 8,28,505 -17,910 -2.3 70,046 9.2

b) Bank Credit to Commercial Sector 21,23,290 3,61,746 27.2 4,30,287 25.4 c) Net Foreign Exchange Assets of Banking Sector 9,30,319 78,291 12.1 2,04,125 28.1

Memo: SCBs Aggregate Deposits 25,94,259 3,23,913 18.1 4,85,210 23.0SCBs Non-food Credit 18,76,672 3,54,193 31.8 4,10,285 28.0

SCBs : Scheduled Commercial Banks.NM3 is the residency-based broad money aggregate and L1, L2 and L3 are liquidity aggregates compiled on the recommendations of the Working Group on MoneySupply (Chairman: Dr. Y.V. Reddy, 1998). Liquidity aggregates are defined as follows:L1 = NM3 + Select deposits with the post office saving banks. L2 = L1 +Term deposits with term lending institutions and refinancing institutions (FIs) + Term borrowingby FIs + Certificates of deposits issued by FIs. L3 = L2 + Public deposits of non-banking financial companies.Note : 1. Data are provisional.

2. Data reflect redemption of India Millennium Deposits (IMDs) on December 29, 2005.3. Government balances as on March 31, 2007 are before closure of accounts.4. Variation during 2006-07 is worked out from March 31, 2006, whereas variation during 2005-06 is worked out from April 1, 2005.5. Postal deposits data pertain to February 2007.

Per

cen

t

Chart II.7: Broad Money Growth (y-o-y)

Fortnight

Monetary Survey

2.67 Broad money (M3) growth was 20.8 per cent,y-o-y, as on March 31, 2007 as compared with 17.0per cent in the previous year (Table 2.27 and Chart II.7).Growth in M3, thus, remained above the projection of15.0 per cent as set out in the Annual Policy Statementin April 2006.

2.68 Aggregate deposits of banks accelerated onthe back of higher time deposits. Demand depositsrecorded a growth of 15.2 per cent (y-o-y) as on March31, 2007 on top of the growth of 26.5 per cent a yearago. Time deposits increased by 22.8 per cent ascompared with 15.3 per cent a year ago, benefiting,inter alia, from higher interest rates and tax benefitsfor deposits of 5 year and above matur ity.Concomitantly, growth in postal deposits deceleratedto 10.5 per cent, year-on-year, as at end-February2007 from 17.2 per cent a year ago.

34


2.69 Growth in broad money (M3) was 20.2 per cent

(y-o-y) as on May 11, 2007 as compared with 18.2per cent a year ago. Of the major components, growthin aggregate deposits accelerated to 21.1 per centfrom 18.6 per cent a year ago.

Bank Credit

2.70 Demand for bank credit continued to remainstrong in 2006-07, albeit with some moderation. Ason March 30, 2007, non-food credit extended byscheduled commercial banks grew by 28.0 per cent(y-o-y) on top of the growth of 31.8 per cent as onMarch 31, 2006. During 2006-07 banks’ investmentsin government securities increased by 10.0 per cent(Table 2.28 and Chart II.8). Growth in banks’ SLRinvestments was, however, lower than that of their netdemand and time liabilities. As a result, commercialbanks’ holdings of government securities declined to28.0 per cent of their net demand and time liabilities(NDTL) at end-March 2007 from 31.3 per cent at end-March 2006.

2.71 Provisional information on sectoraldeployment of bank credit indicates that growth incredit was largely broad-based. The y-o-y growth incredit to industry and agriculture was 28.8 per centand 30.4 per cent, respectively, at end-January 2007.

The increase in industrial credit in consonance withthe buoyancy in industrial activity was mainly onaccount of infrastructure (power, roads, por ts,telecommunication, etc.), metals, textiles, petroleum,chemicals, food processing and engineering. Creditto the housing sector and commercial real estatecontinued to remain strong (Table 2.29).

Table 2.28: Scheduled Commercial Banks Survey(Amount in Rupees crore)

Item Outstanding as on Variation (year-on-year)March 30, 2007 As on March 31, 2006 As on March 30, 2007

Absolute Per cent Absolute Per cent

1 2 3 4 5 6

Sources of Funds

1. Aggregate Deposits 25,94,259 3,23,913 18.1 4,85,210 23.0

2. Call/Term Funding from Financial Institutions 86,151 11,224 15.6 3,007 3.6

3. Overseas Foreign Currency Borrowings 32,377 1,295 4.5 2,543 8.5

4. Capital 33,868 5,705 21.2 1,254 3.8

5. Reserves 1,66,290 34,616 31.3 21,177 14.6

Uses of Funds

1. Bank Credit 19,23,192 3,54,868 30.8 4,16,115 27.6of which: Non-food Credit 18,76,672 3,54,193 31.8 4,10,285 28.0

2. Investments in Government Papers 7,71,060 -19,514 -2.7 70,318 10.0

3. Investments in Other Approved Securities 21,100 -3,295 -16.5 4,388 26.3

4. Investments in Non-SLR Securities 1,43,750 -11,838 -8.0 8,410 6.2

5. Foreign Currency Assets 39,287 14,059 47.8 -4,207 -9.7

6. Balances with the RBI 1,80,222 34,077 36.6 53,161 41.8

Note : Data are provisional.

Fortnight

Chart II.8: Non-food Credit

Gro

wth

rat

e (p

er c

ent)

35


Table 2.29: Deployment of Non-food Bank Credit (Amount in Rupees crore)

Outstanding Year-on-Year Variations

Sector/Industryas on January

2005-06 * 2006-07**19, 2007

Absolute Per cent Absolute Per cent

1 2 3 4 5 6

Non-food Gross Bank Credit (1 to 4) 16,47,521 2,56,580 25.7 3,84,187 30.4

1. Agriculture and Allied Activities 2,01,927 28,089 22.4 47,044 30.4

2. Industry (Small, Medium and Large) 6,34,804 66,480 15.6 1,41,774 28.8Small Scale Industries 1,03,089 7,453 10.0 20,179 24.3

3. Personal Loans 4,34,860 68,386 27.9 1,03,587 31.3Housing 2,21,072 37,431 29.1 46,501 26.6Advances against Fixed Deposits 35,627 2,378 8.0 3,517 11.0Credit Cards 12,307 3,072 53.3 3,749 43.8Education 13,910 3884 75.9 4,742 51.7Consumer Durables 8,731 -220 -2.4 1,690 24.0

4. Other Services 3,75,930 12,049 39.4 91,782 32.3Transport Operators 23,179 1,990 20.7 10,045 76.5Professional & Others 19,377 1,513 11.4 5,252 37.2Trade 99,460 13,975 24.1 24,135 32.0Real Estate Loans 40,790 11,225 84.4 17,899 78.2Non-Banking Financial Companies 41,093 6,023 26.8 10,653 35.0

Memo:

Priority Sector 5,75,282 78,172 20.5 1,11,551 24.1

Industry (Small, Medium and Large) 6,34,804 66,480 15.6 1,41,774 28.8Food Processing 35,619 3,878 15.9 7,675 27.5Textiles 71,274 8,989 20.4 17,849 33.4Paper & Paper Products 10,416 1,650 24.0 1,882 22.1Petroleum, Coal Products & Nuclear Fuels 33,991 2,203 14.1 15,399 82.8Chemical and Chemical Products 51,073 5,265 13.3 6,880 15.6Rubber, Plastic & their Products 8,318 2,403 65.5 2,141 34.7Iron and Steel 59,356 7,841 21.8 15,096 34.1Other Metal & Metal Products 20,261 2,046 17.6 6,460 46.8Engineering 39,741 2,913 9.9 7,212 22.2Vehicles, Vehicle Parts and Transport Equipments 19,311 4,964 41.8 2,483 14.8Gems & Jewellery 22,249 4,276 29.9 3,053 15.9Construction 17,131 3,696 45.5 5,550 47.9Infrastructure 1,28,405 22,717 28.8 27,162 26.8

* : January 20, 2006 over January 28, 2005.** : January 19, 2007 over January 20, 2006.

Note : 1. Data are provisional and relate to select scheduled commercial banks.2. Owing to change in classification of sectors/industries and coverage of banks, data for 2006 are not comparable with earlier data.

2.72 In addition to bank credit, the corporatesector continued to rely on non-bank sources offunds for their financing requirements during 2006-07.Mobilisation of resources through equity issuancesabroad (ADRs/GDRs) during 2006-07 more thandoubled from the level a year ago. Recourse to debtflows in the form of external commercial borrowings(ECBs) dur ing Apr il-December 2006 was alsohigher than that a year ago. Internal sources of funds

continued to provide a strong suppor t to thecorporate sector dur ing Apr il-December 2006(Table 2.30).

2.73 Scheduled commercial banks' non-food creditregistered a growth of 27.2 per cent (y-o-y) as on May11, 2007 on top of 32.3 per cent a year ago, whiletheir investments in Government securities expandedby 9.5 per cent (2.0 per cent a year ago).

36


Price Situation

2.74 Headline inflat ion in major advancedeconomies broadly mirrored movements ininternational crude oil prices during 2006-07. Headlineinflation, which remained firm up to August 2006 inline with the hardening of international crude oilprices, eased during September-October 2006 on

account of base effects and the sharp decline ininternational crude oil prices (Table 2.31 and Chart II.9).However, it rose again during December 2006 - March2007. Core inflation continues to remain firm in majoreconomies. CPI inflation (excluding food and energy)was 2.5 per cent in the US in March 2007 (2.1 percent a year ago) and 2.1 per cent in the OECDcountries in March 2007 (1.6 per cent a year ago).

Table 2.30: Select Sources of Funds to Industry (Rupees crore)

Item 2005-06 2006-07

1 2 3

A. Bank Credit to Industry # 1,27,192 74,981 *(66,244) *

B. Flow from Non-banks to Corporates 1. Capital Issues (i+ii) 13,781 29,180

i) Non-Government Public Ltd. Companies (a+b) 13,408 29,180 a) Bonds/Debentures 245 585 b) Shares 13,163 28,595 ii) PSUs and Government Companies 373 0

2. ADR/GDR Issues 7,263 16,184

3. External Commercial Borrowings (ECBs) 45,078 48,328 *(27,228) *

4. Issue of CPs -1,517 4,970

C. Depreciation Provision + 28,883 24,557 *(22,044) *

D. Profit after Tax + 67,506 75,460 *(52,891) *

# : Data pertain to select scheduled commercial banks. Figures for 2005-06 are not comparable with those of 2006-07 due to increase innumber of banks selected in the sample.

+ : Data are based on audited/ unaudited abridged results of select sample of non-financial non-Government companies.* : Data pertain to April-December.Note : 1. Data are provisional.

2. Data on capital issues pertain to gross issuances excluding issues by banks and financial institutions. Figures are not adjusted forbanks’ investments in capital issues, which are not expected to be significant.

3. Data on ADR/GDR issues exclude issuances by banks and financial institutions.4. Data on external commercial borrowings include short-term credit. Data for 2005-06 are exclusive of the IMD redemption.

Table 2.31: Annual Consumer Price Inflation(Per cent)

Country/Area 2001 2002 2003 2004 2005 2006 2007 P

1 2 3 4 5 6 7 8

Advanced Economies 2.1 1.5 1.8 2.0 2.3 2.3 1.8US 2.8 1.6 2.3 2.7 3.4 3.2 1.9Japan -0.8 -0.9 -0.2 – -0.6 0.2 0.3Euro Area 2.4 2.3 2.1 2.1 2.2 2.2 2.0

Other Emerging Market and Developing Countries 6.7 5.8 5.8 5.6 5.4 5.3 5.4Developing Asia 2.7 2.0 2.5 4.1 3.6 4.0 3.9China 0.7 -0.8 1.2 3.9 1.8 1.5 2.2India 3.8 4.3 3.8 3.8 4.2 6.1 6.2

P: IMF Projections.Source: World Economic Outlook, April 2007, IMF.

37


2.75 Reflecting strong demand, non-oilinternational commodity prices remained at elevatedlevels. Metals prices firmed up further during 2006-07,largely reflecting robust demand and supplyconstraints amidst speculative interest (Chart II.10).Amongst food items, prices of wheat edged higherby 14 per cent in March 2007 (y-o-y), largely reflectingshortfall in global production and steady increase inutilisation. Prices of edible oils also increased; inMarch 2007 (y-o-y), palm oil increased by 41.4 percent and soyabean oil by 33.2 per cent. On the otherhand, crude oil prices eased from the historical peakof US $ 78.4 a barrel on July 14, 2006 to around US$ 51 a barrel in January 2007 on the back of slowdownin global demand, build up of US inventories, and mildwinter in the US. Crude oil prices, however, rose againfrom the last week of January 2007 to about US $ 67

a barrel in late March 2007. Sugar prices have easedin recent months, reflecting improved productionprospects.

2.76 A number of central banks t ightenedmonetary policies during 2006-07 and 2007-08 (April-May) in order to contain inflation expectations. In theeuro area, notwithstanding some easing in inflation,risks to the price outlook are seen on the upside dueto the possibility of further oil price rises, additionalincreases in administered prices and indirect taxesand stronger than currently expected wagedevelopments. The European Central Bank (ECB),therefore, raised the key policy rate by 25 basis pointseach in June, August, October and December 2006,and March 2007 – a total increase of 175 basis pointssince December 2005 – to keep medium to long-terminflation expectations in the euro area anchored tolevels consistent with price stability. In the UK, in viewof strong economic activity, limited spare capacity,rapid growth of broad money and credit, rise in assetprices and expectations about inflation remainingabove the target in the near term, the Bank of Englandraised its policy rate by 25 basis points each in Augustand November 2006, and January and May 2007 to5.50 per cent (Table 2.32). The Reserve Bank ofAustralia raised its policy rate by 25 basis points inNovember 2006 to 6.25 per cent – a total increase of75 basis points since May 2006 – in response tostrong economic activity and underlying inflationpressures. After maintaining zero interest rates for anextended period, the Bank of Japan (BoJ) increasedthe uncollateralised overnight call rate (adopted asthe operating target of monetary policy since March2006) by 25 basis points each in July 2006 andFebruary 2007 to 0.50 per cent. On the other hand,the US Fed, after having raised its target federal fundsrate by 25 basis points each on 17 successiveoccasions between June 2004 and June 2006, has

Mar

-04

May

-04

Ju

l-0

4

Sep

-04

Nov

-04

Jan

-05

Mar

-05

May

-05

Ju

l-0

5

Sep

-05

Nov

-05

Jan

-06

Mar

-06

May

-06

Ju

l-0

6

Sep

-06

Nov

-06

Jan

-07

Mar

-07

Mar

ch 2

004 =

100

Non-Fuel Commodities Food Metals

Crude Oil Agricultural Raw MaterialsSource: International Monetary Fund.

Chart II.10: International Commodity Prices

Mar

-04

Ju

n-0

4

Sep

-04

Dec

-04

Mar

-05

Ju

n-0

5

Sep

-05

Dec

-05

Mar

-06

Ju

n-0

6

Sep

-06

Dec

-06

Mar

-07

Advanced Economies

US UK Euro Area Japan

Per

cen

t

Mar

-04

Ju

n-0

4

Sep

-04

Dec

-04

Mar

-05

Ju

n-0

5

Sep

-05

Dec

-05

Mar

-06

Ju

n-0

6

Sep

-06

Dec

-06

Mar

-07

Select Asian Economies

Per

cen

t

China Korea Thailand Malaysia

Chart II.9: Consumer Price Inflation

38


Table 2.32: Global Inflation Indicators (Per cent)

Country/Region Key Policy Rate Policy Rates Changes in Policy CPI Inflation Growth(As on May Rates (basis points) (y-o-y) (y-o-y)

19, 2007)Since Since 2006 2007 2005 2006end- end- (Mar.) (Mar.) (Q4) (Q4)

March March2005 2006

1 2 3 4 5 6 7 8 9

Developed EconomiesAustralia Cash Rate 6.25 75 75 3.0 2.4 2.7 2.8

(Nov. 8, 2006)Canada Overnight Rate 4.25 175 50 2.2 2.3 2.9 2.3

(May 24, 2006)Euro area Interest Rate on Main 3.75 175 125 2.2 1.9 1.7 3.3

Refinancing Operations (Mar. 8, 2007)Japan Uncollateralised Overnight 0.50 ** 50 -0.2 -0.1 4.0 2.3

Call Rate (Feb. 21, 2007)UK Official Bank Rate 5.50 75 100 1.8 3.1 1.8 3.0

(May. 10, 2007)US Federal Funds Rate 5.25 250 50 3.4 2.8 3.2 3.1

(June 29, 2006)Developing EconomiesBrazil Selic Rate 12.50 (-)675 (-)400 5.3 3.0 1.4 3.8

(Apr. 18, 2007)India Reverse Repo Rate 6.00 125 50 4.9 6.7 9.3 8.6

(July 25, 2006)Repo Rate 7.75

(Mar. 30, 2007) 175 125China Benchmark 1-year 6.57 99 99 0.8 3.3 9.9 10.7

Lending Rate (May 19, 2007)Indonesia BI Rate 8.75 25@ (-)400 15.8 6.5 4.9 6.1

(May 8, 2007)Israel Key Rate 3.75 25 (-)100 3.6 -0.9 4.8 3.7

(Apr. 22, 2007)Korea Overnight Call Rate 4.50 125 50 2.0 2.2 5.3 4.0

(Aug. 10, 2006)Philippines Reverse Repo Rate 7.50 75 0 7.6 2.2 6.1 6.5

(Oct. 20, 2005)South Africa Repo Rate 9.00 150 200 3.4 6.1 4.5 6.1

(Dec. 8, 2006)Thailand 14-day Repurchase Rate 5.00 275 50 5.7 2.0 4.7 4.2

(June 7, 2006)1-day Repurchase Rate 4.00 — (-)94 ^

(Apr. 11, 2007)

** : The Bank of Japan decided on March 9, 2006 to change the operating target of money market operations from the outstanding balance ofcurrent accounts at the Bank to the uncollateralised overnight call rate.

@ : Change since July 2005 when Bank Indonesia adopted BI rate as the reference rate with the formal adoption of inflation targeting.^ : Change over January 16, 2007. Effective January 17, 2007, the 1-day repurchase rate replaced the 14-day repurchase rate as the

policy rate.Note : 1. For India, data on inflation pertain to CPI for Industrial Workers.

2. Figures in parentheses in column (3) give the date when the policy rates were last revised.Source : International Monetary Fund, websites of respective central banks and the Economist.

paused since then as economic growth hasmoderated from its quite strong pace, partly reflectinga cooling of the housing market. The US Fed has

indicated that future policy adjustments will dependon the evolution of the outlook for both inflation andeconomic growth, as implied by incoming information.

39


2.77 In emerging Asia, inflation remains relativelymodest in a number of economies, reflecting bothpre-emptive monetary tightening as well as appreciationof the exchange rates. However, there is an emergingconcern regarding excess liquidity arising particularlyfrom large external capital flows. Consumer price inflationin China increased to 3.3 per cent in March 2007 from0.8 per cent a year ago. In view of stronger growth inmoney supply and credit, the People’s Bank of Chinahas increased the benchmark 1-year lending rate by 27basis points each in April 2006, August 2006, March2007 and by 18 basis points in May 2007 accompaniedby a series of administrative curbs on new projectapprovals. It has also raised the cash reserve ratio by400 basis points since July 2006 in eight steps to 11.50per cent (including the hike of 50 basis points to beeffective from June 5, 2007). Amongst other emergingAsian economies, Korea has kept its rates unchangedsince August 2006. On the other hand, in Thailand andIndonesia, the policy rates have been cut by 94 basispoints (since January 2007) and 400 basis points (sinceMay 2006), respectively, to support growth.

2.78 In India, headline inflation, measured by y-o-ychanges in the wholesale price index (WPI), was at5.7 per cent during the week ended March 31, 2007 ascompared with 4.0 per cent a year ago. The averageWPI inflation rate (average of the 52 weeks) was 5.4per cent in 2006-07 as compared with 4.4 per cent ayear ago (Chart II.11). Inflation movements in 2006-07were driven by primary food articles and manufacturedproducts prices, reflecting the impact of both supply-side and demand-side pressures.

2.79 Prices of primary articles led by wheat, pulses,milk, oilseeds and raw cotton exerted upward pressureson headline inflation during 2006-07 (Table 2.33).Wheat prices rose by 7.6 per cent, year-on-year, onthe back of low domestic stocks and high internationalprices. Prices of pulses increased by 12.0 per centfrom last year’s level, reflecting stagnant domesticproduction. Milk prices increased by 8.4 per cent.Prices of oilseeds increased by 30.6 per cent incontrast to a decline of 9.2 per cent a year ago intandem with international trends. Overall, prices ofprimary articles increased by 10.7 per cent on a y-o-ybasis as on March 31, 2007 (4.8 per cent a year ago).

2.80 Fuel group inflation eased to 1.0 per cent, y-o-y,as on March 31, 2007 from 8.3 per cent a year ago.Fuel group inflation initially rose to a peak of 9.9 percent, y-o-y, on June 17, 2006 under the impact of therise in domestic petrol and diesel prices on June 6,2006. Subsequently, the fuel group’s inflationmoderated due to the base effect and the decline indomestic prices of petrol and diesel in November 2006and February 2007. It may be noted that the pass-through of higher international oil prices has beenrestricted to petrol and diesel. Domestic prices ofliquefied petroleum gas (LPG) and kerosene haveremained unchanged since November 2004 and April2002, respectively, on grounds of societal concerns.

2.81 Manufactured products inflation increased to5.8 per cent, y-o-y, as on March 31, 2007 from 1.9per cent a year ago, led by edible oils/oil cakes,cement, metals and electrical machinery. Metal priceshave generally moved in line with international trends.‘Basic metals, alloys and products’ group inflation was11.0 per cent, y-o-y, as on March 31 2007 as againsta decline of 0.6 per cent a year ago. Domestic pricesof cement increased by 11.6 per cent, y-o-y, over andabove the increase of 14.9 per cent a year ago, partlyreflecting strong domestic demand. Electr icalmachinery prices rose by 12.8 per cent as comparedwith 4.1 per cent a year ago. While grain mill productprices increased by 21.4 per cent in tandem withdomestic wheat prices, domestic sugar prices haveeased in recent months in line with global trends.Edible oil prices increased by 14.7 per cent as againsta decline of 3.3 per cent a year ago.

2.82 Apar t from monetary measures by theReserve Bank to contain inflationary expectations, theGovernment also undertook a number of fiscal andsupply side measures during the year to contain theprice rise in primary commodities as well as somemanufactured items.

03-A

pr-

04

12-J

un

-04

21-A

ug-

04

30-O

ct-0

4

08-J

an-0

5

19-M

ar-0

5

28-M

ay-0

5

06-A

ug-

05

15-O

ct-0

5

24

-Dec

-05

04-M

ar-0

6

13-M

ay-0

6

22-J

ul-

06

30-S

ep-0

6

09

-Dec

-06

17-F

eb-0

7

28-A

pr-

07

Chart II.11: Wholesale Price Inflation

Year-on-year Average Year-on-year excluding fuel

Per

cen

t

40


Table 2.33: Wholesale Price Inflation in India (year-on-year)(Per cent)

Commodity April 1, 2006 March 31, 2007 P

Weight Inflation WC Inflation WC

1 2 3 4 5 6

All Commodities 100.0 4.0 100.0 5.7 100.0

1. Primary Articles 22.0 4.8 25.8 10.7 40.4

Food Articles 15.4 5.9 22.5 8.3 22.3i. Rice 2.4 2.1 1.1 5.7 2.1

ii. Wheat 1.4 12.7 4.3 7.6 1.9iii. Pulses 0.6 33.3 4.5 12.0 1.4

iv. Vegetables 1.5 7.6 2.4 1.4 0.3v. Fruits 1.5 -3.9 -1.9 5.5 1.7

vi. Milk 4.4 1.9 2.0 8.4 6.0vii. Eggs, Meat and Fish 2.2 13.2 7.3 11.1 4.6

Non-Food Articles 6.1 -2.4 -3.5 16.6 15.5i. Raw Cotton 1.4 -1.7 -0.4 21.4 3.6

ii. Oilseeds 2.7 -9.2 -5.5 30.6 11.0iii. Sugarcane 1.3 0.7 0.3 1.1 0.3

Minerals 0.5 43.6 6.9 17.0 2.6

2. Fuel, Power, Light and Lubricants 14.2 8.3 45.5 1.0 4.1i. Mineral Oils 7.0 12.0 37.2 0.5 1.2

ii. Electricity 5.5 4.5 8.3 2.3 2.9iii. Coal Mining 1.8 0.0 0.0 0.0 0.0

3. Manufactured Products 63.8 1.9 27.7 5.8 55.9

i. Food Products 11.5 1.0 2.6 6.4 11.3

of which: Sugar 3.6 6.2 4.7 -12.7 -6.9

Edible Oils 2.8 -3.3 -1.8 14.7 5.1

ii. Cotton Textiles 4.2 2.3 2.1 -1.0 -0.6iii. Man Made Fibres 4.4 -3.9 -2.1 3.7 1.3

iv. Chemicals and Chemical Products 11.9 3.3 9.7 2.9 5.8of which: Fertilisers 3.7 0.2 0.1 1.8 1.0

v. Basic Metals, Alloys and Metal Products 8.3 -0.6 -1.5 11.0 17.6of which: Iron and Steel 3.6 -4.2 -5.1 7.5 5.8

vi. Non-Metallic Mineral Products 2.5 9.6 5.4 9.0 3.7

of which: Cement 1.7 14.9 5.6 11.6 3.3vii. Machinery and Machine Tools 8.4 3.2 5.2 8.0 8.8

of which: Electrical Machinery 5.0 4.1 3.1 12.8 6.9viii. Transport Equipment and Parts 4.3 0.9 0.8 2.1 1.2

Memo:

Food Items (Composite) 26.9 3.9 25.1 7.5 33.6

WPI Excluding Food 73.1 4.0 74.9 5.1 66.4

WPI Excluding Fuel 85.8 2.8 54.5 7.1 95.9

P : Provisional. WC : Weighted Contribution.

2.83 Headline WPI inflation was 5.4 per cent, y-o-y,as on May 5, 2007 as compared with 5.7 per cent atend-March 2007 and 4.4 per cent a year ago.Primary articles and manufactured group inflationhardened to 11.1 per cent (5.1 per cent a year ago)

and 5.1 per cent (2.3 per cent), respectively, whilefuel group inflation softened to 0.7 per cent (9.0 percent). The average WPI inflation rate increased to5.6 per cent as on May 5, 2007 from 4.2 per cent ayear ago.

41


2.84 Consumer price inflation also edged higherand remained higher than the WPI inflation during2006-07. This could be attributed to the higher orderof increase in food prices as well as the higher weightof food items in the CPI (Table 2.34).

2.85 To sum up, demand for bank credit remainedbuoyant dur ing 2006-07. This could beaccommodated by the acceleration in bank deposits.Concomitantly, growth in money supply also remainedhigher than a year ago; it exceeded the indicativeprojections set out in the Annual Policy Statement.Inflation firmed up during 2006-07 driven by primaryfood ar ticles and manufactured product prices,reflecting the inter-play between supply and demandpressures. The domestic oil price pass-throughremains incomplete in respect of LPG and keroseneoil. Reflecting the sharp rise in primary food prices,var ious measures of consumer pr ice inflationremained above the WPI inflation during 2006-07.

IV. FINANCIAL MARKETS

2.86 Financial markets in India remained orderlyduring 2006-07, barring some episodes of volatility.Short-term money rates remained generally withinthe reverse repo rate and repo rate corridor till mid-December 2006. However, beginning the secondfor tnight of December 2006, call rates shot upoccasionally as a result of swings in l iquidityconditions arising from large changes in governmentcash balances and volatile forex flows, as alsoshortage of collateral faced by some participants, ata time when monetary policy was in tightening mode.In the foreign exchange market, the Indian rupee hadrecorded both way movements vis-à-vis the US dollardur ing the f inancial year along with markedappreciation against the US dollar since March 2007.Yie lds in the government secur i t ies markethardened dur ing 2006-07. The equity market

remained orderly during the financial year, barringperiods of volatility during May-June 2006 andFebruary-March 2007. This section takes a reviewand assessment of var ious segments of thefinancial market during the fiscal year 2006-07 and2007-08 (wherever data are available).

Money Market

Call Money Market

2.87 Money market conditions remained largelycomfortable during 2006-07, barring a few spells ofvolatility. Call money rates, which had edged up duringthe second half of 2005-06, eased during April-May2006 and remained close to the reverse repo rate [thelower band of the liquidity adjustment facility (LAF)corridor], reflecting easing of liquidity conditions. Withthe increase in the fixed reverse repo/repo rate by 25basis points effective June 9, 2006, call rates alsoedged up by a similar magnitude. In July 2006, callrates again edged up with the increase in fixed reverserepo/repo rate by 25 basis points (effective July 25,2006). Liquidity conditions became relatively tight inSeptember 2006 when the average call money rateincreased to 6.33 per cent, inter alia, on account ofliquidity pressures emanating from advance taxoutflows and festival season currency demand amidsthigh credit demand. In October 2006, the averagemonthly call money rate increased further to 6.75 percent. With the increase in fixed repo rate by 25 basispoints to 7.25 per cent (the reverse repo rate was leftunchanged) effective October 31, 2006, call ratesedged up somewhat, averaging 6.90 per cent duringthe first three weeks of November 2006. However, asa result of decline in call rates towards the end ofNovember, monthly average call rates declined to 6.69per cent. From the second week of December, call ratesstarted firming up reaching a high of 16.9 per cent onDecember 29, 2006 and averaged 8.63 per cent during

Table 2.34: Consumer Price Inflation (CPI) in India (year-on-year)(Per cent)

Inflation Measure Mar. 2003 Mar. 2004 Mar. 2005 Mar. 2006 Jun. 2006 Sep. 2006 Dec.2006 Mar. 2007

1 2 3 4 5 6 7 8 9

CPI-IW 4.1 3.5 4.2 4.9 7.7 6.8 6.9 6.7CPI-UNME 3.8 3.4 4.0 5.0 6.5 6.6 6.9 7.6CPI-AL 4.9 2.5 2.4 5.3 7.2 7.3 8.9 9.5CPI-RL 4.8 2.5 2.4 5.3 7.2 7.0 8.3 9.2

Memo:

WPI Inflation 6.5 4.6 5.1 4.1 4.8 5.4 5.9 5.7

IW : Industrial Workers. UNME : Urban Non-Manual Employees. AL : Agricultural Labourers. RL : Rural Labourers.

42


the month. Hardening of call rates was due to tighteningof liquidity in the system as a result of CRR hike andadvance tax outflow (Table 2.35). However, call rateseased in January 2007 and averaged 8.18 per cent. InFebruary 2007, the call rate further declined to around6.5 per cent by the end of the second week. Followingthe announcement of a further CRR hike on February13, 2007, it again firmed up to around 8.0 per cent bymid-February before dropping to 6.0 per cent by end ofthe month. Call rates averaged 7.16 per cent duringFebruary 2007.

2.88 Call money rates went below the lower boundof the repo-reverse repo corridor during the first weekand the average rate was at 5.62 per cent till the mid-March. The overnight call rate hovered above theupper bound of the corridor during March 17-31, 2007and ruled above 20 per cent on the following five days.The call rate crossed 50 per cent on March 21 and

March 30, 2007. The average call rate for the monthwas 14.07 per cent. Call money rates eased and on adaily weighted average basis ranged between 3.27-12.83 per cent in the first half of April 2007 as a resultof improvement in the liquidity condition following asharp decline in government cash balances. With thefirst stage of CRR hike announced as part of themonetary measures on March 30, 2007 becomingeffective from April 14, 2007 and government raisingresources as part of its market borrowing programme,the call rate hardened in the second half of Aprilranging between 7.36-15.01 per cent and averaging9.76 per cent. The average call rate for April 2007was 8.33 per cent. During May 2007 (up to May 19,2007), the daily weighted average call money ratesranged between 2.80-9.08 per cent and averaged 7.24per cent, i.e., below the LAF repo rate. Increasedvolatility in money markets in the recent period was,

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

2005-06April 17,213 4.77 7.02 3,001 9,880 43.74 – 1.96 65,638 30,675 1,890 4,136 6,379 1,987May 15,269 4.99 7.11 3,805 10,083 43.49 – 1.57 68,539 22,754 1,971 3,946 6,483 2,002June 20,134 5.10 6.88 6,807 10,871 43.58 -104 1.40 70,651 13,916 2,543 4,843 6,926 2,134July 20,046 5.02 7.13 3,698 11,003 43.54 2,473 1.56 70,758 10,754 3,095 6,150 7,337 2,237August 16,158 5.02 7.04 4,239 11,749 43.62 1,552 0.69 71,346 34,832 3,451 6,624 7,726 2,358September 16,292 5.05 7.04 5,207 11,040 43.92 – 0.62 67,617 30,815 3,871 6,923 8,272 2,512October 17,164 5.12 7.14 2,815 13,087 44.82 – 0.69 68,602 18,608 2,955 6,040 8,220 2,487November 22,620 5.79 7.10 3,314 11,228 45.73 – 0.67 67,041 3,268 2,635 5,480 8,552 2,575December 21,149 6.00 7.13 2,948 13,808 45.64 -6,541 1.51 52,040 1,452 3,516 6,814 9,162 2,773January 17,911 6.83 7.15 3,094 16,713 44.40 – 2.60 40,219 -15,386 3,966 7,472 9,540 2,893February 13,497 6.95 7.32 2,584 15,798 44.33 2,614 2.85 33,405 -13,532 3,688 7,125 10,090 3,019March 18,290 6.58 7.40 2,203 17,600 44.48 8,149 3.11 29,652 -6,319 5,398 9,518 10,857 3,236

2006-07 April 16,909 5.62 7.45 3,685 17,712 44.95 4,305 1.31 25,709 46,088 4,860 9,854 11,742 3,494May 18,074 5.54 7.58 3,550 18,420 45.41 504 0.87 26,457 59,505 4,355 9,155 11,599 3,437June 17,425 5.73 7.86 2,258 15,310 46.06 – 0.73 31,845 48,610 3,261 6,828 9,935 2,915July 18,254 5.86 8.26 2,243 14,325 46.46 – 0.83 36,936 48,027 2,605 5,652 10,557 3,092August 21,294 6.06 8.09 5,786 15,934 46.54 – 1.22 40,305 36,326 2,869 5,945 11,305 3,306September 23,665 6.33 7.76 8,306 18,107 46.12 – 1.31 40,018 25,862 3,411 6,873 12,036 3,492October 26,429 6.75 7.65 4,313 16,924 45.47 – 1.67 41,537 12,983 3,481 6,919 12,637 3,649November 25,649 6.69 7.52 10,654 20,475 44.85 3,198 2.07 38,099 9,937 4,629 8,630 13,416 3,869December 24,168 8.63 7.55 5,362 19,932 44.64 1,818 3.20 38,148 -1,713 4,276 8,505 13,647 3,918January 22,360 8.18 7.71 4,822 21,065 P 44.33 2,830 4.22 39,553 -10,738 4,380 8,757 13,984 4,037February 23,254 7.16 7.90 4,386 20,050 P 44.16 11,862 3.71 40,827 648 4,680 9,483 14,143 4,079March 23,217 14.07 8.00 2,991 24,231 P 44.03 – 4.51 52,944 -11,858 3,716 7,998 12,850 3,731

* : Average of daily weighted call money borrowing rates. @ : Average daily closing rates. + : Outright turnover in Central Government dated securities.# : Average of weekly outstanding MSS. ** : Average daily closing indices. – : Nil. P : Provisional.

Year/Month

AverageCall

Rates*(Per

cent)

Average10-yearYield @

(Percent)

AverageDaily

Turn-overin Govt.

Securities(Rs.

crore)+

AverageDailyInter-bank

Turnover(US $

million)

AverageEx-

changeRate

(Rs. perUS $)

RBI's netForeign

CurrencySales (-) /

Purchases(+) (US $

million

AverageForward

Premia 3month

(Percent)

AverageMSS

Outstan-ding #

( Rs.crore)

AverageDaily

ReverseRepo(LAF)

Outsta-nding

(Rs. crore)

AverageDailyBSE

Turnover(Rs.

crore)

AverageDailyNSE

Turnover(Rs.

crore)

AverageBSE

Sensex**

AverageS&PCNX

Nifty**

Table 2.35: Domestic Financial Markets – Select Indicators

Call Money Govt. Securities Foreign Exchange LiquidityManagement

Equity

AverageDaily

Turn-over(Rs crore)

43


in part, caused by asymmetric distribution of fundsand eligible collateral amongst banks. This wasreinforced by asset liability mismatches in some bankswho had insufficient provisions at the short-end ofmaturity bucket at a time when they were also shortof collateral. This limited their ability to borrow in thecollateralised market or obtain liquidity through theReserve Bank’s LAF window, forcing them to scoutfor funds on adverse terms in the uncollateralisedmarket. On its part, the Reserve Bank has beenaccepting all demands for liquidity made at its LAFwindow. Thus, the liquidity pressures emanating fromadvance tax flows during the second half of March2007, accentuated in April/May and resulted in largerspikes in call rates.

Collateralised Markets

2.89 After the abolition of non-bank participants(other than PDs) from uncollaterised money marketsince August 2005, the collateralised segment hasemerged as the predominant segment of the moneymarket. Interest rates in the collateralised segmentsof the money market – the market repo (outside theLAF) and the Collateralised Borrowing and LendingObligation (CBLO) segments – eased in the first twomonths of 2006-07 as compared with the last quarterof 2005-06. However, the rates in the collateralisedmoney market have increased gradually from June2006, following the fixed reverse repo rate hikes andsubsequent tightening of l iquidity condition inSeptember 2006. The market repo and CBLO rates,which declined to 5.15 per cent and 5.18 per cent,respectively, during April 2006, increased gradually to7.33 per cent and 7.05 per cent, respectively, inDecember 2006. The market repo and CBLO segmentrates declined to 6.76 per cent and 6.67 per cent,respectively, during February 2007 before climbing upto 8.13 per cent and 7.73 per cent, respectively, inMarch 2007 in line with the call money market. On aweighted average basis, the CBLO rate and marketrepo rate averaged 6.70 per cent in February 2007 and7.86 per cent in March 2007. Interest rates in thesesegments, however, remained below the call rate during2006-07 (Chart II.12). Interest rates in the CBLO andthe market repo segments had remained within repo-reverse repo corridor till mid-December 2006. In tandemwith tightness in money markets, interest rates in thesesegments also edged up and hovered around the reporate beginning the second half of December 2006, butremained below the call rate. In the subsequent spellsof liquidity tightening as well, the rates in collateralisedsegments have, by and large, remained anchoredaround the repo rate, except towards end of March,

when the rates exceeded LAF repo rates significantly,but remained well below the call rates.

2.90 During 2006-07, the CBLO and market reporates averaged 6.24 per cent and 6.34 per cent,respectively, as compared with 7.22 per cent in thecall money market. The CBLO and market repo ratesremained well within the corridor, averaging 6.12 and6.76 per cent, respectively, in April 2007. The CBLOand market repo rates declined below the reverse reporate in the first half of May 2007, and then hoveredaround the repo rate in the third week. During Apriland May 2007 (up to May 19, 2007), rates in thesecollateralised segments of the money market more orless stayed inside or around the LAF repo rate.

2.91 The collateral ised market is now thepredominant segment of the money market, with ashare of around 70 per cent in total volume during2006-07. Mutual funds and financial institutions arethe major lenders in the CBLO market, whilenationalised banks are the major borrowers. In themarket repo segment, mutual funds are the majorproviders of funds, while foreign banks, private sectorbanks and primary dealers are the major borrowers.

2.92 A screen-based negotiated quote-drivensystem for all dealings in the call/notice and termmoney market (NDS-CALL), as announced in theAnnual Policy Statement for the year 2005-06, waslaunched on September 18, 2006. NDS-CALL hasbeen developed by the Clearing Corporation of IndiaLimited (CCIL) on behalf of the Reserve Bank and isexpected to bring about increased transparency and

01-M

ar-0

5

01-M

ay-0

5

01-J

ul-

05

01-S

ep-0

5

01

-Nov

-05

01-J

an-0

6

01-M

ar-0

6

01-M

ay-0

6

01-J

ul-

06

01-S

ep-0

6

01

-Nov

-06

01-J

an-0

7

01-M

ar-0

7

Chart II.12: Movement in Key Market Rates

Per

cen

tMarket Repo (Non-RBI) Call Money

CBLO Average

44


better price discovery. Though dealing on this platformis optional, 84 banks (including 16 co-operative banks)and 7 primary dealers have taken membership ofNDS-CALL so far.

Liquidity Situation

2.93 Liquidity conditions remained generallycomfortable during 2006-07, despite sustained growthof bank credit. Liquidity eased during April-June 2006,following reduction in the Centre’s surplus balanceswith the Reserve Bank and the impact of the ReserveBank’s foreign exchange market operations. TheReserve Bank absorbed liquidity through operationsunder the LAF and resumed auctions of Treasury Billsunder the MSS in May 2006. Under the LAF, on anaverage, the Reserve Bank absorbed liquidity throughreverse repos to the extent of Rs.51,490 crore duringApril-June 2006 as against a net injection of liquiditythrough repos to the extent of Rs.11,686 crore duringthe previous quarter (January-March 2006). Theaverage net absorption through reverse repo declinedfrom around Rs.48,000 crore in July 2006 toRs.12,983 crore in October 2006. In November, theaverage net absorption through reverse repo was atRs.9,937 crore. However, December 2006 andJanuary 2007 witnessed net injection of liquidityaveraging Rs.1,713 crore and Rs.10,738 crore,respectively, mainly due to pressure emanating fromadvanced tax outflows and CRR hike in the midst ofhigh credit growth and rise in inflation. Liquidity wasabsorbed through the MSS, fol lowing thereintroduction of issuances under the MSS effectiveMay 3, 2006. An incremental amount of Rs.33,912crore was absorbed under the MSS in the lastfinancial year. The LAF returned to absorption modein the second week of February 2007 and keepingin view the liquidity conditions and the paramountneed to contain inflation expectations, the ReserveBank announced another hike in the CRR onFebruary 13, 2007.

2.94 In February 2007, the average dailyabsorption through reverse repo was at Rs.648 crore.On a review of the liquidity conditions, the ReserveBank introduced a modified arrangement in liquiditymanagement on March 2, 2007, wherein the LAF asa facility for equilibrating very short-term mismatcheswas emphasised, and it was decided that the liquidityabsorption would be modulated through the dailyreverse repo auctions. Accordingly, beginning March5, 2007, daily reverse repo absorption was limited toa maximum of Rs.3,000 crore each day (allocationswould be propor tionate on a pro-rata basis)comprising Rs.2,000 crore in the First LAF and

Rs.1,000 crore in the Second LAF. Between March 5and 15, 2007, liquidity was in surplus mode and dailyabsorption was close to the upper bound of Rs.3,000crore. From March 16, 2007, however, liquidity in thesystem reverted to a deficit mode largely on accountof quarterly direct tax payment schedules. Daily netinjection of liquidity averaged Rs.31,124 crore duringthe second half of March and Rs.11,858 crore for theentire month of March.

2.95 In April 2007, the implementation of CRR hikein two phases impounded liquidity from the system,forcing the LAF window to go to the injection mode.The average daily net injection of liquidity through theLAF operation was Rs.8,937 crore. During the month,absorption took place for only 7 days, i.e., betweenApril 9-15, 2007. In May 2007 (up to May 19, 2007),the Reserve Bank injected liquidity through LAF,except for the period between May 7-13, 2007.

2.96 The major issues relating to l iquiditymanagement in recent years include large andunpredictable nature of capital flows, which increasedliquidity exogenously, putting upward pressure onmoney supply, prices and exchange rates. Thisnecessitated appropriate sterilisation measures.Government cash balances with the Reserve Bankoften display large periodic variation mainly due tolumpy character of direct tax inflows on account ofquarterly payment schedule, the impact of which hasbecome more pronounced in recent quarters due tobuoyancy in tax revenue. The volatile Governmentcash balances also cause unanticipated expansionor contraction of the monetary base, andconsequently, making money supply managementeven more challenging. Over the years, the LAF hasemerged as the principal operating instrument for bothliquidity management and monetary policy. The MSS,on the other hand, has functioned as an additionalinstrument to deal with the enduring capital inflowswithout affecting the short-term liquidity managementrole of the LAF. In addition, modified arrangementsfor the LAF and the MSS put in place in March 2007,are expected to facil i tate the maintenance ofappropriate liquidity in the system and to respondmore swiftly to the evolving liquidity situation in linewith the objectives and stance of monetary policy.

Certificates of Deposit

2.97 The demand for certificates of deposit (CDs)issued by the scheduled commercial banks (SCBs)remained strong during the fiscal year 2006-07. Inview of the sustained credit demand, the SCBsresorted to deposit mobilisation through CDs. The

45


amount of outstanding CDs increased from Rs.43,568crore at end-March 2006 (4.8 per cent of aggregatedeposits of issuing banks) to Rs.93,272 crore (4.83per cent of aggregate deposits of issuing banks withsignificant intra-group variation) by March 30, 2007.The overall weighted average discount rate (WADR)for CDs, which had risen to 8.62 per cent by end-March 2006, declined to 7.03 per cent by end-April2006. The interest rate on CDs firmed up againbeginning July with the WADR rising to 10.75 per centby March 30, 2007. As on April 13, 2007, the WADRof CDs stood at 10.15 per cent. Some of the privatesector and foreign banks are also taking increasedrecourse to the CD route to meet the resource gap.Institutional investors such as mutual funds areinvesting in these certificates to deploy short-termresources.

Commercial Paper

2.98 The total outstanding amount of commercialpaper (CP) issued increased considerably fromRs.12,718 crore as on March 31, 2006 to Rs.17,688crore as on March 31, 2007. The WADR, which hadrisen to 8.59 per cent at end-March 2006, softenedby mid-May 2006. CP rates have been firming upsomewhat since mid-August in tandem with theincrease in money market rates. Corporates havebeen offering typically a yield in the range of 10.25 to12.50 per cent for a CP with a maturity period of morethan 3 months in consonance with other moneymarket segments. Leasing and finance companiesremained the predominant issuers of CP. The shareof issuances by financial institutions recorded anincrease during 2006-07 (Table 2.36). As on April 15,2007, the WADR of CP stood at 10.5 per cent.

Government Securities Market

Central Government Cash Management

2.99 With a view to achieving a smooth transitionto the new regime as envisaged in the FiscalResponsibility and Budget Management (FRBM) Act,2003, the WMA arrangements for 2006-07 wererevised in consultation with the Government of India.As per the revised arrangement, the WMA limits werefixed on a quarterly basis instead of the existing half-yearly basis. Accordingly, the WMA limits for 2006-07were placed at Rs.20,000 crore and Rs.10,000 crorefor the first and second quarters, respectively, andRs.6,000 crore each for the third and fourth quartersof the year. The Reserve Bank would retain theflexibility to revise the limits in consultation with theGovernment taking into consideration the transitionalissues and prevailing circumstances. Furthermore,the interest rates on WMA and overdraft have beenlinked to the repo rate, following its emergence asthe shor t-term reference rate. Accordingly, theinterest rate on WMA is at the repo rate, while onoverdraft it is at the repo rate plus two percentagepoints. Reflecting the improvement in its cashposition, the Central Government did not resort tooverdrafts during 2006-07, but availed of WMA onfive occasions (39 days in all).

Market Borrowings of the Central Government –2006-07

2.100 Under the FRBM Act, 2003, the Reserve Bankhas been prohibited from subscribing to the primaryissues of Central Government securities from thefinancial year beginning April 1, 2006. In order toensure a smooth transition to the new system, theReserve Bank has taken a number of measures tomake the market deeper, broader and more liquid,while improving the trading/sett lement andinstitutional infrastructure.

2.101 Market borrowings (including dated securitiesand 364-day TBs) of the Central Government for2006-07 were budgeted at Rs.1,81,875 crore (netRs.1,13,778 crore) which were Rs.21,857 crore higherthan the actual amount raised in 2005-06. On March24, 2006, the issuance calendar for dated securitiesfor the first half of 2006-07 was fixed at Rs.89,000crore (Rs.81,000 crore raised dur ing thecorresponding period of previous year) in consultationwith the Central Government. The actual amountraised during the first half of the year was Rs.89,000crore, which was as per the issuance calendar. Thecalendar for issuance of Government of India dated

Table 2.36: Commercial Paper – Major Issuers

(Amount in Rs. crore)

Category of Issuer End of

March-05 March-06 March-07

1 2 3 4

Leasing and Finance 8,479 9,400 12,419(59.6) (73.9) (70.2)

Manufacturing 2,881 1,982 2,754(20.2) (15.6) (15.6)

Financial Institutions 2,875 1,336 2,515(20.2) (10.5) (14.2)

Total 14,235 12,718 17,688(100) (100) (100)

Note: Figures in parentheses are percentage share to the total.

46


securities for the second half of the fiscal was issuedon September 25, 2006. The total amount to be raisedwas fixed at Rs.63,000 crore, of which an amount ofRs.57,000 crore was raised.

Dated Securities

2.102 During 2006-07, gross market borrowings byway of dated securities by the Central Governmentamounted to Rs.1,46,000 crore as compared withRs.1,31,000 crore during the previous year. Grossmarket borrowings through dated securities during2006-07 accounted for 94 per cent of the budgetestimates, same as that of the previous year. Threenew securities, viz., (i) a 10-year security (7.59 % GS2016 issued for the first time in April 2006); (ii) a 15-year security (7.94 % GS 2021 issued in May 2006);and (iii) a 30-year security (8.33% GS 2036 issued inJune 2006) were issued to provide benchmark in therespective segments of the secondary market. DuringJune 2006, Rs.4,000 crore was raised outside theissuance calendar to absorb excess liquidity in thesystem. The additional issue was offset by reductionin the auction amount in the subsequent auctions heldin July 2006. The scheduled auction in the 10-14 yearsegment (Rs.5,000 crore) was cancelled in the auctionheld on January 12, 2007, after a review of theGovernment’s borrowing requirements. Of the 33securities issued during 2006-07, 30 securities werere-issues. The total devolvement on PDs during thefinancial year was at Rs.5,604 crore.

2.103 The weighted average yield of dated securitiesissued during 2006-07 was higher at 7.89 per centas compared with 7.34 per cent during 2005-06. Theweighted average maturity of dated securities issuedduring the year worked out to 14.72 years ascompared with 16.90 years during the previous year.

Treasury Bills

2.104 As per the annual issuance calendar that wasissued on March 24, 2006, the notified amounts of 91-day, 182-day and 364-day Treasury Bills under thenormal market borrowing programme were keptunchanged at Rs.500 crore (weekly auction), Rs.500crore (for tnightly auction) and Rs.1,000 crore(fortnightly auction), respectively. During April-June2006, the primary market yields of 91-day, 182-day and364-day Treasury Bills firmed up due to a variety offactors such as expectations of rise in inflation, largerissuances under the MSS and the unexpected hike inrepo and reverse repo rates on June 8, 2006. FromJuly to December 2006, the yields generally remainedflat amidst ample liquidity in the system. However, after

the announcement of a hike in CRR on December 8,2006, the yields for 91-day, 182-day and 364-dayTreasury Bills increased significantly by 45 basis points,36 basis points and 30 basis points, respectively overthe previous auctions. Yields moved further upwardsfollowing another hike in the CRR in February 2007and tight liquidity conditions in the wake of advancetax outflows in mid-March 2007. The closing primarymarket yields for March 2007 in respect of 91-day,182-day and 364-day Treasury Bills were placed at7.98 per cent, 8.20 per cent and 7.98 per cent,respectively, exhibiting increases of 1.87 per cent,1.59 per cent and 1.56 per cent, respectively, overthe yields in the first auctions of 2006-07 (Chart II.13).

2.105 The secondary market yields of Treasury Billsduring April and May 2007 remained range bound.The primary market yields during May 2007 in respectof 91-day Treasury Bills (on May 23, 2007), 182-dayTreasury Bills (on May 16, 2007) and 364-day TreasuryBills (on May 23, 2007) were placed at 7.64 per cent,7.75 per cent and 7.80 per cent, respectively.

2.106 The liquidity position of the States remainedcomfortable during 2006-07. Eight States availed ofWMA and two States resorted to overdraft. The weeklyaverage utilisation of WMA and overdraft by the Statesat Rs.234 crore in 2006-07 was lower than that ofRs.482 crore in 2005-06. Concomitantly, the weeklyaverage investment by the States in 14-dayIntermediate Treasury Bil ls dur ing 2006-07 atRs.43,075 crore was considerably higher than that ofRs.35,278 crore in the previous year.

12-A

pr-

06

10-M

ay-0

6

07-J

un

-06

05-J

ul-

06

02-A

ug-

06

30-A

ug-

06

27-S

ep-0

6

26-O

ct-0

6

22

-Nov

-06

20

-Dec

-06

17-J

an-0

7

14-F

eb-0

7

14-M

ar-0

7

28-M

ar-0

7

Chart II.13: Movement of Primary Yields ofTreasury Bills 2006-07

(April-March)

91 DTB 182 DTB 364 DTB

Yiel

d (

per

cen

t)

47


Market Borrowings of the State Governments

2.107 Following the recommendation of the TwelfthFinance Commission, Central loans for State Planswere eliminated from 2005-06 and the States wereexpected to access the market directly for meetingtheir resource requirements. At the same time, overallborrowings requirements of the States, as a ratio toGDP, moderated in recent years consequent to fiscalconsolidation initiatives and enhanced Centraltransfers. These apart, continuous accretions toNSSF, albeit at a decelerated pace, led to a sharpbuild up of cash balances at the State level, therebyfacilitating lower net (and gross) open marketborrowings by the States during 2006-07 vis-à-vis theprevious year.

2.108 The net allocation (provisional) under themarket borrowing programme for the StateGovernments for 2006-07 was placed at Rs.17,242crore. Taking into account additional allocationsamounting to Rs.2,803 crore and repayments ofRs.6,551 crore during the year, the gross allocationamounted to Rs.26,597 crore as compared with theactual gross borrowings of Rs.21,729 crore in theprevious year. The gross borrowings of the StateGovernments during the year amounted to Rs.20,825crore (raised exclusively through auction route) ascompared with Rs.21,729 crore (Rs.8,723 crorethrough auction route and Rs.11,186 crore throughtap issuance) in the previous year. In the auctions ofState Government market loans during the year, thespreads of the cut-off yields generally remained lowerthan 50 basis points.

2.109 During 2006-07, the weighted average yieldof the securities issued by the State Governmentswas at 8.10 per cent as compared with 7.63 per centduring the previous year. The cut-off yield rangedbetween 7.65 and 8.66 per cent during the sameperiod. All the issues during the fiscal were of 10-year maturity. Six States did not enter the marketduring the year.

2.110 On a review of the State-wise l imits ofNormal WMA, it was decided to keep these limitsunchanged for 2007-08. Accordingly, the aggregateNormal WMA limit was retained at Rs.9,875 crorefor 2007-08.

Secondary Market Transactions in GovernmentSecurities

2.111 The volume of secondary market transactionsincreased marginally to Rs.2,64,868 crore (21 per cent

of which were outright and the remaining on accountof repos) in March 2007 from Rs.2,40,478 crore (19.1per cent of which were outright and the rest onaccount of repos) in March 2006. An inverserelationship was evident between the volume ofoutright transactions and 10-year month-end yield.Turnover in government securities was lowest in July2006 when the yield was at the peak (Chart II.14).Turnover during March 2007 (calculated as twice theoutright transactions and four times the repos) washigher at Rs.9,46,608 crore as against Rs.8,70,109crore during March 2006. Five most traded securitiesin NDS accounted for around 57 per cent of totaltransactions during March 2007, reflecting skeweddistribution of liquidity across securities.

Yield Movement and Yield Curve

2.112 The market borrowing programme of theCentral Government during 2006-07 was higher thanthat in the previous year. Furthermore, oil priceinduced inflationary pressures and upturn in theinternational interest rate cycle resulted in hardeningof yields vis-a-vis the previous year.

2.113 The secondary market yields during 2006-07remained higher than those in the previous year. Froma level of 7.52 per cent at end-March 2006, secondarymarket yields exhibited a sharp rise and movedupwards thereafter up to mid-July 2006, reflecting avariety of factors such as expectations of monetarypolicy t ightening fol lowing the US and other

Ap

r-06

May

-06

Ju

n-0

6

Ju

l-0

6

Au

g-06

Sep

-06

Oct

-06

Nov

-06

Dec

-06

Jan

-07

Feb

-07

Mar

-07

Chart II.14: Government Securities Turnover andYield Curve

Ru

pee

s cr

ore

Per

cen

t

Turnover 10-yr Yield (right scale)

48


economies, high and volatile crude oil pr ices,apprehension over domestic fuel pr ice hike,devolvement at auction held on July 11, 2006 on theprimary dealers and hike in the reverse repo and reporates by 25 basis points effective June 9, 2006. The10-year yield peaked at 8.40 per cent on July 11, 2006.Yields eased thereafter on account of rally in USTreasuries following the pause in the US FederalFunds rate hikes and decline in global crude oil pricessince August 2006. The announcement of issuancecalendar for the second half of the fiscal, which wasas per the market expectation, also helped the yieldsto ease further. Yields started increasing from the firstweek of December 2006 reflecting, inter alia, CRRhikes (in December 2006 February and March 2007)in the context of inflationary pressures, promulgationof SLR Ordinance and tightening of liquidity conditionsfollowing advance tax outflows in December 2006 andMarch 2007. The yields finally closed at 7.97 per centat end-March 2007.

2.114 The announcement of CRR hike on March30, 2007 pushed up the yields to 8.19 per cent byApril 3, 2007. Volatility was witnessed in yieldsduring April and May 2007 due to changes in theliquidity conditions. As on May 24, 2007 the yieldwas at 8.19 per cent.

2.115 The Reserve Bank’s exit from the primaryauctions of central government securities and thecessation of Central loans for State Plansnecessitating mobilisation of resources by the Statesfrom the market warranted not only improved liquiditybut also newer instruments for managing market risksfor a smooth transition to the new environment.Against this backdrop, the steps taken by the ReserveBank towards deepening and widening of thegovernment securities market through measures suchas emphasis on passive consolidation, phasedintroduction of short-selling and ‘When Issued’ marketin government securities and allowing diversificationof activities by the existing participants are expectedto enhance liquidity and facilitate efficient pricediscovery for the smooth conduct of debt managementoperations. As a result of various market developmentmeasures, the combined market borrowingprogramme for 2006-07, though larger than that in2005-06, was completed smoothly.

Foreign Exchange Market

2.116 The foreign exchange market, in general,exhibited orderly conditions with the Indian rupeemoving two-way vis-à-vis the US dollar during

2005-06, despite pressures from the hike in oil pricesand IMD redemptions. During 2006-07, the rupeemoved in a range of Rs.43.14 – 46.97 per US dollarin response to switches in capital flows, movement ofoil prices and liquidity conditions in the market. DuringMay-July 2006, the rupee came under pressure dueto heavy sales by foreign institutional investors (FIIs)in the equity market coupled with interest ratetightening by the major central banks. The continuoushike in oil prices as a result of geo-political risks inthe Middle East region also put downward pressureon the rupee. The rupee started recovering from thelast week of July 2006 due to easing of oil prices. Therupee continued to gain strength against the US dollartill mid-November 2006 and reached the level ofRs.44.45 per US dollar on November 10, 2006tracking the movement of yen/dollar rate, moderatingoil pr ices, FII inf lows and buoyant corporateperformance. However, heavy dollar demand bycorporates and banks during the second week ofNovember led to a sharp depreciation of rupee vis-à-visthe US dollar. The rupee quickly began to appreciatefrom November 16, 2006 due to heavy capital inflowsand tight liquidity conditions in the market. The rupeestood at Rs.43.60 per US dollar on March 30, 2007,at which level it appreciated by 2.3 per cent over itslevel on March 31, 2006. During the same period, therupee experienced a depreciation of 9.1 per centagainst the Pound sterling, 6.8 per cent against theEuro and an appreciation of 2.7 per cent against theJapanese yen.

2.117 During 2007-08 so far (up to May 22, 2007),the rupee appreciated mainly due to strong capitalinflows. The rupee at the level of Rs.40.64 per USdollar as on May 22, 2007 exper ienced anappreciation of 7.3 per cent over its level at end-March2007. Over the same period, the rupee appreciatedby 6.2 per cent, 6.8 per cent and 10.6 per cent againstthe euro, pound ster l ing and Japanese yen,respectively (Chart II.15).

2.118 The forward rate remained in premiumthroughout the year 2006-07. The forward premiadeclined in tandem with narrowing of interest ratedifferentials, following monetary tightening in the USduring April-May 2006. However, it started increasingfrom the second week of June 2006 on account ofrise in interest rate differentials due to increase indomestic interest rates. Tight liquidity conditions alsoresulted in increase in forward premia. The average3-month premia rose from 0.73 per cent in June 2006to 4.51 per cent in March 2007 (Chart II.16) andfurther to 6.91 per cent in April 2007.

49


Capital Market

2.119 Resources mobilised through public issues,private placements and Euro issues were higherdur ing 2006-07 than those in the last year.Continuing the upward trend of 2005-06, the stockmarkets in India firmed up further during 2006-07with the benchmark BSE Sensex closing at an all-time high of 14652.09 on February 8, 2007. However,share prices witnessed a correction thereafter onaccount of sell-off in global equity markets followingrepor ts of crisis in the US sub-prime mortgagelending industry coupled with an unexpected dropin US February retail sales, the rise in internationalcrude oil prices, net sales by FIIs in March 2007 inthe Indian equity market and decline in otherinternational equity markets.

Primary Market

2.120 During 2006-07, the primary market witnessedbuoyant conditions. Resource mobilisation throughpublic issues was higher at Rs.32,382 crore (through119 issues) during 2006-07 as compared withRs.26,940 crore (through 138 issues) during theprevious year (Table 2.37). All the public issues,except one, were by private sector companies.Further, out of 119 public issues, 116 were in the formof equity and three in debt.

2.121 Resource mobilisation through the privateplacement aggregated Rs.1,03,169 crore duringApril-December 2006, which was 50.8 per centhigher than that in the corresponding period of 2005.The public sector entities accounted for 42.0 per centof total resource mobil isation through pr ivateplacement during April-December 2006 as comparedwith 56.9 per cent in the corresponding period of2005 (Table 2.37). Resources mobilised by financialintermediaries (both public and private sector)increased by 63.3 per cent to Rs.71,621 crore duringApril-December 2006 from Rs.43,868 crore in thecorresponding period of the last year.

2.122 Resource mobilisation through Euro issues byway of American Depository Receipts (ADRs) andGlobal Depository Receipts (GDRs) increased by 49.8per cent during 2006-07. There were 40 Euro issuesduring 2006-07 amounting to Rs.17,005 crore ascompared with 48 issues aggregating Rs.11,352 croreduring 2005-06 (Table 2.37).

2.123 Resource mobilisation by mutual funds (netof redemption) increased sharply by 78.1 per centduring 2006-07 to Rs.93,985 crore. UTI Mutual Fundwitnessed higher net inflows of Rs.7,326 crore during2006-07 than Rs.3,424 crore during the previous year.Public sector mutual funds and private sector mutual

Per

cen

t p

er a

nn

um

Mar

-05

Ap

r-05

May

-05

Ju

n-0

5J

ul-

05

Au

g-05

Sep

-05

Oct

-05

Nov

-05

Dec

-05

Jan

-06

Feb

-06

Mar

-06

Ap

r-06

May

-06

Ju

n-0

6J

ul-

06

Au

g-06

Sep

-06

Oct

-06

Nov

-06

Dec

-06

Jan

-07

Feb

-07

Mar

-07

Chart II.16: Movement in Forward Premia

1-month 3-month 6-month

Chart II.15: Rupee vis-à-vis Major Currencies

Rs.

per

Eu

ro/ 1

00 Y

en

Rs.

per

US

dol

lar

Rs.

per

Pou

nd

Ste

rlin

g

02-J

an-0

6

12-F

eb-0

6

25

-Mar

-06

05

-May

-06

15-J

un

-06

26-J

ul-

06

05-S

ep-0

6

16-O

ct-0

6

26

-Nov

-06

06-J

an-0

7

16-F

eb-0

7

29

-Mar

-07

US dollar

02-J

an-0

6

12-F

eb-0

6

25

-Mar

-06

05

-May

-06

15-J

un

-06

26-J

ul-

06

05-S

ep-0

6

16-O

ct-0

6

26

-Nov

-06

06-J

an-0

7

16-F

eb-0

7

29

-Mar

-07

Euro 100 Yen Pound Sterling

50


funds recorded net inflows of Rs.7,621 crore andRs.79,038 crore, respectively, during 2006-07, whichwere significantly higher than those in the previousyear (Table 2.38). Scheme-wise, 5.3 per cent of thenet mobilisation of funds was under liquid/moneymarket or iented schemes dur ing 2006-07 (ascompared with 8.0 per cent during the previous year)and 63.9 per cent under debt oriented schemes (26.5per cent during the previous year). Funds mobilisedunder equity-linked savings schemes, on the otherhand, accounted for 4.7 per cent of net mobilisationof funds as compared with 6.8 per cent during theprevious year. During 2006-07, there was a net outflowof 1.0 per cent under Gilt oriented schemes ascompared with net outflow of 3.0 per cent during theprevious year.

Secondary Market

2.124 The stock markets remained firm till May 10,2006, when both the BSE Sensex and S&P CNX Nifty

closed at all-time high levels of 12612.38 and 3754.25,respectively, mainly on account of net FII investmentson the back of strong macroeconomic fundamentals,robust corporate earnings, firm trend in internationalequity markets and rise in metal prices. However, themarkets witnessed a sharp correction beginning May11, 2006 mainly due to net heavy sales by FIIs causedby a fear of rise in global interest rates, sharp fall inbase metal prices at London Metal Exchange, rise inglobal crude oil prices and fear of higher domesticinflation. The BSE Sensex slipped to 8929.44 by June14, 2006, recording a decline of 20.8 per cent overend-March 2006. Stock markets, however, recoveredthereafter on fresh buying by FIIs and mutual funds,robust Q2 and Q3 corporate results of majorcompanies, upward trend in the international equitymarkets, appreciation of rupee against US dollar, nearnormal monsoon, decline in global crude oil prices,US Federal Reserve’s decision to keep interest ratesunchanged, rise in metal prices on London MetalExchange and other sector and stock specific news.The BSE Sensex reached new all-time high onFebruary 8, 2007 to close at 14652.09. However,between February 9, 2007 and end-March 2007, thekey indices witnessed a downward trend on concernsover rising domestic inflation, nervousness acrossinternational equity markets, reports of crisis in USsub-pr ime mor tgage lending segment, r ise ininternational crude oil prices and net sales by FIIs inthe Indian equity market. The BSE Sensex closed at13072.10 on March 30, 2007, registering an increaseof 1792 points or 15.9 per cent over end-March 2006.During the year 2006-07 on an average basis, itincreased by 48.3 per cent over the previous year.

Table 2.38: Net Resource Mobilisationby Mutual Funds

(Rupees crore)

Category 2004-05 2005-06 2006-07

1 2 3 4

I. UTI Mutual Fund -2,722 3,424 7,326

II. Private Sector 7,599 42,977 79,038

III. Public Sector -2,677 6,379 7,621

Total (I+II+III) 2,200 52,780 93,985

Source : Securities and Exchange Board of India.

Table 2.37: Mobilisation of Resources through the Primary Market*(Amount in Rupees crore)

Item 2004-05 2005-06 2006-07#

No. of Amount No. of Amount No. of AmountIssues Issues Issues

1 2 3 4 5 6 7

A. Public Issues @ 59 21,892 138 26,940 119 32,382(Prospectus and Rights)

I. Public Sector 5 8,410 7 5,786 1 782 II. Private Sector 54 13,482 131 21,154 118 31,600

B. Private Placement 910 83,405 1,112 96,369 1,195 1,03,169 I. Public Sector 193 47,611 168 55,164 84 43,373 II. Private Sector 717 35,794 944 41,205 1,111 59,796

C. Euro Issues@@ 12 2,730 48 11,352 40 17,005

* : Including both debt and equity. # : For ‘Private Placement’, data pertain to April-December.@ : Excluding offer for sale. @@ : Excluding FCCBsNote : Estimates are based on information gathered from arrangers, FIs and SEBI.

51


The BSE 500 and BSE Mid-cap during 2006-07increased by 9.7 per cent and 0.66 per cent,respectively, while the BSE Small-cap declined by1.9 per cent.

2.125 During 2007-08 so far (up to May 21, 2007),the domestic stock markets remained firm withintermittent corrections. Both the BSE Sensex andS&P CNX Nifty closed higher at 14418.60 and4260.90 on May 21, 2007, registering gains of 10.3per cent and 11.5 per cent, respectively, over theirlevel at end-March 2007. Robust Q4 corporate results,strong macroeconomic fundamentals, decline indomestic annual inflation rate, upward trend in majorinternational equity markets, net purchases by FIIsand mutual funds in the Indian equity market, rise inmetal prices on London Metal Exchange and reportsof a normal South-West monsoon forecast by the IndiaMeteorological Department (IMD) aided the marketsentiment.

2.126 The market capitalisation of the BSE surgedto 86.5 per cent of GDP at end-March 2007 from84.7 per cent of GDP at end-March 2006. The totalturnover of BSE and NSE during April-March 2006-07 at Rs.28,99,916 crore recorded an increase of21.6 per cent over the corresponding period of lastyear. The price-earning ratio (P/E) of the BSESensex at 20.33 at end-March 2007 was lower than20.92 at end-March 2006 (Table 2.39). The P/E ratiowas 21.04 as on May 23, 2007. Volatility declinedduring 2006-07.

2.127 An analysis of sectoral trends during 2006-07suggests that buying interest was witnessed in oil and

Table 2.39: Trends in Stock Markets

Item BSE NSE

April-March

2005-06 2006-07 2005-06 2006-07

1 2 3 4 5

1. Average BSE Sensex/S&P CNX Nifty 8280 12277 2513 3572

2. Volatility (Coefficientof Variation) 16.72 11.09 15.60 10.36

3. Turnover(Rs. crore) 8,16,074 9,56,185 15,69,556 19,44,645

4. Market Capitalisation(end-period)(Rs.crore) 30,22,191 35,45,041 28,13,201 33,67,350(Per cent of GDP) 84.7 86.5 78.9 82.1

5. P/E ratio(end-period) 20.92 20.33 20.26 18.40

Source: The Bombay Stock Exchange Limited (BSE) and The NationalStock Exchange of India Limited (NSE).

31-M

ar-0

624-A

pr-

06

12-M

ay-0

631-M

ay-0

619-J

un

-06

05-J

ul-

06

24-J

ul-

06

10-A

ug-

06

30-A

ug-

06

18-S

ep-0

606-O

ct-0

626-O

ct-0

6

14

-Nov

-06

01

-Dec

-06

20

-Dec

-06

10-J

an-0

731-J

an-0

7

20-F

eb-0

709-M

ar-0

7

29-M

ar-0

7

Chart II.17: Trends in Sectoral Stock Indices(Normalised to March 31, 2006=100)

BSE 500 CD CG IT

PSU Bankex FMCG BSE Sensex

gas, IT, banking, capital goods and consumerdurables, while FMCG, healthcare, auto, metal andPSU sector underperformed (Chart II.17). The oil andgas stocks gained primarily on account of rise in globalcrude oil prices. IT stocks capitalised on the risingdemand for IT and IT enabled services abroad coupledwith robust corporate performance of IT companies.Rising demand for credit to meet increasing capacityadditions, undertaking of infrastructure projects andhigh growth in personal loans are mainly responsiblefor boosting banking sector scrips. Capital goodsstocks have risen due to pick up in investment activityand strong industrial and infrastructure performance,reflecting the overall growth in the economy. On theother hand, auto stocks lost on account of rise in steelprices and interest rates, while FMCG stocks suffereddue to lack of demand on account of rise in prices ofconsumer goods.

2.128 According to the SEBI data, investments byFIIs in Indian equities during 2006-07 at Rs.25,236crore were lower than those in 2005-06. However,net investments in debt were at Rs.5,605 crore asagainst net outf lows in the previous year.Investments by mutual funds in equities were lowerat Rs.9,024 crore during 2006-07 than those in thecorresponding period of the previous year. However,investments by mutual funds in debt weresubstantially higher at Rs.52,546 crore in 2006-07than those in 2005-06 (Table 2.40). Net investmentsby FIIs and mutual funds during 2007-08 (up to May22, 2007) aggregated Rs.8,785 crore and Rs.2,704crore, respectively.

52


2.129 The total turnover in the derivatives segmenton NSE during 2006-07 remained significantly higherthan the turnover in the cash segment (Table 2.41).

expansion was more pronounced in respect of theretail sector, par ticularly housing and loans tocommercial real estate. Credit to the priority sectorincreased by 33.7 per cent in 2005-06 as against 40.3per cent in the previous year. The agriculture andhousing sectors were the major beneficiaries, whichtogether accounted for more than two-third ofincremental priority sector lending in 2005-06. Creditto the small scale industries also accelerated. Owingto large credit offtake, the incremental C-D ratioremained generally above 100 per cent during theyear. The growth in deposits (17.8 per cent during2005-06), though higher than the previous year (16.6per cent), was insufficient to meet the high creditdemand forcing the banks to liquidate their holdingsof Government securities.

2.132 Net profits of SCBs, as a group, increased by17.5 per cent as against the decline of 5.9 per cent inthe previous year mainly due to a turnaround in non-interest income (Table 2.42). However, net profit as apercentage of total assets was roughly the same asthat in the previous year. Gross NPAs at 3.3 per centand net NPAs at 1.2 per cent at end-March 2006 weresignificantly lower than those of 5.2 per cent and 2.0per cent, respectively, at end-March 2005. Banks’capital to risk-weighted assets ratio remained moreor less at the previous year’s level (12.3 per cent atend-March 2006 as against 12.8 per cent at end-March 2005), despite sharp increase in r isk-weighted assets, increase in risk weights on lendingto certain sectors and application of capital chargefor market risk.

2.133 Operations of urban co-operative banks(UCBs) witnessed moderate growth during 2005-06facilitated mainly by deposits growth. While loans andadvances and investments witnessed a moderategrowth, non-SLR investments grew significantly. Asharp growth was also noticed in shor t-termdeployment of funds. The financial performance ofscheduled UCBs improved significantly. Asset qualityof UCBs improved markedly, both in absolute termsand relative to the loan portfolio (Table 2.43).

2.134 Till the early 1990s, FIs were funded throughconcessional resources by way of Governmentguaranteed bonds and advances from Long-TermOperations (LTO) Fund of the Reserve Bank.Currently, FIs can raise their total resources, short-term as well as long-term, such that the totaloutstanding of such funds at any point of time doesnot exceed 10 times of their Net Owned Fund (NOF)as per their latest audited balance sheet. Within thisoverall ceiling, an “umbrella limit” has been fixed for

Table 2.41: Turnover in Derivatives Marketvis-à-vis Cash Market in NSE

(Rupees crore)

Year Derivatives Cash

1 2 3

2001-02 1,01,926 5,13,1672002-03 4,39,862 6,17,9892003-04 21,30,610 10,99,5352004-05 25,46,982 11,40,0712005-06 48,24,174 15,69,5562006-07 73,56,242 19,45,285

Source: The National Stock Exchange of India Ltd (NSE).

Table 2.40: Institutional Investmentsin the Stock Market

(Rupees crore)

Year FIIs Mutual Funds

Equity Debt Equity Debt

1 2 3 4 5

2001-02 8,067 685 -3,796 10,9592002-03 2,528 60 -2,067 12,6042003-04 39,959 5,805 1,308 22,7012004-05 44,123 1,759 448 16,9872005-06 48,542 -7,065 14,302 36,801

2006-07 25,236 5,605 9,024 52,546

Source: Securities and Exchange Board of India.

V. BANKS AND FINANCIAL INSTITUTIONS

2.130 Robust macroeconomic performancecontinued to underpin the business operations andfinancial performance of all types of financialinstitutions. The total assets of Scheduled CommercialBanks (SCBs) expanded by 18.4 per cent during2005-06. The ratio of assets of SCBs to GDP at factorcost at current prices increased to 86.9 per cent atend-March 2006 from 82.8 per cent at end-March2005, suggesting a faster growth of the bankingsystem in relation to the real economy. In the backdropof robust growth performance in industrial and servicessectors during 2005-06, bank credit witnessed a strongexpansion for the second year in succession.

2.131 Loans and advances of SCBs registeredrobust growth of 31.8 per cent during 2005-06 on topof the high growth of 33.2 per cent in 2004-05. Thecredit growth was broad-based even as credit

53


Table 2.42: Important Parameters of Select Bank Groups(Per cent)

Bank Group 1996-97 2002-03 2003-04 2004-05 2005-06

1 2 3 4 5 6

Operating Expenses/Total AssetsScheduled Commercial Banks 2.9 2.2 2.2 2.1 2.1Public Sector Banks 2.9 2.3 2.2 2.1 2.1Old Private Sector Banks 2.5 2.1 2.0 2.0 2.1New Private Sector Banks 1.9 2.0 2.0 2.1 2.0Foreign Banks 3.0 2.8 2.8 2.9 2.8

Spread/Total AssetsScheduled Commercial Banks 3.2 2.8 2.9 2.8 2.8Public Sector Banks 3.2 2.9 3.0 2.9 2.9Old Private Sector Banks 2.9 2.5 2.6 2.7 2.7New Private Sector Banks 2.9 1.7 2.0 2.2 2.1Foreign Banks 4.1 3.4 3.6 3.3 3.5

Net Profit/Total AssetsScheduled Commercial Banks 0.7 1.0 1.1 0.9 0.9Public Sector Banks 0.6 1.0 1.1 0.9 0.8Old Private Sector Banks 0.9 1.2 1.2 0.3 0.6New Private Sector Banks 1.7 0.9 0.8 1.1 1.0Foreign Banks 1.2 1.6 1.7 1.3 1.5

Gross NPAs to Gross AdvancesScheduled Commercial Banks 15.7 8.8 7.2 5.2 3.3Public Sector Banks 17.8 9.4 7.8 5.5 3.7Old Private Sector Banks 10.7 8.9 7.6 6.0 4.3New Private Sector Banks 2.6 7.6 5.0 3.6 1.7Foreign Banks 4.3 5.3 4.6 2.8 1.9

Net NPAs to Net AdvancesScheduled Commercial Banks 8.1 4.4 2.9 2.0 1.2Public Sector Banks 9.2 4.5 3.0 2.1 1.3Old Private Sector Banks 6.6 5.5 3.8 2.7 1.6New Private Sector Banks 2.0 4.6 2.4 1.9 0.8Foreign Banks 1.9 1.8 1.5 0.8 0.8

CRARScheduled Commercial Banks 10.4 12.7 12.9 12.8 12.3Public Sector Banks 10.0 12.6 13.2 12.9 12.2Old Private Sector Banks 11.7 12.8 13.7 12.5 11.7New Private Sector Banks 15.3 11.3 10.2 12.1 12.6Foreign Banks .. 15.2 15.0 14.0 13.0

.. : Not Available.

eight institutions, viz., IFCI, EXIM bank, SIDBI, IIBI,TFCI, NABARD, and NHB. In terms of the umbrellalimit, each of these FIs can raise resources throughterm money, CP, CDs, inter-corporate deposits (ICDs)and term deposits, equivalent to 100 per cent of itsNOF as per its latest audited balance sheet.

2.135 The aggregate umbrella limits of these selectFIs for raising resources increased from Rs.16,657crore as on March 31, 2006 to Rs.19,001 crore as onMarch 30, 2007. The aggregate outstanding resourcesraised by these FIs under the umbrella limit increased

from Rs.1,204 crore (7.2 per cent of aggregate limit)as on March 31, 2006 to Rs.3,293 crore (17.33 percent of aggregate limit) as on March 30, 2007. Basedon outstanding position as on March 30, 2007, FIsraised bulk of resources through commercial paper(Rs.2,540 crore), followed by certificate of deposits(Rs.664 crore) and term deposits (Rs.90 crore). FIs,active in mobil ising resources through theseinstruments during 2006-07 have been EXIM Bank,NHB and SIDBI. None of the FIs mobilised resourcesthrough term money or inter-corporate deposit duringthe period.

54


Table 2.44: Financial Institutions –Select Performance Indicators

Indicator 2004-05 2005-06

1 2 3

Balance Sheet Indicators(as percentage total assets)Operating Profits 1.2 1.4Net Profits 0.8 1.0Spread 1.6 1.8

Resource flows(Rupees crore)Sanctions 9,091 11,942Disbursements 6,279 9,237

Note : 1. Data on balance sheet indicators relate to IFCI, IIBI, TFCI,NABARD, NHB, SIDBI and EXIM Bank.

2. Data on resource flows pertain to IFCI, SIDBI and IIBI.

Table 2.43: Urban Co-operative Banks –Select Financial Indicators

Indicator 2004-05 2005-06

1 2 3

Growth in Major Aggregates(Per cent)Deposits -4.7 6.9Credit -1.6 5.2

Financial Indicators@(as percentage of total assets) Operating Profits 0.8 1.1Net Profits 0.2 0.5Spread 1.8 1.9

Gross Non-Performing Assets(as percentage of advances) 23.4 19.7

@ : Relates to Scheduled Urban Co-operative Banks.

2.136 Financial performance of all-India financialinstitutions (AIFIs) improved significantly during2005-06 (Table 2.44). Financial assistance sanctionedand disbursed by FIs, including AIFIs, specialisedfinancial institutions and investment institutions,increased by 38.9 per cent and 33.9 per cent,respectively, during 2005-06 as compared with asharp decline of 45.1 per cent and 37.0 per cent,respectively, during the previous year. Almost allcategories of financial institutions witnessed a highgrowth dur ing 2005-06 as against the var iedperformance witnessed during 2004-05.

2.137 Capital adequacy ratio of FIs, barring the twoloss-making institutions, continued to be significantlyhigher than the prescribed norms. However, CRARof IIBI and IFCI eroded further during the year onaccount of continued financial losses. The higher

Table 2.45: Consolidated Balance Sheets of NBFCs

(Amount in Rupees crore)

Item As at end-March

2004 2005 2006

1 2 3 4

Liabilities

1. Paid up capital 2,327 2,206 1,949 (7.1) (6.1) (5.5)

2. Reserves and Surplus 4,414 4,544 4,838 (13.5) (12.6) (13.6)3. Public Deposits 4,317 3,926 2,667 (13.2) (10.9) (7.5)4. Borrowings 20,852 23,044 23,641 (63.7) (64.0) (66.5)5. Other Liabilities 844 2,283 2,466 (2.6) (6.3) (6.9)

Total Liabilities/Assets 32,754 36,003 35,561

Assets

1. Investments i) SLR Investments 1,707 2,237 1,314

(5.2) (6.2) (3.7)ii) Non-SLR Investments 2,110 1,720 2,275

(6.4) (4.8) (6.4)2. Loans and Advances 12,363 12,749 9,199 (37.7) (35.4) (25.9)3. Hire Purchase Assets 11,649 14,400 19,893 (35.6) (40.0) (55.9)4. Equipment Leasing Assets 3,036 2,025 1,620 (9.3) (5.6) (4.6)5. Bill business 436 471 45 (1.3) (1.3) (0.1)6. Other Assets 1,453 2,401 1,215 (4.4) (6.7) (3.4)

Note : 1. Number of reporting NBFCs declined to 466 in 2006 from703 in 2005.

2. Figures in parentheses are percentages to total liabilities/assets.

lending rates accompanied with reduced costsresulted in higher spread for FIs as the net interestincome as percentage of total assets increased to1.8 per cent in 2005-06 from 1.6 per cent in 2004-05.Non-interest income of FIs also registered asignificant increase during the year.

2.138 Total assets/liabilities of NBFCs (excludingRNBCs), which had increased by 9.9 per cent during2004-05, declined by 1.2 per cent during 2005-06(Table 2.45). Borrowings, which represent a majorsource of funds for NBFCs, increased at a lower rateof 2.6 per cent during 2005-06 as compared with agrowth of 10.5 per cent in the previous year. Whileowned funds (capital and reserves) registered amarginal increase, public deposits declined by 32.1

55


Table 2.46: Profile of Residuary Non-BankingCompanies (RNBCs)

(Rupees crore)

Item As at end-March

2004 2005 2006

1 2 3 4

I. Assets (i to v) 20,362 19,057 21,891(i) Unencumbered approved 5,824 2,037 2,346

securities(ii) Fixed deposits with banks 2,033 4,859 6,070(iii) Bonds or debentures 6,048 9,225 9,577

or commercial papers*(iv) Other investments 2,059 1,639 1,658(v) Other assets 4,398 1,297 2,240

II. Net Owned Funds 1,002 1,065 1,183

III. Total Income (i+ii) 2,055 1,532 1,620(i) Fund Income 2,055 1,530 1,616(ii) Fee Income – 2 3

IV. Total Expenses (i+ii+iii) 1,813 1,396 1,439(i) Financial Cost 1,368 1,176 1,165(ii) Operating Cost 129 146 159(iii) Other cost 316 74 115

V. Provision for Taxation 32 48 22

VI. Operating Profit (PBT) 242 136 180

VII. Net profit (PAT) 210 88 158

* : Of Government companies/public sector banks/public financialinstitutions/corporations.

– : Nil/Negligible.Note : 1. PBT – Profit before tax.

2. PAT – Profit after tax.

per cent during 2005-06. On the asset side, loans andadvances and hire purchase assets togetheraccounted for more than three-fourth of total assets.While loans and advances declined by 27.8 per cent,hire purchase assets increased by 38.1 per centduring 2005-06. Among NBFC groups, while assets/l iabil it ies of hire purchase finance companiesincreased, those of equipment leasing companies,investment and loan companies declined during theyear ended March 2006. This broadly reflected theimpact of resources raised through deposits andborrowings. Hire purchase finance companies werethe largest NBFC group at end-March 2006, followeddistantly by equipment leasing companies, investmentcompanies and loan companies.

2.139 Assets of three RNBCs increased by 14.9 percent during the year ended March 2006. Their assetsin the form of f ixed deposits with banks andunencumbered approved secur it ies increasedsharply, while those in bonds/debentures and otherinvestments increased marginally (Table 2.46). Net

owned funds of RNBCs increased by 11.1 per centduring 2005-06.

2.140 Sustained efforts by the Government, theReserve Bank and by banks themselves have resultedin a competitive, healthy and resilient financial system.The asset quality and soundness parameters of theIndian banking sector, on the whole, are nowcomparable with global levels. This has been achievedin the backdrop of gradual alignment of prudentialnorms with best international standards and in anenvironment of growing competitive pressures.

VI. EXTERNAL SECTOR

Global Economic Outlook

2.141 The global economy continued to expand ata robust pace in 2006. As against the growth rate of4.9 per cent in 2005, the IMF has placed the growthof global economy at 5.4 per cent for 2006 andprojected it to moderate to 4.9 per cent during 2007(Chart II.18). Despite a moderate slowdown in thethird quarter, all the major advanced economiesincluding the US, Japan and OECD countries showeda higher growth in the fourth quarter of 2006 beforedipping in the first quarter of 2007.

2.142 In the US, real GDP growth (year-on-yearbasis) in the fourth quarter of 2006 increased to3.1 per cent from 3.0 per cent in the third quarter(Table 2.47). The acceleration in real GDP growthin the fourth quarter primarily reflected a downturnin imports and acceleration in exports and also

World Advanced Economies

Other Emerging Market and Developing Economies

Chart II.18: World Output Growth

Per

cen

t

P : Projections.

2007

P

2008

P

56


acceleration in private consumption expenditure fornon-durable goods. For the year 2006, as a whole,real GDP growth in the US was marginally higherthan in 2005. The Japanese economy continued torecover in 2006, driven by strong expor ts andsteady domestic demand. In China, GDP growthcontinued to remain robust as both domestic andexternal demand expanded strongly. The rate ofincrease in fixed asset investment remained high,a l though i t s lowed somewhat on account oftightening measures introduced in the mid-2006.

2.143 Growth prospects of global economy remainsubject to certain downside risks. However, the risksto growth outlook are less threatening than wereexpected earlier. Although, overall risk perceptionsabout satisfactory global growth are modest, certainuncertainties and concerns are still raised in termsof revival of inflation pressures as output gapscontinue to narrow, oil price rise, risk of sharperslowdown in US economy in case the housing sectorcontinues to deteriorate, financial market volatility andpossible disorderly adjustment of global imbalances.

2.144 According to the IMF, the world trade volumeincreased by 9.2 per cent in 2006 (7.4 per cent in2005) but its growth is projected to decelerate to 7.0per cent in 2007. Growth in world trade prices ofmanufactures accelerated from 3.4 per cent in 2005to 4.4 per cent in 2006 (Chart II.19). According to theIMF, the private net capital flows to emerging anddeveloping countries recorded a marginal fall from

US$ 257.2 billion in 2005 to US$ 255.8 billion in 2006;capital flows are projected to fall further to US$ 252.7billion in 2007 mainly on account of projected declinein private portfolio flows.

2.145 International financial markets experienced apullback in prices after a brief period of turbulence inMay-June 2006. There has been a significant recoveryof prices across a wide spectrum of assets since end-June. Equity markets have rallied with prices in major

Table 2.47: Country-wise Growth Rates (Year-on-Year basis)(Per cent)

Country/Region 2005 2006-Q1 2006-Q2 2006-Q3 2006-Q4 2006 2007-Q1 2007 P

1 2 3 4 5 6 7 8 9

Advanced EconomiesEuro area 1.4 2.2 2.8 2.8 3.3 2.7 3.1 2.3Japan 1.9 3.0 2.1 1.4 2.2 2.2 2.0 2.3Korea 4.2 6.3 5.1 4.8 4.0 5.0 4.0 4.4OECD 2.5 3.3 3.3 2.9 3.3 3.0 .. 2.5UK 1.9 2.4 2.8 2.9 3.0 2.7 2.8 2.9US 3.2 3.7 3.5 3.0 3.1 3.3 2.1 2.2

Emerging Economies Argentina 9.2 8.6 7.9 8.7 8.6 8.5 .. 7.5Brazil 2.9 3.4 1.2 3.2 3.8 3.7 .. 4.4China 10.4 10.3 10.9 10.7 10.7 10.7 11.1 10.0India 9.2 9.3 8.9 9.2 8.6 9.2 .. 8.4Indonesia 5.7 5.0 5.0 5.9 6.1 5.5 .. 6.0Malaysia 5.2 5.3 6.2 5.8 5.7 5.9 .. 5.5Thailand 4.5 6.1 5.0 4.7 4.2 5.0 .. 4.5

P : IMF Projection. .. Not available.Source : IMF, The Economist, OECD and ECB Bulletin, May 2007.

P : Projections.

Chart II.19: Growth in World Trade Volume and Prices

Per

cen

t

World Trade Volume

World Trade Prices of Manufactures (in US $)

World Trade Prices of Manufactures (in SDRs)

2007

P

2008

P

57


advanced and emerging economies exceeding thecyclical highs reached in May 2006. In most of theemerging economies, financial markets remainedfirm towards the end of 2006. Despite a bout offinancial volatility in February-March 2007 and risingconcerns about the US sub-prime mortgage market,equity markets remain close to all-time highs.Fur thermore, real long term bond yields haveremained below long-term trends, and risks spreadshave narrowed in most markets.

2.146 During 2006, the average petroleum spotprices rose by 20.5 per cent. After reaching a recordhigh of US$ 78.4 a barrel in July 2006, the averagepetroleum spot price fell sharply to around US$ 58–US$ 61 a barrel during October-December 2006which largely reflected some easing of tensions inthe Middle East, improved supply-demand balancein oil markets, and favorable weather conditions inthe second half of 2006. In early 2007, oil priceswitnessed a further brief dip, falling to just over US$50a barrel, before rebounding in late March 2007 toalmost US$65 a barrel. Oil prices recovered with astrengthening of demand due to colder weather,fur ther OPEC production cuts, and declininginventories in key OECD economies. Renewedgeopolitical tensions in the Middle East also pushedprices up at end-March. The International EnergyAgency in its Report released on May 11, 2007, hasplaced the global oil demand at 85.7 million barrelper day (mb/d) for 2007, up from 84.2 mb/d in 2006.

India’s Merchandise Trade

2.147 India’s merchandise trade – both exports andimports – maintained its high growth momentumduring 2005-06. According to DGCI&S, expor tsregistered a growth of 23 per cent in 2005-06compared with 31 per cent in the preceding year. Thegrowth in exports was attributable mainly to thefavourable global demand conditions, increasingcompetitiveness of India’s manufactured products,firming up of commodity prices and suppor tivedomestic policy measures. In 2005, India was one ofthe fastest growing exporting countries in the world(Table 2.48). Merchandise imports also registered agrowth of 29 per cent in 2005-06 on top of 43 percent a year ago due to sharp increase in oil importsin the wake of rise in international crude oil prices.With the imports far outstripping exports, the tradedeficit widened to US $ 40.3 billion in 2005-06 fromUS $ 28.0 billion a year ago.

2.148 Export growth during 2005-06 was broad-based across major product groups. Primary product

Table 2.48: Global Merchandise Export Growth(Per cent)

Country/Region January-December

2005 2006

1 2 3

World 13.9 15.6Industrial Countries 8.5 12.6United States 10.8 14.5Japan 5.2 9.2Germany 7.3 15.1Developing Countries 21.9 19.6China 28.4 27.2India 29.6 21.5Korea 12.0 14.4Indonesia 18.2 16.5Malayasia 12.0 14.0Singapore 15.6 18.4Thailand 14.5 18.7

Sources: 1. International Financial Statistics, IMF.2. DGCI&S for India.

exports recorded a growth of 21 per cent during 2005-06. Manufactured exports maintained the growthmomentum. Export of textiles and textile productsposted an accelerated growth in a quota freeenvironment. Technology intensive items such astransport equipments and machinery and instrumentsalso posted a strong growth. Dur ing 2005-06,petroleum products exports rose sharply by 65 percent and emerged as one of the major export items.

2.149 On the imports front, oil imports surged by 47per cent during 2005-06 (April-March) mainly due toincrease in international crude oil prices. The averagecrude oil price (Indian basket) at US $ 55.3 per barrelwas higher by 42.2 per cent during 2005-06 comparedwith a year ago. In volume terms, the POL importsregistered a lower growth of 4.2 per cent comparedwith 5.5 per cent a year ago.

2.150 Non-oil imports decelerated during 2005-06(April-March) mainly due to deceleration in the importof gold and silver and pearl, precious and semi-precious stones. Imports of ‘mainly’ industrial inputs(non-oil impor ts net of gold and si lver, bulkconsumption goods, manufactured fertilisers andprofessional imports), however, posted a stronggrowth of 34.7 per cent on top of 41.4 per cent a yearago. The growth of capital goods imports (mainlycomprising metals, machine tools, machinery andelectronic goods) at 49.9 per cent during 2005-06(37.5 per cent a year ago) reflected the continuedinvestment demand in an environment of buoyantindustrial activity and capacity building in India’smanufacturing.

58


Table 2.50: India’s Principal Exports

April-March April-March April-January April-January

Item (US $ million) Growth rate (Per cent) (US $ million) Growth rate (Per cent)

2004-05 2005-06 2004-05 2005-06 2005-06 2006-07 2005-06 2006-07

1 2 3 4 5 6 7 8 9

Primary Products 13553 16377 36.9 20.8 12761 14959 29.4 17.2Agricultural & Allied Products 8475 10213 12.5 20.5 8026 9598 22.3 19.6Ores & Minerals 5079 6164 114.4 21.4 4735 5361 43.3 13.2Manufactured Goods 60731 72230 25.2 18.9 58041 67372 22.9 16.1Leather & Manufactures 2422 2691 12.0 11.1 2203 2401 12.1 9.0Chemicals & Related Products 12444 14757 31.7 18.6 11726 13427 20.4 14.5Engineering Goods 17348 21463 39.8 23.7 17175 23468 30.5 36.6Textiles and Textile Products 13555 16350 6.0 20.6 13145 13965 23.0 6.2Gems & Jewellery 13762 15529 30.2 12.8 12593 12850 17.5 2.0Handicrafts 377 458 -24.5 21.3 385 306 22.3 -20.7Carpets 636 848 8.7 33.2 694 742 34.9 6.8Petroleum Products 6989 11526 95.9 64.9 9452 15331 66.8 62.2

Total Exports 83536 103101 30.8 23.4 82396 101846 27.7 23.6

Source: DGCI&S.

Table 2.49: India’s Foreign Trade(US $ million)

Item April-March

2003-04 2004-05 2005-06 2006-07

1 2 3 4 5

Exports 63,843 83,536 103,101 124,598(21.1) (30.8) (23.4) (20.9)

Oil 3,568 6989 11526 ..(38.5) (95.9) (64.9)

Non-Oil 60,274 76,547 91,575 ..(20.2) (27.0) (19.6)

Imports 78,149 111,517 143,430 181,343(27.3) (42.7) (28.6) (26.4)

Oil 20,569 29,844 43,963 57,308(16.6) (45.1) (47.3) (30.4)

Non-Oil 57,580 81,673 99,466 124,035(31.5) (41.8) (21.8) (24.7)

Trade Balance -14,307 -27,981 -40,329 -56,745Oil -17,001 -22,855 -32,437 ..

Non-Oil 2,694 -5,127 -7,892 ..

.. : Not available.Note : Figures in parentheses are year-on-year growth rates.Source: DGCI&S.

2.151 Destination-wise, the US continued to be theprincipal export destination, accounting for 16.8 percent of India’s total exports in 2005-06 (April-March),followed by UAE (8.3 per cent), China (6.6 per cent),Singapore (5.3 per cent) and UK (4.9 per cent).

2.152 Dur ing 2006-07, merchandise expor tsregistered a growth of 20.9 per cent (Table 2.49).Imports posted a growth of 26.4 per cent, with non-oil imports contributing 64.9 per cent of increase inimports. After registering a slowdown at the beginning

of the fiscal year, non-oil imports picked up fromSeptember 2006. Oil imports, on the other hand,moderated due to softening of oil prices.

2.153 Trade deficit during 2006-07 widened to US $56.7 billion from US $ 40.3 billion a year ago. Thenon-oil trade deficit increased by 52.6 per cent to US$ 14.2 billion during April-January 2006-07, while thedeficit on the oil account widened by 23.2 per cent toUS $ 32.3 billion during the same period.

2.154 Commodity-wise data for 2006-07 (April-January) displayed marked dissimilarities in exportperformance (Table 2.50). While engineering goodsand petroleum product posted a high growth, exportgrowth of other major items like primary products,chemicals and related products, textiles and gems andjewellery moderated. Exports of petroleum productsposted a growth of 62.2 per cent in US dollar terms,accounting for 30.2 per cent of the increase in totalexports. Exports of agriculture and allied productsmoderated during April-January 2006-07, even asexpor ts of tea, tobacco, spices and sugar andmolasses posted a high growth. The growth ofmanufactured product exports decelerated to 16.1 percent during the same period from 22.9 per cent a yearago. Among the major items in the manufacturedgoods category, exports of engineering goods (suchas machinery and instruments, manufactures ofmetals, iron and steel and electronics) registered astrong growth, while those of gems and jewellery,chemicals, leather, textiles and handicrafts declinedor decelerated.

59


Table 2.51: Major Destinations of India’s Exports


Country (US $ million) Growth rate (Per cent) (US $ million) Growth rate (Per cent)

2004-05 2005-06 2004-05 2005-06 2005-06 2006-07 2005-06 2006-07

1 2 3 4 5 6 7 8 9

U S A 13766 17353 19.8 26.1 14108 15486 27.2 9.8U A E 7348 8592 43.4 16.9 6847 9873 20.5 44.2U K 3681 5059 21.8 37.4 4164 4547 46.7 9.2Hong Kong 3692 4471 13.2 21.1 3584 3676 25.9 2.6Germany 2826 3586 11.1 26.9 2842 3164 30.4 11.3China 5616 6759 90.0 20.4 5177 6438 45.6 24.3Japan 2128 2481 24.5 16.6 1999 2266 24.9 13.3Belgium 2510 2871 39.0 14.4 2294 2803 17.9 22.2Singapore 4001 5425 88.3 35.6 4382 4766 45.7 8.8Italy 2286 2519 32.2 10.2 1967 2910 12.7 48.0Bangladesh 1631 1664 -6.3 2.0 1354 1310 6.5 -3.2Sri Lanka 1413 2025 7.1 43.3 1648 1712 48.1 3.9France 1681 2080 31.2 23.7 1665 1707 25.5 2.5

Source: DGCI&S.

Table 2.52: India’s Principal Imports


Commodity (US $ million) Growth rate (Per cent) (US $ million) Growth rate (Per cent)

2004-05 2005-06 2004-05 2005-06 2005-06 2006-07 2005-06 2006-07

1 2 3 4 5 6 7 8 9

Petroleum, Petroleum Products &Related Material 29844 43963 45.1 47.3 35647 47609 48.3 33.6Edible Oil 2465 2024 -3.0 -17.9 1627 1798 18.5 10.5Non-Ferrous Metals 1310 1844 38.1 40.8 1519 2142 43.2 41.0Metalliferrous Ores & Metal Scrap 2468 3882 90.5 57.3 3126 6815 61.7 118.0Iron & Steel 2670 4572 77.3 71.3 3844 5046 88.6 31.3Capital Goods 25135 37666 37.5 49.9 25900 34299 39.9 32.4Pearls, Precious &Semi-Precious Stones 9423 9134 32.2 -3.1 8028 5966 10.9 -25.7Textile Yarn, Fabric, etc. 1571 2051 24.9 30.5 1748 1815 37.7 3.8Chemicals, Organic & Inorganic 5700 6984 41.4 22.5 5783 6444 30.0 11.4Gold & Silver 11150 11318 62.6 1.5 9189 12344 2.9 34.3

Total Imports 111517 143430 42.7 33.8 117872 148291 35.1 25.8

Source: DGCI&S.

2.155 During 2006-07 (April-January), exports toUAE posted a growth of 44.2 per cent, thereby raisingits share in total exports to 9.7 per cent. India’s exportsto the US, China, Singapore and the EU decelerated,while those to Eastern Europe and Africa, showed arobust growth (Table 2.51).

2.156 During 2006-07 (April-January), imports ofmainly exports related items, particularly, pearls,precious and semi-precious stones declined, whilethose of gold and silver, capital goods and POLmaintained the growth momentum. Imports of capitalgoods posted a growth of 32.4 per cent during April-

January 2006, reflecting the continued strongdomestic industrial demand (Table 2.52).

Balance of Payments

Current Account

2.157 The sustained rise in invisibles surplus duringthe per iod Apr il-December 2006 continued tomoderate the impact of growing merchandise tradedeficit (Table 2.53 and Chart II.20). Invisible receiptsrose by 29.9 per cent during April-December 2006mainly due to a significant steady growth in software

60


Table 2.53: India’s Current Account(US $ million)

Item April-December

2002-03 2003-04 2004-05 2005-06 PR 2005 PR 2006 P

1 2 3 4 5 6 7

I. Merchandise Balance -10,690 -13,718 -33,702 -51,841 -40,089 -52,302

II. Invisibles Balance (a+b+c) 17,035 27,801 31,232 42,655 28,147 40,481a) Services 3,643 10,144 15,426 23,881 16,416 25,064

i) Travel -29 1,435 1,417 1,389 788 981ii) Transportation -736 879 144 -1,550 -1087 -450iii) Insurance 19 56 148 22 100 365iv) G.N.I.E. 65 28 -10 -197 -107 -97v) Miscellaneous 4,324 7,746 13,727 24,217 16,722 24,265

of which:Software Services 8,863 12,324 16,900 22,262 15,597 20,143

b) Transfers 16,838 22,162 20,785 24,284 16,937 18,943i) Official 451 554 260 182 63 115ii) Private 16,387 21,608 20,525 24,102 16,874 18,828

c) Income -3,446 -4,505 -4,979 -5,510 -5,206 -3,526i) Investment Income -3,544 -3,757 -4,095 -4,921 -4,741 -3,100ii) Compensation of Employees 98 -748 -884 -589 -465 -426

Total Current Account 6,345 14,083 -2,470 -9,186 -11,942 -11,821

G.N.I.E : Government not included elsewhere. P : Provisional. PR : Partially Revised.

Services Transfers Income

Chart II.20: Movement of Invisibles Surplus

2000

Q1

2000

Q3

2001

Q1

2001

Q3

2002

Q1

2002

Q3

2003

Q1

2003

Q3

2004

Q1

2004

Q3

2005

Q1

2005

Q3

2006

Q1

2006

Q3

US

$ m

illio

n

exports, other professional and business services,travel and transportation, besides remittances fromoverseas Indians. Net surplus under software servicesduring April-December 2006 (US $ 20.1 billion)increased by 29.1 per cent over that during April-December 2005. Business services during April-December 2006 at US $ 4.0 billion (US $ 1.5 billion inthe corresponding period of the previous year) were

mainly driven by trade related services, business andmanagement consultancy services, architectural,engineering and other technical services, andservices relating to maintenance of offices. Thesereflect the under lying momentum in trade ofprofessional and technology related services. Privatetransfers (net), comprising primarily remittances fromIndians working overseas, were higher at US $ 18.8billion in April-December 2006 as compared with US$ 16.9 billion in April-December 2005. Investmentincome balance continued to record a deficit aspayments associated with servicing of India’s externalliabilities were in excess of earnings on India’sexternal assets.

2.158 On balance, the net surplus under invisibles(services, transfers and income taken together)increased from US $ 28.1 bill ion during April-December 2005 to US $ 40.5 billion during April-December 2006 (Chart II.21). Due to a higher netinvisibles surplus, current account deficit at US $ 11.8bil l ion remained broadly the same as in thecorresponding period of the previous year (US $ 11.9billion).

Capital Account

2.159 Capital inflows to India have remained largeduring 2006-07 (April-December). The capital inflowsunder FDI, external commercial borrowings, NRI

61


deposits and portfolio investment remained steadyresulting in higher net capital inflows (US $ 27.3 billion)as compared with the previous year (Table 2.54).

2.160 Foreign investment inflows continued to berobust in 2006-07 (April-February). FDI inflows intoIndia (including equity capital of unincorporatedentities, reinvested earnings and inter-corporate debttransactions between the related entities) at US $ 17.1billion during April-February were little less than threetimes of those during the corresponding period of theprevious year (Table 2.55). The pick-up in FDI inflowsreflects growing investor interest in the Indian

Table 2.54: Capital Flows (Net)

(US $ billion)

Item April-March April-December

2004-05 2005-06 2005 2006PR PR P

1 2 3 4 5

Foreign Direct Investment 3.7 4.7 3.3 5.8

Portfolio Investment 9.3 12.5 8.2 5.2

External Assistance 1.9 1.7 1.1 0.9

External CommercialBorrowings 5.2 2.7 -1.2 9.1

NRI Deposits -1.0 2.8 1.1 3.2

Other Banking Capital 4.9 -1.4 0.7 -2.1

Short Term Credits 3.8 1.7 1.7 1.3

Other Capital 0.2 -1.3 -1.5 3.9

Total 28.0 23.4 13.4 27.3

P : Provisional. PR : Partially Revised.

Table 2.55: Foreign Investment Flows by Category

(US $ million)

Item April - February

2004-05 2005-06 P 2005-06 2006-07P

1 2 3 4 5

A. Direct Investment (I+II+III) 6051 7722 5948 171421. Equity (a+b+c+d+e) 3778 5820 4510 15343

a. Government (SIA/FIPB) 1062 1126 1030 2096b. RBI 1258 2233 1559 6737c. NRI – – – –d. Acquisition of Shares* 930 2181 1711 6149e. Equity capital of

Unincorporated bodies # 528 280 210 361

II. Re-invested earnings $ 1904 1676 1257 1730

III. Other Capital $$ 369 226 181 69

B. Portfolio Investment (a+b+c) 9315 12492 11527 9409a. GDRs/ADRs ## 613 2552 2270 3751b. FIIs** 8686 9926 9243 5658c. Offshore Funds and Others 16 14 14 –

C. Total (A+B) 15366 20214 17475 26551

P : Provisional.* : Relates to acquisition of shares of Indian Companies by non-

residents under Section 6 of the FEMA, 1999. Data on suchacquisitions have been included as part of FDI since January 1996.

# : Figures for equity capital of unincorporated bodies for 2005-06 and2006-07 are estimates.

$ : Data for 2005-06 and 2006-07 are estimated as average of previoustwo years.

$$ : Data pertain to inter-company debt transaction of FDI entities.## : Represents the amount raised by Indian Corporates through

Global Depository Receipts (GDRs) and American DepositoryReceipts (ADRs).

** : Represents inflow of funds (net) by Foreign Institutional Investors(FIIs).

Chart II.21: Current Account Balance

US

$ b

illio

n

US

$ b

illio

n

Trade Balance Invisibles Net CAB (Right Scale)

2000

Q1

2000

Q3

2001

Q1

2001

Q3

2002

Q1

2002

Q3

2003

Q1

2003

Q3

2004

Q1

2004

Q3

2005

Q1

2005

Q3

2006

Q1

2006

Q3

economy on the back of strong fundamentals as wellas the impact of pol icy ini t iat ives aimed atrationalising and liberalising the FDI policy andsimplifying the procedures. During 2006, FDI up to100 per cent through Reserve Bank’s automatic routewas permitted for a large number of new sectors,viz., greenfield airport projects, laying of Natural Gas/LNG pipelines, cash and carry wholesale trading,expor t t rading and manufacture of industr ialexplosives and hazardous chemicals. FDI caps underthe automatic route were enhanced to 100 per centfor coal and lignite mining for captive consumptionand setting up infrastructure relating to marketing inpetroleum and natural gas sector. The Governmenthas decided to allow FDI up to 51 per cent, with priorapproval, in retail trade of ‘single brand’ products andenhance the ceiling on FDI in the up-linking of TVchannels, subject to certain conditions. FDI waschannelled mainly into manufacturing, banking,financial, computer and business services and

62


was raised by 25 basis points each in November 2005and April 2006 to LIBOR/SWAP rates of US dollarplus 100 basis points. The ceiling interest rate onFCNR(B) deposits was also raised by 25 basis pointsto ‘‘LIBOR/SWAP rates for the respective currency/maturity’’ in March 2006 from ‘‘LIBOR/SWAP ratesminus 25 basis points’’. Subsequently, in the ThirdQuar ter Review of Annual Policy for 2006-07announced on January 31, 2007, the interest rate ceilingson NR(E)RA & FCNR(B) deposits were reduced by 50basis points and 25 basis points, respectively.

2.164 FDI by Indian corporates abroad has assumedincreasing significance in recent years. Indianinvestments overseas, investments in joint ventures(JV) and wholly owned subsidiaries (WOS) abroadhave emerged as important avenues for promotingglobal business by Indian entrepreneurs, besides asource of increased exports of plants and machineryand goods from India. Joint ventures are perceived

Table 2.56: Inflows under NRI Deposit Schemes

(US $ in Millions)

Scheme April -March April-February

2004-05 2005-06 2005-06 2006-07P

1 2 3 4 5

FCNR (B) 492 1,612 1,219 1,804

NR (E) RA 84 1,177 807 1,744

Total 576 2,789 2,026 3,548

P: Provisional.

Ap

ril

2005

May

200

5J

un

e 2005

Ju

ly 2

005

Au

gust

2005

Sep

tem

ber

2005

Oct

ober

2005

Nov

embe

r 20

05D

ecem

ber

2005

Jan

uar

y 2006

Febru

ary

2006

Mar

ch 2

006

Ap

ril

2006

May

200

6J

un

e 2006

Ju

ly 2

006

Au

gust

2006

Sep

tem

ber

2006

Oct

ober

2006

Nov

embe

r 20

06D

ecem

ber

2006

Jan

uar

y 2007

Febru

ary

2007

Chart II.23: NRI Deposits – Outstanding

US

$ m

illio

n

FCNR (B) NR(E)RA

Ap

ril

May

Ju

ne

Ju

ly

Au

gust

Sep

tem

ber

Oct

ober

Nov

emb

er

Dec

emb

er

Jan

uar

y

Feb

ruar

y

Mar

ch

Chart II.22: Net Inflows/Outflows by ForeignInstitutional Investors

US

$ m

illio

n

construction. Mauritius, the US and United Kingdomremain the dominant sources of FDI into India.

2.161 Net inflows by foreign institutional investors(FIIs) turned negative during May-July 2006 againstthe backdrop of weakness in domestic equity marketsin consonance with the trends in international markets.Between August 2006 and November 2006, however,FIIs made large purchases in the Indian stock markets(Chart II.22). During December 2006, FIIs flows againturned negative in the backdrop of volatility in Asianequity markets subsequent to the tightening of capitalcontrols by Thailand. After witnessing inflows betweenmid-January 2007 and third week of February 2007,FII flows turned negative in the last week of February2007 due to sharp fall in Asian equity markets onaccount of concerns of a slowdown in the USeconomy.

2.162 Net cumulative FII inflows during 2006-07amounted to US $ 3.2 billion (US $ 9.9 billion duringprevious year). Number of FIIs registered with theSEBI increased to 996 at end-March 2007 (882 at end-March 2006). Resources mobilised through issuanceof ADRs/GDRs abroad during April-February 2006-07remained higher than their levels during correspondingperiod of the previous year (Table 2.55).

2.163 Inflows under NRI deposits during April-February 2006-07 amounted to US $ 3.5 billion ascompared with US $ 2.0 bil l ion dur ing thecorresponding period of previous year, partly reflectingthe impact of higher interest rates (Table 2.56 andChart II.23). The ceiling interest rate on NRE deposits

63


Table 2.57: Components of External Debt

Item At the end-of Variation over

March December the period

06 06

(Amount in (US $ (PerUS $ million) million) cent)

1 2 3 4 5

1. Multilateral 32,559 34,569 2,010 6.2(25.8) (24.2)

2. Bilateral 15,727 15,770 43 0.3(12.4) (11.1)

3. IMF 0 0 0 0.04. Trade Credit

a. Above 1 year 5,398 5,957 559 10.4(4.3) (4.2)

b. Up to 1 year* 8,696 10,015 1,319 15.2(6.9) (7.0)

5. Commercial 26,869 35,980 9,111 33.9Borrowings (21.2) (25.2)

6. NRI Deposits 35,134 38,382 3,248 9.2(long- term) (27.8) (26.9)

7. Rupee Debt 2,031 1,983 -48 -2.3(1.6) (1.4)

8. Total Debt 1,26,414 1,42,656 16,242 12.8(100.0) (100.0)

Memo Items:A. Long-Term Debt 1,17,718 1,32,641 14,923 12.7

(93.1) (93.0)B. Short-Term Debt 8,696 10,015 1,319 15.2

(6.9) (7.0)

* : Supplier’s credits of up to 180 days are not included.Note : Figures in parenthesis indicate percentage share in the total debt.Source : Reserve Bank of India and Ministry of Finance, GoI.

Ap

ril

May

Ju

ne

Ju

ly

Au

gust

Sep

tem

ber

Oct

ober

Nov

emb

er

Dec

emb

er

Jan

uar

y

Feb

ruar

y

Mar

ch

Chart II.24: Accretion to Foreign Exchange Reserves

US

$ m

illio

n

as a medium of economic cooperation between Indiaand other countries. Further, transfer of technologyand skill, sharing of results of R&D, access to widerglobal markets, promotion of brand image, generationof employment and utilisation of raw materialsavailable in India and in the host country are thesignificant benefits of such overseas investments.Overseas investments by Indian companies, initiatedwith the acquisition of foreign companies in the ITand related services sector, have now spread to otherareas, particularly pharmaceuticals and petroleum.India’s direct investment abroad continued to showmomentum in Apr il-December 2006 as Indiancompanies continued their overseas acquisitions. Reflecting this, overseas investment undertaken bythe Indian companies rose to US $ 8.7 billion in April-December 2006 from US $ 1.9 bi l l ion in thecorresponding period of last year.

Foreign Exchange Reserves

2.165 India’s foreign exchange reserves comprisingforeign currency assets, gold, Special DrawingRights (SDRs) and Reserve Tranche Position (RTP)in the Fund reached US $ 199.18 billion as on March30, 2007 (Chart II.24). During the first three quartersof 2006-07, net capital inflows more than financedthe current account deficit. Overall, the foreignexchange reserves in 2006-07 increased by US $47.6 billion as compared with an increase of US $10.1 billion in 2005-06. India’s foreign exchangereserves increased further to US $ 204.0 billion ason May 18, 2007.

India’s External Debt

2.166 India’s total external debt at US $ 142.7 billionat the end of December 2006 recorded an increaseof US $ 16.2 billion over the end-March 2006 level(Table 2.57). The rise in external debt outstandingat end-December 2006 was essentially broughtabout by a rise in external commercial borrowings,NRI deposits and shor t- term credit . Highercommercial borrowings and short-term credits couldbe attributed to increased investment and importdemand, while the rise in NRI deposits was onaccount of upward revision in interest rates on thesedeposits. The US dollar continued to dominate thecurrency composition of India’s external debt at end-December 2006 (Chart II.25).

2.167 External debt sustainability indicators haveexhibited continued improvement. The proportion ofshort-term debt in total debt and the ratio of short-term debt to foreign exchange reserves remainedalmost unchanged between end-March 2006 and end-December 2006. The share of concessional debt intotal external debt declined to 28.3 per cent at end-

64


January 2007, have firmed up again in recent months.The industr ial sector remained buoyant withindustrial production growth rate accelerating todouble digit. The manufacturing sector growth, whichtouched a ten-year high, continued to be the keydriver of industrial activity. The strength of theindustrial sector has been underpinned by strongdomestic and expor t demand and comfor tablefinancing conditions as was evident from the highcredit growth and large resources raised by thecorporates from the domestic and internationalcapital markets. High growth in capital goods sectorand large impor t of capital goods point to thestrengthening of investment demand. Businessconfidence surveys conducted by the Reserve Bankand other agencies suggest an optimistic outlook interms of overall economic conditions and investmentclimate. The services sector continued to be the mainengine of the overall growth process. The leadindicators suggest continued robust prospects forgrowth in services. GDP growth for 2006-07, whichwas projected by the Reserve Bank in the range of7.5-8.0 per cent in the Annual Policy Statement inApril 2006, was placed at around 8.5 to 9.0 per centin the Third Quarter Review in January 2007. TheAdvance Estimates by the CSO place the growth at9.2 per cent for 2006-07. The Reserve Bank in itsAnnual Policy Statement for 2007-08 has placed thereal GDP growth for 2007-08 at around 8.5 per cent.

2.169 All the key deficit indicators, viz., gross fiscaldeficit, revenue deficit and primary deficit, as ratiosto GDP, in the revised estimates of the CentralGovernment for 2006-07 were placed lower than thebudgeted targets. This was mainly on account ofbuoyant revenue receipts, both tax and non-tax, whichmore than offset the increased expenditures emergingparticularly in respect of non-Plan components. Thebudget estimates for 2007-08 project a fur therreduction in all the key deficit indicators based oncontinued improvement in tax revenues andcontainment of subsidies. The capital outlays, on theother hand, are budgeted to increase in 2007-08 asagainst a decline recorded in 2006-07. The UnionBudget 2007-08 proposes to continue with thestrategy of sound tax system, with moderate rates,broad tax base with fewer exemptions, andcontainment of non-developmental expenditure, whileproviding for adequate investment in social andphysical infrastructure.

2.170 Inflation movements in 2006-07 were drivenlargely by primary food articles prices and somemanufactured items. The impact of mineral oils, which

Table 2.58: Debt Indicators(in per cent)

Indicators End- End-March 06 December 06

1 2 3

Short-term/Total debt 6.9 7.0Short-term debt/Reserves 5.7 5.7Concessional debt/Total debt 31.2 28.3Reserves/Total debt 120.0 124.3

Source: Reserve Bank of India and Ministry of Finance, GoI.

December 2006 from 31.2 per cent at end-March2006, reflecting a gradual surge in non-concessionalprivate debt in India’s external debt stock. India’sforeign exchange reserves exceeded the external debtby US $ 34.6 billion providing a cover of 124.3 percent to the external debt stock at end-December 2006(Table 2.58).

Others0.4%

Chart II.25: Currency Composition of External Debt –End-December 2006

SDR14.1%

Indian Rupee19.3%

US Dollar46.3%

Japanese Yen12.4%

Euro4.6%

Pound Sterling2.9%

VII. OVERALL ASSESSMENT

2.168 Developments during 2006-07 indicate thatthe Indian economy has been able to maintain thestrong momentum witnessed in the recent past.Domestic and external developments, on the whole,remained conducive to growth. Notwithstandinguneven spatial distribution and initial deficiency, theoverall performance of the South-West monsoon2006 turned out to be close to normal. Oil prices,which eased significantly between August 2006 and

65


was the major driver of inflation over the past twoyears, petered out by early September 2006 onaccount of easing of oil prices and the base effect.The pass-through of higher international oil prices hasbeen restricted to petrol and diesel. The CPI inflationhas remained higher than WPI inflation mainly due toincrease in food prices as well as the higher weightof food items in the CPI. Consistent with the objectiveof price stability, the Reserve Bank continued with itspolicy of active demand management of liquiditythrough judicious and flexible mix of instruments(OMOs, MSS and CRR) to anchor the inflationaryexpectations. Accordingly, it raised the repo rate by50 basis points and the cash reserve ratio by 150basis points in phases with effect from the fortnightbeginning December 23, 2006. In the Annual PolicyStatement for 2007-08, the Reserve Bank indicatedthat its policy endeavour would be to contain inflationclose to 5.0 per cent in 2007-08.

2.171 Financial market conditions remained orderlyduring 2006-07, barring a few episodes of volatility.Short term money market rates remained generallywithin the corridor of reverse repo and repo rate tillmid-December 2006. However, call rates shot upoccasionally thereafter due to swings in liquidityconditions arising from large changes in governmentcash balances and volatile forex flows, as alsoshortage of collaterals faced by some participants,at a time when monetary policy was in tighteningmode. Similarly, yields in the government securitiesmarket also hardened. The equity market turnedvolati le dur ing May-June 2006 due to sel l ingpressure by FIIs in the wake of hardening of interestrates in international markets, concerns over risingdomestic inflation and the nervousness acrossinternational equity markets. However, stock marketshave remained generally stable thereafter, barringsome occasions in February-March 2007 whenequity markets turned volat i le in l ine withinternational markets.

2.172 Operations of banks and other financialinstitutions continued to expand during 2005-06. Thiswas accompanied by improvement in asset quality.Gross and net NPAs are now below 3 per cent and 2per cent, respectively.

2.173 India’s balance of payments position remainedcomfortable. The sustained rise in invisibles surplusduring April-December 2006 helped in financing thegrowing merchandise trade deficit. Travel earnings,business and professional services, software servicesand remittances, invisible receipts in particular, rosesharply. India continued to attract large capital inflows,

both portfolio and FDI. FIIs made large net investments,albeit somewhat lower than last year. Gross FDI inflowsinto India during 2006-07 (April-February) were littleless than three times those in the previous year. Thepick-up in FDI inflows reflects growing investor interestin the Indian economy on the back of strongfundamentals as well as the impact of policy initiativesaimed at rationalising and liberalising the FDI policyand simplifying the procedures.

2.174 India’s comfortable BOP position was alsoreflected in the foreign exchange reserves, which inthe financial year 2006-07 increased by US $ 47.6billion. The external debt sustainability indicators haveimproved further.

2.175 The global economy continued to expand at arobust pace in 2006, notwithstanding somemoderation in the growth momentum in recentquarters. Growth prospects of the global economy,however, remain subject to certain downside risks. Inaddition to the uncertainties regarding the adjustmentin the persisting global imbalances, other major risksinclude the underlying inflationary pressures onaccount of limited spare capacity, emerging wagepressures, notably in the US and possibility of rise incrude oil prices, weakness in the US housing marketand concerns relating to overcomplacency of thefinancial markets about global risks.

2.176 Against this backdrop, barring the emergenceof any adverse and unexpected developments invarious sectors of the economy and keeping in viewthe current assessment of the economy, includingthe outlook for inflation, the Annual Policy Statementfor 2007-08 observed that the step-up in the overallgrowth momentum in the economy during 2006-07occurred in an environment of increasing strengthand dynamism, backed by r ising business andconsumer confidence and increasing internationalinterest. The growth momentum was driven by anincrease in the investment rate, improvement incapital use in both the manufactur ing and theservices sectors and stronger linkages with theglobal economy. While structural changes are takingplace in the economy, the upsurge of demandpressures may contain a cyclical component in thepresence of upside pressures on aggregate demand,support from encouraging global GDP growth, steadyincrease in prices of manufactures, resurgence ofpricing power among corporates, indications of wagepressures in some sectors, strained capacityutilisation and elevated asset prices. The optimismgenerated by robust macroeconomic performanceneeds to be assessed against the evolving

66


configuration of r isks in terms of substantialdeceleration of agriculture, presence of supplyconstraints in agriculture and physical infrastructuregaps, the firming up of inflation due to supplyconstrains, emerging strains on capacity andelevated asset prices. The sustained momentum ofgrowth in the industrial and service sectors issomewhat clouded by supply pressures fromdeceleration in agriculture and large gaps in thephysical infrastructure. There are indications that thepace of growth will continue to be supported bysteady increases in the rate of gross domestic savingand some improvement in the efficiency of capitaluse while recognising that international trade cannot,by its nature, fully mitigate all supply side issuesamong all sectors. The initial effects of the expansionin demand would be ref lected in inf lat ionarypressures and risks to macroeconomic and financialstability which have been in evidence in the form ofsustained demand for capital goods and consumerdurables, high rates of money and credit, indicationsof wage pressures in some sectors, rising input costsand the emergence of pricing power of the corporatesector. The overarching policy challenge is tomanage the transition to a higher growth path whilecontaining inflationary pressures.

2.177 The stance of monetary policy in 2007-08would be conditioned by the patterns in which theglobal and, more par t icular ly, the domesticenvironment unfold. The l ikely evolution ofmacroeconomic and financial conditions indicate anenvironment supportive of sustaining the currentgrowth momentum in India. It is important to reiteratethat monetary policy, while contributing to growth, hasto ensure and maintain price and financial stability.The policy preference for the period ahead is stronglyin favour of reinforcing the emphasis on price stabilityand anchoring inflation expectations. Accordingly, theoverall stance of monetary policy will continue to be:(i) to reinforce the emphasis on price stability and well-anchored inflation expectations while ensuring amonetary and interest rate environment that supportsexport and investment demand in the economy so asto enable continuation of the growth momentum; (ii)to re-emphasise credit quality and orderly conditionsin financial markets for securing macroeconomic and,in particular, financial stability while simultaneouslypursuing greater credit penetration and financialinclusion; (iii) to respond swiftly with all possiblemeasures as appropriate to the evolving global anddomestic situation impinging on inflation expectationsand the growth momentum.

3.1 The money market is a key component of thefinancial system as it is the fulcrum of monetaryoperations conducted by the central bank in itspursuit of monetary policy objectives. It is a marketfor short-term funds with maturity ranging fromovernight to one year and includes f inancialinstruments that are deemed to be close substitutesof money. The money market performs three broadfunct ions. One, i t provides an equi l ibrat ingmechanism for demand and supply of short-termfunds. Two, it enables borrowers and lenders of short-term funds to fulfil their borrowing and investmentrequirements at an efficient market clearing price.Three, it provides an avenue for central bankintervention in influencing both quantum and cost ofliquidity in the financial system, thereby transmittingmonetary policy impulses to the real economy. Theobjective of monetary management by the centralbank is to align money market rates with the keypolicy rate. As excessive money market volatilitycould deliver confusing signals about the stance ofmonetary policy, it is critical to ensure orderly marketbehaviour, from the point of view of both monetaryand financial stability. Thus, efficient functioning ofthe money market is important for the effectivenessof monetary policy.

3.2 In order to meet these basic functionsefficiently, money markets have evolved over timespawning new instruments and participants withvarying risk profiles in line with the changes in theoperating procedures of monetary policy. Changes infinancial market structures, macroeconomicobjectives and economic environment have called forshifts in monetary regimes, which, in turn, havenecessitated refinements both in the operatinginstruments and procedures, and in institutionalarrangements by central banks.

3.3 Internationally, following the breakdown ofthe Bretton Woods system, there was a shift fromrule-based frameworks towards discretion in the useof monetary policy instruments, which ultimately ledto the gradual abandonment of exchange ratetargets. Changes in financial structures and financialinnovations also rendered monetary targetingineffective by making the money demand functionsunstable. Accordingly, since the early 1990s, there

has been a shift towards greater exchange rateflexibility and adoption of inflation targeting by somecentral banks partly because of increased capitalmobility, greater financial market integration andrepeated episodes of currency crises. Commensuratewith these changes, central banks have moved awayfrom conventional (direct) instruments of monetarycontrol (working through the quantum channel)towards more use of indirect instruments (operatingthrough the price channel). Accordingly, the use ofreserve requirements and direct credit controls hasbeen gradually de-emphasised, while relying moreon interest rates for signalling the monetary policystance. As central banks have only limited controlover long-term interest rates, the most commonlyadopted strategy has been to exert direct influenceonly on short-term interest rates and permittingmarket expectations to influence long-term interestrates through financial market inter-linkages. Thus,the choice of monetary policy instruments is guidedby the structure of the money market.

3.4 In India, although the ultimate goals ofmonetary policy, viz., growth and price stability, haveremained unchanged over the years, the ReserveBank has modified its operational and intermediateobjectives of monetary policy several times inresponse to changes in the economic and financialenvironment. For instance, in the mid-1980s, theReserve Bank formally adopted monetary targetingwith feedback as a nominal anchor to fight inflation,partly induced by the large scale monetisation of fiscaldeficits. The operating procedure in this regime wasmodulation of bank reserves by varying reserverequirements. In order to meet reserve requirements,banks borrowed primarily from the inter-bank (callmoney) market. Hence, these transactions werereflective of the overall liquidity in the system.Accordingly, the Reserve Bank focussed on the moneymarket, in particular, the call money market by usingvarious direct instruments of monetary control tosignal the policy stance consistent with the overallobjectives of achieving growth and price stability. Asinterest rates were regulated, monetary managementwas undertaken mainly through changes in the cashreserve ratio (CRR), which was used to influenceindirectly the marginal cost of borrowing by havingan initial impact on the call money market. As the

MONEY MARKETIII

68


success of this strategy was crucially dependent onthe stability of the call money market and its inter-linkages with other money market segments, reformssince the late 1980s, along with changes in thereserve maintenance procedures, have aimed atdeveloping various money market segments throughintroduction of new instruments, increasedparticipation and improved liquidity management inthe system.

3.5 Financial sector reforms since the early1990s have provided a strong impetus to thedevelopment of financial markets, which, along withinterest rate deregulation, paved the way forintroduction of market-based monetary policyinstruments. With financial innovations, moneydemand was seen as less stable and thedisequilibrium in money markets got reflected inshort-term interest rates (Mohan, 2006). Accordingly,since the adoption of the multiple indicator approachin 1998, although monetary aggregates continue tobe an important information variable, interest rateshave emerged as the operational instrument of policy– initially the Bank Rate and then the repo/reverserepo rates under the liquidity adjustment facility(LAF) from June 2000. This shift in emphasis frommoney to interest rates has been spurred byincreased financial liberalisation, greater tradeopenness and capital flows, and innovations inpayment and transactions technologies. Such a shiftwas gradual and a logical outcome of measuresimplemented in the reform period since the early1990s (Reddy, 2002). An array of new money marketinstruments such as commercial paper, certificatesof deposit and repos has been introduced in orderto broaden the money market. Furthermore, withincreased sophistication of financial markets, the riskprof i les of f inancial market par t ic ipants alsochanged, necessitating introduction of derivativeinstruments as effective risk management tools.

3.6 The liberalisation of capital controls resultingin increased integration of the Indian economy withthe global economy, however, posed new challengesand dilemmas for monetary and exchange ratemanagement in the 1990s. These developmentscalled for a greater emphasis on orderly conditionsin financial markets for ensuring financial stability.In this phase, the focus of reforms was on introducinginstruments of various maturities in different moneymarket segments and imparting liquidity to theseinstruments by developing a secondary market, and

streamlining the money market operations. Thisresulted in greater control over the liquidity in thesystem and created an efficient mechanism totransmit interest rate signals. Thus, changes in themonetary policy operating procedures necessitatedrefinements in money market microstructure throughintroduction of new instruments and widening ofpar ticipation under a deregulated interest rateenvironment.

3.7 The need for developed and well-integratedmoney market also assumes critical importance asIndia progressively moves towards greater capitalaccount convertibility, as envisaged by the Committeeon Fuller Capital Account Convertibility (FCAC), whichsubmitted its report to the Reserve Bank in July 2006.Better response to such financial flows by variousmarket segments will depend upon the extent ofintegration as well as the development of necessaryinfrastructure. The greater integration of domestic andinternational markets also calls for flexible use ofmonetary policy instruments for modulating domesticliquidity conditions and correcting any seriousmisalignments between short-term and long-terminterest rates.

3.8 Against the above backdrop, this chaptertraces the evolution of monetary policy operatingprocedures in India as necessitated by the changesin the financial market structure, in particular, themoney market, and the risks/challenges arising outof such market orientation of monetary policy.Section I spells out the theoretical underpinnings ofmoney market for monetary pol icy making.International experience on money market operatingprocedures, the evolving practices in l iquiditymanagement operations and the structure of moneymarket are set out in Section II. Section III presentsa brief review of the money market in India in thepre-reform period. Section IV deals with the changesin the Reserve Bank’s l iquidi ty managementoperations commensurate with the shifts in operatingprocedures. Developments in various segments ofthe money market since the mid-1980s are coveredin Section V. It also discusses the Reserve Bank’sproactive role in mitigating various risks to thefinancial system. Section VI identifies the emergingissues in monetary and liquidity management in Indiaand the need for addressing them in future for thesmooth functioning of the money market and theefficient conduct of monetary policy. Section VIIpresents the concluding observations.

69

MONEY MARKET

I. ROLE OF THE MONEY MARKET -THEORETICAL UNDERPINNINGS

3.9 There is a general consensus amongacademics and central bankers that monetary policyis best geared to achieve price stability. In somecountries, central banks have additional mandatessuch as ensuring full employment, maximising growthand promoting financial stability. In order to meet theseobjectives, central banks intervene in financialmarkets to ensure that short-term interest rates (andexchange rates) and liquidity are maintained atappropriate levels, consistent with the objectives ofmonetary policy. Thus, monetary policy and financialmarkets are linked intrinsically. It is through thefinancial markets that monetary policy affects the realeconomy. Hence, financial markets are the connectinglink in the transmission mechanism between monetarypolicy and the real economy.

3.10 The relationship between monetary policy andfinancial markets is of mutual inter-dependence.Central banks conduct monetary policy by directly andindirectly influencing financial market prices. Financialmarket prices reflect the expectations of marketparticipants about future economic developments.These expectations, in turn, provide valuableinformation to central banks in setting the optimalcourse of monetary policy in the future.

3.11 Monetary policy affects financial marketsthrough various financial price and quantity channels.The transmission process from monetary policy tofinancial markets and finally to the real economy istypically triggered through the use of monetary policyinstruments (reserve requirements, open marketoperations, policy rates and refinance facilities) forcontrolling the operating targets (like reserve moneyand bank reserves) consistent with intermediatetargets such as money supply, which enablesattainment of final objectives of economic growth andpr ice stabil i ty. Typical ly, the monetary pol icyinstrument is a financial market price, which isdirectly set or closely controlled by the central bank.For most central banks with floating exchange rates,the monetary policy instrument is a short-terminterest rate. Changes in the short-term policy rateprovide signals to financial markets, whereby varioussegments of the f inancial system respond byadjusting their rates of return on various instruments,depending on their sensitivity and the efficacy of thetransmission mechanism. Under fixed exchange rateregimes, a particular exchange rate serves as theinstrument. Similarly, under the monetary targetingregime, the operating target is the quantity of central

bank money in the banking system, which isdetermined by the supply of bank reserves. If allfactors having an impact on output and inflation werecompletely known in advance, it would make nodifference whether the central bank conducts policyby fixing the supply of reserves or by setting aninterest rate (Friedman, 2000b). In fact, thesealternative operating strategies would be similar inimpact. However, since many factors that impact thecentral bank’s policy priorities are unpredictable, thechoice of the operating instrument matters for theeffectiveness of monetary policy.

3.12 The theoretical justification for the conduct ofmonetary policy through interest rates is derived from“the appropriate choice of instrument problem” (Poole,1970). It was demonstrated that if aggregate demandshocks in the economy originate from the goodsmarket (the IS curve), then the optimum policy is totarget monetary aggregates for minimising outputfluctuations. On the other hand, if demand shocksoriginate in the money market (the LM curve), fromthe perspective of monetary policy, targeting interestrates is the appropriate approach. The implicationbeing that as f inancial markets develop withincreasing financial innovations, the demand formoney becomes unstable, rendering monetarytargeting redundant. In other words, with the gradualf inancial sophistication of the economy, thespeculative demand for money dominates thetransaction motive. Hence, most developed countriesoperate through an interest rate target.

3.13 The interest rate channel is the primarymechanism of monetary policy transmission inconventional macroeconomic models where anincrease in nominal interest rates, given some degreeof price stickiness, translates into an increase in thereal rate of interest and the user cost of capital(Exhibit III.1) . These changes, in turn, lead to apostponement in consumption or a reduction ininvestment spending thereby affecting the working ofthe real sector, viz., changing aggregate demand andsupply, and eventually growth and inflation in theeconomy (Kuttner and Mosser, 2002). This is themechanism embodied in conventional specificationsof the “IS” curve, both of the “Old Keynesian” variety(Samuelson and Solow, 1960) and the “New Keynesian”models developed during the 1990s (Rotemberg andWoodford, 1997; Clarida, Gali, and Gertler, 1999).However, the macroeconomic response to policy-induced interest rate changes is considerably largerthan that implied by conventional estimates of theinterest elasticities of consumption and investment

70


(Bernanke and Gertler, 1995). This suggests thatmechanisms, other than the interest rate channel, mayalso be at work in the transmission of monetary policy1 .

3.14 Interest rates can influence the monetarypolicymaking process in three dist inct ways(Friedman, 2000a). The first role of interest rates isas an instrument variable that the central bank setsin order to implement its chosen policy. A secondpotential role for interest rates in the monetary policyprocess is again as an instrument variable, but as aninstrument that the central bank varies not forinfluencing output and inflation directly but rather fortargeting the money stock. Finally, most central banksuse short-term interest rate as their monetary policyinstrument variable based on long-term interest ratemovements, which are taken as more of aninformation var iable about potential futuredevelopments. Implicit in this framework, however, isa regular term structure of interest rates wherebypolicy initiatives at the short end are transmittedefficiently to the longer end of the maturity spectrum.This relationship fares better under the assumptionof adaptive expectations (Chow, 1989), while recentempirical evidence suggests that long-term rates arepoor (and biased) predictors of future short-termrates, particularly when expectations are rational(Blinder, 2006).

3.15 Short-term interest rates alone have onlylimited direct effects on the economy. Long-terminterest rates have a stronger impact as theydetermine savings and investment decisions in theeconomy. In order to impact the economy, monetarypolicy impulses must, therefore, be transmitted fromthe money market to the capital market by influencingasset prices such as loan rates, bond rates, exchangerates and stock market valuations. The money marketand the capital market are linked by expectations.Neglecting transaction costs and risk premiums, theexpectations theory of the term structure views thelong-term interest rate as an average of the short-term interest rates expected to prevail till the maturityof the respective instrument. Although current short-term interest rates have some effect on longer-termbond yields, the expectations theory of the termstructure indicates that it is primarily expected futureshort-term interest rates which determine bond yields.In practice, owing to uncertainty about the futureevolution of short-term interest rates and the time-varying risk premiums, the longer the maturity, theweaker the link between current short-term rates andlong-term rates. Therefore, in practice, central bankssometimes find it difficult to guide longer-term interestrates to a level commensurate with what they considerto be the optimal monetary policy stance.

1 The changes in the policy rate, by inducing international interest rate differentials, also have a bearing on exchange rate movements through theuncovered interest rate parity condition.

Source: Adapted from Kuttner and Mosser (2002).

Exhibit III.1: Monetary Policy Transmission through Interest Rate Channel

Monetary Policy Operations (OMO, Reserve Requirements, Refinance)

Change in Reserves

Short-term Interest Rate Monetary Base

Money Supply

Market Interest Rate

Real Interest Rate

Interest Rate Channel

Aggregate Demand

71

MONEY MARKET

3.16 Central banks, nevertheless, operate onshort-term policy rates, which under a regular term-structure and a smooth market continuum would beable to influence long-term interest rates. In order toefficiently transmit monetary policy signals to long-term rates, central banks foster development of themoney market. The money market, thus, serves asthe corner-stone of a competitive and efficient systemof market-based intervention by the central bank. Itstimulates an active secondary bond market byreducing the liquidity risk of bonds and other short-term financial instruments and assists financialintermediaries in managing their liquidity risk. It alsoserves as the medium for Government cashmanagement and provides the first l ink in theimplementation of monetary policy. There are threeconditions which are required to be fulfilled fordeveloping a well-functioning money market. Theseare: (i) banks and other financial institutions must becommercially motivated to respond to incentives,actively manage risk and maximise profit; (ii) thecentral bank must shift from direct to indirect methodsof implementing monetary policy; and (ii i) theGovernment must have a good mechanism of cashmanagement, thereby giving the central bank greaterfreedom in setting its operating procedures.

3.17 The central bank’s operating proceduresgreatly influence the stability of the money market aswell as banks’ incentives to actively use the moneymarket to manage risk. In this regard, operatingprocedures need to be designed appropriately topromote market liquidity, stability and encourageactive risk management. The operating proceduresthat particularly influence banks’ risk managementincentives are the reserve maintenance period, thedefinition of liabilities on which reserves are levied,accommodation policy and the accuracy of operationsdesigned to affect market liquidity - that is, theaccuracy with which the central bank can control thedemand for excess reserves in the system.

3.18 Development of liquidity in the inter-bankmarket - the market for short-term lending/borrowingamongst banks - provides the basis for growth andincreased liquidity in the broader money market,including secondary market for Treasury Bills andprivate sector money market instruments. While thecentral bank’s liquidity management operationsencompass discretionary injections or withdrawals ofprimary money from the financial system at its owninitiative, its accommodation policy comprisesoperations to meet the demand for liquidity frommarket participants. Market liquidity management

refers to actions taken by the central bank to managethe overall level of high-powered money and, throughthis, to regulate money market conditions (Box III.1).The regulation of money market conditions focusseson offsetting the demand for excess reserves in orderto avoid large fluctuations in bank reserves causingvolatility in short-term interest rates. Successfulmarket liquidity management requires that the dailylevel of excess reserves in the banking system beclose to the level demanded by banks.

3.19 Theoretically, the speed of transmission ofpolicy signals to financial asset prices improves withderivatives trading as it enables risk sharing acrossthe market as well as reflects the inter-temporaladjustments of financial asset prices to monetarypolicy signals. A financial derivative contract derivesthe future price for the underlying asset on the basisof its current price and interest rates. Accordingly, theefficient pricing of derivatives is contingent upon anactive and liquid market for the underlying asset. Asthe informational content of the market is reflected inprices of derivatives, there is a case for usingderivatives as monetary policy instruments. It is,however, noted that central banks do not usederivative instruments actively for monetary policypurposes as they are normally considered to be riskyand uncertain. Furthermore, the impact of derivativestrading on the real economy remains ambiguous (Grayand Place, 2001). Der ivatives, however, areincreasingly becoming a useful tool for r iskmanagement in financial markets.

3.20 To sum up, the interest rate channel hasemerged as a key channel of monetary policytransmission mechanism. Although the central bankcan directly influence mainly shor t-term rates,effective transmission of policy signals requires aproper term structure of interest rates, which isdependent on market par ticipants’ expectationsabout the future movements in policy rates. A well-functioning money market is, therefore, essential forconducting indirect, market-based monetary policyoperations and for providing the liquidity necessaryfor the market in government securities and privatesector bonds. By careful management of liquidityconditions, the central bank can realise its monetarypolicy objectives and encourage money markettransactions while ensuring stable market conditions.A vital element for conducting effective monetarypolicy is knowledge of Government cash flows,which, like central bank’s open market operations,also affect bank’s reserve balances.

72


The money market forms the first and foremost link in thetransmission of monetary policy impulses to the realeconomy. Policy interventions by the central bank alongwith its market operations influence the decisions ofhouseholds and firms through the monetary policytransmission mechanism. The key to this mechanism isthe total claim of the economy on the central bank,commonly known as the monetary base or high-poweredmoney in the economy. Among the constituents of themonetary base, the most important constituent is bankreserves, i.e., the claims that banks hold in the form ofdeposits with the central bank. The banks’ need for thesereserves depends on the overall level of economic activity.This is governed by several factors: (i) banks hold suchreserves in proportion to the volume of deposits in manycountries, known as reserve requirements, which influencetheir ability to extend credit and create deposits, therebylimiting the volume of transactions to be handled by thebank; (ii) bank’s ability to make loans (asset of the bank)depends on its ability to mobilise deposits (liability of thebank) as total assets and liabilities of the bank need tomatch and expand/contract together; and (iii) banks’ needto hold balances at the central bank for settlement of claimswithin the banking system as these transactions are settledthrough the accounts of banks maintained with the centralbank. Therefore, the daily functioning of a modern economyand its financial system creates a demand for central bankreserves which increases along with an expansion inoverall economic activity (Friedman, 2000b).

The central bank’s power to conduct monetary policy stemsfrom its role as a monopolist, as the sole supplier of bankreserves, in the market for bank reserves. The mostcommon procedure by which central banks influence theoutstanding supply of bank reserves is through “openmarket operations” – that is, by buying or sell inggovernment securities in the market. When a central bankbuys (sells) securities, it credits (debits) the reserve accountof the seller (buyer) bank. This increases (decreases) thetotal volume of reserves that the banking system collectivelyholds. Expansion (contraction) of the total volume ofreserves in this way matters because banks can exchangereserves for other remunerative assets. Since reserves earnlow interest, and in many countries remain unremunerated,banks typically would exchange them for some interestbearing asset such as Treasury Bill or other short-term debtinstruments. If the banking system has excess (inadequate)reserves, banks would seek to buy (sell) such instruments.If there is a general increase (decrease) in demand forsecurities, it would result in increase (decline) in securityprices and decline (increase) in interest rates. The resultinglower (higher) interest rates on short-term debt instrumentsmean a reduced (enhanced) opportunity cost of holdinglow interest reserves. Only when market interest rates fall

Box III.1 Role of the Money Market in the Monetary Transmission Mechanism

(rise) to the level at which banks collectively are willing tohold all of the reserves that the central bank has suppliedwill the financial system reach equilibrium. Hence, an“expansionary” (contractionary) open market operationcreates downward (upward) pressure on short-term interestrates not only because the central bank itself is a buyer(seller), but also because it leads banks to buy (sell)securities. In this way, the central bank can easily influenceinterest rates on short-term debt instruments. In thepresence of a regular term structure of interest rates andwithout market segmentation, such policy impulses gettransmitted to the longer end of the maturity spectrum,thereby influencing long-term interest rates, which have abearing on household’s consumption and savings decisionsand hence on aggregate demand.

There are alternative mechanisms of achieving the sameobjective through the imposition of reserve requirementsand central bank lending to banks in the form of refinancefacilities. Lowering (increasing) the reserve requirement,and, therefore, reducing (increasing) the demand forreserves has roughly the same impact as an expansionary(contractionary) open market operation, which increases(decreases) the supply of reserves creating downward(upward) pressure on interest rates. Similarly, another wayin which central banks can influence the supply of reservesis through direct lending of reserves to banks. Centralbanks lend funds to banks at a policy rate, which usuallyacts as the ceiling in the short-term market. Similarly,central banks absorb liquidity at a rate which acts as thefloor for short-term market interest rates. This is important,since injecting liquidity at the ceiling rate would ensurethat banks do not have access to these funds for arbitrageopportunities whereby they borrow from the central bankand deploy these funds in the market to earn higher interestrates. Similarly, liquidity absorption by the central bank hasto be at the floor rate since deployment of funds with thecentral bank is free of credit and other risks. Typically, theobjective of the central bank is to modulate liquidityconditions by pegging short-term interest rates within thiscorridor.

While the above mechanism outlines how central bankscan influence short-term interest rates by adjusting thequantity of bank reserves, the same objective can beachieved by picking on a particular short-term interest rateand then adjusting the supply of reserves commensuratewith that rate. In many countries, this is achieved bytargeting the overnight inter-bank lending rate andadjusting the level of reserves which would keep the inter-bank lending rate at the desired level. Thus, by influencingshort-term interest rates, central banks can influenceoutput and inflation in the economy, the ultimate objectivesof monetary policy.

73

MONEY MARKET

II. OPERATING PROCEDURES AND MONEYMARKET - INTERNATIONAL EXPERIENCE

3.21 The objectives, targets and operatingprocedures of monetary policy worldwide havewitnessed considerable shifts in tune with theevolution of monetary theory, central banking regimesand the changing macroeconomic conditions overtime. By the 1970s, most central banks came to acceptprice stability as a key objective of monetary policy -a departure from the earlier prominence given togrowth and employment objectives. In recent years,beyond the traditional growth-inflation trade-off,financial stability has emerged as another keyobjective in the wake of growing financial marketintegration and associated uncertainty and volatilityarising out of contagion. Although a number of centralbanks in developed countries such as the ReserveBank of New Zealand, Reserve Bank of Australia andthe Bank of England have adopted price stability astheir sole objective by adopting an inflation targetingframework, several other countries, viz., the US andJapan continue to pursue dual objectives of pricestability and growth. Similarly, while some emergingmarket economies (EMEs) such as South Africa,Thailand, Korea and Mexico have emphasised solelyprice stability by adopting an inflation targetingframework, some others tend to follow multipleobjectives.

Monetary Policy Frameworks

Intermediate Targets

3.22 As central banks could not always directlytarget the ultimate objective, monetary policy focussedon intermediate targets that bear close relationshipwith the final objective. The selection of intermediatetargets is conditional on the channels of monetarypolicy transmission that operate in the economy. Theprocess of rapid disintermediation sparked off by aspate of financial innovations during the 1980s beganto impact the monetary targeting framework (Solans,2003). Accordingly, with money demand becomingunstable, central banks began to modulate aggregatedemand by targeting interest rates. As a result, centralbanks in the US (1992) and Japan (1994-2001)2,among others, adopted inter-bank rates asintermediate targets. Financial liberalisation, however,has reduced the importance of explicit intermediate

targets in several countries, thereby prompting manycentral banks to adopt a multiple indicator approach.Under this approach, many central banks such as theUS Federal Reserve, the European Central Bank andthe Bank of Japan regularly monitor a number ofmacroeconomic indicators such as prices, outputgaps, and developments in asset, credit and otherfinancial markets, which have a bearing on pricestability.

3.23 Some EMEs such as Russia and Chinacontinue to specify intermediate targets in the formof monetary aggregates. Some other countries suchas Indonesia, however, use indicative monetarytargets more as an important information variable,supplementing it with other indicators of developmentsin f inancial markets and the real economy.Furthermore, along with the adoption of inflationtargeting by many EME central banks, there has beenan increasing focus on the interest rate channel ofthe monetary transmission process.

Operating Targets

3.24 The process of monetary policyimplementation is guided mainly by the choice ofoperating targets. Notwithstanding the policyobjectives, the critical issue facing the monetaryauthorities is to strike a balance in the short-runbetween instruments and targets. In recent years, acertain degree of consensus has emerged both in theindustrialised countries and EMEs to use market-oriented instruments, driven mainly by the rapiddevelopment and deepening of various financialmarket segments, the diversification of financialinsti tut ions and the globalisation of f inancialintermediation (Van’t dack,1999).

3.25 With the gradual development andsophistication of money markets in a deregulatedregime, there has been a shift from Keynesian growth-and full-employment-or iented monetary policyoperating on monetary aggregates to an inflation-oriented monetary policy operating on interest rates.With the growing sophistication of markets, thetraditional dir igiste, direct control approach tomonetary policy has become obsolete, while indirectmarket or iented approach has gained greateracceptance (Forssbaeck and Oxelheim, 2003).

2 The Bank of Japan shifted to quantitative easing policy since March 2001 but again decided on March 9, 2006 to change the operating targetfrom the outstanding balances of current accounts at the Bank to the uncollateralised overnight call rate.

74


3.26 Among the two operating procedures, viz.,through bank reserves and interest rates, the focushas increasingly shifted towards the latter since theearly 1990s due to the broader changes that tookplace in the economic environment (Borio, 1997). Thetrend reflects the growing role played by interest ratesin the transmission mechanism as markets developin a deregulated environment. The sharper focus oninterest rates as the operating target has gone handin hand with a tendency to move towards targetingshort-term interest rates. As a corollary, the overnightrate has emerged as the most commonly pursuedoperating target in the conduct of monetary policy.Hence, the focus has been concentrated on moneymarkets for transmitting monetary policy signals. Thetargeting of short-term interest rates is fully consistentwith a market oriented approach whereby informationabout the expectations of future movements in interestrates is extracted from the prevailing market rates.

3.27 Although countries differ in terms of thechoice of instruments, they could be broadly classifiedon the basis of their key operating targets (interestrates) (Annex III.1). In the first category are countriessuch as the US, Japan, Canada and Australia, wherethe key operating target is the overnight inter-bankrate although the signalling strategies differ. In thecase of other developed countries such as the ECB,the key policy rate is the tender rate that is applicableto regular operations, mainly, the refinancingoperations. Some central banks, however, in countriessuch as the UK, select overnight market interest ratesas their operating target consistent with the officialBank Rate decided by the MPC. In general, thematurity of such interest rates varies from 1 to 2 weeksbut could range between 1 or 2 days to 1-month.

3.28 The operating target in the case of severalEMEs also is the overnight rate - determined in theinter-bank market for settlement balances (Korea andMalaysia) (Annex III.2). In order to promote financialstability, central banks, being the monopolisticsuppliers of primary liquidity, have endeavoured tosmoothen the movements in the overnight rate with ahigh degree of precision through calibratedmodulation of bank reserves. Central banks havegenerally refrained from strict control of interest ratesas it deters the development of money markets.Allowing the volatility in the overnight rate to absorbtemporary pressure could enable central banks topreserve stability in other money market segments.

3.29 Central banks have used several techniquesin order to contain the interest rate volatility - theaveraging of reserve requirements and use of

standing facilities to define an interest rate corridor.Most of these countries steer the overnight rateswithin a corridor - lower bound (floor) set by thedeposit facility and upper bound (ceiling) representedby the lending facility. These corridors are normallyconsiderably wide, allowing for the significant flexibilityin the movement of both policy and overnight rates(Borio, op.cit). With regard to the frequency of interestrate adjustments, most central banks prefer a policyof small and gradual changes.

Operating Procedures

3.30 The operating procedures of l iquiditymanagement have also changed in response to thechanges in the policy environment amidst financialliberalisation. The literature and the central banks’ ownaccounts attribute five main reasons for reform in theiroperating procedures in the industrial countries duringthe 1980s and the 1990s (Mehran et al., 1996 andForssbaeck and Oxelheim, op cit). First, monetarypolicy instruments were changed to adapt to the newoperational frameworks of the respective monetaryauthor it ies. Second, with f inancial deepeningoccurring more or less entirely outside the centralbanks’ balance sheets, the share of the financialsystem over which monetary authorities had directcontrol was reduced, warranting indirect (price-oriented as opposed to quantity-oriented instruments)ways to control the non-monetary components ofliquidity in the financial system. Third, in the wake ofexpansion, diversification and integration of financialmarkets all over the world, greater interest rateflexibility and narrowing of differentials between ratesof return in different currencies warranted instrumentsthat can impart flexibility to liquidity management interms of the timing, magnitude and accuracy. Fourth,the growing importance of expectations in financialmarkets favoured the adoption of instruments that arebetter suited for signalling the stance of monetarypolicy. Finally, there was a growing urge on the partof central banks to stimulate money market activityand improve monetary policy transmission whileemphasising the separation of monetary andGovernment debt management objectives.

3.31 As a result of the changes in the policyenvironment, the following trends could be observedat the international level, particularly during the 1990s(Borio, op.cit and Van’t dack, op.cit). First, there hasbeen a continuous reduction in reserve requirements.The marked international trend towards reduction inreserve requirements over the last decade reflectsthe conscious policy effort to reduce the tax on

75

MONEY MARKET

intermediation with a view to reducing the burden ofinstitutions and generate a level playing field, bothbetween different types of domestic institutions andincreasingly those across national borders. Althoughthe fluctuations in liquidity levels engendered byautonomous factors could be modulated through thebuffer stock property of reserve requirements andthrough active liquidity management by means ofdiscretionary operations3, internationally, the generaldownward trend in reserve ratios has been shiftingthe balance towards liquidity activism. This has alsobeen made possible by the increase in excessmaintenance of reserves whereby banks circumventthe impact of changes in reserve requirements.

3.32 Central banks in EMEs tend to use reserverequirements to offset autonomous influences on bankliquidity more frequently than in developed countries.While reserve requirements play a different role inEMEs than in developed countries, there has been aconvergence towards lower levels whiledeemphasising their role as active instruments ofmonetary control. Thus, in recent years, reserverequirements have been giving way to a more marketoriented approach of impounding liquidity, includingthrough the issue of central bank paper.

3.33 Second, there has been a growing emphasison active liquidity management driven partly by thepressures of increasingly mobile international capitaland decline in reserve requirements. With a view todeveloping money markets by reducing the relianceon accommodation from the central bank and in orderto impart greater flexibility in interest rate adjustments,liquidity management has largely been implementedthrough discretionary operations at the expense ofstanding facilities, particularly since the early 1980s.As a corollary, central banks have widened the rangeof instruments used in their market operations,shortened the maturity of transactions, increased theirfrequency and complemented regular basicrefinancing operations with other f ine-tuningoperations.

3.34 The reliance on market operations rather thanstanding facilities for balancing the market for bankreserves was also necessitated by the need to developmore flexible and less intrusive implementationprocedures. Hence, the main instruments for liquiditymanagement by central banks are discretionarymarket operations. Conversely, standing facilities have

become ‘safety valves’ rather than the keymechanisms for setting the interest rate. They areoperated at the margin in order to bridge temporarymismatches in liquidity. In the case of EMEs also,there has been a movement away from standingfacilities. With the development and integration of newfinancial markets, bank intermediation became lessdominant as households parked a part of their savingsoutside the banking sector. As a result, enterprisesincreasingly started tapping non-bank sources offunding. Consequently, aggregate spending becamesensitive to more than just bank-determined interestrates as policy induced changes in interest rates alsoinfluenced demand through the wealth effect of assetprices. Accordingly, the asset channel of monetarytransmission, which focusses on developing newinstruments and procedures for influencing financialmarket expectations and behaviour, has gained addedimportance.

3.35 Third, among the wide array of monetarypolicy instruments, repos have almost become themain policy tool, which could be considered a majormilestone in the development of money markets.Countries (including EMEs) have preferred reposmore than the outright open market operationsbecause they do not require an underlying market forsecurities and they tend to break the link betweenthe maturity of the paper and that of the transaction.The emergence and subsequent rapid growth ofpr ivate repo markets in recent years, oftenencouraged by the central banks themselves, havespurred the usage of these instruments.

3.36 Most EMEs have assigned repos a major rolein the day-to-day management of bank reserves. Anactive market for repos and reverse repos has beendeveloped in Korea, Mexico and Thailand. Theunderlying eligible assets are mainly government fixedincome securities. In the case of thin markets, centralbanks have responded by widening the range ofeligible securities. The central banks of the US, theECB, the UK, Singapore and Mexico also conductrepo operations involving corporate bonds ascollaterals.

3.37 Besides the rapid growth of domestic repomarkets in recent years, repurchase transactions arenow easily carried out across national borders also.This has been facil i tated by the InternationalSecurities Market Association (ISMA)

4, which plays

3 Discretionary operations include purchase/ sale of securities or more often reverse transactions in domestic or foreign currency.4 Since July 2005, ISMA merged with Primary Market Association to become the International Capital Market Association.

76


an important role by establishing uniform tradingprocedures in the international bond markets. This hashelped large banks/other financial institutions to covershort-term liquidity mismatches. Accordingly, theinternational financial system has experienced anincrease in global integration. It is widely believed thatthe growth of the collateralised repo market hasplayed an important role in enhancing the overallstabil i ty of the f inancial system by removingcounterparty risks through funded credit protectionagainst risky transactions in unsecured wholesalefinancial markets (Joshi, 2005).

3.38 Four th , greater f lexibi l i ty in l iquiditymanagement has been accompanied by a greatertransparency in the policy signals relating to desiredinterest rate levels, driven by the broader changes inthe economic and political environment, including thedecline in inflation to relatively low levels, growingemphasis on inflation targeting, greater autonomy andaccountability of central banks and growing influenceof market forces and expectations in the formation ofinterest rates. The main structural factors shapingpolicy implementation are also induced by thechanges in payment and sett lement systems,particularly, the broad-based introduction of real timegross settlement system.

Central Bank Operations

3.39 With regard to market operations, mostcentral banks conduct at least one transaction at aregular interval in order to meet the basic liquidityneeds of the system. The other complementaryoperations that take place are calibrated responsesto day-to-day market condit ions, f ine-tuningoperations providing liquidity over longer horizons (theUS and Japan) and mopping up of excess liquiditywith a view to inducing ex ante liquidity shortage (theUK). The maturity of these operations is usuallyrelatively short for key operations, shorter for day-to-day calibration and longer for other operations.

3.40 In some countries, outright transactions alsoplay a role. For instance, in the US, periodic purchasesand sales of government securities are used aspermanent additions/withdrawals of reserves. InJapan, the central bank regular ly purchasesgovernment bonds to supply the base money. In thecase of EMEs, outright transactions in the secondarymarkets remain important instruments, particularly tooffset structural liquidity surpluses/shortages. Inrecent years, however, there has been an increasingtrend towards allowing greater leeway to market forcesin determining the interest rates. Hence, there is

reluctance to conduct outright transactions in thegovernment securities market.

3.41 Although country practices vary, the operatingprocedures of monetary policy of most central banksare beginning to converge to one of the variants ofthe three-closely related paradigms. The first set ofcentral banks, including the US Federal Reserve,estimate the demand for bank reserves and then carryout open market operations to target short-terminterest rates, especially if their financial markets aredeep enough to transmit changes at the short end tothe longer end of the term structure. A second set ofcentral banks such as in Russia and Mexico estimatemarket liquidity and carry out open market operationsto target bank reserves, while allowing interest ratesto adjust, especially if their credit channels arestrong. In the third category, a growing number ofcentral banks including the European Central Bank(ECB) and a large number of inflation targetersmodulate monetary conditions in terms of both thequantum and price of liquidity through a mix of openmarket operations (OMOs), standing facilities andminimum reserve requirements and changes in thepolicy rate but do not announce pre-set money orinterest rate targets.

3.42 These developments together with thegrowing integration of markets have warrantedaccurate forecasts of liquidity, par ticular ly theautonomous supply of bank reserves and its demandby the banking system. The operations of centralbanks have become critically contingent on theseforecasts. The features of the forecasting process varysignificantly across the countries, reflecting theiroperating frameworks of monetary policy. SeveralEMEs also conduct forecasts on a regular basis withplanning horizons ranging from one day to severalmonths.

3.43 Regarding the number of instruments, countrypractices differ widely. Central banks in countries suchas Canada conduct one or two type of operations atthe most, which are suff icient for l iquiditymanagement, whereas central banks in Japan andthe UK rely on a broad range of operations. The rangeof underlying securities traded and collateral acceptedis broad in Japan and several European countries,including various types of public and private claims.Conversely, in the US, New Zealand and Australia,central banks operate on the basis of public sectorassets.

3.44 The choice of counterpar t ies var iessubstantially across the countries. For instance, in

77

MONEY MARKET

the US, the Fed deals only with a restricted group ofprimary dealers. In the UK, each market operationand standing faci l i ty has a specific set ofcounterparties. There is a wide range of counterpartiesin different countries. For instance, only banks act ascounterparties in Mexico, while in Korea apart frombanks, merchant banks, investment/trust companiesand securities companies also act as counterparties.While level playing field considerations may favourmany counterparties, efficiency considerations maycall for a system of primary dealers. If the domesticsecurities markets are not deep, central banksengage in foreign exchange swaps for liquiditymanagement purposes (South Africa and Thailand).

3.45 Most central banks, thus, prefer open marketoperations (OMO) as a tool of monetary policy, whichallow them to adjust market liquidity and influencethe interest rate structure across tenors through anauction mechanism in which market participants areable to bid their preferences. The particular form ofoperations such as outright transactions in eligiblesecurities, repos and sometimes standing deposit/lending faci l i ty, often depend on the specif icmacroeconomic conditions and the existing legalframework of the country.

Government’s Surplus Cash Balances

3.46 Government’s large surplus cash balancesheld with the central bank can have a significantimpact on liquidity in the banking system (andthereby could have a bearing on short-term interestrates) necessitating active management of suchsurplus balances. Accordingly, arrangements whichfacilitate transfer of surplus funds from Government’saccount to deficit participants in the system couldhelp in better management of l iquidity. Sucharrangements not only enable the Governments toearn better returns on the cash balances, but alsomitigate volatility in short-term interest rates andkeep overnight money market rates stable. Thecross-country practices on such arrangements varywidely. For instance, while the cash balances of theCentral Government are auctioned (competitively)on a daily basis in Canada, all government balancesare maintained with their respective central banksin Japan and Italy. In the US and France, a significantworking balance is maintained with their centralbanks while amounts beyond the targeted balanceare invested in the market. Such surplus balanceshave also been effectively used as an instrument ofsterilisation by many central banks. The Governmentof Singapore, for instance, issues government

securities in excess of the fiscal requirements andparks the surplus funds with the Monetary Authorityof Singapore (MAS) as deposits, thus, supplementingits draining operations. Countries such as Malaysia,Thailand and Indonesia have modulated excessliquidity in the financial system by diverting government/public sector deposits from the commercial bankingsystem to the central bank.

3.47 To sum up, some lessons emerge from theinternational experience on liquidity management ofboth developed and emerging market economies.First, with the deepening of financial markets and thegrowth of non-bank intermediaries, central banksneed to increase the market orientation of theirinstruments. A large proportion of reserves is suppliedthrough open market operations with standingfaci l i t ies being l imited to providing marginalaccommodation or emergency finance. Furthermore,high reserve requirements tend to inhibit inter-bankactivity. Similarly, easy and cheap access to centralbank standing facilities impedes proactive liquiditymanagement by banks.

3.48 Second, in view of growing complexities ofmonetary management, monetary policy formulationhas been guided by a number of macroeconomicindicators rather than a single intermediate nominalanchor.

3.49 Third , the growing impor tance and theflexibility of financial market price and its transmissionmechanism in a deregulated environmentnecessitated central banks to focus increasingly oninterest rates rather than bank reserves in liquiditymanagement. Central banks need to ensure smoothtrend in interest rates for several reasons. Forinstance, volatile interest rates can obscure policysignals, while more orderly market conditions promotea rapid and predictable transmission of monetarypolicy impulses. Less volatile interest rates may alsohelp financial institutions to better assess and managetheir market risks. Market participants benefit fromstable rates through stabilisation of expectations,which, in turn, promote the development of a termstructure in the money market.

3.50 Fourth, with reduced market segmentationand the greater ease and speed with which interestrate changes are transmitted across the entire termstructure, central banks need to focus on the veryshort end of the yield curve, where their actions tendto have the maximum impact.

3.51 Fifth, the greater market orientation of thecentral banks’ policy instruments has been associated

78


with a preference for flexible instruments. In volatilefinancial conditions, most notably in the EMEs, theflexibility in the design of policy instruments hasemerged as a key consideration.

3.52 Finally , the growing awareness of theimportance of market psychology and expectationshas warranted greater transparency in the conductof monetary policy with special emphasis oncommunication policy for conveying the stance andrationale of policy decisions.

Structure of the Money Market

Instruments

3.53 In view of the rapid changes on account offinancial deregulation and global financial marketsintegration, central banks in several countries havestriven to develop and deepen the money markets byenlarging the ambit of instruments5 and participantsso as to improve the transmission channels ofmonetary policy. The structure of money marketsdetermines the type of instruments that are feasiblefor the conduct of monetary management. Evidenceand experience indicate that preference for market-oriented instruments by the monetary authoritieshelps to promote broader market development(Forssbaeck and Oxelheim, op cit).

3.54 The diminishing role of quantitative controlsand search for alternatives gave rise to three majormarket-or iented instruments, viz., shor t-termsecurities, repurchase operations and swaps. Theseinstruments prompted the central banks to create,stimulate and support the development of marketsparticularly, inter-bank deposit market and short-termsecurities market. In the absence of an efficient inter-bank market, there was a pressing need for the centralbanks to create adequate instruments to absorbliquidity and stimulate the formation of markets foralternative short-term assets. The emergence of theshort-term securities market added a new dimension toliquidity management by central banks. In the absenceof outright transactions in the securities market, theexistence of a liquid securities segment in the moneymarket is often believed to facilitate the central bank’soperations by providing collateral to repurchaseagreements and similar collateralised transactions.

3.55 Among developed countr ies, the moneymarket in the US encompasses a large group of short-

term credit instruments, futures market instrumentsand the Federal Reserve’s discount window (AnnexIII.3). These are generally characterised by a highdegree of safety of principal and are most commonlyissued in units of US $1 million or more. Treasury Billsissued by the US Treasury and the securities issuedby the State and Local Governments have the largestvolume outstanding and constitute the most activesecondary market amongst al l money marketinstruments (MMIs) in the US. A key feature of mostState and local securities is that the interest incomeis generally exempt from federal income taxes, whichmakes them particularly attractive to investors in highincome tax brackets. Non-financial and non-bankfinancial businesses raise funds in the money marketprimarily by issuing commercial paper (CP) - a short-term unsecured promissory note. In recent years, anincreasing number of firms have gained access to thismarket, and issue of CPs has grown at a rapid pace.The outstanding CPs is expected to increase to US $2.17 trillion in 2007. Besides conventional instruments,money market futures and options have also becomepopular in the US money market in the recent period.

3.56 Similarly in the UK, the money market hasemerged as a mechanism for short-term fundingthrough the issuance of money market instrumentsor an active fixed-term cash deposit market. It isprincipally sterling-based but also covers a wide rangeof other currencies. The Government, the bankingsector and industry are among those who raiseresources from the money market through theissuance of Treasury Bills, certificates of deposit(CDs) and bills of exchange (BE)/CPs, respectively.Besides, Acceptances and Local Authority Bills alsoact as MMIs. Commercial bills include bank acceptanceand trade paper. Both overseas and inland trade isfinanced by bank acceptances. Much of the lending inthe market takes place overnight. The bulk (90 per cent)of the MMIs held are CDs and the rest are BEs, TreasuryBills and CPs.

3.57 In the Euro system, during the course of the1990s, repurchase transactions were adopted as amain liquidity management instrument in Denmark(1992), Sweden (1994), Austria (1995), Finland (mid-1990s), Switzerland (1998) and then in the whole Eurosystem since its inception (1999). Several countriessuch as Austria, the Netherlands and Denmark, inthe absence of adequate liquid short-term markets,came to rely on foreign exchange operations

5 Money market instruments facilitate transfer of large sums of money quickly and at a low cost from one economic unit (business,government, banks, non-banks and others) to another for relatively short periods of time.

79

MONEY MARKET

(particularly swaps) for liquidity management. In additionto marketable debt instruments, non-marketable debtinstruments and even some equities are eligible for repos.These are of two types, viz., Tier-1 fulfilling uniform euroarea-wide eligibility criteria of ECB and Tier-2, subjectto the eligible criteria specified by the national centralbanks and the ECB.

3.58 In Japan, the most active money marketsegment involves very short-term transactions, whichinclude the borrowing and lending of funds in the callmarket with or without collateral; the sale andpurchase of short-term securities such as CPs, CDsand short-term government bills such as TreasuryBills; and repo transactions with government and/municipal securities, government guaranteed bonds,corporate bonds and foreign government bonds aseligible collaterals. Purchases of shor t-termgovernment bills are used most frequently.

3.59 In Australia, the list of securities eligible underthe Intra-day Repurchase Agreement Facil i ty(introduced in 1998) has been broadened to coverseveral other instruments. These includecommonwealth government secur it ies (CGS),domestic debt securities and discount instrumentsissued by the central borrowing authorities of Stateand Territory Governments (permitted in 1997), andbank bills and CDs issued by select banks and selectdebt securities of approved supranational institutionsand foreign Governments. At the other end of thespectrum, Canadian MMIs comprise short-term papersof maturity up to 18 months that are issued by theGovernment, banks and corporations and are availablein the US and Canadian dollars. MMIs mainly compriseTreasury Bills and money market strips issued andguaranteed by the Government of Canada. There arealso Government guaranteed CPs, which are short-termpromissory notes issued by the Crown Corporationssuch as Canadian Wheat Board and the FederalBusiness Development Bank. The other MMIs includeTreasury Bills and promissory notes issued by theProvincial Governments, bankers’ acceptances issuedby corporations with an unconditional guarantee of amajor Canadian chartered bank and CPs issued by themajor corporations.

3.60 In several other EMEs such as Russia, SouthAfrica, China, Malaysia and Korea, the main moneymarket instruments are government Treasury Bills,repurchase agreements, bankers’ acceptances, CPsand CDs. In countries such as Thailand and Indonesia,central banks have aimed to expand the range ofinstruments by issuing their own bonds/certificates,viz., Bank of Thailand Bonds and Bank of Indonesia

Certificates. Moreover, in Thailand, other bonds suchas Financial Institution Development Fund Bonds andGovernment Guaranteed State Enterprise Bonds areused for repo operations. Foreign exchange swap isanother instrument that the Bank of Thailand uses toinfluence liquidity conditions in the money market.

Tenor

3.61 In the US, although maturities of MMIs rangefrom one day to one year, the maturity of mostcommon instruments is three months or less. In theUK, the main items in “period money” are borrowedfor 1 and 3 months, but banks may also borrow for aweek or for almost any time up to 12 months. TheCDs issued by the building societies and activelytraded by banks and discount houses have an originalmaturity of less than one year (although some CDshave a maturity of over a year). They are all short-term bearer negotiable debt instruments that areeither issued at a discount or bear a coupon. In thecase of ECB, the maturity of refinancing operationsranges from 1-week to 3-months and for debtsecurities up to 12- months. Japan’s tenor for its repois in the range of 1 week to 6-months. In Canada, thematurity of Treasury Bills ranges from 1-month to 1-year and that of money market STRIPS up to 18months and Government guaranteed CPs from 1-month to 1-year.

3.62 In other countr ies also, money marketinstruments are mostly short-term in nature – withtenor being generally less than a year. In mostcountries, call money transactions and the repurchaseagreements serve as the shorter duration segmentof money markets. The tenor of Treasury Bills is ofnormally 91-day, 182-day and 364-day. MarketStabilisation Bonds in Korea even have 546-daymaturity period. In the case of certain instrumentssuch as negotiable certificates of deposit (NCDs),tenor may be as long as five years also.

Participants

3.63 The major participants in the US money marketare commercial banks, Governments, corporations,Government-sponsored enterprises, money marketmutual funds, futures market exchanges, brokers anddealers and the Fed. Commercial banks are the majorparticipants in the market for federal funds, which arevery short-term, mainly overnight. Banks act asdealers in the money market for over-the-counterinterest rate derivatives, which has grown rapidly inrecent years. The Federal Reserve is also a keyparticipant in the US money market.

80


3.64 Another important group of participants in theUS money markets include money market mutualfunds and local Government investment pools. Thesepools, which were virtually non-existent before themid-1970s, have grown to be one of the largestfinancial intermediaries in the US. A distinct featureof the US money market is that there are groups ofprivately owned financial intermediaries sponsored bythe Government who raise the funds and channelthem to farming and housing sectors of the economy.

3.65 In the UK, trading in the money market takesplace on an over-the-counter (OTC) basis for thesame day settlement. The money market attracts awide range of participants such as the Government,banking sector, industry and financial institutions suchas pension funds. The Bank of England and the UKDebt Management Office also make use of the moneymarket on a daily basis to fulfil their official obligations.Participants in the UK inter-bank market comprise thewhole of the banking community (including thediscount houses) and non-bank institutions (such asbuilding societies) and the market is served by anumber of money market brokers.

3.66 In the Euro system, the ECB, national centralbanks, the Governments and the eligible creditinstitutions participate in the money market. Similarly,in Australia, the Central Government, State andTerr itor ial Governments, the Reserve Bank ofAustralia, banks, Government agencies, otherGovernments of the Commonwealth andsupranational institutions are the major participants.In the case of Canada, the participants include bothFederal and Provincial Governments, banks, majorCrown Corporations such as Canadian Wheat Boardand Federal Business Development Bank.

3.67 In Japan, business units of Japanese andnon-Japanese banks located in Japan participate inthe uncollateralised money market to raise funds. Themajor participants in the uncollateralised overnightcall money market are the city banks which have thelargest share as borrowers, while regional banks actas major lenders. The other participants includeinstitutional investors such as investment trusts, trustbanks, regional banks, life insurance companies,specialised money market brokers and Keito6 . Thecounterparties of the Bank of Japan include banks,securities companies, security finance companies andmoney market brokers (Tanshi companies).

3.68 In most other countries, commercial banks,central banks, regional banks, specialised banks,investment and finance companies, merchant bankingcorporations, investment trust companies, insurancecompanies, securities finance corporations, creditinsurance funds and business enterprises are themajor participants in the money market.

III. MONEY MARKET IN INDIA – UP TO THEMID-1980s

3.69 The Indian money market prior to the 1980swas characterised by paucity of instruments, lack ofdepth and dichotomy in the market structure. Themoney market consisted of the inter-bank call market,Treasury Bills, commercial bills and participationcertificates. Historically, the call money market hasconstituted the core of the money market structure inIndia due to lack of other instruments and strictregulations on interest rates and participation.

3.70 In the call/notice money market, overnightmoney and money at short notice (up to a period of14 days) are lent and borrowed without collateral. Thismarket enables banks to bridge their short-termliquidity mismatches arising out of their day-to-dayoperations. The call money market in India was purelyan inter-bank market until 1971 when the erstwhileUnit Trust of India (UTI) and Life InsuranceCorporation (LIC) of India were allowed to participateas lenders. The interest rate in the call money marketwas freely determined by the market till December1973. However, as call money rates increased sharplyto touch 25-30 per cent, the Indian Banks’ Association(IBA) instituted an administered system of interestrates by imposing a ceiling interest rate of 15 per centin December 1973 so as to maintain systemic stabilityand quell any abnormal rise in the call rates. Theceiling was subject to several revisions but there wereseveral instances of violation of the ceiling ratesthrough other means (like buy-back arrangements)during phases of tight liquidity.

3.71 Treasury Bi l ls const i tuted the maininstrument of shor t- term borrowing by theGovernment and served as a convenient gilt-edgedsecurity for the money market. The characteristicsof high liquidity, absence of default risk and negligiblecapital depreciation of Treasury Bills made themanother attract ive instrument for shor t- terminvestment by banks and other financial institutions.

6 Keito is a central financing organisation for financial co-operatives such as small and medium sized businesses, agriculture, forestry, andfishery co-operatives.

81

MONEY MARKET

The Reserve Bank, being the banker to theGovernment, issued Treasury Bills at a discount. Theissuance system of Treasury Bills migrated from anauction to tap basis in July 1965 with the rate ofdiscount administratively fixed at 3.5 per cent perannum, which was raised to 4.6 per cent by July 1974and remained at that level in respect of 91-dayTreasury Bills till 1991. There was also a system ofad hoc Treasury Bills from 1955, which were createdby the Central Government in favour of the ReserveBank to automatically restore its cash balances tothe minimum stipulated level, whenever there wasexcess drawdown of cash.

3.72 Par ticipation cer t i f icates (PCs) andcommercial bills (under bills rediscounting scheme)were introduced in the money market in 1970. PCswere utilised mostly by financial institutions to parktheir funds for longer maturities and could not bedeveloped for meeting liquidity mismatches betweenfinancial institutions and/or banks. Under the billsrediscounting scheme, the Reserve Bankrediscounted genuine trade bills at the Bank Rate orat a rate specified by it. The underlying purpose ofdeveloping the bill market was to enable banks andother financial institutions to invest their surplus fundsprofitably by selecting appropriate maturities. Over theyears, the rediscounting facility became restrictive andwas made available on a discretionary basis. The mainfactors inhibiting the development of bill finance werelack of a bill culture, non-availability of stamp papersof required denominations, absence of specialisedcredit information agencies and an active secondarymarket. Both these instruments (par ticipationcertificates and commercial bills), however, did notdevelop and activity in these instruments remainedinsignificant.

3.73 As a result of inadequate depth and liquidityin the organised money market, the sectoral financinggaps (i.e., the requirements of unsatisfied borrowersin the organised financial system) were met by theunorganised market. The interest rate in this segmentwas generally higher than that in the organised marketreflective of the actual market conditions. As bankcredit (both aggregate and sectoral) was the principalfocus of monetary policy making under the creditplanning approach adopted in 1967-68, thisdichotomous nature of the money market served therequirement of monetary management.

3.74 To sum up, the money market during thisperiod could not provide an equilibrating marketmechanism for meeting short-term liquidity needs for

banks. The prevalence of administered structure inthe money market did not permit interest rates toreflect the actual extent of scarcity of funds. Owing tolimited participation, money market liquidity was highlyskewed, characterised by a few dominant lenders anda large number of chronic borrowers. Faced with theseimpediments, together with limited Reserve Bank’srefinance, banks often faced either short-term liquidityproblems for meeting the statutory reserverequirements or remained saddled with excessliquidity. Banks parked surplus funds, in the absenceof alternative instruments, in Treasury Bills beforerediscounting them with the Reserve Bank so as tomeet the cash reserve requirements on an averagebasis dur ing the repor ting per iod. This led tosignificant fluctuations in banks’ investments inTreasury Bills and also their cash balances with theReserve Bank, thereby complicating the task ofmonetary management. Furthermore, in addition tothe rediscounted regular Treasury Bills, the ReserveBank also had to hold the ad hoc Treasury Bills (issuedby the Government of India with a fixed 4.6 per centinterest rate since July 1974) under the system ofautomatic monetisation, thereby constraining theemergence of Treasury Bills as a money marketinstrument. Moreover, the government securitiesmarket was also characterised by administeredinterest rates and captive investor base, which madeopen market operations an ineffective instrument ofmonetary control thereby constraining, to a largeextent, the regular management of short-term liquidityby the Reserve Bank.

IV. EVOLUTION OF RESERVE BANK’S LIQUIDITYMANAGEMENT

3.75 The nascent state of development of themoney market in India and the administered interestrate structure inhibited active liquidity managementoperations of the Reserve Bank. The Reserve Bankregulated market liquidity by essentially operatingthrough direct instruments such as CRR and sector-specific refinance. As monetary policy was largelycontingent on the fiscal stance, monetary operationswere undertaken to neutralise the fiscal impact.Consequently, with the dominance of the quantumchannel in the transmission mechanism, there waslittle scope of signalling monetary policy changesthrough indirect instruments. Therefore, the moneymarket increasingly reflected the spillover impact ofmonetary policy operations through direct instruments.The increasingly unsustainable fiscal conditions, asreflected in macroeconomic imbalances, necessitatedstructural reforms from the early 1990s. Consequently,

82


the emphasis on the market paradigm gatheredmomentum, warranting greater use of indirectinstruments for the conduct of monetary policy.Concomitantly, the Reserve Bank refined its operatingprocedures of liquidity management in tandem withthe changing financial landscape. Major developmentsin the liquidity management operations of the ReserveBank and developments of money market have takenplace since the mid-1980s. However, in order toplace these developments in proper perspective, itmay be useful to understand the broad contours ofliquidity management by the Reserve Bank sincethe late 1960s.

3.76 Monetary policy up to the mid-1980s waspredominantly conducted through direct instrumentswith credit budgets for the banks being framed in syncwith monetary budgeting (Mohan, op. cit). This periodwas marked by administered interest rates, creditceilings, directed lending, automatic monetisation ofdeficits and fixed exchange rates. The Indian economyfunctioned essentially as a closed and controlledeconomy with the role of market being virtually non-existent due to the existing structural rigidities in thesystem. In the absence of a formal intermediate target,bank credit - aggregate as well as sectoral – came toserve as a proximate target of monetary policy afterthe adoption of credit planning in 1967-68 (Jalan,2002). The money market was essentially representedby the inter-bank call market, where activity wasmainly driven by the banks’ demand for reserves formeeting their statutory commitments. Furthermore,strong seasonality in demand for money and creditduring agricultural seasons also influenced marketactivity. In the presence of skewed distribution ofliquidity, these factors made the call money rateshighly volatile, necessitating imposition of interest rateceilings. In the absence of stability in the moneymarket, and with planned allocation of credit underan administered structure of interest rates, theReserve Bank had little choice but to conduct itsliquidity management operations through a standardmix of OMOs and changes in the Bank Rate. TheOMOs were conducted through outright transactionsin government securities.

3.77 Although credit planning guided monetarypolicy, the concerns about rising inflation during the1970s and the 1980s attracted a good deal of policyattention. Apart from supply shocks (oil prices andcrop failures), inflation was increasingly believed tobe caused by excessive monetary expansiongenerated by large scale monetisation of fiscal deficitsduring the 1980s. Accordingly, the Reserve Bank

began to pay greater attention to the movements inmonetary aggregates. Against this backdrop, theCommittee to Review the Working of the MonetarySystem (Chairman: Sukhamoy Chakravarty, 1985)recommended a framework of monetary targeting withfeedback. In pursuance of the recommendations ofthis Committee, the Reserve Bank began to target adesirable growth in money supply consistent with atolerable level of inflation and expected output growth(RBI, 1985). Thus, broad money emerged as anintermediate target of monetary policy and theReserve Bank began to formally announce monetarytargets as nominal anchor for inflation.

3.78 The adoption of monetary targetingnecessitated considerable changes in the operatingprocedures of monetary policy. Over the years, theReserve Bank, through its refinancing and openmarket operations, had already succeeded, to a largeextent, in reducing the level of interest rates in generaland the call money rate in particular; albeit by varyingthe ceiling rate (it reached 8.5 per cent by March 1978although it was again raised to 10.0 per cent in April1980). However, the fiscal dominance since the late1970s made the traditional instruments of Bank Rateand OMO less effective. The scope for OMO waslimited as yields were governed by an administeredinterest rate regime, including sale of Treasury Billson tap at a coupon of 4.6 per cent fixed since 1974(Mohan, op. cit). In this scenario, the Reserve Bankbegan to use reserve requirements and creditplanning for modulating monetary and liquidityconditions. As a result, the CRR reached the ceilingof 15 per cent of net demand and time liabilities(NDTL) in July 1989 and the SLR reached the peakof 38.5 per cent in September 1990. The increase inSLR was, however, unable to fully meet the financingrequirements of the Government, thereby leading tomonetary accommodation by the Reserve Bank (RBI,2004a). As monetary financing of fiscal deficits isinflationary beyond a point, an increase in the ReserveBank’s support to the Government was accompaniedby an increase in CRR to rein in monetary expansion.Despite these measures, however, money supplygrowth remained high and contributed to inflation. Thisunderscored the need for monetary-fiscal co-ordination in achieving price stability.

3.79 In tandem with the shifts in operatingprocedures, the proper development of the moneymarket was also emphasised, partly due to thesuccess in lowering the call money rates, albeit,through reductions in interest rate ceilings. TheChakravarty Committee (1985) was the first to make

83

MONEY MARKET

comprehensive recommendations for thedevelopment of the Indian money market.Furthermore, the Reserve Bank set up a WorkingGroup on the Money Market (Chairman: Shri N.Vaghul, 1987) to specifically examine various aspectsfor widening and deepening the money market.Following the recommendations of these twocommittees, several new initiatives were undertakenby the Reserve Bank. These included(i) setting up of the Discount and Finance House ofIndia (DFHI) in 1988 to impart liquidity to moneymarket instruments and help the development ofsecondary markets in such instruments; ( i i)introduction of instruments such as CDs (1989) andCPs (1990) and inter-bank participation certificates(with and without risk) (1988) to increase the rangeof instruments; (iii) freeing of call money rates by May1989 to enable price discovery; and (iv) introductionof auctions of 182-day Treasury Bills (November 1986)with a view to moving towards a system of market-determined yields. Although these measures createdthe ground for the development of a proper moneymarket, the efficient functioning of the market washindered by a number of other structural rigidities inthe system such as skewed distribution of liquidity andthe prevalence of administered deposit and lending rates.

3.80 The process of f inancial l iberal isationintroduced in the early 1990s, as part of the overalleconomic reforms programme, led to a structural shiftin the financing paradigm for the Government and thecommercial sectors. The role of the financial systemwas reassessed and the emphasis shifted from amere channelisation to eff icient al location ofresources to sustain the higher growth. With a viewto improving the resource allocation process andfacilitating efficient price discovery in the financialmarkets, the Reserve Bank initiated a multi-prongedstrategy of institutional reforms. The measuresintroduced by the Reserve Bank were aimed atwidening, deepening and integrating var ioussegments of the financial market, especially themoney market, and smoothening the process oftransmission of policy impulses across marketsegments. Major reforms introduced in the financialmarkets were liberalisation of exchange rates in March1993, deregulation of interest rates, abolition of creditceilings (although directed lending continued),introduction of auctions in Treasury Bills (364-dayTreasury Bills in April 1992 and 91-day Treasury Bills

in January 1993), market borrowing of the Governmentthrough the auction route since 1992-93 (gilt yieldsbecame market determined through rising couponrates) and phasing out of automatic monetisation off iscal deficits (fol lowing the signing of theSupplemental Accord in 1997). All these measurespaved the way for increased financial innovations andmarket sophistication which, along with large swingsin capital flows, induced a degree of instability in themoney demand function, thereby limiting the role ofmoney as an intermediate target.

3.81 Various changes in financial market structurenecessitated a major shift in monetary policyoperating framework in India from monetary targetingto a ‘multiple indicator approach’ in 1998. As part ofthis approach, the Reserve Bank started using theinformation content in interest rates and rates of returnin different markets along with currency, credit, fiscalposition, trade, capital flows, inflation rate, exchangerate, refinancing and transactions in foreign exchange,by juxtaposing it with output data for drawing policyperspectives. The success of this approach requiredgreater monetary policy flexibility, especially in viewof market or ientation of policy. Therefore, theemphasis was placed on the money market as thefocal point for the conduct of monetary policy andfostering its integration with other financial marketsas detailed in the subsequent sections.

3.82 In the changed scenario, monetary policy,which largely operated in a closed economyframework till the early 1990s, had to contend withthe dynamics of an open economy. The transition ofeconomic policies in general, and financial sectorpolicies in particular, from a control oriented regimeto a liberalised but regulated regime was reflected inchanges in the approach of monetary management(Mohan, 2004). Accordingly, in line with the increasingmarket orientation of the economy and shift in theoperating framework, the third phase of liquiditymanagement operations began from the second halfof the 1990s with the Reserve Bank moving away fromdirect instruments of monetary control to indirectinstruments. The CRR was brought down from 15 percent of NDTL (during July 1989-April 1993) to 9.5 percent by November 1997 (it reached a low of 4.5 percent in June 2003)7. The SLR was reduced to thestatutory minimum of 25 per cent by October 1997.Under this system, while reserve requirement was the

7 In the light of developments in current macroeconomic, monetary and anticipated liquidity conditions, the Reserve Bank, on March30, 2007, announced to raise CRR by 50 basis points to 6.50 per cent in April 2007.

84


principal medium of modulating liquidity on a systemicbasis, banks took recourse to Reserve Bank’srefinance facilities to meet their short-term fundingrequirements. Introduction of reverse repos8 (thencalled repos) in 1992 provided an instrument forabsorption of liquidity from banks having surplusfunds. This, in conjunction with government marketborrowing through auctions since 1992-93, raised theyields on government securities (from 6.5 per cent in1985-86 to 11.5 per cent in 1997-98) and led to theshortening of maturity of the Government debt. Thismarked the beginning of development of a secondarymarket in government securities and the marketdetermination of interest rates. With the objective ofmanaging short-term liquidity and smootheninginterest rates in the call/notice money market, theReserve Bank began absorbing excess liquiditythrough auctions of reverse repos. Furthermore, withexchange rate liberalisation (the rupee became fullyconvertible on the current account in 1994) andopening up of the economy, the exchange rate beganto play an important role in monetary management.In the process, the exchange rate becameendogenous to money, income, prices and interestrates and, with f inancial innovations, thedisequilibrium in money markets begun to be reflectedin short-term interest rates (Mohan, op cit). In view ofthese changes, the call money market became the focalpoint of market intervention by the Reserve Bank.

3.83 The volatility in call rates, however, continued,necessitating some instruments for managing liquidity.Against this backdrop, the Committee on BankingSector Reforms (Narasimham Committee II, 1998)stressed that interest rate movements in the inter-bankcall money market should be orderly and this couldonly be achieved if the Reserve Bank has a presencein the market through short-term reverse repos (asper current terminology). Following the committee’srecommendations, the reverse repos, which were inoperation from 1992, got integrated with the interimliquidity adjustment facility (ILAF) introduced in April1999. The absorption of liquidity continued to be atfixed rate reverse repos. Although absorption ofliquidity was done through a single reverse repo rate,the system of injecting liquidity through various ways,including refinance, continued at interest rates linkedto the Bank Rate, which was reactivated in April 1997.

Under the ILAF, the general refinance facility wasreplaced by a collateralised lending facility (CLF) andadditional collateralised lending facility (ACLF) linkedto the Bank Rate. Similarly, export credit refinance andliquidity support to PDs were also linked to the BankRate. Thus, the reverse repo rate (as floor) and theBank Rate (as the ceiling) provided an informalcorridor in the money market.

3.84 In the light of the experience gained in theoperation of ILAF, an Internal Group set up by theReserve Bank recommended gradual implementationof a full-fledged LAF as suggested by the NarasimhamCommittee (1998). Accordingly, the system of ILAFmigrated to a system of Liquidity Adjustment Facility(LAF) in stages beginning June 2000 (Box III.2). Thefixed rate reverse repo was replaced by variablereverse repo auctions, while ACLF and level II liquiditysupport to PDs was replaced by variable reposauctions, conducted on a daily basis. Consequently,the repo rate replaced the earlier Bank Rate as theceiling of the corridor, thereby enabling injection ofliquidity at a single rate (i.e., repo rate), while the floorcontinued to be the reverse repo rate. This signified amajor change in the operating procedure and liquiditymanagement operations by the Reserve Bank as itfacilitated the transition from direct instruments toindirect (market-based) instruments of monetarymanagement. Furthermore, it has also provided thenecessary f lexibi l i ty to the Reserve Bank inmodulating liquidity (both supply of and demand forfunds) on a daily basis through policy rate changes.This has ensured stability in the call money rates,which have generally remained within the corridor(Chart III.1)9. This, in turn, has promoted the stabilityof short-term interest rates in the money market.

3.85 Consider ing the impor tance of guidingmonetary policy operations on a sound basis, theAnnual Policy Statement of April 1999 underlined theneed for developing a short-term operational modelwhich takes into account the behavioural relationshipsamong different segments of the financial system.Under the guidance of a group of eminent academicexper ts, a model was developed and madeoperational in 2002 for forecasting short-term liquidityconditions to facilitate daily liquidity managementoperations of the Reserve Bank.

8 With effect from October 29, 2004, the nomenclature of repo and reverse repo has been interchanged as per international usages.Accordingly, repos now signify injection while reverse repos signify absorption of liquidity.

9 Call rate hardened during the second half of March 2007 as liquidity conditions tightened due to advance tax outflows, year-endconsiderations, sustained credit demand and asymmetric distribution of government securities holdings across banks.

85

MONEY MARKET

As part of financial sector reforms initiated in the early1990s, India began to move away from direct instrumentsof monetary control to indirect ones, which, in turn,warranted a mechanism that can accord greater flexibilityand effective liquidity management so as to maintainorderly conditions in the financial markets, particularly inthe wake of surging volatile capital flows. As a corollary,pursuant to the recommendations of the NarasimhamCommittee (1998), the LAF was introduced in stagescommensurate with the specific features of the Indianfinancial system, the level of market development andtechnological advances in the payment and settlementsystems. In the process, the critical issue facing theReserve Bank was to channelise the various sources ofits liquidity through a single comprehensive window at acommon pr ice. Consequently, an inter im l iquidityadjustment facility (ILAF) was introduced in April 1999which enabled the Reserve Bank to modulate marketliquidity on a daily basis and also transmit interest ratesignals to the market.

With the introduction of ILAF, the general refinance facilitywas replaced by a collateralised lending facility (CLF) upto 0.25 per cent of the fortnightly average of outstandingaggregate deposits in 1997-98 for two weeks at the BankRate and an additional collateralised lending facility (ACLF)for an equivalent amount of CLF at the Bank Rate plus 2per cent. A penal rate of 2 per cent was stipulated for anadditional two week period. However, expor t creditrefinance for scheduled commercial banks was retainedand continued to be provided at the Bank Rate.Simultaneously, a provision for liquidity support to PDsagainst collateral of government securities was also madeavailable. The ILAF was intended to ensure that interestrates move within a reasonable range and promote stabilityin the money market. The transition from ILAF to a full-fledged LAF commenced in June 2000 and progressedgradually in three stages. The first stage began from June5, 2000 when LAF was formally introduced with thereplacement of ACLF and level II support to PDs by variablerate repo auctions with same day settlement.

The second stage commenced from May 2001, when CLFand level I liquidity support for banks and PDs was alsoreplaced by variable rate repo auctions. However, someminimum liquidity support to PDs was retained but at aninterest rate linked to variable rate in the daily reposauctions as determined by the Reserve Bank from timeto time. Furthermore during April 2003, the multiplicity ofrates at which liquidity was being injected was rationalisedwith the back-stop interest rate being fixed at the reverserepo cut-off rate of the regular LAF auctions on that day.

Box III.2Liquidity Adjustment Facility

Concomitantly, a back-stop rate was f ixed at 2.0percentage points above the repo cut-off rate in the eventof no reverse repo in the LAF auctions. On days when noreverse repo/repo bids are received/accepted, back-stoprate was decided by the Reserve Bank on an ad hoc basis.Subsequently from March 29, 2004 the reverse repo ratewas scaled down to 6.0 per cent and aligned with theBank Rate under the revised LAF scheme. A single facilityavailable at a single rate was introduced by mergingnormal facility and back stop facility together. Moreoverin April 2004, fixed rate auctions were re-introduced. Witheffect from October 29, 2004, the nomenclature of repoand reverse repo was interchanged as per internationalusage. The repo now indicates injection of liquidity, whilereverse repo stands for absorption of liquidity.

The full computerisation of Public Debt Office (PDO) ofthe Reserve Bank set the third stage of full-fledged LAFand onset of RTGS marked a major leap forward in thisphase. Repo operations today are mainly throughelectronic transfers and the LAF can be operated atdifferent times of the same day. Consequently, the SecondLAF (SLAF) was introduced from November 28, 2005providing the market participants a second window to fine-tune their management of liquidity. Unlike the past LAFoperations, which were conducted in the forenoon between9.30 am and 10.30 am, the SLAF is conducted by receivingbids between 3.00 pm and 3.45 pm. Although the salientfeatures of SLAF and LAF are same, their settlements areconducted separately on a gross basis. Thus, theintroduction of LAF has been a process and the Indianexperience shows that phased rather than a big bangapproach is required for reforms in the financial sector andin monetary management (Mohan, op. cit).

LAF has now emerged as the pr incipal operatinginstrument of monetary policy. It has helped in stabilisingthe regular liquidity cycles and, subsequently, the volatilityof call money rates by allowing banks to fine-tune theirliquidity needs as per the averaging requirements of CRRover the reporting period. This smoothened the liquiditypositions at the beginning and end of the month. Besides,it helped to modulate sudden liquidity shocks engenderedby temporary mismatches induced by outflows/inflows onaccount of Government auctions/redemptions andadvance tax payments. More importantly, the LAF hasemerged as an effective instrument for maintainingorderly conditions in the financial markets in the face ofvolatile capital flows. Thus, the LAF has imparted a much-needed flexibility to the Reserve Bank in modulating theliquidity in the system and steering the desired trajectoryof interest rates in response to evolving market conditions.

86


3.86 The issue of managing large and persistentcapital flows and synchronicity in monetary policycycles across the globe has added another dimensionto the issue of liquidity management in the Indiancontext in recent years. The period since mid-2002has generally been characterised by surplus liquidityin the system in the wake of large capital inflows andcurrent account surplus (till 2003-04). An enduringchallenge to monetary policy has been to managesuch surplus liquidity so as to keep the call moneyrates stable for overall stability in the market.Accordingly, in order to sterilise the impact of capitalf lows, the Reserve Bank had to operatesimultaneously through the LAF and OMOs (outrighttransactions of dated securities and Treasury Bills).

3.87 The OMOs have been effectively used bythe Reserve Bank since the mid-1990s for sterilisingthe monetary impact of capital flows by offloadingthe stock of government securities to the market(Chart III.2). The net open market sales increasedfrom Rs.10,464 crore in 1996-97 to Rs.53,781 crorein 2002-03. However, repeated recourse to OMOs forsterilisation purposes during this period depleted thestock of government securities held by the ReserveBank from Rs.52,546 crore at end-March 2003 toRs.40,750 crore at end-March 2004, despite theconversion of the available stock of non-marketablespecial securities (of Rs.61,818 crore), created outof past ad hoc and Tap Treasury Bills, into tradablesecurities during the year. Accordingly, the burden ofsterilisation shifted to the LAF, which was essentiallydesigned as a tool of adjusting marginal liquidity. As

a result, the open market sales by the Reserve Bankas a proportion of the accretion of securities to its giltportfolio dropped to about 50 per cent during 2003-04from an average of 90 per cent in the preceding fiveyears following a switch to LAF operations (RBI,2004b).

3.88 Given the finite stock of government securitiesin its portfolio and the legal restrictions on issuing itsown paper, the Reserve Bank felt that instrumentsother than LAF were needed to fulfil the objective ofabsorbing liquidity of a more enduring nature. Thisresulted in the introduction of the market stabilisationscheme (MSS) in Apr i l 2004 as a specialarrangement, following the recommendations of theWorking Group on Instruments of Sterilisation, 2003(Chairperson: Smt. Usha Thorat). Under thisarrangement, the Government issued Treasury Billsand/or dated securities in addition to the normalborrowing requirements for absorbing excess liquidityfrom the system. The ceiling amount, which wasinitially fixed at Rs.60,000 crore was raised toRs.80,000 crore on October 14, 2004 but reduced toRs.70,000 crore on March 24, 2006 and again raisedto Rs.80,000 crore for 2007-08. The MSS proceedsare held in a separate identifiable cash account bythe Government (reflected as equivalent cashbalances held by the Government with the ReserveBank) and are appropriated only for the purpose ofredemption and/or buyback of the Treasury Bills and/or dated securities issued under the MSS. Thus, whileit provided another tool for liquidity management, itwas designed in such a manner that it did not have

Net RBI Credit to the Centre Net Foreign Currency Assets

OMO (Sales)

Chart III.2: Reserve Bank's Open Market Operations

Ru

pee

s cr

ore

05-J

un

-00

11-J

an-0

1

19-A

ug-

01

27-M

ar-0

2

02

-Nov

-02

10-J

un

-03

16-J

an-0

4

23-A

ug-

04

31-M

ar-0

5

06

-Nov

-05

14-J

un

-06

20-J

an-0

7

Chart III.1: LAF Corridor and the Call Rate

Per

cen

t

Call Rate Reverse Repo Rate Repo Rate

87

MONEY MARKET

any fiscal impact except to the extent of interestpayment on the outstanding amount under the MSS.The amount absorbed under the MSS, which hadreached Rs.78,906 crore on September 2, 2005,declined to about Rs.32,000 crore in February 2006due to unwinding of nearly Rs.47,000 crore in view ofoverall marginal liquidity which has transited from thesurplus to the deficit mode. As part of unwinding, freshissuances under the MSS were suspended betweenNovember 2005 and April 2006. In several subsequentauctions during 2006-07, only partial amounts wereaccepted under the MSS. Subsequently, the amountabsorbed under the MSS increased again toRs.62,974 crore in March 2007. The MSS has, thus,provided the Reserve Bank the necessary flexibilityto not only absorb liquidity but also to ease liquiditythrough its unwinding, i f necessary. With theintroduction of the MSS, the pressure of sterilisationon LAF has declined considerably and LAF operationshave been able to fine-tune liquidity on a daily basismore effectively (Table 3.1). Thus, the MSSempowered the Reserve Bank to undertake liquidityabsorptions on a more enduring but still temporarybasis and succeeded in restoring LAF to its intendedfunction of daily liquidity management (Mohan, op cit).

3.89 Furthermore, the build up and volatility inGovernment’s cash balances with the Reserve Bankin recent years have significantly impacted the liquidityconditions. The Working Group on Instruments ofSterilisation favoured revisiting the 1997 agreementso that Government’s surpluses with the ReserveBank are not automatically invested and can remainas interest free balances, thereby releasinggovernment secur it ies for fur ther ster i l isationoperations. Accordingly, the arrangement of allowingthe Central Government to invest the surplus fundsin its own paper since 1997 (to give a notional returnon such balances) was discontinued temporarily fromApril 8, 2004. However, following the introduction ofthe MSS, it was partially restored with a ceiling ofRs.10,000 crore in June 2004, which was furtherraised to Rs.20,000 crore in October 2004. While theGovernment’s surplus cash balances may haveenabled the Reserve Bank to sterilise the monetaryimpact of excess liquidity, at times, it has also resultedin sudden transition in liquidity conditions. The buildup of large and unanticipated cash surpluses of theGovernment with the Reserve Bank and its depletionover a short period poses fresh challenges for liquiditymanagement and maintenance of stable conditionsin the money market.

3.90 The dynamics of surplus liquidity in the recentper iod shows that the total surplus l iquidity

Table 3.1: Liquidity Absorptions

(Rupees crore)

Outstanding LAF MSS Centre’s Totalas on Last Friday Surplus with (2 to 4)of month the RBI @

1 2 3 4 5

2004April 73,075 22,851 0 95,926May 72,845 30,701 0 1,03,546June 61,365 37,812 0 99,177July 53,280 46,206 0 99,486August 40,640 51,635 7,943 1,00,218September 19,245 52,255 21,896 93,396October 7,455 55,087 18,381 80,923November 5,825 51,872 26,518 84,215December 2,420 52,608 26,517 81,545

2005January 14,760 54,499 17,274 86,533February 26,575 60,835 15,357 1,02,767March* 19,330 64,211 26,102 1,09,643April 27,650 67,087 6,449 1,01,186May 33,120 69,016 7,974 1,10,110June 9,670 71,681 21,745 1,03,096July 18,895 68,765 16,093 1,03,753August 25,435 76,936 23,562 1,25,933September 24,505 67,328 34,073 1,25,906October 20,840 69,752 21,498 1,12,090November 3,685 64,332 33,302 1,01,319December -27,755 46,112 45,855 64,212#

2006January -20,555 37,280 39,080 55,805February -12,715 31,958 37,013 56,256March* 7,250 29,062 48,828 85,140April 47,805 24,276 5,611 77,692May 57,245 27,817 0 85,062June 42,565 33,295 8,621 84,481July 44,155 38,995 8,770 91,920August 23,985 42,364 26,791 93,140September 1,915 42,064 34,821 78,800October 12,270 40,091 25,868 78,229November 15,995 37,917 31,305 85,217December -31,685 37,314 65,581 71,311

2007January -11,445 39,375 42,494 70,424February 6,940 42,807 53,115 1,02,862March -29,185 62,974 49,992 83,781

@ : Excludes minimum cash balances with the Reserve Bank.* : Data pertain to March 31. # Reflects IMD redemption of about

Rs.32,000 crore.Note : Negative sign in column 2 indicates injection of liquidity through

LAF repo.

(comprising MSS, LAF and Government surplus) inthe system increased to over Rs.1,25,000 crore inAugust 2005. Reflecting such surplus conditions inthe banking system, the call money rate hoveredgenerally around the lower bound of the corridor (i.e.,the reverse repo rate), which (along with the repo rate)has emerged as the main instrument of policy in theshort-run (see Chart III.1). The Bank Rate now serves

88


Table 3.2: First and Second LAF(Amount in Rupees crore)

Period Average daily Average daily First Average daily Second Share of First LAF in Share of Second LAF inLAF Operations (net) LAF Operations (net) LAF Operations (net) Total LAF (per cent) Total LAF (per cent)

1 2 3 4 5 6

December 2005 -1,452 654 -2,106 64.6 35.4January 2006 15,386 12,938 2,447 72.9 27.1February 2006 13,532 10,850 2,682 74.9 25.1March 2006@ 6,319 5,520 799 54.1 45.9April 2006 -46,088 -18,480 -27,608 41.1 58.9May 2006 -59,505 -29,600 -29,905 49.7 50.3June 2006 -48,611 -25,647 -22,964 52.8 47.2July 2006 -48,027 -26,486 -21,541 55.2 44.8August 2006 -36,326 -21,677 -14,649 59.7 40.3September 2006 -25,862 -12,544 -13,318 47.8 52.2October 2006 -12,262 -5,435 -6,827 44.4 55.6November 2006 -9,937 -1,315 -8,622 13.2 86.8December 2006 1,713 6,548 -4,836 41.6 58.4January 2007 10,738 7,170 3,569 46.8 53.2February 2007 -648 3,211 -3,859 36.4 63.6March 2007 11,858 9,701 2,157 55.5 44.5

@ : Additional LAF conducted on March 31, 2006 has been shown under second LAF.Note: (+) indicates injection of liquidity through LAF repos while (-) indicates absorption of liquidity through LAF reverse repos.

the role of a signalling instrument for the medium-term. Commensurate with these changes, the LAFhas been further refined. Facilitated by the introductionof real time gross settlement (RTGS) system, it has nowbeen possible to operate LAF at different times of thesame day (Second LAF was introduced from November28, 2005) providing market participants a secondwindow to fine-tune the management of liquidity. Theevidence so far suggests active transaction through theSecond LAF during periods of easy liquidity (Table 3.2).

3.91 The surplus liquidity conditions, however, easedto about Rs.55,000 crore by January 2006 following thepressures from redemption of India Millennium Deposits(IMDs) (US $ 7.1 billion or about Rs.32,000 crore onDecember 28-29, 2005). The sustained pick-up in non-food credit (around 30 per cent witnessed since mid-2004), brought the liquidity position from the surplusmode to the deficit mode, leading to injections of liquiditythrough LAF repos during December 2005-February2006 (Chart III.3). To meet their liquidity requirements,banks have been unwinding their excess SLR holdings(from about 13 per cent of NDTL at end-March 2005to about 3 per cent by end-March 2007) above theprescribed minimum of 25 per cent. The depletion ofSLR investments by banks has resulted in call ratesfirming up to the ceiling of the LAF corridor andbeyond, even when reverse repo bids have beenreceived under the LAF and funds have beenabsorbed from the system. This indicates that somebanks overdrew both collateral and cash, therebynecessitating rollovers at the short-end of the market

spectrum leading to pressures on liquidity and interestrates. In this regard, the Government’s decision in theUnion Budget 2006-07 to conver t the entireoutstanding recapitalisation bonds/special securitiesissued to nationalised banks, amounting to Rs. 20,809crore, into tradable, SLR eligible securities couldreduce the pressure on banks seeking appropriatecollaterals.

3.92 In the current phase of monetary tightening,the Reserve Bank has raised the reverse repo rates

Reverse Repo Amount Repo Amount

Call Rate (Right Scale)

Chart III.3: Liquidity Adjustment Facility and the Call Rate

Per

cen

t

Ru

pee

s cr

ore

05-J

un

-00

09-O

ct-0

009-F

eb-0

120-J

un

-01

29

-Nov

-01

03-A

pr-

02

26-J

ul-

02

08

-Nov

-02

21-F

eb-0

313-J

un

-03

23-S

ep-0

306-J

an-0

421-A

pr-

04

02-A

ug-

04

11

-Nov

-04

24-F

eb-0

510-J

un

-05

23-S

ep-0

504-J

an-0

624-A

pr-

06

01-A

ug-

06

13

-Nov

-06

27-F

eb-0

7

89

MONEY MARKET

six times of 25 basis points each since October 2004,which along with the corresponding adjustments inthe repo rate had narrowed down the corridor to 100basis points by April 2005 (which subsequentlyincreased to 175 basis points with the increase in reporate by 25 basis points each on October 31, 2006,January 31, 2007 and March 30, 2007). The ReserveBank has emphasised gradual changes in policy rates,

as large changes in interest rates could be disruptive,particularly in the wake of increased openness of theeconomy and the current stage of development offinancial markets. This approach has been successfulin signalling the market about the need for such pre-emptive actions in order to stabil ise inflationexpectations. Various segments of the financial markethave responded well to the policy signals (Box III.3).

The effectiveness of monetary policy hinges on the abilityof the monetary authority to communicate with the publicin a clear and transparent manner. In this regard, thesignalling of policy assumes key importance as it conveysthe stance of monetary policy. While the signallingmechanisms in developed countries are quite robust, theytend to be weak in emerging market economies,particularly in the wake of market segmentation andabsence of a well-defined transmission mechanism.

Financial markets are typically characterised by asymmetricinformation, where some agents are better informed thanothers, that gets reflected in the problems of moral hazardand adverse selection. Seminal research on the economictheory of information has demonstrated that better-informedagents in a market could credibly “signal” (transmit) theirinformation to less informed agents, so as to avoid some ofthe problems associated with adverse selection and improvethe market outcome (Spence, 1973).

The effectiveness of monetary policy is strongly related tothe signalling of policy, the reason being that importantvariables such as the exchange rate and long-term interestrates reflect expectations about future monetary policy.Central banks usually consider four different types ofsignalling channels, viz., (a) speeches of executives, (b)views about future inflation, (c) changes in policyinstruments and (d) publication of the minutes of policymeetings. In particular, the announcement of an inflationforecast or a monetary conditions index (MCI) is used tosignal central bank’s intentions.

In India, several measures have been initiated in the post-reform per iod to develop indirect instruments fortransmitting policy signals. An important measure was thereactivation of the Bank Rate in April 1997 by initially linkingit to all other rates, including Reserve Bank’s refinancerates. The introduction of fixed rate reverse repo helped increating an informal corridor in the money market with thereverse repo rate as the floor and the Bank Rate as theceiling, which enabled the Reserve Bank to modulate thecall rate within this informal corridor. Subsequently, theintroduction of the Liquidity Adjustment Facility (LAF) fromJune 2000 facilitated the modulation of liquidity conditionsand also short-term interest rates on a daily basis throughthe LAF window, while signalling the medium-term stanceof policy through changes in the Bank Rate.

Box III.3The Interface between Monetary Policy Announcements and Financial Market Behaviour

In the Indian context, some attempts have been made toempir ically examine the interrelationship betweenmonetary policy signals and financial market behaviour ina VAR framework (Bhattacharyya and Sensarma, 2005).Monetary policy signals are proxied by changes in the CRR,the Bank Rate and the LAF reverse repo rate. The impact ofthese signalling instruments of monetary policy is consideredon four segments of the financial market, viz., money market(call money rate), stock market (BSE Sensex), foreignexchange market (3-month forward premia) and thegovernment securities market (yield on 1-year G-sec).

Impulse response analysis is used to study the impact ofa one standard error shock in each policy indicator on thevarious financial market segments. The study reveals thatan increase in the CRR raises the call money rate instantlybecause of the news effect and also over time through theliquidity effect as more resources get impounded causingtightness in liquidity conditions. This is also the case forforward premia and yields on government securities. It hasmore of an instantaneous news impact in the stock marketby depressing the market sentiment.

An increase in the Bank Rate, as the signalling mechanismof policy stance over the medium-term, appears to havean instantaneous effect on call, government securities andforward premia because of the news effect. The long-termimpact, however, gets muted as refinance at the Bank Rateis formula driven and not adequate to have a liquidityimpact. In the stock market, hardening of the Bank Rate isconstrued as restrictive monetary policy, which dampensthe market sentiment.

An increase in the reverse repo rate, as the signallingmechanism of policy stance in the short-term, appears to havean instantaneous effect on call, government securities andforward premia because of the announcement effect andmakes the term-structure steep at the short-end. Like the BankRate, repo rate hike also dampens the market sentiment.

The instantaneous impact of monetary policy signals onmost financial market segments points towards increasingintegration and sophistication of markets. Therefore,increasing reliance on indirect instruments, greater marketintegration and technological innovations prima facie haveimproved the channels of communication between theReserve Bank and the financial market and facilitated theconduct of monetary policy.

90


A liquid money market is an important pre-requisite for theeffective transmission of monetary policy. In particular, adeep and liquid money market contributes towards a moreeffective propagation of the impulses of central bank policyintervention in financial markets. Besides, pr icedetermination is more efficient in a liquid money market andconveys important information to monetary authorities onmarket expectations. In this context, central banks modulateand fine-tune money market liquidity not only for monetarymanagement but also in their quest for preserving financialstability.

Measures of money market liquidity are based on threedimensions, viz., tightness, depth and resiliency. Tightnessrefers to how far transaction prices diverge from the averagemarket price, i.e., the general costs incurred irrespective ofthe level of market prices. Depth denotes either the volumeof trades possible without affecting prevailing market prices,or the amount of orders in the order books of market makersat any time period. Finally, resiliency refers either to thespeed with which price fluctuations resulting from the tradeare dissipated, or the speed with which imbalances in orderflows are adjusted. Other measures such as the numberand volume of trades, trading frequency, turnover ratio, pricevolatility and the number of market participants are oftenregarded as readily available proxies for market liquidity.

As the buying and selling rates in any market transactionare commonly referred as bid and offer (ask) rates in financialmarket parlance, one of the most frequently used measuresof tightness is the bid-ask spread. The bid-ask spread, i.e.,the differential between the lowest bid quote (the price atwhich a market participant is willing to borrow in the inter-bank market) and the highest ask quote (at which the agentis willing to lend) represents an operational measure of theprice of the agents’ services in the absence of othertransaction costs. Depth is reflected by the maximum sizeof a trade for any given bid-ask spread. The turnover ratio,i.e., the turnover in the money market as a percentage oftotal outstanding money market transactions, also providesan additional measure of the depth of the market. However,a more accurate measure of market depth would take intoaccount advances of both actual and potential transactionsarising out of portfolio adjustments. Finally, while there is noappropriate measure of resiliency, one approach is toexamine the speed of the restoration of normal marketconditions (such as the bid-ask spread and order volume)after transactions are completed. Thus, a relatively moreliquid money market, ceteris paribus, requires less time toexecute a transaction, operates on a narrower bid-askspread, supports higher volumes for a given spread andrequires relatively less time for the restoration of the “normal”bid-ask spread following a high value transaction.

Box III.4Market Microstructure: Issues in Money Market Liquidity

On the basis of these criteria, the Indian money marketappears to be a reasonably deep, vibrant and liquid market(based on overnight data on bid-ask spread from April 1,2004 to February 28, 2007). During this period, the bid-ask spread has varied within a range of (-)0.37 to (+)1.32basis points with an average of 16 basis points andstandard deviation (SD) of 11 basis points (coefficient ofvariation is 0.69). Despite a higher degree of variation, thebid-ask spread remained within the 2-SD band around theaverage during most of the period (Chart). Considerablevolatility above the average was witnessed up to December2004. It eased up significantly during the major part of 2005but increased subsequently during the early part of 2006.During 2006-07, while bid-ask spreads ruled below theaverage till August 2006, increase in spreads beyond the2-SD band were noticed during end-December 2006 onaccount of tightness in liquidity due to the impact of thestaggered hike of 0.5 percentage point in the CRR and theadvance tax flows from the banking system. The bid-askspread hardened significantly in March 2007, reflecting tight

liquidity conditions on account of advance tax outflows,year-end considerations and sustained credit demand.However, events such as the blast of July 11, 2006 inMumbai did not have any significant impact on the bid-askspread in the call money market.

Differences in market microstructure can affect marketliquidity considerably. In this regard, evolution of marketstructure is mostly dr iven by the rapid structural,technological and regulatory changes affecting globalfinancial markets. In the Indian context, the gradual shifttowards a collateralised market, phasing out of non-bankparticipants from call money market, reductions in statutoryreserve requirements, introduction of new instruments suchas CBLO, implementation of RTGS and facilitating thetrading through NDS-CALL are some of the factors that havecontributed to the development of a relatively vibrant andliquid money market.

3.93 Despite al l these developments, thebehaviour of call rates, which occasionally breached

the corridor has called for a re-look at the marketmicrostructure (Box III.4). Accordingly, as part of the

01-A

pr-

04

20

-May

-04

02-J

ul-

04

13-A

ug-

04

27-S

ep-0

40

6-N

ov-0

41

5-D

ec-0

419-J

an-0

525-F

eb-0

506-A

pr-

05

16

-May

-05

21-J

un

-05

29-J

ul-

05

05-S

ep-0

511-O

ct-0

51

9-N

ov-0

52

4-D

ec-0

531-J

an-0

60

8-M

ar-0

618-A

pr-

06

25

-May

-06

29-J

un

-06

03-A

ug-

06

08-S

ept-

06

16-O

ct-0

62

3-N

ov-0

62

9-D

ec-0

607-F

eb-0

7

Chart: Bid Ask Spread in the Call Money Market

Per

cen

t

Bid-Ask Spread Mean Mean+2SD Mean-2SDSource: Reuters

91

MONEY MARKET

policy strategy of focusing on market microstructure,the Reserve Bank took several initiatives for furtherdeepening the money market along with other marketsegments in order to enhance the effectiveness ofthe rate channel of monetary transmission. A numberof measures were taken by the Reserve Bank toenable the exit of non-bank participants from the callmoney market in a gradual manner. Instruments suchas market repo (repo outside the Reserve Bank’sLAF) and collateralised borrowing and lendingobligation (CBLO) introduced in 2003, through theClear ing Corporation of India Limited (CCIL),enabled smooth migration of non-bank participantsfrom the uncollateralised call money segment to thecollateralised segments. The collateralised marketis now the predominant segment of the moneymarket with a share of around 70 per cent in totalvolume during 2006-07. This also provided analternative avenue for banks to park their surplusfunds beyond one day. Fur thermore, this wasfacilitated by the standardisation of accountingpractices, broad-basing of eligibility criteria in thecollateralised markets, exemption of CBLO from theCRR requirements and anonymity provided by theorder matching systems in the CBLO market.Moreover, minimum maturity period for CPs (October2004) and CDs (April 2005) were shortened from 15days to 7 days. These developments helped in thesmooth transformation of the call money market intoa pure inter-bank market in August 2005.

3.94 Availability of alternative avenues (such asthe market repo and CBLO) for deploying short-termfunds by market participants has also enabled thealignment of other money market rates with theinformal interest rate corridor of reverse repo andrepo rates under the LAF. Accordingly, although thecall rate has at times breached the corridor, theweighted average overnight rate moved largely withinthe informal corridor set by LAF rates (Chart III.4).

3.95 To sum up, various policy initiatives by theReserve Bank in terms of widening of market-basedinstruments and shortening of maturities of variousinstruments have not only helped in promoting marketintegration but also enabled better l iquiditymanagement and transmission of policy signals bythe Reserve Bank. Following the recommendationsof the Technical Group on Money Market (2005), theReserve Bank’s focus on the money market has beenon encouraging the growth of the collateralisedmarket, developing a rupee yield curve and providingavenues for better risk management by marketparticipants.

V. MONEY MARKET DEVELOPMENTS –MID-1980s ONWARDS

3.96 As discussed earlier, the Vaghul WorkingGroup (1987) recommended several measures forwidening and deepening the money market. Some ofthe major recommendations, inter alia, included (i)activating existing instruments and introducing newinstruments to suit the changing requirements ofborrowers and lenders; (ii) freeing interest rates onmoney market instruments; and (iii) creating an activesecondary market through establishing, wherevernecessary, a new set of institutions to impart sufficientliquidity to the system. The Committee on the FinancialSystem, 1991 (Chairman: Shri M. Narasimham)further recommended phased rationalisation of theCRR for the development of the money market.Second generation reforms in the money marketcommenced when the Committee on Banking SectorReforms, 1998 (Chairman: Shri M. Narasimham)recommended measures to facilitate the emergenceof a proper interest rate structure reflecting thedifferences in liquidity, maturity and risk.

3.97 In pursuance of the recommendations of thetwo committees, a comprehensive set of measures wasundertaken by the Reserve Bank to develop themoney market. These included (i) withdrawal ofinterest rate ceilings in the money market; (ii)introduction of auctions in Treasury Bills; (iii) abolitionof ad hoc Treasury Bills; (iv) gradual move away fromthe cash credit system to a loan-based system; (v)relaxation in the issuance restrictions and subscription

Ap

r-04

Ju

n-0

4

Au

g-04

Oct

-04

Dec

-04

Feb

-05

Ap

r-05

Ju

n-0

5

Au

g-05

Oct

-05

Dec

-05

Feb

-06

Ap

r-06

Ju

n-0

6

Au

g-06

Oct

-06

Dec

-06

Feb

-07

Chart III.4: Overnight Interest Rates

Per

cen

tMarket Repo (Non-RBI) Reverse Repo

Average Call Money CBLO Repo

92


10 Satellite Dealers (SDs) were also allowed to operate in the call/notice money market until they were phased out from May 2002.

Table 3.3: Activity in Money Market Segments

(Rupees crore)

Average Daily Turnover # Outstanding Amount

Year Call Money Market Repo Collateralised Term Money Commercial Certificates ofMarket (Outside the Borrowing and Market Paper Deposit

LAF) LendingObligation

(CBLO)

1 2 3 4 5 6 7

1997-98 22,709 – – – 2,806 9,349

1998-99 26,500 – – – 4,514 6,876

1999-00 23,161 6,895 – – 7,014 1,908

2000-01 32,157 10,500 – – 6,751 1,199

2001-02 35,144 30,161 – 195 7,927 949

2002-03 29,421 46,960 30 341 8,268 1,224

2003-04 17,191 10,435 515 519 7,835 3,212

2004-05 14,170 17,135 6,697 526 11,723 6,052

2005-06 17,979 21,183 20,039 833 17,285 27,298

2006-07 21,725 33,676 32,390 1,012 21,314 64,814

# : Turnover is twice the single leg volumes in case of call money and CBLO to capture borrowing and lending both, and four times in case ofmarket repo (outside LAF) to capture the borrowing and lending in the two legs of a repo.

norms in the case of many money marketinstruments; (vi) introduction of new financialinstruments; (vii) widening of participation in themoney market; and (viii) development of a secondarymarket. All these policy measures have helped indeveloping the money market significantly over theyears as reflected in the volumes and turnover invarious market segments (Table 3.3).

Call/Notice Money Market

3.98 Prior to the mid-1980s, as discussed earlier,the market participants heavily depended on the callmoney market for meeting their funding requirements.However, inherent volatility in the market impededefficient price discovery, thereby hampering theconduct of monetary policy. Against this backdrop, theChakravar ty Committee (1985) recommendedactivation of the Treasury Bills market (with thediscount rate being market related) to reducedependence on the call money market and abolishceilings on the call rate along with permitting moreinstitutional participation to widen the market base.The Vaghul Committee, in view of the continuedexistence of an unaligned overall interest ratestructure, recommended abolition of the ceilinginterest rate on the call money market. However, it

held the view that the call money market shouldcontinue to remain a strictly inter-bank market (barringLIC and the erstwhile UTI which could continue aslenders only) and recommended the setting up of aFinance House of India to impart liquidity to short-term money market instruments.

3.99 The reforms commenced with the setting upof an institution, viz., the Discount and Finance Houseof India (DFHI) in 1988 as a money market institutionto impart liquidity to money market instruments.Interest rate in the call money market was deregulatedwith the withdrawal of the ceiling rate with respect toDFHI from October 1988 and with respect to the callmoney market in May 1989. Although the VaghulCommittee had recommended that call/notice moneyshould be restricted to banks only, the Reserve Bankfavoured the widening of the call/notice money market.In the absence of adequate avenues for deploymentof short-term surpluses by non-bank institutions, alarge number of non-bank participants such as FIs,mutual funds, insurance companies and corporateswere allowed to lend in the call/notice money market,although their operations were required to be routedthrough the PDs from March 199510 . In this context,PDs and banks were permitted to both lend andborrow in the market. The Reserve Bank exempted

93

MONEY MARKET

inter-bank liabilities from the maintenance of CRR/SLR (except for the statutory minimum) effective April1997 with a view to imparting stability to the callmoney market.

3.100 The Narsimham Committee (1998), however,noted that the money market continued to remainlopsided, thin and extremely volatile. While the non-bank participation was a source of comfort, it hadnot led to the development of a stable market withdepth and liquidity. The non-bank participants, unlikebanks, were not subjected to reserve requirementsand the call/notice money market was characterisedby predominant lenders and chronic borrowerscausing heavy gyrations in the market. There wasalso over-reliance of banks in the call/notice moneysegment, thereby impeding the development of othersegments of the money market. The Reserve Bankalso did not have any effective presence in themarket and operated with pre-determined lines ofrefinance. As interest rates in other money marketsegments move in tandem with the inter-bank callmoney rate, the volatility in the call segment inhibitedproper risk management and pricing of instruments.Thus, freeing of interest rates did not result in a well-defined yield curve (Box III.5). Furthermore, banks’role in the money market was further impaired bythe health of their own balance sheets, lack ofintegrated treasury management and sound asset-liability management.

3.101 The Narasimham Committee (1998) madeseveral recommendations to further develop themoney market. First, it reiterated the need to makethe call/notice money market a strictly inter-bankmarket, with PDs being the sole exception, as theyperform the key function of equilibrating the callmoney market and are formally treated as banks forthe purpose of inter-bank transactions. Second, itrecommended prudential limits beyond which banksshould not be allowed to rely on the call moneymarket. The access to the call money market shouldonly be for meeting unforeseen fund mismatchesrather than for regular financing needs. Third, theReserve Bank’s operations in the money marketneed to be market-based through LAF repos andreverse repo auctions, which would determine thecorridor for the market. Fourth, non-bank participantscould be provided free access to rediscounting ofbills, CP, CDs, Treasury Bills and money marketmutual funds.

3.102 Following the recommendations of theReserve Bank’s Internal Working Group (1997) and

the Narasimham Committee (1998), steps weretaken to reform the cal l money market bytransforming it into a pure inter-bank market in aphased manner. The corporates, which were allowedto route their transactions through PDs, were phasedout by end-June 2001. The non-banks’ exit wasimplemented in four stages beginning May 2001whereby limits on lending by non-banks wereprogressively reduced along with theoperationalisation of negotiated dealing system(NDS) and CCIL until their complete withdrawal inAugust 2005. In order to create avenues fordeployment of funds by non-banks following theirphased exit from the call money market, several newinstruments were created such as market repos andCBLO. Maturities of other existing instruments suchas CPs and CDs were also gradually shortened inorder to align the maturity structure to facilitate theemergence of a rupee yield curve. The Reserve Bankhas been modulating liquidity conditions throughOMOs ( including LAF), MSS and ref inanceoperations which, along with stipulations of minimumaverage daily reserve maintenance requirements,have imparted stability to the call money market.

3.103 Despite these reforms, however, thebehaviour of banks in the call market has not beenuniform. There are still some banks, such as foreignand new private sector banks, which are chronicborrowers and public sector banks, which are thelenders. Notwithstanding excessive dependence ofsome banks on the call money market, the short-term money markets are characterised by highdegree of stability. The Reserve Bank has instituteda series of prudential measures and placed limitson borrowings and lendings of banks and PDs in thecall/notice market to minimise the default risk andbring about a balanced development of variousmarket segments. In order to improve transparencyand strengthen efficiency in the money market, it wasmade mandatory for all NDS members to report alltheir call/notice money market transactions throughNDS within 15 minutes of conclusion of thetransaction. The Reserve Bank and the marketparticipants have access to this information on afaster frequency and in a more classified manner,which has improved the transparency and the pricediscovery process. Furthermore, a screen-basednegotiated quote-driven system for all dealings inthe call/notice and the term money markets (NDS-CALL), developed by CCIL, was operationalised onSeptember 18, 2006 to br ing about increasedtransparency and better price discovery in thesesegments. Although the dealing on this platform is

94


opt ional, 85 banks and 7 PDs have takenmembership of NDS-CALL.

3.104 Various reform measures over the years haveimparted stability to the call money market. It haswitnessed orderly conditions (barring a few episodes

of volatility) and provided the necessary platform forthe Reserve Bank to conduct its monetary policy. Thebehaviour of call rates has, histor ically, beeninfluenced by liquidity conditions in the market. Callrates touched a peak of about 35 per cent in May1992, reflecting tight liquidity on account of high levels

The existence of a wide, deep and liquid money marketis critical for the development of a smooth yield curve,which facilitates the conduct of monetary policy. As moneymarket determines the cost of liquidity and anchors theshort-end of the yield curve, the development of a deepand liquid money market is imperative for the emergenceof a yield curve which would credibly transmit monetarypolicy signals. In this regard, the Reserve Bank has takenseveral measures since the mid-1990s to develop a short-term yield curve with deep liquidity. These are: (i)exempting inter-bank liabilities from the maintenance ofCRR; (ii) operationalising the LAF whereby the reverserepo and repo rates are used as policy instruments tomodulate liquidity conditions and stabilise call rates withinthe LAF corridor; (iii) transforming the call money marketinto a pure inter-bank market by phasing out the non-bank lenders; (iv) developing other market segments withadequate access for non-banks; (v) developing a relativelyvibrant non-RBI repo market; and (vi) developing theCBLO market as yet another instrument of overnightborrowing/lending facility.

Notwithstanding these initiatives, a short-term yield curvewhich is readily amenable for policy purposes is yet toemerge. In this regard, the single largest impediment forthe emergence of a short-term yield curve has been thenon-existence of a vibrant and liquid term-money market,mainly due to the inability of market participants to buildlong-term interest rate expectations, skewed distributionof market liquidity, reduction in the minimum maturityperiod of term deposits of banks, and tendency on thepart of banks to deploy their surplus funds in LAF auctionsrather than in the term money market.

As a result, the yield curve has been flattening in recentyears; it even remained inverted for a very brief period.For instance, the absorpt ion of l iquidi ty throughsterilisation operations had led the call rates and the cut-off yield on 91-day Treasury Bills to edge above the yieldof 364-day Treasury Bills, leading to an inversion of asegment of the yield curve for a few days in October 2003.

The prolonged flattening of the yield curve has, however,been influenced by structural factors such as considerablesoftening of yields due to dismantling of administeredinterest rate regime, favourable inflationary expectationsand excess liquidity in the wake of capital flows. The

Box III.5Development of a Short-Term Yield Curve – Some Issues

moderation in yields has also been suppor ted byrat ional isat ion of smal l savings interest ratesadministered by the Government. The stickiness of thereverse repo/repo rate could also have contributed to theflattened yield curve. Maintaining the reverse repo/reporate at the unchanged level for an extended period oftime could have also led to distor tions in the termstructure of interest rates. This can be understood by thefact that while the 10-year gilt yield declined by 257 basispoints during May 2002 to April 2004, the reverse reporate declined by only 150 basis points while call moneyrates declined by 180 basis points during the same period.These structural factors appeared to have contributed tothe f lattening of the yield curve. Owing to thesedistortions, the Indian yield curve does not fully reflectthe market expectat ions on inf lat ion and growthprospects.

An important objective of money market reforms by theReserve Bank in recent years has been to facilitatetransparency in transact ions in order to reducetransactions cost and improve price discovery. TheClearing Corporation of India Limited (CCIL), by providingfor guaranteed sett lement of al l t rades, ensuresprevent ion of gr id- lock in f inancial t ransact ions.Furthermore, the introduction of CBLO by the CCIL inJanuary 2003 and operationalisation of an order matching(OM) anonymous trading screen has made tradingtransparent and on a real time basis, thereby making themoney market more efficient. In order to further enhancetransparency in the money market, screen-based tradingthrough the NDS-CALL was operationalised in September2006. The full implementation of the real time grosssettlement (RTGS) would further aid this process bycontributing to systemic stability.

Notwithstanding considerable progress, a proper short-term yield curve, which facilitates the transmission ofmonetary policy signals and provides a benchmark forthe pricing of other short-term debt instruments, is yet toemerge fully. In this regard, the constant interactionbetween the Reserve Bank and market par ticipantsthrough frequent meetings, speeches, interviews, pressreleases and publications is progressively expected tomute the surpr ise element of monetary policy andfacilitate the process of formation of market expectations,which would increasingly get captured in the yield curve.

95

MONEY MARKET

of statutory pre-emptions and withdrawal of allrefinance facilities, barring export credit refinance.After some softness, call rates again came underpressure to touch 35 per cent in November 1995,partly reflecting turbulence in the foreign exchangemarket. The Reserve Bank supplied liquidity throughrepos and enhanced refinance facilities while reducingthe CRR to stabilise the market. After softening to asingle digit level, the rate hardened again to touch 29per cent in January 1998, reflecting mopping up ofliquidity by the Reserve Bank to ease foreignexchange market pressure. Barring these episodesof volatility, call rates remained generally stable in the1990s. After the adoption of the LAF in June 2000,the call rate eased significantly to a low of 4.5 percent in September 2004, reflecting improved liquidityin the system following increased capital inflows.However, it came under some pressure in December2005 on account of IMD redemptions and increasedto about 7 per cent in February 2007, partly due tomonetary tightening (Chart III.5)11. With the institutionof LAF and consequent improvement in liquiditymanagement by the Reserve Bank, the volatility incall rates has come down significantly compared tothe earlier periods. The mean rate has almost halvedfrom around 11 per cent during April 1993-March 1996to about 6 per cent during April 2000-March 2007.

Volatility, measured by coefficient of variation (CV) ofcall rates, also halved from 0.6 to 0.3 over the sameperiod. Thus, while statutory pre-emptions like CRRand SLR, and reserve maintenance period were themain factors that influenced call rates in the pre-reformperiod, it is the developments in other marketsegments, mainly the foreign exchange and thegovernment securities market along with the ReserveBank’s liquidity management operations that havebeen the main driver of call rates in the post-reformperiod. This signifies increased market integration andimproved liquidity management by the Reserve Bank.

3.105 With the transformation of the call moneymarket into a pure inter-bank market, the turnover inthe call /notice money market has declinedsignificantly. The activity has migrated to otherovernight collateralised market segments such asmarket repo and CBLO. The daily average turnoverin the call money market, which was Rs.35,144 crorein 2001-02, declined to Rs.14,170 crore in 2004-05before increasing again to Rs.21,725 crore during2006-07. The recent rise in call money market turnoverreflects the general tendency of heightened marketactivity following the imbalance between growth inbank credit and bank deposits in recent years againstthe backdrop of sustained pick-up in non-food credit.

Term Money Market

3.106 The term money market is another segmentof the uncollateralised money market. The maturityperiod in this segment ranges from 15 days to oneyear. The term money market has been somewhatdormant in India. It was also a strictly regulated marketup to the late 1980s with the ceiling rates of interest(10.5-11.5 per cent) across the various maturitybuckets. Historically, statutory pre-emptions on inter-bank liabilities, regulated interest rate structure, cashcredit system of financing, high degree of volatility inthe call money rates, availability of sector-specificrefinance, inadequate asset liability management(ALM) discipline among banks and scarcity of moneymarket instruments of varying maturities were citedas the main factors that inhibited the development ofthe term money market.

3.107 In order to activate the term money market,several policy measures were taken by the Reserve

11 Call money rate hardened during the second half of March 2007 (averaging about 20 per cent), reflecting tight liquidity conditions onaccount of advance tax outflows, year-end considerations, sustained credit demand and asymmetric distribution of government securitiesholdings across banks.

Jan

-60

Dec

-63

Nov

-67

Oct

-71

Sep

-75

Au

g-79

Ju

l-8

3

Ju

n-8

7

May

-91

Ap

r-95

Mar

-99

Feb

-03

Jan

-07

Chart III.5: Call Money Rate

Per

cen

t

96


Bank. In pursuance of the Vaghul Working Group’srecommendations, the administered interest ratesystem in this market was dismantled in 1989. In orderto promote this segment, the participation waswidened by allowing select financial institutions in1993 to borrow from the term money market for amaturity period of 3-6 months. Term money of originalmaturity between 15 days and 1 year was exemptedfrom the CRR in August 2001. Furthermore, no limitswere stipulated for transactions in the term moneymarket, unlike under the call/notice money market.

3.108 Despite various reforms, the average dailyturnover in this segment continues to be quite low. Itincreased moderately from Rs.195 crore in 2001-02to Rs.1,012 crore during 2006-07. The factors stillhindering the development of this segment of themoney market include: (i) the inability of participantsto build interest rate expectations over the medium-term due to which there is a tendency on their part tolock themselves in the short-term; (ii) the distributionof liquidity is also skewed with public sector banksoften having surplus funds and foreign banks beingin deficit in respect of short-term resources. Sincethe deficit banks depend heavily on call/notice money,more often, surplus banks exhaust their exposurelimits to them; (i i i ) corporates’ overwhelmingpreference for ‘cash credit’ system rather than ‘loan’generally forces banks to deploy a large amount inthe call/notice money market rather than in the termmoney market to meet sudden demand fromcorporates; (iv) the steady reduction in the minimummaturity period of term deposits offered by banks; and(v) the tendency on the part of banks to deploy theirsurplus funds in LAF auctions rather than in the termmoney market, reflecting risk-averse behaviour.

3.109 It is widely accepted that the banking sectorneeds a deep and liquid term money market formanaging its liquidity as also a smoother rupee yieldcurve. The recent reform measures such as thephasing out of non-banks from the call/notice moneymarket and institution of prudential call/notice moneyexposure limits for banks and PDs are expected toswitch market participants to other market segments.The development of an efficient repo market couldprovide benchmarks to all fixed income segments,including the term money market. In order to improvetransparency, strengthen efficiency and facilitate abetter price discovery process in the term moneymarket, the Technical Group on Money Marketrecommended that term money transactions shouldalso be conducted on a screen-based negotiatedquote driven platform.

Market Repos

3.110 Repo (Repurchase Agreement) instrumentsenable collateralised short-term borrowing throughthe sell ing of debt instruments. Under a repotransaction, the security is sold with an agreement torepurchase it at a pre-determined date and rate.Reverse repo is a mirror image of repo and representsthe acquisition of a security with a simultaneouscommitment to resell.

3.111 In developed financial markets, repurchaseagreements (repos) are recognised as a very usefulmoney market instrument enabl ing smoothadjustment of shor t-term liquidity among variedcategories of market participants such as banks,financial institutions, securities and investment firms.Compared with pure cal l /not ice/term moneytransaction, which is non-collateralised, repo is fullycollateralised by securities, thereby offering greaterflexibility and minimising default risk. Furthermore,repo has several advantages over othercollateralised instruments also. One, while obtainingtitles to securities in other collateralised lendinginstruments is a time-consuming and uncer tainprocess, repo entails instantaneous legal transfer ofownership of the eligible securities. Two, it helps topromote greater integration between the money andthe government securities markets, thereby creatinga more continuous yield curve. Additionally, repo canalso be used to faci l i tate Government’s cashmanagement (Gray, 1998). Central banks all over theworld also use repo as a very powerful and flexiblemoney market instrument for modulating marketliquidity. Since it is a market-based instrument, itserves the purpose of an indirect instrument ofmonetary policy at the short-end of the yield curve.

3.112 Since forward trading in securities wasgenerally prohibited in India, repos were permittedunder regulated conditions in terms of participantsand instruments. Reforms in this market haveencompassed both institutions and instruments. Bothbanks and non-banks were allowed in the market. Allgovernment securities and PSU bonds were eligiblefor repos till April 1988. Between April 1988 and mid-June 1992, only inter-bank repos were allowed in allgovernment secur it ies. Double ready forwardtransactions were part of the repos market throughoutthis period. Subsequent to the irregularities insecurities transactions that surfaced in April 1992,repos were banned in all securities, except TreasuryBills, while double ready forward transactions wereprohibited altogether. Repos were permitted onlyamong banks and PDs. In order to reactivate the repos

97

MONEY MARKET

market, the Reserve Bank gradually extended reposfacility to all Central Government dated securities,Treasury Bills and State Government securities. It ismandatory to actually hold the securities in theportfolio before undertaking repo operations. In orderto activate the repo market and promote transparency,the Reserve Bank introduced regulatory safeguardssuch as delivery versus payments (DvP) systemduring 1995-96. The Reserve Bank allowed all non-bank entities maintaining subsidiary general ledger(SGL) account to participate in this money marketsegment. Furthermore, non-bank financial companies,mutual funds, housing finance companies andinsurance companies not holding SGL accounts werealso allowed by the Reserve Bank to undertake repotransactions from March 2003, through their “giltaccounts” maintained with custodians. With theincreasing use of repos in the wake of phased exit ofnon-banks from the call money market, the ReserveBank issued comprehensive uniform accountingguidelines as well as documentation policy in March2003. Moreover, the DvP III mode of settlement ingovernment securities (which involves settlement ofsecurities and funds on a net basis) in April 2004facilitated the introduction of rollover of repo transactionsin government securities and provided flexibility tomarket participants in managing their collaterals.

3.113 The operationalisation of the NegotiatedDealing System (NDS) and the Clearing Corporationof India Ltd. (CCIL) combined with prudential limitson borrowing and lending in the call/notice market forbanks also helped in the development of market repos.Reflecting this, the average daily turnover of repotransactions (other than the Reserve Bank) increasedsharply from Rs.11,311 crore during April 2001 to Rs.42,252 crore in June 2006 in line with the phasingout of non-banks from the call/notice money market -a process which was completed by August 2005.Subsequently, the turnover in this segment becamesubdued. In this segment, mutual funds and someforeign banks are the major providers of funds, whilesome foreign banks, private sector banks and primarydealers are the major borrowers.

Collateralised Borrowing and Lending Obligations(CBLO)

3.114 The CBLOs were operationalised as a moneymarket instrument by the CCIL on January 20, 2003.The product was introduced with the objective ofproviding an alternative avenue for managing short-term liquidity to the market participants who wererestricted and/or phased out of the call money market.The market was quick to reap the benefits of

anonymous trading system. Mutual funds andcooperative banks were the main beneficiaries of thisscheme. The anonymous, order-driven and onlinematching system was a milestone in the Indian debtmarket.

3.115 With the transformation of the call moneymarket into a pure inter-bank market (with PDs) sinceAugust 2005 and imposition of prudential limits onborrowing/lending by banks and PDs in the call moneymarket, the activity has migrated to the CBLO segmentas it enables market participants to manage their short-term liquidity. Accordingly, the average daily turnover inthe CBLO segment increased from Rs.515 crore in2003-04 to Rs.32,390 crore during 2006-07. Theincrease in turnover could be attributed partly to theincrease in the number of participants from 30 in July2003 to 153 by March 2007. The composition of marketparticipants has undergone changes with mutual fundsand insurance companies emerging as the majorlenders in the CBLO market, while nationalised banks,PDs and non-financial companies as the majorborrowers during 2006-07. Thus, the CBLO and themarket repo (the collateralised segment) have nowemerged as the predominant money market segmentswith a combined share of nearly 70 per cent of the totalturnover in 2006-07.

3.116 As borrowings in the CBLO segment are fullycollateralised, the rates in this segment are expectedto be comparable with the repo rates. The movementsin the daily average rates in the overnight call, therepo and the CBLO markets for the period fromJanuary 2003 to March 2007 show that CBLO ratesmoved between the call and the repo rates up toNovember 2003 due to a l imited number ofparticipants. From November 2003, the CBLO rateshave aligned with the repo rates on account ofincrease in the number of par t icipants. Thetransparent nature and real time basis of deals in theCBLO segment have helped in enhancing efficiencyof the money market.

Treasury Bills

3.117 In India, prior to the institution of reforms, the91-day Treasury Bil ls were sold on tap at anadministered rate of discount, which was fixed at 4.6per cent from July 1974. They, however, could notemerge as a useful money market instrument due tothe administered nature of interest rates, whichreflected the perspective of the issuer rather than thebuyer. A reform process in this segment started withthe introduction of 182-day Treasury Bills fromNovember 1986. This was followed by the phasing

98


out of tap Treasury Bills and an introduction ofauctioning system in 91-day Treasury Bills. Theinstitution of DFHI as a money market institution alongwith other steps taken to develop the market createdthe ground for the emergence of 91-day Treasury Billsas an important market segment. Treasury Bills with364-day maturity were introduced in April 1992 andtendered through auction-determined rates ofdiscount. Subsequently, 91-day Treasury Bills wereintroduced on an auction basis in January 1993. Therewas also a system of 91-day ad hoc Treasury Bills,which were issued by the Central Government to theReserve Bank with a de jure objective of bridgingtemporary mismatches. De facto, however, they turnedout to be a permanent source of meeting CentralGovernment’s resource requirement throughmonetisation of fiscal deficit. A major reform occurredin April 1997, when the system of ad hoc TreasuryBills was abolished and 14-day intermediate TreasuryBills and auction bills were introduced to enable bettercash management by the Government and to providealternative avenues of investments to the StateGovernments and some foreign central banks. Thus,Treasury Bills of different tenors were introduced toconsolidate the market for imparting liquidity, whileyields were made market determined through auctionsfor their use as a benchmark for other short-termmarket instruments.

3.118 The Reserve Bank now auctions 91-dayTreasury Bills on a weekly basis and 182-day TreasuryBills (re-introduced in April 2005) and 364-dayTreasury Bills on a fortnightly basis on behalf of theCentral Government. Treasury Bills market being atthe heart of money market development, the ReserveBank has been paying special attention to this marketsegment. The amounts earmarked for auctions arepre-announced and bids received from non-competitive bidders have been kept outside thenotified amount since April 1998. The dates ofpayment are synchronised on the following Friday afterthe auctions with a view to providing fungible stock ofvarying maturities and to activate the secondarymarket in Treasury Bills. To impart liquidity to TreasuryBills and also to enable investors to acquire thesebills in between the auctions, primary dealers (PDs)quote their bid daily and offer discount rates.

3.119 In view of the limited stock of governmentsecurities with the Reserve Bank, which constrainedoutright OMOs for sterilisation purposes, TreasuryBills were made eligible for issuance under the MSS.The notified amount of Treasury Bills issued underthe MSS has varied during the year keeping in view

the prevailing liquidity conditions. The primary marketyields of Treasury Bills edged higher during 2005-06mirroring the liquidity conditions as well as movementsin LAF rates. The hardening of primary yields sinceSeptember 2005 mainly reflects liquidity tighteningdue to festival demand for cash, quarterly advancetax outflows and IMD redemption on December 29,2005 and strong credit demand (Chart III.6). Thus,Treasury Bills have not only served the Governmentin their cash management, but have also beeneffectively used for sterilisation purposes under theMSS. The persistent use of these instruments forsterilisation, however, could undermine their role asbenchmarks for other money market instruments.

3.120 The Reserve Bank has been modifying thenotified amounts for auctioning of Treasury Bills intune with the evolving liquidity conditions. Reflectingthe relatively tight liquidity conditions during 2006-07, the bid-cover ratios have generally declined,especially in respect of 91-day and 182-day TreasuryBills (Table 3.4).

Commercial Paper

3.121 Commercial Paper (CP) is issued in the formof a promissory note sold directly by the issuers toinvestors, or else placed by the borrowers throughagents such as merchant banks and security houses.When it is issued by corporate borrowers directly toinvestors in the money market and by the process ofsecuritisation, the intermediation function of the bankis obviated. CP was introduced in India in January

02-M

ay-0

120-A

ug-

01

12

-Dec

-01

03-A

pr-

02

24-J

ul-

02

13

-Nov

-02

05-M

ar-0

325-J

un

-03

15-O

ct-0

304-F

eb-0

426-M

ay-0

415-S

ep-0

405-J

an-0

527-A

pr-

05

17-A

ug-

05

07

-Dec

-05

29-M

ar-0

619-J

ul-

06

08

-Nov

-06

28-F

eb-0

7

Chart III.6: Yields on Treasury Bills

Date of Auction

Per

cen

t

364-day 91-day Reverse Repo Rate

99

MONEY MARKET

1990, in pursuance of the Vaghul Committee’srecommendations, in order to enable highly rated non-bank corporate borrowers to diversify their sourcesof shor t-term borrowings and also provide anadditional instrument to investors. CP could carry aninterest rate coupon but is generally sold at a discount.Since CP is freely transferable, banks, financialinstitutions, insurance companies and others are ableto invest their short-term surplus funds in a highlyliquid instrument at attractive rates of return.

3.122 The terms and conditions relating to issuingCPs such as eligibility, maturity periods and modesof issue have been gradually relaxed over the yearsby the Reserve Bank. The minimum tenor has beenbrought down to seven days (by October 2004) instages and the minimum size of individual issue aswell as individual investment has also been reducedto Rs. 5 lakh with a view to aligning it with other moneymarket instruments. The limit of CP issuance was first

carved out of the maximum permissible bank finance(MPBF) limit and subsequently only to its cash creditportion. A major reform to impart a measure ofindependence to the CP market took place when the“stand-by” facility of the restoration of the cash creditlimit and guaranteeing funds to the issuer on maturityof the paper was withdrawn in October 1994. As thereduction in the cash credit portion of the MPBFimpeded the development of the CP market, theissuance of CP was delinked from the cash credit limitin October 1997. It was converted into a “stand alone”product from October 2000 so as to enable the issuersof the services sector to meet short-term workingcapital requirements. Banks were allowed to fixworking capital limits after taking into account theresource pattern of the companies’ finances, includingCPs. Corporates, PDs and al l-India f inancialinstitutions (FIs) under specified stipulations havebeen permitted to raise short-term resources by theReserve Bank through the issue of CPs. There is no

Table 3.4: Treasury Bills – Primary Market

Month Notified Amount Average Implicit Yield at Minimum Cut-off Price Average Bid-Cover Ratio*(Rupees crore) (Per cent)

91-day 182-day 364-day 91-day 182-day 364-day

1 2 3 4 5 6 7 8

2005-06April 19,000 5.17 5.36 5.62 4.03 4.48 2.54May 15,000 5.19 5.35 5.58 3.30 3.37 2.29June 18,500 5.29 5.37 5.61 1.54 2.42 1.81July 11,500 5.46 5.67 5.81 1.21 1.79 1.68August 21,000 5.23 5.42 5.63 3.07 2.68 2.54September 23,000 5.24 5.37 5.70 1.52 1.45 1.61October 15,000 5.50 5.71 5.84 1.69 1.53 3.44November 11,000 5.76 5.85 5.96 2.12 1.92 2.30December 5,000 5.89 6.00 6.09 3.07 2.97 2.36January 5,000 6.25 6.22 6.21 2.86 2.83 2.72February 5,000 6.63 6.74 6.78 3.04 2.07 2.71March 6,500 6.51 6.66 6.66 4.17 3.43 3.36

2006-07April 5,000 5.52 5.87 5.98 5.57 4.96 2.02May 18,500 5.70 6.07 6.34 1.88 1.84 1.69June 15,000 6.14 6.64 6.77 1.63 1.35 2.11July 16,500 6.42 6.75 7.03 1.82 1.55 3.12August 19,000 6.41 6.70 6.96 2.03 2.71 3.48September 15,000 6.51 6.76 6.91 1.35 1.80 2.92October 15,000 6.63 6.84 6.95 1.31 1.20 2.02November 18,500 6.65 6.92 6.99 1.33 1.22 2.49December 15,000 7.01 7.27 7.09 1.19 1.29 3.34January 19,000 7.28 7.45 7.39 1.02 1.35 1.74February 15,000 7.72 7.67 7.79 2.48 2.56 3.16March 15,000 7.68 7.98 7.90 2.08 2.15 3.87

* : Ratio of competitive bids amount received (BR) to notified amount (NA).Note : 1. 182-day Treasury Bills were re-introduced with effect from April 6, 2005.

2. Notified amount is inclusive of issuances under the MSS.

100


lock-in period for CPs. Furthermore, guidelines wereissued permitt ing investments in CPs only indematerialised form effective June 30, 2001 whichhas enabled a reduction in the transaction cost. Inorder to rationalise and standardise, whereverpossible, various aspects of processing, settlementand documentation of CP issuance, several measureswere under taken with a view to achieving thesettlement on a T+1 basis. For further deepening themarket, the Reserve Bank issued draft guidelines onsecuritisation of standard assets on April 4, 2005.Accordingly, the reporting of CP issuance by issuingand paying agents (IPAs) on NDS platformcommenced effective April 16, 2005. The FCACobserved that CPs being short-term instruments, anyunlimited opening up of issuance could haveimplications for short-term debt flows. It, therefore,recommended for prudential limits even under fullconvertibility.

3.123 The issuance of CP has generally beenobserved to be inversely related to call money rates.Activity in the CP market reflects the state of marketliquidity as its issuances tend to rise amidst ampleliquidity conditions when companies can raise fundsthrough CPs at an effective rate of discount lower thanthe lending rate of banks. Banks also prefer investingin CPs during credit downswing as the CP rate worksout higher than the call rate. Thus, the averageoutstanding amount of CPs declined from Rs.2,280crore during 1993-94 to Rs.442 crore during 1995-96amidst tight liquidity but moved up to Rs.17,285 croreduring 2005-06. It increased further to Rs.21,314 croreduring 2006-07. Leasing and finance companiescontinue to be the predominant issuers of CPs.Discount rates on CPs have firmed up in line with theincreases in policy rates during 2005-06 and 2006-07(Chart III.7).


3.124 In order to widen the range of money marketinstruments and provide greater f lexibi l i ty toinvestors for deploying their short-term surplusfunds, certificates of deposit (CDs) were introducedin June 1989. They are essentially securitised short-term time deposits issued by banks and all-Indiafinancial institutions during periods of tight liquidity,at relatively higher discount rates as compared toterm deposits. The guidelines concerning CDs havealso been relaxed over time. These include (i) freeingof CDs from interest rate regulation in 1992; (ii)lowering the minimum maturity period of CDs issuedby banks to 7 days (April 2005) with a view to aligning

the minimum tenor for CPs and CDs asrecommended by the Narasimham Committee(1998); (iii) permitting select all-India financialinstitutions to issue CDs for a maturity period of 1 to3 years; (iv) abolishing limits to CD issuances as acertain proportion of average fortnightly outstandingaggregate deposits effective October 16, 1993 witha view to enabling it as a market determinedinstrument; (v) reducing the minimum issuance sizefrom Rs. 1 crore in 1989 to Rs. 1 lakh in June 2002;(vi) withdrawal of restriction on minimum period fortransferability with a view to providing flexibility anddepth to the secondary market activity; (vii) requiringbanks and FIs to issue CDs only in dematerialisedform, effective June 30, 2002, in order to impart moretransparency and encourage secondary market; and(viii) permitting banks in October 2002 to issuefloating rate CDs as a coupon bearing instrumentso as to promote flexible pricing in this instrument.The FCAC Committee recommended for prudentiall imits on opening up CDs even under ful lconvertibility.

3.125 Activity in the CD market also mirrors liquidityconditions but unlike CPs, the CD issuances by banksand FIs pick up during periods of tight liquidity. Forinstance, the average outstanding amount of CDs rosefrom Rs.8,266 crore during 1992-93 to Rs.14,045crore during 1995-96. It further increased to Rs.21,503crore in June 1996 reflecting the credit pick-up.Another phase of tight liquidity during the East Asiancrisis led to increased market activity in this segment.

15-A

pr-

93

30

-Nov

-93

15-J

ul-

94

28-F

eb-9

515-O

ct-9

531-M

ay-9

615-J

an-9

731-A

ug-

97

15-A

pr-

98

30

-Nov

-98

15-J

ul-

99

29-F

eb-0

015-O

ct-0

031-M

ay-0

115-J

an-0

231-A

ug-

02

15-A

pr-

03

30

-Nov

-03

15-J

ul-

04

28-F

eb-0

515-O

ct-0

531-M

ay-0

615-J

an-0

7

Chart III.7: Commercial Paper

Per

cen

t

Ru

pee

s cr

ore

Outstanding Amount Average Discount Rate (right scale)

101

MONEY MARKET

Subsequently, the outstanding amount declined toRs.949 crore during 2001-02, reflecting the state ofeasy liquidity on account of large capital inflows. Theaverage outstanding amount of CDs increased againto Rs.64,814 crore during 2006-07 as banks continuedto supplement their efforts at deposit mobilisation inorder to support the sustained credit demand. Interestrates on CDs softened in recent years in line withother money market instruments, although there wassome hardening during 2006-07 (Chart III.8).

Volatility in Money Market Segments

3.126 An analysis of the trends in interest ratesacross the various instruments in the money marketbrings out the following salient features. First, since theintroduction of reforms, all money market rates havewitnessed considerable softening commensurate withthe progressive reduction in inflation, reflecting lowerinflation expectations. Softening of interest rates hasalso been on account of several other factors such asthe deepening of the market through establishment ofappropriate market intermediaries, increase in thenumber of participants, prevalence of comfortableliquidity conditions arising out of large capital inflowsand a distinct policy preference for a softer interestrate regime. The volatility in call money rates hasreduced after the introduction of LAF and the settingup of an informal corridor of reverse repo and repo rates(Table 3.5). The stability in the overnight money marketwas further facilitated by introduction of new instrumentssuch as market repo and CBLO. Increased stability in

Table 3.5: Volatility in Money Market Rates

April 1993- April 1996- April 2000-Item March 1996 March 2000 March 2007

1 2 3 4

Call MoneyAverage (Per cent) 11.1 8.0 6.3SD 6.7 3.7 1.9CV 0.6 0.5 0.3

Commercial PaperAverage (Per cent) 13.4 11.7 7.8SD 2.6 2.2 1.8CV 0.2 0.2 0.2

Certificates of DepositAverage (Per cent) 12.2 11.6 6.9SD 2.2 2.4 1.7CV 0.2 0.2 0.2

Term Money @Average (Per cent) – – 6.5SD – – 1.4CV – – 0.2

Market Repo*Average (Per cent) – – 5.4SD – – 1.1CV – – 0.2

CBLO*Average (Per cent) – – 5.3SD – – 1.1CV – – 0.2

@ : For the period May 2001 to March 2007.* : For the period April 2004-March 2007.SD : Standard Deviation. CV : Coefficient of Variation.Note: Calculated on monthly average data.

call rates and various other reforms have also imparteda degree of stability to other market instruments suchas CPs and CDs. The lower volatility is in consonancewith the Reserve Bank’s emphasis on financial stabilityas a key consideration of monetary policy.

Interest Rate Derivatives

3.127 Interest rate deregulation has made financialmarket operations relatively efficient and cost effectivebut has also exposed market participants to variousrisks. This necessitated introduction of derivativeinstruments to manage these r isks throughunbundling of risks. The derivative contracts can betraded either over-the-counter (OTC) or in stockexchanges (exchange-traded). OTC contracts aretraded directly between two eligible parties, with orwithout the use of an intermediary and without goingthrough the stock exchanges. On the other hand,exchange-traded (ET) derivatives are transacted instock exchanges as standardised products throughscreen-based trading.

02-A

pr-

93

29-O

ct-9

327-M

ay-9

42

3-D

ec-9

421-J

ul-

95

16-F

eb-9

627-S

ep-9

625-A

pr-

97

21

-Nov

-97

19-J

un

-98

15-J

an-9

913-A

ug-

99

10-M

ar-0

006-O

ct-0

004-M

ay-0

13

0-N

ov-0

128-J

un

-02

24-J

an-0

322-A

ug-

03

19-M

ar-0

415-O

ct-0

413-M

ay-0

50

9-D

ec-0

507-J

ul-

06

02-F

eb-0

7

Chart III.8: Certificates of Deposit

Ru

pee

s cr

ore

Per

cen

t

Outstanding Amount Average Discount Rate (right scale)

102


3.128 Derivative trading in India witnessed someactivity from July 1999 when the Reserve Bankallowed scheduled commercial banks (excludingRegional Rural Banks), PDs and all-India financialinstitutions to undertake Forward Rate Agreements(FRA)/Interest Rate Swaps (IRS) for managinginterest rate risks in their balance sheets. In order towiden the market, mutual funds were allowed toparticipate for the purpose of hedging their ownbalance sheet risks from November 1999. The use of‘interest rate implied in the foreign exchange forwardmarket’ as a benchmark, in addition to the domesticmoney and debt market rates, was permitted fromApril 2000. The activity gathered momentum afterexchange-traded derivatives by way of futures wereintroduced in Mumbai Stock Exchange (BSE) andNational Stock Exchange (NSE) from June 2000.

3.129 Initially, banks/PDs/FIs were permitted toundertake different kinds of plain vanilla products suchas FRAs/IRS with tenors ranging from one month toone year. The Foreign Exchange Management Act(FEMA), 2000 permitted banks to provide r iskmanagement tools such as swaps, options, caps,collars and FRAs to clients to hedge interest rate riskarising out of foreign currency liabilities. Even thoughthe derivative transactions have grown significantlyin recent years, the market is essentially one of vanillaproducts. Active participants in the market are alsolimited, mainly some foreign and private sector banks,PDs and all-India financial institutions. The ReserveBank allowed banks and PDs to transact in exchangetraded interest rate futures (IRFs) from June 2003to hedge their interest rate risk effectively. While PDswere allowed to hold trading as well as hedgingpositions in IRFs, banks were allowed only to hedgetheir underlying government securities [in availablefor sale (AFS) /held for trading (HFT) categorypor t fol ios] through IRFs. The National StockExchange (NSE) introduced futures on a notional 10-year government security, a 3-month Treasury Billrate and a 10-year government zero coupon in June2003. Activity in the IRF market has, however, notpicked up because of valuation problems as alsobecause banks have been allowed only to hedge butnot to trade.

3.130 Innovations in OTC derivatives have beenlimited due to several structural shor tcomings,including lack of clear accounting and disclosurestandards, lack of adequate knowledge of uses andrisks inherent in derivative transactions, particularlythose involving complex structures, legaluncertainties surrounding the use of OTC derivatives

and uncertainties about regulations with regard tocertain complex products. To address these issues,the Reserve Bank constituted a number of workinggroups.

3.131 The Working Group on Rupee Derivatives(Chairman: Shri Jaspal Bindra), which submitted itsReport in January 2003, was set up to suggest themodalities for introducing derivatives having explicitoption features such as caps/collars/floors in therupee derivative segment and also the norms forcapital adequacy, exposure limits, swap position,asset liability management, internal control and otherrisk management methods for these derivatives.Recognising the ambiguity regarding the legality ofthe OTC derivative contracts as the main factorinhibit ing their growth, the Group proposedappropriate amendments in the Reserve Bank of IndiaAct, 1934 to provide legality to OTC derivatives.Accordingly, the Union Budget, 2005-06 proposed totake measures to provide clear legal validity to suchcontracts. The Reserve Bank of India Act, 1934 hassince been amended, which now provides legalsanctity to OTC derivatives if at least one of the partiesto the transaction is the Reserve Bank or any agencyfalling under its regulatory purview.

3.132 The Internal Working Group on RupeeInterest Rate Der ivatives (Chairman: Shr i G.Padmanabhan) recommended the harmonisation ofregulations between OTC interest rate derivativesand ET interest rate der ivat ives. I t alsorecommended that banks that have adequateinternal risk management and control systems anda robust operational framework be permitted to holdtrading positions in the interest rate futures (IRF)market. The Securities and Exchange Board of India(SEBI) revisited the issue pertaining to introductionof new futures contracts in consultation with theFixed Income Money Market and Der ivat ivesAssociation of India (FIMMDA) and permitted tradingof interest rate futures contract on an underlying 10-year coupon-bearing notional bond from January 5,2004. The Reserve Bank released comprehensivedraft guidelines in December 2006 on derivativescovering broad generic principles for undertakingderivative transactions, management of risk andsound corporate governance requirements.

3.133 Reflecting these measures, the rupeederivative market has grown significantly. FRAs/IRStransactions, in terms of outstanding notional principalamount, rose from Rs.4,249 crore in March 2000 toRs.21,94,637 crore at end-March 2006.

103

MONEY MARKET

(ii) Interest Rate Swaps

3.134 In the interest rate swap market, apart fromincrease in volumes, the market also witnessedemergence of interest rate benchmarks such asMumbai Inter-Bank Offered Rate (MIBOR), theMumbai Inter-Bank Forward Offered Rate (MIFOR)(which is a combination of the MIBOR and forwardpremium) and other multiple benchmarks, whichessentially have linkages to the movement in overseasinterest rates. MIBOR linked short-term paper up to365 days, with/without daily call/put options, hasemerged as an important instrument which enablestop rated corporates to raise funds from non-bankentities, particularly from mutual funds.

3.135 Overnight Index Swaps (OIS) help inmanaging interest rate risk by converting fixed ratereceivables to floating and vice versa without takingcredit risk as this tool is built on a notional principal.Banks can use this instrument to effectively managetheir liquidity by converting their fixed term depositsinto floating rate. This instrument is also used for assetliability management and as a positioning tool forputting on carry trades. MIFOR swaps, on the otherhand, are used to hedge interest rate risk as well ascurrency risk by an entity which has exposure toforeign currency borrowing by taking an oppositeposition in MIFOR swap.

3.136 The 5-year OIS yields rose considerably fromaround 4.70 per cent in the beginning of January 2004to about 7.90 per cent on March 28, 2007. The OIScurve steepened during the period from January 2004to October 2004 with spreads between 1 year and 5year tenors increasing from 26 basis points (bps) to140 bps, but later flattened to reach 22 bps byDecember 8, 2006. Inversion of the curve wasobserved with the spread turning negativeintermittently between the last week of December

2006 to third week of March 2007. OIS yields arepositively correlated to the government securities (G-Sec) yields. For most part of 2004, OIS curve wasabove the G-sec curve as it priced in expectations ofa turnaround in interest rate cycle. In the absence ofshort selling, G-Sec markets were unable to pricethese expectations effectively. Subsequently, as G-Sec markets reacted to the rising interest ratescenario, the G-Sec yields edged above the OIS curve(Chart III.9). The OIS curve remaining below the G-Sec curve for a sustained period of time was probablya reflection of the liquidity conditions as swap curvesnormally stay above the Treasury curve. Thus, duringsituations of tight liquidity, the OIS - G-Sec spreadtends to be narrow.

MIFOR (Mumbai Inter-Bank Forward Offered Rate)Swaps

3.137 The yields on MIFOR swaps have risen duringthe last three years in line with the general increasein interest rates. The 5-year MIFOR swap rateincreased from 3.85 per cent at the beginning ofJanuary 2004 to 8.16 per cent on March 28, 2007.The MIFOR curve flattened with the 1-year to 5-yearspreads steadily declining from a high of 200 bps inthe beginning of January 2004 before turning negativefrom December 2006 to March 2007, it touched (-)119 bps on March 28, 2007. The MIFOR curve hasremained consistently below the G-Sec curve duringlast three years except from June to August 2004.This was mainly for the reason that MIFOR curve isinfluenced largely by the implied rupee interest ratesin the forward premia, which, in the absence ofcovered interest parity, tend to diverge from interestrate differential. Between mid-November 2006 and thethird week of March 2007, the MIFOR curve wasabove the G-Sec curve. Five-year MIFOR was above

1-year 2-year 5-year

OIS Yields

Per

cen

t

01-J

an-0

4

31

-Mar

-04

29-J

un

-04

27-S

ep-0

4

26

-Dec

-04

26

-Mar

-05

24-J

un

-05

22-S

ep-0

5

21

-Dec

-05

21

-Mar

-06

19-J

un

-06

17-S

ep-0

6

16

-Dec

-06

16

-Mar

-07

G-Sec and OIS Yields

Per

cen

t

01-J

an-0

4

31

-Mar

-04

29-J

un

-04

27-S

ep-0

4

26

-Dec

-04

26

-Mar

-05

24-J

un

-05

22-S

ep-0

5

21

-Dec

-05

21

-Mar

-06

19-J

un

-06

17-S

ep-0

6

16

-Dec

-06

16

-Mar

-07

G-Sec OIS

Chart III.9: OIS and G-Sec Yields

104


G-Sec of corresponding tenor by 53 bps as onJanuary 29, 2007 and 28 bps as on February 12,2007, as forward premia moved up sharply during thisperiod (Chart III.10).

Monetary Policy and Swap Rates

3.138 Swap rates generally move in tandem withG-sec yields. Accordingly, whenever there was a hikein the policy rate, all swap rates, viz., OIS and MIFORgenerally reacted similarly (Chart III.11). The onlyexception was on October 25, 2005, when swap ratesdid not react to the hike in reverse repo rate by 25bps to 5.25 per cent. This was mainly due to marketparticipants refraining from taking firm positions sincethe Bank Rate was left unchanged. Furthermore, themarket did not perceive the hike in the repo rate by

25 bps on October 31, 2006 as tightening of monetarypolicy stance as the reverse repo rate was leftunchanged.

3.139 While the introduction of new instruments,including derivatives, has deepened the moneymarket, the market is still not mature enough forcomplex products. With ful ler capital accountconver tibility the market par ticipants would beexposed to cer tain risks. Therefore, the fur therdevelopment of hedging instruments such as interestrate futures assumes critical importance. Effective riskmanagement by market participants also calls foraccess initially to a liquid IRF market and eventuallyto an interest rate options market, which, in turn,would increase liquidity in the government securitiesmarket. As demand for complex derivate productsgrows over time, there would be a need for banks tolay down appropriate policies for marketing suchproducts to their clients and put in place a mechanismfor close monitoring and stricter regulations.

Other Money Market Segments

(a) Inter-Bank Participation Certificates (IBPCs)

3.140 As an additional instrument for modulatingshort-term liquidity within the banking system, it wasdecided, in principle, to introduce two types ofparticipation certificates (PCs) in October 1988 - oneon risk sharing basis and the other without riskshar ing. These were made str ict ly inter-bankinstruments confined to scheduled commercial banks,excluding regional rural banks. PCs, however, havenot been used widely so far. These instruments areused only to obviate short-term liquidity problems bysome banks by parting with standard assets. At times,these assets are also used to equilibrate prioritysector norms by banks.

Per

cen

t

1-year 2-year 5-year

01-J

an-0

4

31

-Mar

-04

29-J

un

-04

27-S

ep-0

4

26

-Dec

-04

26

-Mar

-05

24-J

un

-05

22-S

ep-0

5

21

-Dec

-05

21

-Mar

-06

19-J

un

-06

17-S

ep-0

6

16

-Dec

-06

16

-Mar

-07

MIFOR SWAP Yields

Per

cen

t

MIFOR and G-Sec Yields

01-J

an-0

4

31

-Mar

-04

29-J

un

-04

27-S

ep-0

4

26

-Dec

-04

26

-Mar

-05

24-J

un

-05

22-S

ep-0

5

21

-Dec

-05

21

-Mar

-06

19-J

un

-06

17-S

ep-0

6

16

-Dec

-06

16

-Mar

-07

G-Sec MIFOR

Chart III.10: MIFOR SWAP and G-Sec Yields

01-J

an-0

4

31-M

ar-0

4

29-J

un

-04

27-S

ep-0

4

26

-Dec

-04

26-M

ar-0

5

24-J

un

-05

22-S

ep-0

5

21

-Dec

-05

21-M

ar-0

6

19-J

un

-06

17-S

ep-0

6

16

-Dec

-06

16-M

ar-0

7

Chart III.11: Monetary Policy and Swap Rates

G-Sec OIS MIFOR Reverse Repo Rate

Per

cen

t

105

MONEY MARKET

(b) Money Market Mutual Funds (MMMFs)

3.141 Money market mutual funds were introducedin India in April 1991 to provide an additional short-term avenue to investors and to bring money marketinstruments within the reach of individuals. A detailedscheme of MMMFs was announced by the ReserveBank in April 1992. The portfolio of MMMFs consistsof short-term money market instruments. Investmentsin such funds provide an opportunity to investors toobtain a yield close to short-term money market ratescoupled with adequate liquidity. The Reserve Bankhas made several modifications in the scheme tomake it more flexible and attractive to banks andfinancial institutions. In October 1997, MMMFs werepermitted to invest in rated corporate bonds anddebentures with a residual maturity of up to one year,within the ceiling existing for CPs. The minimum lock-in period was also reduced gradually to 15 days,making the scheme more attractive to investors.

Market Integration

3.142 The success of monetary policy depends onthe speed of adjustment in money market rates inresponse to changes in the policy rates for effectivetransmission of monetary policy impulses to theeconomy. This, in turn, depends on the developmentand integration of various market segments. In linewith the progress of financial sector reforms in India,various segments of the money market are gettingincreasingly integrated as reflected in the close co-movement of rates in various segments. The structureof returns across markets has shown greaterconvergence after the introduction of LAF,differentiated by matur ity, l iquidity and r isk ofinstruments (Chart III.12).

3.143 Strengthening of linkages amongst marketsegments suggests greater operational efficiency ofmarkets as well as the conduct of monetary policy.On the flip side, however, increased integration hasresulted in increased contagion as turbulenceor iginating in one market segment is swift lytransmitted across all segments. Recent experienceof financial market operations in various countriessuggests that market integration tends to strengthenduring episodes of volatility, pointing to a swiftertransmission of market pressures from one segmentto another. This imposes additional constraints on themanagement of market conditions necessitatingsimultaneous policy actions in various marketsegments to limit contagion in the presence ofasymmetric integration of markets. The monetary

policy reaction has been in terms of a combination ofinstruments, including regulatory action, to ensure therapid restoration of stability in financial markets. Inthis regard, the Reserve Bank has been able tomaintain orderly market conditions in recent yearsamidst heightened volatility in international financialmarkets (see also Chapter VIII).

Risk Management

3.144 The money market is characterised by variousrisks, viz., default risk, interest rate risk, exchangerate risk and settlement risk. Given the increasingmarket orientation of monetary policy in India, greaterflexibility provided to banks and the focus on interestrates as the main policy instrument, sound riskmanagement is critical for orderly market behaviourand overall financial stability. Accordingly, the ReserveBank has been laying greater emphasis on developingefficient r isk management practices by marketparticipants.

3.145 A potential source of default risk in the moneymarket emanates from the uncollateralised nature ofthe call money market. In this market, transactionsare traditionally undertaken over the counter throughtelephonic deals, which lack standardisation andguarantee of settlement against default. This problemhas been addressed by mandatory reporting of thedeals by the participants in an electronic platform.Moreover, a screen based quote driven system (NDS-CALL) has been developed by the CCIL on behalf ofthe Reserve Bank for greater transparency and price

Ap

r-93

Ju

l-9

4

Oct

-95

Jan

-97

Ap

r-98

Ju

l-9

9

Oct

-00

Jan

-02

Ap

r-03

Ju

l-0

4

Oct

-05

Jan

-07

Chart III.12: Money Market Rates

Call Rate Yield on 91-day Treasury Bill

CP Rate CD Rate

Per

cen

t

106


discovery in the call/notice and the term moneymarkets. Furthermore, as large recourse to theuncollateralised money market segment carries apotential risk of systemic instability arising out ofdefaults, prudential limits have been placed on callmoney exposures of banks and PDs. Moreover, non-bank participants with a distinctly different maturityprofile of sources and uses of funds have beenallowed to migrate from the call money segment tothe collateralised segments (market repos andCBLOs). The shift ing of non-banks to thecollateralised segment has enhanced financialstability by reducing systemic risks. Besides, it hasalso promoted better asset-liability management onthe part of banks. Cumulatively, these measures haveresulted in the dominance of the collateralisedsegment in the overnight money market.

3.146 In view of the growing inter-linkages betweenthe money and the foreign exchange markets on theone hand, and greater integration of the domesticmarket with global markets on the other, it isnecessary that the market participants appropriatelyhedge the risks in their balance sheets emanatingfrom movements in both international interest ratesand exchange rates. In this regard, the Reserve Bankhas introduced derivative instruments such as FRAs/IRS/IRFs for hedging exposures. Although derivativesfacil itate r isk management, they, being highlyleveraged, are more volatile than the underlyingassets. This calls for monitoring and regulation ofspeculative derivative positions. The Reserve Bank,therefore, has been emphasising monitoring andregulation of derivative transactions.

3.147 The institutionalisation of a central counterpartyin the form of Clearing Corporation of India (CCIL) from2002, which guarantees settlement of transactions, hasfacilitated the mitigation of settlement risks andprevention of gridlock in the financial system arisingout of bunching of transactions. The introduction ofRTGS has further mitigated the settlement risk andthe occurrence of gridlock.

VI. THE WAY FORWARD

3.148 Wide-ranging reforms have been undertakento develop the money market and strengthen its rolein the transmission mechanism of monetary policy.Three major considerations that have guidedrationalisation of the structure in the money marketare: (i) ensuring balanced development of variousconstituents of the money market, especially thegrowth of the collateralised market vis-a-vis theuncollateralised market; (ii) preserving integrity and

transparency of the money market by ensuring betterdisclosure of information; and (iii) rationalising variousclasses of par ticipants across different marketsegments in order to strengthen the efficacy of theLAF of the Reserve Bank. As a result of various reformmeasures, the money market in India has undergonesignificant transformation in terms of volume, numberof instruments and participants, and adoption of riskmanagement practices. There are, however, still anumber of concerns as well as issues that need to beaddressed to enable it to play a more effective role,especially in the wake of move towards fuller capitalaccount convertibility. These issues broadly relate tomarket development and liquidity management.

Market Development

Greater Flexibility for Participants in the Call MoneyMarket

3.149 In view of the transformation of the call moneymarket into a pure inter-bank market, there is a needto consider greater flexibility to banks and PDs toborrow or lend in this market, provided they have putin place appropriate risk management systems whichwould address the asset-liability mismatches in theirbalance sheets. In this context, banks have alreadystarted operating in an environment that requiresgreater harmonisation between sources anddeployment of funds for asset-liability management(ALM) purposes. Direct regulation in the form ofprudential limits on borrowing and lending eventuallywould need to graduate to a system, where such limitsare taken care of by banks’ own internal systems ofALM framework. This would correct large mismatchesbetween sources and uses of funds by banks andthereby help the Reserve Bank in the properassessment of market conditions for the conduct ofits liquidity management operations. There is also, atthe same time, a greater need for closely monitoringthe movements of call money rates.

Extension of the Repo Market

3.150 It has been the endeavour of the ReserveBank to develop the repo market not only for easingpressure from the uncollateralised call money marketbut also to facilitate the emergence of a short-termrupee yield curve for pricing fixed income securities.At present, only Central and State Governmentssecurities are eligible for market repo. However, StateGovernment securities do not have wider acceptabilityas there are hardly any repo operations based onthem. As the fixed income money market has beenoverwhelmingly dependent upon Central Government

107

MONEY MARKET

securities, there is a need to consider broad-basingthe pool of eligible securities. In this context, fullydematerialised corporate bonds with internationallyaccepted accounting practices could eventually beconsidered as eligible collaterals. The developmentof a proper settlement system for such instrumentswould be a prior necessity for progress in thisprocess. There is also a need to exercise caution toensure that only highly rated instruments qualify forsuch a facility. This is critical from the point of view ofpreserving market integrity. In future, the growth ofmarket repo will be driven by the “short selling” activityin the government securities market as a repoedsecurity can now be delivered up to five days in viewof the recent changes in the regulations governingshort sales.

Development of a Vibrant Term Money Market

3.151 The term money market has not developedfor several reasons, as discussed in detail earlier. Oneof the major reasons for this is that market participantshave been unable to take a long-term view of interestrates despite availability of Treasury Bills of varyingmaturities and a reasonably developed swap market.In order to enable market participants to take a long-term view on interest rates, it is imperative that theALM framework is strengthened and greater flexibilityis allowed to the personnel managing treasuryoperations in banks. The skewness in liquidity in themoney market in terms of chronic lenders andborrowers would get corrected as banks developbetter ALM systems. The development of the termmoney market is vital for strengthening properlinkages between the foreign exchange market andthe domestic currency market, which, in turn, wouldprovide an impetus to the derivative segment.

Relook at Inter-Bank Participation Certificates

3.152 Inter-Bank Participation Certificates, whichcan be used for evening out short-term liquiditymismatches by banks, were introduced in October1988 in order to infuse greater degree of flexibility intheir credit portfolios. In view of rapid credit growth inrecent years, interest in IBPCs has again arisen. Inthis context, since considerable time has elapsedsince the guidelines on the scheme of IBPCs wereissued, the IBPC scheme with respect to duration,quantum in terms of the proportion to the loan amount,eligible participants and transferability of IBPCs needsa thorough review. Depending on the results of sucha review, extending the use of this instrument couldalso facilitate the asset liability management by banks,

improve day-to-day liquidity management and helpdevelop a market for credit risk transfer instrumentsbetween banks.

Issues Pertaining to CP

3.153 Despite the de-linking of issuance from fund-based working capital l imits and completedematerialisation of CP issuances, the CP marketcontinues to lack the desired level of activity. In termsof extant guidelines, only companies rated P-1 or P-2by CRISIL or such equivalent rating by other agencies,can issue CP. As the market attains a reasonable levelof maturity while the rating criterion may continue,the requirement of rating for issuing CP could be mademore flexible so that a more structured market isavailable to investors depending on their risk appetite.

Futures on Policy Linked Interest Rates

3.154 Going forward, an Indian variant of the FederalFunds Futures on interest rates linked to the ReserveBank’s key policy rates may emerge. Trading in thefutures market would reveal important informationabout market expectation on the future course ofmonetary policy. For instance, the trading of theFederal Funds Futures provides key information tothe Federal Open Market Committee (FOMC) in theUS in formulating its monetary policy.

Promoting Financial Stability

3.155 Default risk in the money market has thepotential to create a contagion in the financial marketsand, therefore, needs to be mitigated. In this regard,experiences of developed economies show thatgenerally the self-regulatory organisations (SROs)regulate activities of participants in the money marketin terms of their capital adequacy and conduct ofbusiness. Also, default resolution in most of thesemarkets is undertaken through the Contract Law andthe Bankruptcy Law. In view of internationalexperience, there may be a case for empowering asuitable self-regulatory organisation appropriately toact as a catalyst for the development of marketmicrostructure.

3.156 One of the fundamental forces that couldcontribute to more organic integration across varioussegments of the financial market is the technologicalupgradation of the payment and settlement system.The accomplishment of virtual Public Debt Office(PDO) and Deposit Accounts Department (DAD) atthe Reserve Bank, coupled with the operationalisationof the centralised funds management system (CFMS)

108


in a relatively low CRR regime should foster greaterintegration of various segments of the domesticmarket. While these developments could enhancethe efficiency of the financial market, there is alsothe r isk of faster t ransmission of contagion.Therefore, risk containment in the new environmentwould be a major challenge for the Reserve Bankand it would have to remain flexible in the deploymentof its instruments while simultaneously interveningin various market segments in order to strengthenfinancial stability.

Liquidity Management

3.157 Although significant progress has been madein refining the liquidity management practices in India,several new challenges have emerged. First, duringperiods of abundant liquidity, the LAF windowbecomes a first resort for parking surplus funds bybanks. Second, the Reserve Bank has developed theMSS as a sterilisation mechanism for arresting theliquidity impact of foreign exchange inflows of a moreenduring nature, while the LAF continues to be usedfor managing liquidity at the margin. There is, however,no way of knowing ex-ante whether the liquiditysituation is temporary or permanent. Furthermore, theMSS remains immobilised for the entire period of itsmaturity. There is, therefore, a need to explore furtherinstruments/options to under take l iquiditymanagement, particularly in the context of a move tofuller capital account convertibility. Third, the ReserveBank may not be in a position to conduct sterilisationoperations indefinitely as its inventory of Governmentpaper is limited. There is also a limit on MSSissuances. Fur thermore, the Reserve Bank haswithdrawn from pr imary market auctions ofGovernment paper from April 1, 2006 in terms ofprovisions of the Fiscal Responsibility and BudgetManagement (FRBM) Act, 2003. Fourth, the absenceof a vibrant corporate debt market continues toimpede further refinements in liquidity managementin terms of eligible instruments as collaterals. In thiscontext, it may be noted that State DevelopmentLoans, which are treated as eligible securities forcollaterals under LAF operations effective April 3,2007, have widened the collateral base for LAF. Fifth,as many banks are now operating close to theprescribed levels of SLR securities, in case of liquiditytightness, banks may find it difficult to approach theLAF window in the absence of sufficient collateral

securities. Sixth, while the Reserve Bank now holdsLAF auctions twice on each working day to facilitateintra-day liquidity, a moral hazard issue arises assome market par ticipants may not be activelymanaging their own liquidity in the wake of theReserve Bank’s market operations.

3.158 The above issues need to be addressed,especially in the wake of a progressive move to fullercapital account convertibility. First, there is a need tofur ther refine the system of assessing liquidityconditions, which calls for an improved framework ofliquidity forecasting. The short span within whichliquidity conditions have been changing by a largeamount has posed a major challenge for targetingshort-term interest rates. The understanding of thefiscal position and the Government’s cash balancesas also the timing and extent of capital inflowsassumes added significance. In this context, theremay be a need to consider the regular release ofinformation on Government cash balances held withthe Reserve Bank. Second, progressively moreweightage needs to be given to movements ininternational interest rates in view of increased capitalmobility. Third, destabilising large and sudden capitalflows call for more flexible and swift monetary policyresponses through small and gradual changes inpolicy rates, as has been practised in recent years,as large changes can be disruptive. Fourth, openmarket operations (OMOs), apart from being used formodulating liquidity conditions, could also be used tocorrect any serious distortions in the yield curve.Finally, while the Reserve Bank has progressivelydeemphasised the use of reserve requirements asan instrument of monetary policy, given the presentstate of market development, it is necessary to retainthe flexibility of using reserve requirements, as andwhen necessary12.

VII. SUMMING UP

3.159 Since the early 1990s, the money market hasundergone a significant transformation in terms ofinstruments, par t icipants and technologicalinfrastructure. Various reform measures have resultedin a relatively deep, liquid and vibrant money market.The transformation has been facilitated by theReserve Bank’s policy initiatives as also by a shift inthe monetary policy operating procedures fromadministered and direct to indirect market-based

12 The provisions of Section 3 of the Reserve Bank of India (Amendment) Act, 2006 came into force effective April 1, 2007, which provide thenecessary flexibility to the Reserve Bank in the use of the CRR.

109

MONEY MARKET

instruments of monetary management. The changesin the money market structure and monetary policyoperating procedures in India have been broadly instep with the international experience and bestpractices.

3.160 Along with the shifts in the operatingprocedures of monetary policy, the l iquiditymanagement operations of the Reserve Bank havealso been fine-tuned to enhance the effectiveness ofmonetary policy signalling. The increasing financialinnovations in the wake of greater openness of theeconomy necessitated the transition from monetarytargeting to a multiple indicator approach with greateremphasis on rate channels for monetary policyformulation. Accordingly, short-term interest rateshave emerged as a key instrument of monetary policysince the introduction of LAF, which has become theprincipal mechanism of modulating liquidity conditionson a daily basis.

3.161 In line with the shifts in policy emphasis,various segments of the money market have beendeveloped. The call money market was transformedinto a pure inter-bank market, while other moneymarket instruments such as market repo and CBLOwere developed to provide avenues to non-banks formanaging their short-term liquidity mismatches.Furthermore, issuance norms and maturity profilesof other money market instruments such as CPs andCDs were aligned for effective transmission of policyintent across various segments. The abolition of adhoc Treasury Bills and introduction of Treasury Billsauction have led to the emergence of a risk free rate,which acts as a benchmark for pricing other moneymarket instruments. The increased market orientationof monetary policy and greater integration of domesticmarkets with global financial markets, however, havenecessitated the development of an institutionalframework for appropriate risk management practices.

Accordingly, the Reserve Bank’s emphasis has beenon encouraging migration towards the collateralisedsegments and developing derivatives for hedgingmarket risks. This has been complemented by theinstitutionalisation of CCIL as a central counterpartyto mitigate the settlement risk. The upgradation ofpayment technologies has further enabled marketpar t icipants to improve their asset l iabi l i tymanagement. Cumulatively, these measures havehelped in containing volatility in the money market,thereby improving the signalling mechanism ofmonetary policy while ensuring financial stability.

3.162 Notwithstanding the considerable progressmade so far, there is a need to develop the moneymarket further, particularly in the context of a movetowards fuller capital account convertibility. Furtherdevelopment of the money market calls for better ALMpractices by banks and other market participants,which would enable banks to evolve appropriateprudential limits on their call money exposures fromtheir internal control systems. In order to develop theterm money market, participants need to take a long-term view on interest rates. Furthermore, there is aneed to expand the eligible set of underlying collateralsecurities for repo transactions. This would not onlyfacilitate liquidity management but also promote thedevelopment of underlying debt instruments. Finally,liquidity forecasting techniques need to be furtherrefined for proper assessment of liquidity conditionsby the Reserve Bank. This would facilitate finerchanges in the operating procedures of liquiditymanagement and enable the Reserve Bank to flexiblymeet the emerging challenges. As thesedevelopments take place, it needs to be understoodthat monetary management in India will continue tobe conducted in an intermediate regime that will haveto respond creatively and carefully to the emergingand evolving monetary and macroeconomicconditions, both domestic and global.

110


AN

NE

X II

I.1:

Op

erat

ing

Pro

ced

ure

s o

f L

iqu

idit

y M

anag

emen

t in

Dev

elo

ped

Co

un

trie

s

*:

Vol

unta

ry r

eser

ves

aver

agin

g sc

hem

e w

ith r

eser

ves

rem

uner

ated

at t

he B

ank

Rat

e pr

ovid

ed o

n av

erag

e th

ey fa

ll w

ithin

+ o

r -

1% o

f tar

gets

set

by

sche

me.

@:

The

EC

B s

ets

thre

e ke

y in

tere

st r

ates

for

the

euro

are

a, w

hich

det

erm

ine

the

stan

ce o

f the

EC

B’s

mon

etar

y po

licy.

The

se in

clud

e in

tere

st r

ates

on

the

mai

n re

finan

cing

ope

ratio

ns, t

he m

argi

nal l

endi

ng fa

cilit

y an

d th

ede

posi

t fa

cilit

y.

So

urc

e: W

ebsi

tes

of r

espe

ctiv

e ce

ntra

l ban

ks a

nd H

awki

ns. J

(20

05).

Dai

ly

One

per

wee

kpl

us o

ne p

erm

onth

(lo

ng-

term

rep

os)

One

per

wee

kpl

us o

ne p

erm

onth

on

are

gula

r ba

sis

Mor

e th

anon

e pe

r day

Dai

ly

Dai

ly

Twic

e a

day

Prim

ary

deal

ers

Elig

ible

UK

ban

ks, b

uild

ing

soci

etie

s &

sec

uriti

es d

eale

rs.

Cre

dit i

nstit

utio

ns m

eetin

g ce

rtai

nop

erat

iona

l req

uire

men

ts,

mut

ual

fund

s,

corp

orat

ions

, ins

uran

ceco

mpa

nies

& o

ther

inst

itutio

nal

inve

stor

s.

Maj

or p

laye

rs: d

omes

tical

ly li

cens

edba

nks,

fore

ign

bank

s an

d se

curit

ies

com

pani

es &

mon

ey m

arke

tbr

oker

s.

Any

mem

ber

of R

eser

ve B

ank

Info

rmat

ion

& T

rans

fer

Sys

tem

- la

rge

dom

estic

ban

ks, f

ew la

rge

non-

ban

kfin

anci

al in

stitu

tions

& lo

cal b

ranc

hes

of s

ome

glob

al b

anks

.

Thos

e pa

rtie

s w

ho h

ave

ente

red

Mas

ter

Rep

urch

ase

Agr

eem

ent w

ithth

e R

eser

ve B

ank.

Prim

ary

deal

ers

Dire

ct o

blig

atio

ns o

f the

Gov

t. or

thos

efu

lly g

uran

teed

by

Fede

ral G

ovt.

agen

cies

& c

orpo

rate

bon

ds.

UK

and

EE

A G

ovt.

& m

ajor

inte

rnat

iona

lor

gani

satio

ns’ b

onds

(S

terli

ng a

nd E

uro)

.

Bot

h m

arke

tabl

e &

non

-mar

keta

ble

priv

ate

& p

ublic

inst

rum

ents

.

Bot

h pu

blic

deb

ts s

uch

as J

GB

s &

priv

ate

debt

s su

ch a

s C

Ps

& b

ank

loan

s.

Com

mon

wea

lth g

ovt.

secu

ritie

s,do

mes

tic d

ebt s

ecur

ities

& d

isco

unt

inst

rum

ents

issu

ed b

y S

tate

& te

rrito

rial

Gov

t., b

ank

bills

& C

Ds

issu

ed b

y se

lect

bank

s, s

ecur

ities

of s

upra

natio

nal &

fore

ign

Gov

t. ag

enci

es h

avin

g G

ovt.

gura

ntee

.

Gov

t. se

curit

ies

Sec

uriti

es is

sued

& g

uara

ntee

d by

the

Gov

t. of

Can

ada

& th

e pr

ovin

cial

Gov

t.,ba

nker

s’ a

ccep

tanc

es,

prom

isso

ry n

otes

,C

Ps,

sho

rt-te

rm m

unci

pal p

aper

,co

rpor

ate

& m

unci

pal b

onds

with

min

imum

issu

er c

redi

t rat

ings

.

US

A

UK

EC

B

Japa

n

Aust

ralia

New

Zea

land

Can

ada

To p

rom

ote

max

imum

sust

aina

ble

outp

ut,

empl

oym

ent &

stab

le p

rices

Pric

e st

abili

ty

Pric

e st

abili

ty,

high

leve

l of

empl

oym

ent,

bala

nced

&su

stai

nabl

ede

velo

pmen

t

Pric

e st

abili

ty &

toco

ntrib

ute

to th

eso

und

deve

lopm

ent

ofna

tiona

l eco

nom

y

Mai

nly

pric

est

abili

ty b

esid

es,

mai

nten

ance

of

full

empl

oym

ent,

econ

omic

pros

perit

y &

wel

fare

Pric

e st

abili

ty

Low

and

sta

ble

infla

tion

Fede

ral f

unds

rate

Ove

rnig

ht m

arke

tin

tere

st r

ate

cons

iste

nt w

ithB

ank

Rat

e

No

offic

ial

oper

atin

gta

rget

@

Ove

rnig

ht c

all

mon

ey r

ate

Cas

h ra

te

Offi

cial

cas

hra

te

Ove

rnig

ht r

ate

Mul

tiple

indi

cato

rs o

fcu

rren

t & p

rosp

ectiv

eec

onom

ic d

evel

opm

ents

.

Mon

etar

y an

d cr

edit

aggr

egat

es,

deve

lopm

ents

in in

tere

st r

ates

, etc

.

Mon

ey &

bro

ad a

sses

smen

t of

outlo

ok fo

r pr

ice

deve

lopm

ents

&th

e ris

ks to

pric

e st

abili

ty u

sing

finan

cial

& o

ther

eco

nom

icin

dica

tors

.

Ove

rall

econ

omic

& fi

nanc

ial

indi

cato

rs-

who

lesa

le p

rices

,co

rpor

ate

serv

ice

pric

es &

mon

eyst

ock.

Infla

tion

& g

row

th p

rosp

ects

,m

oney

& c

redi

t con

ditio

ns.

GD

P, o

utpu

t ga

p, b

usin

ess

cycl

ein

dica

tors

.

Out

put

gap

&

wid

e ra

nge

ofin

dica

tors

in v

ario

us m

arke

ts.

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes*

Yes

Yes

Freq

uenc

yof

Mar

ket

Ope

ratio

ns

Elig

ible

Cou

nter

part

ies

Elig

ible

Col

late

ral

12

34

56

78

910

1112

Cou

ntry

Obj

ectiv

eIn

term

edia

te /

Ope

ratin

gTa

rget

Key

Pol

icy

Indi

cato

rsK

ey In

stru

men

ts o

f D

iscr

etio

nary

Liq

uidi

ty

CR

RO

MO

Rep

oS

tand

ing

Faci

litie

sO

ther

s

111

MONEY MARKET

AN

NE

X II

I.2:

Op

erat

ing

Pro

ced

ure

s o

f L

iqu

idit

y M

anag

emen

t in

Em

erg

ing

Mar

ket

Eco

no

mie

s

Freq

uenc

yof

Mar

ket

Ope

ratio

ns

Elig

ible

Cou

nter

part

ies

Elig

ible

Col

late

ral

12

34

56

78

910

11 12

Cou

ntry

Obj

ectiv

eIn

term

edia

te /

Ope

ratin

gTa

rget

Key

Pol

icy

Indi

cato

rsK

ey In

stru

men

ts o

f D

iscr

etio

nary

Liq

uidi

ty

CR

RO

MO

Rep

oS

tand

ing

Faci

litie

sO

ther

s

* : P

ositi

on re

port

ed a

s of

200

3.#

: Rep

o/re

vers

e re

po u

nder

Liq

uidi

ty A

djus

tmen

t Fac

ility

.So

urce

: Web

site

s of

res

pect

ive

Cen

tral b

anks

and

Haw

kins

. J (

2005

).

Dai

ly &

wee

kly

Dai

ly

Dai

ly

1 o

r 2 p

erw

eek

Twic

e a

day-

Rep

o

Dai

ly

Dai

ly

Twic

e a

day

Wee

kly

Twic

e a

day

For l

oans

: fin

anci

ally

sou

nd c

redi

tin

stitu

tions

com

plyi

ng w

ith t

here

gula

tory

req

uire

men

ts a

ndha

ving

acc

ount

s i

n 22

Ban

k of

Rus

sia

regi

onal

bra

nche

s.Fo

r dep

osits

: ban

ks, s

ettle

men

t non

-ba

nk c

redi

t ins

titut

ions

con

duct

ing

depo

sit a

nd le

ndin

g op

erat

ions

.

Ban

king

inst

itutio

ns, w

hich

hav

esi

gned

IS

DA

/ISM

A a

gree

men

t.

21 c

omm

erci

al b

anks

& b

ills

finan

ce c

ompa

nies

.

LAF:

ban

ks a

nd p

rimar

y de

aler

sM

SS:

bank

s,

prim

ary

deal

ers,

all-I

ndia

fina

ncia

l ins

titut

ions

&ot

hers

.

Prim

ary

deal

ers,

com

mer

cial

bank

s, fi

nanc

e co

mpa

nies

,fin

ance

& s

ecur

ities

com

pani

es &

spec

ialis

ed fi

nanc

ial i

nstit

utio

ns.

Prim

ary

deal

ers

Bank

s, m

erch

ant b

anks

, inve

stm

ent

trust

and

sec

uritie

s co

mpa

nies

.

Pri

mar

y de

aler

s,

seco

ndar

yde

aler

s -

bank

s, m

erch

ant b

anks

& s

tock

bro

king

firm

s (in

the

case

of re

po o

nly

PD

s).

Ban

k of

R

ussi

a Lo

mba

rd

List

of

Sec

uriti

es,

prom

isso

ry n

otes

and

rig

hts

of c

laim

und

er lo

an a

gree

men

ts, F

eder

al&

Reg

iona

l Gov

t. bo

nds,

Ban

k of

Rus

sia

& c

redi

t in

stitu

tions

' bo

nds,

mor

tgag

eba

cked

bon

ds, r

esid

ent c

orpo

rate

bon

ds,

bond

s of

in

tern

atio

nal

finan

cial

orga

nisa

tions

.

All C

entra

l gov

t. se

curit

ies,

Res

erve

Ban

kB

ills

& la

nd b

ank

bills

.

Elig

ible

bill

s, b

anke

rs’ a

ccep

tanc

es, t

rade

acce

ptan

ces

&

prom

isor

y no

tes

colla

tera

lised

aga

inst

T-b

ills.

Cen

tral

Go

vt.

Sec

uri

ties

& S

tate

Dev

elop

men

t Lo

ans.

Pub

lic d

ebt

secu

ritie

s -

Gov

t. bo

nds,

T-bi

lls,

FID

F bo

nds

& G

ovt.

guar

ante

edS

tate

ent

erpr

ise

bond

s &

BO

T bo

nds.

Gov

t. se

curit

ies

for

repo

Cre

dit s

ecur

ities

(inc

ludi

ng b

ills e

ligib

le fo

rdi

scou

nt),

Tr

easu

ry

bond

s,

Gov

t.gu

aran

teed

bon

ds,

mar

ket

stab

lisat

ion

bond

s &

land

dev

elop

men

t bon

ds.

Sin

gapo

re g

ovt.

secu

ritie

s - T

-bill

s,bo

nds

and

non-

mar

keta

ble

SG

S b

onds

.

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes#

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Rus

sia

Sou

th A

frica

Mex

ico

Chi

na

Indi

a

Thai

land

Indo

nesi

a

Mal

aysi

a

Kore

a*

Sin

gapo

re

Sta

bilit

y of

curr

ency

&se

ttlem

ent

syst

em

Pric

e st

abili

ty

Pric

e st

abili

ty

Sta

bilit

y of

the

curr

ency

&th

ereb

y pr

omot

eec

onom

ic g

row

th

Gro

wth

, pric

ean

d fin

anci

alst

abili

ty

Pric

e st

abili

ty

Pric

e st

abili

ty

Mon

etar

y &

finan

cial

sta

bilit

yfo

r gr

owth

Pric

e st

abili

ty

Pric

e st

abili

ty a

sa

soun

d ba

sis

for

sust

aina

ble

econ

omic

gro

wth

Mon

etar

y ba

se

Rep

urch

ase

rate

Ban

k re

serv

es

Mon

ey s

uppl

y/ex

cess

res

erve

s

Ove

rnig

ht r

ate

Rep

urch

ase

rate

(14-

day)

Ban

k In

done

sia

Rat

e

Ove

rnig

htin

tere

st r

ate

Ove

rnig

ht c

all

rate

Wei

ghte

dex

chan

ge r

ate

Mul

tiple

indi

cato

rs- m

oney

, cre

dit,

inte

rnat

iona

l int

eres

t ra

tes,

yie

ldcu

rve,

out

put

gap,

ass

et p

rices

,B

OP

pos

ition

, exc

hang

e ra

te, e

tc.

Mon

ey &

mon

etar

y ba

se,

infla

tion

indi

cato

rs,

empl

oym

ent,

exch

ange

rat

e &

Bal

ance

of

Paym

ents

.

Mul

tiple

indi

cato

rs: b

road

mon

ey,

inte

rest

rate

s, d

ata

on c

urre

ncy,

cred

it, fi

scal

pos

ition

, tra

de,

capi

tal f

low

s, in

flatio

n ra

te,

exch

ange

rate

, oup

ut d

ata,

etc

.

Fore

cast

s fo

r in

flatio

n, e

cono

mic

grow

th, m

onet

ary

aggr

egat

es &

deve

lopm

ents

in e

cono

mic

&fin

anci

al s

ecto

r.

Rea

l int

eres

t rat

es, i

nfla

tion

&in

flatio

n in

dica

tors

, ass

et p

rices

,cr

edit,

mon

ey &

pot

entia

l out

put.

Indi

cato

rs o

f fut

ure

infla

tion.

Inte

rest

rat

es &

for

war

d fo

rex

rate

s.

Ban

k of

Rus

sia

Bon

ds&

cur

renc

ysw

aps

Fore

ign

curr

ency

swap

s

Pol

icy

orie

nted

finan

cial

bon

ds&

cen

tral

ban

kbo

nds

Mar

ket

Sta

bilis

atio

nSc

hem

e

Issu

ance

of

Ban

k of

Tha

iland

Bon

ds &

fore

ign

curre

ncy

swap

s

Ban

k of

Indo

nesi

aC

ertif

icat

es

Ban

k N

egar

aB

ills

Liqu

idity

adju

stm

ent

loan

s an

d in

tra-

day

over

draf

ts

Fore

x sw

aps

&re

vers

e sw

aps

112


ANNEX III.3: Structure of Money Markets

Country

1

USA

Instruments

2

Federal Funds

Discount window


Negotiable Certificates of Deposit

Eurodollar CDs

Eurodollar Time Deposits

Repurchase Agreements

Treasury Bills

Municipal Notes

Commercial Paper

Bankers’ Acceptances

Government-SponsoredEnterprise Securities· Discount Notes· Bonds

Shares in Money Market Instruments· Money market mutual funds· Local Government Investment Pools

Futures Contracts

Options

Interest Rate Swaps

Tenor

3

Mostly overnight(there are also long-term forfew weeks)

Usually overnight

Mostly 1-12 months(some have 5 years or more)

1-12 months

Mostly 3-6 months(some have long-term)

Overnight, 1-week,1-6 months & longer

Short-term: overnight or a few daysLonger-term: 1, 2, 3-weeks & 1, 2, 3,6-months.

4, 13 & 26-weeks(52-weeks bill suspended in 2001)

30-days to 1-year

Mostly 270-daysAverage 30-days

Up to 270-days.

30 to 360-daysMore than 1-year

Less than 90-daysAverage: 318-days(1-1044 days)

3-months

Exercise at strike price on or before pre-arranged expiration date.

Exchange of interest streames over thelives of underlying debt issues.

Major Participants

4

Banks & other depository institutions.

Banks & other depository institutions*

Banks (money centre banks & largeregional banks)*

Well capitalised banks.

Banks (foreign branches of US banks orforeign banks located abroad)*. Theseare sold to brokers, investment banks,institutional investors, & largecorporations.

Banks*

Banks, securities dealers, non-financialcorporations & Governments (principalparticipants).

US Government & primary dealers.

State/ Local Governments.

Non-financial & financial businesses(corporations & foreign Governments)*.

Non-financial & financial businesses(firms involved in imports & exports)*.

Farm Credit System, Federal Home LoanBank System & Federal NationalMortgage Association*.

Money market mutual funds & LocalGovernment Investment Pools.

Dealers & banks*

Dealers, banks & non-banks

Dealers, banks & non-banks

* Principal borrower.

113

MONEY MARKET

ANNEX III.3: Structure of Money Markets (Contd.)

Reserves Averaging

Standing Lending & Deposit Facilities

OMOs: Repurchase Agreements(Gilts, HM Government non-sterlingmarketable debt, Sterling Treasury Bills,Bank of England Euro Bills & Euro notes,eligible bank & local authority bills, Sterlingdenominated securities issued byEuropean Economic Area, CentralGovernments & International institutions).

Treasury Bills

Bills of Exchange.


Commercial Paper· Bank Acceptance· Trade Paper

Main refinancing operations

Long-term refinancing operations (Tier-1& Tier-2 assets)

Fine-tuning/structural reverse transactions(Tier-1 & Tier-2 assets)

Fine-tuning/structural outright purchase(Only Tier-1 assets)

Fine-tuning foreign exchange swap

Marginal lending facility(Tier-1 & Tier-2assets)

Structural issuance of debt securities

Deposit facility

Call money marketShort-term securities:· Commercial Paper· Certificates of Deposit· Treasury Bills

1-month between MPC decision dates

Overnight

1-week at Bank Rate;3, 6, 9, 12-months at market rates

Upto 1-year (Some have maturity over1-year)

1-week

3-months

Non-standardised

Non-standardised

Non-standardised

Overnight

Less than 12-months

Overnight

43 banks & building societies

More than 60 UK banks & buildingsocieties

43 UK banks, building societies &securities dealers.

Issued by the Government.

Issued by banks.

Issued by building societies & traded bybanks & discount houses.

Issued by Industry

Traders

Counterparties: eligible credit institutions.

Eligible credit institutions.





UK

ECB@

Japan

@ Source : Blenck D, et al. (2001).

Country

1

Instruments

2

Tenor

3

Major Participants

4

114



Repurchase Agreements(Eligible collateral: Government bonds/bills, Government guranteed bonds,municipal bonds, & foreign Governmentbonds, commercial bills, corporate bonds& asset backed securities)

Non-collateralised market

Outright transactionsGovernment Securities:· Treasury Notes· Treasury Bonds· Treasury Indexed Bonds

Semi-Government Securities:· Semi-Government Promissory Notes· Semi-Government Bonds· Semi-Government Indexed Bonds

Repurchase AgreementsGovernment Securities:· Treasury Notes· Treasury Bonds· Treasury Indexed Bonds

Semi-Government securities:· Semi-Government Promissory Notes· Semi-Government Bonds· Semi-Government Indexed Bonds

Domestic Securities

Accepted Bills of Exchange


Treasury Bills

Money Market Strips

Government Guaranteed CommercialPaper

Treasury Bills & Promissory Notes


Commercial Paper

1-week to 6-months

Of less than 18-monthsOf less than 18-months

Of less than 18-monthsOf less than 18-monthsOf less than 18-months

1-month to 1-year

Up to 18-months

1-month to 1-year

1-month to 1-year

1-month to 1-year

1-month to 1-year

Counterparties: Banks, securitiescompanies, securities financecompanies, money market brokers(Tanshi companies).

City banks (borrowers), regional banks(lenders), investment trusts, trustbanks, regional banks, Keito , l i feinsurance companies, specialisedmoney market brokers.

Issued by Commonwealth Governments.

Issued by State Government & TerritoryCentral Borrowing Authorities.

Issued by Commonwealth Governments.

Issued by State Government & TerritoryCentral Borrowing Authorities

Issued by the foreign Sovereigns,Supranationals & Government AgencySecurities.

Issued by eligible banks.

Issued by eligible banks.

Issued by the Government of Canada.

Issued by the Government of Canada.

Issued by the Crown Corporations suchas Canadian Wheat Board, FederalBusiness Development Bank, etc.

Issued by the Provincial Governments

Issued by the corporations (with anunconditional guarantee of a majorCanadian chartered bank)

Major corporations.

Australia

Canada

Country

1

Instruments

2

Tenor

3

Major Participants

4

115

MONEY MARKET


Refinancing Mechanisms:· Intra-day loans· Overnight loans· Lombard loans· Loans against collateral (Promissory

Notes) & guarantees

Repo operations:· Government Bonds· Federal Government Bills· Bank of Russia Bonds

Securities accepted as Collateral for Bankof Russia loans:· Regional Government Bonds· Credit institutions’ bonds· Mortgage backed bonds· Resident corporate bonds· Bonds of international financial

institutions

Currency swaps.

Deposit operations:· Deposit operations at fixed rates· Deposit operations at auction rates

Inter-bank lending instruments:Repurchase Agreements or outright basis(OMOs) :· Government Securities· Negotiable Certificates of Deposit· Commercial Paper

Discount WindowEligible bills:· Bankers’ Acceptances· Trade Acceptances· Promissory Notes

Call Money

Notice Money

Term Money

1-working day7 or 14-days

Up to 180-days

Overnight, 3 & 6-months6-months3 to 6-months

Daily (with overnight & 1-week)Weekly (4-weeks & 3-months)

1, 7, 20, 30, 60, 90 & 120-days.

Overnight

2 to 14-days

15-days to 1-year

Financially sound credit institutionscomplying with the regulatoryrequirements.

Credit institutions having account in 22Bank of Russia regional branches

Banks, settlement non-bank creditinstitutions & non bank credit institutionsconducting deposit & lending operations.

Participants in OMOs: Central Bank, largedomestic commercial banks & otherfinancial institutions approved by PBC.

Participants in inter-bank market: Allauthorised commercial banks, trust &investment corporations, financial leasingcompanies, finance companies ofbusiness conglomerates, urban credit co-operatives, & rural credit co-operatives,securities companies, insurancecompanies, & financing intermediaries.

Scheduled commercial banks (excludingRRBs), co-operative banks, primary deal-ers (PDs), & till August 5, 2005 select all-India FIs, insurance companies & mutualfunds.

Banks, all-India financial institutions &PDs.

Russia

China

India #

# :Year in parentheses denote the year of introduction of the instrument.

Country

1

Instruments

2

Tenor

3

Major Participants

4

116



Certificates of Deposit (1989)

Commercial Paper (1990)

Forward Rate Agreements/Interest Rate Swaps (1999)

Bills Rediscounting

Repurchase Agreements (1992)

· Market Repo

· RBI Repo (LAF)

Treasury Bills

Inter-bank ParticipationCertificates (1988)

CBLO (2003)

Repurchase Operations:· Government Bonds· Treasury Bills· Financial Institution Development Fund

(FIDF) Bonds· Government Guaranteed State

Enterprises’ Bonds

Bilateral Repurchase Operations

Bank of Thailand (BOT) Bonds

Foreign Exchange Swaps

Minimum 7-days

Minimum 7-days

Contracts are available for maturitiesupto 10-years.

1-day to 1-year

1-day*

91, 182 & 364-days

91 to 180-days

1-day to 1-year

1, 7, 14-days, 1, 2, 3 & 6-months

14-day

12-months or less.

Overnight up to 1-year(Typically concentrated on the short ends-up to 3-month)

Scheduled commercial banks (excludingRRBs & Local Area Banks) & select all-India financial institutions.Corporates, all-India financial institutions& PDs.

Scheduled commercial banks, PDs & all-India financial institutions.

Banks, PDs, select all-India financial in-stitutions, insurance companies & mutualfunds.

Banks, PDs, all-India financial institutions,insurance companies, mutual funds &listed corporates.

Banks and PDs.

Banks, PDs, financial institutions & othernon-bank entities.

Scheduled commercial banks.

Scheduled commercial banks, Co-operative banks, PDs, select all-Indiafinancial institutions, insurancecompanies, mutual funds & othercorporates.

60 members: commercial banks, financecompanies, finance & securitiescompanies, & specialised financialinstitutions, FIDF.

Bilateral primary dealers.

Commercial banks, specialised financialinstitutions, finance companies, finance& securities companies, Governmentpension fund, provident funds, mutualfunds, social security office, life & non-life insurance companies & otherinstitutions having current account at BOT.

Both onshore & offshore commercialbanks.

Thailand

* : The Reserve Bank retains the option to conduct longer term repo under the LAF depending on market conditions and other relevant factors.

Country

1

Instruments

2

Tenor

3

Major Participants

4

117

MONEY MARKET


End-of-day Liquidity Window

Bank of Indonesia Certificates (SBI)

Fasilitas Bank Indonesia (FASBI) depositfacility.SBI Repurchase Agreements-phased outin Aug, 2005 & replaced by Fine-TuneExpansion (FTE)

SWBI or Wadiah Certificate (SBI usingSharia principles)

Malaysian Government Securities

Treasury Bills

Repurchase Agreements (Repos)(The securities normally used in repotransactions are Malaysian GovernmentSecurities, Bankers’ Acceptances &Negotiable Certificates of Deposits,Treasury Bills, Cagamas Bonds, CentralBank Certificates, other trade bills, etc.)

Bank Negara Bills

Bank Negara Monetary Notes

Direct borrowing



Call money

Repo(Securities eligible for OMOs: GovernmentBond, Government Guaranteed Bonds &land development bonds)

Commercial banks, finance companies,finance & securities companies &specialised financial institutions.

Banks

Security institutions, banking system &the employees’ provident fund.

Commercial banks, discount houses,principal dealers & finance companies.

Commercial banks, merchant banks,finance companies & discount houses.

Business enterprises, banks, discounthouses, statutory authorities, savings &pension funds, the Government & indi-viduals.

Commercial banks & merchant banks

Commercial banks, specialised banks,regional banks, investment & financecompanies, merchant bankingcorporations, investment trust companies,insurance companies, the KoreaSecurities Finance Corporation, theCredit Insurance Fund & foreign bankbranches in Korea.

Select financial institutions.

Overnight

1- month & 3-months

1 to 14-days

1 to 14-days

91, 182, 364-days

Overnight to a few months

1-year

Up to 3-years

Up to 6-months (average: 20-30 days)

In multiples of 3-months, up to 5-years

30 to 200-days

Overnight, 3, 5, 7, 9, 11& 15-days loans.

15 to 91-days.

Indonesia

Malaysia

Korea

Country

1

Instruments

2

Tenor

3

Major Participants

4

118


ANNEX III.3: Structure of Money Markets (Concld.)

364-days

14-2 years & 546-days

Not more than 1-month

Close of business day.

91-days & 182-days.

Up to 3-years.

Up to 3-months & in some cases longer.

1 to 7-days.

28 to 56-days.

3-month to 15 years with 3-month &1-year benchmarks for T-Bills & 2, 5, 7,10 & 15-year benchmark for bonds.

Overnight.

Select financial institutions.

Applicant banks

Select commercial banks, special banks,local banks & foreign banks.

Banks.

Eligible non-finance companies,investment & finance companies &merchant banking corporations.

Primary dealers.

Banks, mining houses, pension funds,insurance companies, commercialcompanies, municipal authorities, publiccorporations & individuals

Merchant banks & commercial banks.

Reserve Bank & other financialinstitutions.

Banks.

Primary dealers, secondary dealerscovering banks, merchant banks, & stockbroking firms, finance companies,insurance companies, corporations &individuals. (In the case of the repo, onlyPDs).

Banks.

Treasury Bills

Market Stablisation Bonds.

Liquidity adjustment loans.

Intraday overdrafts.


Commercial Paper.

Treasury Bills

Negotiable Certificates of Deposit.

Bankers’ Acceptances.

Repurchase Agreements.

Reserve Bank Debentures.

Foreign Currency Swaps.

Repos/reverse repos

Singapore Government Securities.

End-of-day Liquidity Facility.

Forex Swaps & Reverse swaps.

Source: Websites of respective central banks.

South Africa

Singapore

Country

1

Instruments

2

Tenor

3

Major Participants

4

4.1 Credit markets have, historically, played acrucial role in sustaining growth in almost allcountries, including advanced countries, which nowhave fully developed capital markets. Credit marketsperform the critical function of intermediation of fundsbetween savers and investors and improve theallocative efficiency of resources. Banks, which aremajor players in the credit market, play an importantrole in providing various financial services andproducts, including hedging of risks. Credit marketsalso play a key role in the monetary transmissionmechanism.

4.2 Extension of credit, however, also poses somerisks, which range from pure credit risk to the risk ofover-lending. While pure credit risk is the risk of lossdue to non-payment by the borrower, even thoughadequate precautions are taken at the time of loanorigination, the risk of over-lending arises when banksextend loans without appropriate credit appraisal anddue diligence on account of excessive optimism aboutfuture prospects. While pure credit risk may not bewidespread and may normally not create systemicproblems, over-lending is unsustainable andpotentially destabilising for the system. Regulators inall countries, therefore, while seeking to maintainadequate growth, guard against its adverse impactby instituting appropriate regulatory and supervisorypolicies and strengthening of prudential norms.

4.3 The credit market in India has traditionallyplayed a predominant role in meeting the financingneeds of various segments of the economy. Creditinstitutions range from well developed and large sizedcommercial banks to development finance institutions(DFIs) to localised tiny co-operatives. They provide avariety of credit facilities such as short-term workingloans to corporates, medium and long-term loans forfinancing large infrastructure projects and retail loansfor various purposes. Unlike other segments of thefinancial market, the credit market is well spreadthroughout the country and it touches the lives of allsegments of the population.

4.4 Prior to initiation of financial sector reformsin the early 1990s, the credit market in India wastightly regulated. Bank credit was the principal focusof monetary policy under the credit planning approachadopted in 1967-68. In the absence of a formal

intermediate target, bank credit – aggregate as wellas sectoral – came to serve as a proximate target ofmonetary policy. Monetary policy up to the mid-1980swas predominantly conducted through directinstruments with credit budgets for banks beingframed in sync with monetary budgeting (Mohan,2006a). The credit market was characterised by creditcontrols and directed lending. Various credit controlsexisted in the form of sectoral limits on lending, limitson borrowings by individuals, stipulation of marginrequirements, need for prior approval from theReserve Bank, if borrowing exceeded a specified limit(under the Credit Author isation Scheme), andselective credit controls in the case of sensitivecommodities. Lending interest rates by all types ofcredit institutions were administered. Credit marketswere also strictly segmented. While commercial bankscatered largely to the short-term working capitalrequirements of industry, development financeinstitutions focused mainly on long-term finance.Competition in the credit market was also limited. Thisled to several inefficiencies in the credit market.

4.5 A wide range of regulatory reforms,therefore, were introduced as part of financial sectorreforms in the early 1990s to improve the efficiencyof the credit market. As a result, the credit market inIndia has undergone structural transformation. Thecredit market has become highly competitive eventhough the number of credit institutions has reduceddue to merger/conversion of two DFIs into banks,weeding out of unsound NBFCs and restructuringof urban co-operative banks and RRBs. Creditinstitutions now offer a wide range of products. Theyare also free to price them depending on their riskperception.

4.6 In the above backdrop, this chapter analysestrends in the credit market in India, with a specialfocus on various aspects of rapid credit growth inrecent years. The chapter is divided into six sections.Section I briefly explains the significance of the creditmarket in economic growth. The structure of thecredit market in India is delineated in Section II.Policy developments relating to the credit marketsince the early 1990s have been set out in SectionIII. Trends in credit growth in India in the post-reformperiod are analysed in Section IV. Recent trends inbank credit growth and their implications are also

CREDIT MARKETIV

120


analysed in this section. Section V suggests somemeasures with a view to further strengthening therole of the credit market in India. Concludingobservations are presented in Section VI.

I. SIGNIFICANCE OF THE CREDIT MARKET

4.7 There is a broad consensus, among bothacademics and policy makers, that a developedfinancial system spurs economic growth through anumber of channels: (i) acquisition of information onfirms; (ii) intensity with which creditors exert corporatecontrol; (iii) provision of risk-reducing arrangements;(iv) pooling of capital; and (v) ease of makingtransactions (Levine, 2004). There are twomechanisms for mobilising savings and channelingthem into investments, viz., bank-based and market-based, as alluded to in Chapter I. Empirical evidencereveals that while a more developed financial sectoris associated with higher income levels, there is noclear pattern with regard to financial structure.

4.8 In most countries, both the systems exist evenas one system may be more dominant than the other.However, of the two systems, credit institutions havethe distinct advantage in information gathering andprocessing to monitor the efficiency and productivityof projects. In fact, in recent years the existence ofbanks, which are the major players in the creditmarket, is attr ibuted more to their informationgathering capacity arising out of the existence ofasymmetric information and moral hazard problems,than to the classic explanation relating to their abilityto mobilise savings and channeling them intoinvestment. Savers usually have incompleteinformation on the affairs of companies, which makesit more difficult for companies to obtain direct financingfrom the market. Intermediation by banks mitigatessuch agency problems. When the cost of acquiringinformation on a company by the providers of financialresources is high, the process of financing companiescan be done more efficiently if the prospectiveinvestors are able to delegate the collection of suchinformation to a specialised organisation (Diamond,1984). Thus, financial intermediation is justified onthe grounds of information gathering and company-monitoring functions performed by banks. By reducingthe costs of acquiring and processing information,financial institutions encourage mobilisation of savingsand improve resource allocation. Banks can alsodiversify risk among a number of companies.

4.9 Firms in developing countries generally tendto rely more on debt finance, including bank credit.The emphasis on credit rather than equity arises due

to various reasons. The cost of equity in developingeconomies is often much higher than the cost of debtdue to the existence of higher perceived risk premiathan in developed countr ies. The existence ofartificially repressed interest rates contributes furtherto the problem. The other reasons for the heavyreliance on debt in developing countries include thefragility of their equity markets, lack of suitableaccounting practices and the absence of adequatecorporate governance practices. Given the highdependence on bank credit and lack of substitutesfor external finance, firms in developing economiesare generally highly sensitive to changes in the costand flow of credit.

4.10 Credit markets in developing countries, inparticular, play an important role, where apart fromindustry, agriculture is also an important segment ofthe economy. Besides, there are also a large numberof small and medium enterprises in the industrial andservice sectors, which are not able to access thecapital market and have to depend on the creditmarket for their funding requirements. Thus, theimportance of banks and other lending institutions indeveloping countries can hardly be overemphasised.

4.11 Commercial banks, given their preeminentposition in the regulated financial sector, dominate thecredit market. The quantity of loans created by thebanking system is generally a function of both thewillingness and ability of banks to lend. In an economywith ceilings on lending rates, banks face a highercredit demand than they can effectively supply, thus,necessitating reliance on a credit rationing mechanism.In a non-repressed financial system, on the otherhand, the borrowers are, in principle, differentiatedalong the lines of risk characteristics and riskierborrowers are charged higher interest rates to accountfor default probabilities. This, however, may create theproblem of adverse selection. Though riskier projectsbring higher returns, banks, out of sustainabilityconsideration, need to optimise the risk of their portfolio.

4.12 Another impor tant factor influencing thesupply of credit is the amount of reserves availablefrom the central bank to the banking system. A largepre-emption of central bank money by theGovernment may constrain reserve supply to thebanking system, thus, affecting their capacity for creditcreation. Moreover, credit expansion could also bean endogenous process, i.e., it is the demand forcredit that may drive the banking system’s ability tocreate credit in the economy.

4.13 Development of the credit market plays animpor tant role in the monetary transmission

121

CREDIT MARKET

mechanism. The traditional interest rate channel,represented by the ‘money view’, mainly focuses onthe liability side as banks create money throughchequable deposits. The asset side is not emphasisedas firms’ financial structure is believed to be neutral toborrowings through loans from banks or throughissuance of securities. This is based on the assumptionthat different financial assets such as bonds and bankloans are perfect substitutes. However, in terms of‘credit view’, bonds and bank loans are not seen asperfect substitudes primarily because of informationasymmetries. Firms facing informational problems findit more expensive to borrow through bonds than availingloans from banks.

4.14 According to the ‘credit view’, the direct effectof monetary policy is amplified by changes in theexternal finance premium (EFP) in the same direction.An EFP is the difference in cost of funds raisedexternally (by way of issuing equity or debt) and fundsgenerated internally (retained earnings). Thus,monetary tightening increases EFP, while easing ofmonetary policy reduces EFP. As a result, the impactof a given change in short-term policy interest rates ondemand and output is magnified, which reinforces theeffects of variation in interest rates (Bernanke andGertler, 1995). In this context, the most representativetheoretical model of the credit view is that of Bernankeand Blinder (1988). It is a modification of the IS/LMframework and contains all the elements that allow forthe theoretical definition of imperfect substitutionbetween credit on the one hand, and bonds andsecurities on the other (Box IV.1). As a policy guide,Bernanke and Blinder conclude that if money demandshocks are more important than credit demand shocks,then a policy of targeting credit is probably better thana policy of targeting money.

4.15 Given that a developed financial intermediationsystem facilitates growth, policy makers tend toliberalise the system to facilitate financial development.The literature, however, suggests that authoritiesshould take adequate caution in adopting a liberalisedpolicy frameworks intended to develop the financialsector (IMF, 2006). Lax supervision and rudimentaryregulation of newly liberalised financial institutions,often combined with a volatile macroeconomicenvironment, have led to systemic crises (Lindgren,et al, 1996 and Caprio and Klingebiel, 2003). Similarly,there is econometric evidence that shows that bankingcrises are more likely to occur in countries associatedwith liberalised credit markets operating in weakinstitutional environments. The East Asian crisisunderlined the risks to economic stability and growththat a weak or vulnerable financial sector could pose.

II. INSTITUTIONAL STRUCTURE OF THECREDIT MARKET IN INDIA

4.16 The credit market structure in India hasevolved over the years. A wide range of financialinstitutions exist in the country to provide credit tovarious sectors of the economy. These includecommercial banks, regional rural banks (RRBs), co-operatives [comprising urban cooperative banks(UCBs), State co-operative banks (STCBs), districtcentral co-operative banks (DCCBs), pr imaryagricultural credit societies (PACS), state co-operativeand agricultural rural development banks (SCARDBs)and primary co-operative and agricultural ruraldevelopment banks (PCARDBs)], financial institutions(FI) (term-lending institutions, both at the Centre andState level, and refinance institutions) and non-banking financial companies (NBFCs) (Exhibit IV.1).

4.17 Scheduled commercial banks constitute thepredominant segment of the credit market in India. Inall, 83 scheduled commercial banks were in operationat end-March 2006. The commercial banking sectoris undergoing a phase of consolidation. There havebeen 12 mergers/amalgamations since 1999. TheRRBs, which were set up in the 1970s to provideagricultural and rural credit, are being restructured atthe initiative of the Government of India. Till October31, 2006, 137 RRBs were amalgamated to form 43new RRBs, bringing down the total number of RRBsin the country to 102 from 196 at end-March 2005.

4.18 The co-operative banking system, with twobroad segments of urban and rural co-operatives, formsan integral part of the Indian financial system. Urbancooperative banks, also referred to as primary co-operative banks, play an important role in meeting thegrowing credit needs of urban and semi-urban areasof the country. The UCBs, which grew rapidly in theearly 1990s, showed certain weaknesses arising outof lack of sound corporate governance, unethicallending, comparatively high levels of non-performingloans and their inability to operate in a liberalisedenvironment. Accordingly, some of the weak UCBs havebeen either liquidated or merged with other banks. Asa result, the number of UCBs declined from 1,942 atend-March 2001 to 1,853 by end-March 2006.

4.19 Historically, rural co-operative credit institutionshave played an important role in providing institutionalcredit to the agricultural and rural sectors. These creditinstitutions, based on the nature of their lendingoperations, have typically been divided into two distinctsegments, commonly known as the short-term co-operative credit structure (STCCS) and the long-termco-operative credit structure (LTCCS). The STCCS,

122


The impact of monetary policy on the real economy operatesthrough various channels. Under the conventional approach,referred to as the ‘money view’, monetary policy influencesthe economy via the interest rate. The alternate channel, thatemphasises credit conditions as the route of monetarytransmission, is of relatively recent origin and is referred toas the ‘credit view’. Genesis of the credit view could be tracedto the celebrated work of Bernanke and Blinder (1988), whichpresented the IS-LM framework augmented with bank-intermediated loans. It argued that since loans and bondsare not perfect substitutes, monetary policy operates not onlythrough the conventional money channel but also through thecredit channel. According to the ‘credit view’, a change inmonetary policy that raises or lowers open market interestrates tends to change the external finance premium in thesame direction. External finance premium is the differencebetween the cost of funds raised externally and the fundsraised internally. Because of this additional effect of policy onthe external finance premium, the impact of monetary policyon the cost of borrowing and consequently on real spendingand real activity is magnified (Bernanke and Gertler, 1995).There are three reasons for which the credit channel isimportant. First, evidence suggests that credit marketimperfections of the type crucial to the credit channel do indeedaffect firms’ employment and spending decisions. Second,evidence suggests that small firms, which are more likely tobe credit constrained, are hurt more by tight monetary policythan their larger counterparts. Third, asymmetric information- the core of credit channel analysis - proves to be highlyuseful in explaining some other important phenomena: e.g.,why do financial intermediaries exist; structure of the financialsector; and why do financial crises occur (Mishkin, 1996).

There are two channels through which credit conditions areexpected to affect monetary transmission. First, the ‘banklending’ channel, that operates through modulation of bankreserves, is affected by monetary policy. Contractionary/expansionary policy limits or enhances the ability of banks tolend and thereby reduces/increases investment and output.The second, the ‘balance sheet’ channel works through networth of the borrowers. Contractionary policy would raiseinterest rates and thereby reduce the value of the collateraland net worth of the borrowers. This, accordingly, limits theability of borrowers to borrow and invest. Further, the literaturealso points out a direct connection between the balance sheetchannel and housing demand by features such as down-payment requirements, up-front transaction costs andminimum income to interest payment ratios. However,empirical evidence suggests that effectiveness of the credit

Box IV.1The Credit Channel of Monetary Policy

channel depends upon conditions such as existence of bank-dependent borrowers, for instance, small and low net worthfirms (Gertler and Gilchrist, 1993 and 1994), substitutionbetween retail and bulk deposits and ability of the central bankto constrain banks’ potential to lend.

Empirical work to draw inferences on the existence of thecredit channel in India is rather limited. A recent studyexamining the impact of financial liberalisation shows thatbanks in general are constrained in their lending operationsby the availability of insured deposits and these constraintsare more severe for those banks that lend predominantlyagainst collateral. In India more than eighty five per cent ofbank lending is against collateral. This implies a potentiallyimportant influence of the bank lending channel. A veryrecent attempt in estimating the bank lending channel hasbrought out a number of facets of the transmissionmechanism - by employing structural VAR methodology onmonthly data for all the Indian scheduled commercial banksspanning from April 1993 to April 2002 (Pandit, et al, 2006).First, the study validates the existence of a bank lendingchannel in the Indian context. This implies that the centralbank, while formulating monetary policy, is likely toencounter independent shifts in the loan supply. Second,evidence seems to point to the fact that large banks with awider resource base can more successfully insulate theirloan supply from contractionary policy shocks vis-à-vissmall banks. Third, the quantitative instruments such asthe cash reserve ratio (CRR) continue to be important alongwith the price instruments such as the Bank Rate. Finally,prudential regulations have an important role to play ininfluencing lending decisions of banks. In particular, theintroduction of capital adequacy ratios has made banksmore concerned with the risk-return profile of loans, sinceadditional lending warrants augmenting of capital base inorder to adhere to the regulatory capital standards.

References:

Bernanke, Ben, and A. Blinder. 1988. “Credit, Money andAggregate Demand.” American Economic Review 135-139,May.

Bernanke, Ben, and M. Gertler. 1995. “Inside the Black Box:The Credit Channel of Monetary Policy Transmission.”Journal of Economic Perspectives, Vol.9: 27-48.

Pandit, B.L., Ajit Mittal, Mohua Roy and Saibal Ghosh. 2006.“Transmission of Monetary Policy, and the Bank LendingChannel: Analysis and Evidence for India.” DRG Study No.25, Reserve Bank of India.

comprising PACS at the village level, DCCBs at theintermediate level, and the STCBs at the apex level,provide crop and other working capital loans to farmersand rural artisans primarily for short-term purposes.The LTCCS, comprising SCARDBs at the State level

and PCARDBs at the district or block level, providetypically medium and long-term loans for makinginvestments in agriculture, rural industries and, in therecent period, housing. However, the structure of ruralco-operative banks is not uniform across all the States

123

CREDIT MARKET

of the country. Some States have a unitary structurewith the State level banks operating through their ownbranches, while others have a mixed structureincorporating both unitary and federal systems.

4.20 Financial institutions owed their origin to theobjective of state driven planned economic development,when the capital markets were relativelyunderdeveloped and judged to be incapable ofmeeting adequately the long-term requirements of theeconomy. Over the years, a wide range of FIs, mostlyGovernment owned, came into existence to cater tothe medium to long-term financing requirements ofdifferent sectors of the economy. FIs played a key rolein extending development finance in India and for thispurpose they were given access to concessionalfinance in the form of Government guaranteed bondsand Long-Term Operations (LTO) Fund of the ReserveBank. However, the government’s fiscal imperativesand market dynamics forced a reappraisal of thepolicies and strategy with regard to the role of FIs inthe economy and the concessional finance wasphased out by the mid-1990s. A major restructuringin the financial sector occurred when two major FIs,viz., ICICI and IDBI converted into banks. Thus, thisparticular segment of the credit market has shrunksignificantly in recent years.

4.21 NBFCs encompass a heterogeneous groupof intermediaries and provide a whole range of

financial services. Though heterogeneous, NBFCscan be broadly classified into three categories, viz.,asset finance companies (such as equipment leasingand hire purchase), loan companies and investmentcompanies. A separate category of NBFCs, called theresiduary non-banking companies (RNBCs), alsoexists as it has not been categorised into any one ofthe above referred three categories. Besides, thereare miscellaneous non-banking companies (ChitFund), mutual benefit financial companies (Nidhis andunnotified Nidhis) and housing finance companies.The number of NBFCs operating in the country was51,929 in 1996. Following the amendments to theprovisions contained in Chapter III-B and Chapter III-C of the Reserve Bank of India Act, NBFCs both,deposit taking and non-deposit taking, are requiredto compulsorily register with the Reserve Bank. Oneof the conditions for registration for NBFCs was aminimum net owned fund (NOF) of Rs.25 lakh at theentry point. This limit was subsequently enhanced toRs.2 crore for new NBFCs seeking grant of Certificateof Registration on or after April 21, 1999. The ReserveBank received 38,244 applications for grant ofcertificate of registration (CoR) as NBFCs till end-March 2006. Of these, the Reserve Bank approved13,141 applications, including 423 applications ofcompanies authorised to accept/hold public deposits.Due to consolidation in the sector, the number ofNBFCs declined to 13,014 by end-June 2006.

Exhibit IV.1: Credit Market Structure(End-March 2006)

Commercial Banks(216, including 133 RRBs) Financial Institutions

Non-Banking FinancialCompanies (13,014)

Co-operative Institutions

All-India Financial Institutions(Term-lending) (4)

Specialised FinancialInstitutions

State Level Institutions(SFCs, SIDCs.)

Urban Co-operativeBanks (1,853)

Rural Co-operativeInstitutions

Short-Term(109,177)

Long-Term(747)

STCBs(31)

DCCBs(367)

PACs(108,779)

SCARDBs(20)

PCARDBs(727)

Note : Figures in parentheses represent number of institutions in the respective category. Numbers relate to end-March 2005 in respect of ruralco-operatives and end-June 2006 in respect of NBFCs.

Source : Report on Trend and Progress of Banking in India, 2005-06, Reserve Bank of India.

124


1 Priority sector comprises agriculture (both direct and indirect), small scale industries, small roads and water transport operators, smallbusiness, retail trade, professional and self-employed persons, state sponsored organisations for Scheduled Castes/Scheduled Tribes,education, housing (both direct and indirect), consumption loans, micro-credit, loans to software, and food and agro-processing sector.

2 Under Section 18 of the Banking Regulation Act, 1949, all scheduled banks are required to maintain SLR, i.e., a certain proportion of theirdemand and time liabilities (DTL) as on the last Friday of the second preceeding fortnight as liquid assets (cash, gold valued at a price notexceeding the current market price or unencumbered approved securities valued at a price as specified by the Reserve Bank from time totime). Following the amendment of the Act in January 2007, the floor rate of 25 per cent for SLR was removed.

4.22 Of al l insti tut ions, in terms of assets,commercial banks constitute the largest category,followed by rural co-operatives (Chart IV.1).

III. POLICY DEVELOPMENTS IN THE CREDITMARKET IN INDIA

4.23 The credit market, with commercial banks asits predominant segment, has been the major sourcefor meeting the finance requirements in the economy,both for the private sector and the Central and StateGovernment enterprises. In addition to sharing ofresources between the private and the public sectors,a significant proportion of credit by commercial banksis earmarked for the priority sector1 . For a fewdecades preceding the onset of banking and financialsector reforms in India, credit institutions operated inan environment that was heavily regulated andcharacterised by barriers to entry, which protectedthem against competition. The issue of allocation ofbank resources among various sectors was addressedthrough mechanisms such as SLR, credit authorisationscheme (CAS), fixation of maximum permissible bankfinance (MPBF) and selective credit controls. Thisregulated environment set in complacency in the

manner in which credit institutions operated andresponded to the customer needs. The interest rateplayed a very limited role as the equilibratingmechanism between demand and supply of resources.The resource allocation process was deficient, whichmanifested itself in poor asset quality. They also lackedoperational flexibility and functional autonomy.

4.24 As part of financial sector reforms in the early1990s, wide ranging reforms were introduced in thecredit market with a view to making the creditinstitutions more efficient and healthy. The reformprocess initially focused on commercial banks. Aftersignif icant progress was made to transformcommercial banks into sound institutions, the reformprocess was extended to encompass other segmentsof the credit market. As part of the reform process,the strategy shifted from micro-management to macrolevel management of the credit market. Thesemeasures created a conducive environment for banksand other credit institutions to provide adequate andtimely finance to different sectors of the economy byappropriately pricing their loan products on the basisof the risk profile of the borrowers.

4.25 Lending interest rates were deregulated witha view to achieving better price discovery and efficientresource allocation. This resulted in growing sensitivityof credit to interest rates and enabled the ReserveBank to employ market based instruments ofmonetary control. The Statutory Liquidity Ratio (SLR

2)

has been gradually reduced to 25 per cent. The CashReserve Ratio (CRR) was reduced from its peak levelof 15.0 per cent maintained during 1989 to 1992 to4.5 per cent of Net Demand and Time Liabilities(NDTL) in June 2003. The reduction in statutory pre-emptions has significantly augmented the lendableresources of banks. Although the Reserve Bankcontinues to pursue its medium-term objective ofreducing the CRR, in recent years, on a review ofmacroeconomic and monetary conditions, the CRRhas been revised upwards in phases to 6.5 per cent.

4.26 While the stipulation for lending to the prioritysector has been retained, its scope and definition havebeen fine-tuned by including new items. Further,restrictions on banks’ lending for project finance

Chart IV.1: Total Assets of Financial Intermediaries –Relative Shares (end-March 2006)

Scheduled Commercial Banks

Regional Rural Banks and Local Area Banks

Urban Co-operative Banks

Rural Co-operatives

All India Financial Institutions

NBFCs (including RNBCs)

Source : Report on Trend and Progress of Banking in India, 2005-06,Reserve Bank of India.

125

CREDIT MARKET

activity and for personal loans were gradually removedin order to enable banks to operate in a flexiblemanner in the credit market. As part of the financialsector reforms, the regulatory norms with respect tocapital adequacy, income recognit ion, assetclassif ication and provisioning have beenprogressively aligned with international best practices.These measures have enhanced transparency of thebalance sheets of banks and infused accountabilityin their functioning. Accounting standards anddisclosure norms were also strengthened with a viewto improving governance and bringing them inalignment with international norms. As part of thereform programme, due consideration has been givento diversification of ownership of banking institutionsfor greater market accountability and improvedefficiency. Accordingly, several public sector banksexpanded their capital base by accessing the capitalmarket, which diluted Government ownership. Toprovide banks with additional options for raisingcapital funds with a view to enabling smooth transitionto Basel II, the Reserve Bank, in January 2006,allowed banks to augment their capital funds by issueof additional instruments.

4.27 With a view to enhancing efficiency andproductivity through competition, guidelines were laiddown for establishment of new banks in the privatesector. Since 1993, 12 new private sector banks havebeen set up. Foreign banks have also been allowedmore liberal entry. Considering the special nature ofbanks, guidelines on ownership and governance inprivate sector banks were also issued in February 2005(Box IV.2). As a major step towards enhancingcompetition in the banking sector, foreign directinvestment in the private sector banks is now allowedup to 74 per cent (including investment by FIIs), subjectto conformity with the guidelines issued from time totime. A roadmap for foreign banks, articulating aliberalised policy consistent with the WTOcommitments was released in March 2005. For newand existing foreign banks, it was proposed to gobeyond the existing WTO commitment of 12 branchesin a year.

4.28 A large magnitude of resources of creditinstitutions had become locked up in unproductiveassets in the form of non-performing loans (NPLs).Apart from limiting the ability of credit institutions torecycle their funds, this also weakened them byadversely affecting their profitability. The ReserveBank and the Central Government, therefore, initiatedseveral institutional measures to recover the past duesto banks and FIs and reduce the NPAs. These were

Debt Recovery Tribunals (DRTs), Lok Adalats(people’s courts), Asset Reconstruction Companies(ARCs) and the Corporate Debt Restructuring (CDR)mechanism. Settlement Advisory Committees havealso been formed at regional and head office levelsof commercial banks. Furthermore, banks can also issuenotices under the Securitisation and Reconstruction ofFinancial Assets and Enforcement of Security Interest(SARFAESI) Act, 2002 for enforcement of securityinterest without intervention of courts. Further, banks,Fls and NBFCs (excluding securitisation companies/reconstruction companies) have been permitted toundertake sale/purchase of NPAs. Thus, banks andother credit institutions have been given a menu ofoptions to resolve their NPA problems.

4.29 Diversification of credit risk is essential forexpanding the flow of credit. Excessive concentrationof lending to certain sectors leads to a higher riskburden. There are various options available for sharingof risk. Asset securitisation allows banks to conserveregulatory capital, diversify asset risks and structureproducts to reflect investors’ preferences (IMF, 2006).There are various instruments for sharing andtransferring credit risk. One such instrument is assetsecuritisation (Box IV.3).

4.30 With a view to ensuring healthy developmentof the securitisation market, the Reserve Bank issuedguidelines on securitisation of standard assets onFebruary 1, 2006 to banks, financial institutions andnon-banking financial companies.

4.31 Comprehensive credit information, whichprovides details pertaining to credit facilities alreadyavailed of by a borrower as well as his repaymenttrack record, is critical for the smooth operations ofthe credit market. Lack of credit history is an importantfactor affecting the credit flow to relatively lesscreditworthy borrowers. In the absence of credithistory, pricing of credit can be arbitrary, the perceivedcredit risk can be higher and there can be adverseselection and moral hazard. Accordingly, a schemefor disclosure of information regarding defaultingborrowers of banks and financial institutions wasintroduced. In order to facilitate sharing of informationrelating to credit matters, a Credit Information Bureau(India) Limited (CIBIL) was set up in 2000 (Box IV.4).

4.32 Most of the reform measures initiated forcommercial banks such as deregulation of lendinginterest rates, prudential norms relating to capitaladequacy/asset classification provisioning, and NPAsmanagement were also extended to other creditinstitutions as well with some modifications asappropriate.

126


Box IV.2Credit Market Reforms

Lending Interest Rates

• Lending interest rates of commercial banks werederegulated in October 1994 and banks were requiredto announce their prime lending rates (PLRs).

• The Reserve Bank mooted the concept of benchmarkprime lending rate (BPLR) on April 29, 2003 to addressthe need for transparency in banks’ lending rates as alsoto reduce the complexity involved in pricing of loans.

• Banks now are free to prescribe respective BPLRs, asalso lend at sub-BPLR rates.

• Banks are also permitted to offer floating rate loan productslinked to a market benchmark in a transparent manner.

Term-lending by Banks

• Various restrictions on term loans by banks weregradually phased out by 1997. In terms of the guidelinesprevailing before the initiation of economic reforms in1991, banks were expected to extend term loans forsmall projects in participation with the State levelinstitutions, though it was not mandatory.

• For large projects, however, they were allowed toparticipate compulsorily in participation with all-IndiaFIs, subject to the condition that the share of thebanking system would be restricted to 25 per cent ofterm loan assistance from banks and FIs and theaggregate term finance from the banking system couldnot exceed Rs.75 crore.

Asset Classification and Provisioning, and CapitalAdequacy

• In terms of asset classification and provisioning normsprescribed in 1994, banks are required to classifyassets into four categories, viz., standard assets, sub-standard assets, doubtful assets and loss assets, withappropriate provisioning requirements for eachcategory of assets.

• The concept of ‘past due’ in the identification of non-performing assets (NPAs) was dispensed with effectivefrom March 2001, and the 90-day delinquency normwas adopted for the classification of NPAs with effectfrom March 2004.

• As a major step towards tightening of prudential normsfrom the year ended March 2005, an asset is required tobe classified as doubtful if it remains in the sub-standardcategory for 12 months as against the earlier norm of 18months. Banks are now required to make provisioningagainst standard assets to the tune of 0.40 per cent exceptfor certain specified sectors. These include directadvances to agriculture and SME sectors (0.25 per cent),residential housing loan beyond Rs.20 lakh (1.0 per cent)and personal loans (2.0 per cent). (In case of specifiedsectors, the general provisioning requirement increasedfrom 0.4 per cent to 1.0 per cent in May 2006 and furtherto 2.0 per cent in January 2007).

• Banks were advised to adopt graded higherprovisioning in respect of: (a) secured portion of NPAsincluded in 'doubtful' for more than three yearscategory; and (b) NPAs which have remained in'doubtful' category for more than three years as onMarch 31, 2004. Provisioning ranging from 60 per centto 100 pre cent over a period of three years in a phasedmanner, from the year ended March 31, 2005 has beenprescribed. However, in respect of all advancesclassified as 'doubtful for more than three years' on orafter April 1, 2004, the provisioning requirement hasbeen stipulated at 100 per cent. The provisioningrequirement for unsecured portion of NPAs under theabove category was retained at 100 per cent.

• Banks were subject to capital adequacy norms in 1994,according to which, banks were required to maintaincapital to risk weighted asset ratio of 8 per cent.Subsequently, the ratio was raised to 9 per cent in 1999.

Exposure Limits

• Regulatory limits on banks’ exposure to individual andgroup borrowers in India were prescribed to avoidconcentration of credit

• The applicable limit is 15 per cent of capital funds in thecase of a single borrower and 40 per cent in the case ofa group of borrowers. Credit exposure to borrowersbelonging to a group may exceed the exposure norm of40 per cent of bank’s capital funds by an additional 10per cent (i.e., up to 50 per cent), provided the additionalcredit exposure is on account of extension of credit toinfrastructure projects. Credit exposure to a singleborrower may exceed the exposure norm of 15 per centof bank’s capital funds by an additional 5 per cent (i.e.,up to 20 per cent). In addition, banks may, in exceptionalcircumstances, with the approval of their boards, considerenhancement of the exposure to a borrower up to a further5 per cent of capital funds.

Competition Enhancing Measures

• Public sector banks were allowed to raise capital from theequity market up to 49 per cent of the paid-up capital.

• A comprehensive policy framework was laid down onFebruary 28, 2005 for ownership and governance inprivate sector banks. The broad principles underlyingthe framework ensure that : (i) ultimate ownership andcontrol is well diversified; (ii) important shareholdersare ‘fit and proper’; (iii) directors and CEO are ‘fit andproper’ and observe sound corporate governanceprinciples; (iv) private sector banks maintain minimumcapital (initially Rs.200 crore, with a commitment toincrease to Rs.300 crore within three years)/net worth(Rs.300 crore at all times) for optimal operations andfor systemic stability; and (v) policy and processesare transparent and fair.

127

CREDIT MARKET

4.33 The credit derivatives are gaining increasingpopularity in many countries. Since the early 1990s,

Box IV.4Credit Information Bureaus

Credit bureaus (or credit reference agencies) are useful asthey help lenders to assess credit worthiness of individualborrowers and their ability to pay back a loan. As credit bureauscollect and collate personal financial data on individuals fromfinancial institutions, a form of price discrimination can bemodelled taking into account credit rating and past behaviourof borrowers. The information is generally aggregated andmade available on request to contributing companies for thepurposes of credit assessment and credit scoring.Establishment of credit information bureaus can facilitate inobtaining the credit history of the borrowers and, thus, helpthe banks in correctly assessing the creditworthiness.

The CIBIL provides a vital service, which allows its membersto make informed, objective and faster credit decisions. CIBIL’saim is to fulfill the need of credit granting institutions forcomprehensive credit information by collecting, collating anddisseminating credit information pertaining to both commercialand consumer borrowers, to a closed user group of members.Banks, financial institutions, non-banking financial companies,housing finance companies and credit card companies use

CIBIL’s services. Data sharing is based on the principle ofreciprocity, which means that only members who havesubmitted all their credit data, may access Credit InformationReports from CIBIL.

With a view to strengthening the legal mechanism andfacilitating credit information companies to collect, processand share credit information on borrowers of banks/FIs, adraft Credit Information Companies (Regulation) Bill waspassed in May 2005 and notified in June 2005. TheGovernment and the Reserve Bank have framed rules andregulations for implementation of the Act, with specificprovisions for protecting individual borrower’s rights andobligations. The rules and regulations were notified onDecember 14, 2006. In terms of the provisions of the Act,after obtaining the certificate of registration from the ReserveBank to commence/carry on business of credit informationcompanies will be able to collect all types of credit information(positive as well as negative) from their member creditinstitutions and disseminate the same in the form of creditreports to the specified users/individuals.

Box IV.3Asset Securitisation

Securitisation is a process through which illiquid assets aretransformed into a more liquid form of assets and distributedto a broad range of investors through capital markets. Thelending institution’s assets are removed from its balance sheetand are instead funded by investors through a negotiablefinancial instrument. The security is backed by the expectedcash flows from the assets. Securitisation as a techniquegained popularity in the advanced countries in the 1970s.Favourable tax treatment, legislative enactments, establishmentof Government-backed institutions that extend guarantees,and a pragmatic regulatory environment appear to havecontributed to the successful development of this market.

Securitisation involves pooling similar assets together in aseparate legal entity or special purpose vehicle (SPV) andredirecting the cash flows from the asset pool to the newsecurities issued by the SPV. The SPV is a device to ensurethat the underlying assets are insulated from the risks ofdefault by the originator of the assets. In general, there aretwo main advantages of securitisation. First, it can turnordinary illiquid assets into reasonably liquid instruments.Second, it can create instruments of high credit quality out ofdebt of low credit quality.

Securitisation is designed to offer a number of advantages tothe seller, investor and the debt market. For the seller ororiginator, securitisation mainly results in receivables beingreplaced by cash, thereby improving the liquidity position. Itremoves the assets from the balance sheet of the originator,thus, freeing capital for other uses, and enabling restructuringof the balance sheet by reducing large exposures or sectoral

concentration. It facilitates better asset liability management(ALM) by reducing market risks resulting from interest ratemismatches. The process also enables the issuer to recycleassets more frequently and thereby improves earnings. Forinvestors, securitisation essentially provides an avenue forrelatively lower risk investment. Credit enhancement providesan opportunity to investors to acquire good quality assetsand to diversify their portfolios. From the point of view of thefinancial system as a whole, securitisation increases thenumber of debt instruments in the market, and providesadditional liquidity in the market. It also facilitates unbundling,better allocation and management of project risks. It widensthe market by attracting new players due to availability ofsuperior quality assets.

Securitisation, however, if not carried out prudently canleave risks with the originating bank without allocatingcapital to back them. The main risk for a bank arises if atrue sale has not been achieved and the selling bank isforced to recognise some or all of the losses if the assetssubsequently cease to perform. Also, funding risks andconstraints on liquidity may arise if assets designed to besecur it ised have been or iginated, but because ofdisturbances in the market, the securities cannot be placed.There is also a view that there is at least a potential conflictof interest if bank originates, sells, services and underwritesthe same issue of securities.

Reference:

BIS. 2006a. Quarterly Review, June.

there has been proliferation of different types of creditderivatives in several countries (Box IV.5).

128


4.34 The risk management architecture of banksin India has strengthened and they are on the way tobecoming Basel II compliant, providing adequatecomfort level for the introduction of credit derivatives.Accordingly, the Reserve Bank, as part of the gradual

process of financial sector liberalisation in India,permitted banks and primary dealers to begintransacting in single-entity credit default swaps (CDS)in its Annual Policy Statement for 2007-08 releasedon April 24, 2007.

Box IV.5Credit Derivatives

A credit derivative is a contract (derivative) to transfer therisk of the total return on a credit asset falling below anagreed level, without transfer of the underlying asset. Thisis usually achieved by transferring risk on a credit referenceasset. Early forms of credit derivatives were financialguarantees. Three common forms of credit derivatives arecredit default swap (CDS), total return swap (TRS) andcredit linked note (CLN). Credit derivatives are designedto allow independent trading/hedging of credit risk. It isalso possible to transfer and/or transform credit riskthrough securitisation. Credit derivative is a logicalextension of two of the most significant developments inthe financial markets, viz., securitisation and derivatives.

A CDS consists of swapping, usually on an ongoing basis,the risk premium inherent in an interest rate on a bond ora loan in return for a cash payment that is made in theevent of default by the debtor. The CDS has become themain driver of the credit derivatives market, offering liquidprice discovery and trading on which the rest of the marketis based. It is an agreement between a protection buyerand a protection seller, whereby the buyer pays a periodicfee in return for a contingent payment by the seller upon acredit event happening in the reference entity. Thecontingent payment usually replicates the loss incurredby creditor of the reference entity in the event of its default.It covers only the credit risk embedded in the asset, risksarising from other factors, such as interest rate movements,remain with the buyer.

A TRS – also known as total rate of return swap – is acontract between two counterparties, whereby they swapperiodic payments for the period of the contract. Typically,one party receives the total return (interest payments plusany capital gains or losses for the payment period) from aspecified reference asset, while the other receives aspecified fixed or floating cash flow that is not related tothe creditworthiness of the reference asset, as with a vanillainterest rate swap. The payments are based upon the samenotional amount. The reference asset may be any asset,index or basket of assets. The TRS is simply a mechanismthat allows one party to derive the economic benefit ofowning an asset without use of the balance sheet, andwhich allows the other to effectively "buy protection" againstloss in value due to ownership of a credit assets.

While the CDS provides protection against specific creditevents, the total return swap protects against the loss ofvalue irrespective of cause, whether default and wideningof credit spreads, among others.

A CLN is an instrument whose cash flow depends upon acredit event, which can be a default, credit spread, or ratingchange. The definition of the relevant credit events must benegotiated by the parties to the note. A CLN, in effect,combines a credit-default swap with a regular note (withcoupon, maturity, redemption). Given its regular-notefeatures, a CLN is an on-balance sheet asset, unlike a CDS.

Banks and the financial institutions derive at least threemain benefits from credit der ivatives. One, creditderivatives allow banks to transfer credit risk and hencefree up capital, which can be used for other productivepurposes. Two, banks can conduct business on existingclient relationships in excess of exposure norms andtransfer away the risks. For instance, a bank which has hitits exposure limits with a client group may have to turndown a lucrative guarantee deal. However, with creditderivatives, the bank can take up the guarantee andmaintain its exposure limits by transferring the credit riskon the guarantee or previous exposures. This allows bankto maintain client relationships. Three, banks can constructand manage a credit risk portfolio of their own choice andrisk appetite unconstrained by funds, distribution and saleseffort.

However, the use of credit derivatives also raises someconcerns. One, some of the credit derivatives, which arebeing used, are at their infancy and need to mature.Introduction of such products, therefore, may be potentiallydestabilising. Two, the measurement and management ofcredit risk is much more complicated than market risk.Third, documentation risk is an important aspect of creditderivatives. Fourth, certain incentive issues arise with theuse of credit derivatives. This is because such instrumentstypically change the under lying borrower-lenderrelationship and establish new relationships betweenlenders that become risk shedders and the new risk takers.This new relationship has the potential for market failuredue, for instance, to asymmetric information.

Reference:

The Reserve Bank of India. 2003. Report of Working Groupon Introduction of Credit Derivatives in India (Convenor:B. Mahapatra). Mumbai, March.

IMF. 2002. Monetary and Financial Statistics Manual.

Ueda Kazuo. 2003. ‘On Credit Risk Transfer Instrumentsand Central Banks’. 18th Annual General Meeting, Tokyo,April.

129

CREDIT MARKET

IV. TRENDS IN CREDIT – THE 1990s ANDONWARDS

Credit Trends – All Institutions

4.35 Total loans outstanding by al l creditinsti tut ions (commercial banks, DFIs and co-operatives) combined together increased at acompound annual rate of 15.7 per cent during the1990s and by 17.7 per cent per annum during thecurrent decade so far (up to 2005-06). As percentageof GDP, loans outstanding increased from 34.2 percent at end-March 1991 to 54.1 per cent at end-March2006, suggesting increased credit penetration in thecountry (Table 4.1).

4.36 Dur ing the 1990s, the credit growth ofcommercial banks was lower than that of creditinstitutions in the co-operative sector. However, thetrend has reversed during the current decade (up to2005-06) with credit growth of commercial banksbeing significantly higher than the credit growth of theco-operative institutions. Credit growth of NBFCsduring the first five years of the current decade wassignificantly lower than the growth of total credit byall institutions. Loans and advances by DFIs declined

during the period from 2000-01 to 2005-06, essentiallydue to the conversions of two large DFIs into banks(Table 4.2).

4.37 Reflecting movements in growth rates, theshare of commercial banks’ credit in total outstandingcredit by all institutions increased significantly from59.7 per cent at end-March 1991 to 78.2 per cent atend-March 2006. During the same period, the shareof RRBs and SCARDBs also increased marginally.The share of all other credit institutions declined. Apartfrom aggressive retail lending strategies adopted bycommercial banks, which captured some of thebusinesses of NBFCs, increased and diversifiedlending into rural areas contributed to the rise in theshare of commercial banks. Conversion of two DFIsinto commercial banks also contributed to the increasein the share of commercial banks in the currentdecade and a sharp decline in the share of FIs (Table4.3). In the case of co-operative institutions, whichare financially weak and inadequately capitalised,reforms have been initiated very recently, which mayhelp in reversing the declining share of co-operativeinstitutions.

4.38 Since commercial banks account for morethan three-fourths of total credit outstanding anddetailed data on credit by other institutions are notreadily available, analysis in the remaining part of thechapter is based largely on credit extended byscheduled commercial banks.

Table 4.2: Institution-wise Growth ofOutstanding Credit

(Compound Annual Growth Rate)(Per cent)

Category 1991-92 to 2000-01 to1999-2000 2005-06

1 2 3

1. Commercial Banks 15.8 23.0

2. RRBs (and LABs) 15.4 21.1

3. Financial Institutions 14.2 -5.9

4. Urban Cooperative Banks 21.4 7.3

5. State Cooperative Banks 16.3 7.6

6. District Central Cooperative Banks 16.0 10.3

7. Primary Agricultural Credit Societies 17.9 9.3

8. SCARDBs 27.0 7.5

9. PCARDBs 15.9 9.1

All Institutions 15.7 17.7

Note : Data are provisional.Source : Report on Trend and Progress of Banking in India, various

issues, Reserve Bank of India.

Table 4.1: Total Outstanding Credit byall Credit Institutions

End-March Total Credit Annual Credit-GDPOutstanding Growth Ratio

(Rs. crore) (Per cent) (Per cent)

1 2 3 4

1991 1,94,654 – 34.21995 3,47,125 22.7 34.32000 7,25,074 17.1 37.12001 7,94,125 9.5 37.82002 8,93,384 12.5 39.22003 10,77,409 20.6 43.82004 11,99,607 11.3 43.42005 14,81,587 23.5 47.42006 19,28,336 30.2 54.1

Compound Annual Growth Rate (Per cent)

1991 to 2000 15.72000 to 2006 17.7

Note : 1. Data are provisional.

2. Data include commercial banks, RRBs, LABs, DFIs,UCBs, STCBs, DCCBs, PACSs, SCARDBs andPCARDBs.

3. In case of non-availability of data for select co-operatives,data for the previous year have been repeated.

Source : Report on Trend and Progress of Banking in India, variousissues, Reserve Bank of India.

130


Trends in Scheduled Commercial Bank Credit

4.39 Bank credit, after witnessing an erratic patternin the first half of the 1990s, showed a decelerationfrom 1996-97 to 2001-02, growing at an average annualrate of 15.1 per cent as compared with 19.5 per cent inthe preceding four years (Chart IV.2). Several factors,both on the demand and the supply sides, contributedto the contraction of credit. On the supply side,introduction of prudential norms relating to incomerecognition, asset classification and provisioning in

the mid-1990s made banks cautious. Application ofnorms revealed large gross NPAs with banks (15.7per cent of their gross advances at end-March 1997).Banks, therefore, became wary of enlarging their loanpor tfolio. The relatively high level of NPAs, inparticular, had a severe impact on weak banks. Banks’capacity to extend credit was also impaired due tolittle headroom available in the capital adequacy ratio(8.7 per cent at end-March 1996). Banks found risk-adjusted returns on government securities moreattractive. Hence, despite lowering of statutory pre-emption in the form of SLR, banks continued to investin government securities, far in excess of therequirements. Banks’ investment in SLR securities atend-March 1996 was 36.9 per cent of net demand andtime liabilities (NDTL) as against the statutoryrequirement of 31.5 per cent. Banks’ investments in SLRsecurities remained more or less at that level (36.7 percent) by end-March 2002, even as the SLR was broughtdown significantly to 25 per cent.

4.40 On the demand side also, several factorscontributed to the decline in demand for credit by thecorporate sector. The industrial sector witnessedmassive expansion in capacity in certain sectors,especially cement and steel, in the initial phase ofreforms. However, as the quantitative restrictions wereremoved and import tariffs reduced, the corporatesector faced intense competition during the latter partof the 1990s. The focus of the corporate sector, thus,shifted from expanding capacity to restructuring andthe industrial sector slowed down significantly. Theaverage annual growth rate of industrial productionwas 5.2 per cent during 1996-97 to 2001-02 ascompared with 9.4 per cent in the preceding threeyears. This affected the demand for credit by thecorporate sector. Increased competition also forcedcorporates to restructure their balance sheets,whereby they increased their reliance on retainedearnings and reduced their borrowings. This wasevident from the debt-equity ratio, which declined froman average of 85.5 per cent during 1990-91 to 1994-95 to 65.2 per cent during 1995-96 to 1999-2000 (seeTable 7.5 of Chapter VII).

4.41 Although the Reserve Bank pursuedaccommodative monetary policy during this period(1996-97 to 2001-02) by reducing the CRR and thepolicy rates, viz., the Bank Rate and the reverse reporate (the then repo rate), credit offtake did not pickup. Downward stickiness of nominal interest rates onthe one hand, and falling inflation rate on the other,led to a significant rise in real interest rates. Theaverage real lending rates of banks increased to 12.5per cent during 1996-97 to 2001-02 as against 6.5

Table 4.3: Distribution of Credit –Category-wise Share

(Per cent)

Category End-March

1991 2006

1 2 3

1. Commercial Banks 59.7 78.2

2. RRBs (and LABs) 1.8 2.1

3. All-India Financial Institutions 24.9 5.8

4. Urban Co-operative Banks 4.1 3.6

5. State Co-operative Banks 3.4 2.1

6. District Central Co-operative Banks 6.0 4.2

7. Primary Agricultural Credit Societies 3.3 2.5

8. SCARDBs 0.7 0.9

9. PCARDBs 1.0 0.7

All Institutions 100.0 100.0

Note : Data are provisional.Source : Report on Trend and Progress of Banking in India, various

issues, Reserve Bank of India.

Gro

wth

Rat

e (p

er c

ent)

Chart IV.2: Bank Credit and Non-food Credit Growth

Total Bank Credit Non-food Credit

131

CREDIT MARKET

per cent during 1990-91 to 1995-96 (Mohan, 2003).This also appeared to have contributed to slacknessin credit expansion.

4.42 Credit growth accelerated in 2002-03 only todecelerate sharply in 2003-04 even when theindustr ial sector was buoyant due mainly tocontraction in food credit and increased recourse bycorporates to internal sources of financing andincreased external commercial borrowings. During2004-05 to 2006-07, bank credit expanded at a robustpace of around 30 per cent. Major factors thatcontributed to the acceleration in credit growth werepick-up in economic growth, improvement in assetquality of the credit institutions, moderation in inflationand inflation expectations, decline in real interestrates, rising income of households and increasedcompetition with the entry of new private sector banks(as detailed in the subsequent sections). The removalof restrictions on retail credit and project finance bybanks also created new sources of credit demand.

Sectoral Deployment of Credit

4.43 Reforms and the evolving economic structurehad a profound impact on the flow of bank credit tovarious sectors of the economy during the 1990s andthe current decade. Credit growth to agriculture duringthe 1990s slowed down to almost one-half ascompared with the 1980s (Table 4.4). However, thetrend was reversed beginning from 2002-03 as a resultof concerted efforts made by the Reserve Bank andthe Government to increase the flow of credit toagriculture. Credit to the industrial sector slowed

down, albeit marginally, in the 1990s and the currentdecade as compared with the 1980s. A significantdevelopment during the current decade, however, hasbeen the rapid credit expansion to the householdsector (personal loans) in the form of housing andother retail loans.

4.44 The share of agriculture and industrial sectorsin total bank credit declined between end-March 1990and end-March 2005, while that of personal loans andprofessional services increased sharply.

Agriculture

4.45 As a result of the sharp deceleration in thegrowth of credit to agriculture, the share of agriculturein total bank credit declined sharply from 15.9 percent at end-March 1990 to 9.6 per cent by end-March2001 (Table 4.5). During this period, however, theshare of agriculture in GDP also declined significantly.As a result, credit intensity of the agriculture sector(credit to agriculture sector as percentage of sectoralGDP) remained broadly at the same level. In the earlypart of the current decade, the Government and theReserve Bank took a series of measures to facilitatethe flow of credit to the agriculture sector. These, interalia, included: (i) rescheduling of short-term loans tomedium and long-term loans, following agriculturaldistress in several parts of the country; (ii) highertargets fixed under the Special Agricultural CreditPlans of public sector banks and making it applicableto private sector banks also; and (iii) advising banksto double the flow of credit within three years startingfrom 2004-05. Credit growth to agriculture picked up

Table 4.4: Sector-Wise Credit of Commercial Banks – Compound Annual Growth Rate(Per cent)

Period Agriculture Industry Transport Professional Personal Trade Finance Total BankOperators Services Loans Credit

1 2 3 4 5 6 7 8 9

1980-81 to 1989-90 18.1 17.4 13.6 20.7 25.3 11.8 29.2 17.2

1990-91 to 1999-00 10.6 15.4 9.4 16.8 22.7 17.3 25.6 16.0

2000-01 to 2004-05 22.2 15.9 11.2 30.4 37.7 12.6 27.4 20.2

Memo:End-March

2001 13.3 10.6 7.7 31.3 27.7 25.0 21.0 17.0

2002 23.7 14.9 7.1 44.0 25.1 12.7 42.2 21.8

2003 18.6 14.1 0.9 22.4 38.1 3.2 34.6 15.2

2004 26.7 8.1 18.7 29.5 57.2 -2.5 16.4 16.4

2005 29.2 33.5 22.8 25.8 42.9 27.8 24.3 30.9

Source: Basic Statistical Returns of Scheduled Commercial Banks, various issues, Reserve Bank of India.

132


significantly from 2003-04 onwards. The share ofagricultural credit in total bank credit also increasedto 10.8 per cent by end-March 2005. The gap betweenthe share of agriculture credit in total bank credit andits share in GDP narrowed down to less than 8percentage points at end-March 2006 from 17.4 per cent

at end-March 1995. Furthermore, credit intensity of theagriculture sector increased sharply from 11.1 per centin 2001-02 to 27.0 per cent by 2005-06 (Chart IV.3).The number of borrowal accounts in the agriculturesector also increased to 26.66 millions in 2004-05 from19.84 millions in 2000-01.

Table 4.5: Distribution of Outstanding Credit of Scheduled Commercial Banks

(Per cent to total credit)

Sector Mar-90 Mar-95 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05

1 2 3 4 5 6 7 8 9

Agriculture 15.9 11.8 9.9 9.6 9.8 10.0 10.9 10.8Industry 48.7 45.6 46.5 43.9 41.4 41.0 38.0 38.8Transport 3.2 1.9 1.8 1.6 1.4 1.2 1.3 1.2Personal Loans and Professional Services 9.4 11.3 14.4 15.8 16.8 19.6 25.3 27.0of which:

Loans for Purchase of Consumer Durables 0.4 0.3 0.6 0.6 0.5 0.4 0.5 0.6Loans for Housing 2.4 2.8 4.0 4.7 5.0 6.5 9.7 11.0

Trade 13.9 17.1 15.6 16.6 15.4 13.8 11.5 11.2Financial Institutions 2.1 3.8 4.8 4.9 5.7 6.7 6.7 6.4Miscellaneous / All Others 6.8 8.5 7.1 7.5 9.5 7.7 6.2 4.6Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Source: Basic Statistical Returns of Scheduled Commercial Banks in India, various issues, Reserve Bank of India.

End-March

Share in NFC Share in GDP

Share of Agriculture Sector in GDP and Non-Food Credit

Per

cen

t


Per

cen

t


Per

cen

t

Share of Industry in GDP and Non-Food Credit

Share of Services Sector in GDP and Non-Food Credit

Credit Intensity of Agriculture

Ou

tsta

nd

ing

Cre

dit

as

per

cen

tage

of

Sec

tora

l G

DP

Ou

tsta

nd

ing

Cre

dit

as

per

cen

tage

of

Sec

tora

l G

DP

Ou

tsta

nd

ing

Cre

dit

as

per

cen

tage

of

Sec

tora

l G

DP

Credit Intensity of Industry

Credit Intensity of Services

Chart IV.3: Sectoral GDP and Credit

133

CREDIT MARKET

Trends in Priority Sector Advances

4.46 Prior to the nationalisation of banks in 1969,banks’ lending was confined primarily to big businessand trading in the metropolitan and urban centres.After the nationalisation of banks, the Government ofIndia undertook corrective measures to rectify the lop-sided lending by banks. Accordingly, in 1972, banks

were advised to extend credit to certain activities,known as the priority sectors. With a view to aligningbank credit to the changing needs of society, thescope and definition of the priority sector have beencontinuously fined-tuned by including new items asalso by enhancing credit limit of the constituent sub-sectors (Box IV.6).

Box IV.6Policies Relating to the Priority Sector, Micro-finance and Credit Cards in Rural Areas

Priority Sector

• Domestic scheduled commercial banks and foreignbanks are required to extend a minimum of 40 per centand 32 per cent, respectively, of their net bank credit(NBC) to the priority sector with sub-targets set forlending to various sub-sectors.

• Major categories of priority sector credit includeagriculture and allied activities, small scale industries,housing loans and education loans, among others.

• The scope of the priority sector has been expandedover the years to include export activity, education,housing, software industry, venture capital, leasing andhire purchase.

Micro-finance

• The SHG-bank linkage programme, launched in Indiain 1992 as a pilot project, envisages (i) organising therural poor into Self-help Groups (SHGs); (ii) buildingtheir capacities to manage their own finances; and (iii)then negotiating bank credit on commercial terms.

• The target-group broadly comprises small and marginalfarmers, landless agricultural and non-agriculturallabourers, artisans and craftsmen, and other rural poorengaged in small businesses such as vending andhawking.

• There are two major models under micro-finance,namely, Self-Help Group-Bank Linkage (SHG-BL) andMicro-Finance Institutions (MFIs).

Kisan Credit Card

• The Kisan Credit Card (KCC) scheme, introduced inAugust 1998, enables farmers to purchase agriculturalinputs and draw cash for their production needs.

• The Scheme was revised in November 2004 to coverterm credit as well as working capital for agricultureand allied activities, in addition to short-term creditlimits available separately for crop/s.

• Short-term credit/crop loans as well as working capitalfor agriculture and allied activities are repayable in 12

months, while term loans are repayable within amaximum period of 5 years, depending on the type ofactivity/investment.

• The Scheme is being implemented by all commercialbanks, RRBs, state co-operative banks/DCCBs/PACSand scheduled primary co-operative banks.

General Credit Card

• The guidelines on general credit cards (GCC) wereissued on December 27, 2005, with a view to providingeasy credit to banks’ customers in rural areas.

• The objective of the GCC scheme is to provide hassle-free credit to the customers of banks based on theassessment of cash flow without insistence on security,purpose or end-use of the credit. This is in the natureof overdraft or cash-credit with no end-use stipulations.

• GCC may not necessarily be in the form of a card andcan be issued in the form of a Pass Book, if the holder ofGCC desires to operate cash withdrawals from bankbranch.

• The credit facility extended under the scheme is in thenature of revolving credit. The GCC holder is entitledto draw cash up to the limit sanctioned from thespecified branch of the bank.

• Banks have the flexibility to fix the limit on GCC basedon the assessment of income and cash flow of theentire household. However, total credit facility underGCC for an individual should not exceed Rs.25,000and interest rate on the facility may be charged, asconsidered appropriate and reasonable.

• Banks may utilise the services of local post offices,schools, primary health centers, local governmentfunctionaries, farmers’ association/club, well-establishedcommunity-based agencies and civil societyorganisations for sourcing of borrowers for issuing GCC.

• To incentivise the banks to issue GCC, fifty per cent ofcredit outstanding under GCC, up to Rs.25,000, iseligible for being treated as indirect agriculturalfinancing for the purpose of priority sector target.

134


4.47 Credit growth to the priority sector showed adistinct improvement in recent years growing at anaverage annual rate of 25.7 per cent during the periodfrom 2000-01 to 2005-06 as compared with 13.1 percent during the 1990s. This was mainly due toincreased lending to cer tain sectors such asagriculture and housing. Despite this increase, prioritysector advances declined from 40.1 per cent of nonfood gross bank credit (NFGBC) at end-March 1990to 36.3 per cent by end-March 2006 (Table 4.6). Withhigher credit growth during 2004-05 and 2005-06 byboth public and private sector banks, the prioritysector credit target of 40.0 per cent of net bank credit(NBC) was achieved by end-March 2006.

4.48 Within the priority sector, credit to agriculture,which grew at an average annual rate of 11.2 per centduring the 1990s, accelerated to 25.7 per cent duringthe six-year period ended March 2006. Despite thisincrease, the share of agriculture in total priority sectoradvances declined from 40.9 per cent at end-March1990 to 33.8 per cent at end-March 2006 (Table 4.6).The share of agricultural loans as per cent of NBC ofpublic sector banks was at 15.3 per cent at end-March

2005 and 15.2 per cent at end-March 2006. Theagriculture loans as per cent of NBC of private sectorbanks at 13.5 per cent each at end-March 2005 and2006 were, much, lower than the stipulated target of18 per cent. Some banks, especially new privatesector banks and foreign banks, lack adequate branchnetwork in rural areas as a result of which some ofthese banks find it difficult to achieve their prioritysector credit targets. To address the problem, bankswere asked to make deposits, to the extent of shortfall,in the Rural Infrastructure Development Fund (RIDF)of the National Bank for Agriculture and RuralDevelopment (NABARD) for achieving the lendingtarget. Foreign banks are required to make depositsin the Small Industries Development Bank of India(SIDBI).

4.49 For increasing the flow of credit to agricultureand other rural sectors of the economy, severalinnovative measures were initiated in the form of Self-Help Group (SHG) - Bank Linkage programme andKisan Credit Card (KCC) schemes. Micro-finance isnow increasingly being recognised as a cost effectiveand sustainable way of expanding outreach of the

Table 4.6: Trends in Outstanding Priority Sector Advances

(Amount in Rs. crore)

Total Priority Sector Advances Agriculture Advances SSI Advances

End-March Amount Annual Per cent Amount Annual Per cent Amount Annual Per centGrowth of Growth of Growth of

(Per cent) NFGBC (Per cent) NFGBC (Per cent) NFGBC

1 2 3 4 5 6 7 8 9 10

1990 40,383 18.0 40.1 16,526 18.5 16.4 15,543 18.3 15.41991 42,915 6.3 37.8 16,750 1.4 14.8 17,181 10.5 15.11992 45,425 5.8 37.4 18.157 8.4 15.0 18,150 5.6 15.01993 49,832 9.7 35.5 19,963 9.9 14.2 20,026 10.3 14.31994 53,880 8.1 36.9 21,208 6.2 14.5 22,617 12.9 15.51995 64,161 19.1 34.7 23,983 13.1 13.0 27,638 22.2 15.01996 73,329 14.3 33.0 27,044 12.8 12.2 31,884 15.4 14.41997 84,880 15.8 33.8 31,442 16.3 12.5 35,944 12.7 14.31998 99,507 17.2 34.6 34,869 10.9 12.1 43,508 21.0 15.11999 1,14,611 15.2 35.2 39,634 13.7 12.2 48,483 11.4 14.92000 1,31,827 15.0 35.1 44,381 12.0 11.8 52,814 8.9 14.12001 1,54,414 17.1 36.0 51,922 17.0 12.1 56,002 6.0 13.02002 1,75,259 13.5 36.3 60,761 17.0 12.6 57,199 2.1 11.82003 2,11,609 20.7 34.1 73,518 21.0 11.9 60,394 5.6 9.72004 2,63,834 24.7 36.2 90,541 23.2 12.4 65,855 9.0 9.02005 3,81,476 44.6 38.2 1,25,250 38.3 12.5 74,588 13.3 7.52006 5,09,910 33.7 36.3 1,72,292 37.6 12.3 90,239 21.0 6.4

Average Annual Growth (Per cent)

1990 to 2000 13.1 11.2 13.6

2001 to 2006 25.7 25.7 9.5

NFGBC: Non Food Gross Bank Credit.Source: Handbook of Statistics on the Indian Economy, 2005-06, Reserve Bank of India.

135

CREDIT MARKET

banking sector to the rural poor. The relative absenceof interest subsidies, the high repayment performanceand reduced transaction costs to lenders are someof the major advantages of micro-finance. There isnow a growing realisation among the lending agenciesthat micro-finance programmes are bankable,creditwor thy and profitable. Banks are nowdiscovering that people at the bottom of the pyramidcan be brought into their business models.

4.50 The SHG-Bank Linkage programme is one ofthe two models of micro-finance. The flow of credit tothe rural sector is hampered for two reasons. One,credit is largely collateral based, and two, loandelinquencies are generally higher. Formation of jointl iabi l i ty groups in the form of SHGs helps inovercoming both these problems. The responsibilityfor repayment of the loan is borne jointly by all themembers of SHGs, who are engaged in someeconomic activity that generates the income neededfor the repayment. Experience of SHGs in countriessuch as Bangladesh also shows that loan delinquencyis lower in the case of SHGs due to peer pressure.The main advantages of the program are on-timerepayment of loans to banks; reduction in transactioncosts for both, the poor and the banks; door-stepsavings and credit facilities available to the poor; andexploitation of the untapped business potential inrural India.

4.51 The Self-Help Group (SHG)-Bank Linkageprogramme has emerged as an important model ofmicro-finance activity in the country (see Box IV.5).As at end-March 2006, 2.2 million SHGs were linkedto banks with cumulative bank loans amounting toRs.11,398 crore (Table 4.7). The share of commercialbanks in financing SHGs has increased over theyears. The number of families assisted has increasedby about five-fold from 5 million in 2001 to 24 millionin 2005. Further, the average bank loan per SHGincreased from Rs.18,227 in 2001 to Rs.32,012 in2005.

4.52 The SHG-Bank Linkage programme, whichti l l now has been concentrated largely in theSouthern States, is expected to gain further groundwith the NABARD taking up a programme forintensification of these activities in 13 identifiedStates, accounting for 70.0 per cent of the rural poorpopulation.

4.53 Although various types of products wereavailable for providing credit to farmers, they lackedflexibility in terms of amount needed for day to dayrequirements and its timely availability. In order tomeet the liquidity requirement of farmers in a flexible

manner, the Kisan Credit Card (KCC) scheme wasintroduced in August 1998 to enable the farmers topurchase agricultural inputs and draw cash for theirproduction needs. At the inception of the scheme, itwas envisaged that investment credit requirementsof farmers, viz, allied and non-farm activities wouldalso be covered under the scheme. Since theseactivities were outside the ambit of the KCC schemeas announced in 1998, farmers had to approach thebanks separately for their additional requirements,entailing additional time and cost, and observingbanks’ procedural formalit ies, includingdocumentation. Therefore, revised KCC guidelineswere issued in November 2004. The revised schemeaims at providing adequate and timely credit for thecomprehensive credit requirements of farmers undera single window, with f lexible and simplif iedprocedures, adopting whole farm approach, includingthe shor t-term credit needs and a reasonablecomponent for consumption needs (see Box IV.5).

4.54 The KCC scheme has since stabilised. Thecumulative number of KCCs issued by commercialbanks, RRBs and co-operatives was at 59 million atend-March 2006 and the cumulative amountsanctioned was Rs.1,81,992 crore. While the numberof KCCs issued by commercial banks increased inrecent years, those issued by co-operative banks andRRBs declined. The share of co-operative banks inthe cumulative number of KCCs issued was 51.5 percent, followed by commercial banks (36.9 per cent)and RRBs (11.6 per cent). The amount sanctioned asper cent of total outstanding loans was at 21.3 per cent

Table 4.7: Progress of SHG-BankLinkage Programme

Year Total SHGs financed Bank Loansby banks (Nos. 000) (Rs. crore)

During Cumula- During Cumula- Cumulativethe tive the tive as Per

Year Year Cent ofTotalBank

Credit

1 2 3 4 5 6

1992-99 33 33 57 57 0.021999-00 82 115 136 193 0.042000-01 149 264 288 481 0.092001-02 198 461 545 1,026 0.172002-03 256 717 1,022 2,049 0.282003-04 362 1,079 1,856 3,904 0.462004-05 539 1,618 2,994 6,898 0.632005-06 620 2,239 4,499 11,398 0.76

Source: NABARD and RBI.

136


in case of RRBs and 7.5 per cent in case of co-operatives. Amount sanctioned by commercial banksas per cent of the total loans outstanding to agriculturewas 9.8 per cent at end-March 2006 (Table 4.8).

4.55 Another important segment of the prioritysector is the small scale industries (SSIs) sector. Ananalysis of credit flow to this sector is provided in thesubsequent section.

Industry

4.56 The credit extended to the industrial sectordecelerated marginally in the 1990s (16.4 per cent)and the current decade so far (15.8 per cent) incomparison with the 1980s (16.7 per cent) (see Table4.4). The share of industry in total bank credit declinedsharply from 48.0 per cent at end-June 1990 to 38.8per cent at end-March 2005 (see Table 4.5).

4.57 Banks’ support to the industrial sector in theform of non-tradit ional instruments such ascommercial paper, shares/bonds/ debentures issuedby corporates, which increased sharply in the secondhalf of the 1990s, also declined/decelerated beginningwith 2001-02 (Table 4.9).

4.58 Deceleration in the financial support bybanks to industry, despite the robust performanceof the industrial sector during last few years, wasmainly due to their increased reliance on retainedearnings and increased access to the domestic andinternational capital markets. Creditworthy corporatesalso resor ted to large external commercialborrowings (Table 4.10).

4.59 As a result of reduced reliance of industryon bank credit, the gap between the share of theindustrial sector in total non-food credit and its sharein GDP narrowed down significantly. The industrialsector accounted for 54.3 per cent of bank credit asagainst its share of 22.0 per cent in GDP in 1990-91. By 2005-06, however, the share of the industrialsector in non-food credit declined sharply to 39.1per cent, even as i ts share in GDP decl inedmarginally to 20.8 per cent. This was reflected inincreased credit intensity of industry, which wasalready significantly higher than the other sectors.

Table 4.9: Non-SLR Investments of ScheduledCommercial Banks

End- Share in Total Non-SLR Total Non-SLRMarch Investments (Per cent) Investments

CP Shares Bonds/ Amount Annual ShareDeben- (Rs. Growth in Total

tures crore) (Per Assets ofcent) Banks

(Per cent)

1 2 3 4 5 6 7

1998 7.5 7.1 85.4 32,461 74.8 5.41999 8.3 8.1 83.7 48,376 49.0 6.92000 8.2 7.8 84.0 61,408 26.9 7.32001 10.6 7.5 81.9 75,844 22.9 7.62002 10.5 7.3 82.2 80,999 6.8 7.12003 4.3 9.7 86.0 92,854 14.6 6.62004 4.2 9.7 86.0 88,985 -4.2 5.42005 4.2 12.7 83.1 93,664 5.3 4.72006 6.1 16.1 77.9 79,464 -15.2 3.42007 11.0 22.0 67.0 83,466 5.0 2.9

Note : Data based on last reporting Friday of the financial year. Dataexclude banks’ investments in instruments of financial institutionsand mutual funds.

Source : Reserve Bank of India.

Table 4.8: Progress of Kisan Credit Cards Scheme(Numbers in Million; Amount in Rupees Crore)

Year Co-operative Banks RRBs Commercial Banks Total

No. Amount* Share in No. Amount* Share in No. Amount* Share in No. Amount* Share inTotal Loans Total Loans Aggregate

Outstanding Loans Outstanding Loans(Per cent) Outstanding to Agriculture Outstanding#

(Per cent) (Per cent) (Per cent)

1 2 3 4 5 6 7 8 9 10 11 12 13

1998-99 0.16 826 0.9 0.01 11 0.1 0.62 1,473 3.6 0.78 2,310 1.61999-00 3.60 3,606 3.1 0.17 405 3.2 1.37 3,537 7.2 5.13 7,548 4.22000-01 5.61 9,412 6.9 0.65 1,400 9.2 2.39 5,615 9.5 8.65 16,427 7.82001-02 5.44 15,952 10.4 0.83 2,382 13.2 3.07 7,524 11.6 9.34 25,858 10.92002-03 4.58 15,841 8.3 0.96 2,955 13.8 2.70 7,481 9.3 8.24 26,277 9.02003-04 4.88 9,855 4.1 1.27 2,599 10.2 3.09 9,331 9.4 9.25 21,785 5.92004-05 3.56 15,597 6.1 1.73 3,833 11.6 4.40 14,756 11.2 9.68 34,186 8.12005-06 2.60 20,339 7.5 1.25 8,483 21.3 4.16 18,779 9.8 8.01 47,601 9.5Total @ 30.41 91,428 – 6.88 22,068 – 21.80 68,496 – 59.09 1,81,992 –

*: Amount sanctioned. @ : Total represents aggregate number of cards issued and amounts sanctioned since 1998-99.# : Aggregate loans outstanding include total loans of co-operatives, RRBs and agricultural loans of commercial banks.Source: NABARD and RBI.

137

CREDIT MARKET

Table 4.10: Non-Bank Sources of Funds for Industry(Rs. crore)

Year Capital ADR/GDR External Issue of Financial Retained DepreciationIssues * Issues + Commercial CPs # Assistance Earnings ** Provision **

Borrowings $ by FIs (net)

1 2 3 4 5 6 7 8

1997-98 2,171 – 14,028 854 – 6,873 11,3121998-99 2,484 – -2,504 3,270 – 4,517 12,9441999-00 2,350 2,144 2,993 893 – 4,678 14,7102000-01 2,505 3,433 -3,182 183 9,084 5,186 15,7592001-02 1,951 1,528 -11,308 1,378 -3,469 2,584 17,4512002-03 642 3,426 -3,593 -1,475 -5,672 8,288 18,3062003-04 2,422 3,098 16,098 3,382 2,723 15,645 20,4082004-05 10,456 2,960 41,106 5,104 7,885 28,384 22,6972005-06 13,781 7,262 45,078 -1,517 8,687 48,402@ 28,883

* : Gross issuances excluding issues by banks and financial institutions. Figures are not adjusted for banks’ investments in capital issues.+ : Including Global Depository Receipts (GDRs)/American Depository Receipts (ADRs) and Foreign Currency Convertible Bonds (FCCBs), excluding

issuances by banks and financial institutions.$ : Including short-term credit and adjusted for redemption of RIBs and IMDs.# : Excluding issuances by financial institutions and banks’ investments in CPs.@ : Estimate; taken as 71.7 per cent of profits after tax, the same proportion as was observed for select companies in 2004-05.** : Based on select non-government, non-financial public limited companies.– : Not available.Note : Data are provisional.Source : Reserve Bank of India.

Table 4.11: Type of Credit to Industry By Banks (Rs. crore)

End-March Short-Term Loans* Medium-Term Loans Long-Term Loans Total Credit

Amount Share in Amount Share in Amount Share inTotal Credit Total Credit Total Credit

(Per cent) (Per cent) (Per cent)

1 2 3 4 5 6 7 8

1995 77,134 82.5 5,438 5.8 10,874 11.6 93,4461996 97,809 81.7 6,620 5.5 15,273 12.8 1,19,7021997 1,09,666 79.6 8,136 5.9 19,987 14.5 1,37,7891998 1,23,408 78.0 10,578 6.7 24,261 15.3 1,58,2471999 1,36,488 76.1 10,660 5.9 32,150 17.9 1,79,2982000 1,52,369 74.3 13,928 6.8 38,777 18.9 2,05,0742001 1,70,114 74.8 16,067 7.1 41,341 18.2 2,27,5222002 1,65,828 63.0 22,313 8.5 74,910 28.5 2,63,0512003 1,79,687 59.5 22,366 7.4 99,853 33.1 3,01,9062004 1,89,918 57.9 32,187 9.8 1,06,084 32.3 3,28,1892005 2,29,672 52.4 46,535 10.6 1,62,296 37.0 4,38,503

* : Short-term credit includes cash credit, overdraft, demand loans, packing credit, export trade bills purchased and discounted, export trade billsadvanced against, advances against export cash incentives and duty drawback claims, inland bills purchased and discounted (trade and others),advances against import bills, foreign currency cheques, TCs/DDs/TTs/MTs purchased.

Source: Basic Statistical Returns of Scheduled Commercial Banks in India, various issues, Reserve Bank of India.

Credit intensity of industry rose despite the slowdownof credit to the SSI sector as explained subsequently.In this context, two important developments need tobe noted. One, during this period two major DFIsconver ted into banks which, at the t ime ofconversion, had a huge por tfolio of loans andadvances. Although a portion of those loans mighthave been repaid, given the typical five to seven yearmatur ity of their loans, it is believed that the

converted entities might still be carrying a sizeableportion of those loans in their books. Two, banks now,apart from extending working capital finance, alsoextend medium and long-term finance, including forinfrastructure projects. The share of medium andlong-term credit to industry in total credit by banksto the industrial sector increased sharply from 17.5per cent at end-March 1995 to 47.6 per cent by end-March 2005 (Table 4.11).

138


4.60 A part of the increase in medium and long-termcredit to industry in recent years emanated fromincreased credit to the infrastructure sector (Table 4.12).

4.61 Short-term credit intensity of the industrialsector, which had risen sharply between 1997-98 and2000-01, declined significantly thereafter (Chart IV.4).This mainly reflected the impact of two factors, viz.,increased access of the domestic and theinternational capital markets and increase in theretained earnings of the corporate sector resultingfrom increased profitability.

4.62 As a result of sharp increase in medium andlong-term credit, the share of short-term credit inoverall credit has declined. Within short-term credit,

the share of cash credit has declined sharply (Chart IV.5).Several factors appear to have contributed to thistrend. One, corporates in recent years raised largeresources through issuance of commercial paper(CP) and ECBs. Two, corporates have also becomecash rich due to their improved profitability in recentyears. Banks have traditionally extended credit to theindustry largely in the form of cash credit limits andoverdraft. This system, however, places the onus ofcash management on banks rather than on thecorporates. Hence, the shift in favour of demandloans in recent years is a healthy development. Forworking capital limit of Rs.10 crore and above,however, ‘loan system’ was introduced in April 1995.The percentage of loan component was gradually

Table 4.12: Bank Credit to the Infrastructure Sector(Rs. crore)

End-March

Sector 1998 1999 2000 2001 2002 2003 2004 2005 2006

1 2 3 4 5 6 7 8 9 10

Infrastructure 3,163 5,941 7,243 11,349 14,809 26,297 37,224 79,009 1,08,787(87.8) (21.9) (56.7) (30.5) (77.6) (41.6) (112.3) (37.7)

of which:Power 697 2,109 3,289 5,246 7,373 15,042 19,655 38,744 57,863Telecommunication 2,045 2,273 1,992 3,644 3,972 5,779 8,408 15,794 17,713Roads and Ports 421 1,559 1,962 2,459 3,464 5,476 9,161 14,472 18,975

Note: 1. Figures in parentheses are annual growth rates.2. Data relate to select SCBs, which account for around 90 per cent of the bank credit extended by all scheduled commercial banks.

Source: Handbook of Statistics on the Indian Economy, 2005-06, Reserve Bank of India.

Cas

h C

red

it

Ove

rdra

ft

Dem

and

Loa

ns

Med

ium

Ter

m L

oan

s

Lon

g Te

rm L

oan

s

Pack

ing

Cre

dit

Inla

nd

an

d F

orei

gn B

ills

Chart IV.5: Types of Borrowings by thePrivate Corporate Sector

Sh

are

in T

otal

Cre

dit

to

Priv

ate

Cor

por

ate

Sec

tor

(per

cen

t)

Sh

ort-

term

Cre

dit

as

Per

cen

t of

in

du

stri

al G

DP

End-March

Chart IV.4: Short-term Credit Intensity ofthe Industrial Sector

139

CREDIT MARKET

enhanced to 80 per cent. The ‘loan system’ wasliberalised in October 2001 with banks having freedomto decide the cash credit and loan component forworking capital.

Credit to the Small Scale Industries Sector

4.63 The small scale industries (SSI) sector is animportant segment of the Indian economy. However,credit flow to the small scale industries sectordecelerated in recent years as is evident from variousindicators. First, the average annual growth of SSIadvances decelerated to 9.5 per cent during 2001-2006 from 13.6 per cent during the 1990s. Second,the share of the SSI sector in total priority sectoradvances declined steadily from 44 per cent at end-March 1998 to 18 per cent at end-March 2006. Third,the share of credit to the SSI sector in NBC declinedfrom 15.7 per cent at end-March 1990 to 8.6 per centat end-March 2004. SSI advances by public sectorbanks were 8.1 per cent of net bank credit at end-March 2006 as compared with 9.5 per cent at end-March 2005. In the case of private sector banks, SSIadvances accounted for 4.2 per cent of NBC at end-March 2006 as compared with 5.4 per cent at end-March 2005. Fourth, although credit growth to the SSIsector accelerated in 2004-05 and 2005-06, the shareof SSI credit in total non-food gross bank credit andin total credit to the industrial sector continued todecline (Chart IV.6). Fifth, the number of loan accountsof the SSI sector in commercial banks declined from219 million in 1992 to 93 million in 2005.

4.64 The main reason for slowdown of credit to theSSI sector was its poor performance and consequentrisk aversion by banks (Table 4.13). The activity ofthe SSI sector slowed down significantly between1997-98 and 2002-03 with the value of productiongrowing at an average annual rate of 7.7 per cent ascompared with 11.1 per cent in the 1980s.

4.65 The poor performance of the SSI sector wasalso reflected in the significantly higher level of NPAsin this sector (Table 4.14). Banks, therefore, becamesomewhat r isk-averse and they reduced theirexposure to the SSI sector.

4.66 In recent years (i.e., from 2003-04 to 2005-06),the performance of the SSI sector has improved.Accordingly, NPAs in the SSI sector have also declinedsignificantly. This was reflected in the improved flowof credit to the SSI sector in 2004-05 and 2005-06(see Table 4.6). As a result, the credit intensity of theSSI sector, after declining almost consistentlybetween 1997-98 and 2004-05, increased somewhatin 2005-06 (Chart IV.7).

4.67 The credit to the SSI sector, to an extent, doesnot give a true picture as different banks appeared tohave followed different definitions of the SSI sector. The

Table 4.13: Performance of the SSI Sector –Major Parameters

Item 1990-91 2000-01 2005-06

1 2 3 4

1. No. of Units (‘000) 6,790 10,110 12,340

2. Value of Production at1993-94 Prices (Rs. crore) 84,728 1,84,401 2,75,581

3. Employment (‘000) 15,830 23,870 29,490

4. Exports (Rs. crore) 9,664 69,797 97,644 *

5. Share of SSI exportsin Total Exports (Per cent) 29.7 34.3 33.3 *

Memo: Average Annual GrowthRate (Per cent)

1980-81 1990-91 2000-01to to to

1989-90 1999-00 2005-06

1. Value of Production at1993-94 Prices 11.1 1.8 8.4

2. Employment 6.0 7.0 4.3

3. Exports 20.9 22.3 16.3

* : Relates to 2003-04.Source: Handbook of Statistics on the Indian Economy, 2005-06,

Reserve Bank of India.

Chart IV.6: Trends in Credit to the SSI Sector

Share of SSI in Total Credit to Industry

Share of SSI in Total Non-Food Credit

Non-Food Credit Growth (Right Scale)

Sh

are

(per

cen

t)

Gro

wth

Rat

e (p

er c

ent)

140


definition of small and medium enterprises has nowbeen clearly laid down in the Micro, Small and MediumEnterprises Act, 2006. Therefore, it is expected thatthere would be an improvement in the data reportingand the proper assessment of credit to the SMEsector. Given the significance of the small and mediumenterprises, several measures have also been takenby the Reserve Bank to enhance the flow of credit tothe SME sector (Box IV.7). These measures, togetherwith decline in NPAs in recent years, are expected tohave a significant impact on the flow of credit to theSMEs sector in the coming years.

Services

4.68 While credit extended by commercial banksto al l the sub-sectors in the services sectoraccelerated in the current decade (up to 2005-06) ascompared with the 1990s, the acceleration was morepronounced in the case of personal loans andprofessional services. The share of the services sector

Table 4.14: Gross NPAs of Scheduled CommercialBanks in the SSI Sector

End-March SSI Sector* All Sectors**

1 2 3

2001 20.3 11.4

2002 20.7 10.4

2003 19.0 8.8

2004 14.9 7.2

2005 11.6 5.2

2006 8.4 3.3

* : Gross NPAs as percentage of gross advances to the SSI sector.** : Gross NPAs as per cent of gross advances to all sectors.Note : Data are provisional.Source : Off-site Returns, Reserve Bank of India.

Box IV.7Credit Flow to Small Scale and Medium Industries – Recent Measures

The SSI sector depends primarily on finance from banksand other financial institutions. Several measures havebeen initiated in recent years with a view to increasingthe flow of credit to SSI units. These include refining thedefinition of small scale and tiny enterprises; broadeningthe scope for indirect finance to these industries; makinginvestments in several avenues such as securitised assets,lines of credit, bills-discounting, leasing and hire purchaseeligible for priority sector advances; and modification oftargets for priority sector lending to SSIs. Besides, inpursuance of the recommendations made by severalworking groups and high powered committees appointedby the Central Government and the Reserve Bank, a setof comprehensive guidelines to be followed for advancesto all categories of borrowers in the SSI sector has beenevolved.

Based on the recommendations of the Working Group onFlow of Credit to the SSI Sector (Chairman: Dr. A.S.Ganguly), the Reserve Bank (2004) advised banks, interalia, (i) to identify new clusters and adopt cluster-basedapproach for financing the small and medium enterprises

(SME) sector; (ii) widely publicise the successful workingmodels of NGOs; (iii) sanction higher working capital limitsto SSIs in the North-Eastern region for maintaining higherlevels of inventory; and (iv) explore new instruments forpromoting rural industry.

The Reserve Bank advised all public sector banks onAugust 19, 2005 to align their flow of credit to small andmedium enterprises in line with the package announcedby the Hon’ble Finance Minister. These measures, interalia, include : (i) units with investment in plant andmachinery in excess of SSI limit and up to Rs.10 croremay be treated as medium enterprises (ME) (only SSIfinancing will be included in the priority sector); (ii) banksmay fix self-targets for financing the SME sector so as toreflect a higher disbursement over the immediatelypreceding year, while the sub-targets for financing tiny unitsand smaller units to the extent of 40 per cent and 20 percent, respectively, may continue; and (iii) banks may initiatenecessary steps to rationalise the cost of loans to the SMEsector by adopting a transparent rating system with cost ofcredit being linked to the credit rating of an enterprise.

Cre

dit

Ou

tsta

nd

ing

as P

er c

ent

of V

alu

e of

Ou

tpu

t

Chart IV.7: Credit Intensity of the SSI Sector

141

CREDIT MARKET

in total bank credit increased sharply from 30.9 percent in 1990-91 to 48.7 per cent in 2005-06,essentially reflecting its growing share in total GDP;the services sector contributed 60.7 per cent of GDPin 2005-06 as against 46.7 per cent in 1990-91. Creditintensity of the services sector increased from 14.9per cent in 1990 to 15.2 per cent in 2001 and furtherto 36.5 per cent in 2006 (see Chart IV.4). Faster creditgrowth to the services sector was mainly on accountof a sharp rise in credit demand from the householdsector, a trend which star ted in the 1990s andgathered further momentum in the current decade.

Emergence of Household Credit

4.69 Until the early 1990s, there were severalrestr ictions for granting of personal loans. Forinstance, in the case of housing loans, the restrictionswere in the form of (i) limits on total amount of housingloan to be given by all the banks in a given year;(ii) limits on maximum loan amount to individuals;(iii) prescription of rate of interest according to loansize; (iv) prescription of margin requirement; and(v) prescription of maximum period of repayment. Allthese conditions/restrictions were gradually removedin the early 1990s and banks were given freedom todecide the quantum, rate of interest, marginrequirement, repayment period and other relatedconditions. These relaxations had a positive impacton the growth of personal loans.

4.70 Household or personal loans, on an average,registered a rise of 38.2 per cent during the five-year period ended March 2005 as compared with25.2 per cent in the 1990s; overall bank credit duringthis period increased by 20.3 per cent. Consequently,the share of personal loans in total bank creditincreased from 9.4 per cent at end-March 1990 to14.4 per cent in 2000 and further to 22.2 per cent atend-March 2005 (Table 4.15). Latest available datareveal that the share of personal loans increasedfurther to 25.2 per cent of non-food gross bank creditat end-March 2006.

4.71 The number of personal loan accounts alsoincreased sharply from 1995 (Chart IV.8).

4.72 Within personal loans, housing loans accountedfor a little over one half of total loans, distantly followedby advances made against fixed deposits with a shareof around 10.0 per cent (Table 4.16).

4.73 Housing loans grew at an average annual rateof 47.7 per cent during the five year period from 2000-01to 2004-05. The average housing loan amountincreased almost four times between end-March 2000

and end-March 2005. At end-March 2005, the averagehousing loan outstanding per account at Rs.3.45 lakh,which was more than two times the average amountin respect of all types of accounts of commercial banks(Table 4.17).

4.74 The share of housing loans increased steadilyfrom 2.7 per cent of total loans of commercial banksat end-March 1991 to 11.0 per cent at end-March 2005(Chart IV.9).

Table 4.15: Growth and Share of PersonalLoans in Total Bank Credit

(Per cent)

End- March Annual Annual Share ofGrowth of Growth of Personal

Total Bank Personal Loans inCredit Loans Total

BankCredit

1 2 3 4

2001 17.0 27.7 12.2

2002 21.8 25.1 12.6

2003 15.2 38.1 15.1

2004 16.4 57.2 20.3

2005 30.9 42.9 22.2

Average (2001 to 2005) 20.3 38.2 16.5

Source: Basic Statistical Returns of Scheduled Commercial Banksin India, various issues, Reserve Bank of India.

Accounts Amount

Chart IV.8: Share of Personal Loans Accounts/Amount inTotal Accounts/Amounts of Scheduled Commercial Banks

Per

cen

t

142


Table 4.16: Composition of Household CreditProvided by Commercial Banks

(Per cent)

Category Share in Total Annual GrowthPersonal Loans during 2005-06

end-March end-March2005 2006

1 2 3 4

i) Housing Loans 52.5 52.7 44.8

ii) Advances AgainstFixed Deposits 12.2 9.9 16.9

iii) Credit Cards Outstanding 2.4 2.6 59.3

iv) Education 2.1 2.8 96.5

v) Loans for Purchase ofConsumer Durables 3.7 2.5 -3.3

vi) Others 27.2 29.5 57.0

Total (i to vi) 100.0 100.0 44.4

Source: Annual Report, 2005-06, Reserve Bank of India.

Table 4.17: Trends in Housing Loans Providedby Commercial Banks

(Per cent)

Year Annual Share of Average AverageGrowth of Housing amount per amount

Housing Loans in Housing of allLoans Total Loan Loan

Personal Account AccountsLoans (Rs.)* (Rs.)*

1 2 3 4 5

2000-2001 37.2 38.5 1,02,354 1,02,825

2001-2002 29.2 39.8 1,80,728 1,16,336

2002-2003 49.5 43.1 2,00,594 1,27,073

2003-2004 73.9 47.7 2,81,205 1,32,597

2004-2005 48.6 49.5 3,45,830 1,49,378

Average 47.7 43.7 2,22,142 1,25,642(2000-01 to 2005-06)

*: As at end of March.Source : Basic Statistical Returns of Scheduled Commercial Banks

in India, various issues, Reserve Bank of India.

4.75 The share of personal loans in total creditextended by respective bank group at end-March 2000was highest in respect of foreign banks and lowest inrespect of private banks. In recent years, however,private sector banks became very aggressive in theretail loan segment. As a result, by end-March 2005,the share of personal loans in total credit extended

by private banks and foreign banks reached almostat the same level (Chart IV.10).

4.76 The sharp increase in bank credit to thehousehold sector has been contributed by severalfactors. First, the demand for credit by the industrialsector slowed down, especially between 1996-97 and2001-02, due to their focus on restructuring andconsolidation, as alluded to earlier. This encouragedbanks to focus on retail loans. High level of NPAs, inparticular, might have encouraged banks to focusincreasingly on retail portfolio. From the banks’

Amount Share in Total Bank Credit (right scale)

Chart IV.9: Trends in Housing Loans

Ru

pee

s cr

ore

Per

cen

t

Chart IV.10: Share of Personal Loans in Total Credit*

*: Share in total credit of the respective bank group.

Per

cen

t

SBI andAssociates

NationalisedBanks

PrivateBanks

ForeignBanks

AllSCBs

143

CREDIT MARKET

viewpoint, the retail and mortgage loans, being small,do not involve much exposure to a single borrower.As a result, the average risk associated with retailloans is lower as they are spread across diversifiedcustomers provided banks do not dilute the creditappraisal standards in an enthusiasm to increaselending to this sector. Also, in the case of mortgageloans, there is adequate collateral structure,particularly for housing and auto loans. It is easier todetermine the realistic sale value of housing, unlikecommercial property in the case of corporate loans.Second, with high economic growth, job opportunitieshave expanded and income levels have risen. Taxrates have also moderated over the years. As a result,disposable incomes have risen sharply in recentyears. This has increased the capacity of theborrowers to repay the loans. Third, with the declinein inflation and stable inflationary expectations, theinflation risk premium fell resulting in decline in bothnominal and real interest rates. This encouraged thehouseholds to avail credit for various purposes suchas purchase of houses, automobiles and consumerdurable items. Fourth, increase in real estate pricesas also the stock market might have also boosted thehousehold demand for bank credit due to wealtheffect, although exposure of Indian households to theequity market, at present, is limited.

4.77 The rapid growth in the housing market, inparticular, has been supported, inter alia, by theemergence of a number of second tier cities asupcoming business centres and increase in IT andIT-related activities, which have had a positive impacton household’s demand for housing. Further, taxincentives offered to salary earners made housingloans more attractive by bringing down the effectiverate of interest. Also, comfortable liquidity position withbanks, which created easy credit condit ions,encouraged them to look to new clients and emergedas another significant factor that drove the growth ofthe housing market in India in recent years.

4.78 The phenomenon of rapid credit expansionto the household sector, however, is not confined toIndia alone as household borrowing has grownsharply in many other countries, especially emergingmarket economies, since the 1980s, both in absoluteterms and relative to household incomes (Box IV.8).

4.79 In view of rapid credit expansion, the ReserveBank in April 2006 indicated that growth of non-foodbank credit, including investments in bonds/debentures/shares of public sector undertakings andprivate corporate sector and commercial paper, willbe calibrated to decelerate to around 20 per cent

during 2006-07 from a growth of above 30 per cent.Besides, the Reserve Bank initiated several prudentialpolicy measures (Box IV.9).

4.80 As a result of the increased share of mediumand long-term credit to industry and to the householdsector for housing loans, the share of medium andlong-term loans in total credit increased sharply inrecent years (Chart IV.11).

Financing of Credit Growth

4.81 Banks in India have traditionally relied ondeposits for funding their credit expansion. With rapidgrowth in credit in the recent period, incrementalcredit-deposit ratio exceeded 100 per cent in 2004-05,before sliding marginally below 100 per cent in 2005-06(Chart IV.12).

4.82 In order to sustain large credit expansionsince 2004-05, banks resorted to large non-depositresources in the form of (i) capital and reserves;(ii) overseas foreign currency borrowings; and (iii) call/term funding from financial institutions. During 2005-06,banks liquidated large excess investments to the tuneof Rs.1,09,834 crore in SLR securities. Non-depositsources and liquidation of securities together financed34.7 per cent of incremental credit in 2004-05 and45.7 per cent in 2005-06 (Table 4.18).

4.83 As a result of liquidation of securities forfunding credit expansion in the recent years, the shareof credit in total assets of scheduled commercialbanks increased sharply, while that of investmentdeclined (Chart IV.13).

4.84 A distinct feature of banks’ operations in thelast 10 years has been flexible adjustment of theinvestment portfolio in line with the changing creditdemand. As credit demand slowed down in the secondhalf of the 1990s, banks remained invested in SLRsecurities, even when SLR was brought downsignificantly. However, as credit demand picked up,banks liquidated SLR investments (2004-05 and 2005-06). Liquidation of holdings on the one hand, and theexpansion of net demand and time liabilities on theother, have brought down the holding of SLRsecurities very close to the statutory limit of 25 percent (Chart IV.14).

Factors behind Rapid Credit Expansion

4.85 Apart from the specific factors alluded toearlier, several other factors, such as increasedfinancial deepening, increased competit ion,improvement in asset quality of banks and rapidproduct innovations, have also contributed to the rapidcredit expansion in recent years.

144


Box IV.8Household Credit Market – International Experience

In the recent period, a significant development in credit marketsall over the world has been the rapid growth of credit availed ofby the households, often outstripping that of corporate credit.While banks have been expanding their retail business throughincreased mortgage and credit card lending, households havebeen eager to finance their consumption and residentialinvestment through bank credit (Mohanty, et al, 2006). While thehousehold credit market has already developed in the maturemarket economies (MME), it is only recently that the householdcredit market has started developing in emerging marketeconomies (EME).

Lower inflation and interest rates, higher income levels, higherasset prices (particularly housing), financial liberalisation,reduced corporate demand for credit and increased presence ofretail lending-oriented foreign banks, were the main factors thatcontributed to the growth of the household credit market invarious countries (IMF, 2006). The demand for bank credit andalso household credit is highly pro-cyclical. Boost to households’current incomes, at the back of strong economic growth, coupledwith expectations about future income has boosted the demandfor household credit. With the decline in inflation and its stabilityover the medium term, inflation expectations as well as theinflation risk premium have fallen, thus, bringing down bothnominal and real interest rates. This has attracted potential homeowners to the mortgage market. Rapid increase in real estateprices, which increases expectations about future returns, hasalso been a key factor in boosting the demand for householdcredit. In developed countries, the increase in the value ofresidential property in recent years was even higher than theincrease in the value of global shares. The removal of restrictionson bank lending to housing and consumer sectors has alsofacilitated higher credit flow as latent demand was eventuallymaterialised. On the supply side, the changes in banks’ capacityand willingness to lend facilitated expansion in household credit.Improvement in creditors’ rights and improvement in informationsharing among lenders eased the supply-led credit constraints(Mohanty, et al 2006).

A comparison of the nature of the household credit market invarious regions in the world reveals some interesting trends.Despite sharp credit growth in recent years, the penetration ratesfor consumer credit, housing loans and use of credit cards, inemerging market economies, in general, are much lower than inmature market economies. Among the emerging economies,household credit as a percentage of GDP was highest in Asia,followed by emerging Europe and Latin America (Table A).

Table A: Cross-country Trends in Household Credit – 2005(Per cent)

Item Emerg- Emerg- Latin Mature All India*ing ing America Markets Count-

Europe Asia ries

1 2 3 4 5 6 7

i) Household credit aspercentage to GDP 12.1 27.5 9.2 58.0 29.2 9.9

ii) Share of household credit intotal private sector credit 38.9 31.4 35.7 41.5 37.5 24.5

iii) Share of housing loans intotal household credit 27.9 54.2 37.5 77.5 52.9 52.7

* : Data pertain to 2005-06.Source : International Monetary Fund (2006) and Reserve Bank of India.

In emerging Europe, a significant share of household credit isdenominated in foreign currency. However, in Asia it is almostentirely denominated in local currency. Banks, particularly foreignbanks, are the largest providers of household credit, includinghousing loans in the emerging markets followed by Governmentsponsored lending institutions, non-bank financial companiesand, to a lesser extent, the informal sector. There is a view thathousehold borrowings can continue to grow at a fast rate in manyemerging economies as they have a higher debt absorptioncapacity (Mohanty, et al, 2006). The level of indebtedness ofhouseholds, as revealed by the ratio of household credit topersonal disposable income, is substantially lower in emergingmarket countries than mature market economies (Table B).

International experience reveals that while sound developmentof the household credit market as such is beneficial for borrowers,lenders, the financial system and the economy as a whole, thepace of household credit expansion should be consistent withthe underlying macroeconomic, prudential and institutionalframework to avoid the likely adverse impact of bust of creditboom. Policy support required for the healthy development ofthis segment of the credit market should, inter alia, include: (i)prudential regulation like appropriate risk weighting, capitaladequacy, classification and provisioning of loans; (ii) legalenvironment for enabling securitisation, effective enforcementof collateral, provision and sharing of credit information, promotionof rating agencies and credit bureaus and transparency in lending,consumer protection and consumer education; (iii) improvementin the availability of data to monitor and assess the build-up ofcredit, household debt and net worth and asset prices; (iv)maintenance of adequate reserves by the country as well as thelending institution, if households carry large interest andexchange rate exposures; and (v) formulation of adequatecontingency plans in the event of large interest and exchangerate movements.

References:

IMF. 2006. Global Financial Stability Report, September.

Mohanty, M.S., Gert Schnabel, and Pablo Gracia-Luna. 2006.“Banks and Aggregate Credit: What is New?” BIS Papers No.28,BIS, August.

Table B: Ratio of Household Credit to Personal Disposable Income(Per cent)

Item 2000 2001 2002 2003 2004 2005

1 2 3 4 5 6 7

Emerging MarketsHungary 11.2 14.4 20.9 29.5 33.9 39.3Poland 10.1 10.3 10.9 12.6 14.5 18.2Korea 33.0 43.9 57.3 62.6 64.5 68.9Philippines 1.7 4.6 5.5 5.5 5.6 ..Thailand 26.0 25.6 28.6 34.3 36.4 ..

Mature MarketsAustralia 83.3 86.7 95.6 109.0 119.0 124.6France 57.8 57.5 58.2 59.8 64.2 69.2Germany 70.4 70.1 69.1 70.3 70.5 70.0Japan 73.6 75.7 77.6 77.3 77.9 77.8Spain 65.2 70.4 76.9 86.4 98.8 112.7United States 104.0 105.1 110.8 118.2 126.0 132.7

Source: IMF (2006).

145

CREDIT MARKET

4.86 The rapid credit expansion, to an extent,reflects increased financial deepening as a result ofderegulation. The credit-GDP ratio in India has beenlow in comparison with other advanced and emergingmarket economies and is now moving up with theincrease in credit penetration (Chart IV.15).

4.87 With the entry of new private sector banks inthe credit market, competition among banks hasintensified, which is reflected in the increase in theshare of new private sector banks (about 15 per centin both total bank credit and assets at end-March2006). Increased competition has led to narrowing of

margins. In order to make up for squeeze in margins,banks have tended to increase credit volumes byaggressively marketing their products to upcomingservices and the household sector.

4.88 One of the major reasons for slowdown incredit in the second half of the 1990s was large NPAs,which impaired banks ability to extend credit.However, as a result of various reform measures,there has been significant improvement in the assetquality over the years, partly as a result of expansionof loan volumes and partly on account of write-offsand recovery of past dues (Chart IV.16).

Box IV.9 Rapid Increase in Credit – Prudential Measures

The general provisioning requirement on standardadvances in specific sectors, i.e., personal loans, loansand advances qualifying as capital market exposures,residential housing loans beyond Rs.20 lakh andcommercial real estate loans were increased from 0.40per cent to one per cent in April 2006 and further to twoper cent on January 31, 2007. Further, the risk weight onexposures on commercial real estate was increased from125 per cent to 150 per cent. Banks’ total exposure toventure capital funds was included as a part of their capitalmarket exposure and they were required to assign a riskweight of 150 per cent to such exposures.

The Reserve Bank used prudential measures incombination with increase in the policy rates. Keeping inview the persistent growth of credit to the retail sector and

also keeping in view the general inflationary conditions,the repo rate was increased by 175 basis points in stagesto 7.75 per cent by April 14, 2007 from its lowest level of6.0 per cent in September 2004. Further, the CRR wasraised by 200 basis points in stages from 4.5 per cent inSeptember 2004 to 6.5 per cent. The Reserve Bankincreased the provisioning requirement for banks’ exposurein the standard asset category to systemically importantNBFCs to two per cent from the earlier level of 0.4 percent. Further, risk weight for banks’ exposure to suchNBFCs was increased to 125 per cent from the existinglevel of 100 per cent. Banks were prohibited from grantingfresh loans in excess of Rs.20 lakh against the NR(E)RAand FCNR(B) deposits, either to depositors or to thirdparties.

Per

cen

t

Chart IV.11: Share of Medium and Long-termLoans in Total Credit

End-March

Chart IV.12: Incremental Credit-Deposit Ratio

Per

cen

t

146


4.89 Incremental NPAs during last five yearsremained in the range of Rs.20,000-26,000 crore. Ascredit has expanded rapidly, incremental NPAs aspercentage of incremental bank credit, which wereas high as 31.7 per cent in 2001-02, declined to 5.3per cent in 2005-06 (Chart IV.17). A sharp decline inincremental NPAs also reflects signif icantimprovement in credit appraisal, improved r iskmanagement and better resource allocation process.This has encouraged banks to enlarge their lendingoperations.

4.90 One of the major reasons for rapid creditexpansion, especially to the agriculture and thehousehold sectors has been innovative tailor-madeproducts introduced by banks in recent years. Untilthe early 1990s, banks’ operations were subject togeneral restrictions and they were offering plain vanilla

type of credit products such as short-term, medium-term and long-term loans to their customers. However,with increased freedom to decide interest rates andrelaxations in deployment of funds, banks startedintroducing innovative products to suit the needs ofthe borrowers as well as to enable them to mitigatethe risks faced by the corporates. The range of loanproducts offered by banks has widened considerablyin recent years, especially in the case of personal loansegment.

4.91 Apart from introducing new loan products,banks have also added frills and features to theexisting loan products to serve the needs of allsegments of the economy, both in rural and in urbanareas. Loan products have not only been customisedto suit to the specific requirements of borrowers, butalso their repayment capacity and convenience.

Table 4.18: Non-Deposit Sources of Funds(Amount in Rs. crore)

Non-Deposit Sources of Funds Funds from Unwinding of Investments

Year Overseas Accretion Call/Term Total Non- Offloading Offloading Total Liquidation ofForeign to Capital Funding Non- Deposit of Excess of non- Offloading Investments

Currency and from deposit Resources SLR SLR of as aBorrowings Reserves Financial sources of as a Investments Investments SLR and proportion to

Institutions Funds proportion to non- incrementalincremental SLR Bank CreditBank Credit Investments (per cent)

(per cent)

1 2 3 4 5 (2 to 4) 6 7 8 9 (7+8) 10

2000-01 -369 6,878 -168 6,341 8.4 -21,129 -14,436 -35,565 -47.12001-02 -88 8,807 463 9,182 11.7 -33,557 -5,155 -38,712 -49.42002-03 5,963 15,511 9,609 31,083 22.3 -54,740 -11,855 -66,595 -47.72003-04 9,784 16,723 12,032 38,539 34.5 -72,868 3,869 -68,999 -61.82004-05 8,529 29,134 44,853 82,516 31.8 12,196 -4,679 7,517 2.92005-06 4,168 44,039 13,621 61,828 15.2 1,09,834 14,200 1,24,034 30.52006-07 2,543 22,431 3,007 27,981 6.7 59,569 -4,002 55,567 13.4

Note : (-) in columns 7-10 denotes net purchase of securities.Source: Reserve Bank of India.

Investment Credit

Trends in Major Assets Items of Scheduled Commercial Banks

Per

cen

t of

Tot

al A

sset

s

Gro

wth

Rat

e (p

er c

ent)

Credit Growth and Investment in Government Securities

Investment in Government andOther Approved Securities

Bank Credit

Chart IV.13: Credit and Investment

147

CREDIT MARKET

4.92 Banks are now also offer ing credit toagriculture with greater vigour for activities such asleased land cultivation, agri-clinics, land developmentand reclamation, irr igation projects, forestry,construction of cold storages and godowns,processing of agri-products, agri-input dealers, alliedactivities such as dairy, fisheries, poultry, sheep-goat,piggery, rearing of silk worms, among others.Likewise, in the industrial sector, besides extendingworking capital finance and overdraft facilities, banksare now increasingly also providing project finance in

the form of term loans. For the small and mediumenterprise sector, banks offer loan products such asopen term loans, flexi loans and general purposeterm loans. Banks have also been increasing theirexposure to the infrastructure sectors such as roadand urban infrastructure, power and utilities, oil andgas, other natural resources, ports and airports,telecommunications, among others.

4.93 Product innovations have been the mostsignificant in the personal loan segment. Housingloans are offered with several frills such as free

Gross NPAs Net NPAs

Chart IV.16: Non-Performing Assets ofScheduled Commercial Banks

As

Per

cen

t of

Ad

van

ces

Chart IV.14: SLR Investments by ScheduledCommercial Banks

Per

cen

t of

ND

TL

Actual SLR Maintained by SCBs

Statutory SLR Requirement

Per

cen

t

Chart IV.15: Credit-GDP Ratio Chart IV.17: Incremental Accretion to NPAs

Incremental Accretion to NPA

Ratio of Incremental NPA to Credit Ratio (right scale)

Rs.

cro

re

Per

cen

t

148


3 Quandt-Andrews Break point test for endogenous structural break, applied to growth trend in non-food credit (NFC), suggestsendogenous structural break at the beginning of 2003-04. For the estimation, monthly observations, in log form from April 1996 toMarch 2007 were used. The estimates are given below:

LNFC = 11.25 + 0.02 T + AR (1) R–2 = 0.98, DW = 2.17

(7.3) (2.7)

Maximum Wald F-statistic = 32.00 was obtained in May 2002(0.00)

Note: Figures in parentheses represent ‘t’ statistics.

personal accident insurance, eligibility for otherpersonal loans, 100 per cent funding (in the case ofselect projects), fixed or floating interest rates or partfixed and part floating. Housing loans are now givenfor home improvement, home extension, landpurchase, among others. Clean personal loans (somebanks call it as express loans) are offered for anypersonal purposes such as renovation of house,marriage, holiday, children’s education, purchase ofcomputers and for meeting medical expenses.Besides, loans are also given against gold collaterals.Special loans are offered to professionals such asdoctors, engineers, teachers and nurses. Some bankshave come out with specific loan products foreducation. Credit cards and education loans haveemerged as other important categories of personalloan segment.

The Recent Phase of Rapid Credit Growth – Isthere a Structural Break?

4.94 Non-food credit of scheduled commercialbanks, after remaining subdued for several years,started accelerating from 2002-03 onwards. Theaverage annual growth of non-food credit during thefive-year period from 2002-03 to 2006-07 was 24.9per cent as against the average growth of 15.4 percent during the 1990s. Credit growth, in real terms,also witnessed a sharp expansion (Table 4.19).

4.95 The expansion in non-food credit during therecent years was significantly higher than the growthof the real economy. This was reflected in the sharpincrease in total bank credit to GDP ratio, whichincreased from 25.9 per cent in 2001-02 to 42.2 percent by 2005-06 (see Chart IV.15).

4.96 Analysis of data suggests that nature of creditgrowth from May 2002 has been structurally atvariance from the historical trends3. There arealternative views focusing on demand or supply sidefactors to explain this phenomenon in emergingeconomies. To ascertain these aspects in the Indiancontext, empirical analysis was carried out for the preand post-break period. It suggests that while lendabledeposits, output gap and interest rate influenced credit

Table 4.19: Trends in Credit Growth

(Per cent)

Period/Year Non-Food Credit Non-Food Credit(Nominal) (Real)

1 2 3

Average Annual Growth1970-71 to 1979-80 17.4 8.51980-81 to 1989-90 17.8 9.81990-91 to 1999-00 15.4 7.32000-01 to 2006-07 21.8 16.7

Memo: Annual Growth

2000-01 14.9 7.72001-02 13.6 10.02002-03 18.6 15.22003-04 18.4 12.92004-05 27.5 21.02005-06 31.8 27.42006-07 28.0 22.6

Note : Data are adjusted for mergers and conversion during 2002-03and 2004-05, respectively, while for the presence of 27fortnights during 2005-06. Real non-food credit has beenobtained by deflating nominal non-food credit by annualaverage growth of wholesale price index (WPI).

Source : Handbook of Statistics on the Indian Economy 2005-06,Reserve Bank of India.

expansion in the pre-break period, lendable depositsand output gap together with asset prices emergedas the key determinants of rapid credit growth in thepost-break period (Box IV.10).

4.97 As seen above, in addition to structuralfactors, credit expansion was also pro-cyclical innature, which indicates that strong income growthrecorded in recent years has also significantlycontributed to credit growth. This characteristic ofcredit could also be inferred from comparison of thecyclical component in credit vis-à-vis that of GDP(Chart IV.18).

4.98 The cyclical nature of credit is a phenomenonwhich is common to several other emergingeconomies as bank credit to the private sector andoutput are closely related (Mohanty et al, 2006). Apartfrom the factors indicated above, acceleration in creditcould also be reflective of ‘crowding in’ of privatespending by the recent moderation in fiscal deficit ofboth the Central and State governments.

149

CREDIT MARKET

Until the early 1990s, deposit rates, lending rates andallocation of resources to different sectors were largelyregulated. The scenar io changed thereafter with theimplementation of prudential norms and freeing of interestrates and removal of other restrictions on banking operations.These developments enhanced the sensitivity of bankoperations to asset quality and oriented them to operate onthe basis of their commercial judgment.

In this backdrop and the cross country experience aboutthe determinants of credit expansion, an empirical exerciseestimating relationship between non-food credit (NFC),lendable deposits (LD), level of NPAs, output gap (OG),commercial paper yield (CPRATE) and asset pr ices(represented by BSE SENSEX), index of house rentals (HPI)was conducted for the period from April 1996 to March 2006.As there was a structural break in the relationship in April2003, the separate estimations were also done for the periodprior and subsequent to the break. Output gap has beenestimated by de-trending the output series using HP-filter. HPIis drawn from consumer price index for industrial workers.Lendable deposits are aggregate deposits net of reserverequirement. CP yield in place of BPLR has been used asinterest rate variable as predominant proportion of total bankcredit is extended below BPLR. It could reasonably be assumedthat effective lending rate would have proximity to the CP rate,which is market determined. Equations have been estimated indifference form. Estimated equation and plot of actual andestimated values (Chart A) are set out below:

Period - April 1996 to March 2006

DNFC = 20779.0 + 674.7 OG - 1150.0 NPAR - 0.18 DSLR (-3)

(3.3) (3.2) (1.65)

- 341.4 CPRATE + 6.4 DBSE + 173.5 DHPI (-3) + 0.5 DLD (0.6) (2.2) (2.5) (10.0)

R–2 = 0.74, D.W. = 1.63

Note: Figures in parentheses represent ‘t’ statistics.

The results indicate that availability of lendable resources,followed by level of NPA and asset prices are the majordeterminants of credit expansion. Moreover, credit is positivelyrelated to the output gap, indicating the pro-cyclical nature ofcredit growth. In order to have a better insight into the dynamicsof the relationship over the period, separate estimations wereattempted for the period prior and subsequent to the structuralbreak. Estimated equations and the plots of actual and estimatedvalues (Chart B and C) are set out below:

Period - April 1996 to April 2002DNFC = 17521.1 + 517.1 OG - 556.1 NPAR - 0.13 DSLR (-2)

(3.2) (1.5) (1.23) - 779.3 CPRATE + 1.73 DBSE + 90.0 DHPI (-3) + 0.43 DLD

(2.1) (0.8) (1.6) (6.1)

R–2

= 0.52, D.W. = 1.96

Regression estimates for the period April 1996 to March 2003indicate that availability of lendable resources, interest rateand level of NPAs are important determinants of creditexpansion. Apart from these, credit also responds positivelyto surplus output gap. Importantly, asset prices did not playany significant role till March 2003 in credit expansion.

Period - May 2002 to March 2006DNFC = 42522.5 + 1153.9 OG - 2793.4 NPAR(-1)

(2.1) (2.5)- 0.01 DSLR (-2) - 2638.6 CPRATE(-3)

(0.1) (0.7)+ 18.5 DBSE + 319.5 DHPI (-3) + 0.49 DLD

(2.4) (2.0) (5.6)

R–2 = 0.74, D.W. = 1.96

Lag structure of the explanatory variables was determinedthrough general to specific procedure beginning with 6 lags forall the variables. Insignificant lags were omitted in stages.

Empirical results for the subsequent period, i.e., May 2002 toMarch 2006 show that besides lendable resources and level ofNPAs, asset prices emerged as the major determinant of creditexpansion. During this period, output gap continued to besignificant but lost its explanatory power. Interest rate was notsignificant determinant of credit growth, suggesting that assetprices and consequent wealth effect overshadowed the cost asthe determinants of credit demand.

Gain in the significance of NPA level during the period allaysthe apprehensions that with booming asset prices andconsequent rise in net worth of individuals might have impairedthe sensitivity of banks towards asset quality. Though the SLRholding of the banks had the expected sign in both the periods,it was not statistically significant, implying that banks holdgovernment securities on their on volition and it is not aconstraint for credit expansion.

Determinants as observed above are also indicative of the creditchannels of monetary policy. Significance of the NPA levelsuggests the growing sensitivity of banks to asset quality andthis probably indicates the significance of the balance sheet routeof credit channel. Similarly, significance of lendable depositssuggests that the monetary authority could affect lending capacityof the banks. This, in turn, suggests that the bank lending routeof credit channel is also possibly operative in the Indian economy.

Box IV.10Determinants of Bank Credit

Aug-

96

Feb

-97

Aug-

97

Feb

-98

Aug-

98

Feb

-99

Aug-

99

Feb

-00

Aug-

00

Feb

-01

Aug-

01

Feb

-02

Aug-

02

Feb

-03

Aug-

03

Feb

-04

Aug-

04

Feb

-05

Aug-

05

Feb

-06

Chart A: Determinants of Credit –April 1996 to March 2006

Ru

pee

s cr

ore

Actual Fitted

Ru

pee

s cr

ore

Actual Fitted

Ru

pee

s cr

ore

Actual Fitted

Chart B: Determinants of Credit –April 1996 to April 2002

Chart C: Determinants of Credit –May 2002 to March 2006

Aug-

96

Nov

-96

Feb

-97

May

-97

Aug-

97

Nov

-97

Feb

-98

May

-98

Aug-

98

Nov

-98

Feb

-99

May

-99

Aug-

99

Nov

-99

Feb

-00

May

-00

Aug-

00

Nov

-00

Feb

-01

May

-01

Aug-

01

Nov

-01

Feb

-02

May

-02

Ju

l-0

2S

ep-0

2N

ov-0

2J

an-0

3M

ar-0

3M

ay-0

3J

ul-

03

Sep

-03

Nov

-03

Jan

-04

Mar

-04

May

-04

Ju

l-0

4S

ep-0

4N

ov-0

4J

an-0

5M

ar-0

5M

ay-0

5J

ul-

05

Sep

-05

Nov

-05

Jan

-06

Mar

-06

150


Rapid Credit Growth – Implications

4.99 Rapid credit expansion could be indicativeof financial deepening as well as cyclical upturncaused by business cycle representing improvementin investment opportunity. However, excessive cyclicalfluctuations caused by over-optimism about futureearnings could be potential ly destabil ising.International experience indicates that an excessivecredit expansion may be unsustainable. Over-optimism about future earnings could boost assetvaluations, which artificially enhance the net worth offirms and their capacity to borrow and spend. Sinceperformance cannot match the over-optimisticexpectation, the process becomes unsustainablebeyond a point. Lending booms can lead tovulnerability of the banking system (Box IV.11).

Monetary Policy Response to Rapid CreditExpansion – International Experiences

4.100 While there is no consensus with regard towhat the policy response should be to the rapidcredit expansion, the dominant view seems toindicate that generalised policy tightening could becounter-productive and the appropriate responseshould be to strengthen the financial system byadopting suitable prudential and supervisory norms(Box IV.12). A menu of policy options are availableincluding prudential and supervisory measures tomanage key risks arising out of rapid credit growth(Annex I and II).

The Indian scenario

4.101 Although credit in India has expanded rapidly,a detailed sector-wise analysis shows that its spreadis quite broad-based across all the sectors. In fact,credit to agriculture has picked-up, which is a healthydevelopment and the result of conscious policy efforts.Credit to small scale industry has also picked upduring last two years, which is again a welcome sign.Credit to industry, on the whole, has deceleratedsomewhat.

4.102 However, credit to the household sector hasgrown rather rapidly. In this context, it needs to benoted that credit to the private sector, on the whole,in India is low in comparison with many othercountries (Table 4.20). Besides, credit penetrationin India is also low in comparison with severalemerging market economies. In terms of number ofloan accounts per 100 persons, India was placedlower than several other emerging market economies(Table 4.21). The number of credit accounts ofscheduled commercial banks in 2005 as per cent ofadult population was only 9.5 per cent in rural areasand 14.2 per cent in urban areas. Further, onlyaround one-third of the rural households and one-half of the urban households had credit accountswith commercial banks in 2005. While the overallcredit penetration was higher in urban areas, smallloan accounts (with credi t l imit of less thanRs.25,000) are concentrated largely in rural areas(61.6 per cent in 2005) (Table 4.22).

4.103 Credit penetration in India has not only beenlow, it is also unevenly spread across different regions(Table 4.23). Thus, large credit expansion, to anextent, reflects increasing financial deepening.

4.104 Furthermore, according to the latest NationalSample Survey Organisation (NSSO) survey, thehousehold indebtedness in 2002 was only 26.5 percent in rural areas and still lower at 17.8 per cent inurban areas (Table 4.24).

4.105 Moreover, the extent of financial leverage ofthe households, as revealed by the debt-asset ratio,in India was very low at 2.84 per cent in rural areasand 2.82 per cent in urban areas in 2002 (Table 4.25).Though this ratio might have gone up in thesubsequent years, as personal loans have increasedsignificantly, it is still expected to be much lower thanmany other emerging countries, especially whenincome levels in India have also risen sharply in recentyears.

Real NFC Real GDP

Chart IV.18: Cyclical Component as Percentage of Actual*

Per

cen

t

*: After estimating the trend of the variable by Hodrick Prescot filter, cyclicalcomponent was derived (actual minus the trend), which was then taken as percent of actual variable.

151

CREDIT MARKET

Box IV.11Credit Boom: Analytical Issues

Analytically, credit can grow rapidly for three reasons, viz.,(i) financial deepening (trend); (ii) normal cyclical upturns(credit expansion); and (iii) excessive cyclical movements(credit booms) (IMF, 2004). When an economy develops,credit generally grows faster than GDP - a process knownas financial deepening, reflecting the growing importanceof financial intermediation. Temporarily, credit can alsoexpand more rapidly than GDP because firms’ investmentand working capital needs fluctuate with the business cycle.Rapid lending may, thus, represent a permanent deepeningof the financial system and an improvement of investmentopportunities that are beneficial to the economy. Creditgrowth associated with these two factors is desirable,which can broadly be considered as a case of creditexpansion. If the credit expansion is accompanied by anexcessive cyclical movement (over-optimism about futureearnings), it can be a case of credit boom. In practice, itis difficult to distinguish among three factors, viz., financialdeepening, financial accelerator and over-optimism aboutfuture earnings, driving credit growth and to determine a‘neutral’ level or rate of growth for credit (Hilbers, et al,2005). International exper ience indicates that anexcessive credit expansion (boom) is unsustainable andpotentially destabilising.

Financial accelerator is one of the important and familiarmechanisms that can lead to a credit boom, where shocksto asset prices get amplified through balance sheeteffects (Bernanke and Gilchrist, 1999). During a boom,asset prices increase which, in turn, lead to increases inborrowers’ net worth. This facilitates new lending, therebyfueling higher asset demand and, in turn, higher assetprices (Gourinchas, et al, 2000). The financial acceleratorresults from financial market imperfections due toinformation asymmetry, institutional shortcomings, orperverse incentives facing borrowers and lenders. Over-optimism about future earnings could boost assetvaluations, which artificially enhance the net-worth offirms and, in turn, their capacity to borrow and spend.Since performance cannot match the over-optimisticexpectation, the process becomes unsustainable beyonda point. Though lending booms are associated with outputgains, they can lead to vulnerability of the bankingsystem.

On the basis of cross-country experiences, severalmethods could be used to ascertain whether there is a

credit expansion phase or a credit boom phase or a merecontinuation of the trend. IMF (2004) defined the episodesof rapid and sustained credit growth, if the average realcredit growth exceeded 17.0 per cent (median rate of realcredit growth in credit booms in 28 EMEs during 1970-2002.) over a three-year period. A credit boom can bedefined as a situation where credit/GDP ratio is fourpercentage points above its trend. Ottens, Lambregts andPoelhekke (2005) defined a lending boom episode as twoconsecutive periods in which the ratio of nominal privatecredit to nominal GDP deviates from trend by a certainthreshold. This threshold var ies from 2.0 to 10.0percentage points of GDP (credit gap).

Although various methods can be used, it may be possiblethat an identified phase may actually be not a boom periodas credit expansion, above the threshold, could be due tofinancial deepening and business cycles. It is difficult toidentify the booms when they are happening. Only whenthe boom has fully blown up, it may be possible todistinguish it. Hence, policy makers need to look at othermacroeconomic developments such as investment boom,consumption boom, current account deficits and increasein the relative price of non-tradables, etc., to have a clearperspective.

References:

Bernanke, Ben, and Simon Gilchrist. 1999. “The FinancialAccelerator in a Quantitative Business Cycle Framework.”in Handbook of Macroeconomics, (ed.) John Taylor andMichael Woodford Vol.1C, Amsterdam: North-Holland.

Gour inchas, Pierre-Oliver, Valdes Rodr igo, andLanderreche, Oscar. 2000. “Lending Booms: Some StylizedFacts.” MIT, February.

Hilbers, Paul, Inci Otker-Robe, Ceyla Pazarbasioglu, andGudrun Johnsen. 2005. “Assessing and Managing RapidCredit Growth and the Role of Supervisory and Prudentialpolicies.” IMF Working Paper, WP/05/151, July.

IMF. 2004. World Economic Outlook, April.

Ottens, Daniel, Edwin Lambregts, and Steven Poelhekke,2005. “Credit Boom in Emerging Market Economies: ARequipe for Banking Crisis?.” DNB Working Papers,Natherlands Central Bank.

4.106 To assess the possible vulnerability of India’sbanking sector following rapid growth in credit, theIMF (2006) conducted stress test under threealternative scenar ios, viz. , ( i) an increase inprovisioning to the levels consistent with international

best practices; (ii) an increase in NPAs by 25 percent; and (iii) an increase in NPAs due to a portionof the “new” loans becoming non-performing. Theresults reveal that the banking system as a whole isresi l ient to the t ightening of provisioning

152


Table 4.20: Credit to the Private Sector(Per cent to GDP)

Country 1980 1985 1990 1995 2000 2001 2002 2003 2004 2005

1 2 3 4 5 6 7 8 9 10 11

Mexico 19 13 17 29 18 16 19 17 17 18Indonesia 9 19 47 54 20 18 19 21 24 25Russian Federation .. .. .. 9 13 16 18 21 24 26Poland .. 4 21 17 27 27 27 28 27 28Sri Lanka 17 21 20 31 29 28 29 30 32 ..Philippines 42 27 22 45 44 40 37 35 34 31Brazil 42 42 39 37 36 35 36 35 35 41India 25 30 30 29 32 33 37 37 41 47Chile 47 69 47 54 63 63 65 62 63 66Canada 67 65 76 77 77 80 81 81 86 88France 101 74 94 86 85 88 86 89 91 94Thailand 41 58 83 140 108 97 103 103 97 96Japan 132 151 196 203 193 187 176 103 99 99Singapore 81 106 97 106 111 130 114 115 106 102Australia 26 35 62 69 87 88 91 98 102 109Germany 77 84 89 100 119 118 117 115 112 112Malaysia 49 87 69 124 140 149 146 141 130 127New Zealand 21 25 76 92 113 112 114 118 121 133Spain 74 67 78 72 98 101 106 114 125 146Hong Kong, China .. .. 161 150 153 152 148 149 148 146United Kingdom 28 47 116 115 133 138 142 148 156 166United States 112 128 144 173 231 225 212 236 249 260

.. : Not available.Source: World Development Indicators, Online Database, World Bank and Reserve Bank of India.

Box IV.12Credit Boom and Monetary Policy

There is no consensus among policy makers and academicsabout central bank reaction to a situation of credit boom. Onestrand of view asserts that monetary policy should be used totarget the economy and not the asset markets. To the extent astock market boom causes or simply forecasts sharply higherspending on consumer goods, policy tightening might beemployed to contain incipient inflation and not the asset priceboom. This view doubts the ability of monetary authority toaddress the asset price bubble. It is often difficult to adjudge ex-ante as to whether asset price movements are bubbles or not.Second, even if the bubble is identified, the typical monetarytightening measures such as increase in interest rates may notbe effective in deflating an asset price bubble (Mohan, 2005).Again, if a central bank believes that a bubble does exist, it wouldbe substituting its judgment for that of the market and it impliesthat it is better equipped than financial professionals.

On the other hand, there are experts who believe that existenceof bubble could be diagnosed on the basis of indicators such asrapid growth of credit, returns on stocks, price-earning ratio, etc.However, the issue remains, whether these rates/ratios arereliable indicators. Moreover, monetary policy is often consideredto be too blunt an instrument to achieve financial stability byselectively targeting a sector of the economy. A generalisedapproach towards bubble popping may succeed only at the riskof strangulating a genuine economic boom.

There is another view which states that credit booms andconsequent asset bubbles are essentially the result of inadequateregulation. Financial liberalisation in the face of poorly regulatedand supervised banks and inappropriate incentive structure haveled to increased boom and bust credit cycles in emergingeconomies (Hernandez et al, 2002 and Barth et al, 2002). Thus,monetary authority should ideally use its regulatory andsupervisory powers to prepare the financial system for thecontingency of a large shock to asset prices (Bernanke, 2002).

References:

Barth, James R., Gerard Caprio Jr., and Ross Levin. 2002.“Financial Regulation and Performance: Cross-countryEvidence.” in Banking, Financial Integration and InternationalCrisis. (eds.) Lenardo Hernandez and Klaus Schmidt-Hebbel.113-41. Central Bank of Chile, Santiago.

Bernanke, Ben S. 2002. “Asset Price Bubbles and MonetaryPolicy.” BIS Review, No.59, BIS.

Hernandez, L., and O. Landerretche. 2002. “Capital Inflows,Credit Booms and Macroeconomic Vulnerability: The Cross-Country Experience.” in Banking Financial Integration andInternational Crises, Central Bank of Chile, Santiago.

Mohan, Rakesh. 2005. “Some Apparent Puzzles for ContemporaryMonetary Policy.” RBI Bulletin, December.

requirements and to the deterioration in asset qualitythat may accompany during periods of rapid credit

growth (Table 4.26). The analysis suggests thatthough the recent rapid credit growth does pose

153

CREDIT MARKET

Table 4.22: Commercial Bank Credit Penetrationin India

Item 1981 1991 2001 2005

1 2 3 4 5

1. Number of Credit Accountsas per cent of Adult Populationa) Rural 4.9 7.7 7.9 9.5b) Urban 4.5 12.8 8.0 14.2

2. Number of Credit Accounts asper cent of Number of Householdsa) Rural 18.0 44.3 26.5 32.2b) Urban 15.1 29.9 28.4 50.2

3. Amount of Credit as per cent of GDPa) Rural 13.0 17.3 15.8 22.3b) Urban 20.0 24.8 31.1 45.0

4. Small Borrrowal Accounts asper cent of all Credit Accountsa) Rural – – 80.0 61.6b) Urban – – 50.7 32.2

5. Share of Small Borrowal Accountsin Total Credit Accountsa) Rural – – 25.4 14.4b) Urban – – 2.0 0.9

– : Not available.Source : Basic Statistical Returns of Scheduled Commercial Banks,

in India, various issues, Reserve Bank of India.

some risks, at the moment these risks do not appearto be significant as the aggregate ratio of credit to

GDP is still moderate, capital adequacy ratios aresufficiently high and the NPA ratios are low.

Pricing of Credit

4.107 In April 2003, the system of PLRs wasreplaced by a system of benchmark prime lendingrate (BPLR) as indicated in Section III. Bulk of thebank lending, however, has been taking place at sub-BPLR rates. The share of sub-BPLR lendingincreased steadily to 82.0 per cent by March 2007(Table 4.27).

4.108 An analysis of the trends in BPLR vis-à-vispolicy rates suggests some downward stickiness inBPLR. In response to decline in the policy rates, bankstended to alter the margin below BPLR in line withthe market condition, while leaving the BPLRunchanged. On the other hand, hike in policy rates werepromptly followed by upward revisions in BPLR. Asa result, the spread between the BPLR and the policyrate tended to widen over the years (Chart IV.19).

Table 4.21: Number of Loan Accounts –Select Countries

(Per 100 persons)

Country As at Loan Account

1 2 3

1. Argentina December 2003 15.4

2. Bangladesh December 2003 5.5

3. Belgium December 2002 5.9

4. Brazil June 2002 5.0

5. Chile December 2003 41.8

6. Denmark December 2002 45.1

7. Greece December 2003 77.6

8. India March 2006 15.8

9. Italy December 2002 32.8

10. Malaysia December 2003 32.9

11. Pakistan December 2004 2.2

12. Russia December 2003 5.4

13. Singapore January 2005 51.3

14. Spain December 2003 55.6

15. Thailand December 2004 24.8

16. Turkey December 2003 26.5

Source : Beck, Kunt and Peria (2005) and Reserve Bank of India.

Table 4.23: Region-Wise Number of CreditAccounts per 100 Persons – Scheduled

Commercial Banks in India

1991 2005 1991 2005 1991 2005

Region Rural Urban Total

1 2 3 4 5 6 7

Northern 6.6 5.1 5.9 6.7 6.4 5.7North-East 4.4 3.2 4.4 3.9 4.4 3.3Eastern 7.2 4.2 4.3 4.3 6.6 4.2Central 5.8 4.2 4.4 4.5 5.5 4.3Western 6.2 4.2 4.8 12.2 5.7 7.5Southern 13.6 12.7 7.6 17.4 11.8 14.2All-India 7.9 6.0 5.5 9.8 7.3 7.0

Source : Mohan (2006b).

Table 4.24: Incidence of Indebtedness ofHouseholds in India*

(Per cent)

Year Rural Urban

1 2 3

1971 42.8 –1981 20.0 17.41991 23.4 19.32002 26.5 17.8

* : Incidence of Indebtedness defined as percentage of households indebted in total num ber of households debted amongthose surveyed.

– : Not Available.

Source : NSSO (2006a).

154


Table 4.26: Stress Tests: Capital Adequacy Ratiounder various Scenarios

(Per cent)

All Pubic Old New Foreign TenBanks Sector Private Private Banks Largest

Banks Banks Sector BanksBanks

1 2 3 4 5 6 7

Actual at end-March 2005 12.8 12.8 12.5 12.1 14.1 12.7

Stress Test Scenarios

i) IncreasedProvisioning 12.0 11.9 10.7 11.7 13.8 11.8

ii) NPAs increasedby 25 Per cent 10.4 10.0 7.5 11.1 13.2 10.1

iii) New Loansbecome NPAsat the samerate as OldLoans 9.4 8.8 6.0 10.7 12.8 9.0

Source : Rozhkov (2006).

Table 4.27: Share of Loans Extended at Sub-BPLR Rates by Scheduled Commercial Banks*

(Per cent)

Period Public Private Foreign All BanksSector Sector BanksBanks Banks

1 2 3 4 5

September 2004 33.2 50.4 64.5 38.9December 2004 62.0 75.3 80.9 65.1

March 2005 50.6 78.1 88.6 58.9June 2005 57.3 80.5 89.7 64.2September 2005 60.9 80.9 85.5 66.8

December 2005 59.4 83.0 84.9 68.4March 2006 63.6 85.1 85.1 69.2

June 2006 66.5 88.0 80.0 74.8September 2006 70.6 87.5 80.1 75.3

December 2006 72.5 88.2 78.6 77.3March 2007 76.3 91.8 72.4 82.0

– : Not available.* : As per cent of total lending.Source: Reserve Bank of India.

4.109 The policy rate was revised downwards 10times between October 13, 2000 and October 25,2005. During this period, however, the BPLR by one

representative large bank was revised only 6 timesand the lag varied between 6 to 13 months. However,on occasions when the policy rate was revisedupwards, the bank was quick to respond with the timelag as low as 20 days (Table 4.28).

4.110 While the BPLR exhibited stickiness, effectivelending rates appeared to be sensitive to marketconditions. Since bulk of the lending has been takingplace at sub-BPLR rates, the rate of discount oncommercial paper (CP rate) could be taken as a goodproxy for effective bank lending rates in the country.The CP rate was found to be moving in tandem withthe weighted average yield on government securities(Chart IV.20).

Table 4.25: Debt-Asset Ratio of Households

(Per cent)

Year Rural Urban

1 2 3

1971 4.42 –1981 1.83 2.541991 1.78 2.512002 2.84 2.82

– : Not available.Source: NSSO (2006a).

01

-Nov

-00

01-F

eb-0

10

1-M

ay-0

101-A

ug-

01

01

-Nov

-01

01-F

eb-0

20

1-M

ay-0

201-A

ug-

02

01

-Nov

-02

01-F

eb-0

30

1-M

ay-0

301-A

ug-

03

01

-Nov

-03

01-F

eb-0

40

1-M

ay-0

401-A

ug-

04

01

-Nov

-04

01-F

eb-0

50

1-M

ay-0

501-A

ug-

05

01

-Nov

-05

01-F

eb-0

60

1-M

ay-0

601-A

ug-

06

01

-Nov

-06

01-F

eb-0

7

Changes in Policy Rates and Lending Rates

Chart IV.19: Policy Rates and Lending Rates of Banks

Bank Rate PLR Repo Rate Reverse Repo Rate

Per

cen

t

13-O

ct-0

013-J

an-0

113-A

pr-

01

13-J

ul-

01

13-O

ct-0

113-J

an-0

213-A

pr-

02

13-J

ul-

02

13-O

ct-0

213-J

an-0

313-A

pr-

03

13-J

ul-

03

13-O

ct-0

313-J

an-0

413-A

pr-

04

13-J

ul-

04

13-O

ct-0

413-J

an-0

513-A

pr-

05

13-J

ul-

05

13-O

ct-0

513-J

an-0

613-A

pr-

06

13-J

ul-

06

13-O

ct-0

613-J

an-0

7

Benchmark Prime Lending Rate Spread (BPLR - Repo)

Per

cen

t

155

CREDIT MARKET

Cost of Intermediation

4.111 The calibrated deregulation of the bankingsystem and the entry of several private and foreignbanks gradually induced greater competit ion,prompting banks to alter their business strategy andmanagement practices which, along withtechnological developments, led to overallimprovement in efficiency. This was reflected in theintermediation cost (operating expenses aspercentage to total assets), which decelerated from2.77 per cent in 1996 to 2.11 in 2006. Notwithstandingthis improvement, intermediation cost of banks in Indiais still high in comparison with other countries (Table4.29). There is, thus, scope to bring it down to thelevel of intermediation cost of banks in other Asiancountries.

Transformation of the Credit Market

4.112 The analysis in the preceding sections revealsthat there has been a profound transformation of thecredit market since the early 1990s. Prior to initiationof financial sector reforms, credit institutions borrowed

and lent funds at fixed interest rates and faced littlecompetition. Banks operated under regulatoryconstraints, whereby bulk of their resources were pre-empted in the form of CRR and SLR. Banks alsolacked operational flexibility and functional autonomy.Credit institutions intermediated funds inefficiently,which was reflected in their high NPAs, highintermediation cost and low profitability.

Table 4.28: Changes in the Repo Rate andAdvance Rate of Scheduled Commercial Banks

Repo Rate Advance Rate of Commercial Banks*

Effective Rate Effective RateDate (Per cent) Date (Per cent)

1 2 3 4

13.10.2000 10.25 01.03.1999 12.00

06.11.2000 10.00 01.04.2000 11.25

09.03.2001 9.00 12.08.2000 12.00

30.04.2001 8.75 19.02.2001 11.50

07.06.2001 8.50

28.03.2002 8.00 01.04.2002 11.00

12.11.2002 7.50 01.11.2002 10.75

07.03.2003 7.10

19.03.2003 7.00 05.05.2003 10.50

31.03.2004 6.00 01.01.2004 10.25

26.10.2005 6.25

24.01.2006 6.50

09.06.2006 6.75 01.05.2006 10.75

25.07.2006 7.00

31.10.2006 7.25 02.08.2006 11.00

31.01.2007 7.50 22.12.2006 11.50

31.03.2007 7.75 20.02.2007 12.25

* : Data pertain to one representative large bank.

Table 4.29: Intermediation Cost of Banks of MajorAsian Countries*

(Per cent)

Year China Korea Malaysia Thailand India

1 2 3 4 5 6

1996 1.23 2.24 1.42 1.50 2.94

1997 1.24 2.55 1.49 2.05 2.85

1998 1.40 2.53 1.68 2.54 2.63

1999 1.18 1.53 1.50 2.20 2.67

2000 1.12 1.46 1.70 1.98 2.50

2001 1.10 1.42 1.80 2.01 2.64

2002 1.05 1.39 1.73 1.78 2.19

2003 1.01 1.38 1.61 1.71 2.24

2004 – – – – 2.21

2005 – – – – 2.13

2006 – – – – 2.11

– : Not Available* Intermediation cost represents operating expenses as percentage

to total assets.Source :1. Mohan (2006c).

2. Report on Trend and Progress of Banking in India,various issues, Reserve Bank of India.

Lending Rate Commercial Paper Rate

Yield of Government Securities

Chart IV.20: Lending Rate and Yield onGovernment Securities

Per

cen

t

156


4.113 The initiation of financial sector reformsfacilitated a gradual move away from a financiallyrepressed regime to a liberalised regime. Banks nowoperate in an environment in which they have thefreedom to innovate and expand their business. Withderegulation of interest rates, banks price theirproducts freely both on the liability and the asset sides.The competition has intensified on account of entryof new private sector banks and enhanced presenceof foreign banks. Several other significant changeshave also occurred both on the supply and demandsides of the credit market.

4.114 On the supply side, reduction in statutory pre-emptions boosted the supply side of the credit.Accommodative monetary policy followed by theReserve Bank between April 1998 and October 2004also provided ample liquidity to the system, which hada positive impact on the supply of credit. Theintroduction of asset classification norms have madebanks very sensitive to their asset quality, wherebybanks restrict the supply of credit when faced withlarge NPLs and increase the supply when NPLs areat reasonable levels. The cleansing of balance sheetsby banks have enabled them to recycle the resourceslocked up in unproductive assets and improve theirprofitability. With the introduction of capital adequacynorms, banks are able to expand the credit volumesonly after expanding the capital base. Raising ofcapital by banks from the market has, therefore,become critical in their lending operations. It has alsosubjected them to market discipline and encouragedthem to improve corporate governance practices. Withthe increased competition, spreads of banks havecome under pressure. In order to maintain theirprofitability, banks, therefore, have tended to increasethe credit volumes. Thus, from an environment whenbanks resorted to some sort of credit rationing, theyare now increasingly exploring new avenues ofexpanding their business volumes. In the process, thesegmentation of the credit market has almostdisappeared with banks now providing also long-termresources, apart from the traditional short-term funds.

4.115 On the demand side, robust economic growthhas increased the demand for credit. Apart from thetraditional sectors, the household sector has emergedas the major driver of demand for bank credit. Risingincome levels and increase in asset prices havestimulated the demand for credit by the household sector.

4.116 The credit market is now also closelyintegrated with other market segments such as themoney, the government securities, the foreignexchange markets, the equity market and the debt

market. Conditions in the money market have a directimpact on the credit market, albeit, with a lag. On theother hand, credit market conditions impact thegovernment securities market. Banks have resorted toliquidation of government securities in order to fund theircredit demand. The linkage between the credit marketand the equity market has also grown on account ofparticipation by banks in the equity market for raisingcapital. Securitisation of assets has also linked the creditmarket with the corporate debt market. To the extent,the inter-linkages of the credit market with the othermarkets have grown, the efficacy of transmission channelof monetary policy has also increased.

4.117 Information technology (IT) has made steadyinroads into the credit institutions and has broughtabout a significant change in many aspects in the formof computerisation of transactions and new deliverychannels such as ATMs. With migration of traditionalpaper-based funds movements to quicker and moreefficient electronic mode, funds transfers havebecome easy and efficient to perform. Quicker fundsettlement has a direct bearing on the availability ofmoney which, in turn, has a positive impact on theliquidity management. The increased competition andderegulation have exposed credit institutions tovarious risks, which have encouraged them to adoptappropriate risk management. Banks with proper riskmanagement system are able to properly price theirproducts and services. Thus, the credit market overthe years has become highly competitive, moreefficient and better integrated with other markets.

4.118 To sum up, a wide range of credit institutionsoperate in the country. The relative significance ofbanks, which are already predominant players in thecredit market, has increased partly due to conversionof two DFIs into banks. After witnessing sluggishconditions in the second half of the 1990s, creditextended by banks expanded rapidly beginning 2002-03, underpinned by robust macroeconomicperformance. The decline in NPLs in recent years alsoappeared to have encouraged banks to enlarge theircredit portfolio. A welcome development has beenlarge credit expansion to the agriculture sector in thelast few years, reversing the decelerating trend of the1990s. This was also reflected in the increased creditintensity of the agriculture sector. In comparison withthe 1980s, credit to the industry slowed downsomewhat in the 1990s as also during the currentdecade so far (up to 2005-06). This was despite thesharp increase in medium and long-term credit toindustry, which is supposedly for the project-relatedactivity. This suggests that banks have been filling the

157

CREDIT MARKET

gap created by the conversion/merger of two DFIsinto banks. Credit intensity of the industrial sector,on the whole, has increased. Credit growth to the SSIsector, which decelerated sharply between 1999-2004, reversed from 2004-05. A signif icantdevelopment in recent years has been a sharp declinein the share of cash credit and increase in the shareof demand loans.

4.119 A major development in the credit market hasbeen rapid expansion of credit to the householdsector, underpinned by benign interest rateenvironment and increase in income levels. Householdcredit now constitutes a significant share of total bankcredit. Empirical evidence suggests that credit trendssince May 2002 are structurally at variance with thepast relationships. Cross-country experience showsthat rapid credit expansion has led to difficulties inseveral countries. In the Indian context, however, theindebtedness of the household sector, the main driverof credit growth in recent years, is at a low level. Thebanking sector is robust with a high level of capitaladequacy and low level of NPAs. Stress tests alsosuggest that the banking sector is resilient enough towithstand adverse impacts that may arise out of rapidcredit expansion.

4.120 Although deposits continue to be the mainsource of funds, banks’ reliance on non-deposit resourceshas increased. While the BPLR is exhibiting downwardstickiness, banks are extending a large portion of theircredit at sub-BPLR rates. As a result, the effectivelending rates are in sync with the market conditions.The cost of intermediation has declined steadily eventhough it is still higher than many other EMEs.

V. THE WAY FORWARD

4.121 With the initiation of financial sector reforms,the Reserve Bank gradually relaxed various controlsin the credit market and switched over from micro-regulation to macro and prudential regulation.Restr ict ions on credit and their pr icing wereprogressively removed. This combined with increasedcompetition induced banks, major players in the creditmarket, to diversify their loan portfolios in line withthe diversification of the economy. However, whilecredit flows to agriculture and the SME sector haveincreased in recent years, the need is to furtherincrease the flow of credit to these sectors, particularlyto SMEs. To facilitate increased access to formalchannels of credit and to enable the credit market to

play an important role to sustain the growth process,several short to medium-term issues need to beaddressed.

Rural Credit

4.122 According to the latest available All-IndiaDebt and Investment Survey 2002, the share ofinstitutional agencies in outstanding cash debts of thehouseholds declined from 66.3 per cent in 1991 to57.1 per cent in 2002, with a corresponding increasein reliance on informal channels of credit. Although,the share of institutional credit might have risen onaccount of significant increase in bank credit toagr iculture in recent years, concerns aboutinadequate access to credit in rural areas remain.

4.123 Although the supply led approach to ruralcredit prior to the 1990s ensured availability of creditat a subsidised rate, it turned out to be financiallyunsustainable as it impacted the health of creditinstitutions adversely. While there is certainly a needto increase the flow of credit to the agricultural sector,there are some critical issues that need to beaddressed. Some of these issues have already beenraised by the Hon’ble Prime Minister4 . These are: (i)What do farmers need – a lower rate of interest orreliable access to credit at reasonable rates?; (ii) Isour existing institutional framework adequate formeeting the requirements of our farmers who are adiverse lot?; (iii) Do we need to create new institutionalstructures such as SHG, micro-finance institutions,etc., to provide improved and reliable access to credit?Or do we need to bring in money lenders under someform of regulation? It is necessary to find answers tothese questions in the near future.

4.124 Reliable access to credit is more crucial thanthe cost of credit. The Reserve Bank, therefore, hasbeen initiating several measures from time to time toextend the outreach of the credit institutions inunderserved areas. The branch licensing policyfavours opening branches in unbanked districts/areas.Banks have also been permitted to use the servicesof business facilitators and business correspondentsto extend their outreach. Banks are now increasinglyroping in non-government organisations, SHGs, andMFIs to act as intermediaries. The SHG-Bank linkageprogramme is expected to gain further ground withNABARD taking up a programme for intensificationof these activities in 13 identified States, whichaccount for 70.0 per cent of the rural poor population.

4 Address at the Second Agriculture Summit, October 18, 2006.

158


4.125 Some aspects of operations of MFIs, however,have also raised some concerns. Although micro-finance activities should be commercially viable, it isreported that some MFIs are charging very high interestrates, which could prove to be counter-productive inthe long run. While informality of micro-financestructure is important, NABARD and banks need tobuild appropriate indigenous/local safeguards againstsuch practices and in their relationship with MFIs.

Credit to the SME Sector

4.126 SMEs are more constrained in their financingoptions than large firms. In the absence of adequatecredit from the credit institutions, they have to dependlargely on their internal generation, which constrainstheir growth. As credit to the SME sector is crucial forsustaining the growth momentum in the economy, theReserve Bank has taken several measures tostreamline the credit flow and address structuralproblems in credit delivery to this sector. This isshowing some encouraging results and the need isto sustain the recent growth trends. One major issueis that banks perceive the SME sector as more riskyand, hence, they charge relatively high rate of intereston loans and insist on collateral.The Reserve Bankhas advised banks not to insist on collateral for loansup to Rs.5 lakh and for loans above Rs.5 lakhs andup to Rs.25 lakh, banks may consider dispensing withthe collateral requirement based on good track recordand financial position of the SSI unit. There are severalways which may resolve this issue and facilitateextension of credit without collateral. One such optionis the availability of credit history of the borrowers.However, building up of credit history of a largenumber of borrowers spread throughout the country,especially small borrowers, is a difficult task. TheCredit Information Bureau (India) Limited has alreadybecome operational. The Credit Information Act waspassed in May 2005, and rules and regulationsthereunder have also been notified.This will facilitateformation of more credit information companies.These companies would collect and disseminatecredit information about the borrowers and may alsointroduce credit scoring as in other countries. Theseshould help in improving the quality of credit, reducingthe transaction cost and improving the flow of creditto the SME sector. Another option to avoid thecollateral requirement is to introduce independentrating of borrowers, both individuals and firms. Atpresent, rating penetration is very low in the countryand cost involved in getting the rating is high.Concerted efforts, therefore, need to be made to

popularise rating as a concept acceptable to both thelenders and the borrowers. Yet another option is toconsider future cash flows as collateral security suchas account receivables in place of asset basedcollateral.

4.127 There has been a burst of entrepreneurshipacross the country, spanning rural, semi-urban andurban areas. This has to be nurtured and financed. Itis only through growth of enterprises across all sizesthat competition will be fostered. A small entrepreneurtoday will be a big entrepreneur tomorrow, and mightwell become a multinational enterprise eventually ifgiven the comfort of financial support. But we alsohave to understand that there will be failures as wellas successes. Banks will, therefore, have to tone uptheir risk assessment and risk management capacities,and provide for these failures as part of their riskmanagement. Despite the risk, financing of first timeentrepreneurs is necessary for financial inclusion andgrowth. The financing of non-agriculture serviceenterprises in rural areas would generate new incomeand employment opportunities (Mohan, 2006b).

Increasing Credit Penetration

4.128 Although India has a well-diversified financialsystem with a wide variety of credit institutions, creditpenetration continues to be relatively low incomparison with several other developed andemerging economies. This is despite the fact thatseveral measures have been taken in the recent pastto bring more and more people, especially the under-privileged and low income households, into thebanking fold. In an ideal world, competitive pressureswould ensure that the banking needs of all thesegments of the population are met. However, theexperience shows that some intervention may berequired to ensure that people with low incomes areprovided with credit facilities at a reasonable cost.Concerted efforts, therefore, need to be made toincrease the credit penetration in the country. Majorreasons for low credit penetration are lack ofawareness of facilities, high transaction cost of doingbusiness in rural areas and inability of the poor peopleto provide collaterals.

4.129 The under-privileged sections of the societywith low income levels generally hesitate to visit thebank and are driven to local money lenders. There is,therefore, need to devise some mechanisms to impartfinancial education, especially in rural areas. Thefocus of financial education should be on educatingthe general public about the benefits of using formalcredit institutions for their requirements.

159

CREDIT MARKET

4.130 A major issue in increasing credit penetrationis the collateral that banks insist on for extending loans.While banks are being induced to provide small loanswithout collateral, banks need to consider alternativeways to reduce their dependence on collateral.

4.131 Another major issue in increasing the flow ofcredit is related to the high transaction costs. This,however, could be resolved through appropriateapplication of technology. Banks need to look into lowcost delivery alternatives offered by IT. It can make acritical contribution by reducing cost and time inprocessing of applications, and maintaining andreconciliation of accounts. Use of a variety of devicessuch as weekly banking, mobile banking, satelliteoffices, and adoption of hub and spoke models canconsiderably cut the overhead cost for enabling bankingservices in remote areas. Once the data base and thetrack record are established, a multitude of financialservices can be offered, including savings, remittances,transaction and banking such as receipt of salaries,pensions and payments for utilities, loans including homeloans, insurance and mutual fund products.

4.132 One aspect, however, that needs to be takencare of while introducing IT-based products andservices is low level of literacy and technologyorientation and awareness about IT-based productsin rural areas. Language is another barrier in the useof technology, which is largely English-based. Thus,banks would have to make efforts to popularise thenew IT-based products. In this regard, due considerationto regional languages and programmes to impartsome basic education in IT needs to be given.

4.133 However, the policy on increasing creditpenetration may not yield the desired results byfocusing on commercial banks alone. A comprehensiveapproach involving other institutions such as co-operatives and State level financial institutions is alsodesirable. Moreover, it is necessary to create anenvironment that promotes the emergence ofsustainable financial service providers to work inunder-served markets.

Pricing of Credit

4.134 Pricing of credit has drawn considerableattention since the deregulation of bank lending rates.Although interest rates are now driven by demand-supply forces, some downward stickiness has beenobserved in banks’ BPLR. Further, around 82 per centof the lending by banks is taking place at sub-BPLRrates, which raises several concerns. While bettercreditworthy corporates are getting credit at sub-

BPLR rates, the agriculture and SSIs sectors andother borrowers, in general, are charged BPLR or insome cases even higher rates. The administeredinterest rate is applicable only in the case ofagricultural loans below Rs. 2 lakh and export credit.Banks can also extend short-term production creditto farmers up to Rs. 3 lakh at an interest rate of 7 percent on which the banks are being provided interestsubvention of 2 per cent by the Government. The AllIndia Debt and Investment Survey 2002 found thatabout 82 per cent of the rural debt as of June 30,2002 was in the interest range of 12 to 20 per cent,while prime lending rates (PLRs) of banks were inthe range of 11 to 12 per cent.

4.135 Lending below the BPLR has severalimplications. First, it lacks transparency and, hence,affects both lenders and borrowers. Second, tocompensate for sub-BPLR lending, other segmentsare charged higher rate of interest, thus, leading tocross subsidisation of the economically well-offborrowers by the economically poor borrowers.Though the Reserve Bank has been advising banksto evolve their own BPLR by taking into account thecost of funds, transaction cost and reasonable coverfor the riskiness, fixation of the BPLR continues to bemore arbitrary than rule based. It is, therefore, feltthat the concept of arriving at the BPLR needs to belooked into with a view to making it more transparent.

Improving Efficiency

4.136 Improved efficiency in lending operations (andalso in other banking business) can reduce theoperating expenditure, interest spread and cost ofintermediation in general (Mohan, 2006c). This mayhelp in reducing the rate of interest on loans and, thus,facilitating improved credit flow to the various sectorsof the economy. Although the intermediation cost inIndia has declined since the early 1990s, it is still highin comparison with other advanced and emergingmarket economies. It is, therefore, imperative that theintermediation cost is brought down. Technologicalimprovement in bank operations holds the key infurther improving efficiency and, thus, reducing thecost of operations.

Credit Counselling

4.137 While there is a need to encourageinnovations and competition in the marketplace, it isalso necessary to provide adequate protection toconsumers. However, some of today’s products havebecome difficult for consumers to understand because

160


they are complex, and lack transparency andstandardised information. Credit is a source of risk.However, some consumers could take out loans thatare inappropriate and expensive. Some consumersmay also be dr iven into debt by change incircumstances. There is, therefore, need to provideconsumers with right information and at the right timeto enable them to take informed decisions. With thechanging growth dynamics, certain segments of thepopulation could also become susceptible toexcessive optimism in the economic environment. Inview of these reasons, it would be very useful toestablish credit counselling institutions for educatingindividuals to assess their credit demand and debtmanagement in order to mitigate the bankruptcy risk.Furthermore, credit counselling institutions can alsoremove asymmetric information in rural credit and canhelp individuals by guiding them to access credit fromvarious available sources. From the perspective of aregulator, financial education delivered through creditcounselling can empower the common person and,thus, reduce the market failure attr ibutable toinformation asymmetries.

4.138 In several countries, the system of creditcounselling organisastions is already in operation. Thefirst well-known credit counselling agency was createdin 1951 in the United States to promote financialliteracy and help consumers to avoid bankruptcy.Subsequently, several other countries establishedsuch organisations. For instance, the Banking Codein the UK provides that member banks shall discussfinancial problems with customers and together evolvea plan for resolving these problems. Canadaestablished a non-profit counselling organisation in2000 called Credit Counselling Canada (CCC), whichseeks to enhance the quality and availability of not-for-profit credit counselling for all its citizens. The BankNegara Malaysia has established a Credit Counsellingand Debt Management (CCDM) agency to provideadvice to individuals on credit counselling and loanrestructuring. The arrangement is expected to be aprompt and cost-effective means of debt settlementbased on the repayment plan between the creditorand the debtor without intervention of courts. In viewof r ising personal bankruptcies, pr imar i ly onunsecured debt, Credit Counselling of Singapore(CCS) was established in 2003 to assist financiallydistressed consumers. In India, the working groupconstituted by the Reserve Bank to examineprocedures and processes for agricultural loans(Chairman: Shri C. P. Swarankar) recommended thatbanks should actively consider opening of counsellingcentres, either individually or with pooled resources,

for credit and technical counselling with a view togiving special thrust to the relatively underdevelopedregions.

Strengthening of Credit Appraisal, PrudentialRegulation and Supervisory Standards

4.139 While increase in credit in the Indian contextreflects financial sector deepening, the process hasto be gradual. Excessive credit expansion could leadto macroeconomic and financial vulnerabilities. Therapid credit growth has been often considered as riskyas even weaker borrowers may be judgedcreditwor thy. Excessive optimism about futureearnings might lead banks to focus on credit creationto the detriment of credit monitoring and risk appraisal,which could lead to increase in non-performing loans.In view of rapid credit growth in recent years, banksneed to strengthen their credit appraisal standardsand ensure appropriate post-disbursal monitoring.

4.140 Prudential regulation and supervision isextremely important during periods of rapid creditexpansion. The Reserve Bank has already takenseveral significant prudential measures to moderatethe credit growth to the sensitive sectors. As statedin the Mid-term Review of the Annual PolicyStatement, 2005-06, a supervisory review processwas initiated in respect of select banks havingsignificant exposure to certain sectors, namely, realestate, highly leveraged NBFCs, venture capital fundsand capital markets. The quality of supervision hasimproved significantly with the setting up of the Boardfor Financial Supervision, which now gives focusedattention to the supervision of all financial institutions.Efforts are also being made to make the supervisorysystem risk-based, for which pilot runs are on.Appropriate early warning system and the surveillancesystems are also in place. The need, however, is tokeep the supervisory machinery well-functioning.

VI. SUMMING UP

4.141 The credit market is the most significantsegment of the financial market structure in India. Thecredit market in India has witnessed significanttransformation in the last 15 years in terms of type ofborrowers/type of instruments and price of credit. Withthe conversion of two DFIs into banks and reductionin the business operations of NBFCs, thepredominance of banking institutions in the creditmarket has increased. However, with enhancedfreedom for business operations and increasedpresence of private and foreign banks and non-bankcredit institutions, the credit market has become highly

161

CREDIT MARKET

competitive as new banks are making every effort toincrease their share in the credit market. The creditmarket has also diversified in terms of borrowing entitiesand the purposes for which credit is extended. Reflectingthe changing structure of the economy, the servicessector along with the household sector have emergedas significant borrowers from the banking sector.

4.142 The trend of declining share of credit toagriculture in the 1990s has been reversed as therehas been rapid credit expansion to this sector in thelast few years. This reflects the concerted efforts beingmade by the Reserve Bank and the Government.Credit to industry slowed down in the 1990s and thecurrent decade as compared with the 1980s. Internalfunds generation, as a result of improved financialperformance, has limited the short-term borrowingneeds of industry. Credit growth to the SSI sector,which had decelerated between 1999-2000 and 2003-04, has accelerated in the last two years. The need isto further strengthen the flow of credit to the SSIsector. Banks in recent years have reoriented theirservices to the household sector. Increase in the shareof medium and long-term loans to industry and thestrong growth of housing loans resulted in sharpincrease in the share of medium and long-term loans intotal credit in recent years. Given the short-termcharacter of bank deposits, a significant increase inoverall medium and long-term credit may haveimplications for banks’ asset liability management (ALM).

4.143 Bank credit has expanded at a rapid pacefrom 2002-03. One of the most significant changes inthe composition of bank credit in recent years hasbeen the large increase in the share of the householdsector. Rapid credit expansion, to an extent, has beenencouraged by improvement in asset quality as creditintermediation function was impaired in the mid-1990son account of high level of NPAs. Empirical evidencesuggests that credit trends since May 2002 arestructurally at variance with the past relationships,although credit expansion in recent years has alsobeen pro-cyclical in nature.

4.144 Many other emerging market economieshave also been experiencing rapid credit expansionin recent years. Several factors have contributed torapid credit expansion in emerging marketeconomies such as robust growth, macroeconomicstabi l isat ion, strong economic out look andimprovement in business confidence. However, in thecase of India, the credit-GDP ratio has been low incompar ison with other EMEs. Strong credit

expansion in recent years, thus, to some extentreflects the financial deepening process. Althoughborrowings by the household sector have increasedsharply in recent years, the debt-asset ratio of thehousehold sector continues to be low. However, thereis a need to recognise that large accumulation ofdebt could leave households prone to future interestrate/exchange rate shocks as banks have transferreda large part of their market risk to households, thus,raising concerns over sustainability of high creditgrowth to households. Insofar as the banking sector isconcerned, it, in general, has high capital adequacyratio and low level of non-performing loans. Stresstests suggest that the banking sector in India isresilient enough to withstand any adverse impactarising out of rapid expansion in credit. Nevertheless,keeping in view the risks arising out of rapid creditgrowth, the Reserve Bank initiated several prudentialand monetary measures to slowdown the flow of creditto the sensitive sectors and maintain the asset qualityof banking institutions. The need for banks is tostrengthen credit appraisal and post-disbursalmonitoring.

4.145 A proper functioning of the credit marketdepends on adequate competition. In a competitiveenvironment, the more efficient institutions capturethe market share at the expense of less efficient ones,which improves the overall efficiency of the system.This benefits both the credit institutions and theirclients. While gains to credit institutions occur in theform of higher profits, to consumers they occur in theform of lower cost of the services. The process ofconsolidation and restructuring that is underway inthe credit market in India may result in weeding outthe inefficient players and the credit market maybecome more efficient in future.

4.146 Robust economic growth has increased thedemand for credit. Proper functioning of creditinstitutions in general and banks in particular is keyto sustained economic growth. In the current situationof high credit expansion, banks have been unwindingtheir surplus investments in SLR securities, over andabove the prescribed minimum. This unwinding wouldsoon reach a limit. Therefore, banks need to makesustained efforts for mobilising stable retail depositsby extending banking facilities and wide-spreadingtheir deposit base. In particular, banks would need todevise imaginative ways to mop up the resources inrural areas to balance their deposit mobilisation andcredit expansion.

162


An

nex

IV.1

: M

enu

of

Po

licy

Op

tio

ns

in R

esp

on

din

g t

o R

apid

Cre

dit

Gro

wth

Po

licy

Op

tio

ns

Mac

roec

onom

icP

olic

y M

easu

res

Fis

cal

mea

sure

sM

onet

ary

mea

sure

sE

xcha

nge

rate

pol

icy

resp

onse

-In

tere

st r

ate

tight

enin

g

-R

eser

vere

quire

men

ts

-Li

quid

ass

etre

quire

men

ts

-S

teril

isat

ion

oper

atio

ns

-In

crea

seex

chan

gera

tefle

xibi

lity

-In

gen

eral

mai

ntai

n a

cons

iste

ntm

ix o

f am

onet

ary

and

exch

ange

rate

pol

icy

Sup

ervi

sory

/M

onito

ring

Mea

sure

s

Mar

ket

Dev

elop

men

tM

easu

res

Adm

inis

trat

ive

Mea

sure

sP

rom

otio

n of

Bet

ter

Und

erst

andi

ng o

fR

isks

-H

ighe

rdi

ffere

ntia

ted

capi

tal

requ

irem

ents

-T

ight

er/

diffe

rent

iate

dlo

ancl

assi

ficat

ion

and

prov

isio

ning

rule

s

-T

ight

er e

ligib

ility

crite

ria fo

r ce

rtai

nlo

ans

-D

ynam

icpr

ovis

ioni

ng

-T

ight

er c

olla

tera

lru

les

-R

ules

on

cred

itco

ncen

trat

ion

-T

ight

enin

g ne

top

en fo

reig

nex

chan

gepo

sitio

n lim

its

-M

atur

itym

ism

atch

regu

latio

ns a

ndgu

idan

ce t

oav

oid

exce

ssiv

ere

lianc

e on

sho

rt-

term

bor

row

ing

-In

crea

sing

disc

losu

rere

quire

men

ts fo

rba

nks

on r

isk

man

agem

ent

and

inte

rnal

con

trol

polic

ies

and

prac

tices

-C

lose

r on

site

/of

f-si

tein

spec

tions

/su

rvei

llanc

e of

pote

ntia

llypr

oble

m b

anks

-P

erio

dic

stre

sste

stin

g

-P

erio

dic

mon

itorin

g/su

rvey

of b

anks

and

cust

omer

sex

posu

re

-In

crea

sing

supe

rvis

ory

coor

dina

tion

ofba

nks

and

non-

bank

fin

anci

alin

stitu

tions

-Im

prov

ed d

ialo

gue

and

exch

ange

of

info

rmat

ion

betw

een

dom

estic

and

hom

esu

perv

isor

s of

fore

ign

bank

s

-E

ncou

ragi

ngde

velo

pmen

t of

hedg

ing

inst

rum

ents

to

man

age

risk

requ

irem

ents

-D

evel

opin

g as

set

man

agem

ent

inst

rum

ents

to

deal

with

dist

ress

ed a

sset

s

-D

evel

opin

gse

curit

ies

mar

kets

to

redu

cede

pend

ence

on

bank

cre

dit

and

impr

ove

dive

rsifi

catio

n of

bank

s’ c

redi

tris

ks

-Im

prov

ing

cre

dit

cultu

re(e

stab

lishm

ent

ofcr

edit

bure

aus,

cred

it re

gist

ry,

stro

nger

lega

lsy

stem

, cr

edito

rsrig

hts,

etc

.)

-Im

prov

ing

bank

s’an

d co

rpor

atio

ns’

acco

untin

gst

anda

rds

-O

vera

ll or

ban

k-by

ban

k cr

edit

limits

-C

ontr

ols

onca

pita

l flo

ws

e.g.

,

-co

ntro

l on

fore

ign

borr

owin

g by

bank

s an

d/or

bank

cus

tom

ers

-di

ffere

nt r

eser

vere

quire

men

ts o

ndo

mes

tic a

ndfo

reig

n cu

rren

cy

-ta

xes

on f

inan

cial

inte

rmed

iatio

n

-S

tren

gthe

ning

bank

s’ a

bilit

y to

mon

itor,

asse

ssan

d m

anag

e

-P

ublic

ris

kaw

aren

ess

cam

paig

ns,

pres

sst

atem

ents

, et

c.

-D

iscu

ssio

ns/

mee

tings

with

bank

s (“

mor

alsu

asio

n”)

to w

arn

or p

ersu

ade

bank

s to

slo

wdo

wn

cred

itex

tens

ion

-F

isca

ltig

hten

ing

-A

void

ing

fisca

l/qu

asi-

fisca

lin

cent

ives

that

may

enco

urag

ece

rtai

nle

ndin

g

Pru

dent

ial

Mea

sure

s

So

urc

e: H

ilber

s, e

t al,

2005

.

163

CREDIT MARKET

Annex IV.2: Supervisory Measures to Manage Key Risks of Rapid Credit Growth

Type of risk Specific Measures

Credit risk ● Higher and/or differentiated capital requirements or application of risk weights based on loan type, maturity, andcurrency composition of credit.

● Raising general provisions, incorporating various elements of risks (e.g., in foreign currency loans, offshore,derivatives, or other off-balance sheet activities) in loan classification and provisioning requirements (e.g., forbank with rapidly growing portfolios); or dynamic provisioning.

● Tightening eligibility requirements for certain types of loans including through limits on loan-to-value ratios forcertain loans (e.g., for mortgages or foreign exchange loans).

● Tighter (or appropriate) collateral requirements (e.g., specifying assets eligible for collateral, marked-to-marketasset valuation).

● Rules on credit concentration (limits against large exposures to a single borrower or a group of related borrowersand against connected lending; and limits against credit concentration in particular industries, sectors, or regions).

● Use of periodic stress tests of banks’ balance sheets against interest rate, exchange rate, and asset pricechanges (by banks themselves as well as supervisory authorities).

● More intensive surveillance and onsite/offsite inspection of potential problem banks.

● Improved reporting/disclosure rules for banks’ and their borrowers’ balance sheets and banks’ risk management,and internal control policies and practices.

● Periodic and close monitoring of banks’ foreign-currency-denominated (or indexed) loans to domestic customers,which do not have adequate sources of foreign exchange or are otherwise unable to hedge the risks involved,including through requirements to conduct periodic surveys of banks’ and their borrowers’ foreign exchangeexposures.

Direct/indirect ● Tightening of net open position limits for banks to limit direct foreign exchange risks.foreign exchange ● Imposing differentiated capital requirements or risk weights based on the currency composition of credit to limit

indirect risks exposure to foreign exchange risks.

● Incorporating unhedged foreign exchange exposure in the criteria for loan classification and provisioning rules.

● Tightening eligibility requirements for foreign exchange loans, including by limiting such loans to borrowers withforeign exchange income or adequate hedging, to limit indirect exposure to foreign exchange risks.

● Periodic stress testing of banks’ balance sheets with respect to exchange rate changes (by banks themselvesas well as supervisory authorities).

● More intensive surveillance and onsite/offsite inspection of banks with a large share of foreign exchange lendingin their overall portfolios, including to ensure that banks have appropriate internal procedures for risk measurement,assessment, and management.

● Adequate monitoring of banks’ direct and indirect exposure to foreign exchange risks through improved reporting/disclosure rules for banks and their borrowers’ open positions in foreign currency or through a requirement toconduct periodic surveys of banks’ and their borrowers’ foreign exchange exposures (by banks themselves and/or by supervisory authorities).

Liquidity/maturity ● Imposing differentiated capital requirements or risk weights based on the maturity composition of credit.risks ● Maturity mismatch regulations (active management of maturity mismatches between bank assets and liabilities,

with limits established against such gaps and limits on various instrument exposures incurred by the bank).

● Use of periodic stress tests of banks’ balance sheets under alternative scenarios for interest rate changes (bybanks themselves as well as supervisory authorities).

● Enhanced monitoring and reporting requirements on : i) the maturity structure of interest-sensitive assets andliabilities broken down into several daily, weekly, monthly, and quarterly maturity “buckets”, ii) the maturity structurefor each currency in which the bank has a substantive position, iii) the types of interest-bearing securities andtheir maturity breakdown and iv) banks’ liquid assets, expected future cash flows and liquidity gaps for specifiedfuture periods, and details of liquidity management.

● Guidance to banks to avoid over-reliance on short-term inter-bank borrowing and encouraging access to diversifiedfunding bases in terms of sources of funds and the maturity breakdown of the liabilities taking into accountdifferences in volatility and reliability of domestic and external sources of liquidity.

Source: Hilbers, et al, 2005.

5.1 The government securities market is at thecore of financial markets in most countries. It dealswith tradeable debt instruments issued by theGovernment for meeting its financing requirements.1

The development of the primary segment of thismarket enables the managers of public debt to raiseresources from the market in a cost effective mannerwith due recognition to associated risks. A vibrantsecondary segment of the government securitiesmarket helps in the effective operation of monetarypolicy through application of indirect instruments suchas open market operations, for which governmentsecurities act as collateral. The government securitiesmarket is also regarded as the backbone of fixedincome secur it ies markets as it provides thebenchmark yield and imparts liquidity to other financialmarkets. The existence of an efficient governmentsecurities market is seen as an essential precursor,in particular, for development of the corporate debtmarket. Furthermore, the government securitiesmarket acts as a channel for integration of varioussegments of the domestic financial market and helpsin establishing inter-linkages between the domesticand external financial markets.

5.2 The government secur it ies market haswitnessed significant transformation across countriesover the years in terms of system of issuance,instruments, investors, and trading and settlementinfrastructure. It has grown internationally in tune withthe financing requirements of Governments. The fiscaldiscipline exercised by many countries in recent yearshas restricted the size of the market. Accordingly,countries have focussed on improving trading liquidityof the market through various measures. Manycountries in the recent past have pursued a strategyof managing the cost of Government borrowing in themedium to long-term so as to reduce the rollover riskand other market risks in the debt stock, although thismay entail higher debt service costs in the short run.Historically, in most countries, the central banks asmanagers of public debt have played a key role indeveloping the government securities markets.

Although debt management author it ies areincreasingly being established outside the centralbanks in various countries, central banks continue toplay a major role in developing the trading andsettlement infrastructure of the government securitiesmarket.

5.3 The evolution of the government securitiesmarket in India has been in line with the developmentsin other countries. Slow development of the market inthe 1970s and the 1980s was shaped by the need tomeet the growing financing requirements of theGovernment. This essentially resulted in financialrepression as progressively higher statutoryrequirements were stipulated, mandating banks toinvest in government securities at administeredinterest rates. Although this captive financing providedlow cost resources to the Government, it impeded thedevelopment of the market and distorted the interestrate structure. Furthermore, such arrangements,along with automatic monetisation of Governmentdeficits, hampered the conduct of monetary policy.

5.4 Recognising the need for a well developedgovernment securities market, the Reserve Bank, incoordination with the Government, initiated a seriesof measures from the early 1990s to deregulate themarket of administered price and quantity controls.Consequently, the government securities market haswitnessed significant transformation in variousdimensions, viz., market-based price discovery,widening of investor base, introduction of newinstruments, establishment of primary dealers, andelectronic trading and settlement infrastructure. This,in turn, has enabled the Reserve Bank to perform itsfunctions in tandem with the evolving economic andfinancial conditions.

5.5 Wide ranging reforms in the governmentsecurities market were largely undertaken in responseto the changing economic environment. Increasedborrowing requirements of the Government, stemmingfrom high fiscal deficits, had to be met in a costeffective manner without distorting the financial

GOVERNMENT SECURITIESMARKETV

1 Governments issue securities with maturities ranging from less than a year to a very long-term stretching up to 50 years. Typically, short-termmaturities up to one year, viz., Treasury Bills, form a part of the money market and facilitate the Government's cash management operations,while bonds with maturities more than a year facilitate its medium to long-term financing requirements. This chapter discusses developmentswith respect to bonds with maturities more than a year. Treasury Bills being short-term instruments are covered in Chapter III.

system. The underlying perspective of the reformprocess was, therefore, to raise government debt atmarket related rates through an appropr iatemanagement of market borrowing. There was also aneed to develop a benchmark for other fixed incomeinstruments for the purposes of their pricing andvaluation. An active secondary market for governmentsecurities was also needed for operating monetarypolicy through indirect instruments such as openmarket operations and repos. Reforms, therefore,focussed on the development of appropriate marketinfrastructure, elongation of matur ity profi le,increasing the width and depth of the market,improving risk management practices and increasingtransparency.

5.6 As stipulated under the Fiscal Responsibilityand Budget Management Act, 2003, the ReserveBank has withdrawn from participating in the primarymarket for government securities from April 1, 2006.The increasing move towards fuller capital accountconvertibility as recommended by the Committee onFul ler Capital Account Conver t ibi l i ty (FCAC)(Chairman: Shri S.S. Tarapore) would necessitatemeasures that promote greater integration of thedomestic financial markets with global markets. Thedeepening of the government securities market is,therefore, essential not only for transmission ofpolicy signals but also for developing the derivativesmarket which would meet future challenges thrownup by further liberalisation of the capital account.Moreover, an environment of freer capital flows willalso necessitate widening of the governmentsecurities market with further diversification of theinvestor base.

5.7 Against this backdrop, this chapter traces thedevelopment of the government securities market inIndia since the early 1990s, in order to identify thekey issues that need to be addressed to meet theemerging challenges. The chapter is organised in sixsections. Section I sets out the theoreticalunderpinnings, and principles and policy strategy fordeveloping a deep and liquid government securitiesmarket. Section II presents international experiencesin terms of key features of the government securitiesmarket in developed and developing countries.Section III outl ines the developments in thegovernment securities market in India since the early1990s and the role played by the Reserve Bank inshaping it. An assessment of the governmentsecurities market in terms of various indicators ispresented in Section IV. Drawing from the lessonsfrom international experiences, Section V raises thekey issues that need to be addressed for enabling

the government securities market to play a moreeffective role in the emerging scenario. The finalsection presents concluding observations.

I. ROLE OF THE GOVERNMENT SECURITIESMARKET

Theoretical underpinnings

5.8 The supply of government securities isgenerally exogenous to the market, determined mainlyby the fiscal policy of the Government. The demandfor government securities may be fragmented intoseveral components implying that the demand curveis not uniformly downward sloping, but is rather kinked(Commonwealth of Australia, 2002). For instance, thedemand by investors such as insurance companiesand superannuation funds is in the nature of ‘buy andhold’ as the revenue streams from governmentsecurities generally match with their liability paymentstream. These investors may have very few substitutesand, hence, their demand is less price sensitive.Mandated investments in government securities bybanks and other institutions would also fall into thecategory of ‘buy and hold’. The demand from otherinvestors in government securities is more for activetrading and portfolio management. These investorsmay have many substitutes for government securitiesand, hence, their demand is generally more priceelastic. The overall demand elasticity is, therefore,determined by the balance between these two groupsof investors. Greater the share of active investors,higher is the demand elasticity or price sensitivity ofgovernment secur it ies. Increased volume ofgovernment securities may increase concerns of adefault by the Government which may affect the riskcharacteristics of the instrument. This may result in afall in prices as yields steepen. At the other end ofthe spectrum, very limited supply of governmentsecurities may generate concerns over liquidity.Illiquidity premium can then drive down the prices,although there could be some resistance to thedownward bias, if ‘buy and hold’ investors dominatethe market. Thus, very high volumes as well as verylow volumes of government securities may result in afall in prices of government securities.

5.9 Activity in the government securities marketcan affect overall investment in the economy in twoways. First, it may adversely affect private investmentby directly competing for the limited resources. As theinterest rate on private bonds is determined by theusual downward sloping demand and upward slopingsupply curves, the interest rate in the economy wouldbe determined by the combined demand for and

165

GOVERNMENT SECURITIES MARKET

166


supply of government securities and private bonds.An increase in the supply of government securities inthe face of high budget deficits would drive down theirprices, leading to a substitution of private bonds withgovernment securities, particularly, by investorswhose demand is driven by trading and portfoliomanagement requirements. This phenomenon is oftendescribed as ‘crowding out’.

5.10 Second, the government securities marketcan also have a positive influence on pr ivateinvestment by enabling the development of privatebond market in two ways: (i) by putting in place a basicfinancial infrastructure, including laws, institutions,products, services, repo and derivatives markets; and(ii) by playing a role as an informational benchmark.A single private issuer of securities would never beof sufficient size to generate a complete yield curveand his securities would not be riskless because only

the Government has the power to print domesticcurrency (Herring and Chatusripitak, 2000). Thus, theyield curve of government securities serves as apublic good in financial markets (Box V.1).

5.11 One of the key features of development of thegovernment securities market is the evolution of yieldcurve over a reasonably long period. The upwardsloping yield curve, which is considered to be theusual term structure, may reflect either the presenceof interest rate risk premium or the so called Hicksianliquidity premiums, or it may simply reflect the market’santicipation about the upward trend in the generallevel of interest rates over the period. Theoreticalanalysis confirms that in an efficient market, yieldcurve will solely depend upon the market’s responseto collective beliefs about future interest ratemovements, i.e., interest rates derived from theprevailing term structure of interest rates are correct

Yield curve, also known as term structure of interest rates,is the representation of zero coupon yields of a series ofmaturities at a point of time. It is constructed by plottingthe yields against the respective maturity periods ofbenchmark fixed-income securities. The yield curve is ameasure of market’s expectations of future interest rates,given the current market conditions. Securities issued bythe Government are considered risk-free, and as such,their yields are often used as the benchmarks for fixed-income securities with the same maturities.

Graphic Representation of a Normal Yield Curve

Box V.1Role of Government Securities Yield Curve as a Public Good

curve has informational value to bond issuers for pricingas well as timing of their issue depending on the expectedperformance of the economy. Investors can also use thecurve in choosing the right tenor of investment. Foroverseas investors, expected performance of differentcountries could be compared by looking at the respectiveyield curves to make investment decisions.

Most other interest rates are measured on the basis of thegovernment securities yield curve, viz., credit curve andswap curve. Similarly pricing of other financial instrumentuses the government securities yield curve in some formor the other. Thus, the yield curve acts as a kind of publicgood that is used constantly by participants in the financialsystem.

The efficiency of the yield curve as a public good isenhanced under the following two conditions. First,macroeconomic volatility, especially inflation volatility, mustbe low so that a nominal yield curve is informative aboutthe real cost of borrowing. Second, the government mustissue a sufficient volume of debt. Yield is described as anapparatus which allows abstraction of irrelevant factorsand focuses on factors relevant for interest rate risk onportfolios (Krstic and Marinkovic,1997).

The fact that the yield curve acts as a public good enjoinsupon all participants, in particular the regulators, theresponsibility of ensuring that it is free from any undesirableand manipulative influence, as this would lead to a loss in itsinformational value and result in market inefficiency broughtabout by incorrect pricing of other financial instruments.

The difference between short and long ends of the yieldcurve (spread) determines the shape of the curve whichis an important indicator of the expected performance ofthe economy and inflation. Since the government securitiesyield curve represents the risk-free interest rates, it is usedfor pricing other instruments of various maturities. The yield

Years to Maturity

Yiel

d (

%)

167


forecast of future interest rates. Thus, developmentof the government securities market is essential forestablishing the risk-free benchmarks in financialmarkets and ensuring their functioning in an efficientmanner.

Significance of the Government Securities Market

5.12 The need to develop the governmentsecurities market emerges from the three roles itseeks to play, i.e., for the financial markets, for theGovernment and for the central bank (Reddy, 2002).As alluded to earlier, the government securitiesmarket serves as the backbone of fixed incomemarkets through the creation of risk-free benchmarksof a sovereign borrower. Ipso facto, it acts as a channelof integration of various segments of the financialmarket. The government securities market constitutesa key segment of the financial market, offering virtuallycredit risk-free highly liquid financial instruments,which market participants are more willing to transactand take positions. The wil l ingness of marketparticipants to transact in government securities, inturn, imparts liquidity to these instruments, whichbenefits all segments of the financial market.Consequently, government securities are used bydealers as a major hedging tool for interest rate riskand as underlying assets and collateral for relatedmarkets, such as repo, futures and options (BIS,1999).Furthermore, large borrowings by the Governmentalso provide an impetus to the development of thebond market.

5.13 From the perspective of an issuer, i.e., theGovernment, a deep and liquid government securitiesmarket facilitates its borrowings from the market atreasonable cost. A greater ability of the Governmentto raise resources from the market at marketdetermined rates of interest allows it to refrain frommonetisation of the deficit through central bankfunding. It also obviates the need for a captive marketfor its borrowings. Instead, investor participation isvoluntary and based on risk and return perception. Adeveloped government securities market providesflexibility to the manager of public debt to optimisematurity and cost of even a lumpy governmentborrowing.

5.14 For the central bank, a developed governmentsecurities market allows greater application of indirector market-based instruments of monetary policy suchas open market (including repo) operations. A greaterrecourse to the market by the Government for meetingits funding requirements expands the eligible set ofcollaterals, thereby enabling the central bank to

conduct monetary policy through indirect instruments.The expanding quantum of eligible collaterals hasimpar ted f lexibi l i ty to central banks of manydeveloping economies in their conduct of monetarypolicy, especially in sterilising the capital flows. As apart of reforms, even if the central bank’s participationin the primary market of government securities isphased out, the stock of government securities in thefinancial system would continue to enable the centralbank to re-balance its portfolio through participationin the secondary market.

5.15 The government securities market, which isoften the predominant segment of the overall debtmarket in many economies, plays a crucial role inthe monetary policy transmission mechanism. Thus,irrespective of whether the central bank acts asmanager of public debt or not, there are three mainchannels through which government debt structuremight influence monetary conditions, viz., quantityof debt, composition of debt and ownership of debt(Box V.2).

Principles and Policy Strategy for a Liquid Market

5.16 In the aftermath of financial crises in the late1990s in many economies, a consensus emergedon the need to develop deep and liquid financialmarkets, especially government securities markets.Studies suggested that the size is a key determinantof liquidity of the government securities market(McCauley and Remolona, 2000). A critical issue inthis regard is trading liquidity, i.e., the ability of themarket to execute transactions at short notice, lowcost and with little impact on price (Lagana et al.,2006). The extent of liquidity in a market is usuallycaptured by any or all of the four indicators, viz., width(width of the bid-ask spread), depth (the ability to carryout large trading without significant changes in pricelevels), immediacy (the ability to carry out largetrading promptly without significant changes in pricelevels) and resilience (the ability of prices to quicklyreturn to normal) (Harris, 1990). The Bank forInternational Settlements (BIS) identif ied fourinterrelated general principles for designing deep andliquid markets (Box V.3).

5.17 A five-pronged policy strategy can be pursuedto promote liquidity in the government securitiesmarket (BIS, op.cit). First, there is a need to pursue acoherent public debt management strategy wherebydistribution of government securities across variousmaturities and frequency of their issuances aremodulated appropriately so as to facilitate sufficientsupply of instruments for enhancing market liquidity.

168


The absolute size of Government borrowings, especiallywhen the financial markets are underdeveloped, oftenraises concerns about public debt management as therecould be recourse to short-term financing from the centralbank leading to monetary expansion. However, as thepublic debt/GDP ratio declines and government securitiesmarket develops with introduction of new instruments (likeindex-linked gilts), new issuing techniques (such asauctions) and improved market infrastructure, practicalconcerns about debt management impinging on monetarycontrol get reduced. For instance, in the United Kingdom,a steady decline in the debt/GDP ratio and the emergenceof a new structure in capital markets, after reforms of theLondon securities market in 1986, alleviated many of theseconcerns.

The composition of debt in terms of maturity pattern mayalso influence the conduct of monetary policy. One viewis that monetary authorities may keep interest rates lowwhen there is large short-term debt so as to reduce therollover cost. A contrary view is that they may react moreaggressively to inflationary shocks when maturity structureof debt is short so as to minimise the future rollover costresulting from higher expected inflation and higher future

Box V.2Government Debt Structure and Monetary Conditions

nominal interest rates. The Government’s decision to issueshort versus long maturity debt, or conventional versusindex-linked debt may affect real yields, depending uponthe substitutability of the instruments, thereby affectingthe interest sensitive sectors of the economy.

The central policy concern about the ownership of publicdebt is related to the composition in terms of holding bybanks and non-banks. Several empirical studies, using datamainly from the United States, found that increased debtissuances could lead to increase in bank holdings of debt.New issues of debt taken up by banks act as a substitutefor lending to the private sector and, therefore, reduce thesupply of bank credit to it. During monetary tightening,however, banks would extend loans to the private sectorby running down their holdings of government debt. Thus,banks’ holding of public debt acts as a buffer. Theexperience in the United Kingdom was, however, contraryas the available evidence found that debt sales to bankshad only a small impact on either money supply growth orbank lending.

Source:

Bank of England. 1999. “Government Debt Structure andMonetary Conditions.” Quarterly Bulletin, November.

This can be ensured through large size of issuances,which, by creating of a homogeneous stock with acommon matur ity date, enhances l iquidity.Alternatively, even where the government’s borrowingrequirement is fixed, a debt manager can still enlargethe size of issuances of specific securities asdemanded by investors at ‘key maturities’ across theyield curve by reducing the number of originalmaturities and/or reducing the frequency of issuances.A standard practice to enlarge the issue size, however,is to conduct regular reissuances of identicalsecurities in several consecutive auctions instead ofa single auction. Buyback of illiquid or older securitiesmay also enable large sized issuances.

5.18 Second, as taxes increase the transactioncosts and hinder market liquidity, there is a need toweigh the potential increase in tax revenue againstthe potential decline in market liquidity. The liquidityimpairing effect of transaction tax, however, couldbe mit igated by exempting the act ive marketparticipants.

5.19 Third, there is a need to enhance transparencyof issuers, issue schedule and market information.Greater transparency by Governments in furnishingof information plays an important role in improvingliquidity of government securities. Adherence to a

regular issuance cycle and pre-announcement of issueschedule provide an opportunity to investors to plantheir por tfolio management. In this regard, theexistence of ‘when issued’ trading in governmentsecurities enables better market acceptability ofissuances with availabil i ty of t ime betweenannouncement and actual auction dates. A greaterdegree of transparency observed by marketpar ticipants also improves market l iquidity.Dissemination of market information on a real timebasis, without disclosing identity of marketparticipants, narrows bid-ask spreads and improvesmarket liquidity.

5.20 Fourth, standardisation, robust trading rulesand safe infrastructure reduce transaction costs.Safety in trading and settlement is a pre-requisitefor better liquidity. It is desirable to shorten settlementlags to T+3 or still shorter and adopt delivery-versus-payment (DvP) pract ices in the governmentsecurities market. Standardisation of trading andsettlement practices effectively enlarges supply ofsecur it ies by removing fragmentation. I t alsoencourages foreign participation. The permission todealers to carry short sales also improves marketliquidity as they can respond to customers’ buyorders quickly.

169


A few general inter-related principles emerge from theexperience of the mature markets that can guide thecreation of deep and liquid government securities marketsin countries after due adjustment to suit particular marketsituations (BIS, 1999). First, there is a need to maintain acompetitive market structure in the government securitiesmarket to facilitate efficient price discovery. A governmentsecurity, like any financial instrument, can be tradedthrough a wide variety of mechanisms like over-the-counter(OTC) markets, organised exchanges and other platformswhich cannot be placed in either of these categories. Afundamental strategy is to infuse competition amongdealers which would narrow bid-ask spreads and increaseliquidity of the market. In the case of exchanges, even whentheir number is limited, dynamic competition between theleading exchange and other exchanges, and between theOTC market and organised exchanges contribute to marketliquidity. Thus, it is necessary to maintain a ‘contestablemarket’ where the dominant market participants can bechallenged by new entrants if monopolistic or oligopolisticpractices develop.

Second, the government securities market needs to havea low level of fragmentation offering instruments whichhave high degree of substitutability. Market liquidity tendsto be enhanced when instruments can be substituted onefor another since the market for each of them becomesless fragmented. A high degree of substitutability enhancestrading supply of securities which facilitates in meeting thetransaction demand. However, there is also a need to havesome degree of heterogeneity in instruments for cateringto specif ic investor needs. The trade-off betweenhomogeneous product of large volume and someheterogeneity can be resolved by having a system ofissuing government bonds at several ‘key maturities’ fromthe short end to the long end of the yield curve.

Box V.3Principles of a Deep and Liquid Government Securities Market

Third, liquidity of the government securities market can beimproved by lowering transaction costs, which include taxes,cost of sustaining necessary infrastructure and compensationfor liquidity provision services. Higher transaction costs widenthe gap between the effective price received by sellers of theinstrument and that paid by buyers, thereby making it difficultto match sell and buy orders. This leads to low market liquidity.Some transaction costs, however, are inevitable such as thoseassociated with ensuring sound payment and settlementinfrastructure and improving overall robustness of the market.Thus, transaction costs need to be minimised as long as thisdoes not reduce the security of the market in question.

Fourth, there is a need to ensure a sound, robust andsafe market infrastructure comprising (i) payment andsettlement systems; (ii) the regulatory and supervisoryframework; and (iii) market monitoring and surveillance.This increases the resilience of the government securitiesmarket against external shocks and contr ibutes tocontinuous price discovery, thereby enhancing marketliquidity.

Finally, there is a need to promote heterogeneity of marketpar ticipation in terms of transaction needs, r iskassessments and investment horizons to promote liquidityin the government securities market. Furthermore, apartfrom varied domestic investor base, there is also a needto permit foreign participants. Non-residents may have riskappetite different from that of residents, which wouldprompt them to react differently to new information.However, liberalisation to encourage foreign participationhas to be calibrated appropriately after paying dueattention to sequential development of domestic markets.

Source:

BIS. 1999. “How Should We Design Deep and Liquid Markets?The Case for Government Securities.” Basel, October.

5.21 Finally, the development of related marketssuch as repo, futures and options also improves marketliquidity of the government securities market byenabling participants to undertake hedging, arbitrageoperations and speculative transactions. Repotransactions enable market participants to finance longpositions and cover short positions. A well structuredfutures market reduces hedging costs and, thus, makesit easier to undertake cash transactions. An optionsmarket provides flexibility for hedging and arbitrage.

5.22 Central banks also impact liquidity of thegovernment securities market through the variousroles they perform. First, information on the policydecisions, release of data on various economicindicators and notification of open market operations

(OMO) by central banks get incorporated into marketprices. Second, as major market participants, centralbanks’ conduct of OMO using government securitiesaffects supply of securities in the financial system.Third, central banks influence market liquidity byproviding clear ing and settlement services ofgovernment securities.

II. INTERNATIONAL EXPERIENCE

5.23 The government secur it ies market hasgenerally increased in size across countries intandem with the growing financing requirements ofGovernments over the years. Notwithstanding theonset of fiscal consolidation processes and theconsequent shrinking supply of issuances in the

170


primary market in some countries in recent years,public debt managers have honed the developmentof the government securities market through variousmeasures. Several Governments now raise fundsthrough market-based mechanisms in a transparentand predictable fashion. They have also strived tobroaden the investor base for the issuances ofgovernment securities. The Governments and centralbanks have adopted a strategy of jointly working withmarket participants to promote the development ofthe secondary market for government securities asalso to establish sound clearing and settlementsystems to handle transactions in governmentsecurities. While an abiding objective of public debtmanagement in various countries has continued tobe minimising the cost of government borrowings, astriking feature in the last two decades has been topursue this objective with a focus particularly onmanaging risks inherent in the debt portfolio (IMF-World Bank, 2002).

Size and Liquidity of Government Securities Market

5.24 Historically, government securities marketsgrew with the need to finance government budgetdeficits. Since the 1970s, government securitiesmarkets in the United States (US) and in many otherindustrial countries underwent significant expansionin terms of size. Large fiscal deficits resulted inincreased issuances of treasury bills and bonds. TheUS government securities market was, historically, thelargest. However, as a result of fiscal consolidation inthe 1990s, the government bond market shranksharply in the US. On the other hand, the size of theJapanese Government Bonds (JGBs) marketexpanded substantially to about 150 per cent of GDPby 2005. In many other countries, including India, thesize of the government securities market increasedbetween 2000 and 2005 (Chart V.1).

5.25 Although the size continues to be a keydeterminant of liquidity of the government securitiesmarket, managers of public debt have pursued astrategy of keeping ‘trading liquidity’ sufficient evenin countries where the size of issuances has shrunkin the primary market. Most studies analysing liquidityin the government securities market consider twomeasures of liquidity, viz., bid-offer or bid-ask spreadand trading volume. Lower the bid-ask spread, loweris the transaction cost and hence, higher is the liquidity

in the market. The bid-ask spread in the governmentsecurities market was one of the lowest in Japan,South Korea and Malaysia. In terms of the turnoverratio, the US treasuries market was the most liquidmarket in 2005, despite a fall in its size. Thegovernment securities market in the Peoples’ Republicof China (PRC) turned out to be one of the least liquidmarkets in terms of both the turnover ratio and thebid-ask spread (Table 5.1).

Management of Public Debt and Role of theCentral Bank

5.26 The degree of involvement of central banksin the government bond market varies significantlyacross countries. At one end are countries such asJapan, the US, Australia, the UK (since 1998) andRepublic of Korea, where the finance ministry solelydecides the fiscal policy, government debt relatedissues and the course of operation of the governmentbond market. The Governments in these countries,however, co-ordinate with central banks, which maybe independently pursuing monetary policy andselling/buying securities in the secondary market.2

At the other end are countries in which central banks,being statutory bodies under the jurisdiction ofMinistry of Finance, operate in the government bondmarket at the behest of their Governments. Forinstance, in Malaysia, the central bank is one of the

2 There are central banks which issue their own bonds, adding to the conflict between the monetary and fiscal policy operations and underliningthe need for further coordination between the Ministry of Finance and the central bank. These instruments can also fragment the governmentbond market (Mohanty, 2001).

Jap

an US

Ital

y

Fran

ce

Ger

man

y

UK

Ch

ina

Sou

th K

orea

Mal

aysi

a

Mex

ico

Chart V.1: Size of Government Securities Market-Select Countries

Ou

tsta

nd

ing

Am

oun

t (P

er c

ent

of G

DP

)

171


Table 5.1: Indicators of Liquidity in Domestic Currency Government Bond Markets –Select Countries - 2006

Country Generic term for government securities Turnover Rank based Bid-ask spread Rank based onratio on turnover ratio bid-ask spread

1 2 3 4 5 6

Canada – 4.0 *** 7 5.00 * 7Japan Japanese Government Bonds 6.0 6 0.58 1US US treasuries (Notes and Bonds) 40.0 *** 1 3.10 * 5Italy BTP 10.8 ** 3 6.00 * 8France OAT 38.5 ** 2 10.00 * 10Germany Bunds 10.1 ** 4 4.00 * 6Australia Commonwealth Government securities (CGS) 9.0 *** 5 – –UK Gilts 9.0 *** 5 4.00 * 6PRC Treasury bonds 1.4 12 7.60 9Korea Korea Treasury Bonds (KTB) 2.6 8 1.30 2Malaysia Malaysian Government securities (MGS) 1.9 10 2.25 3Thailand – 1.7 11 3.00 4Mexico CETES 2.5 9 – –

**, * and *** indicate data for 1997, 2002 and 2005, respectively.– : Not available.Source: Ric Battelino (2004), Tomita (2002), Hattori et al (2001), <www.adb.org>.; <www.asianbondsonline.adb.org>; and McCauley and

Remolona (2000).

five statutory bodies under the Ministry of Finance.As a banker to the Government, it advises on thedetails of government securities issuances andfacilitates such issuances through various marketinfrastructures that it owns and operates. Centralbanks in some countries assume twin responsibilitiesof conducting independent monetary policy andmanaging public debt. For instance, in Thailand, thecentral bank is responsible for monetary policy anddeveloping the bond market for private and publicsaving and debt management. Hence, the monetarypolicy stance of the Bank of Thailand is set keepingin view certain objectives relating to fiscal deficit andfuture financing needs of the Government. Theexperiences of these countries indicate that thedegree of independence of the central bank may bea necessary but not a sufficient condition for thedevelopment of the government bond market.

5.27 The underlying objective of public debtmanagement in various countries, regardless ofwhether the manager is the central bank or agovernment agency, continues to be minimisation ofthe cost of government borrowings. There has,however, been an increasing focus on managementof r isks in recent years. In par ticular, the debtmanagement framework focuses on the need toundertake government borrowings at the lowestpossible cost over a medium to long-term timeframerather than taking recourse to risky debt structures,which may have lower costs in the short run but could

be risky and trigger high debt servicing costs in thelong run. At the same time, the Governments in somecountries, which find the cost of issuing long-termsecurities at fixed rate very high, are opting for short-term securities while pursuing a strategy of developingthe domestic debt market so as to reduce rollover riskand other market risks in the debt stock over time(IMF-World Bank, 2002).

Primary Market

Issuance Procedures

5.28 The issuance of government securities incountries, which are in the early stages of marketdevelopment, is normally undertaken by way ofdiscret ionary non-market placement such asunderwriting by a syndicate of financial institutions.This route becomes preferable as free competitionis impeded when there are fewer participants. InKorea, prior to the Asian crisis, a part of the bondissue was underwr i t ten by some f inancia linstitutions and the Bank of Korea. The Bank ofKorea, however, stopped underwriting governmentbonds from June 1998. The People’s Republic ofChina had adopted an underwr iting syndicatesystem in 1991, which was abandoned in 1995 tomake way for auctions. In Malaysia, governmentbonds are issued through auctions but they are alsooccasionally privately placed with specific financialinstitutions.

172


5.29 In cases where the government is uncertainabout the full subscription to the issue and the priceit would fetch, it may also ask the central bank of thecountry to underwrite a part of the fresh issue. InMalaysia, the central bank can par t icipate ingovernment bond auctions and can take up to 10 percent of the total issue amount in order to obtainsecur it ies for market operations such as therepurchase agreements.

5.30 In order to improve the government securitiesmarket and to widen the investor base, it becomesessential for a country to move over time towards themarket mechanism by way of competitive publicauctions. Auctions are also used by some countriesin combination with tap sales of securities. TheGovernments in most countries use pre-announcedauctions to issue debt. The conventional auctions ofgovernment securities follow multiple-price auctionsystem for issuances of conventional securities anduniform price auction system for securities withspecial features such as inflation-indexed bondswhere there is market uncertainty (Box V.4). The US,however, has switched over to uniform price auctionformat so as to broaden its investor base as bidderstended to be more aggressive in this format due to areduction in the ‘winner’s curse’. In 2000, the KoreanGovernment moved to a uniform price auction formatfrom multiple price auction system. Chinese treasurybonds are auctioned using the uniform price auctionmethod. On the other hand, Thailand and Malaysia usemultiple price auction for issuing government bonds.

5.31 Most Governments rely on underwritingsyndicates for borrowings in foreign markets in orderto help them price and place securities with foreigninvestors. This is because borrowings are usually notundertaken in sufficient volume or on a regular enoughbasis to warrant the use of an auction technique. Forinstance, smaller countries of the European MonetaryUnion (EMU) such as Portugal use syndications tolaunch first tranche of each new bond so as to havemore control over the issue price and diversify investorbase to facilitate future issuances of governmentsecurities by the auction system.

5.32 There are also some countries such asSweden and the UK, which raise foreign currencyfunds by issuing first domestic currency debt and thenswapping it with foreign currency obligations. Thistechnique has the added benefit of maintaining largeissuances in the domestic markets even whendomestic borrowing requirements are moderate.Large industrial countries such as the US and Japanissue only local currency denominated securities in

their domestic markets and avoid raising fundsoffshore.

Transparency and Efficiency

5.33 Governments in most countries have becomemore transparent in their auction processes in thedomestic market to reduce market uncertainty in theprimary market and lower borrowing costs. Pre-announced borrowing plans and auction schedulesenable the prospective investors to plan in advancetheir subscriptions to new issuances of governmentsecurities by adjusting their portfolios. The rules andregulations governing the primary auctions and theroles and responsibilities of primary dealers aredisclosed well in advance to market participants. InBrazil and Poland, the Ministry of Financedisseminates the basic rules for issuances ofgovernment securities to market participants while thedetails of specific issuances are described in Lettersof Issue placed on the website. While the Governmentin Poland announces the auction dates at thebeginning of the year, in Brazil the dates areannounced a month in advance.

5.34 The auction processes are also becomingmore efficient through automation. The Governmentsin Ireland, Portugal and Jamaica are already usingelectronic auction system for issuance of securities,which has considerably reduced the time lag betweenthe close of bidding and announcement of results.

Investor Base

5.35 Many countries such as Morocco and SouthAfr ica have moved progressively away fromregulations that mandated investors to hold aprescribed portion of their assets in governmentsecurities. While the removal of such captive investorbase may have increased interest rates to market-clearing levels in the short run, the ensuing deep andliquid government securities market in the medium tolong-term is expected to reduce the debt service costsfor the governments in future (IMF-World Bank, 2002).

5.36 Most countries have adopted a system ofprimary dealers (PDs) for ensuring that auctions arewell-bid. PDs also act as a regular source of liquidityin the secondary market and provide usefulinformation for managers of public debt on marketdevelopments and debt management issues. Somegovernments have felt the need to offer specialprivileges to PDs for promoting market development,especially at an early stage of development. As PDscontinuously give two-way price quotes, they provide

173


Pricing in an auction can be on a multiple price basis (alsocalled American auction or discriminatory price auction)or a uniform price basis (also called Dutch auction). Inany auction, buyers typically submit bids that specify aquantity and a price (or a yield) at which they wish topurchase the quantity demanded. Once submitted, thesebids are ranked from the highest to the lowest price (orfrom the lowest to the highest yield) and the quantity forsale is awarded to the best bids (i.e., highest prices orlowest yields).

Under the uniform price auction, each successful bidderpays the lowest price accepted by the debt manager, i.e.,all the successful bidders will pay the same price,irrespective of their actual bid price. Under the multipleprice auction, however, each successful bidder will paythe actual price at which he has bid (even if the cut-offprice arrived at the auction may be lower). This results in‘winner’s curse’, whereby successful bidders pay more thanthe common market value of the security after auctions.

Uniform price auctions lead to a better distribution ofauction awards. Under this system, the participants tendto bid more aggressively without fear of ‘winner’s curse’.This is because they will get the securities issued at theprice quoted by the lowest accepted bid and not the actualthat they have bid, unlike in the case of multiple priceauctions. Hence, uniform price auctions are expected toenhance market efficiency. An important disadvantage ofthe uniform price system, however, is that of indiscriminateor irresponsible bidding which may be out of alignmentwith the market, as bidders are sure to succeed at themost favourable rate.

Under multiple or discriminatory price auctions, biddersget differential rates in accordance with their need andassessment of price. This is likely to ensure greatercommitment to bidding than in the uniform system. Theintensity of demand in the market is also clearly reflectedin the bidding pattern.

An alternative to these two mechanisms that has beenused in Spain since January 1987 is the so-called ‘Spanishauction’. It is a hybrid system combining the features ofboth the uniform-pricing and the discriminatory-pricingmechanisms. Under the Spanish auction system, winning

Box V.4 Auction Pricing – Uniform versus Multiple

bids that are above the weighted average winning bid willhave to pay the same price, viz., the weighted averagewinning bid, as in a uniform-price auction. Winning bidsthat are below the weighted average winning bid will haveto pay fully, as in a discriminatory-price auction.

By modelling auction behaviour, some researchers foundthat uniform price auctions are unfavourable to the issuerin terms of revenues, whether bidders are risk neutral orrisk averse (Wilson, 1979). Some other researchers,however, found that discriminatory auctions yield uniqueequilibrium with greater expected revenues than theuniform auctions if bidders are risk neutral (Back andZender, 1993 and Wang and Zender, 2002). Wang andZender also found that uniform price auctions have a morefavourable impact on revenue if the bidders are risk averseand the number of bidders are large in relation to thesupply. Uniform price auctions are, however, found topermit self-enforcing collusive bidding strategies (Back andZender, 1993), particularly under perfect information ifbuyers are allowed to communicate with one anotherbefore the auctions take place (Goswami, Noe and Rebello,1996). Besides average revenue to the issuer, the choiceof auction procedure may also affect the volatility of pricesover time. Auction-to-auction volatility was found toincrease significantly after the introduction of uniformpricing for select securities by the U.S. Treasury (Malvey,Archibald and Flynn, 1997). In the case of multiple priceauctions, experiences indicate that volatility increases withthe duration of assets (Sweden) and market uncertainty(Portugal) (Nyorborg, Rydqvist and Sundaresan, 2002 andGordy, 1999). Exper iments conducted on Spanishauctions show that both uniform and Spanish auctionsraise significantly higher revenue than multiple pricebased auctions as the latter leads to less aggressivebidding than the other two. However, auction-to-auctionvolatility was higher both in uniform price and Spanishauctions compared to multiple price auctions (Abbink,Brandts and Pezanis-Christou, 2002). Thus, empiricalevidence about the superiority of one type of auction overthe other seems inconclusive. Cross-country experienceshows that although both the methods are used,securities are mostly auctioned using discriminatoryauction method.

confidence to those who wish to buy or sell securities.Apart from the provision of liquidity to the market, thecompetition among PDs has facilitated efficient pricediscovery in the government bond market.

5.37 In the US, PDs (though not designated asmarket makers), in existence from 1966, serve as asource of market intelligence to the Federal Reserve.

They work with the Federal Reserve to develop ahealthier treasury market. In the UK, a system of PDsor Gilt-Edged Market Makers (GEMM) has been inexistence since 1986. These act as market makers,par t icipate in gi l t auctions held by the DebtManagement Office (DMO), give two-way quotesfacilitating the secondary market activity in gilts andprovide market information to the DMO. Similarly, in

174


Malaysia and the Republic of Korea, the system ofPDs as market makers was introduced in 1988 and1999, respectively. In the Peoples’ Republic of China,there are two segments of the secondary market forgovernment bonds, viz., the inter-bank market andthe stock exchange market. A market making systemin the inter-bank market has been established since2004. Certain commercial banks and securities firmshave been assigned the task of providing two-wayquotes for government bonds.

5.38 Some industrial countries such as Denmark,Japan and New Zealand do not have a system of PDs.The IMF-World Bank survey reported that the abolitionof the PD system had significantly reduced theGovernment’s borrowing costs in one particularcountry. In the case of some developing countries withsmall government securities market and a fewparticipants, the preference is to let the marketparticipants decide their own market makers. Even inlarge industrial countries, such as the US, the auctionsystem is not restricted to PDs alone. Other marketparticipants are allowed access as well, provided theyhave a payment system in place to facilitate settlementof auction obligations. Thus, each country needs toweigh the benefits of the PD system against the costs.The trade-off between the two is likely to depend onthe state of market development.

5.39 In addition to banks, institutional investorssuch as employees’ provident funds and pensionfunds have also become important participants in thegovernment bond market in several countr ies.Government bonds in Malaysia were, in fact,developed to cater to the investment needs of suchinstitutions. In Australia, contractual institutions andeven banks were given heavy tax incentives forinvesting in government bonds in the early phase ofdevelopment. Institutional investors have normally along-term horizon and hence, they can be a majorsource of investment in government (particularlyinfrastructure related) bonds. However, as a result oftheir long-term investment horizon, most of theseinstitutions are ‘buy and hold’ investors, which canimpede liquidity in the market.

5.40 Captive market arrangements that areadopted in some countries include mandating certaininstitutional investors, such as banks or contractualsaving institutions, to hold a certain percentage oftheir assets in government bonds. Such arrangementsalso prevent investors from trading in governmentsecurities. Most developed countries, in the courseof their market development, have discontinued anyform of mandated investment in government bonds.

In OECD countries investments in government bondsare no longer mandated. However, in some developingcountries, captive market arrangements continue toexist. For instance, in the People’s Republic of China,investment funds are subject to a mandatory 20 percent investment in government bonds.

5.41 Retail investors do not make a significantcontribution to trading activity in the market but aslong-term investors, they impart stability to the market.Thus, many countries have drawn retail investors tobroaden the market. For instance, the JapaneseGovernment launched special Japanese GovernmentBond (JGB) issues in 2003 and 2006 exclusively forretail investors (floating and fixed rate) with tenor, rateand other features suiting their requirements. Thisinstrument is available with banks and post offices.Brazil also began issuing securities to small investorsover the Internet in January 2002.

5.42 Countries have also increasingly relaxedforeign par ticipation in auctions of governmentsecurities. Among the developing countries, foreignownership of government bonds is permitted in Malaysia,the Republic of Korea and Thailand. In the People’sRepublic of China, foreign investors (institutional orindividual), barring foreign institutional investorsholding the Qualified Foreign Institutional Investorslicense, are not allowed to invest in government bonds.

Instrument Development

5.43 The profile of government securities differsacross countries in terms of (i) maturity; (ii) ways offixing coupon and principal payment; (iii) methods ofcoupon and principal settlement; and (iv) investororientation. An analysis of evolution of variousinstruments in the government bond markets showsthat normally countries in the nascent stage ofdevelopment of government bond markets preferredto concentrate exclusively on simple and standardisedinstruments. Over the years, they moved towards amix of conventional and, more advanced and complexinstruments. The instrument development has becomeincreasingly more sensitive to various risks associatedwith trading in government bonds.

5.44 Most of the government securities markets indeveloped countries are characterised by instrumentswith tenors ranging from short to long-term. Forinstance, the US treasuries market primarily offerstwo types of conventional government bonds, viz.,treasury notes (maturing between two and 10 years)and bonds (with maturity of 10 years or above) with asemi-annual coupon or interest payment. The 10-year

175


treasury note, the most traded US treasury security, istaken as an indicator of the government debt market inthe US. The 30-year bond was reintroduced by the USgovernment in 2006. In the UK, conventional governmentsecurities or gilts, with tenors of 5, 10 and 30 years,constitute the largest share of liabilities of the UKGovernment. It reintroduced the issue of its ‘ultra-long’50-year gilt in 2005. The Japanese Central Governmentissues JGBs with maturity ranging from 2 to 5-year(medium-term), 10-year (long-term), 15-year (floating),20-year and 30-year fixed bonds (super long-term).

5.45 Generally, medium and long-term bondsissued by various Governments carry a fixed couponrate. The rate of interest paid on such bonds is fixedat the time of issue. For instance, all medium, longand super-long JGBs, except the 15-year JGBs, arefixed interest rate instruments. The 15-year JGB is afloating rate instrument, the coupon rate of which isaligned to a reference rate plus a constant spreadand varies in line with the changes in the referencerate. Value of fixed interest securities falls when themarket rate of interest rises. The value of a floatinginterest bond, however, remains constant even in theface of a rise in the market rate of interest becauseits coupon payments also rise. This helps in mitigatinginterest or market risk. Given its less risky nature,the Governments initially issue securities with floatinginterest rates. As the market develops, however, theGovernments move towards fixed interest rate long-term securities. Floating rate instruments have,historically, been used by some of the developedcountries to lengthen the maturity of government debt(IMF-World Bank, 2001).

5.46 Inflation-indexed bonds have gainedprominence over floating rate instruments as a betterhedge against inflation. The UK introduced indexlinked gilts in 1981, followed by the issue of capitalindexed bonds by Australia in 1985.3 The UK alsoissued a 50-year ‘ultra-long’ inflation indexed gilt in2005. Canada, the US, France, and most recently,Japan have been some of the other countries fromthe developed world, which have started the issue ofinflation-indexed bonds. Japan issues an inflation-indexed JGB only with one term, i.e., 10 years. TheUS issues treasury inflation protected securities(TIPS) and Canada issues real return bonds. In index-linked bonds, either both coupon and principalpayment (as in the UK) or just the principal (as inJapan) are adjusted for changes in inflation. An

adjustment for inflation is particularly beneficial in thecase of long-term government bonds, as the risk ofvariation in price levels of such bonds is high. Mostcountries have been slowly moving towards theinternational best practice of a three-month indexationlag between the publication of the consumer price indexinformation and the actual indexation of the bond asagainst an eight-month lag earlier.

5.47 The rationale behind issuing inflation-indexedgovernment bonds by the developed countries is toenable the Governments to reduce borrowing costsby avoiding the need to compensate investors for theinflation uncertainty premium that exists in nominalbonds. Also, if the market for inflation-indexedsecurities is liquid and reasonably stable, then thespread between nominal and inflation-indexed yieldsof government debt can serve as a useful indicator ofexpected inflation for central banks in the conduct ofmonetary policy. Most countries, however, have foundit difficult to develop a liquid secondary market forinflation-indexed government securities, implying thatthe yields paid by the Governments may include apremium to compensate investors for liquidity. TheGovernments in some developing countries have alsointroduced inflation-indexed bonds. Unlike thedeveloped countries, however, the objective ofintroducing such bonds in the developing countriesis to extend the yield curve.

5.48 Under the system of separate trading ofregistered interest and pr incipal of secur it ies(STRIPS), the interest and principal can be tradedseparately as zero coupon bonds, which help inimproving liquidity and widening the investor base ofthe government securities market. Furthermore,STRIPS can also be reconstituted into a bond. Asmarket participants constantly check the price ofstripped bonds with the conventional bonds, stripbonds enable better pricing of traditional couponbonds. The US began stripping of designated treasurysecurities in 1985. The UK introduced stripping ofconventional fixed coupon in 1997, followed by Japanin 2003 for designated book entry securities. In theUS, STRIPS are not issued by the Government directly.They are registered as book entry securities by theGovernment but are created by financial sector entitiessuch as banks. In the UK, anyone can trade or holdSTRIPS but only a market maker (Gilt Edged MarketMaker), Debt Management Office (DMO) or Bank ofEngland can strip a strippable gilt or reconstitute it.

3 The Australian capital indexed bonds, however, have been discontinued since 2003.

176


5.49 Most Asian countries such as South Koreadid not rely significantly on government bonds priorto the Asian financial crisis. With deterioration of thefiscal position in the post-crisis period, the SouthKorean Government had to resort to heavy issue ofbonds in order to bring the economy back on the pathof recovery. This necessitated strengthening of thegovernment bond market infrastructure. Initially, theKorean Government simplif ied a number ofinstruments that were earlier traded by convertingthem all into treasury bonds.4 In the Korean treasurybonds market, bonds with medium-term maturity, viz.,three and five years have emerged as the benchmarkbonds. Furthermore, Korea has allowed stripping ofKorean Treasury Bonds (KTBs). In Thailand, theissuance of domestic government bonds dates backto 1933, though the market remained largelyunderdeveloped. After the Asian cr isis, whichhighlighted the importance of the bond market, theGovernment started issuing bonds in large quantumto recapitalise the ailing banking sector in theeconomy.5 Thai government securities are issued asfixed rate coupon bonds or interest accumulatedbonds and have a maturity profile of one to 10 years.However, there is little diversity in the range ofinstruments available in the government bond market.Consequently, the Bank of Thailand is now in theprocess of developing inflation indexed bonds andSTRIPS (zero coupon bonds). The MalaysianGovernment Securities (MGS) were, historically,issued to meet the investment needs of employees’provident fund. By the 1990s, the Government beganto use them as tools for financing part of its budgetdeficit. MGSs are coupon bearing instruments with amaturity period varying between three and 20 years.Coupon payments are made once in six months. Inthe People’s Republic of China, the need to developthe government bond market was ser iouslyrecognised when the overdrawing facility from thePeople’s Bank of China was discontinued in 1994.Treasury bonds in the People’s Republic of China,apart from treasury bills (with less than one yearmaturity), include fiscal bonds, special purchasebonds, construction bonds and inflation proof bonds(where principal is linked to the price index). Thesebonds are issued by the Chinese Government.Construction bonds are issued to raise funds forcertain projects, while special purchase bonds areissued to pension fund and unemployment insurance

funds for employees in the domestic enterprises. TheGovernment of the Republic of China (Taiwan) alsointroduced STRIPS with a maturity of five years in 2005.

Benchmarking and Consolidation

5.50 Several governments have progressivelystr ived to minimise the fragmentation of thegovernment debt stock by creating a limited numberof benchmark securities at key points of the yieldcurve. They generally use conventional governmentpaper devoid of embedded options for this purpose.Typically, benchmark securities are constructed byissuing the same secur ity in several auctions(‘reopenings’) and by repurchasing, prior to maturity,older issues that are no longer actively traded in themarket. In Brazil, Denmark, Ireland, New Zealand,South Africa, Sweden and the UK, where domesticborrowing requirements are modest or have generallydeclined over time as a result of fiscal surpluses, debtmanagers have repurchased securities which are nolonger actively traded in order to maximize the sizeof new debt issues. This has enabled them to minimisethe fragmentation of debt and concentrate marketliquidity in a small number of securities, therebyensuring active trading even though the total debtstock may be declining. Denmark, Sweden and theUK also offer market participants a facility to borrowtemporarily or obtain by repo, specific securities thatare in short supply in the market though at penal ratesso that the government securities market is notaffected by the pricing distortions in the market. SouthKorea also has a system of fungible or reopenedissues of KTBs, wherein on-the-run bonds issued overa certain period of time are given the same maturityand coupon rate. In the UK, the Debt ManagementOffice (DMO) has recently introduced the conventionalgilts with aligned coupon dates in order to facilitatefungibility between coupon STRIPS of various typesof gilts. The US also permits such fungibility of couponSTRIPS, irrespective of the underlying US treasurybond but not of principal STRIPS.

Consultation with Market Participants

5.51 Many countries have adopted a consultativeapproach for developing the government securitiesmarket by maintaining an active investor relationsprogramme. Under this programme, managers of

4 The Government converted various types of instruments, viz., Public Funds, Foreign Exchange Stabilisation Fund Bonds (FESFBs) and borrowingsfrom funds like Post Office Deposits to Treasury Bonds.

5 These bonds were issued through the Financial Institutions Development Fund (FIDF).

177


public debt meet the major market par ticipantsregularly to discuss the funding requirements of theGovernment, market developments and devise waysto develop the primary market. Such programmeshave proved useful, especially for countries managingtheir public debt under stress. For instance, public debtmanagers in South Africa operate an investor relationsprogramme and conduct road shows to meetinvestors, PDs and other market participants forexplaining developments in the South Afr icangovernment securities market and explain to themdevelopments in government finances.

Secondary Market

5.52 The secondary market for governmentsecurities provides a platform for original investors totrade their holdings before maturity. Traditionally, thetrading platform was over-the-counter (OTC) beforeintroduction of trading in stock exchanges in variouscountries. For instance, in China, trading in treasurybonds was banned till 1980. Subsequently, an OTCtrading was initiated. Trading at the Shanghai StockExchange commenced in 1992. Banks trade in theinter-bank market, which is largely a repo and ‘buyand hold’ market. Since 1997, banks in China havebeen prohibited from trading in stock exchanges toavoid speculation. In Thailand, the Thai Bond MarketAssociation began trading in government bonds in1998. The central bank of Malaysia operates thecentralised data base on Malaysian debt securities,i.e., Bond Information and Dissemination System(BIDS), which facilitates OTC trading of governmentbonds in Malaysia.

5.53 The public debt managers actively work withmarket par ticipants and others to improve thesecondary market for government securities througha system of intermediaries, a broad investor base andan efficient clearing system. For instance, Italy,Poland, Portugal, Sweden and the U.K. have workedclosely with the market to introduce electronic tradingin government securities. In Thailand, the BondElectronic Exchange (BEX), a subsidiary of a stockexchange, began trading in government bonds in2005. Furthermore, Italy has sought to work with theconcerned participants to alleviate distortions causedby the tax treatment of returns on governmentsecurities. The debt mangers in Japan, New Zealand,

South Africa and the U.K. have also jointly workedwith market participants to develop ancillary marketssuch as futures, repo and STRIPS. These have helpedin deepening the government securities market.

5.54 The managers of public debt also work withthe relevant stakeholders to devise sound clearingand settlement systems for government securitiesmarkets. For instance, Brazil, Japan and Polandintroduced real time gross settlement system (RTGS)for government securities transactions. The authoritiesin Jamaica are also working with market participantsto dematerialise government securities within thecentral depository in order to increase efficiency ofsecondary market trading.

Market practices

5.55 Market practices have also been liberalisedin many countries to improve liquidity in the secondarymarket of government securities.

Short Selling

5.56 Shor t selling is now permitted in manycountries. For instance in Australia, a seller is allowedto sell securities to a purchaser without having theright of transfer of the ownership.6 In the US, as partof the legal requirement, the seller needs to confirma broker the delivery of the shorted securities. In thePeople’s Republic of China, short selling of treasurybonds takes place in the Shanghai and Shenzhenstock exchanges through a repurchase agreement.Short selling is restricted to less than one year and isnot allowed at the traditional OTC exchange oftreasury bonds. In Malaysia, the right of short sellingMGS, but in a covered way, has been given to all inter-bank participants, which include commercial banks,finance companies, merchant banks and discounthouses registered under the Banking and FinancialInstitutions Act. However, there are restrictions on thetype of securities that can be sold short and the extentto which the seller can take a short position.

‘When issued’ Trading of Government Securities

5.57 Trading of government securities between thetime a new issue is announced and the time it isactually issued is generally called ‘when issued’ (WI)

6 Short selling involves benefiting from the fall in price of a security. If the price of a security is declining, one can borrow a security in orderto sell it, expecting that it would decline further, and then buy it at a lower price and make delivery. The difference between the sale andpurchase price of the security is the profit. It involves four steps, viz., an investor borrowing a stock, selling that stock, then 'closing' hisposition by buying the stock and then returning it back to the lender. If the price falls, he makes a profit, otherwise a loss.

178


(or ‘when as and if issued’ in the US) trading. It workslike future trading of securities where long and shortpositions are allowed prior to the issue date of thesecurities. The trading of WI is on a yield basis ascoupon is determined only after the auction. WI tradingfacilitates price discovery and helps in improvingliquidity in the government bond market. Furthermore,it substantially brings down the risk of underwriting.The restrictions on WI trading were removed by theUS Treasury on treasury notes and bonds in the1970s. Japan, however, considered WI trading asillegal until recently. Following the guidelines laid downby the Japanese Securities Dealers Association(JSDA) regarding the exact definition and legalperspectives of the WI trading of JGBs, WI trading ofJGBs took shape in Japan in 2004. In Malaysia, thedate of announcement of a primary issue is done onFully Automated System for Issuing/Tendering (FAST)and the issue is opened for WI. The WI issues areautomatically processed through FAST. The date ofsettlement of WI trades is within two business daysafter the issue date.

Risk Management

5.58 Although government bonds are free fromcredit risk, they are subject to market or interest raterisk. In the case of foreign currency bonds, they alsocarry exchange rate risk. Market participants havetraditionally hedged market r isks by trading ingovernment bond futures. In futures trading,participants can hedge their positions, because theycan fix prices at which the trade would settle in future.Development of futures has been instrumental inraising the trading turnover of physical securities inseveral countries.

5.59 In Australia, development of government bondfutures was a part of the reform measures relating tothe bond markets adopted in the 1980s. The Australianfutures market has become the most active futuresmarket for trading in fixed interest government bonds,particularly of three-year and 10-year maturities.Trading in Japanese Government Bonds (JGBs)futures began with a 10-year security in 1985, whichhas become one of the largest traded futures in theworld. The Tokyo Stock Exchange introduced tradingin options of JGB futures in 1990. The Republic ofKorea introduced government bond futures in 1999.The two types of bond futures currently available inKorea are of 3-year and 5-year maturity. Similarly,Malaysia too has futures contracts on three-year, five-year and 10-year MGSs. The derivatives on treasurybonds in the People’s Republic of China, were earlier

introduced in 1993. However, their trading wasdiscontinued in 1995 due to excessive speculationand lack of knowledge about controlling the risksinvolved in such trading. In September 2005, theChinese Securities Regulatory Commission (CSRC)declared that it would work towards the introductionof futures and other derivative products in the Chinesesecurities market.

5.60 The Governments are becoming increasinglyaware of the need to manage financial and operationalrisks of their debt portfolio. The framework used totrade-off expected costs and risks in the debt portfoliodiffers across countries. Many countries use simplemodels based on deterministic scenarios, while onlya few (Brazil, Denmark, Columbia, New Zealand andSweden) use stochastic simulations. Several countriesalso use stress testing as a means to assess themarket risk in the debt portfolio and robustness ofdifferent issuance strategies. Many of them adoptcash flow modelling for analysing costs and risks forassociated debt issuance structures, whereby debt-service costs and their volatility in the medium to long-term are assessed. The rationale for this technique isthat the cost of debt is best considered in terms of itsimpact on the Government’s budget, and that cashflow measures are a natural way of quantifying thisimpact. Risk is typically measured as the potentialincrease in costs resulting from financial and othershocks.

5.61 Some countries have adopted the asset-liability management (ALM) approach in a limited wayby analysing the risk characteristics of governmentfinancial assets and debt jointly to determine theappropriate structure of debt and assets. The publicdebt management offices in many countries areaddressing management of operational risk by puttingin place a formal institutional framework. Middleoffices are involved in analysing risk and designingas well as implementing risk control procedures.These debt offices are also trading their debt or takingtactical risk positions.

Development of Payment and Settlement Systemfor Government Securities

5.62 Countries are striving for an efficient paymentand settlement system of government securitiestransactions so as to reduce the market risk, defaultrisk and systemic risk. The settlement system hasmigrated from the physical mode to the dematerialisedmode, wherein securities are recorded in electronicbook entry form. Several countries are now movingtowards electronic trading of government securities.

179


Countries have also introduced the DvP mechanismwhich ensures that delivery occurs if and only ifpayment occurs and vice versa. This settlementsystem has replaced designated-time net settlementsystem whereby only the net payment/receiptamounts were settled at a certain designated time bya RTGS system. These steps have virtually eliminatedthe settlement risk.

5.63 In many countr ies, which have adoptedelectronic transfers of government securities, centralbanks have been instrumental in providing a clearingand settlement platform for government securities.This is true even in those countries in which the centralbank does not operate as the debt manager to theGovernment. For instance, the Reserve Bank ofAustralia has adopted the Reserve Bank Informationand Transfer System (RITS) from the 1980s. DvP wasintroduced in the RITS in 1991. All operators in themarket are members of the RITS and they use thissystem for settling transactions in government bonds.RITS has also been linked to the RTGS. Japanintroduced DvP for JGBs in 1994 in its payment andsettlement system, Bank of Japan NET (BOJ NET). Itlinked the BOJ NET JGB service and BOJ NET fundtransfer system. Japan moved to RTGS in 2001. Thesecurities in the UK are held in demat form and aretransferred electronically on the basis of DvP throughthe settlement system operated by CREST, which isthe central securities depository for UK gilts and Irishsecurities. The Bank of Thailand, which acts as aregistrar and depository of Thai government bonds,restructured the Bank of Thailand Automated HighValue Transfer Network (BAHTNET), the electronicsettlement platform, to facilitate RTGS and DvP ingovernment bonds in 2001. In the Peoples’ Republic ofChina, the Government Securities Trading System andPeople’s Bank of China’s large-value payment systemwere interconnected in 2004, making way for DvPsettlements in the inter-bank bond market.

5.64 The Joint Task Force of the Committee ofPayment and Settlement System (CPSS) and theTechnical Committee of the International Organizationof Securities Commissions (IOSCO) in its reportreleased in 2001 recommended that countries adopta rolling settlement, wherein the final settlement wasnot to exceed T+3 days.7 The repor t urged thecountries to ultimately strive towards the same daysettlement. Among the developed countries, thesettlement cycle for outright sales is T+1 in the USand the UK and T+3 in Japan.

5.65 To sum up, international experience of variousaspects of government securities markets showssome differences across the countries in terms ofstructure, instruments, trading and settlement practices,and risk management system. Nevertheless, somecommon lessons could be drawn. One, the developmentof the government securities market across the yieldcurve may entail some short-term costs as thegovernments move away from a purely captive marketto a diversified investor base in the medium to long-term.Two, debt issuance needs to be done in a predictablemanner using standardised instruments so that theissuer’s behaviour doesn’t disrupt market activity. Three,a demonstrated commitment to develop the governmentsecurities market enhances the liquidity and reduces thecosts of government borrowings.

5.66 A select cross-country review showed a mixedpicture. In several countries, the function of issue andmanagement of public debt no longer rests withcentral banks. This is more so in countries that havedeveloped debt markets and where government debtissuance is not dominant. In many other countries,central banks continue to be debt managers for thegovernment. However, in almost all countries centralbanks do play a vital role in developing theinfrastructure for trading and sett lement ofgovernment securities in the secondary market. Theyare regulators of PDs, who act as market markers forgovernment securities. Furthermore, central bankshave been instrumental in developing payment andsettlement systems for government securities, whichhave contributed significantly towards an efficient andsecure trading in government securities.

III. GOVERNMENT SECURITIES MARKET ININDIA – POLICY DEVELOPMENTS

5.67 The development of the governmentsecurities market in India in the pre-reform period wasmainly constrained, like in most developing countries,by almost unlimited automatic monetisation of theCentral Government budget deficits, captive investors(predominantly banks and insurance companies) andadministered coupon rates on government securitiesat artificially low levels. As a result, the secondarymarket for government securities was almost non-existent. This impinged on the price discoveryprocess, which is crucial for the development of anymarket. Since interest rates were kept low in order toensure low cost of Government borrowing, real ratesof return remained negative for several years.

7 T represents the trade date and 3 indicates three business days following the trade date.

180


Artificially low yields on government securitiesaffected the interest rate structure in the system. Inorder to compensate for low yield on governmentsecurities, banks charged higher interest rates to thecommercial sector.

5.68 Higher interest rates for the pr ivatecommercial sector not only adversely impactedinvestment activity and economic growth, but alsoaffected the financial health of the banking systemas bad debts mounted over time. Low economicgrowth resulted in lower revenues for the Government,both tax and non-tax, necessitating higher borrowing.This was largely met through the mechanism of adhoc Treasury Bills issued by the Government to theReserve Bank and the progressive increase in SLR,as a result of which the government securities marketremained dormant. Driven by the compulsions ofautomatic monetisation, which resulted in expansionof monetary base, the Reserve Bank had toprogressively raise the cash reserve ratio (CRR) ofbanks for monetary management. In the face of largegovernment borrowings and the need to restore the

health of the financial system, the Reserve Bank, inconsultation with the Government, initiated reformsin the government securities market as a part offinancial sector reforms in the early 1990s. Thesereforms were broadly aimed at removing theimperfections in the market and creating enablingconditions for its development.

5.69 The Reserve Bank, as a monetary authority,has a special interest in developing the governmentsecurities market given its criticality in acting as thetransmission channel of monetary policy. Moreover, itis important for the Reserve Bank, as a manager ofpublic debt, to have a well-developed governmentsecurities market as it provides flexibility to exercisevarious options for optimising maturity as well asinterest cost to the Government. It also helps inminimising the market impact of large or lumpygovernment debt operations and ensuring bettercoordination between monetary policy and debtmanagement policy. A comprehensive legal frameworkexists, which defines the role of the Reserve Bank inthe government securities market (Box V.5).

Reserve Bank’s operations in the government securitiesmarket are governed by Sections 20, 21 and 21A of theReserve Bank of India Act, 1934. Under these provisions,the Reserve Bank is entrusted with the function ofmanagement of public debt and issue of new loans of theUnion Government and the State Governments. The legalframework for Reserve Bank’s conduct of open marketoperations is provided under Section 17(8) of the ReserveBank of India Act, 1934, under which the Reserve Bank isauthorised to purchase and sell securities of the UnionGovernment or a State Government of any maturity andthe security of a local authority specified by the CentralGovernment on the recommendations of the Central Boardof the Reserve Bank. Central Government securities areused by the Reserve Bank for its open market operationsand liquidity adjustment facility (LAF). Effective April 3,2007, the State Development Loans were also permittedas eligible securities for LAF operations. The new ChapterIII-D of the Reserve Bank of India (Amendment) Act, 2006has empowered the Reserve Bank to determine policyrelating to interest rate products and regulate the agenciesdealing, inter alia, in securities.

The Reserve Bank derives its regulatory power over thegovernment securities market from Section 16 of theSecurities Contract (Regulation) Act (SCRA), 1956,amended in March 2000, under which the Government hasdelegated the powers exercisable by it to the Reserve Bank.The Reserve Bank is, thus, authorised to regulate dealingsin government securities, money market securities, gold

Box V.5Reserve Bank and the Government Securities Market – Legal Framework

related securities and securities derived from these securitiesas also ready forward contracts in debt securities.

The Government Securities Act, which seeks to replacethe Public Debt Act, 1944, was passed in August, 2006.This Act envisages the consolidation and amendment ofthe law relating to issue and management of governmentsecurities by the Reserve Bank. The Act includes theprovisions of the erstwhile Public Debt Act relating toissuance of new loans, payment of half-yearly interest,retirement of rupee loans and all matters pertaining to debtcertificates and registration of debt holdings. Besides, thenew Act gives flexibility for holding government securitiesin depositories, while at the same time specificallyexcluding government securities from the purview of theDepositories Act, 1996. The Act enables lien marking andpledging of securities for raising loans against governmentsecur it ies, recognises electronic form of recordmaintenance, enlarges dematerialisation facility throughBond Ledger Account and liberalises norms relating tonomination and legal representation. The Act also providesthe Reserve Bank with substantive powers to design andintroduce an instrument of transfer suited to the computerenvironment. It also allows the Reserve Bank to issueduplicate securities, new securities on conversion,consolidate with other like government securities, sub-divide the securities and renew, strip (separately forinterest and principal) or reconstitute the securities. TheAct, however, is yet to come into force, pending notificationof Rules under it.

181


5.70 Recognising the impor tance of thegovernment securities market, the Reserve Bank, inconsultation with the Government, undertook wideranging reforms to develop this market. The majorobjectives of reforms were to (i) grant operationalautonomy to the Reserve Bank; (ii) improve institutionalinfrastructure; (iii) impart liquidity and increase thedepth of the market; ( iv) improve marketmicrostructure; (v) create an enabling sound legal andregulatory framework; and (vi) increase transparency(Reddy, 2000). Keeping these objectives in view,reforms were undertaken to strengthen the primaryand the secondary segments of the governmentsecurities market. In the primary segment, measureswere taken to raise resources from the market in acost effective manner, particularly in the light of thetransition to market related interest rate structure fromthe administered interest rate regime. In thesecondary segment, measures were initiated toimprove liquidity in the market. Measures were alsoundertaken to improve the trading systems, clearingand sett lement infrastructure and the r iskmanagement framework.

Primary Market

5.71 In the primary market, a price discoverymechanism was activated by introducing an auctionsystem. Efforts were also made to broaden theinvestor base and promote voluntary subscriptions ingovernment securities. To provide a wider menu, newinstruments were introduced from time to time to suitthe investor requirements.

Issuance Procedures

5.72 In the initial phase of reforms, the focus wason migration from the administered interest rateregime to a market or iented pr ice discoverymechanism. Accordingly, a system of auctions wasintroduced in 1992 for Central Government securitieswhereby the amount is notified but the coupon rate isauction determined. Tap issuances, for which thecoupon rate was pre-determined but the amount wasnot notified, were also conducted from time to timeup to 2000.

5.73 Since the inception of the auction system,multiple price auction system has been used for datedsecurities. The uniform price auction format, followedfor the issuance of 91-day Treasury Bills fromNovember 1998, was extended to auctions of CentralGovernment dated securities on a selective basis from2001. While both methods of pricing are used, multipleprice auction is the most frequently used selling

technique for issuance of dated securities. Theuniform pricing technique is used when there is marketuncer tainty. I t is also used for issuing newinstruments, such as floating rate bonds and bondswith embedded options, as well as bonds with longtenor as in such cases the market does not have areference rate.

5.74 Auctions of government securities between1992-93 and 1998-99 were conducted solely on thebasis of yield (coupon). In order to consolidateoutstanding loans for ensuring sufficient volumes andliquidity in any one issue, price-based auctions wereintroduced in May 1999, whereby new loans are raisedthrough re-issuances of existing securities with pre-determined coupons. This helps the price discoveryof a security already in existence in the market. Yield-based auctions are, thus, employed in respect of newissuances, and price-based auctions in respect ofreissue of existing securities.

5.75 Apar t from allotment through auction, asystem of non-competitive bidding was introduced inJanuary 2002 to encourage retail investors who donot have sufficient expertise in such bidding. TheReserve Bank also participated on a non-competitivebasis in the government securities auctions up to April1, 2006 to primarily take up some part of the issuesin the case they were not fully subscribed.

5.76 Unlike Central Government’s marketborrowings, a predominant share of StateGovernments’ market borrowings was conducted byway of tap issues up to 2005-06. The traditional tranchemethod (under which government securities wereissued with a pre-determined coupon and notifiedamounts for each State) was employed between 1991-92 and 1997-98. Beginning 1998-99, a combination ofthe auction method and tap method has beenemployed. The State Governments could opt for auctionroute between 5 to 35 per cent of the allocated marketborrowings (subsequently raised to 50 per cent). Theumbrella tap tranche method was introduced during2001-02 to avoid the risk of under-subscription of anyissue of the State Governments. Under this method,after receiving the concurrence of the StateGovernments, the Reserve Bank announces the nameof the States participating in the tap, the aggregatetargeted amount to be raised and the coupon ratewhich is fixed uniformly for all the States. The targetedamount in respect of individual States is not separatelyannounced. Up to December 2002, the tap wasnormally kept open till the targeted amount wasreceived for each State. This resulted in keeping thetap open for more than two days in respect of a few

182


States. As this procedure subjected the States toreputational risk, which varied with the number of daystaken to close the tap, it was decided in January 2003to close the tap at the end of the second day even ifthe targeted amount is not mobilised. The names of theStates whose issues are not fully subscribed as well asthe amount of under-subscription are not disclosed.

Investor Base

5.77 The presence of a large and diverse investorbase with different perceptions and l iquidityrequirements reduces the borrowing cost for theGovernment, dampens market volatility by avoidingunidirectional movements and encouragescompetition in the market. Prior to introduction ofreforms, the investor base for government securitiesconsisted of institutions such as banks, financialinstitutions, provident funds, insurance companiesand pension funds, which are statutorily mandated to

invest in these securities. To meet the growingfinancing needs of the Government, the SLR for bankswas raised over a period of time to reach the peakrate of 38.5 per cent of NDTL in February 1992. Withthe onset of reforms in the early 1990s and distinctmove away from direct instruments of monetary policyto market-based indirect instruments, the SLR forbanks was progressively brought down to 25 per centby October 1997. Banks, on their own volition,however, continued to hold investments ingovernment securities and other approved securitiesin excess of the stipulated requirement. With the entryof co-operative banks, regional rural banks, mutualfunds, especially gilt funds, and non-banking financialcompanies, the investor base has widened over time(Box V.6).

5.78 Apart from mandatory investments, banksand other f inancial institutions may also holdgovernment securities as part of their trading portfolio.

Banks are the largest investors in government securities. Interms of the SLR provisions of the Banking Regulation Act,1949, banks are required to maintain a minimum of 25 percent of their net demand and time liabilities (NDTL) in liquidassets such as cash, gold and unencumbered governmentsecurities or other approved securities as Statutory LiquidityRatio (SLR). The minimum SLR stipulation for scheduledurban co-operative banks (UCBs) is the same as forscheduled commercial banks (SCBs) from April 1, 2003.However, for non-scheduled UCBs, the minimum SLRrequirement is 15 per cent for banks with NDTL of over Rs.25crore and 10 per cent for the remaining non-scheduled UCBs.The minimum SLR stipulation for regional rural banks (RRBs)is the same as for SCBs. From April 1, 2003, the coverageunder the SLR has also been made akin to SCBs. Alldeposits with sponsor banks, which were earlier consideredas part of the SLR, were to be converted into approvedsecurities on maturity in order to be reckoned for the SLRpurpose. Recently, the Banking Regulation Amendment Act,2007 has removed the floor limit of 25 per cent for SLR forscheduled banks.

The second largest category of investors in the governmentsecurities market is the insurance companies. According tothe stipulations of the Insurance Regulation andDevelopment Authority of India (IRDA), all companiescarrying out the business of life insurance should invest aminimum of 25 per cent of their controlled funds ingovernment securities. Similarly, companies carrying ongeneral insurance business are required to invest 30 percent of their total assets in government securities and otherguaranteed securities, of which not less than 20 per centshould be in Central Government securities. For pension

Box V.6Mandated Investments in Government Securities

and general annuity business, the IRDA stipulates that 20per cent of their assets should be invested in governmentsecurities.

The non-Government provident funds, superannuation fundsand gratuity funds are required by the Central Governmentfrom January 24, 2005 to invest 40 per cent of theirincremental accretions in Central and State governmentsecurities and/or units of gilt funds regulated by theSecurities and Exchange Board of India (SEBI) and any othernegotiable securities fully and unconditionally guaranteedby the Central/State Governments. The exposure of a trustto any individual gilt fund, however, should not exceed fiveper cent of its total portfolio at any point of time.

Non-banking financial companies (NBFCs) accepting publicdeposits are required to maintain 15 per cent of suchoutstanding deposits in liquid assets, of which not less than10 per cent should be maintained in approved securities,including government securities and government guaranteedbonds. Investment in government securities should be indemater ialised form, which can be maintained inConstituents’ Subsidiary General Ledger (CSGL) Accountof a SCB/Stock Holding Corporation of India Limited (SHCIL).In order to increase the security and liquidity of their deposits,residuary non-banking companies (RNBCs), are requiredto invest not less than 95 per cent of their aggregate liabilityto depositors (ALD) as outstanding on December 31, 2005and entire incremental deposits over this level in directedinvestments, which include government securities, rated andlisted securities and debt oriented mutual funds. From April1, 2007, the entire ALD is required to be invested in directedinvestments only.

183


Measures were taken to promote voluntary holdingof government securities among other investorcategories. For this purpose, specialised institutionswere developed. The Discount and Finance House ofIndia (DFHI), set up in April 1988, primarily fordeveloping the money market, was also allowed toparticipate in the government securities market. Inorder to develop an efficient institutional infrastructurefor an active secondary market in governmentsecurities and public sector bonds, the SecuritiesTrading Corporation of India (STCI) commenced itsoperations in June 1994. With the introduction of thePD system, both DFHI and STCI later transformedthemselves into PDs.

Primary Dealer System

5.79 A system of market intermediaries in theform of PDs was made functional in 1996 with theobjectives of suppor ting the market borrowingprogramme of the Government, strengthening thesecurities market infrastructure and improving thesecondary market liquidity in government securities.PDs were also expected to encourage voluntaryholding of government securities among investors.The PD system was essentially conceived forinstitutions whose basic interest is not to holdsecurities but to participate in primary auctions withthe intent to access the securities in the secondarymarket. PDs are responsible for ensuring the successof primary auctions. To discharge their obligationseffectively, PDs have been given privileges in termsof provision of current account and SGL facilities withthe Reserve Bank. They also have access to the liquidityadjustment facility (LAF) of the Reserve Bank.

5.80 Prior to April 2006, the success of PDs in theprimary auctions was ensured through a scheme ofunderwriting, and a system of bidding commitmentsand success ratios in the auctions. Underwritingcommitments were separately decided prior to theactual auction for primary issuance, with the PDsbidding to underwrite various amounts at variouscommission rates. The Reserve Bank decided theactual allotment of the underwriting commitment,taking into account various factors such as thelikelihood of devolvement and the commission sought.The full notified amount was rarely allotted inunderwriting auctions. Since underwriting was a purelyvoluntary responsibility, the success of primaryauctions was sought to be achieved through biddingrequirements, which were set at the beginning of thefiscal year for each PD, depending mainly on its capitalsize. In order to ensure against defensive bidding, the

stipulation of a success ratio of 40 per cent of biddingcommitments was mandated. The performance of PDsin respect of bidding commitments and success ratioswere monitored cumulatively over the year.

5.81 The PD system was revamped to ensure amore dynamic and active participation of PDs in viewof the provisions of the Fiscal Responsibility andBudget Management (FRBM) Act, 2003 whereby theReserve Bank was prohibited from participating in theprimary market effective April 1, 2006. In pursuanceof the recommendation of the Technical Group onCentral Government Securities Market, the ReserveBank permitted banks to undertake PD business andalso allowed banks having PD subsidiaries to mergethem departmentally, subject to certain conditions.The Reserve Bank also issued revised guidelines forPDs to ensure that there is no under-subscription inthe auctions. A new incentive structure in theunderwriting auctions has been put in place to ensure100 per cent underwriting and to elicit competitivebidding from PDs. The Reserve Bank has also revisedthe liquidity support facility to stand alone PDs basedon their performance in the primary auctions and theturnover in the secondary market (Box V.7). Standalone PDs have been permitted to diversify theiractivities in addition to their core business ofgovernment securities, subject to limits, so as toenable them to manage risk efficiently. There are 17PDs at present, of which 11 are stand alone PDs andsix are bank-PDs.

5.82 The presence of PDs in the governmentsecurities market has brought about an element ofdynamism, both in the primary and the secondarysegments. PDs have been actively participating in theauctions of government securities. By providingcontinuous two-way quotes, PDs act as marketmakers in the secondary market. The liquidity in thesecondary market, in turn, lends support to thesuccess of primary market operations. The PD systemalso facilitates open market operations of the ReserveBank, besides taking over the responsibility of marketmaking from the Reserve Bank.

5.83 A system of satellite dealers (SDs), as a secondtier of dealer system in trading and distribution, was putin place in December 1996 to broaden the market andto impart momentum to the secondary market activity.SDs, with their good distribution channels, were expectedto add depth to secondary market trading and widenthe investor base through their retail outlets. The SDsystem was, however, discontinued from May 31, 2002as it did not yield the desired results.

184


The Reserve Bank no longer participates in primary issuesof government securities from April 1, 2006, in accordancewith the provisions of FRBM Act, 2003. An InternalTechnical Group on Central Government Securities Market,which was constituted in December 2004 to examine theimplications of the Reserve Bank’s withdrawal from theprimary market on its debt management function and toaddress the emerging needs, submitted its report in July2005. In line with the recommendations of the Group andafter discussions with the market participants, a revisedscheme of underwr it ing commitment for PDs wasformulated in April 2006, which replaced the earlierrequirements of bidding commitment and voluntaryunderwriting by PDs.

As per the revised scheme, the underwriting commitmentis divided into two parts, viz; (i) minimum underwritingcommitment (MUC), and (ii) additional competitiveunderwriting (ACU). The MUC of each PD is computed toensure that at least 50 per cent of each issue is mandatorilycovered by the aggregate amount of MUC of PDs. TheMUC is uniform for all PDs, irrespective of their capital orbalance sheet size. Given that there are 17 PDs at present,each PD is required to underwrite about 3 per cent of thenotified amount of each auction as MUC. The remainingportion of the notified amount is open to competitiveunderwriting through underwriting auctions. Each PD isrequired to bid in the ACU for a minimum of 3.0 per centand not more than 30 per cent of the notified amount. Allsuccessful bidders in the ACU get commission as per theauction rules.

Besides the changes in underwriting for PDs, the permittedstructure of PD business has been expanded to includebanks, subject to certain minimum eligibility criteria. Bankswhich do not have a partly or wholly owned subsidiary,are eligible to apply for the PD license if they fulfil thefollowing criteria: (a) minimum net owned funds (NOF) ofRs.1,000 crore; (b) minimum CRAR of nine per cent; and(c) net NPAs of less than three per cent and a profit makingrecord for the last three years. Indian banks and foreign

Box V.7Revised Guidelines for Primary Dealers

banks in India which are undertaking PD business throughpartly/wholly owned subsidiaries and through groupcompanies, respectively, are also allowed to undertake PDbusiness departmentally by merging/taking over PDbusiness from their subsidiaries/group companies, subjectto fulfilling the above mentioned criteria. The bank-PDsare subject to all obligations applicable to stand alone PDsand as may be prescribed from time to time. Bank-PDsare required to maintain separate books of accounts fortransactions relating to PD business (distinct from thenormal banking business) with necessary audit trails. Theyare required to ensure that, at any point of time, there is aminimum balance of Rs.100 crore of government securitiesearmarked for PD business. Bank-PDs are also requiredto adhere to the following prudential norms:

• No separate capital adequacy is prescribed for PDbusiness, and the capital adequacy requirement for abank will also apply to its PD business.

• The government dated securities and Treasury Billsunder PD business are reckoned for the SLR purpose.

• The investment valuation guidelines as applicable tobanks with regard to ‘held for trading’ portfolio are alsoapplicable to the por tfolio of Government datedsecurities and Treasury Bills earmarked for PD business.

• The Reserve Bank’s instructions to PDs are alsoapplicable to bank-PDs, to the extent applicable.

Following the revised scheme of underwriting commitmentand the discontinuance of bidding commitment, themethodology for calculating limits for PDs under theReserve Bank’s Liquidity Support Scheme has also beenrevised. Of the total liquidity support, 50 per cent of theamount is divided equally among all the stand alone PDs.The remaining half is divided amongst the PDs, based ontheir performance in the primary and the secondarymarkets, giving due weightage to their turnover in TreasuryBills and dated government securities. The PD-wisequantum of liquidity support is revised every half-year(April-September and October-March) based on the marketperformance of PDs in the preceding six months.

Gilt Funds

5.84 In order to promote retai l holding ingovernment securities and broaden the investor base,mutual funds, which invest exclusively in governmentsecurities, were envisaged. These mutual funds,which are regulated by the Securities Exchange Boardof India (SEBI), have been provided liquidity facilityby the Reserve Bank since April 1996 for meetingtheir temporary cash mismatches. Under the scheme,liquidity support to eligible gilt funds is provided byway of repo at the Bank Rate up to a limit of 20 per

cent of the outstanding value in government securitiesfor a maximum period of 14 days. At present, thereare 15 dedicated gilt funds eligible to draw liquiditysupport from the Reserve Bank.

Foreign Institutional Investors

5.85 In order to encourage foreign participation,foreign institutional investors (FIIs) were allowed inJanuary 1997 to set up 100 per cent debt funds to investin Central and State Government securities, both in theprimary and the secondary markets, within the overall

185


debt ceilings that are announced from time to time. Equityfunds set up by FIIs are allowed to invest in debt up to amaximum of 30 per cent of their total investments. Thepresent ceiling on investment by FIIs (both debt andequity funds) in government securities is US$ 2.6 billionof which US$ 2.0 billion is earmarked for 100 per centdebt funds, while the balance US$ 0.6 billion is for otherFIIs. According to the Reserve Bank’s Mid-term Reviewof the Annual Policy for the Year 2006-07, FIIs would bepermitted to invest in Central and State Governmentsecurities by an incremental amount of 5 per cent oftotal net issuances (issuance minus repayments) in theprevious financial year and the existing limit will beenhanced to US $ 3.2 billion by March 31, 2007.

Retail Investors

5.86 Since the process of bidding in the auctionsrequires technical expertise, generally it is the largeand informed investors such as banks, PDs, financialinstitutions, mutual funds and insurance companiesthat participate in the auctions. As a large section ofmedium and small investors remained out of theprimary market for government securities, a schemeof non-competitive bidding was introduced in January2002 to enable small and medium investors toparticipate in the primary auction of governmentsecurities without having to quote the yield or pricein the bid. Apart from encouraging wider participationand retail holding of government securities, thisscheme enables individuals, firms and other mid-segment investors, who do not have the expertise tobid competitively in the auctions, to get a fair chanceof assured allotments at the rate which emerges inthe auction. The scheme provides for allocation up to5 per cent of the notified amount in the specifiedauctions of dated securities at weighted average rateof accepted bids. The investor is permitted to makeonly a single bid per auction and the size of the bidcan vary from a minimum of Rs.10,000 to Rs.2 crore.Eligible investors have to come through a bank orPD for auction. In view of their statutory obligations,RRBs, UCBs and NBFCs can also apply under thisScheme within the ceiling of Rs.2 crore.

5.87 To ensure higher retail participation, it isimportant to improve liquidity in the secondary market.Towards this end, the Reserve Bank has beenencouraging PDs to offer two-way quotes to retailinvestors and become members of the stockexchanges. Screen-based order driven trading instock exchanges was also introduced in January 2003to encourage retail participation in the governmentsecurities market.

Instruments

5.88 Diversif ication of available instrumentsencourages participation of varied investors, asdifferent categories of investors require differentkinds of instruments to meet their specific needs.While banks require government securities for theirasset liability management in addition to maintainingthe prescribed SLR, insurance companies andprovident funds require long-term investments tomatch their liabilities. Prior to the reforms initiatedin the early 1990s, most of the government bondswere in the form of plain vanilla fixed couponsecurities. Since 1994, the Reserve Bank has beendeveloping a range of instruments to cater to thediversified requirements and hedging needs ofinvestors. These include zero coupon bonds, capitalindexed bonds, floating rate bonds and bonds withcall and put options.

5.89 Zero Coupon Bonds (ZCBs) were introducedon January 17, 1994. ZCBs, which do not haveregular interest (coupon) payments like traditionalbonds, are sold at a discount and redeemed at paron final maturity. The ZCBs were beneficial, both tothe Government because of the deferred paymentof interest and to the investors because of thelucrative yield and absence of reinvestment risk.There were four issuances of ZCBs between 1994and 1996.

5.90 Par t ly paid stock was introduced onNovember 14, 1994 whereby payment for theGovernment stock was made in four equal monthlyinstalments. Designed for institutions with regularf low of investible resources requir ing regularinvestment avenues, this instrument attracted goodmarket response and was actively traded. There was,however, only one more issue of partly paid stockon June 24, 1996.

5.91 Floating Rate Bonds (FRBs) were first issuedon September 29, 1995 but were discontinued afterthe first issuance due to lack of market enthusiasm.They were reintroduced on November 21, 2001 ondemand from market par t icipants, with somemodif icat ion in the structure. There were 10issuances of the FRBs till October 9, 2004. Althoughthere was initially an overwhelming market responseto these issuances, FRBs were discontinued due tothe waning market interest reflected in the partialdevolvement in the last two auctions on the ReserveBank and PDs. Erosion in the market interest forFRBs at that time was, inter alia, due to strong creditpick-up and low secondary market liquidity in FRBs.

186


In the secondary market, liquidity in FRBs, is lowdue to (i) low trading interest of market participantsin FRBs as such instruments, by design, are hedginginstruments and offer limited scope for trading gains;(ii) no reissuance of FRBs on account of complexitiesassociated with pricing; (iii) preference of commercialbanks to place these bonds under ‘held to maturity’(HTM) category, reducing the availability of bondsfor trading; and (iv) complex pricing method whichdeterred market par ticipants from under takingoutright transactions in FRBs.

5.92 A capital indexed bond (CIB) was issued onDecember 29, 1997 with a maturity of 5 years. Thebond provided for inflation hedging for the principal,while the coupons of the bond were not protectedagainst inflation. The issue of this bond met withlacklustre response, both in the primary and thesecondary markets due to the limited hedgingagainst inf lat ion. Therefore, there were nosubsequent issuances. An attempt is being made toreintroduce these bonds and towards this end, adiscussion paper was also widely circulated in May2004. The proposed modified structure of the CIBwould be in line with the internationally popularstructure, which offers inflation linked returns on boththe coupons and principal repayments at maturity.The coupon rate for the bonds would be specified inreal terms. This rate would be applied to the inflation-adjusted principal to calculate the periodic semi-annual coupon payments. The principal repaymentat maturity would be the inflation-adjusted principalamount or its original par value, whichever is greater.Thus, there is an in-built insurance that at the timeof redemption the principal value would not fall belowthe par value. The inflation protection for the couponsand the principal repayment on the bond would beprovided with respect to the Wholesale Price Index(WPI) for all commodities (1993-94=100).

5.93 Government securities with embedded calland put options were introduced in July 2002 for a10-year maturity using uniform price based auctionmethod. On these securities, the Government hasthe discretion to exercise the ‘call option’, after givinga notice of two months, whereby the securities maybe prematurely redeemed at par on or af tercompletion of five years tenure from the date ofissuance of securities on any coupon payment datefalling thereafter. The holders of the Governmentstock also have the discretion to exercise ‘put option’whereby premature redemption may be made underthe same conditions as the call option. There wasonly one issuance of this instrument.

When Issued Market

5.94 A ‘when issued’ (WI) market facilitatesefficient distribution of auctioned stock by stretchingthe actual distribution period for each issue andallowing the market more time to absorb large issueswithout disruption. It also facilitates an efficient pricediscovery process for both the issuer and the investoras it reduces uncertainties surrounding auctions byenabling bidders to gauge the market demand andaccordingly price the securities being offered. PDsare also able to manage their auction risk by sellingin ‘WI’ markets even before the auction. As part ofthe restructuring of the debt issuance framework,guidelines for trading in ‘WI’ market were issued bythe Reserve Bank in May 2006. A limit of 5 per cent(only buy side) of notified amount was prescribed forbanks and 10 per cent (both buy and sell) for PDs.‘WI’ trading, which commenced in August 2006, wasinitially permitted in reissued securities. It takes placefrom the date of announcement of auction till one dayprior to allotment of auctioned securities. The revisedguidelines extending ‘WI’ trading to new issuances ofCentral Government securities on a selective basiswere issued in November 2006. ‘WI’ trading in newissuances will come into effect after the necessarysoftware modifications are carried out in the NDS-OM trading platform.

Conversion of Recapitalisation Bonds into TradeableSecurities

5.95 The Union Budget, 2006-07 announced theunwinding of the entire outstanding recapitalisationbonds/special securities amounting to Rs.20,809crore issued to nationalised banks through conversioninto tradeable, SLR eligible, Central Governmentdated securities. Accordingly, recapitalisation bonds/special securities worth Rs.8,709 crore issued to 19nationalised banks were converted into marketablesecurities on February 15, 2007. Apart from beingreckoned as an eligible investment for the purpose ofSLR, these securities are also eligible for readyforward transactions (repo). This will increase theliquidity in the system.

Transparency

5.96 Measures have been taken to increase thetransparency in the auction process. Issuanceprocedures for government securities are detailed ina general notification issued by the Government fromtime to time. In addition, the features of each issueare also advised to the public in the form of a specificnotification issued three to seven days prior to the

187


auction of government secur ities. Results areannounced soon after the auction and details of alltransactions settled through subsidiary general ledger(SGL) accounts are given on the same day by way ofpress releases on the Reserve Bank’s website.Furthermore, in order to provide clear and timelyinformation about the borrowing programme, theReserve Bank introduced an issuance calendar forauctions in Central Government securities from thefinancial year beginning April 2002. The StateGovernments are also encouraged, as announced inthe Reserve Bank’s Annual Policy Statement 2006,to develop an advance indicative open marketborrowings calendar. In operational terms, issuanceof a calendar has to tackle the trade-off betweencertainty to the market and flexibility to the issuer interms of market timing.

Secondary Market

5.97 The development of primary market forgovernment securities with diversified investor basealso hinges upon the existence of a well-developedsecondary market. This, in turn, requires participantswith varied liquidity requirements and differingperceptions regarding the future movement of interestrates. A deep and liquid market is efficient and lessvolatile. Hence, the Reserve Bank has been takingparallel measures to develop the secondary segmentof government securities as well.

Consolidation of Government Securities

5.98 The Reserve Bank has been pursuing a policyof passive consolidation through reissuance/reopenings of existing securities since April 1999 inorder to benchmark securities across the yield curveand improve fungibility and liquidity of securities. Thereissues are, however, limited by the maximumoutstanding amount that is perceived as ‘manageable’in terms of redemption in the year of maturity. While re-issuance has achieved some degree of consolidation,there are still a large number of small sized securities,most of which are not actively traded in the market. Thelack of liquidity underscores the need for adequatenumber of securities with sufficient stock.

5.99 Despite the effor ts taken in passiveconsolidation of securities, a large proportion of thebanks’ holding of Central Government domestic debt,contracted under the high interest rate regime of the

past, is thinly traded. While such securities shouldhave ordinarily commanded a premium over their facevalue in a scenario of softening of interest rates, bankswere often unable to encash them due to limitedliquidity. In view of this, a debt buyback scheme wasintroduced on July 19, 2003 on a purely voluntarybasis for banks that were in need of liquidity. Bankswere allowed additional deduction for income taxpurposes if they declared the premium received asbusiness income and used it for provisioning of theirNPAs. To enable them to take benefit of the structureof tax incentives for the premium received under thebuyback scheme, banks were exempted from therequirement of appropriating the profit on sale ofsecurities from the ‘held to maturity’ (HTM) categoryto ‘capital reserve account’, as a one time measure.8

5.100 The Technical Group on Central GovernmentSecurities Market recognised the need for a fasterway to consolidate stock through the process of activeconsolidation which would involve, in one form or theother, buying back a large number of small sizedilliquid government securities from existing holdersand issuing fewer liquid securities in exchange. In thiscontext, the Reserve Bank in its Annual PolicyStatement for 2006-07 has proposed to identify andbuy illiquid securities from the secondary market.Once a critical amount of these securities is acquired,these would be bought back by the Government toextinguish the stock. The modalities for consolidationare being worked out in consultation with theGovernment. The Union Budget for 2007-08 has madea provision of Rs.2,500 crore as premium on buybackof secur it ies under the proposed active debtconsolidation scheme.

5.101 In February 2007, the Reserve Bankintroduced a debt buyback scheme for specified StateDevelopment Loans (SDLs) of two StateGovernments, viz., Or issa and Rajasthan.Accordingly, securities of Orissa Government with aface value of Rs.308 crore and those of RajasthanGovernment with a face value of around Rs.84 crorewere bought back. In the second round of debt buyback,the Orissa Government securities amounting to Rs.86crore were bought back in March 2007.

Sale of Auctioned Stock

5.102 In order to deepen the government securitiesmarket and enable the mitigation of price risk, the

8 In October 2000 banks were advised that profit on sale of investments in HTM category should be first taken to the profit and loss account andthereafter be appropriated to the capital reserve account.

188


Reserve Bank permitted from October 2000, the saleof government securities allotted to successful biddersin primary issues on the day of allotment to entitieshaving SGL account. These are settled under theReserve Bank’s DvP system, thereby removingrestriction on the period between sale and purchase.This facility was extended in respect of sale toconstituent subsidiary general ledger (CSGL) accountholders and sale between CSGL account holders,effective May 11, 2005.

Valuation of Government Securities

5.103 Marking to market of government securitiesis important for the development of the secondarysegment of government securities market. Valuationof securities at market prices requires the existenceof a yield curve. The Reserve Bank was providing theinformation on yields on government securities acrossvarious maturities for the purpose of valuation ofunquoted government securities. With effect fromSeptember 2000, the Reserve Bank has moved awayfrom this practice and such valuation at present isdone on the basis of the prices/yield to maturity (YTM)rates put out by the Fixed Income Money MarketDerivatives Association of India (FIMMDA)/PrimaryDealers’ Association of India (PDAI) at periodicintervals.

Short Selling in Government Securities

5.104 In the absence of a facility of short selling ingovernment secur it ies, par t icipants generallyrefrained from taking positions in a falling market,which resulted in drying up of volumes. Trading activity,which normally peaked during the bullish times,petered out when the yields started moving up. Tokeep the markets liquid and active even during thebearish times, and more importantly, to give theparticipants a tool to better manage their interest raterisk, intra-day short selling in government securitieswas permitted among eligible par ticipants, viz.,scheduled commercial banks (SCBs) and PDs inFebruary 2006 on the basis of the recommendationsof the Technical Group on the Central GovernmentSecurities Market. The introduction of short sellingalso paved the way for ‘when issued’ trading in August2006. As part of the phased introduction of short sale,the short positions have been permitted to be carriedbeyond intra-day for a period of five trading days,effective January 31, 2007. As this arrangement resultsin carrying short positions across settlement cycles,participants are allowed to deliver a shorted security byborrowing it from the repo market.

Information Dissemination

5.105 Information asymmetry impedes thedevelopment of secondary market since participantsmake pricing decisions based on the available data.Transparency and information dissemination with theminimum time lag are, therefore, very crucial fordevelopment of the market. Making use oftechnological resources, efforts have been made todisseminate trade information on a real time basis to awider market. The price information on the trades ismade accessible through the Reserve Bank’s website.

Market Infrastructure

5.106 As par t of financial sector reforms, theReserve Bank has taken several initiatives fordeveloping the technological infrastructure for theefficient functioning of the government securitiesmarket. These measures were accompanied by anassessment of the risk management systems underthe new institutional arrangements.

Trading Infrastructure

5.107 A well-developed government securitiesmarket requires a system of transparent pricing andallotment mechanism which reduces transaction costand improves market efficiency. In June 1994, theNational Stock Exchange (NSE) introduced atransparent fully automated screen-based tradingsystem known as National Exchange for AutomatedTrading (NEAT) in the wholesale debt market (WDM)segment for facilitating trading in various debtinstruments, including government securities.

5.108 Although the WDM segment of the NationalStock Exchange has the facility to match trades, ithas been used mostly for reporting of negotiated dealsintermediated by the brokers registered with theexchange. The settlement of these deals is, however,done between the counter parties and without theinvolvement of the stock exchange. Participants in thesecondary market are limited to banks, financialinstitutions, mutual funds, FIIs and Trusts.

5.109 In order to facilitate easier access, widerreach and active participation in the governmentsecurities market, a facility of retail trading in stockexchanges, viz., National Stock Exchange (NSE),Bombay Stock Exchange (BSE) and Over the CounterExchange of India (OTCEI) was provided fromJanuary 16, 2003. Primary (urban) co-operative banksand FIs were permitted to transact in dated CentralGovernment securities in dematerialised form onautomated order driven systems of stock exchanges

189


from March 13, 2003 and from June 1, 2003,respectively. For this purpose, banks and financialinstitutions have been permitted to open demataccounts with depository participants in addition totheir SGL accounts. The minimum order size has beenkept low at Rs.1,000 (face value) to take care of theinterests of the small investors. Trades in governmentsecurities are cleared by the respective clearingcorporations of the exchanges. The settlementprocedure through settlement banks and demataccounts with depository participants (institutionspermitted by the SEBI to open demat accounts) isakin to any other transaction on the exchange.However, despite the presence of technologicalinfrastructure, trading through stock exchanges hasnot shown marked improvement.

5.110 The Reserve Bank introduced the NegotiatedDealing System (NDS) in February 2002 with theobjectives of (a) ushering in an automated electronicreporting and settlement process; (b) facilitating onlineelectronic bidding in primary auctions; and (c)providing an electronic dealing platform for trading ingovernment securities in the secondary market. TheNDS, which is available on a secure network, i.e.,Indian Financial Network (INFINET) to a closed usergroup, facilitates straight-through settlement ofsecondary market transactions, thereby enhancingtransparency and transactional efficiency. The NDShas greatly enhanced operational efficiency of themarket by automating the flow of traded data into thesettlement system. It has also facilitated disseminationof price information almost on a real time basis tomarket participants, enabling them to execute tradingdecision more effectively. The NDS has, however,gained popularity more as a reporting platform for thetrade concluded bilaterally in OTC markets than as atrading platform as originally envisaged.

5.111 In order to provide the NDS members with amore efficient trading platform, the NDS-OM (NDS-Order Matching) trading module was operationalisedin August 2005 on the basis of the recommendationsof the Working Group on Screen Based Trading inGovernment Securities (Chairman: Shri.R.H.Patil).The NDS-OM is an anonymous order matchingsystem which allows straight-through processing(STP). It is purely order-driven with all the ordersmatched on a strict price/time priority basis. Theexecuted trades f low straight to the Clear ingCorporation of India Ltd. (CCIL) in a ready-for-settlement stage. The CCIL is the central counterpartyto each trade undertaken on the system. Participantshave the option of using the NDS or the NDS-OM for

their trading operations. The settlement of both typesof transactions is, however, integrated. In the firstphase of operationalisation of NDS-OM, only ReserveBank regulated entities, i.e., banks, PDs and FIs werepermitted to access the system. Subsequently,insurance companies were also allowed access.Those insurance companies, which did not have acurrent account with the Reserve Bank, were allowedto open a special current account with it. Consequentto the announcement made in the Union Budget for2006-07, access to NDS-OM was further extendedto all qualified mutual funds, provident funds andpension funds. While large participants in thesecategories can have a direct access to NDS-OMsystem by obtaining the direct membership, smallparticipants are envisaged to access the systemthrough their principal member (CSGL route). TheNDS-OM system has been well received by marketpar t icipants as it enhances operational andtransactional efficiencies. This system, which accountedfor over 60 per cent of the total traded volume ingovernment securities, has provided an efficient pricediscovery mechanism, reducing the bid-ask spreads andintra-day price volatility.

Settlement Practice and Infrastructure

5.112 A fast, transparent and efficient clearingsystem constitutes the basic foundation of a well-developed secondary market in governmentsecurities. Dematerialised holding of governmentsecurities in the form of Subsidiary General Ledger(SGL) was introduced to enable holding of securitiesin an electronic book entry form by participants. Thebook entry form enhances the transactional efficiencyand mitigates risks associated with the physicalmovement of securities by obviating the movementof physical secur it ies dur ing transfers. Adematerialisation drive has also been undertaken toconvert all physical holdings of government securitiesinto dematerialised form. Consequently, at present,about 99 per cent of government securities holdings(in value terms) are held in dematerialised form.

5.113 The Delivery versus Payments (DvP) systemin India was operationalised in 1995 to synchronisetransfer of securities with cash payments, therebyeliminating settlement risk in securities transactions.The Reserve Bank operates a government securitiessettlement system for financial entities with SGLaccounts in its Public Debt Offices through DvPSystem. Under the current system, banks, financialinstitutions, insurance companies and PDs areallowed to hold SGL accounts for securities and

190


current accounts for cash. For these participants, thesettlement is done through the DvP system. Otherpar ticipants such as corporates, mutual funds,provident funds, co-operative banks and societies,and individuals, who are not allowed to hold directSGL accounts with the Reserve Bank, can operatevia the constituents’ SGL account maintained by SGLaccount holders. Detailed guidelines have been issuedto ensure that entities providing custodial services fortheir constituents employ appropriate accountingpractices and safeguards.

5.114 The DvP system, which was initially on thebasis of gross settlement for both securities and funds(DvP–I method), shifted to DvP-II method wheresettlement for securities was on a gross basis butsettlement of funds was on a net basis. Both fundsand securities are settled on a net basis (DvP-IIImethod) since 2004. Each security is deliverable/receivable on a net basis for a particular settlementcycle and securities are netted separately for SGLand CSGL transactions. Netting of funds is done on amultilateral basis. These changes facilitated therollover of repurchase transactions and also sale ofsecurities purchased during the same settlementcycle without waiting for delivery. The DvP III hashelped participants to manage their interest rate riskmore efficiently by enabling them to cover theirpositions on the day of allotment in the auction. Netsettlement of funds has also enhanced trading activityby reducing the fund requirement (gross to net) duringthe settlement cycle.

5.115 The CCIL was established on February 15,2002 to act as the clearing house and as a centralcounterparty through novation for transactions ingovernment securities. The CCIL has 154 membersparticipating in the securities settlement segment. Theestablishment of CCIL has ensured guaranteedsettlement of trades in government securities, therebyimparting considerable stability to the markets.Through the multilateral netting arrangement, thismechanism has reduced funding requirements fromgross to net basis, thereby reducing liquidity risk andgreatly mitigating counterparty credit risk. The CCILhas been equipped with the risk management systemto limit the settlement risk (Box V.8). Operationalguidelines were issued to the CCIL in April 2003 for alimited purpose government securities lendingscheme. Accordingly, the CCIL has been permittedto enter into an arrangement with any of its membersfor borrowing government securities for the purposeof handling securities shortage in settlement. Alltransactions in government securities concluded or

reported on NDS as well as transactions on the NDS-OM have to be necessarily settled through the CCIL.The net obligations of members are arrived at by theCCIL for both funds and securities and then sent tothe Reserve Bank for settlement under the DvPmechanism.

5.116 As a step towards introducing the nationalsettlement system (NSS) with the aim of settlingcentrally the clearing positions of various clearinghouses, the integration of the integrated accountingsystem (IAS) with the real time gross settlementsystem (RTGS) was initiated in August, 2006. Thisfacilitates settlement of various CCIL-operatedclearings (inter-bank government securities, inter-bank foreign exchange, CBLO and National FinancialSwitch) through multilateral net settlement batch(MNSB) mode in the RTGS in Mumbai. Onstabilisation of MNSB in Mumbai, settlements atother centres under the NSS would be taken up in aphased manner.

Settlement cycle

5.117 The government securities market earlierfollowed both T+0 and T+1 settlement systems. Inorder to provide participants with more processingtime and facilitate better funds and risk management,the settlement cycle for secondary market governmentsecurities transactions has been standardised to T+1,effective May 11, 2005.

Risk Management

5.118 Marking to market of securities is essentialto establish the current value and recognise profitsor losses in the books of account. In terms of theReserve Bank’s guidelines, the investment portfolioof banks is required to be classified into threecategories, viz., ‘held for trading’ (HFT), ‘availablefor sale’ (AFS) and ‘held to matur i ty’ (HTM).Securities classified under HFT are to be marked tomarket on a monthly basis, if not more frequently.Securities in the AFS category are to be marked tomarket at year-end, i f not more f requent ly.Securities in the HTM category can be carried atbook value, subject to certain conditions. Banks arenot allowed to book the mark to market gains.

5.119 As government securities are exposed tomarket risks, the Reserve Bank has been prescribingnorms to ensure that banks and other entitiesregulated by it maintain adequate cover against suchrisks. As an initial step towards prescribing capitalcharge for market r isk, the Reserve Bank had

191


The CCIL is responsible for the settlement of trades inthe government securities market. It also acts as thecentral counterparty to the trades done by its members,thereby absorbing the risk of its members from failedtrades arising out of defaults by their counterparties. Assettlement in the government securities market is basedon DvP, the risk from a default is the market risk, i.e., thechange in price of the concerned security. The CCIL seeksto cover these risks through its margining process. Itcollects initial margin and mark to market margin fromthe members in respect of their outstanding trades. Boththese margins are computed trade-wise and thenaggregated member-wise.

Initial margin is collected to cover the likely risk from futureadverse movements in prices of the concerned securities.It is computed based on security specific (Initial) marginfactor. The margin factor for a security is approximatelyequal to the 3-day Value at Risk for the security. Foroffsetting trades in a security for a settlement date, nettingis allowed for arriving at the initial margin.

Mark to Market (MTM) margin is collected to cover thenotional loss (i.e., the difference between the currentmarket price and the contract price of the security coveredby the trade) already incurred by a member. MTM marginimposed on a day is payable on the next business day,barring certain exceptions.

Additional Initial Margin: Sometimes trades are conductedat prices which are different from the prevailing prices inthe market. This increases risk to the system as the liabilityin the case of a default is guaranteed. A provision is beingcreated to subject such trades to additional initial margin(AIM) for an amount equal to the difference between thetrade consideration and the value of the trade at such MTMprice. The margin would be an intra-day margin andreleased at the end of the day, after such trades aresubjected to the MTM margining.

In addition to these margins, the CCIL may also collectvolatility margin and concentration margin.

Volatility Margin: To take care of sudden volatility in themarket, CCIL may also impose a volatility margin. Volatilitymargins would be imposed after advising the members ofsuch imposition through notifications to be sent throughCCIL report server and CCIL website. Volatility marginrates would either be a percentage of existing marginfactors or at rates specified for the individual securitiesand would be calculated in the same way as initial margin.Once imposed, all outstanding trades will be subjected tovolatility margin. Volatility margin can also be withdrawnanytime during the day.

Concentration Margin: This constitutes the marginobligation required to be fulfilled by a member in relationto its outstanding exposure to a security or to a group of

Box V.8Risk Management Practices adopted by the CCIL

securities, for a settlement date or for a number ofsettlement dates, beyond pre-determined limit(s). The CCILhas not yet set any such limits.

Members are required to keep balances in the SettlementGuarantee Fund (SGF) in such a manner that the same isenough to cover the requirements for both initial marginand MTM margin for the trades done by such members. Incase of any shortfall, CCIL makes margin call and theconcerned member is required to meet the shortfall beforethe specified period of the next working day. Members'contribution to the SGF is in the form of eligible CentralGovernment securities/Treasury Bills and cash, with the cashcomponent being not less than 10 per cent of the total marginrequirement at any point of time. Based on the liquidity andtenor, the CCIL specifies the securities which can be depositedtowards SGF by any member. SGF contribution in the form ofsecurities is subject to haircut, which is the margin kept asideto take care of any loss arising out of any adverse movementin the market price during the period between two re-valuations.The SGF in the form of securities is revalued daily to ensurethat the market value of such securities does not fall below themargin requirements.

Liquidity Risk: To mitigate liquidity r isk and ensureuninterrupted settlement, the CCIL is required to arrangefor liquidity, both in terms of funds and securities. The CCILhas arranged for lines of credit from banks to enable it tomeet any reasonable shortfall of funds arising out of a defaultby a member either in its securities segment or foreignexchange segment. Members' contributions to the securitysegment of the SGF are mainly in the form of securities. Byspecifying the list of securities acceptable for contributionto the SGF, the CCIL ensures that the most liquid securitiesin which a significant portion of the trades are settled arelikely to be available in the SGF. For requirements of othersecurities, the CCIL has put in place a limited purposesecurity borrowing arrangement with two major marketparticipants.

Default Handling: In case a member defaults in his securitiespay-in obligation, the CCIL meets the shortfall by borrowingsecurities under the Securities Line of Credit or by usingsecurities available either in its SGF or as proprietaryholding. In case it is not possible to meet the shortfall dueto non-availability of the security, the CCIL allocates theamount of shortage not handled using its predefinedalgorithm. In case a member defaults in funds pay-inobligation, the CCIL meets the shortage through its lines ofcredit. The margin contributed by the defaulter member isalso available as recourse. The CCIL also withholds payoutsdue to the defaulter member as a part of this process anddisposes this if the defaulter member does not replenishthe shortage within the pre-specified time of the next day.

Source:

Clearing Corporation of India Limited. 2006. Fact Book.

192


stipulated that banks assign a risk-weight of 2.5 percent to cover market risk in respect of governmentsecurities from the year ended March 2001. However,subsequently banks were required to charge capitalfor market risk in terms of Basel norms. Accordingly,banks were required to maintain capital charge formarket risk for the HFT category from March 2005and for AFS category from March 2006. They arerequired to measure the general market risk chargefor interest rate risk by calculating the price sensitivity(modified duration) of each position separately. Thecapital requirements are to be maintained on acontinuous basis and banks are required to maintainrisk management systems to monitor and controlintra-day exposures to market risks.

5.120 The Reserve Bank imposed cer tainrestrictions on the operation of co-operative bankswith effect from June 7, 2003, in the light of fraudulenttransactions in government securities in physical formby a few co-operative banks with the help of somebroker entities. Accordingly, participants were requiredto necessarily hold their investments in governmentsecurities portfolio in either SGL (with the ReserveBank) or a gilt account (with State co-operative bank/PD/FIs/sponsor banks in case of RRBs) or SHCIL orin a demater ial ised account with depositoryparticipants (DPs) of National Security DepositoryLimited (NSDL)/Central Depository Services (India)Limited (CDSL), depending on the concernedinstitution. Each entity was restricted to opening onlyone gilt account or dematerialised account. In casethe gilt accounts are opened with a SCB or state co-operative bank, the account holder is required to opena designated fund account (for all gilt account relatedtransactions) with the same bank. Furthermore, allReserve Bank regulated entities have been prohibitedfrom conducting transactions in securities in physicalform.

Government Securities Market and DebtManagement Policy

5.121 An abiding responsibility of the ReserveBank as a debt manager has been to minimise thecost of public debt keeping in view the rollover riskwithin the overall objectives of monetary policy,particularly in the light of the transition to a systemof market-determined cost of Government borrowingsfrom the 1990s.

5.122 The manoeuvrability of the Reserve Bank asthe debt manager for ensur ing interest ratesconducive to promoting economic growth on the onehand, and financial stability on the other, wasconstrained by the high volume of Governmentdomestic debt. As the large stock of Government debtcreated uncertainties in financial markets, fuellinginvestor expectations of higher interest rates, theReserve Bank had to place bond issuances at theshorter end of the market during the first eight yearsof the 1990s. Thus, taking into consideration themarket perception and the transition from pre-announced coupon to market related rates as well asthe need to widen the investor base, the maximummaturity was reduced from 20 years to 10 years andthe minimum maturity from five years to two years.As a result, the share of short dated securities (i.e.,under five years) as a proportion of total outstandingdated securities rose sharply between March 1991and March 1998, while that of securities with a tenorabove 10 years declined.

5.123 The Reserve Bank also pursued a strategyof funding operations of 91-day and 364-day auctionTreasury Bills between 1993-94 and 1997-98, whichinvolved the conversion of these Treasury Bills intodated securities at the option of holders.9 Thelengthening of maturity of Treasury Bills through suchconversion smoothened the cash f low of theGovernment. The market’s holding of a short-termsecurity was thus funded into a longer maturity. Thisobviated the problems inherent in sharp liquidityincreases in the system, thereby reducing volatility inthe short-term rates.

5.124 The pursuit of the objective of minimising costby shortening the maturity of government securitiesduring the first half of the 1990s inevitably led to asharp bunching of securities for redemption andfrequent rollover of short-term issues. This posedproblems for the Reserve Bank in the managementof liquidity. In order to avoid such bunching of futurerepayments, the Reserve Bank adopted a consciousstrategy from 1998 to elongate the maturity profile ofGovernment debt through issuances of long-termpapers to reduce refinancing risk. In doing so, theReserve Bank also had to careful ly weighconsiderations of minimising the cost of borrowingsagainst considerations of elongating the maturityprofile which could invariably involve increasing

9 This was a departure from the funding operations in earlier years wherein Reserve Bank's holding of ad hoc Treasury Bills was funded intospecial securities without maturity.

193


interest costs. However, soft interest rate conditionsfrom the late 1990s to 2004-05 due to benign inflationenvironment helped the Reserve Bank in lowering theyield on government securities, while simultaneouslyincreasing the tenor progressively up to 30 years,which had ranged up to 10 years in most of the 1990s.This reduced the potential redemption pressure andthe refinancing risk and also helped in developing theyield curve for longer tenors.

Government Securities Market and MonetaryPolicy

5.125 The measures undertaken by the ReserveBank to develop the primary and secondary segmentof government securities market has facilitated thechanges in the monetary policy framework to reflectthe increased market orientation (Annex V.1). Theemphasis progressively shifted from the use of directinstruments of monetary control such as reserverequirements and credit controls to indirectinstruments such as open market operations (OMOs).

5.126 A pre-requisite for the development of OMOas an active tool of monetary policy was a well-developed market for government securities which,in turn, hinged upon the existence of a price discoverymechanism. The first step in this direction was theintroduction of an auction system in 1992, whichsignalled the transition to a market-related interestrate system. The abolition of automatic monetisationthrough ad hoc Treasury Bills and the introduction ofWays and Means Advances (WMA) system from April1997 provided operational autonomy and greatermarket orientation for government securities. Althoughthe Reserve Bank continued to absorb governmentsecurities through devolvement/private placements,these were essentially market driven, and wereconducted with a view to offloading them in the marketwhen the liquidity conditions stabilise. Thus, thestrategy of combining private placement/devolvementwith outright OMO was employed to neutralise theimpact of temporary tightness in liquidity conditionson the interest cost of government debt. This was incontrast to the de facto ‘privately fixed privateplacement’ in the era of the ad hoc Treasury Bills,which virtually left little manoeuvrability for the conductof monetary policy.

5.127 The stock of government securities in theReserve Bank’s portfolio built over the years and theactivation of the secondary market for governmentsecurities enabled the Reserve Bank to use OMOeffectively for sterilising the impact of large capital

inflows. The Reserve Bank also converted its stockof non-marketable securities created out of fundingof ad hoc and tap Treasury Bills into marketablesecurities and effected OMO sales for absorbingstrong capital flows witnessed in 1997-98 and during2002-04. Continued recourse to open marketoperations for sterilisation, however, depleted theReserve Bank’s stock of government securities. Themarket stabilisation scheme (MSS) was, therefore,introduced in April 2004 for mopping up liquidity ofa more enduring nature. Under this scheme, CentralGovernment securities and Treasury Bills are issuedin addition to the normal market borrowing programmeand the resources raised are held by the Governmentin a separate identifiable cash account maintainedand operated by the Reserve Bank, which is to beappropriated only for the purpose of redemption and/or buyback of issuances under the MSS.

5.128 To sum up, in the initial phase of reforms, theprice discovery mechanism in the governmentsecurities market was accorded importance withtransition from the administered interest rate systemto the auction system. During the mid-1990s, the focuswas on scaling down of mandatory investment andpromoting voluntary investment by the traditionalinvestors. This period also witnessed establishment ofdedicated market intermediaries in the form of PDs.Several innovative products were introduced to providea wide menu of instruments to the investors. Theinvestor base has widened since the late 1990s toinclude corporate/mid segment and retail investors. Themeasures taken to develop the secondary marketinclude the development of new benchmarkgovernment securities by consolidating securities inkey maturities; enhancing fungibility and liquiditythrough re-issuances of existing loans; and improvingmarket efficiency through introduction of short selling.The Reserve Bank has taken measures in recent yearsto enhance transparency through announcement of acalendar for conducting auctions. Appropriate tradingand settlement infrastructure has been put in place toensure risk free settlement and market liquidity. To meetthe debt management objectives of minimising cost ofdebt and roll-over risks, the Reserve Bank has followedthe strategy of elongating maturity during benigninterest rate conditions.

IV. GOVERNMENT SECURITIES MARKET IN INDIA:ANALYSIS AND ASSESSMENT

5.129 An assessment of the impact of the measurestaken to develop the government securities marketsince the early 1990s reveals significant growth of

194


Table 5.2: Government Securities Market in India*

Indicator 1991-92 1995-96 2000-01 2003-04 2004-05 2005-06

1 2 3 4 5 6 7

Outstanding stock (end-March)(Rs. crore) 76,908 1,69,526 4,53,668 8,24,612 9,29,612 10,32,296

Outstanding stock as ratio of GDP(end-March) (Per cent) 11.8 14.3 21.6 29.8 29.7 28.9

Turnover / GDP (Per cent) – – 49.7 115.2 56.7 37.9

Average maturity of the securitiesissued during the year (Years) – 5.70 10.6 14.94 14.13 16.89

Weighted average cost of the securitiesissued during the year (Per cent) 11.78 13.75 10.95 5.71 6.11 7.34

PD share in government securitiesmarket # (Per cent)

a) Primary market – – – 51.47 52.88 40.36b) Secondary market turnover – – – 23.91 28.24 31.13

* : Central Government securities. # : Pertain to Central and State Governments.

the market in terms of both size and liquidity. Theoutstanding stock of government securities hasincreased significantly, both in absolute terms and inrelation to GDP, in tandem with the growing financingrequirement of the Government. Significant changesin the primary market have also been observed interms of wider participation and better price discovery.The system of PDs has emerged as an importantelement, both in the primary and secondary segmentsof the government securities market (Table 5.2).

Magnitude of Government Securities

5.130 With the phasing out of ad hoc Treasury Billsand earmarking of small saving collections for theStates, the Central Government has been financingits deficit largely through market borrowings.Accordingly, the share of market borrowings infinancing Central Government’s gross fiscal deficitincreased to around 70 per cent in 2005-06 fromaround 18 per cent in 1990-91. The share of marketborrowings in financing the gross fiscal deficit of theState Governments, however, showed a modestincrease on account of availability of other sourcesof financing such as small savings. As a result, marketborrowings financed around 46 per cent of combinedgross fiscal deficit of the Centre and States in 2005-06 as compared with around 20 per cent in 1990-91.Accordingly, the outstanding stock of both the Centraland State Governments’ securities has increasedsignificantly over the years. Implementation of theMSS from 2004-05 has also contributed to the growthof outstanding government securities in recent years(Table 5.3).

Elongation of Maturity Profile

5.131 As part of prudent debt management strategy,the Reserve Bank has elongated the maturity profileof the outstanding stock of government securities byissuing securities of longer maturity. The weightedaverage maturity of primary issuances of the CentralGovernment securities increased to 14-15 yearsduring the first half of the current decade as comparedwith 6.6 years in 1997-98. Mirroring this pattern,the weighted average maturity of outstanding stockof government securities increased to 9.9 years atend-March 2006 from 6.5 years at end-March 1998(Chart V.2).

Table 5.3: Outstanding Stock of Central and StateGovernment Securities

(Rs. crore)

End-March Centre States Combined

1 2 3 4

1991 70,377 15,644 86,0211992 76,909 18,971 95,8791993 81,693 23,646 1,05,3391994 1,10,581 26,087 1,36,6681995 1,37,515 31,208 1,68,7231996 1,69,526 37,931 2,07,4571997 1,92,893 43,582 2,36,4751998 2,49,024 50,828 2,99,8521999 3,11,605 61,531 3,73,1362000 3,81,881 73,885 4,55,7662001 4,53,668 86,765 5,40,4332002 5,36,324 1,04,026 6,40,3502003 6,74,203 1,33,090 8,07,2932004 8,24,612 1,79,465 10,04,0772005 9,29,612 2,35,172 11,64,784

195


Table 5.5: Maturity Profile of Outstanding Stock ofCentral Government Securities

(per cent of total)

Year Under Between 5 Over 10 years5 years and 10 years

1 2 3 4

1990-91 8.6 5.6 85.81991-92 7.4 16.8 75.81992-93 8.1 14.2 77.81993-94 21.4 22.3 56.31994-95 25.3 27.4 47.31995-96 38.3 30.3 31.31996-97 45.2 29.0 25.81997-98 41.0 40.8 18.21998-99 41.4 42.4 16.11999-00 37.5 38.7 23.92000-01 35.0 39.3 25.72001-02 30.6 35.6 33.82002-03 26.4 34.7 39.02003-04 22.4 30.9 46.62004-05 23.8 30.5 45.72005-06 23.8 29.8 46.5

5.132 In pursuance of the policy of elongating thematurity of government securities, the maximummaturity of securities issued was extended to 25years in 2001-02 and further to 30 years in 2002-03.Long-dated securities with residual maturity of 20years and above increased from a mere twosecurities out of 32 issuances in 1998-99 to 12securities in 2005-06, indicating the growing appetitefor these securities among insurance companies andpension funds. The weighted average maturity ofsecurities issued during 2002-03 declined marginallymainly because of the issuance of securities forprepayment of foreign debt on a maturity matchedbasis for an average tenor of 9.3 years. Apart fromthe objective of smooth debt management, thematurity profile was also elongated keeping in viewthe investor response, particularly the non-bankinvestors such as insurance companies. The shareof securities with maturities of more than 10 yearsconstituted 74 per cent of total issuances during2005-06, while securities issued below 5-yearmaturity were insignificant (Table 5.4).

5.133 Reflecting the elongation of maturity of theprimary issuances, the composition of outstandinggovernment secur it ies has undergone atransformation with the sharp increase in the shareof securities with more than 10-year maturity in totaloutstanding stock since 1998-99 (Table 5.5).Elongation of maturity profile has enabled theformation of yield curve for a longer horizon.

Table 5.4: Maturity Profile of Central GovernmentSecurities Issued during the Year

(Per cent of total)

Year Under 5 years 5-10 years over 10 years

1 2 3 4

1997-98 18 82 01998-99 18 68 141999-00 0 35 652000-01 6 41 532001-02 2 24 742002-03 0 36 642003-04 5 18 772004-05 4 19 772005-06 0 26 74

Yields on Government Securities in the PrimaryMarket

5.134 The process of maturity elongation wasfacilitated by the benign interest rate regime whichprevailed during the first half of the current decade.This brought down the cost of resources raised forfinancing the Government deficit. The weightedaverage yields, which started moderating from 1996-97, declined to 5.7 per cent and 6.1 per cent for theCentral and State Government secur it ies,respectively, by 2003-04 (Table 5.6).

5.135 The weighted average yield on governmentsecurities, however, took an upturn in 2004-05 andcontinued to rise in 2005-06. This was on account ofthe hardening of interest rates due to uncertaintysurrounding international oil prices, upturn in globalinterest rate cycle, buoyant domestic growth and rise

New Issues Outstanding Stock

Chart V.2: Weighted Average Maturity ofCentral Government Securities

Year

s

196


in domestic inflation. As discussed above, the averagematurity of the primary issuances increased mainlydue to encouraging investor response (Chart V. 3).

Market Development

5.136 Evolution of an efficient and active market forgovernment securities has been a key objective ofdebt management operations of economic reformssince beginning. Measures taken to achieve thisobjective were aimed broadly at widening theparticipation base, diversification of instruments and

development of market infrastructure in terms oftrading, clearing and settlement systems.

Primary Dealers

5.137 The PD system has fur thered thedevelopment of the government securities market byfacilitating better distribution of primary auctionedstock as well as providing the liquidity in the secondarymarket (Table 5.7). The share of PDs in the primaryissuances, however, declined in the recent period onaccount of increased bidding interest by insurancecompanies, particularly in the long dated securities,and by banks.

Diversification of Instruments

5.138 As alluded to earlier, measures taken todiversify instruments to meet diverse funding andhedging needs of participants include the issuancesof zero coupon bonds, capital indexed bonds, floatingrate bonds, and bonds with call and put options. Theinitial market response to the auctions of zero couponbonds in the mid-1990s was overwhelming, with valueof bids received being more than twice the notifiedamount. The last auction conducted on October 7,1996 was, however, undersubscribed, resulting inpartial devolvement on PDs and the Reserve Bank.The market response to other new products waslukewarm, as a result of which such instruments wereissued intermittently. More recently, FRBs werereintroduced with ten issuances between November6, 2001 and October 9, 2004. The market response,however, tapered off with the last two FRBs devolvingpartially on the Reserve Bank and PDs.

Table 5.6: Weighted Average Interest Rate onGovernment Securities

(Per cent)

Year Centre States

1 2 3

1990-91 11.4 11.51991-92 11.8 11.81992-93 12.5 13.01993-94 12.6 13.51994-95 11.9 12.51995-96 13.8 14.01996-97 13.7 13.81997-98 12.0 12.81998-99 11.9 12.41999-00 11.8 11.92000-01 11.0 11.02001-02 9.4 9.22002-03 7.3 7.52003-04 5.7 6.12004-05 6.1 6.42005-06 7.3 7.6

Table 5.7: Role of Primary Dealers in theGovernment Securities Market

(Per cent)

Year Share in Share in Share ofPrimary Turnover Government

Subscription (Outright) Securities in Total Assets

of PDs

1 2 3 4

2001-02 65.01 27.70 79.8

2002-03 58.49 26.99 83.9

2003-04 51.47 23.91 82.2

2004-05 52.88 28.24 71.5

2005-06 40.36 31.13 60.9

Note: Data exclude devolvement but include MSS and non-competitive bids.

Weighted Average Yield (per cent)

Weighted Average Maturity (years)

Chart V.3: Yield and Maturity of Central GovernmentDated Securities

Per

cen

t /

Year

s

197


Consolidation of Debt

5.139 One of the key issues in the development ofthe market for a better price discovery is liquidity ofsecurities. It was observed that of the universe of largenumber of outstanding securities, only a few securitiesare actively traded in the secondary market. TheReserve Bank has been persisting with the policy ofpassive consolidation through re-issuance of existingsecurities with a view to enhancing liquidity in thesecondary segment of the government securitiesmarket. The share of re-issuances in the total securitiesissued was 97.7 per cent during 2005-06 (Chart V.4).

5.140 Active consolidation of government securitieshas also been attempted under the debt buybackscheme introduced in July 2003. Under the scheme,government securities with a face value of Rs.14,434crore were bought back by offering a premium fixedon a transparent basis and four existing securities ofequal face value were reissued in a pre-announcedmanner. The market value of the securities boughtback amounted to Rs.19,394 crore.

Turnover in the Government Securities Market

5.141 As a result of the developmental measuresundertaken, the volume of transactions in the secondarysegment of the government securities market increasedmanifold over the past decade. However, markets areactive and liquid when interest rates decline but turnlacklustre and illiquid when rates rise. This hasresulted in the slowdown in the turnover in recentyears (Chart V.5).

5.142 The trading pattern of government securitiesindicates that most of the trading activity takes place inCentral Government securities. The share of StateGovernments’ securities in annual turnover of thegovernment securities market was less than 1 per centbefore 2003-04, while their share in outstandinggovernment securities was around 16-17 per cent. Theshare of State Government securities in the totalturnover, however, improved to around 3 per cent in2004-05 (Table 5.8).

5.143 Another feature of the trading pattern hasbeen the concentration of trading mostly in securitieswith maturity of more than 10 years (Chart V.6). Therehas, however, been a decline in outright transactionsin government securities market in 2004-05 and 2005-06,mainly in respect of securities with more than 10 years

Table 5.8: Annual Turnover in the GovernmentSecurities Market

(Rs. crore) [Share in total(Per cent)]

Year Centre States Centre and Centre StatesStates

1 2 3 4 5 6

1998-99 2,83,334 3,032 2,86,366 98.9 1.11999-00 8,15,075 7,357 8,22,432 99.1 0.92000-01 10,13,470 5,900 10,19,370 99.4 0.62001-02 22,63,781 12,135 22,75,916 99.5 0.52002-03 25,77,170 18,016 25,95,186 99.3 0.72003-04 31,43,646 32,563 31,76,209 99.0 1.02004-05 17,70,446 52,929 18,23,375 97.1 2.92005-06 13,47,009 40,139 13,87,148 97.1 2.9

Annual Turnover Yield on 10-year security (end-March)

Chart V.5: Yield and Annual Turnover (market value)

Rs.

cro

re

Yiel

d i

n p

er c

ent

Chart V.4: Share of Re-issues in the Total Issuanceof Central Government Securities

Per

cen

t

198


of maturity. The outright transactions in respect ofsecurities with 4-6 years of maturity increased duringthis period.

5.144 The decline in the share of longer maturitysecurities in the total trading volume could beattributed to the general upward movement in interestrates and the consequent shift in the participants’preference for short-term securities. In the risinginterest rate scenario, participants prefer reducing theduration by investing in shorter duration bonds, whichskews trading activity more towards shorter segmentof the yield curve. This also reflected the change inpolicy whereby, from September 2, 2004, banks wereallowed to exceed the limit of 25 per cent of totalinvestments under ‘held to maturity’ (HTM) categoryprovided that the excess comprised only SLRsecurities and the total SLR securities held in the HTMcategory are not more than 25 per cent of theirdemand and time liabilities (DTL). To facilitate this,banks were allowed to shift SLR securities to the HTMcategory during 2004-05 as a one-time measure.Decline in activity at the longer end of the yield curvecould also be attributed to the increase in the shareof ‘buy & hold’ investors such as insurance companiesand PFs in total government securities.

5.145 Security-wise analysis indicates that thenumber of actively traded securities is very low ascompared with the total number of outstandingsecurities. As at end-December 2006, there were 102Central Government securities with an outstandingamount of Rs.10,55,703 crore. Of these, 46

securities with outstanding issues of Rs.10,000 croreor more accounted for 77 per cent of the totaloutstanding amount. The turnover to totaloutstanding ratio dipped sharply to 1.1 in 2005-06from more than 3 in 2003-04. On a daily basis, hardly10-12 securities are traded, of which the activelytraded securities are 4-5. Without active trades inthe markets, the yield curve is kinked, therebymaking it difficult to price securities. This also leadsto a situation where securities of similar maturityprofiles trade at different yields, with sizeableilliquidity premiums on some occasions.

Holding Pattern of Government Securities

5.146 The ownership pattern of the governmentsecurities suggests that the investor base has beendiversified by the entry of cooperative banks,regional rural banks, mutual funds and non-bankingfinancial companies in the recent period. The entryof 100 per cent gilt mutual funds has broadenedthe retail investor base. As a result, the share of‘others’ category in the outstanding governmentsecurities has increased, par ticularly in recentyears (Chart V.7). Nevertheless, commercial banksand Life Insurance Corporation of India (LIC)continued to hold the largest share of governmentstocks. The share of LIC’s holding in the Centraland State governments securities consistentlyincreased to 20.5 per cent at end-March 2005 from17.9 per cent at end-March 1999. The share ofcommercial banks’ holding, on the other hand,declined steadily from 2001-02.

Below 3 Yrs 4-6 Yrs 7-9 Yrs 10 Yrs and Above

Chart V.6: Secondary Market Outright Transactions -Central Government Securties

Per

cen

t to

tot

al

RBI Commercial banks LIC

UTI NABARD EPFS Others

Chart V.7: Holding Pattern of Central andState Governments Securities

Per

cen

t of

tot

al

199


5.147 The holding of government securities bycommercial banks has been driven by interest ratechanges, apart from the SLR requirement. As part ofthe financial reforms, the SLR requirement for bankswas gradually reduced to 25 per cent by October 1997from the peak of 38.5 per cent in February 1992.Banks, however, maintained an average SLR of 37.3per cent of net demand and time liabilities during theperiod 1998-99 to 2002-03. Owing to decline ininterest rates and low demand for credit, banks foundit attractive to invest in SLR securities. In the recentyears, however, banks restricted incremental investmentand liquidated excess investment in governmentsecurities in recent years on account of rise in interestrates and increased credit demand. Thus, SLR securitiesheld by commercial banks are now very close to theprescribed limit of 25 per cent (Chart V.8).

Yield Curve

5.148 The need for elongation of maturity patternwas realised in the mid-1990s but the investorpreference was for short-term maturity due to marketuncertainty. As inflation conditions stabilised, thestrategy of elongating the yield curve by issuing a fineblend of long-term and short-term securities, suitingthe preference of both the issuer and the investor,has been followed since the late 1990s. The yieldcurve in India, however, has generally remained flat.The response of short-term rates to changes in thepolicy rates has been quicker and more pronouncedthan long-term rates, reflecting the ripple impact of

policy changes. During 2002-03, repo rate cuts,reduction in administered interest rates andexpectations of further reductions in US interest ratesresulted in easing of liquidity condition and downwardmovements in yields. The decline in yield was,however, more at the longer end of the maturity thanthat at the shorter end on account of active trading atthe long-end in a period of low interest rates. Thisresulted in flatness in the yield curve. In fact, therewere occasions when the yield curve inverted inrespect of some maturities (Chart V.9).

5.149 Reflecting the instability in the shape of theyield curve, the yield spread across various maturitiesshowed volatile movements. The yield spread betweenthe 1-year and 5-year benchmark securities declinedto 9 basis points in January-February 2003, whenuncertainty regarding the Iraq war dominated themarket. Yield spread across all the maturities from 1-year benchmark securities remained low in the phaseof declining interest rates up to May 2004 andincreased thereafter along with the rise in yields(Chart V.10).

5.150 With the issuance of 30-year paper in 2002-03,the yield curve has formed for longer horizon,although it is not liquid at the longer end. The yieldcurve in India, however, is still at a nascent stage ofdevelopment with liquidity confined only to a fewmaturity buckets. Nevertheless, the issuances/re-issuances of securities in key maturities are beingundertaken to develop the yield curve as a liquid andreliable risk-free benchmark.

22-M

ar-0

2

12-J

ul-

02

01

-Nov

-02

21-F

eb-0

3

13-J

un

-03

03-O

ct-0

3

23-J

an-0

4

14-M

ay-0

4

03-S

ep-0

4

24

-Dec

-04

15-A

pr-

05

05-A

ug-

05

25

-Nov

-05

17-M

ar-0

6

07-J

ul-

06

27-O

ct-0

6

16-F

eb-0

7

Chart V.8: Investment in SLR Securities byScheduled Commercial Banks

Per

cen

t of

ND

TL

Investment in SLR securities (% of NDTL) SLR

Mar-97 Mar-01 Mar-03

Mar-04 Mar-05 Mar-06

Chart V.9: Yield Curve Movement - SGL Transactions

Years to maturity

Per

cen

t

200


FRBM Stipulations and Market Operations

5.151 As stipulated in the FRBM Act, 2003, theReserve Bank withdrew from participating in theprimary market for Central Government securitiesfrom April 1, 2006. In order to ensure a smoothtransition to the new system, the Reserve Bank hastaken a number of measures to make the marketdeeper, broader and more liquid while improvingtrading/settlement and institutional infrastructure. Inthe auctions held in June and July 2006, the notifiedamounts were altered taking into account the liquidityconditions and investor demand. An additionalissuance was also done in June 2006 to absorbexcess liquidity. As a result, aggregate amount ofissuances during the first half of 2006-07 was as perthe indicative calendar issued by the Government ofIndia, in consultation with the Reserve Bank. In thesecond half of 2006-07, the scheduled auction in the10-year segment scheduled to be held in January 12,2007 was, however, cancelled and the notified amountin the auction held in March 2007 was reduced afterrevising the Government’s borrowing requirement.During the year, 33 securities were issued. Of these,30 securities were reissues, while three were newsecurities of 10-year, 15-year and 30-year maturitiesissued to provide benchmarks in the respectivesegments. The total issuance of dated securitiesduring 2006-07 at Rs.1,46,000 crore was higher thanRs.1,27,000 crore raised in the preceding year. Theweighted average maturity of dated securities of the

Central Government at 14.72 years during 2006-07was lower than 16.90 years in the preceding year.The weighted average yield of dated securitiesissued during 2006-07, on the other hand, increasedto 7.89 per cent from 7.34 per cent in the precedingyear (Chart V.11).

5.152 The PD system migrated to the revisedscheme from April 2006 smoothly. During 2006-07,the share of PDs in dated securities increasedmarginally to 32 per cent from 31 per cent in theprevious year, mainly reflecting the subdued biddingby banks due to hardening of yields. Their share inthe auction Treasury Bills (including those issuedunder the MSS) was placed at 34 per cent of thenotified amount as compared with 35 per cent duringthe previous year. Thus, the share of PDs in theprimary subscriptions during 2006-07 was more orless same as in the previous year.

5.153 The secondary market showed increasedactivity during 2006-07 (up to February 2007) ascompared with the previous year, notwithstanding thefirming up of yields. Month-end yields, which hadpeaked in July 2006, moved downward up toNovember 2006. Yields moved up subsequently,reflecting tighter liquidity conditions, edging up ofinflation and promulgation of the Ordinance removingthe stipulated SLR floor of 25 per cent of NDTL. Totalturnover up to February 2007 amounted toRs.19,27,465 crore, registering an increase of 52.9per cent over the same period of the previous year.

May

-02

Ju

l-0

2S

ep-0

2N

ov-0

2J

an-0

3M

ar-0

3M

ay-0

3J

ul-

03

Sep

-03

Nov

-03

Jan

-04

Mar

-04

May

-04

Ju

l-0

4S

ep-0

4N

ov-0

4J

an-0

5M

ar-0

5M

ay-0

5J

ul-

05

Sep

-05

Nov

-05

Jan

-06

Mar

-06

5 yrs yield spread 10 yrs yield spread

15 yrs yield spread 20 yrs yield spread

Perc

enta

ge p

oin

ts

Chart V.10: Movements in Yield Spread

Weighted Average Maturity

Weighted Average Yield (Right scale)

Chart V.11: Yield and Maturity of Central GovernmentDated Securities – Primary Auctions

Mat

uri

ty (

Year

s)

Yiel

d (

Per

cen

t)

201


Yield on 10-year maturity at end-February 2007 at7.98 per cent was higher by 61 basis points than thatduring the previous year (Chart V.12).

When Issued Market

5.154 The guidelines for trading in ‘when issued’(WI) market were issued by the Reserve Bank on May3, 2006. The actual trading in ‘WI’ market commencedwith the auction of Central Government securities inthe calendar week August 1 to 8, 2006. Tradingvolumes in the ‘WI’ market, however, have beeninsignificant (Chart V.13). Volumes in recent monthshave been adversely affected by expectations ofreduction in SLR and overall liquidity constraints.

5.155 With more number of participants graduallyputting in place their internal policies, it is expectedthat the trading volumes in the ‘WI’ market would pickup. The extension of ‘WI’ trading to select newlyissued securities as announced in the Mid-termReview of Annual Policy for the Year 2006-07, whichwould commence after the software modifications aremade in NDS-OM, is expected to spur the growth ofvolumes in this segment.

Market Integration

5.156 The progress of financial sector reforms inIndia has been marked by a growing integration ofvar ious segments within the financial market.Evidence of market inter-linkages is reflected in the

close co-movement of rates of return. Data on yieldsof various instruments indicate that the movementsin yields of 10-year government securities are almostin perfect synchronisation with that of 364-dayTreasury Bills. Yields of 14-day Treasury Bills alsomoved in line with 10-year maturity during the currentdecade (Chart V.14).

5.157 In order to examine the improvement in themarket integration process across various maturitysegments, the correlations of ‘first difference’ of the

Ap

r-98

Oct

-98

Ap

r-99

Oct

-99

Ap

r-00

Oct

-00

Ap

r-01

Oct

-01

Ap

r-02

Oct

-02

Ap

r-03

Oct

-03

Ap

r-04

Oct

-04

Ap

r-05

Oct

-05

Chart V.14: Yields on Various Government SecuritiesMarket Instruments

Per

cen

t

10-Year G-Sec 14 Day T-bill 364-Day T-bill

Au

g-06

Sep

-06

Oct

-06

Nov

-06

Dec

-06

Jan

-07

Feb

-07

Mar

-07

Chart V.13: Trading Volumes in When Issued Market

Rs.

cro

re

Ap

r

May

Ju

n

Ju

l

Au

g

Sep Oct

Nov

Dec

Jan Feb

Mar

Chart V.12: Monthly Yields and Turnover inCentral Government Securities

2006-07 Turnover 2005-06 Turnover

2006-07 Yield 2005-06 Yield

Turn

over

in

Rs.

cro

re

10 y

ears

yie

ld i

n p

er c

ent

202


yields on 10-year government securities with ‘firstdifference’ of yields on 14-day Treasury Bills and 364-day Treasury Bills yields were examined.10 Thecorrelations indicate that the yield on 10-yeargovernment securities showed greater integrationwith higher matur ity segment. The degree ofintegration across all segments has, however, improvedsignificantly in the current decade (Table 5.9).

5.158 An overall assessment indicates that variousmeasures under taken have led to signif icantimprovement in the functioning of the governmentsecurities market. The primary market has attained agreater resilience, benefiting from measures taken forthe development of institutions and instruments. Theestablishment of the sett lement and tradinginfrastructure has led to increased activity in thesecondary market. The development of the marketand the prudent debt management strategy haveenabled smooth transition to the FRBM phase. Thus,the government securities market in India haswitnessed a transition to an increasingly broad-basedmarket characterised by an efficient auction process,an active secondary market and a liquid yield curveup to 30 years (Mohan, 2006). Some concerns,however, include lukewarm response to the newinstruments; relative flatness of the yield curve; andasymmetric response to interest rate movements inthe secondary market.

V. THE WAY FORWARD

5.159 The government securities market is typicallythe seminal and organic component of financialmarkets in most countries. It is a veritable public goodin the sense that all credit/debt market instruments,including derivatives are typically priced on the basisof this market. Various measures, therefore, havebeen initiated by the authorities to develop and fosterdeep, liquid and efficient government securities

markets in several countries. First, while the large sizeof issuances of government securities contributes tomarket liquidity, countries facing fixed or decliningborrowing requirements have proactively enhancedmarket liquidity by enlarging issuances of benchmarksecurities at ‘key maturities’ and weeding out others.For instance, when government financing needsdeclined in the US in 1997, the issuances of 3-yearTreasury notes were discontinued, instead of cuttingthe overall issue size throughout the yield curve.Alternatively, some countries have also reduced thefrequency of new issuances to enhance the issue sizeto promote liquidity of the market. Second, a keystrategy has also been to infuse competition amongdealers for eff icient pr ice discovery. Dynamiccompetition among the exchanges on the one hand,and between OTC and organised exchanges on theother, contribute to market liquidity. Third, countriesare also becoming more transparent in terms ofissuance schedule and dissemination of marketinformation. Fourth, several countries have enhancedsafety in trading and settlement of governmentsecurity transactions by shortening and standardisingsettlement lags and adopting the DvP system. Theyhave also allowed short sales to promote marketmaking. In this context, they have standardised rulesand practices for failed deliveries and have openedwindows for special security lending and/or repofacilities through which authorities can providesecurities in short supply.

5.160 Countries are increasingly adopting suitablemodels for assessing the trade-off between expectedcosts and risks in debt portfolio. Several countries alsoadopt stress testing to assess the market risk of thedebt portfolio. Countries typically measure risk interms of potential increase in costs resulting fromfinancial and other shocks. Brazil, Portugal andSweden are also using concepts such as cost-to-budget or ‘budget-at-risk’ to reflect joint analysis of

10 The co-movements in yields on various instruments could reflect the 'random walk' behaviour of the variables. The 'random walk' of the seriesalso results in high correlations between 'levels' of the yields on various instruments under discussion. The application of 'unit root tests' indicatedthat all the four series under discussion are non-stationary at levels but stationary at first difference.

Table 5.9: Correlation of Yield on 10-year Government Securities with Other Instruments

Instrument Correlation between Levels Correlation between First Difference

April April September April April September1998- 1998- 2000- 1998- 1998- 2000-

January 2006 August 2000 January 2006 January 2006 August 2000 January 2006

1 2 3 4 5 6 7

14-Day Treasury Bills 0.88 -0.04 0.89 0.24 0.17 0.25

364-Day Treasury Bills 0.98 0.37 0.98 0.62 0.62 0.62

203


debt and GDP or budget flows to shocks. Variouscountries are using different variants of ‘at risk’ modelsto consider exposure of debt portfolio to differentmarket variables. The institutional set up in mostcountries now has a middle office for managing thecost and risk dimensions of debt portfolio.

5.161 Managers of public debt in many countriesare actively managing their debt portfolio. Whilefactors prompting them to take positions vary acrosscountries, a common feature is that many countrieshave centralised their debt management activitiesoutside the central bank. When central banks as debtmanagers take active positions in the debt market,they need to be consistent with regard to the policysignals that they convey to financial markets. Severaldebt management authorities also take advantage ofprice anomalies by undertaking a buyback of illiquidsecurities and substituting them with liquid securities.Cross country experience brings out that whethercentral banks act as managers of public debt or not,they play a vital role in (i) developing the tradinginfrastructure for government securities in thesecondary market; (ii) evolving suitable payment andsettlement systems; and (iii) promoting safety andefficiency in government security transactions. Wheredebt management is outside the central bank, carehas to be taken to ensure that trading activities of thedebt manager do not conflict with the central bank’smonetary management. Consequently, even whendebt management is outside the central bank,arrangements have to be made for appropriatecoordination so that conflicting signals are not given.

5.162 As documented, a great deal of developmenthas taken place in India’s government securitiesmarket but it still needs to acquire more depth andliquidity across all the maturities so as to generate ameaningful yield curve over the whole range. Someof the major issues that need to be addressed forfurther developing the government securities marketare set out below.

Consolidation and Liquidity

5.163 As noted above, liquidity is an essentialfeature of a vibrant government securities market.Trading in the government securities market in Indiais limited to a few securities. The yield curve is kinkeddue to the presence of a large number of securitiesattracting i l l iquidity premium, whereby twogovernment securities having similar maturity andcoupon may trade at different yields. While the processof passive consolidation has improved liquidity, thereis a need to pursue the strategy of active consolidation

by way of buyback of illiquid securities and issuancesof liquid securities. This strategy, however, needs tobe in tune with the market requirements so as toprovide adequate menu for choice. From theperspective of the issuer, it is important to note thatcreation of a few benchmarks may lead to theassociated problem of bunching of repayments androllover. Thus, while pursuing the strategy of activeconsolidation, there would be a need to closelymonitor the trade-off between creation of benchmarksacross a few maturities and the repayment schedule.

Price Discovery and Short Sale

5.164 Activity in the government securities marketin India has been characterised by asymmetricresponse of participants to the interest rate cycle,i.e., market turnover spurts during an interest ratedownturn but slumps during the cycle of r isinginterest rates. This is partly because participants arenot allowed to undertake ‘short sale’ in governmentsecurities. Lack of ability to sell short prevents a two-way expression of interest rate views. On the onehand, investors, who expect the interest rate todecline, take only ‘long position’, thereby exposingthemselves to possible capital losses in caseexpectations are not met. On the other hand,investors expecting interest rate to increase cannotexpress their expectations due to lack of ‘short sale’facility. This situation also results in over-pricing/under-pricing across different segments due todemand and supply imbalances. In this context, intra-day short selling was permitted only from February2006 and the period was recently extended to fivetrading days effective January 31, 2007. There is aneed to monitor the functioning of short sales, beforecontemplating the removal of the five-day limit.

Promoting Retail Segment for Government Securities

5.165 There is a need to promote retail and mid-segment investors. Al though retai l investorsconsti tute a small por t ion of the governmentsecurities market, they, as long-term investors,impart stability to the market. This will also benefitsmall investors by providing them access to risk freegi l t edged secur i t ies. Retai l investment ingovernment securities may be promoted directly orthrough gilt mutual funds. Although a system hasbeen put in place whereby commercial banks canhave a const i tuent SGL account for holdinggovernment securities on behalf of their customersin safe custody in demat form, many of them haveyet to make this facility available to their branch

204


customers. PDs also need to make a greater effortto promote the mid-segment investors such asprovident and pension funds, co-operative banks andtrusts. In this context, the Internal Technical Groupon Central Government Secur i t ies Marketrecommended that PDs must make at least 10 percent of their secondary market transactions (outright)with non-NDS members. Implementing thisrecommendation would help in widening the investorbase for government securities. It may, therefore, bedesirable to implement policies and processeswhereby banks and PDs can operate as activemarket makers and encourage greater participationby retail investors, both individuals and institutions,in the government securities market.

Book Building by Primary Dealers

5.166 The Internal Technical Group on CentralGovernment Securities Market suggested bookbuilding as one of the measures for restructuring theprimary issuance framework in the post-FRBMperiod. The book building method may be moresuitable when market conditions are highly uncertain,thereby mitigating the bidding risk at auctions. It couldalso be used when new instruments are issued forthe first time for which market response is not known.Select PDs may be appointed as arrangers for theissue. Three or four arrangers may be appointed foran issue so as to avoid emergence of anymonopolistic practices. Each PD would arrange toplace the stock within a price range mutually agreedto by it with the Reserve Bank. As PDs undertake toarrange the issue, the success of the issue isguaranteed, albeit at a cost. This method can also beused as an incentive for PDs for better performancein the primary and secondary markets. PDs may beselected for book building by ranking them accordingto the stipulated criteria in terms of success in primaryauctions and turnover in the secondary market.

Diversification of Instruments

5.167 Trading activity in the recently introduced‘when-issued’ segment of the government securitiesmarket is still at a nascent stage and volumes arelow. The activity is, however, likely to pick up after theoperationalisation of ‘WI’ trading in new issuances ona selective basis, in addition to ‘WI’ trading in re-issuances, and also with increased market familiaritywith this trading practice. Similarly, FRBs, which areprimarily used to hedge against volatility in interestrates, have elicited limited investor response. A majorfactor inhibiting investor response to FRBs is

complexity in the valuation of these bonds. Capital-indexed bonds, which provided hedge againstinflation, also showed lacklustre response frominvestors. A restructured version of the same, as hasbeen proposed by the Reserve Bank, incorporatingappropriate selection of an inflation index andreducing indexation lag, may encourage marketresponse to this instrument. A common elementresponsible for the slow progress in the developmentof new instruments is the lack of familiarity, whichimplies that market needs some more time to adjustbefore showing appetite for the new instruments.

Roadmap for STRIPS

5.168 The Reserve Bank is actively taking stepsfor developing a market in separate trading ofregistered interest and pr incipal of securit ies(STRIPS). The implementation of STRIPS wouldfacilitate creation of a series of benchmark rates andenable evolution of a market structure for selling thesecurities in retail. Apart from expanding the investorbase, the introduction of STRIPS would also facilitatethe development of a proper yield curve (Box V.9).With the passage of the Government Securities Act,2006, a framework is being put in place forintroduction of STRIPS. There is, however, a needto have a sizeable stock of securities with identicalcoupon payment dates so as to enable ‘bunching’. Thisinvolves a strategy for primary issuances, which wouldalign the coupon payments of underlying securities. Itmay be noted that the process of aligning couponpayments commenced in August 2003. For this purpose,the System Requirement Study (SRS) has alreadyexamined the required technological and operationalarrangements.

Low Liquidity of State Government Paper

5.169 The trading pattern in the secondary marketreveals that State Government securities are thinlytraded. This is mainly due to the absence of criticalminimum mass necessary for active trading. This, inturn, reflects limited recourse by the States to marketborrowings and fragmentation across issuers (28States). Predominance of ‘buy-and-hold’ investors insuch securities could also have contributed to illiquidityin State Government securities.

5.170 The need to improve l iquidity in StateGovernment securities is felt all the more as the Statesmay have to increase their recourse to marketborrowings for several reasons. First, in accordancewith the Twelfth Finance Commission (TFC)’s

205


The investor in a coupon bond receives coupon paymentsperiodically followed by the final coupon payment and theface value of the bond at the time of maturity. In contrast,a zero coupon bond (ZCB) entails payment of face valueof the bond at the maturity without any coupon paymentsthereby doing away with re-investment risk of a couponbond. The uncertainty regarding re-investment in couponbond poses a problem in valuation. For valuing a couponbond at a given point of time, it is assumed that eachcoupon payment is reinvested at the same rate – the yieldto maturity (YTM) rate. The market value is computed asthe aggregate of the present values of all future couponflows, and the present values, in turn, are arrived at bydiscounting all the coupon flows at the same YTM rate.

STRIPS are like a ZCB whereby coupons and theunderlying security are detached and can be tradedseparately as zero coupon bonds. The zero coupon yieldcurve is required for valuing STRIPS or ZCBs. Zero couponcurve can also be used for valuing coupon bonds; only, insuch a case, each cash flow has to be discounted at therespective rates given by the zero coupon yield curveinstead of discounting all cash flows at a (YTM) rate readoff from a conventional yield curve. In case the zero couponyield curve is upward sloping, the YTM will be lower thanthe zero coupon yield at maturity since, when discountingon the zero curve, the earlier cash flows are discounted atlower yields and the subsequent ones, at higher yields.The industry practice is to use the YTM rate read off fromthe conventional yield curve for discounting the cash flowsin the case of coupon bonds. The trading of STRIPS in themarket will lead to derivation of a true zero coupon yieldcurve which will result in a more accurate valuation ofgovernment securities.

Stripping of coupons increases depth and liquidity byattracting more participants and higher volumes in trading,since an investment in STRIPS would enable a trader to

Box V.9Separate Trading of Registered Interest and Principal of Securities (STRIPS)

increase the duration of his portfolio without putting morecash. It also provides new avenues to PDs as market makersand also attracts retail investors. Long-term investors suchas pension funds and insurance companies can useSTRIPS to narrow the gap between the maturities of theirassets and liabilities, besides earning a guaranteed return.It would enable corporate entities to manage their cash flowswithout re-investment risk. Trading in STRIPS increases theduration and convexity and involves lower cash outlay,thereby enabling the participants to minimise the lossesduring rising interest rates and maximise gains during fallinginterest rates. STRIPS would make foreign institutionalinvestors (FIIs) more inclined towards investing in sovereigndebt on account of higher duration at lower cash outlay.

The Informal Working Group on ‘Stripping of Gilts: Scope,Mechanics and Operational Aspects,’ constituted in 1997,identified the following as the pre-requisites for thedevelopment of a gilt STRIPS market: (i) a favourabletaxation environment; exclusive use of book-entry, ordematerialised system for undertaking transactions ingilts; (ii) Public Debt Offices (PDOs) disseminatinginformation to the investing public on strippable securitiesand segment-wise holdings of STRIPS, and makingSTRIPS issues sufficiently large in volume (throughvar ious methods such as reissues in designatedstrippable securities, making coupons from differentstrippable securities fungible, etc.) so as to ensureliquidity in STRIPS; (iii) ensuring transparency andpredictability in gilt market operations by ushering in anautomated and risk-free clearing and settlement systemand; (iv) use of modern technology for successfulimplementation of stripping and reconstitution.

Source:

Reserve Bank of India. 2002. “Report of the Working Groupfor Suggesting Operational and Prudential Guidelines onSTRIPS.” August.

recommendations, the Central Government’s loansfor State Plans have been discontinued. Second, theminimum obligation of the State Governments toborrow from the National Small Saving Fund (NSSF)has been reduced from 100 per cent to 80 per cent ofnet collections, effective April 1, 2007. This mayencourage the States to rely more on marketborrowings as interest rates on market borrowings arestill below that of NSSF. Third, the small savingscollection has also decelerated on account ofnarrowing of interest rate spreads between smallsavings and bank deposits and the extension of taxincentives to bank deposits of five years and above.Enhanced liquidity in State Government securitieswould, therefore, enable the States to reduce their

borrowings costs. In this context, the Working Groupon Liquidity of State Government Secur it ies(Chairman: Shri V.K. Sharma) considered passiveconsolidation of securities as a crucial strategy forimproving the liquidity. This would, however, requirethe State Governments to improve their fiscal position,get credit rating of their paper and take recourse toauctions more frequently. The Group recommendeda more active role of PDs in terms of providing two-way quotes for State Development Loans (SDLs) anddeveloping the retail investor base. The Group alsorecommended a minimum size of Rs.1,000 crore pertranche of market borrowing, introduction of shortsales and reserved allotment at cut-off price/yield toencourage retailing and market making. It also

206


suggested introduction of non-competitive bidding inthe primary auctions of SDLs, use of OTC derivativeswith State Government securities as the underlyinginstrument, introduction of LAF repos using StateGovernment securities and use of SDLs as collateralfor provision of intra-day liquidity under the RTGS.The Group recommended the alignment of taxstructure on small savings with SDLs to widen theinvestor base and the establishment of specialpurpose vehicle (SPV) to issue SPV securities backedby the Central Government guarantee for consolidationof outstanding State Government securities to build upvolumes. During 2006-07, the State Governments haveraised resources exclusively through auctions.Furthermore, the Annual Policy Statement of theReserve Bank for 2006-07 proposed to extend non-competitive bidding facility to primary auctions of SDLsand also to introduce purchase and resale of SDLs bythe Reserve Bank under the overnight LAF repooperations. Active consolidation through debt buybackof specified SDLs of two State Governments has alsobeen introduced. These efforts may be continued toimprove liquidity in State Government securities.

Fair Value Accounting

5.171 Banks are reluctant to hold governmentsecurities in the AFS category in a rising interest ratescenario, as the depreciation of securities is requiredto be charged to the Profit & Loss (P&L) account,while appreciation is to be ignored. If depreciation aswell as appreciation is permitted to be charged to theReserve Account instead of P&L account, bankswould have a greater incentive to hold/trade ingovernment securities than at present. InternationalAccounting Standard (IAS) 39 permits charging ofdepreciation on AFS securities to the equity account.Similarly, in line with the international practice, thefair value accounting method recognises both gainsand losses on the HFT portfolio, thereby affordingflexibility to market participants. In this regard, theReserve Bank released the draft guidelines in July2006 on classification and valuation of investments.According to the draft guidelines, a gain or loss arisingfrom valuation changes in the AFS portfolio will bereflected under the head ‘unrealised gain/loss on AFSportfolio’ in the Reserve Account. Statutory reserverequirements and prudential norms will not beapplicable on balances under this head. On sale, thecumulative gain or loss under this head will berecognised in the P&L account. The implementationof these guidelines should encourage trading ingovernment securities.

FRBM and SLR Flexibility

5.172 The Reserve Bank has been successfullymanaging the borrowing requirements of theGovernment through a prudent debt managementstrategy. The strategy of the Reserve Bank to takedevolvement/private placement, particularly in thephase of tight liquidity, was critical in managing theborrowings programme of the Government. With thestipulation in the FRBM Act that the Reserve Bankshall not subscribe to primary issuances of CentralGovernment securities after April 1, 2006, managingGovernment borrowings and liquidity in the marketnecessitated certain changes in the operation ofmonetary policy and debt management. Accordingly,the Reserve Bank effected institutional changes soas to ensure that debt management objectives aremet without distorting the market conditions.

5.173 At present, the demand for governmentsecurities is largely driven by the SLR requirements.As many banks are now holding SLR securities closeto the prescribed minimum level, the growth indemand for government securities in future may bein tandem with the expansion of NDTL of banks.However, in the wake of the amendment of theBanking Regulation Act, 1949, which providesflexibility in fixing the SLR requirement, non-bank investorcategory would have to make up for any shortfall indemand for government securities by banks. Though theFRBM Act places a limit on fiscal deficit of the CentralGovernment at 3 per cent of GDP from 2008-09, thismay not result in significant reduction in the absolutelevel of net issuance of government securities,considering the robust growth in nominal GDP. Thus, itis crucial to diversify the investor base, match instrumentprofile with the market requirement and promote liquidityin the market.

Impact of Capital Account Convertibility

5.174 The government securities market is nowlargely driven by domestic macroeconomic conditions,and financial market development and sentiment. Afuller capital account convertibility regime implies ahigher degree of integration of domestic financialmarkets with the rest of the world and also an increasein foreign exchange flows. In a well-developed andintegrated financial system, volatility in any marketsegment gets transmitted to other segments as well.As alluded to earlier, integration of the governmentsecur it ies market with the money market hasincreased in recent years. FIIs could also be expectedto play a greater role in the government securitiesmarket in future as the calibrated measures are taken

207


for fuller capital account convertibility over time.Expansion of access by foreign investors to the Indiangovernment securities market will have to be donecarefully, taking into account issues related toopportunities for arbitrage, overall macroeconomicconditions and the need for financial stability.

5.175 In the above scenario, external macroeconomicdevelopments would play an increasingly importantrole in the government securities market. Therefore,to maintain the resilience of the domestic governmentsecurities market, it would be critical to increase thedepth of the market and diversify the domestic investorbase. The greater diversity in perception arising fromforeign investors should help in promoting the overallstability of the government securities market over thelong-term. However, the increased participation offoreign investors would need to be managed carefully.

5.176 To sum up, although the governmentsecurities market has witnessed significant changesin recent years, it is still in the process of maturing interms of depth as well as liquidity. While the totaloutstanding stock of Central and State Governmentsecurities has grown to about Rs.12 lakh crore, mostof the trading in Central Government securities isconcentrated in select maturities, with the 10-yearmaturity, on an average, accounting for about 50 percent of the daily trading volume. The liquidity in mostother Central Government and State Governmentsecurities is low. Participants in the governmentsecurities market include mainly banks, insurancecompanies and provident funds. In order to improvedepth and liquidity of the government securitiesmarket, there is a need to promote non-mandatedinvestor base. Short selling represents a major policyadvance as stated earlier, and going forward, it isexpected to deliver the required liquidity, depth andefficiency in the cash as well as interest rate derivativemarkets.

VI. SUMMING UP

5.177 The government securities markets havegained importance in most countries in the overallfinancial system in recent years. Initiatives have beentaken to make them more vibrant and active byimproving liquidity and depth; enhancing transparencyof primary issuances; widening investor base; fine-tuning auction procedures; benchmarking andconsolidating across key maturities; developing newinstruments; and putting in place appropr iatesafeguards and sound trading and settlementinfrastructure. Furthermore, managers of public debtacross countries are paying greater attention to

minimising the cost of borrowings in the medium tolong-term, while striking a balance between the costsand the risks in the short run.

5.178 The government securities market in Indiahas evolved over the years. Several measures havebeen initiated since the early 1990s to develop a deepand liquid government securities market for reducingthe cost of government market borrowings, providingappropriate benchmarks for pricing other financialinstruments and conducting monetary policy in aflexible manner. While significant progress has beenmade in this direction, the evolving economicconditions and the move towards fuller capital accountconvertibility necessitate further fine-tuning of theoperating framework so as to ensure smooth debtmanagement operations.

5.179 The switchover to auction based system ofissuance of government securities in the early 1990swas a major step towards development of thegovernment securities market. The investor base hasbecome more voluntary and diversified with theparticipation by non-banking entities. Taking intoaccount market preferences, new instruments withinnovative features have been introduced from timeto time. Technological developments have enabledthe introduction of screen-based anonymous tradingand repor t ing platform. This has faci l i tateddissemination of trading information with a minimumtime lag, besides enabling electronic bidding inprimary auctions and facilitating efficient ordermatching. Furthermore, the operationalisation of theCCIL has ensured guaranteed settlement of tradesand has, therefore, imparted considerable stabilityto the government securities market. The strategyof consolidation of government securities mainlythrough re-issuances has resulted in critical massin key maturities, facilitating the emergence ofmarket benchmarks. The operation of a system ofmarket intermediar ies in the form of PDs hasfacilitated the Reserve Bank’s smooth withdrawalfrom the primary market from April 1, 2006 asprovided in the FRBM Act.

5.180 The functioning of the government securitiesmarket since the mid-1990s indicates consistentincrease in the size of the market in tandem with thegrowth in market borrowings of both the Central andthe State Governments. The weighted average costof market borrowings declined consistently up to2003-04, which enabled elongation of weightedaverage matur ity of pr imary issuances. TheGovernment has been raising progressively highershare of market borrowings through re-issuances

208


under the strategy of passive consolidation of debt.Reflecting the effectiveness of various measuresinitiated to develop the market, turnover in thesecondary market has increased manifold over theyears, before declining in 2004-05 and 2005-06. Theholding pattern of government debt shows someincrease in the relative share of non-banks, reflectinga progressive diversification of the investor base. Thegovernment securities market has increasinglydisplayed co-movements with the money market andhas also responded to the changes in internationalinterest rates from time to time.

5.181 Notwithstanding the substantial progress inthe government securities market, certain issues needto be addressed for its further development. Underthe FRBM regime, the Reserve Bank cannotpar ticipate in the pr imary market. PDs, asunderwriters, are, therefore, required to absorb the

unsubscr ibed secur it ies in the auctions. Anyconsequent escalation in the cost of governmentborrowing can be mitigated by greater diversificationof the investor base. It also needs to be widened tocounter the possible reduction in the captive investorbase. Increase in trading volumes in the secondarymarket would largely hinge on the improvement intrading liquidity in key maturities across the yieldcurve. This would require active consolidation ofgovernment securities, in addition to the presentsystem of passive consolidation. The development ofa critical mass in the key securities and the matchingof coupon payment dates would also pave the wayfor the introduction of STRIPS. Illiquidity in StateGovernment securities affects the cost of borrowingfor the State Governments. Therefore, there is a needto extend measures taken for enhancing liquidity inCentral Government securities to State Governmentsecurities as well.

209


ANNEX V.1: Reforms in the Government Securities Market

Year

1

June

1992

January

1994

August

1994

March

1995

July 1995

September

1995

January

1997

March

1997

April 1997

July 1997

December

1997

April 2000

Reform Initiated

2

Introduction of auction method for issue

of Central Government securities.

Zero Coupon Bond was issued for the

first time. Securities Trading Corporation

of India (STCI) commenced operations.

Agreement between the Reserve Bank

and Government of India on limiting

issue of ad hoc Treasury Bills.

Primary Dealer system introduced.

Delivery versus Payment (DvP) system

in government securities was introduced.

Floating Rate Bonds (FRBs) introduced.

Technical Advisory Committee (TAC)

was constituted.

Introduction of WMA system for Centre.

FIMMDA was established.

Foreign Institutional Investors (FIIs)

were permitted to invest in government

securities.

Capital Indexed Bonds were issued.

Sale of securities allotted in primaryissues on the same day.

Objective

3

To make yields on government

securities market determined.

To add new instruments and

intermediaries.

To do away with automatic monetisation.

To strengthen the market Intermediation

and support primary issue.

To reduce settlement risk.

To add more instruments.

To advise Reserve Bank on developing

government securities, money and forex

markets.

Discontinuation of automatic

monetisation.

Introduction of self regulation and

development of market practices and

ethics.

To broaden the market.

To help investors hedge inflation risk.

To improve secondary market.

Outcome

4

Price discovery has improved over a

period of time.

STCI and other PDs have become

important intermediaries in the

government securities market.

Cash management of Government has

improved.

PD system has evolved as an important

segment of government securities

market.

Transition from DvP–I method (funds and

securities settlement on gross basis) to

DvP-III method (funds and securities

settlement on net basis) has been made.

FRBs were discontinued after the first

issuance due to lack of market enthusiasm.

FRBs were reintroduced in November 2001

but were again discontinued in October

2004.

Plays a pivotal role in implementing the

Reserve Bank’s reform agenda based

on a consultative approach.

Transparency and pricing has improved.

Has imparted greater autonomy in

monetary policy making.

Market practices have improved.

FIIs have become important players in the

market, particularly in the Treasury Bill

segment.

Efforts are being made to revitalise this

product.

This has also helped in managing the

overnight risk.

(Contd.)

210


ANNEX V.1: Reforms in the Government Securities Market (Concld.)

Year

1

Reform Initiated

2

Objective

3

Outcome

4

Stability in market has improved, greatly

mitigating the settlement risk.

The position is being reported

periodically to BFS.

The measure is helping the small

investors as well.

This has not taken off very well. Efforts

are being made to improve the position.

Activity in the repo market has

improved.

These futures have not taken off.

Other measures for active consolidation

being considered.

Running successfully.

Running successfully.

Over 60 per cent of transactions in

government securities are done through

NDS-OM.

Is in a nascent stage of development.

Is in a nascent stage of development.

Awaiting notification of the Rules.

February

2002

June 2002

October

2002

January

2003

February

2003

June 2003

July 2003

March

2004

April 2004

August

2005

February

2006

August

2006

August

2006

Clearing Corporation of India Limited

(CCIL) was established.

PDs were brought under the jurisdiction

of Board for Financial Supervision

(BFS).

Trade data of NDS made available on

Reserve Bank website.

Retail trading of government securities

permitted on stock exchanges.

Regulated constituents permitted

participation in repo markets.

Interest Rate Futures were introduced.

Government Debt buyback scheme was

implemented.

Introduction of DvP III.

Introduction of RTGS.

The Negotiated Dealing System-Order

Matching (NDS-OM), an anonymous

order matching system which allows

straight-through processing (STP) was

established.

Intra-day short selling permitted. This was

later extended to five trading days,

effective January 31, 2007.

Commencement of ‘When Issued’ trading.

Government Securities Act, 2006

passed by the Parliament.

To act as a clearing agency for

transactions in government securities.

For integrated supervision of market.

To improve transparency.

To facilitate easier access and wider

participation.

To widen the market.

To facilitate hedging of interest rate risk.

To reduce interest burden of government

and help banks offload illiquid securities.

To obtain netting efficiency and to

enable rollover of repos.

To provide real time, online, large value

inter-bank payment and settlements.

To provide the NDS members with a

more efficient trading platform.

To improve liquidity in market, particularly

in the rising interest rates phase.

Efficient price discovery and distribution

of auctioned stock.

To facilitate wider par ticipation in

government securities market and create

the enabling provisions for issue of

Separately Traded Registered Interest

and Principal Securities (STRIPS).

6.1 Globally, operations in the foreign exchangemarket started in a major way after the breakdown ofthe Bretton Woods system in 1971, which also markedthe beginning of floating exchange rate regimes inseveral countr ies. Over the years, the foreignexchange market has emerged as the largest marketin the world. The decade of the 1990s witnessed aperceptible policy shift in many emerging marketstowards reorientation of their financial markets interms of new products and instruments, developmentof insti tut ional and market infrastructure andrealignment of regulatory structure consistent with theliberalised operational framework. The changingcontours were mirrored in a rapid expansion of foreignexchange market in terms of participants, transactionvolumes, decline in transaction costs and moreefficient mechanisms of risk transfer.

6.2 The origin of the foreign exchange market inIndia could be traced to the year 1978 when banksin India were permitted to undertake intra-day tradein foreign exchange. However, it was in the 1990sthat the Indian foreign exchange market witnessedfar reaching changes along with the shifts in thecurrency regime in India. The exchange rate of therupee, that was pegged earlier was floated partiallyin March 1992 and fully in March 1993 following therecommendations of the Report of the High LevelCommittee on Balance of Payments (Chairman: Dr.C.Rangarajan). The unification of the exchange ratewas instrumental in developing a market-determinedexchange rate of the rupee and an important step inthe progress towards current account convertibility,which was achieved in August 1994.

6.3 A further impetus to the development of theforeign exchange market in India was provided withthe setting up of an Exper t Group on ForeignExchange Markets in India (Chairman: Shri O.P.Sodhani), which submitted its report in June 1995.The Group made several recommendations fordeepening and widening of the Indian foreignexchange market. Consequently, beginning fromJanuary 1996, wide-ranging reforms have beenundertaken in the Indian foreign exchange market.After almost a decade, an Internal Technical Groupon the Foreign Exchange Market (2005) wasconstituted to undertake a comprehensive review of

the measures initiated by the Reserve Bank andidentify areas for further liberalisation or relaxationof restrictions in a medium-term framework.

6.4 The momentous developments over the pastfew years are reflected in the enhanced risk-bearingcapacity of banks along with rising foreign exchangetrading volumes and finer margins. The foreignexchange market has acquired depth (Reddy, 2005).The conditions in the foreign exchange market havealso generally remained orderly (Reddy, 2006c).While it is not possible for any country to remaincompletely unaffected by developments ininternational markets, India was able to keep thespillover effect of the Asian crisis to a minimumthrough constant monitoring and timely action,including recourse to strong monetary measures,when necessary, to prevent emergence of self-fulfilling speculative activities (Mohan, 2006a).

6.5 Against the above background, this chapterattempts to analyse the role of the central bank indeveloping the foreign exchange market. Section Iprovides a brief review of different exchange rateregimes being fol lowed in emerging marketeconomies (EMEs). Section II traces the evolution ofIndia’s foreign exchange market in line with the shiftsin India’s exchange rate policies in the post-independence period from the pegged to the marketdetermined regime. Various regulatory and policyinitiatives taken by the Reserve Bank and theGovernment of India for developing the foreignexchange market in the market determined set uphave also been highlighted. Section III presents adetailed overview of the current foreign exchangemarket structure in India. It also analyses the availablemarket infrastructure in terms of market players,trading platform, instruments and sett lementmechanisms. Section IV assesses the performanceof the Indian foreign exchange market in terms ofliquidity and efficiency. The increase in turnover inboth onshore and offshore markets is highlighted inthis section. Empirical exercises have also beenattempted to assess the behaviour of forward premia,bid-ask spreads and market turnover. Havingdelineated the market profi le, Section V thendiscusses the journey of the Indian foreign exchangemarket since the early 1990s, especially through

FOREIGN EXCHANGE MARKETVI

212


periods of volatility and its management by theauthorities. As central bank intervention has been animportant element of managing volatility in the foreignexchange market, its need and effectiveness in amarket determined exchange rate and open capitalregime has been examined in Section VI. Section VIImakes certain suggestions with a view to furtherdeepening the foreign exchange market so that it canmeet the challenges of an integrated world. SectionVIII sums up the discussions.

I. EXCHANGE RATE REGIMES IN EMERGINGMARKETS

6.6 The regulatory framework governing theforeign exchange market and the operational freedomavailable to market participants is, to a large extent,influenced by the exchange rate regime followed byan economy. In this section, therefore, we take a lookat the exchange rate regimes that the EMEs haveadopted during the 1990s.

6.7 The experience with capital flows in the1990s has had an important bearing on the choiceof the exchange rate regime by EMEs in recentyears. The emphasis on corner solutions - a fixedpeg a la the currency board without monetary policyindependence or a freely floating exchange rateretaining discretionary conduct of monetary policy -is distinctly on the decline. The trend seems to beclear ly in favour of intermediate regimes withcountry-specific features and with no fixed targetsfor the level of the exchange rate.

6.8 An impor tant feature of the conduct ofmonetary policy in recent years has been the foreignexchange market interventions either by the centralbank on its own behalf or on behalf of public sectorentities to ensure orderly conditions in markets andto fight extreme market turbulence (Box VI.1).Besides, EMEs, in general , have also beenaccumulating foreign exchange reserves as aninsurance against shocks. It is a combination ofthese strategies which wi l l guide monetaryauthorities through the impossible trinity of a fixedexchange rate, open capital account and anindependent monetary policy (Mohan, 2003). Thedebate on appropriate policies relating to foreignexchange markets has now converged around somegenerally accepted views: (i) exchange rates shouldbe flexible and not fixed or pegged; (ii) there iscont inuing need for many emerging marketeconomies to be able to intervene or manageexchange rates- to some degree - if movements arebelieved to be destablising in the short run; and

(iii) reserves should at least be sufficient to take careof fluctuations in capital flows and liquidity at risk(Jalan, 2003).

6.9 Broadly, the overall distribution of exchangerate regimes across the globe among main categoriesremained more or less stable during 2001-06, thoughthere was a tendency for some countries to shiftacross and within exchange regimes (Table 6.1). Asat end-April 2006, there were more floating regimes(79 countries including 53 managed floats and 26independent floats) than soft pegs (60 countries) orhard pegs (48 countries) (Exhibit VI.1). Managedfloats are found in all parts of the globe, whileconventional fixed pegs are mostly observed in theMiddle East, the North Africa and parts of Asia. Onthe other hand, hard pegs are found primarily inEurope, Sub-Saharan Africa (the CFA zones) andsmall island economies (for instance, in the EasternCaribbean). While 20 countries moved from a softpeg to a floating regime during the past four years,this was offset by a similar number of other countriesabandoning the floating arrangements in favour ofsoft pegs.

6.10 The substantial movement between soft pegsand floating regimes suggests that floating is notnecessarily a durable state, particularly for lower andmiddle-income countries, whereas there appears tobe a greater state of flux between managed floatingand pegged arrangements in high-income economies.The frequency with which countries fall back to pegsafter a relatively short spell in floating suggests thatmany countries face institutional and operationalconstraints to floating. The preference for tightermanagement seems to have intensified recently as anumber of countries have enjoyed strong externaldemand and capital inflows. Other notable trendsincluded a shift away from currency baskets, with theUS dollar remaining the currency of choice forcountries with hard pegs as well as soft pegs. Onethird of the dollar pegs are hard pegs and theremaining are soft pegs. The choice of the US dollarfor countries with soft pegs reflects its continuedimportance as an invoicing currency and a high shareof trade with the US or other countries that peg tothe US dollar. The euro is the second most importantcurrency and serves as an exchange rate anchor forcountries in Europe and the CFA franc zone in Africa.

6.11 During the last 15 years, there was ageneral tendency among the emerging marketeconomies to adopt a more flexible exchange rateregime (Table 6.2). In emerging Asia, there is a broadconsensus that the soft US dollar peg operated by a

213

FOREIGN EXCHANGE MARKET

Economic literature suggests that, at an aggregated level,the adoption of more flexible exchange rate regimes inEmerging Market (EM) countries has been associatedwith greater monetary policy independence. EM countrieswith exchange rate anchors are generally associated withpegged regimes. Here, the exchange rate serves as thenominal anchor or intermediate target of monetary policy.Around 27 per cent of the EM countr ies fol lowedexchange rate anchors at the end of April 2006 (Table).When the exchange rate is directly targeted in order toachieve pr ice stability, intervention operations areunsterilised with inter-bank interest rates adjusting fully.In Singapore, while pursuing a target band for theexchange rate is the major monetary policy instrument,the central bank’s decision on whether to steriliseintervention is made with reference to conditions in thedomestic markets1 .

In other regimes, where the exchange rate is not themonetary pol icy anchor, any l iquidi ty impact ofintervention that would cause a change in monetaryconditions is generally avoided. Most foreign exchangeoperations are sterilised. Interventions may also be usedin coordination with changes in monetary policy, givingthe latter a greater room for manoeuvre. For example,where a change in monetary policy is unexpected,surprising the market can erode confidence or destabilisethe market. Intervention may help minimise the costs ofsurprising financial markets, allowing monetary policygreater capacity to move ahead of market expectations.

Around 17 per cent of the EM countries have adoptedmonetary aggregate target, most of which are associatedwith managed floating exchange rate regimes. In the caseof a monetary aggregate target, the monetary authorityuses its instruments to achieve a target growth rate for amonetary aggregate (reserve money, M1, M2, etc.), andthe targeted aggregate becomes the nominal anchor orintermediate target of monetary policy.

Around 43 per cent of the EM countries have adoptedinflation targeting as their monetary policy regime, wherechanges in interest rates are the principal instrumentsof monetary policy. Inflation targeting involves the publicannouncement of medium-term numerical targets forinflation with an institutional commitment by the monetaryauthority to achieve these targets. Here, intervention

Box VI.1 Exchange Rate Regimes and Monetary Policy in EMEs

becomes important when movements in the exchangerate inconsistent with economic fundamentals threatento push inflation outside the target band. However, wherethe exchange rate is responding appropriately to a “real”shock, it may be necessary either to acknowledge theexpected departure from the inflation target for someperiod of time or to offset the shock by altering monetarypolicy. Most of the countries with inflation targeting asthe monetary policy regime have adopted independentfloating as the exchange rate policy. Empirical evidencesuggests that most emerging economies that moved toa free float, introduced full-fledged inflation targeting onlyafter a transition. There are other EM countries, viz.,Algeria, India, Romania, and Russia, which have noexplicitly stated nominal anchor, but rather monitorvarious indicators in the conduct of monetary policy. Insome of the EM countries, coordinating these policiesmay be more di f f icul t because foreign exchangeoperations are not the responsibility of the monetaryauthority. In such instances, the maintenance of a closedialogue between the respective authorities is importantin avoiding any conflict arising between monetary andexchange rate policies.

1 EMEAP Study on Exchange Rate Regimes, June 2001.

Table: Monetary Policy Framework - April 2006

Exchange Rate Monetary InflationAnchor Aggregate Target

Target

Bulgaria Argentina Brazil

Ecuador China Chile

Egypt Indonesia Colombia

Hong Kong Tunisia Czech Republic

Malaysia Uruguay Hungary

Venezuela Korea

Morocco Mexico

Hungary Peru

Philippines

Poland

South Africa

Thailand

Turkey

Source : Annual Report on Exchange Arrangements andExchange Restrictions, 2006, IMF.

number of Asian countries contributed to the regionalfinancial crisis in 1997-98. Since the Asian financialcrisis, several Asian economies have adopted moreflexible exchange rate regimes except for Hong Kong,

which cont inued with i ts currency boardarrangement, and China, which despite someadjustments, virtually maintained its exchange ratepeg to the US dollar. After experiencing some

214


Table 6.1: Evolution of Exchange Rate Regimes, 1996 - April 2006(Number of countries; end-December data)

Regime 1996 2001 2002 2003 2004 2005 2006 April

1 2 3 4 5 6 7 8

I. Hard Pegs 30 47 48 48 48 48 48

No separate legal tender 24 40 41 41 41 41 41

Currency board arrangements 6 7 7 7 7 7 7

II. Soft Pegs 94 58 59 59 59 61 60

a. Conventional Pegged arrangements 50 42 46 46 48 49 49 Pegs to Single Currency 36 32 36 38 40 44 44 Pegs to Composite 14 10 10 8 8 5 5

b. Intermediate Pegs 44 16 13 13 11 12 11

Pegged within horizontal bands 18 5 5 4 5 6 6

Crawling Pegs 14 6 5 6 6 6 5

Crawling Bands 12 5 3 3 0 0 0

III. Floating Regimes 60 81 80 80 80 78 79

Managed Floating 37 43 45 46 49 52 53

Independently Floating 23 38 35 34 31 26 26

Note : To ensure comparability, all data are based on the current de facto methodology applied retroactively, unless otherwise specified.

Source : Annual Report on Exchange Arrangements and Exchange Restrictions, 2006, IMF and other sources.

transitional regime, Malaysia started pegging to theUS dollar on September 1, 1998, but shifted overrecently (July 2005) to a managed float regime. Incontrast, Thailand, Indonesia, Korea, the Philippinesand Taiwan have floated their currencies since thecrisis, while adopting a monetary policy strategybased on inflation targeting. The Monetary Authorityof Singapore (MAS) continues to monitor the

Singapore dollar against an undisclosed basket ofcurrencies of Singapore’s major trading partners andcompetitors. The Taiwanese government replaced itsearlier managed foreign exchange rate by a floatingrate in 1989, consequent to an increase in its tradesurplus and the resulting rise in the foreign exchangereserves.

215


6.12 Most of the Latin American economies havea history of very high inflation rates. As such, inflationcontrol has been a major objective of exchange ratepolicies of these countries in recent years. Startingfrom the end of 1994, a floating rate policy wasmaintained in Mexico, with the Bank of Mexicointervening in the foreign exchange market underexceptional circumstances to minimise volatility andensure an orderly market. Chile adopted exchangerate flexibility in 1999, after experiencing an exchangerate band for the previous 17 years starting from 1982.After pursuing various forms of exchange rate pegsfor more than four decades, which included occasionaldevaluation as also a change of the currency,Argentina had to finally move away from its currencyboard linked to the US dollar in January 2002. Brazil,after having a floating exchange rate regime withminor interventions in 1990s, adopted anindependently floating exchange rate regime in theaftermath of its currency crisis in 19992.

6.13 An analysis of the complexities, challengesand vulnerabilities faced by EMEs in the conduct ofexchange rate policy and managing volatilities inforeign exchange market reveal that the choice of aparticular exchange rate regime alone cannot meetall the requirements. The emerging consensus is thatfor successful conduct of exchange rate policy, it isessential for countries to pursue sound and crediblemacroeconomic policies so as to avoid the build-upof major macro imbalances in the economy. Second,it is essential for EMEs to improve the flexibility oftheir product and factor markets in order to cope andadjust to shocks arising from the volatility of currencymarkets and swings in the terms of trade in worldproduct markets. Third, it is crucial for EMEs todevelop and strengthen their financial systems inorder to enhance their resilience to shocks. In addition,a sound and efficient banking system together withdeep and liquid capital market contributes to theefficient intermediation of financial flows. This couldhelp prevent the emergence of vulnerabilities in thefinancial system by minimising unsound lendingpractices that lead to the build-up of excessiveleveraging in the corporate sector and exposure toforeign currency borrowings. Fourth, countries wouldneed to build regulatory and supervisory capabilitiesto keep pace with financial innovations and theemergence of new financial institutions’ activities, andnew products and services, which have complicatedthe conduct of exchange rate policy. Fifth, policymakers need to promote greater disclosures andtransparency.

6.14 Fur thermore, the perception about thevolatility and flexibility in exchange rate is contextual.What may be perceived as f lexible for someeconomies may turn out to be volatile for othereconomies. The level of development andpreparedness of financial markets and their risk-taking ability is crucial in this context (Reddy, 2007).If the level of development and preparedness offinancial markets is low, a small movement inexchange rate could be interpreted as volatile, whileeven large movement in exchange rate in developedforeign exchange markets may not be seen asvolatile. Thus, as financial markets develop in anemerging economy, the tolerance to volati l i tyimproves and hence what was once volatility wouldlater become flexibility. A key issue, therefore, forthe authorities is where and when to make policyadjustments, including the use of official intervention

2 Brazil had an adjustable band during 1995 to 1999 in a programme to control money creation.

Table 6.2: Emerging Market Countries:Transition to More Flexible Exchange Rate

Regimes: 1990 - April 2006

Transition Type Country

1 2

Move towards a more flexible Algeria Koreaexchange rate regime Argentina Mexico

Brazil Peru

Chile Poland

Colombia Romania

Czech Republic Russia

Egypt Slovakia

India Thailand

Indonesia Turkey

Move towards a less flexible China Uruguayexchange rate regime Malaysia

Hong Kong

Ecuador

Venezuela

Bulgaria

Note : The Classification of the countries’ exchange rateregimes is based on the IMF’s de facto classificationand does not necessarily represent the views of theauthorities.

Source: Annual Repor t on Exchange Arrangements andExchange Restrictions, IMF, various issues.

216


to help avoid substantial volatility and seriousmisalignments.

6.15 With gradual liberalisation and opening upof the capital account, capital flows to EMEs,par t icular ly to Asian economies increasedsignif icant ly dur ing the 1990s, posing newchallenges for central banks. Surges in capital flowsand their associated volatility have implications forthe conduct of monetary policy by central banks. Thechallenges facing central banks pertain to liquiditymanagement, exchange rate and foreign exchangereserve management. Central banks in theseeconomies, thus, need to be equipped to deal withlarge capital flows. Since capital flows in somecountries in recent years have been associated withvarious crises, there is also a rethinking aboutunfettered capital account liberalisation.

6.16 Intervention by most Asian central banks inforeign exchange markets has become necessaryfrom time to time primarily because of the growingimportance of capital flows in determining exchangerate movements in these economies as against tradedeficits and economic growth, which were importantin the earlier days. The latter does matter, but onlyover a period (Jalan, 2003). On a day-to-day basis, itis capital flows, which influence the exchange rateand interest rate arithmetic of financial markets.Capital movements have also rendered exchangerates significantly more volatile than before (Mohan,2003). For the relatively open economies, this raisesthe issue of appropriate monetary policy response tosharp exchange rate movements since exchange ratevolatility has had significant real effects in terms offluctuations in employment and output and thedistribution of activity between tradable and non-tradable, especially in the developing countries, whichdepend on export performance as a key to the healthof their balance of payments. In the f iercelycompetitive trading environment, countries seek toexpand market shares aggressively by paring downmargins. In such cases even a small change inexchange rates can develop into significant andpersistent real effects. Thus, in order to benefit frominternational capital inflows, host countries need topursue sound macroeconomic policies, developstrong institutions, and adopt appropriate regulatoryframeworks for the stability of financial systems andsustained economic progress.

6.17 To sum up, while some flexibility in foreignexchange markets and exchange rate determinationis desirable, excessive volatility can have adverse

impact on price discovery, export performance,sustainability of current account balance, andbalance sheets in view of dollarisation. The EMEs’experience has highlighted the need for developingcountries to allow greater flexibility in exchangerates. However, the authorities also need to havethe capacity to intervene in foreign exchangemarkets in view of herd behaviour. With progressiveopening of the emerging markets to financial flows,capital flows are playing an increasingly importantrole in exchange rate determination and are oftenreflected in higher exchange rate volatility. Againstthis backdrop, it would be appropriate to have a peepinto the exchange rate regime followed in India andthe evolution of foreign exchange market in the postindependence period.

II. INDIAN FOREIGN EXCHANGE MARKET:A HISTORICAL PERSPECTIVE

Early Stages: 1947-1977

6.18 The evolution of India’s foreign exchangemarket may be viewed in line with the shifts in India’sexchange rate policies over the last few decades froma par value system to a basket-peg and further to amanaged float exchange rate system. During theperiod from 1947 to 1971, India followed the par valuesystem of exchange rate. Initially the rupee’s externalpar value was fixed at 4.15 grains of fine gold. TheReserve Bank maintained the par value of the rupeewithin the permitted margin of ±1 per cent usingpound sterling as the intervention currency. Since thesterling-dollar exchange rate was kept stable by theUS monetary authority, the exchange rates of rupeein terms of gold as well as the dollar and othercurrencies were indirect ly kept stable. Thedevaluation of rupee in September 1949 and June1966 in terms of gold resulted in the reduction of thepar value of rupee in terms of gold to 2.88 and 1.83grains of fine gold, respectively. The exchange rateof the rupee remained unchanged between 1966and 1971 (Chart VI.1).

6.19 Given the fixed exchange regime during thisperiod, the foreign exchange market for all practicalpurposes was defunct. Banks were required toundertake only cover operations and maintain a‘square’ or ‘near square’ position at all times. Theobjective of exchange controls was primarily toregulate the demand for foreign exchange for variouspurposes, within the limit set by the available supply.The Foreign Exchange Regulation Act initiallyenacted in 1947 was placed on a permanent basis

217


in 1957. In terms of the provisions of the Act, theReserve Bank, and in certain cases, the CentralGovernment controlled and regulated the dealingsin foreign exchange payments outside India, exportand import of currency notes and bullion, transfersof securities between residents and non-residents,acquisition of foreign securities, etc3 .

6.20 With the breakdown of the Bretton WoodsSystem in 1971 and the f loatat ion of majorcurrencies, the conduct of exchange rate policyposed a serious challenge to all central banks worldwide as currency fluctuations opened up tremendousopportunities for market players to trade in currenciesin a borderless market. In December 1971, the rupeewas linked with pound sterling. Since sterling wasfixed in terms of US dollar under the SmithsonianAgreement of 1971, the rupee also remained stableagainst dollar. In order to overcome the weaknessesassociated with a single currency peg and to ensurestability of the exchange rate, the rupee, with effectfrom September 1975, was pegged to a basket ofcurrencies. The currency selection and weightsassigned were left to the discretion of the ReserveBank. The currencies included in the basket as wellas their relative weights were kept confidential inorder to discourage speculation. It was around thistime that banks in India became interested in tradingin foreign exchange.

Formative Period: 1978-1992

6.21 The impetus to trading in the foreignexchange market in India came in 1978 when banksin India were allowed by the Reserve Bank toundertake intra-day trading in foreign exchange andwere required to comply with the stipulation ofmaintaining ‘square’ or ‘near square’ position only atthe close of business hours each day. The extent ofposition which could be left uncovered overnight (theopen position) as well as the limits up to which dealerscould trade during the day were to be decided by themanagement of banks. The exchange rate of therupee during this period was officially determined bythe Reserve Bank in terms of a weighted basket ofcurrencies of India’s major trading partners and theexchange rate regime was characterised by dailyannouncement by the Reserve Bank of its buying andselling rates to the Authorised Dealers (ADs) forundertaking merchant transactions. The spreadbetween the buying and the selling rates was 0.5 percent and the market began to trade actively withinthis range. ADs were also permitted to trade in crosscurrencies (one convertible foreign currency versusanother). However, no ‘position’ in this regard couldoriginate in overseas markets.

6.22 As opportunities to make profits began toemerge, major banks in India started quoting two-way prices against the rupee as well as in crosscurrencies and, gradually, trading volumes began toincrease. This led to the adoption of widely differentpractices (some of them being irregular) and theneed was felt for a comprehensive set of guidelinesfor operation of banks engaged in foreign exchangebusiness. Accordingly, the ‘Guidelines for InternalControl over Foreign Exchange Business’, wereframed for adoption by the banks in 1981. The foreignexchange market in India ti l l the early 1990s,however, remained highly regulated with restrictionson external transactions, barriers to entry, lowliquidity and high transaction costs. The exchangerate during this period was managed mainly forfacilitating India’s imports. The strict control onforeign exchange transactions through the ForeignExchange Regulations Act (FERA) had resulted inone of the largest and most efficient parallel marketsfor foreign exchange in the world, i.e., the hawala(unofficial) market.

6.23 By the late 1980s and the early 1990s, it wasrecognised that both macroeconomic policy and

3 The Act was later replaced by a more comprehensive legislation, i.e., the Foreign Exchange Regulation Act, 1973.

218


structural factors had contributed to balance ofpayments diff icult ies. Devaluations by India’scompetitors had aggravated the situation. Althoughexports had recorded a higher growth during thesecond half of the 1980s (from about 4.3 per centof GDP in 1987-88 to about 5.8 per cent of GDP in1990-91), trade imbalances persisted at around 3 percent of GDP. This combined with a precipitous fall ininvisible receipts in the form of private remittances,travel and tourism earnings in the year 1990-91 ledto further widening of current account deficit. Theweaknesses in the external sector were accentuatedby the Gulf crisis of 1990-91. As a result, the currentaccount deficit widened to 3.2 per cent of GDP in1990-91 and the capital f lows also dr ied upnecessitating the adoption of exceptional correctivesteps. It was against this backdrop that Indiaembarked on stabilisation and structural reforms inthe early 1990s.

Post-Reform Period: 1992 onwards

6.24 This phase was marked by wide rangingreform measures aimed at widening and deepeningthe foreign exchange market and liberalisation ofexchange control regimes. A crediblemacroeconomic, structural and stabi l isat ionprogramme encompassing trade, industry, foreigninvestment, exchange rate, public finance and thefinancial sector was put in place creating anenvironment conducive for the expansion of tradeand investment. It was recognised that trade policies,exchange rate policies and industrial policies shouldform par t of an integrated policy framework toimprove the overall productivity, competitiveness andefficiency of the economic system, in general, andthe external sector, in particular.

6.25 As a stabilsation measure, a two stepdownward exchange rate adjustment by 9 per centand 11 per cent between July 1 and 3, 1991 wasresorted to counter the massive drawdown in theforeign exchange reserves, to instill confidenceamong investors and to improve domesticcompetitiveness. A two-step adjustment of exchangerate in July 1991 effectively brought to close theregime of a pegged exchange rate. After the Gulfcrisis in 1990-91, the broad framework for reforms inthe external sector was laid out in the Report of theHigh Level Committee on Balance of Payments(Chairman: Dr. C. Rangarajan). Following therecommendations of the Committee to move towardsthe market-determined exchange rate, the LiberalisedExchange Rate Management System (LERMS) was

put in place in March 1992 initially involving a dualexchange rate system. Under the LERMS, all foreignexchange receipts on current account transactions(exports, remittances, etc.) were required to besurrendered to the Authorised Dealers (ADs) in full.The rate of exchange for conversion of 60 per cent ofthe proceeds of these transactions was the marketrate quoted by the ADs, while the remaining 40 percent of the proceeds were converted at the ReserveBank’s official rate. The ADs, in turn, were requiredto surrender these 40 per cent of their purchase offoreign currencies to the Reserve Bank. They werefree to retain the balance 60 per cent of foreignexchange for selling in the free market for permissibletransactions. The LERMS was essential ly atransitional mechanism and a downward adjustmentin the official exchange rate took place in earlyDecember 1992 and ultimate convergence of the dualrates was made effective from March 1, 1993, leadingto the introduction of a market-determined exchangerate regime.

6.26 The dual exchange rate system was replacedby a unified exchange rate system in March 1993,whereby all foreign exchange receipts could beconverted at market determined exchange rates. Onunification of the exchange rates, the nominalexchange rate of the rupee against both the US dollaras also against a basket of currencies got adjustedlower, which almost nullified the impact of the previousinflation differential. The restrictions on a number ofother current account transactions were relaxed. Theunification of the exchange rate of the Indian rupeewas an important step towards current accountconvertibility, which was finally achieved in August1994, when India accepted obligations under ArticleVIII of the Articles of Agreement of the IMF.

6.27 With the rupee becoming fully convertible onall current account transactions, the risk-bearingcapacity of banks increased and foreign exchangetrading volumes star ted r is ing. This wassupplemented by wide-ranging reforms undertakenby the Reserve Bank in conjunction with theGovernment to remove market distor tions anddeepen the foreign exchange market. The processhas been marked by ‘gradualism’ with measuresbeing undertaken after extensive consultations withexperts and market participants. The reform phasebegan with the Sodhani Committee (1994) which ini ts repor t submit ted in 1995 made severalrecommendations to relax the regulations with a viewto vitalising the foreign exchange market (Box VI.2).

219


The Expert Group on Foreign Exchange Markets in India(Chairman: Shri O.P.Sodhani), which submitted its Reportin 1995, identified various regulations inhibiting thegrowth of the market. The Group recommended that thecorporates may be permitted to take a hedge upondeclaring the existence of an exposure. The Grouprecommended that banks should be permitted to fix theirown exchange position limits such as intra-day andovernight limits, subject to ensuring that the capital isprovided/earmarked to the extent of 5 per cent of thislimit based on internationally accepted guidelines. TheGroup also favoured fixation of Aggregate Gap Limit(AGL), which would also include rupee transactions, bythe managements of the banks based on capital, risktaking capacity, etc. It recommended that banks beallowed to initiate cross currency positions abroad andto lend or borrow short-term funds up to six months,subject to a specif ied cei l ing. Another impor tantsuggestion related to allowing exporters to retain 100per cent of their export earnings in any foreign currencywith an Authorised Dealer (AD) in India, subject toliquidation of outstanding advances against export bills.The Group was also in favour of permitting ADs todetermine the interest rates and maturity period inrespect of FCNR (B) deposits. It recommended selectiveintervention by the Reserve Bank in the market so as toensure greater orderliness in the market.

In addition, the Group recommended various other short-term and long-term measures to activate and facilitatefunctioning of markets and promote the developmentof a vibrant derivative market. Short-term measures

Box VI.2 Recommendations of the Expert Group on Foreign Exchange Markets in India

recommended included exemption of domestic inter-bank borrowings from SLR/CRR requirements tofacil i tate development of the term money market,cancellat ion and re-booking of currency options,permission to offer lower cost option strategies such asthe ‘range forward’ and ‘ratio range forward’ and permittingADs to offer any derivative products on a fully coveredbasis which can be freely used for their own asset liabilitymanagement.

As part of long-term measures, the Group suggestedthat the Reserve Bank should invite detailed proposalsfrom banks for offering rupee-based derivatives, shouldrefocus exchange control regulation and guidelines onrisks rather than on products and frame a fresh set ofguidelines for foreign exchange and derivatives riskmanagement.

As regards accounting and disclosure standards, themain recommendations included reviewing of policyprocedures and transactions on an on-going basis by arisk control team independent of dealing and settlementfunctions, ensuring of uniform documentation and marketpractices by the Foreign Exchange Dealers’ Associationof India (FEDAI) or any other body and development ofaccounting disclosure standards.

Reference:

Reserve Bank of India. 1995. Repor t on ForeignExchange Markets in India (Chairman : Shr i O.PSodhani), June.

Most of the recommendations of the SodhaniCommittee relating to the development of the foreignexchange market were implemented during the latterhalf of the 1990s.

6.28 In addition, several initiatives aimed atdismantling controls and providing an enablingenvironment to all entities engaged in foreignexchange transactions have been undertaken sincethe mid-1990s. The focus has been on developing theinstitutional framework and increasing the instrumentsfor effective functioning, enhancing transparency andliberalising the conduct of foreign exchange businessso as to move away from micro management offoreign exchange transactions to macro managementof foreign exchange flows (Box VI.3).

6.29 An Internal Technical Group on the ForeignExchange Markets (2005) set up by the ReserveBank made various recommendations for furtherliberalisation of the extant regulations. Some of the

recommendations such as freedom to cancel andrebook forward contracts of any tenor, delegation ofpowers to ADs for grant of permission to corporatesto hedge their exposure to commodity price risk inthe international commodity exchanges/markets andextension of the trading hours of the inter-bankforeign exchange market have since beenimplemented.

6.30 Along with these specific measures aimed atdeveloping the foreign exchange market, measurestowards liberalising the capital account were alsoimplemented during the last decade, guided to a largeextent since 1997 by the Report of the Committee onCapital Account Convertibility (Chairman: Shri S.S.Tarapore). Various reform measures since the early1990s have had a profound effect on the marketstructure, depth, liquidity and efficiency of the Indianforeign exchange market as detailed in the followingsection.

220


III. FOREIGN EXCHANGE MARKET STRUCTURE

Market Segments

6.31 Foreign exchange market activity in mostEMEs takes place onshore with many countriesprohibiting onshore entities from undertaking theoperations in offshore markets for their currencies.Spot market is the predominant form of foreignexchange market segment in developing andemerging market countries. A common feature is thetendency of importers/exporters and other end-users

to look at exchange rate movements as a source ofreturn without adopting appropriate risk managementpractices. This, at times, creates uneven supply-demand conditions, often based on ‘‘news and views’’.Though most of the emerging market countries allowoperations in the forward segment of the market, it isstill underdeveloped in most of these economies. Thelack of forward market development reflects manyfactors, including limited exchange rate flexibility, thede facto exchange rate insurance provided by thecentral bank through interventions, absence of a yield

Institutional Framework

• The Foreign Exchange Regulation Act (FERA), 1973was replaced by the market friendly Foreign ExchangeManagement Act (FEMA), 1999. The Reserve Bankdelegated powers to authorised dealers (ADs) torelease foreign exchange for a variety of purposes.

• In pursuance of the Sodhani Committee’srecommendations, the Clearing Corporation of IndiaLimited (CCIL) was set up in 2001.

• To further the participatory process in a more holisticmanner by taking into account all segments of thefinancial markets, the ambit of the Technical AdvisoryCommittee (TAC) on Money and Securities Marketsset up by the Reserve Bank in 1999 was expanded in2004 to include foreign exchange markets and theCommittee was rechristened as TAC on Money,Government Secur it ies and Foreign ExchangeMarkets.

Increase in Instruments in the Foreign ExchangeMarket

• The rupee-foreign currency swap market was allowed.

• Additional hedging instruments such as foreigncurrency-rupee options, cross-currency options,interest rate swaps (IRS) and currency swaps, caps/collars and forward rate agreements (FRAs) wereintroduced.

Liberalisation Measures

• Authorised dealers were permitted to initiate tradingpositions, borrow and invest in overseas market,subject to certain specifications and ratification byrespective banks’ Boards. Banks were also permittedto (i) fix net overnight position limits and gap limits(with the Reserve Bank formally approving the limits);(ii) determine the interest rates (subject to a ceiling)and matur ity per iod of FCNR(B) deposits with

Box VI.3Measures Initiated to Develop the Foreign Exchange Market in India

exemption of inter-bank borrowings from statutory pre-emptions; and (iii) use derivative products for asset-liability management.

• Participants in the foreign exchange market, includingexporters, Indians investing abroad, and FIIs werepermitted to avail forward cover and enter into swaptransactions without any limit, subject to genuineunderlying exposure.

• FIIs and NRIs were permitted to trade in exchange-traded der ivative contracts, subject to cer tainconditions.

• Foreign exchange earners were permitted to maintainforeign currency accounts. Residents were permittedto open such accounts within the general limit of US $25,000 per year, which was raised to US $ 50,000 peryear in 2006, has further increased to US $ 1,00,000since April 2007.

Disclosure and Transparency Initiatives

• The Reserve Bank has been taking initiatives in puttingin public domain all data relating to foreign exchangemarket transactions and operations. The Reserve Bankdisseminates: (a) daily reference rate which is anindicative rate for market observers through its website,(b) data on exchange rates of rupee against somemajor currencies and foreign exchange reserves on aweekly basis in the Weekly Statistical Supplement(WSS), and (c) data on purchases and sales of foreigncurrency by the Reserve Bank in its Monthly Bulletin.The Reserve Bank has already achieved full disclosureof information pertaining to international reserves andforeign currency liquidity position under the SpecialData Dissemination Standards (SDDS) of the IMF.

Reference:

Mohan, Rakesh. 2006. “Financial Sector Reforms andMonetary Policy: The Indian Experience.” RBI Bulletin,July.

221


curve on which to base the forward prices and shallowmoney markets, in which market-making banks canhedge the maturity risks implicit in forward positions(Canales-Kriljenko, 2004).

6.32 Most foreign exchange markets in developingcountr ies are either pure dealer markets or acombination of dealer and auction markets. In thedealer markets, some dealers become market makersand play a central role in the determination ofexchange rates in flexible exchange rate regimes.Market makers set two-way exchange rates at whichthey are willing to deal with other dealers. The bid-offer spread reflects many factors, including the levelof competition among market makers. In most of theEMEs, a code of conduct establishes the principlesthat guide the operations of the dealers in the foreignexchange markets. It is the central bank, orprofessional dealers association, which normallyissues the code of conduct (Canales-Kriljenko, 2004).In auction markets, an auctioneer or auctionmechanism allocates foreign exchange by matchingsupply and demand orders. In pure auction markets,order imbalances are cleared only by exchange rateadjustments. Pure auction market structures are,however, now rare and they generally prevail incombination with dealer markets.

6.33 The Indian foreign exchange market is adecentralised multiple dealership market comprisingtwo segments – the spot and the derivatives market.In the spot market, currencies are traded at theprevailing rates and the settlement or value date istwo business days ahead. The two-day period givesadequate time for the parties to send instructions todebit and credit the appropriate bank accounts athome and abroad. The der ivatives marketencompasses forwards, swaps and options. Thoughforward contracts exist for maturities up to one year,majority of forward contracts are for one month, threemonths, or six months. Forward contracts for longerper iods are not as common because of theuncertainties involved and related pricing issues. Aswap transaction in the foreign exchange market is acombination of a spot and a forward in the oppositedirection. As in the case of other EMEs, the spotmarket is the dominant segment of the Indian foreignexchange market. The derivative segment of theforeign exchange market is assuming significance andthe activity in this segment is gradually rising.

Market Players

6.34 Players in the Indian market include (a) ADs,mostly banks who are authorised to deal in foreign

exchange, (b) foreign exchange brokers who act asintermediaries, and (c) customers – individuals,corporates, who need foreign exchange for theirtransactions. Though customers are major players inthe foreign exchange market, for all practical purposesthey depend upon ADs and brokers. In the spot foreignexchange market, foreign exchange transactions wereearlier dominated by brokers. Nevertheless, thesituation has changed with the evolving marketconditions, as now the transactions are dominatedby ADs. Brokers continue to dominate the derivativesmarket.

6.35 The Reserve Bank intervenes in the marketessentially to ensure orderly market conditions. TheReserve Bank undertakes sales/purchases of foreigncurrency in periods of excess demand/supply in themarket. Foreign Exchange Dealers’ Association ofIndia (FEDAI) plays a special role in the foreignexchange market for ensuring smooth and speedygrowth of the foreign exchange market in all itsaspects. All ADs are required to become members ofthe FEDAI and execute an undertaking to the effectthat they would abide by the terms and conditionsstipulated by the FEDAI for transacting foreignexchange business. The FEDAI is also the accreditingauthority for the foreign exchange brokers in the inter-bank foreign exchange market.

6.36 The licences for ADs are issued to banks andother institutions, on their request, under Section10(1) of the Foreign Exchange Management Act,1999. ADs have been divided into different categories.All scheduled commercial banks, which include publicsector banks, private sector banks and foreign banksoperating in India, belong to category I of ADs. Allupgraded full fledged money changers (FFMCs) andselect regional rural banks (RRBs) and co-operativebanks belong to category II of ADs. Select financialinstitutions such as EXIM Bank belong to categoryIII of ADs. Currently, there are 86 (Category I) ADsoperating in India out of which five are co-operativebanks (Table 6.3). All merchant transactions in theforeign exchange market have to be necessarilyundertaken directly through ADs. However, to providedepth and liquidity to the inter-bank segment, ADshave been permitted to utilise the services of brokersfor better pr ice discovery in their inter-banktransactions. In order to further increase the size ofthe foreign exchange market and enable it to handlelarge flows, it is generally felt that more ADs shouldbe encouraged to participate in the market making.The number of participants who can give two-wayquotes also needs to be increased.

222


6.37 The customer segment of the foreignexchange market comprises major public sector units,corporates and business entit ies with foreignexchange exposure. It is generally dominated byselect large public sector units such as Indian OilCorporation, ONGC, BHEL, SAIL, Maruti Udyog andalso the Government of India (for defence and civildebt service) as also big private sector corporateslike Reliance Group, Tata Group and Larsen andToubro, among others. In recent years, foreigninstitutional investors (FIIs) have emerged as majorplayers in the foreign exchange market.

Sources of Supply and Demand in the ForeignExchange Market

6.38 The major sources of supply of foreignexchange in the Indian foreign exchange market arereceipts on account of exports and invisibles in thecurrent account and inflows in the capital accountsuch as foreign direct investment (FDI), portfolioinvestment, external commercial borrowings (ECB)and non-resident deposits. On the other hand, thedemand for foreign exchange emanates from importsand invisible payments in the current account,amortisation of ECB (including short-term tradecredits) and external aid, redemption of NRI depositsand outflows on account of direct and portfolioinvestment. In India, the Government has no foreigncurrency account, and thus the external aid receivedby the Government comes directly to the reservesand the Reserve Bank releases the required rupeefunds. Hence, this particular source of supply offoreign exchange is not routed through the marketand as such does not impact the exchange rate.

6.39 During last five years, sources of supply anddemand have changed significantly, with largetransactions emanating from the capital account,unlike in the 1980s and the 1990s when current

account transactions dominated the foreign exchangemarket. The behaviour as well as the incentivestructure of the participants who use the market forcurrent account transactions differ significantly fromthose who use the foreign exchange market for capitalaccount transactions. Besides, the change in thesetraditional determinants has also reflected itself inenhanced volatility in currency markets. It nowappears that expectations and even momentaryreactions to the news are often more important indetermining fluctuations in capital flows and hence itserves to amplify exchange rate volatility (Mohan,2006a). On many occasions, the pressure onexchange rate through increase in demand emanatesfrom “expectations based on cer tain news”.Sometimes, such expectations are destabilising andoften give rise to self-fulfilling speculative activities.Recognising this, increased emphasis is being placedon the management of capital account throughmanagement of foreign direct investment, portfolioinvestment, external commercial borrowings, non-resident deposits and capital outflows. However, thereare occasions when large capital inflows as also largelumpiness in demand do take place, in spite ofadhering to all the tools of management of capitalaccount. The role of the Reserve Bank comes intofocus during such times when it has to prevent theemergence of such destabilising expectations. In suchcases, recourse is undertaken to direct purchase andsale of foreign currencies, sterilisation through openmarket operations, management of liquidity underliquidity adjustment facility (LAF), changes in reserverequirements and signaling through interest ratechanges. In the last few years, despite large capitalinflows, the rupee has shown two - way movements.Besides, the demand/supply situation is also affectedby hedging activities through various instruments thathave been made available to market participants tohedge their risks.

Derivative Market Instruments

6.40 Derivatives play a crucial role in developingthe foreign exchange market as they enable marketplayers to hedge against underlying exposures andshape the overall risk profile of participants in themarket. Banks in India have been increasingly usingderivatives for managing risks and have also beenoffering these products to corporates. In India, variousinformal forms of derivatives contracts have existedfor a long time though the formal introduction of avariety of instruments in the foreign exchangederivatives market started only in the post-reformperiod, especially since the mid-1990s. Cross-

Table 6.3: Authorised Dealers (Category-I) in theForeign Exchange Market

(As on March 31, 2007)

Category Number

1 2

Public Sector Banks 27Private Sector Banks 31Of which:

Co-operative Banks 5Foreign Banks 28

Total 86


223


Foreign Exchange Forwards

Authorised Dealers (ADs) (Category-I) are permitted toissue forward contracts to persons resident in India withcrystallised foreign currency/foreign interest rate exposureand based on past performance/actual import-exportturnover, as permitted by the Reserve Bank and to personsresident outside India with genuine currency exposure tothe rupee, as permitted by the Reserve Bank. The residentsin India generally hedge crystallised foreign currency/foreign interest rate exposure or transform exposure fromone currency to another permitted currency. Residentsoutside India enter into such contracts to hedge ortransform permitted foreign currency exposure to therupee, as permitted by the Reserve Bank.

Foreign Currency Rupee Swap

A person resident in India who has a long-term foreigncurrency or rupee liability is permitted to enter into such aswap transaction with ADs (Category-I) to hedge ortransform exposure in foreign currency/foreign interest rateto rupee/rupee interest rate.

Foreign Currency Rupee Options

ADs (Category-I) approved by the Reserve Bank and ADs(Category-I) who are not market makers are allowed to

Box VI.4Foreign Exchange Derivative Instruments in India

sell foreign currency rupee options to their customers ona back-to-back basis, provided they have a capital to risk-weighted assets ratio (CRAR) of 9 per cent or above. Theseoptions are used by customers who have genuine foreigncurrency exposures, as permitted by the Reserve Bankand by ADs (Category-I) for the purpose of hedging tradingbooks and balance sheet exposures.

Cross-Currency Options

ADs (Category-I) are permitted to issue cross-currencyoptions to a person resident in India with crystallised foreigncurrency exposure, as permitted by the Reserve Bank. Theclients use this instrument to hedge or transform foreigncurrency exposure arising out of current account transactions.ADs use this instrument to cover the risks arising out ofmarket-making in foreign currency rupee options as well ascross currency options, as permitted by the Reserve Bank.

Cross-Currency Swaps

Entities with borrowings in foreign currency under externalcommercial borrowing (ECB) are permitted to use crosscurrency swaps for transformation of and/or hedgingforeign currency and interest rate risks. Use of this productin a structured product not conforming to the specificpurposes is not permitted.

currency derivatives with the rupee as one leg wereintroduced with some restrictions in April 1997.Rupee-foreign exchange options were allowed in July2003. The foreign exchange derivative products thatare now available in Indian financial markets can begrouped into three broad segments, viz., forwards,options (foreign currency rupee options and crosscurrency options) and currency swaps (foreigncurrency rupee swaps and cross currency swaps)(Box VI.4).

6.41 Available data indicate that the most widelyused derivative instruments are the forwards andforeign exchange swaps (rupee-dollar). Options havealso been in use in the market for the last four years.However, their volumes are not significant and bid-offer spreads are quite wide, indicating that the marketis relatively illiquid. Another major factor hindering thedevelopment of the options market is that corporatesare not permitted to write/sell options. If corporateswith underlying exposures are permitted to write/sellcovered options, this would lead to increase in marketvolume and liquidity. Further, very few banks aremarket makers in this product and many deals aredone on a back to back basis. For the product to reach

the farther segment of corporates such as small andmedium enterprises (SME) sector, it is imperative thatpublic sector banks develop the necessaryinfrastructure and expertise to transact in options. Inview of the growing complexity, diversity and volumeof derivatives used by banks, an Internal Group wasconstituted by the Reserve Bank to review the existingguidelines on der ivatives and formulatecomprehensive guidelines on derivatives for banks(Box VI.5).

6.42 With regard to forward contracts and swaps,which are relatively more popular instruments in theIndian derivatives market, cancellation and rebookingof forward contracts and swaps in India have beenregulated. Gradually, however, the Reserve Bank hasbeen taking measures towards eliminating suchregulations. The objective has been to ensure thatexcessive cancellation and rebooking do not add tothe volatility of the rupee. At present, exposuresarising on account of swaps, enabling a corporate tomove from rupee to foreign currency liability (derivedexposures), are not permitted to be hedged. Whilethe market participants have preferred such a hedgingfacility, it is generally believed that equating derived

224


exposure in foreign currency with actual borrowing inforeign currency would tantamount to violation of thebasic premise for accessing the forward foreignexchange market in India, i.e., having an underlyingforeign exchange exposure.

6.43 This feature (i.e., ‘the role of an underlyingtransaction in the booking of a forward contract’) isunique to the Indian derivatives market. The insistenceon this requirement of underlying exposure has to beviewed against the backdrop of the then prevailingconditions when it was imposed. Corporates in Indiahave been permitted increasing access to foreigncurrency funds since 1992. They were also accordedgreater freedom to under take active hedging.However, recognising the relatively nascent stage ofthe foreign exchange market initially with the lack ofcapabilities to handle massive speculation, the‘underlying exposure’ criterion was imposed as a pre-requisite. Exporters and importers were permitted tobook forward contracts on the basis of a declarationof an exposure and on the basis of past performance.

Eligible limits were gradually raised to enablecorporates greater flexibility. The limits are computedseparately for export and import contracts. Documentsare required to be furnished at the time of maturity ofthe contract. Contracts booked in excess of 25 percent of the eligible limit had to be on a deliverablebasis and could not be cancelled. This relaxation hasproved very useful to exporters of software and otherservices since their projects are executed on the basisof master agreements with overseas buyers, whichusually do not indicate the volumes and tenor of theexpor ts (Repor t of Internal Group on ForeignExchange Markets, 2005). In order to provide greaterflexibility to exporters and importers, as announcedin the Mid-term review of the Annual Policy 2006-07,this limit has been enhanced to 50 per cent.

6.44 Notwithstanding the initiatives that have beentaken to enhance the flexibility for the corporates, theneed is felt to review the underlying exposure criteriafor booking a forward contract. The underlyingexposure criteria enable corporates to hedge only a

The draft comprehensive guidelines issued on December 11,2006 cover broad generic principles for undertaking derivativetransactions, permissible categories of derivative instruments,defining the role of market makers and users, suitability andappropriateness policies, risk management and corporategovernance aspects, and internal control and audit.Subsequently, a modified version of these guidelinesincorporating the comments of a wide spectrum of banks andmarket participants was issued by the Reserve Bank on April20, 2007. These guidelines for accounting and valuation ofderivatives, already circulated, are expected to provide aholistic framework for regulating the derivatives business ofbanks in future. Comprehensive guidelines contain four mainmodifications in the existing guidelines pertaining toinstruments in foreign exchange derivatives. First, users suchas importers and exporters having crystallised unhedgedexposure in respect of current account transactions may writecovered call and put options in both foreign currency/rupeeand cross currency and receive premia. Second, marketmakers may write cross currency options. Third, marketmakers may offer plain vanilla American foreign currencyrupee options. Fourthly, a person resident in India havingforeign exchange or rupee liability is permitted to enter into aforeign currency rupee swap for hedging long-term exposure,i.e., exposure with residual maturity of three years or more.

For risk management and corporate governance relatedto banks’ exposure to derivatives markets, basic principlesof a prudent system have been specified in thecomprehensive guidelines. These basic principles mainly

Box VI.5Derivatives Market: Comprehensive Guidelines

entail (i) appropriate oversight by the board of directors andsenior management; (ii) adequate risk management processthat integrates prudent risk limits, sound measurementprocedures and information systems, continuous riskmonitoring and frequent management reporting; and(iii) comprehensive internal controls and audit procedures.

Regarding risk management, the guidelines explainidentification and accurate measurement of various typesof risks, by the market makers, involved in derivativeactivities. Accurate measurement of derivative relatedrisks is necessary for proper monitoring and control and,therefore, all significant risks should be measured andintegrated into an entity-wide risk management system.The guidelines further elucidate various risk limits, viz.,market risk limits, credit limits, and liquidity limits, whichserve as a means to control exposures to various risksassociated with derivative activities. Apart from abovementioned principles, the guidelines also include therequirement of a mechanism for an independentmonitoring of each entity and controlling of various risksin derivatives. Furthermore, the guidelines cover detailspertaining to internal audit, prudential norms relating toderivatives, prudential limits on derivatives, and regulatoryreporting and balance sheet disclosures.

Reference:

Reserve Bank of India. 2006. Comprehensive Guidelineson Derivatives Market.

225


part of their exposures that arise on the basis of thephysical volume of goods (exports/imports) to bedelivered4 . With the Indian economy gettingincreasingly globalised, corporates are also exposedto a variety of ‘economic exposures’ associated withthe types of foreign exchange/commodity risks/exposures arising out of exchange rate fluctuations.At present, the domestic prices of commodities suchas ferrous and non-ferrous metals, basic chemicals,petro-chemicals, etc. are observed to exhibit worldimport parity. Given the two-way movement of therupee against the US dollar and other currencies inrecent years, it is necessary for the producer/consumer of such products to hedge their economicexposures to exchange rate fluctuation. Besides,price-fix hedges are also available for traders globally.They enable importers/exporters to lock into a futureprice for a commodity that they plan to import/exportwithout actually having a crystallised physicalexposure to the commodity. Traders may also beaffected not only because of changes in rupee-dollarexchange rates but also because of changes in crosscurrency exchange rates. The requirement of‘underlying criteria’ is also often cited as one of thereasons for the lack of liquidity in some of thederivative products in India. Hence, a fixation on the‘underlying criteria’ as India globalises may hinder theful l development of the forward market. Therequirement of past performance/under lyingexposures should be eliminated in a phased manner.This has also been the recommendation of both thecommittees on capital account convertibility. It is citedthat this pre-requisite has been one of the factorscontributing to the shift over time towards the non-deliverable forward (NDF) market at offshore locationsto hedge such exposures since such requirement isnot stipulated while booking a NDF contract. Anattempt has been made recently provide importersthe facility to partly hedge their economic exposureby permitting them to book forward contracts for theircustoms duty component.

6.45 The Annual Policy Statement for 2007-08,released on April 24, 2007 announced a host ofmeasures to expand the range of hedging toolsavailable to market participants as also facilitatedynamic hedging by residents. To hedge economicexposures, it has been proposed that ADs (Category-I) may permit (a) domestic producers/users to hedgetheir price risk on aluminium, copper, lead, nickel

and zinc in international commodity exchanges,based on their underlying economic exposures; and(b) actual users of aviation turbine fuel (ATF) tohedge their economic exposures in the internationalcommodity exchanges based on their domesticpurchases. Authorised dealer banks may approachthe Reserve Bank for permission on behalf ofcustomers who are exposed to systemic internationalprice risk, not covered otherwise. In order to facilitatedynamic hedging of foreign exchange exposures ofexporters and importers of goods and services, ithas been proposed that forward contracts bookedin excess of 75 per cent of the eligible limits have tobe on a deliverable basis and cannot be cancelledas against the existing limit of 50 per cent. With aview to giving greater flexibility to corporates withoverseas direct investments, the forward contractsentered into for hedging overseas direct investmentshave been allowed to be cancelled and rebooked. Inorder to enable small and medium enterprises tohedge their foreign exchange exposures, it has beenproposed to permit them to book forward contractswithout underlying exposures or past records ofexports and imports. Such contracts may be bookedthrough ADs with whom the SMEs have creditfacilities. They have also been allowed to freelycancel and rebook these contracts. In order to enableresident individuals to manage/hedge their foreignexchange exposures, it has been proposed to permitresident individuals to book forward contracts withoutproduction of underlying documents up to an annuallimit of US $ 100,000, which can be freely cancelledand rebooked.

Foreign Exchange Market Trading Platform

6.46 A variety of trading platforms are used bydealers in the EMEs for communicating and tradingwith one another on a bilateral basis. They conductbilateral trades through telephones that are laterconfirmed by fax or telex. Some dealers also tradeon electronic trading platforms that allow for bilateralconversations and dealing such as the ReutersDealing 2000-1 and Dealing 3000 Spot systems.Bilateral conversations may also take place overnetworks provided by central banks and over privatesector networks (Brazil, Chile, Colombia, Korea andthe Philippines). Reuters’ Dealing System has beenthe most popular trading platform in EMEs.

4 These are generally categorised as ‘transactions exposure’ which is the extent to which the value of transactions already entered into is affectedby exchange rate risk and ‘contractual exposure’ that connotes the extent of exposures associated with contractual agreements.

226


6.47 In the Indian foreign exchange market, spottrading takes place on four platforms, viz., FX CLEARof the CCIL set up in August 2003, FX Direct that is aforeign exchange trading platform launched by IBSForex (P) Ltd. in 2002 in collaboration with FinancialTechnologies (India) Ltd., and two other platforms bythe Reuters - D2 platform and the Reuters MarketData System (RMDS) trading platform that have aminimum trading amount limit of US $ 1 million. FX-CLEAR and FX Direct offer both real time ordermatching and negotiation modes for dealing. The RealTime Matching system enables real time matching ofcurrency pairs for immediate and auto execution inboth the spot and forward segments. In theNegotiated Dealing System, on the other hand,participant is free to choose and negotiate with hiscounter-party on all aspects of the transaction,thereby offering him flexibility to select the underlyingcurrency as well as the terms of trade. These tradingplatforms cover the US dollar-Indian Rupee (USD-INR) transactions and transactions in major crosscurrencies (EUR/USD, USD/JPY, GBP/USD etc.),though USD-INR constitutes the most of the foreignexchange transactions in terms of value. It is the FXCLEAR of the CCIL that remains the most widely usedtrading platform in India. This platform has been givento members free of cost. The main advantage of thisplatform is its offer of straight-through processing(STP) capabilities as it is linked to CCIL’s settlementplatform.

6.48 In the forward segment of the Indian foreignexchange market, trading takes place both over thecounter (OTC) and in an exchange traded market withbrokers playing an impor tant role. The tradingplatforms available include FX CLEAR of the CCIL,RMDS from Reuters and FX Direct of the IBS.

6.49 In order to enhance the efficiency andtransparency of the foreign exchange market andmake it comparable with the markets of other EMEs,the Committee on Fuller Capital Account Convertibility(FCAC, 2006) has proposed the introduction of anelectronic trading platform for the conduct of all foreignexchange transactions. Under such an arrangement,an authorised dealer will fix certain limits for its clientsfor trading in foreign exchange, based on a creditassessment of each client or deposit funds ordesignated securities as collateral. A number of smallforeign exchange brokers could also be given accessto the foreign exchange trading screen by theauthor ised dealers. In the case of electronictransaction, the buy/sell order for foreign exchangeof an authorised dealer’s client first flows from the

client’s terminal to that of the authorised dealers’dealing system. If the client’s order is within theexposure limit, the dealing system will automaticallyroute the order to the central matching system. Afterthe order gets matched, the relevant details of thematched order would be routed to the client’s terminalthrough the trading system of the authorised dealer.Such a system would also have the advantage of thecustomer having the choice of trading with the bankquoting the best price and the Reserve Bank’sintervention in the foreign exchange market couldremain anonymous. For very large trades, a screennegotiated deal system has been proposed by theCommittee on Fuller Capital Account Convertibility.

Risk Management and Settlement of Transactionsin the Foreign Exchange Market

6.50 The foreign exchange market is characterisedby constant changes and rapid innovations in tradingmethods and products. While the innovative productsand ways of trading create new possibilities for profit,they also pose various kinds of risks to the market.Central banks all over the world, therefore, havebecome increasingly concerned of the scale of foreignexchange settlement risk and the importance of riskmitigation measures. Behind this growing awarenessare several events in the past in which foreignexchange settlement risk might have resulted insystemic risk in global financial markets, including thefailure of Bankhaus Herstatt in 1974 and the closureof BCCI SA in 1991.

6.51 The foreign exchange settlement risk arisesbecause the delivery of the two currencies involvedin a trade usually occurs in two different countries,which, in many cases are located in different timezones. This risk is of particular concern to the centralbanks given the large values involved in settlingforeign exchange transactions and the resultingpotential for systemic risk. Most of the banks in theEMEs use some form of methodology for measuringthe foreign exchange settlement exposure. Many ofthese banks use the single day method, in which theexposure is measured as being equal to all foreignexchange receipts that are due on the day. Someinstitutions use a multiple day approach for measuringrisk. Most of the banks in EMEs use some form ofindividual counterpar ty l imit to manage theirexposures. These limits are often applied to the globaloperations of the institution. These l imits aresometimes monitored by banks on a regular basis. Incertain cases, there are separate limits for foreignexchange settlement exposures, while in other cases,

227


limits for aggregate settlement exposures are createdthrough a range of instruments. Bilateral obligationnetting, in jurisdictions where it is legally certain, isan important way for trade counterparties to mitigatethe foreign exchange settlement risk. This processallows trade counterparties to offset their grosssettlement obligations to each other in the currenciesthey have traded and settle these obligations with thepayment of a single net amount in each currency.

6.52 Several emerging markets in recent yearshave implemented domestic real t ime grosssettlement (RTGS) systems for the settlement of high-value and time critical payments to settle the domesticleg of foreign exchange transactions. Apart from riskreduction, these initiatives enable participants toactively manage the time at which they irrevocablypay away when selling the domestic currency, andreconcile final receipt when purchasing the domesticcurrency. Participants, therefore, are able to reducethe duration of the foreign exchange settlement risk.

6.53 Recognising the systemic impact of foreignexchange settlement risk, an important element in theinfrastructure for the efficient functioning of the Indianforeign exchange market has been the clearing andsettlement of inter-bank USD-INR transactions. Inpursuance of the recommendations of the SodhaniCommittee, the Reserve Bank had set up the ClearingCorporation of India Ltd. (CCIL) in 2001 to mitigaterisks in the Indian financial markets. The CCILcommenced sett lement of foreign exchangeoperations for inter-bank USD-INR spot and forwardtrades from November 8, 2002 and for inter-bankUSD-INR cash and tom trades from February 5, 2004.The CCIL undertakes settlement of foreign exchangetrades on a multilateral net basis through a processof novation and all spot, cash and tom transactionsare guaranteed for settlement from the trade date.Every eligible foreign exchange contract enteredbetween members gets novated or replaced by twonew contracts – between the CCIL and each of thetwo parties, respectively. Following the multilateralnetting procedure, the net amount payable to, orreceivable from, the CCIL in each currency is arrivedat, member-wise. The Rupee leg is settled throughthe members’ current accounts with the Reserve Bankand the USD leg through CCIL’s account with thesettlement bank at New York. The CCIL sets limits foreach member bank on the basis of certain parameterssuch as member’s credit rating, net worth, asset valueand management quality. The CCIL settled over900,000 deals for a gross volume of US $ 1,180 billionin 2005-06. The CCIL has consistently endeavoured

to add value to the services and has gradually broughtthe entire gamut of foreign exchange transactionsunder its purview. Intermediation, by the CCIL thus,provides its members the benefits of risk mitigation,improved efficiency, lower operational cost and easierreconciliation of accounts with correspondents.

6.54 An issue related to the guaranteed settlementof transactions by the CCIL has been the extensionof this facility to all forward trades as well. Memberbanks currently encounter problems in terms of hugeoutstanding foreign exchange exposures in theirbooks and this comes in the way of their doing moretrades in the market. Risks on such huge outstandingtrades were found to be very high and so were thecapital requirements for supporting such trades.Hence, many member banks have expressed theirdesire in several fora that the CCIL should extend itsguarantee to these forward trades from the trade dateitself which could lead to significant increase in theliquidity and depth in the forward market. The risksthat banks today carry in their books on account oflarge outstanding forward positions will also besignificantly reduced (Gopinath, 2005). This has alsobeen one of the recommendations of the Committeeon Fuller Capital Account Convertibility.

6.55 Apart from managing the foreign exchangesettlement risk, participants also need to managemarket risk, liquidity risk, credit risk and operationalrisk efficiently to avoid future losses. As per theguidelines framed by the Reserve Bank for banks tomanage risk in the inter-bank foreign exchangedealings and exposure in derivative markets as marketmakers, the boards of directors of ADs (category-I)are required to frame an appropriate policy and fixsuitable limits for operations in the foreign exchangemarket. The net overnight open exchange position andthe aggregate gap limits need to be approved by theReserve Bank. The open position is generallymeasured separately for each foreign currencyconsisting of the net spot position, the net forwardposition, and the net options position. Various limitsfor exposure, viz., overnight, daylight, stop loss, gaplimit, credit limit, value at risk (VaR), etc., for foreignexchange transactions by banks are fixed. Within thecontour of these limits, front office of the treasury ofADs transacts in the foreign exchange market forcustomers and own proprietary requirements. Theseexposures are accounted, confirmed and settled byback office, while mid-office evaluates the profit andmonitors adherence to risk limits on a continuousbasis. In the case of market risk, most banks use acombination of measurement techniques including

228


VaR models. The credit risk is generally measuredand managed by most banks on an aggregatecounter-party basis so as to include all exposures inthe underlying spot and derivative markets. Somebanks also monitor country risk through cross-bordercountry risk exposure limits. Liquidity risk is generallyestimated by monitoring asset liability profile invarious currencies in various buckets and monitoringcurrency-wise gaps in various buckets. Banks alsotrack balances to be maintained on a daily basis inNostro accounts, remittances and committed foreigncurrency term loans while monitoring liquidity risk.

6.56 To sum up, the foreign exchange marketstructure in India has undergone substantialtransformation from the early 1990s. The marketparticipants have become diversified and there areseveral instruments available to manage their risks.Sources of supply and demand in the foreignexchange market have also changed in line with theshifts in the relative impor tance in balance ofpayments from current to capital account. There hasalso been considerable improvement in the marketinfrastructure in terms of trading platforms andsettlement mechanisms. Trading in Indian foreignexchange market is largely concentrated in the spotsegment even as volumes in the derivatives segmentare on the rise. Some of the issues that need attentionto further improve the activity in the derivativessegment include flexibility in the use of variousinstruments, enhancing the knowledge andunderstanding the nature of r isk involved intransacting the derivative products, reviewing the roleof underlying in booking forward contracts andguaranteed settlements of forwards. Besides, marketplayers would need to acquire the necessary expertiseto use different kinds of instruments and manage therisks involved.

IV. FOREIGN EXCHANGE MARKET: ANASSESSMENT

6.57 The continuous improvement in marketinfrastructure has had its impact in terms of enhanceddepth, liquidity and efficiency of the foreign exchangemarket. The turnover in the Indian foreign exchangemarket has grown significantly in both the spot andderivatives segments in the recent past. Along withthe increase in onshore turnover, activity in theoffshore market has also assumed importance. Withthe gradual opening up of the capital account, theprocess of price discovery in the Indian foreignexchange market has improved as reflected in thebid-ask spread and forward premia behaviour.

Foreign Exchange Market Turnover

6.58 As per the Triennial Central Bank Survey bythe Bank for International Settlements (BIS) on“Foreign Exchange and Derivatives Market Activity”,global foreign exchange market activity rose markedlybetween 2001 and 2004 (Table 6.4). The strong growthin turnover may be attributed to two related factors.First, the presence of clear trends and higher volatilityin foreign exchange markets between 2001 and 2004led to trading momentum, where investors took largepositions in currencies that followed persistentappreciating trends. Second, positive interest ratedifferentials encouraged the so-called “carry trading”,i.e., investments in high interest rate currenciesfinanced by positions in low interest rate currencies.The growth in outright forwards between 2001 and2004 reflects heightened interest in hedging. Withinthe EM countries, traditional foreign exchange tradingin Asian currencies generally recorded much fastergrowth than the global total between 2001 and 2004.Growth rates in turnover for Chinese renminbi, Indianrupee, Indonesian rupiah, Korean won and newTaiwanese dollar exceeded 100 per cent betweenApril 2001 and April 2004 (Table 6.5). Despitesignificant growth in the foreign exchange marketturnover, the share of most of the EMEs in total globalturnover, however, continued to remain low.

6.59 The Indian foreign exchange market hasgrown manifold over the last several years. The dailyaverage turnover impressed a substantial pick up fromabout US $ 5 billion during 1997-98 to US $ 18 billionduring 2005-06. The turnover has risen considerablyto US $ 23 billion during 2006-07 (up to February2007) with the daily turnover crossing US $ 35 billionon certain days during October and November 2006.The inter-bank to merchant turnover ratio has halvedfrom 5.2 during 1997-98 to 2.6 during 2005-06,

Table 6.4: Global Foreign Exchange Market Turnover(Daily averages in April, in billions of US dollars)

Item 1989 1998 2001 2004

1 2 3 4 5

Spot Transactions 317 568 387 621Outright Forwards 27 128 131 208Foreign Exchange Swaps 190 734 656 944Estimated Gaps in Reporting 56 60 26 107Total “Traditional” Turnover 590 1,490 1,200 1,880

Memo:Turnover at April 2004 Exchange Rates 650 1,590 1,380 1,880

Source : Triennial Central Bank Survey on “Foreign Exchange andDerivatives Market Activity”, Bank for International Settlement,2005.

229


reflecting the growing participation in the merchantsegment of the foreign exchange market (Table 6.6and Chart VI.2). Mumbai alone accounts for almost80 per cent of the foreign exchange turnover.

6.60 Turnover in the foreign exchange market was6.6 times of the size of India’s balance of paymentsduring 2005-06 as compared with 5.4 times in 2000-01(Table 6.7). With the deepening of the foreignexchange market and increased turnover, income ofcommercial banks through treasury operations hasincreased considerably. Profit from foreign exchangetransactions accounted for more than 20 per cent oftotal profits of the scheduled commercial banksduring 2004-05 and 2005-06 (Chart VI.3).

Table 6.6: Indicators of Indian Foreign ExchangeMarket Activity

(US $ billion)

Item 1997-1998 2005-2006 2006-2007@

1 2 3 4

Total Annual Turnover 1,306 4,413 5,734Average Daily Turnover 5 18 23Average Daily Merchant Turnover 1 5 7Average Daily Inter-bank Turnover 4 13 18Inter-bank to Merchant ratio 5.2 2.6 2.6Spot/Total Turnover (%) 51.6 50.5 52.4Forward/Total Turnover (%) 12.0 19.0 18.0Swap/Total Turnover (%) 36.4 30.5 29.6

@ : April-February.Source : Reserve Bank of India.

Table 6.5: Traditional Foreign Exchange MarketTurnover in EM Currencies - April 2004(Daily averages, in millions of US dollars)

Spot Forward Swap Total Growthsince2001

(%)

1 2 3 4 5 6

Chinese renminbi 992 811 9 1,812 530Hong Kong dollar 6,827 2,221 24,133 33,181 21Indian rupee 2,877 1,531 1,658 6,066 114Indonesian rupiah 760 267 1,025 2,051 283Korean won 10,510 6,048 4,592 21,151 117Malaysian ringgit 351 237 399 987 7Philippine peso 345 232 188 765 52Singapore dollar 5,177 1,242 10,591 17,010 32New Taiwan dollar 3,607 2,798 856 7,261 129Thai baht 1,333 490 1,669 3,492 88

Memo:

US dollar 528,639 170,357 874,083 1,573,080 48Euro 272,887 88,243 298,231 659,361 49Pound sterling 82,839 31,338 185,241 299,417 93Japanese yen 130,382 47,135 181,715 359,231 35

Source : BIS Quarterly Review, March 2005.

Table 6.7: Relative Size of the ForeignExchange Market in India

Year Foreign Balance of Foreign Col. 2 Col. 2Exchange Payment Currency over over

Market- Size Assets of Col. 3 Col. 4Annual (US $ RBI*

Turnover billion) (US $(US $ billion) billion)

1 2 3 4 5 6

2000-01 1,387 258 40 5.4 352001-02 1,421 237 51 6.0 282002-03 1,560 267 72 5.8 222003-04 2,118 362 107 5.9 202004-05 2,892 481 136 6.0 212005-06 4,413 664 145 6.6 30

* As at end-March.Source : Reserve Bank of India.

6.61 The bank group-wise distr ibution of theturnover (as a proportion of the total turnover for therespective year) reveals that foreign banks accountfor the largest share in total turnover, though theirshare declined from 59 per cent in 1996-97 to 42 percent during 2005-06 (Table 6.8). The share of publicand private sector banks increased correspondingly.Turnover of some of the new private sector banks, inparticular, increased sharply during this period.

6.62 The spot market remains the most importantforeign exchange market segment accounting for 51per cent of the total turnover. Its share, however, hasdeclined marginally in recent years due to a pick upin the turnover in derivative segment (Chart VI.4).

230


Table 6.9: Derivatives Turnover in India(US $ billion)

Item 2000-01 2005-06 2006-07 (Up toFebruary 2007)

1 2 3 4

Forward 163 839 1,035Swap 565 1,344 1,695Options@ 0 11 38

@ : Rough estimate.Source : Reserve Bank of India.

6.63 As mentioned ear l ier, the spot marketcomprises inter-bank and retail/merchant segments.It is the inter-bank transactions that dominate the spotsegment. The merchant segment of the spot marketis generally dominated by the Government of India,select large public sector units, such as Indian OilCorporation (IOC), and the FIIs. As the foreignexchange demand on account of public sector unitsand the Government tends to be lumpy and uneven,resultant demand-supply mismatches entai loccasional pressures on the foreign exchange market,warranting market interventions by the Reserve Bank.However, in recent years, a two-way movement in theexchange rate has been observed, partly on accountof flows by FIIs. This, in turn, provided flexibility in theoperation of ADs and suggests an increase in depthand liquidity in the market.

6.64 In the derivatives market, foreign exchangeswaps account for the largest share of the total

derivatives turnover in India, followed by forwards andoptions (Table 6.9). Options have remainedinsignificant despite being in existence for four years.With restrictions on the issue of foreign exchangeswaps and options by corporates in India, the turnoverin these segments (swap and options) essentiallyreflects inter-bank transactions.

6.65 The forward segment of the derivativesmarket has both merchant and inter-bank participants.However, unlike in the spot segment, it is the merchantturnover that accounts for the larger share in theforward market (Char t VI.5). The inter-bank tomerchant turnover ratio that was close to unity till2000, declined sharply thereafter mainly due to thefaster growth of the merchant turnover, reflectinggrowing trade activity, robust corporate performanceand increased liberalisation.

6.66 Against the backdrop of the substantialincrease in turnover in the Indian foreign exchangemarket, it is useful to explore the factors determining Table 6.8: Foreign Exchange Turnover –

Bank Group-wise Share(in per cent)

Category 1996-97 2005-06of Banks Merchant Inter- Total Merchant Inter- Total

bank bank

1 2 3 4 5 6 7

Public Sector 8 21 29 6 26 32Private Sector 2 10 12 9 17 26Foreign 7 52 59 12 30 42Total 17 83 100 27 73 100


231


the trading volume. The limited available literaturesuggests that the expected turnover increases withthe increase in number of active traders, informationflows and amount of disagreement in the market andthat it may change over time (Tauchen and Pitts,1983). Evidence in the Indian context reveals thatgrowth in number of transactions, as expected, resultsin an increase in the trading volume in the foreignexchange market5 . The coefficient is, however, lowreflecting the relative stability of the market implyingthat large fluctuations in number of deals may not havesubstantial impact on market turnover. Apart from thenumber of trades in the market, the trading volume isalso determined by a host of other factors, viz. - thenumber of instruments available to market

participants, depth of the market and the increasingopenness of the economy, which have not beencaptured in the analysis.

6.67 The information about the future tradingvolume is useful for determining the spread of theexchange rates so as to reduce transaction costs andenable better price discovery. An efficient pricediscovery mechanism necessitates the study of pricevolatility and trade volume relationship. Empiricalanalysis6 of the relationship between the changes inthe trading volume and exchange rate return revealsthat the variation in trade volume could lead toincrease in the flexibility in the movement of exchangerates7 , which have been observed in the last few

5 The ARDL approach to cointegration analysis was applied on the data from Clearing Corporation of India Ltd (CCIL) for the periodNovember 12, 2002 through December 5, 2006, since the foreign exchange volumes variable was found to be non-stationary I(1)while the number of deals variable was stationary I(0) in level form. They were found to share a long-run relationship, based on whichthe following error correction version of ARDL (4, 4) with lag lengths selected by Schwarz Bayesian Criterion was estimated.

∆VOL = -0.14C – 0.45∆VOLt-1 – 0.24∆VOLt–2 – 0.13∆VOLt-3

(-3.37) (-13.02)* (-6.58)* (-4.17)*

+ 0.19∆NDt–1 + 0.10∆NDt–2 + 0.06∆NDt–3 + 0.44∆ND - 0.11εt-1

(11.24)* (6.08)* (3.97)* (136.49)* (-5.40)*R–2 = 0.97 DW = 2.03

The figures in the brackets are t-values; *denote significance at 1 per cent level. ∆ denotes the first difference of the respective variable;C is the intercept, VOL and ND are the log of foreign exchange trading volume in crore of rupees and number of deals per day respectively.Trading volume is the volume of transaction in the cash, tom, spot and forward segments.

6 In financial market, the volatility is time variant. Therefore, to handle the behaviour of the data, it is more appropriate to apply ARCH type of modelinstead of any constant variance approach. GARCH (1,1) framework was used to study this relationship.

7 The presence of ARCH effect in the exchange rate return series was tested before estimating GARCH(1,1) model. The mean equation ofGARCH(1,1) is an ARMA(2,2) model where the coefficients are found significant while estimating through OLS. The GARCH(1,1) is estimatedfor the period November 12, 2002 to December 5, 2006 and variables are Rupees/Dollar return and total trading volume in cash, tom, spot andforward segments. The estimated equation is:

ht = 0.01 + 0.01∆VOL + 0.54ht – 1 + 0.38εt – 1

(5.07)* (10.29)* (6.65)* (4.81)*R–2 = 0.004; DW=1.93; LM(8) = 6.28(0.62)

#; Wald Stat = 2.23(0.14)

#; Log likelihood = 159.15; AIC = -0.32.

h : the time-varying volatility of exchange rate return; ε represent the conditional error terms and ∆VOL is the first difference of log trading volume.

Figures in the brackets are t-values; *denotes significance at 1 per cent level; # : figures in the respective brackets are p-values.

232


8 Using the rupee-dollar bid-ask absolute spread (SPD), 1 month ATM rupee-dollar option price volatility (IV) as a proxy for expected volatility anddaily turnover (VOL) in the foreign exchange market (turnover in spot, forward and swap), the OLS equation is estimated for the period July 7,2003 to August 31, 2006. The spread and turnover/trading volume are in log forms.

log SPD = -4.56 – 0.01 log VOL + 3.29 IV(-31.63)* (-0.94) (5.18)*

R–2

= 0.15; DW = 2.10Figures in the brackets are t-values and *denotes significance at 1 per cent level.

years. Thus, increase in trading volume and theconsequent increase in flexibility implying two-wayexpectations is healthy for the development of themarket.

Market Efficiency

6.68 With the exchange rate primarily gettingdetermined by the forces of demand and supply, theissue of foreign exchange market efficiency hasassumed importance in India in recent years. Marketsare perceived as efficient when market prices reflectall available information, so that it is not possible forany trader to earn excess profits in a systematicmanner. The efficiency/l iquidity of the foreignexchange market is often gauged in terms of bid-askspread. The bid-ask spread reflects the transactionand operating costs involved in the transaction of thecurrency. These costs include phone bills, cablecharges, book-keeping expenses and trader salaries,among others. In the spot segment, it may also includethe risks involved in holding the foreign exchange.These costs/bid-ask spread are expected to declinewith the increase in the volume of transactions in thecurrency. The finance theory identifies three basicsources of bid-ask spreads: (a) order processingcosts, (b) inventory holding costs, and (c) informationcosts of market making, and each one is influencedby trading volume in a particular manner (Hartmann,1999). The low and stable bid-ask spread in the foreignexchange market, therefore, indicates that market isefficient with underlying low volatility, high liquidity andless of information asymmetry.

6.69 The spread in the Indian foreign exchangemarket has declined overtime and is very low atpresent. In India, the normal spot market quote hasa spread of 0.25 of a paisa to 1 paise, while swapquotes are available at 1 to 2 paise spread. A closerlook at the bid-ask spread in the rupee-US dollarspot market reveals that during the initial phase ofmarket development (i.e., till the mid-1990s), thespread was high and volatile due to a thin marketwith unidirectional behavior of market participants(Chart VI.6). In the subsequent period, with relativelydeep and liquid markets, the bid-ask spread declined

sharply and has remained low and stable, reflectingefficiency gains.

6.70 It was empirically observed that expectedvolatility of the rupee-dollar exchange rate couldimpact the spread which increases with the increasein volatility8. However, the trading volume has negligibleimpact on the exchange rate spread. The intercept ofthe estimated equation is highly significant showingthe flatness of the spread in the Indian foreign exchangemarket. The flat and low spread can be attributed tolower volatility in the foreign exchange market.

Behaviour of Forward Premia

6.71 An important aspect of functioning of theforeign exchange market relates to the behaviour offorward premia in terms of its linkages with economicfundamentals such as interest rates and its ability topredict future spot rates. An analysis of forwardpremia, essentially reflects whether a currency is ata premium/discount with respect to other reservecurrencies. Forward premia is particularly importantfor importers and exporters who need to hedge theirrisks to foreign currency. The forward market in India

233


is active up to six months where two-way quotes areavailable. In recent years, however, the segment upto one year maturity has also gained liquidity. The linkbetween the forward premia and interest ratedifferential seems to work largely through leads andlags. The integration between the domestic marketand the overseas market is more often through theforward market. The integration has been facilitatedby allowing ADs to borrow from their overseas officesor correspondents and invest funds in overseasmoney market. The forward segment is also influencedby a number of other factors: (i) importers andexporters availing or extending credit to overseasparties (importers can move between sight paymentand 180 days usance depending on the global interestrate, domestic interest rate and expectations on futurespot rate); (ii) importers switching between rupeecredit and foreign currency credit; (iii) the decision tohedge or not to hedge the exposure, depending onexpectations and forward premia; (iv) exportersdelaying payments or advance receivables, subjectto condit ions on repatr iat ion and surrender,depending upon the interest on rupee credit, thepremia and interest rate overseas; and (v) availing ofpre/post-shipment credit in foreign exchange andswitching between rupee and foreign currency credit.

6.72 With the opening up of the capital account,the forward premia is getting gradually aligned withthe interest rate differential reflecting growing marketefficiency. While free movement in capital accountis only a necessary condition for full developmentof, the forward and other foreign exchangederivatives markets, the sufficient condition isprovided by a deep and liquid money market with awell-defined yield curve.

6.73 In the post-liberalisation phase, the forwardpremia of the US dollar vis-à-vis Indian rupee hasgenerally remained high indicating that rupee was ata discount to the US dollar. In recent times, however,reflecting the build-up of foreign exchange reserves,the strong capital flows and the confidence in theIndian economy, the forward premia has come downsharply from the peak reached in 1995-96. For a shortperiod in 2003-04, the forward premia turned negativedefying the traditional theory according to which thecurrency of a country with higher inflation rate/interestrate should be at a discount vis-à-vis other country’scurrency. This was the period when Indian rupee wasgaining strength against the US dollar, whichdepreciated against most other currencies. The periodsince 2002 has, in fact, witnessed sharp co-movementof forward premia and exchange rate with the premia

exhibiting a decline, whenever rupee appreciated(Chart VI.7).

6.74 Forward premia is also affected bymovements in call rates, reflecting the principle ofinterest-rate parity. Tightening of liquidity in thedomestic market immediately pushes up call rates,which in turn, pushes up forward premia. Wheneverliquidity in the domestic market is tightened, banksand other market players sell the US dollar in cash orspot market and buy in the forward market pushingforward premia upward (Chart VI.8).

234


6.75 Several studies have analysed the behaviourof forward premia and have attempted to explore thefactors that determine it in the Indian foreign exchangemarket. Forward premia of Indian rupee is driven to alarge extent by the interest rate differential in the inter-bank market of the two economies, FII flows, currentaccount balance as well as changes in exchange ratesof US dollar vis-à-vis Indian rupee (Sharma and Mitra,2006). Another study has observed that the forwardpremia for the period 1997 to 2002 systemicallyexceeded rupee depreciation, implying that there hasbeen an asymmetric advantage to sellers of dollarforwards (Ranade and Kapur, 2003).

6.76 One way of assessing market efficiency is toobserve the forward rate behaviour as to whetherforward rates are unbiased predictor of future spotrates. For the period April 1993 to January 1998, itwas found that forward rates cannot effectively predictthe future spot rates and there is no co-integrationbetween forward rates and future spot rates (Joshiand Saggar, 1998). An analysis using the data for themore recent period during January 1995 to December2006 reveals that the ability of forward rates incorrectly predicting the future spot rates has improvedover time and that there is some co-integratingrelationship between the forward rate and the futurespot rate9 . This could be attributed to the gradualopening up of the Indian economy, particularly in thecapital account, together with other reform initiativesundertaken to develop the forward market such asintroduction of new instruments, trading platforms andmore players.

Non-Deliverable Forward (NDF) Market

6.77 In addition to the onshore spot and derivativesmarket, another segment that is fast picking up is the

offshore non deliverable forward (NDF) market. NDFsare synthetic foreign currency forward contracts onnon-convertible or restricted currencies traded overthe counter outside the direct jurisdiction of therespective national authorities of restricted currencies.The demand for NDFs arises principally out ofregulatory and liquidity constraint issues of theunderlying currencies. These derivatives allowmultinational corporations, portfolio investors, hedgefunds and proprietary foreign exchange accounts ofcommercial and investment banks to hedge or takespeculative positions in local currencies. While themultinational companies deal in both the long andshort end of the market, the short end of the marketis particularly dominated by the hedge funds. Thepricing is influenced by a combination of factors suchas interest rate differential between the twocurrencies, supply and demand, future spotexpectations, foreign exchange regime and centralbank policies. The settlement of the transaction is notby delivering the underlying pair of currencies, but bymaking a net payment in a convertible currency equalto the difference between the agreed forwardexchange rate and the subsequent spot rate. Theseare generally settled in US dollar. The currencies thatare traded in the Asian NDF markets are Chineseyuan, Korean won, Taiwanese dollar, Philippine peso,Indonesian rupiah, Malaysian ringgit, Thai baht,Pakistani rupee and Indian rupee. The market is veryliquid in Korean won, Chinese yuan and Taiwanesedollar followed by Indian rupee (Ma et al, 2004).

6.78 The NDF market in Indian rupee (INR NDF)has been in existence for over the last 10 years or so,reflecting onshore exchange controls and regulations.However, liquidity in the NDF market has improvedsince the late 1990s as foreign residents who hadgenuine exposure to the Indian rupee but were unable

9 To study the relationship between future spot rate and forward rate, the following equation was estimated:st+1 = α + βƒ t

1m + εt

Where st+1 is 1 month ahead (log) rupee-dollar future spot rate at time t, ƒ t1m is 1 month (log) forward rate and εt is the residual term.

For the forward rate to be unbiased predictor of future spot rate, the hypothesis test could be α = 0 and β = 1 and a white noise error term. Thelong run relationship between them is studied using cointegration between future spot rate and forward rate which states that one can predict oneof them with the information of the other.

st+1 = 0.04 + 0.99 ƒ t1m

(1.25) (107.41)*

R–2 = 0.99; DW = 1.45;

F stat (for α = 0 and β = 1) = 1.83 (0.16)#

ADF = -8.94 (0.00)#

Figures in brackets are t-values; * denotes significance at 1 per cent level; #: figures in the respective brackets are p-values.

The results indicate that one month forward rate is an unbiased predictor of 1 month ahead future spot rate as the joint hypothesis of α = 0 andβ = 1 is not rejected and the error term follows first order autocorrelation. Further, both the rates are cointegrated as reflected by the ADFstatistics of the error term.

235


to adequately hedge their exposure in the domesticmarket due to prevailing controls participated in theNDF market. However with the gradual relaxation ofexchange controls, reasonable hedging facilities areavailable to offshore non-residents who haveexposures to the Indian rupee, especially whencompared with the hedging facilities provided bysome other competing Asian countries. Besides, theINR NDF market also derives its liquidity from(i) non-residents wishing to speculate on the Indianrupee without any exposure to the country; and(ii) arbitrageurs who try to exploit the differentials inthe prices in the two markets10.

6.79 The INR NDFs have grown in volume anddepth over the years. While these are largelyconcentrated in Singapore, they are also in existencein London and New York. In the wake of the Asiancrisis, offshore implied interest rates were higher thanonshore rates, reflecting ongoing depreciationpressure in the offshore trading during that period.Since 2003, however, offshore expectation of furtherrupee appreciation has driven offshore impliedinterest rates below onshore rates. Though anaccurate assessment of the volumes is difficult,estimated that the daily volumes for INR NDF hoveredaround US $ 100 million in 2003/2004 (Ma et al , 2004)although repor tedly NDF volumes have grownsubstantially in the recent period. As compared withsome other Asian currencies traded in the NDF marketsuch as the Korean won, Chinese yuan and Taiwanesedollar, turnover in INR NDF is small. While thesevolumes are not large enough to affect the domesticonshore market under regular market conditions, involatile market conditions, however, these may impactthe domestic spot markets. In fact, available dataindicate a strong correlation between rupee-dollarspot, forward and NDF rates (Chart VI.9). As pricesin the NDF market can be a useful informational toolfor the authorities and investors to gauge marketexpectations of potential pressures on exchange rate,it may be useful from the policy angle to takecognisance of the developments in the NDF markets.

6.80 With regard to the regulatory aspects on theNDF market, there are no controls on the offshoreparticipation in INR NDF markets. Domestic bankingentities have specified open position and gap limitsfor their foreign exchange exposures and throughthese limits domestic entities could play in the NDF

markets to take advantage of any arbitrageopportunity.

6.81 Some Asian author it ies are nowcontemplating the liberalisation of their currencymarkets. An important issue that they face is how tofacilitate the transition from offshore NDF markets toregular onshore or deliverable forward markets.Despite the benefits of NDF markets for hedgingpurposes in Asia, par ticularly for currencies ofcountries attracting significant foreign investment,market participants indicate a number of limitationswhich are likely to be relevant in a period of transition.The first and most important limitation in Asia is thatonly global institutions and a limited number ofdomestic insti tut ions are able to use theseinstruments. Besides, for most markets there is limitedliquidity in contracts with a maturity over one year.Lastly, there is no guarantee that the holder of thecontract will actually be able to trade foreign exchangeat the fixing rate. An implication of this is that when achange in the exchange rate regime is anticipated,the validity of the fixing rate as an indication of wherea trade can be transacted is significantly diminished.

6.82 To sum up, with increase in depth and liquidity,the Indian foreign exchange market has evolved intoa mature market over a period of time. The turnoverhas increased over the years. With the gradual

10 For the Indian rupee, it is believed that arbitrage is profitable when there is difference of around 10 paise in the forwards prices. Such opportuni-ties are not very common, but tend to occur whenever speculative actions increase.

236


opening up of the capital account, the forward premiais getting increasingly aligned with the interest ratedifferential. There is also an evidence of enhancedefficiency in the foreign exchange market as reflectedin low bid-ask spreads. After having studied thedevelopment of the market structure and assessedtheir impact on liquidity and efficiency parameters,the next section dwells on the developments in theforeign exchange market in the post-liberalisationperiod, with focus on how the policy mix used by theReserve Bank led the Indian economy to withstandseveral domestic as well as external shocks, includingthe contagion effect of the Asian crisis.

V. BEHAVIOUR OF THE FOREIGN EXCHANGEMARKET IN THE POST-UNIFICATION PERIOD

6.83 As in most other EMEs, the Indian foreignexchange market has also witnessed occasionalperiods of volatility in the post-1993 period. However,unlike many other EMEs where volatilities havepersisted for prolonged periods resulting in severeimbalances and crises, the Indian experience reflectsan effective and timely management of volatility inthe foreign exchange market. The exchange ratepolicy is guided by the need to reduce excess volatility,prevent the emergence of destabilising speculativeactivities, help maintain adequate level of reservesand develop an orderly foreign exchange market. Witha view to reducing the excess volatility in the foreignexchange market arising from lumpy demand andsupply as well as leads and lags in merchanttransactions, the Reserve Bank undertakes sale andpurchase operations in the foreign exchange market.Such interventions, however, are not governed by anypre-determined target or band around the exchangerate. The experience with the market-determinedexchange rate system since 1993 can be describedas generally satisfactory as orderliness prevailed inthe Indian market during most of the period. A fewepisodes of volatility that emerged were effectivelymanaged through a combination of timely andeffective monetary as well as administrativemeasures, which ensured return of orderliness to themarket, within the shortest possible time.

First Phase of Stability: March 1993 to July 1995

6.84 In March 1993, as a precursor to currentaccount convertibility, India moved from the dualexchange rate regime to a unified market determinedexchange rate system under which the exchange rateis determined by the forces of supply and demand.On unification of the exchange rates, the nominal

exchange rate of the rupee against both the US dollaras also against a basket of currencies got adjusteddownwards. The Real Effective Exchange Rate(REER) of the rupee in the months following theunif ication represented almost an equil ibr iumsituation. This was also borne out by the currentaccount, which was more or less in balance in 1993-94. Exchange rate policy in the post-unification periodwas aimed at providing a stable environment by givinga boost to exports and foreign investment in line withthe structural and stabilisation programme.

6.85 With the liberalisation in the capital accountin the area of foreign direct investment and portfolioinvestments, capital inflows surged during 1993-94and 1994-95. The large inflows tended to exertappreciating pressure on the rupee. In order to obviateany nominal appreciation of the rupee, which couldhave eroded export competitiveness, the ReserveBank purchased a por tion of such inflows andaugmented the reserves. The foreign currency assetsof the Reserve Bank rose from US $ 6.4 billion inMarch 1993 to US $ 20.8 billion in March 1995,representing over seven months of import cover. Asa result, the exchange rate of the rupee reflected aprolonged period of stability and remained almoststable at Rs.31.37 per US dollar from March 1993 toJuly 1995. During this period, the sterilisationoperations were on a lower scale, resulting insomewhat larger growth in monetary aggregates.Thus, the focus of exchange rate policy during thisper iod was on preserving the externalcompetitiveness at a time when the economy wasundergoing a structural transformation. The Buildingup of the reserves was also one of the considerations.

First Phase of Volatility: August 1995 to March1996

6.86 After a long spell of stability during 1993-95,the rupee came under some pressure in the thirdquarter of calendar year 1995 on account of a suddenand sharp reversal of sentiment and expectations ofmarket participants. Slowing down of capital inflowsin the wake of the Mexican crisis, a moderate wideningof the current account deficit on resurgence of activityin the real sector and the rise of US dollar againstother major currencies after a bearish phase werethe main factors contributing to this trend. During thisperiod, there was a sharp movement in exchange rateoften resulting in overshooting. During most periodsthe opening rate in the foreign exchange marketmoved beyond the Reserve Bank buying and sellingrange and a distinct downward trend was seen. Some

237


of the structural weaknesses of the Indian inter-bankmarket like thinness and lack of heterogeneity of viewsamong market participants became apparent. The bid-offer spread widened to about 20 paise; on certaindays the spread was as wide as 85 paise, resulting intremendous buying pressure in the face of meagersupply. To eliminate the inconsistency of its buyingrate, the Reserve Bank stopped publishing its quoteon the Reuter screen with effect from October 4, 1995offering only a buying quote to banks on specificrequest.

6.87 With the objective of having an active marketintervention strategy, it was decided to keep a watchover day-to-day merchant demands of some largebanks which handled more than 50 per cent of theimport payments. As the main buying requirements ofthese banks were in respect of mainly public sectorundertakings, a system was put in place to obtaininformation about their daily requirements. Marketintelligence and information gathering werestrengthened and the Reserve Bank started obtainingdirect price quotes from leading foreign exchangebroking firms. Two basic approaches on interventionwere adopted. On days when there was informationabout large all round demand, an aggressive stancewas taken with intensive selling in larger lots till therate was brought down decisively. On other occasions,continual sale of small/moderate amounts wasundertaken to prevent unduly large intra-day variations.While the first approach was aimed at absorbing excessmarket demand, the second at curbing one ‘ratcheteffect’.11 The size of individual intervention deals wasusually in the range of US $ 1-2 million, although somelarge size deals not exceeding US $ 5 million were alsoresorted to occasionally.

6.88 Direct intervention was supplemented byadministrative measures such as imposition of interestsurcharge on import finance and the tightening ofconcessions in export credit for longer periods.Consequent upon tightness in liquidity conditions dueto intervention which led to soaring of call money rates,money market support was restored with the easingof CRR requirements on domestic as well as non-resident deposits from 15.0 per cent to 14.5 per centin November 1995. With a view to discouraging theexcessive use of bank credit for funding the demandfor foreign exchange, interest surcharge on importfinance was raised from 15 to 25 per cent. The schemefor extending Post-shipment Expor t Credit

denominated in US dollar (PSCFC) was discontinuedwith effect from February 8, 1996 as it enabledexporters to earn a positive differential over the costof funds simply by drawing credit and selling forward,thereby receiving the premia. Moreover, to curbexcessive speculation in the forward market,cancellation of forward contracts booked by ADs foramounts of US $ 1,00,000 and above was required tobe reported to the Reserve Bank on a weekly basis.The decisive and timely policy actions brought stabilityto the market and the rupee traded within the rangeof Rs.34.00 to Rs.35.00 per US dollar in the spotsegment during the period from October 1995 toMarch 1996.

Second Phase of Stability: April 1996 to Mid-August 1997

6.89 The foreign exchange market witnessedremarkable stability during the period from April 1996to mid-August 1997. During this period, the spotexchange rate remained in the range of Rs.35.50-36.00 per US dollar. The stability in the spot rate wasreflected in forward premia as well. The premia, whichremained within 6 to 9 per cent (six month) duringthe financial year 1996-97, declined further during thefirst five months of 1997-98 within a range of 3 to 6per cent following easy liquidity conditions. From thesecond quarter of calendar year 1996 onwards, capitalflows restored and the reserve loss was recoupedwithin a short period of time.

Second Phase of Volatility: Mid-August 1997 toAugust 1998

6.90 The year 1997-98 and the first quarter of1998-99 posed serious challenges to exchange ratemanagement due to the contagion effect of the South-East Asian currency crisis and some domestic factors.There were two periods of significant volatility in theIndian foreign exchange market: (i) from mid-August1997 to January 1998, and (ii) May 1998 till August1998. Response to these episodes includedintervention in both the spot and forward segmentsof the foreign exchange market and adoption ofstringent monetary and administrative measures,which were rolled back immediately on restoration oforderly conditions.

6.91 During the latter part of the calendar year1996 and early months of calendar year 1997,anticipation of stabil i ty in general and even

11 The ‘ratchet effect’ means that in a bearish market situation if the rate falls even due to situational factors it does not recover easily even onreversal of those factors.

238


Table 6.11 : Reserve Bank’s Intervention in theForeign Exchange Market

(US $ billion)

Year Purchase Sale Net Outstanding Net ForwardSales/Purchase

1 2 3 4 5

1995-96 3.6 3.9 -0.3 – 1996-97 11.2 3.4 7.8 – 1997-98 15.1 11.2 3.9 -1.81998-99 28.7 26.9 1.8 -0.81999-00 24.1 20.8 3.3 -0.72000-01 28.2 25.8 2.4 -1.32001-02 22.8 15.8 7.0 -0.42002-03 30.6 14.9 15.7 2.42003-04 55.4 24.9 30.5 1.42004-05 31.4 10.6 20.8 02005-06 15.2 7.1 8.1 02006-07@ 24.5 0 24.5 0

@ : April-February.Source : Reserve Bank of India.

Table 6.10: REER and NEER of Select Asian Countries(Base: 2000=100)

Country 1995 1997 2000 2001 2002 2003 2004 2005

1 2 3 4 5 6 7 8 9

Real Effective Exchange Rate (REER)China 84.7 100.4 100.0 104.3 101.9 95.2 92.7 92.5India 101.7 103.0 100.0 100.9 96.9 96.6 98.4 103.7Japan 108.2 85.3 100.0 89.0 83.0 83.6 84.5 79.4Malaysia 122.7 122.6 100.0 104.9 105.0 99.2 94.9 95.2Philippines 120.4 128.7 100.0 95.6 96.2 89.1 86.2 92.3Singapore 106.2 110.2 100.0 100.5 97.9 94.3 93.3 92.1

Nominal Effective Exchange Rate (NEER)China 82.2 92.5 100.0 105.5 105.1 98.6 94.2 94.3India 117.0 114.3 100.0 97.9 93.3 90.1 88.6 91.3Japan 99.4 81.3 100.0 90.5 85.7 85.4 87.1 85.3Malaysia 127.6 126.8 100.0 105.4 104.8 99.6 95.9 95.5Philippines 145.8 142.5 100.0 90.9 89.7 81.3 75.7 76.9Singapore 97.1 105.6 100.0 101.6 100.8 98.4 97.9 98.7

Note : Rise in index implies appreciation.For India data pertain to 6 currency trade-based index.

Source : International Financial Statistics, IMF, 2006 and Reserve Bank of India.

appreciation of rupee in some quarters led manymarket participants to keep their oversold or shortpositions unhedged and substitute partly domesticdebt by foreign currency borrowings to take advantageof interest arbitrage. This tendency was evident in theincreased demand for loans out of FCNR(B) funds.The relatively stable exchange rates of the Asiancurrencies prior to this period had contributed to theirappreciation in real terms (Table 6.10). In the wake ofdevelopments in the South East Asia and marketperceptions of exchange rate policy, marketparticipants rushed to cover unhedged positions. TheReserve Bank also subtly managed to talk down therupee in August 1997.

6.92 In response to the developments in the foreignexchange market, the Reserve Bank intervened bothin the spot and the forward segments of the market toprevent sharp depreciation of the rupee and to curbvolatility, especially in the forward segment, which ledto rise in outstanding forward liabilities by US $ 904million in September 1997. In October 1997, theReserve Bank allowed banks to invest and borrowabroad up to 15 per cent of unimpaired Tier I capital,which led to the resumption of capital flows andincrease in volumes in the foreign exchange market,particularly in the outright forward and swap segments.In such market condition, the Reserve Bank undertookintervention in both spot and forward segment andliquidated its forward liabilities (Table 6.11).

6.93 Thereafter, however, persistent excessdemand conditions combined with considerable

volatility prevailed in the foreign exchange market.Market sentiment weakened sharply from November1997 onwards in reaction to intensification of the crisisin the South-East Asia, and bearishness in domesticstock markets. Between November 1997 and January1998, the exchange rate of the Indian rupeedepreciated by around 9 per cent. The Reserve Bankundertook wide ranging and strong monetary andadministrative measures on January 16, 1998 in orderto curb the speculative tendencies among the marketplayers and restore orderly conditions in the foreignexchange market (Box VI.6). As a result of monetarymeasures of January 16, 1998, the stability in the

239


Box VI.6Policy Measures Undertaken in the Wake of Asian Crisis

November 26, 1997(i) Export Credit : Interest rate on post-shipment rupee export credit on usance bills for period (comprising usance period of export bills

transit period as specified by the FEDAI and grace period wherever applicable) beyond 90 days and up to six monthsfrom the date of shipment was increased from 13 per cent to 15 per cent per annum.

November 28, 1997(i) CRR : Deferment of future programme of bringing about a reduction in cash reserve ratio (CRR).(ii) Repos : Introduction of fixed rate repos at 4.5 per cent to absorb surplus liquidity.(iii) Export Credit : With effect from December 15, 1997 interest rate on post-shipment rupee export credit of 15 per cent was to made

applicable from the date of advance. Exporters were expected to take advantage of the time gap available up toDecember 15, 1997 by expediting realisations of their export proceeds.

December 1, 1997(i) Forward Contracts : Ban on rebooking of cancelled forward contracts on non-trade transactions for the same underlying exposure, only

rollover allowed.

December 2, 1997(i) CRR : Increase in CRR by 0.5 percentage points to 10 per cent with effect from fortnight beginning December 6, 1997.(iii) Forward Contracts : The facility granted to ADs in April 1997 to offer forward contracts based on past performance and declaration of

exposure was suspended and forward contracts were allowed based only on documents evidencing exposure.(iii) NRI Deposits : Abolition of 10 per cent incremental CRR on NRE(R)A and NR(NR)RD schemes with effect from December 6, 1997.

December 3, 1997(i) Forward Contracts : Reporting of cancellations of forward contracts beyond US $ 500,000 and merchant sales of US $ 2 million and above.(ii) Repos : Interest rate on fixed rate repos was raised to 5 per cent with effect from December 3, 1997.

December 4, 1997(i) Repos : Interest rate on fixed rate repos was raised to 6.5 per cent.

December 11, 1997(i) Repos : The interest rate on fixed rate repos was raised to 7.0 per cent.

December 17, 1997(i) Export Credit : Imposition of interest rate of 20 per cent per annum (minimum) on overdue export bills from the date of advance. In

case of demand bills and short-term usance bills, the higher rate of interest was not applicable where the total periodof credit, including the period of overdue was less than one month from the date of bill/ negotiation.

(ii) Surcharge on Import Finance : Imposition of interest rate surcharge of 15 per cent of the lending rate (excluding interest tax) on import finance.

December 19, 1997(i) Overseas Investments : Overnight investments from nostro accounts were included in the 15 per cent of unimpaired Tier I capital limit for

overseas investments by ADs.

December 31, 1997(i) Export Credit : Increase in the interest rate on post-shipment rupee export credit (measures undertaken on November 26 and 28,

1997) was rolled back. In other words, rate of interest on post-shipment rupee export credit (other than againstoverdue export bills) for period beyond 90 days and up to six months was to be 13 per cent per annum with effect fromJanuary 1, 1998. Hence, the position prevailing prior to November 26, 1997 was restored.

(ii) Export Credit : Imposition of interest rate of 20 per cent per annum on overdue export bills was made applicable for the overdueperiod and not from the date of advance and this rate was to be applicable in respect of certain chronic cases (whereeven six months ago, the bills were overdue).

January 6, 1998(i) Overnight Position Limits : Banks would have to square up their foreign exchange position on a daily basis.

January 16, 1998(i) CRR : Increase in CRR by 0.5 percentage points to 10.5 per cent with effect from fortnight beginning January 17, 1997.(ii) Repos : Interest rate on fixed rate repos was raised to 9.0 per cent from 7.0 per cent.(iii) Repos : Reverse repos facility was made available to Primary Dealers in Government Securities market at the Bank Rate on a

discretionary basis and subject to stipulation of conditions relating to their operations in the call money market.(iv) Surcharge on Import Finance : Interest rate surcharge on import finance was increased from 15 per cent to 30 per cent.(v) Overnight Position Limits : It was decided to withdraw the across-the-board formal stipulation regarding square/near- square positions and

restore to banks the freedom to run exposure within the limits approved. Banks were, however, advised to use theirovernight position limits for genuine transactions.

(vi) Overseas Investments : To meet genuine operational requirements in foreign exchange transactions, requests of individual banks would beconsidered in regard to limits on nostro account balances.

(vii) Bank Rate : The Bank rate was increased from 9 per cent to 11 per cent with corresponding increase in the interest rate on ExportCredit Refinance as well as General Refinance.

(viii) Refinance : Export refinance limit was reduced from 100 to 50 per cent of the increase in outstanding export credit eligible forrefinance over the level of such credit as on February 16, 1996.

(ix) Refinance : General refinance limit was reduced from 1 per cent to 0.25 per cent of the fortnightly average outstanding aggregatedeposits in 1996-97.

Note : Effective October 29, 2004, India switched over to the international usage of the term ‘repo’ and ‘reverse repo’. Thus, ‘repo’ mentioned here is sameas ‘reverse repo’ presently used.

240


foreign exchange market returned and moreimpor tantly, the expectations of the marketpar ticipants about fur ther depreciation in theexchange rate of rupee were somewhat contained.The volatility in the market as measured by month-wise coefficient of variation reduced from 1.26 percent in January 1998 to 0.49 per cent in February1998 and further to 0.08 per cent in March 1998. Theexchange rate of rupee, which had depreciated to Rs.40.36 per US dollar as on January 16, 1998,appreciated to Rs. 39.50 on March 31, 1998. The sixmonth forward premia, which reached a peak ofaround 20 per cent in January 1998, came down to7.0 per cent by end March 1998.

6.94 As normalcy returned in the foreign exchangemarket, the monetary measures were eased. Interestrate on fixed rate ‘repos’ (now ‘reverse repo’) wasreduced to 7 per cent as on April 2, 1998 and furtherto 6 per cent on April 29, 1998. On April 29, 1998 theexport refinance limit was also increased from 50 percent to 100 per cent of the incremental export crediteligible for refinance. The CRR and the Bank rate werealso reduced to earlier levels. India emerged relativelyunscathed from the 1997 crisis due to the proactivepolicy responses initiated by the Reserve Bank. Itacted swiftly to curb speculative activities and changemarket expectations. Direct interventions followed byadministrative measures were undertaken, initially.However, when the volatility continued and sentimentremained unchanged, monetary measures wereundertaken to reverse unidirectional expectations.

6.95 Management of the external sector continuedto be a major challenge even in the post Asian crisisperiod, particularly during May to August 1998 as aresult of bearishness in domestic stock exchanges,uncertainties created by internal developments andthe strengthening of US dollar against majorcurrencies, particularly yen. Furthermore, during thisphase India was confronted with cer tain otherdevelopments like economic sanctions imposed byseveral industrial countries, suspension of freshmultilateral lending (except for certain specifiedsectors), downgrading of country rating byinternational rating agencies and reduction ininvestment by foreign institutional investors (FIIs).While Moody’s downgraded India’s sovereign ratingfrom investment to non-investment grade, Standard& Poor’s changed the non-investment grade outlookfor India from stable to negative (Table 6.12). As aresult of these developments, exchange rate againwitnessed increased pressure during May to August1998. The exchange rate of the rupee, which wasRs.39.73 per US dollar at end April 1998, depreciated

gradually to around Rs. 42.50 per US dollar by theend-June 1998. During this phase too, apart fromdirect intervention, the Reserve Bank took recourseto monetary and other measures from time to time inorder to bring about orderliness in the foreignexchange market.

6.96 Apart from monetary measures, importantmeasures that were announced by the Reserve Bankon June 11 and August 20, 1998 included withdrawalof the facility of rebooking of cancelled forwardcontracts for trade related transactions, includingimports (earlier, the restriction was only for non-traderelated transactions), stoppage of the practice of somecorporates to cover the forward commitment by firstlocking into a forward rate and thereafter covering thespot risk, and advising ADs to report their openposition as well as peak intra-day positions to theReserve Bank. Certain liberalisation measures werealso taken, which included increasing the participantsin the forward market by allowing FIIs to take forwardcover on their equity exposure and allowing exportersto use their balances in (EEFC) accounts for allbusiness related payments in India and abroad at theirdiscretion.

6.97 A dist inguishing aspect of the foreignexchange market interventions during the 1997-98volatility episode was that instead of doing thetransactions directly with ADs, a few select publicsector banks were chosen as intermediaries for thispurpose. Under this arrangement, public sector banksundertook deals in the inter-bank market at thedirection of the Reserve Bank for which it providedcover at the end of the business hours each day. Carewas taken to ensure that the public sector banks’ owninter-bank operations were kept separate from thetransactions undertaken on behalf of the ReserveBank. Periodic on-site scrutiny of the records andarrangements of these banks by the Reserve Bankwas instituted to check any malpractice or deficiencyin this regard. The main reason for adopting an indirectintervention strategy in preference to a direct one wasa judgmental view that this arrangement would providea cover for Reserve Bank’s operations and reducesits visibility and hence would be more effective. Thisview was premised on the assumption that buying/selling by a market-maker will have a pronouncedimpact on market sentiment than would be the caseif it does the same directly. The fact that the ReserveBank was intervening in the market through a fewother public sector banks was not disclosed, thoughin due course of time, it was known to the market.Besides, as a measure of abundant precaution andalso to send a signal internationally regarding the

241


Table 6.12: India’s Sovereign Credit Rating by S&P, Moody’s and Fitch Ratings

Fitch Ratings

BB+(March)BB+(September)

BB+(May)

BB(November)

BB+(January)

BBB -(August)

BBB -

Grade and Outlook

Stable

Negative

Stable

Stable

Investment GradeStable


Year

1990

1991

1992

1994

1995

1996

1997

1998

2000

2001

2002

2003

2004

2005

2006

2007

S & P’s Rating

BBB(September)

BBB-(March)

BB +(June)

BB+

BB +

BB +(October)

BB +(October)

BB(May)

BB +(October)

BB(August)

BB(September)

BB(December)

BB(August)

BB +(February)

BB +(December)

BB+(April)

BBB-(January)

Grade and Outlook

Stable

Credit Watch

Credit Watch Removed(September)

Non-Investment GradeStable

Non-Investment Grade


Non-Investment GradePositive


Non-Investment GradeNegative







Stable



Moody’s Rating

Baa1(October)

Baa3(March)Ba2(June)

Baa3(December)

Baa3(October)

Baa3(February)

Ba2(June)

Ba2(August)

Ba2

Ba1(February)

Baa3(January)

Baa3(April)

Baa2(May)

Baa2

Grade and Outlook

Watch List(1-8-1990)

Investment Grade

Investment Grade

Investment Grade

Investment GradeNegative





Investment Grade

Investment Grade,Stable

Investment Grade,Stable

Standard and Poor’s

Investment Grade : AAA, AA+, AA, A+, A,BBB+, BBB, BBB-

Non-Investment Grade : BB+, BB, BB-, B+, B, B-

Default Grade : CCC+, CCC, CCC-,CC, C

Moody’s

Investment Grade : Aaa, Aal,Aa2, Aa3, Al,A2, A3, Baal, Baa2,Baa3,

Non-Investment Grade : Bal, Ba2, Ba3, Bl, B2, B3

Default Grade : Caa, Ca, C

Fitch Ratings

Investment Grade : AAA, AA+, AA, A+, A,BBB+, BBB, BBB-

Non-Investment Grade : BB+, BB, BB-, B+, B, B-

Default Grade : CCC+, CCC, CCC-,CC, C

242


Table 6.13: Daily Exchange Rate Volatility in Select Emerging Economies(Annualised; in per cent)

Currency 1993-1995 1996-2000 2001 2003 2004 2005 2006

1 2 3 4 5 6 7 8

Indian Rupee 7.5 4.3 1.6 2.1 4.7 3.5 4.0South Korean Won 2.6 22.2 8.1 8.3 6.5 6.8 6.9South African Rand 5.3 11.4 20.2 20.9 21.4 15.4 16.0Turkish New Lira 29.3 5.4 63.1 16.2 12.2 10.4 16.6Indonesian Rupiah 2.1 43.4 21.7 6.8 7.7 9.1 8.9Thai Baht 1.7 18.3 4.9 4.4 4.3 4.7 6.2New Taiwan Dollar 3.7 5.3 3.6 2.7 4.9 4.9 4.9Singapore Dollar 3.7 7.4 4.5 4.5 4.6 4.4 3.9Philippine Peso 6.8 12.9 17.6 4.1 3.1 4.1 4.6

Note : Volatility has been calculated by taking the standard deviation of percentage change in daily exchange rates.Source : Reserve Bank of India and IMF.

intrinsic strength of the economy, India floated theResurgent India Bonds (RIBs) in August 1998, whichwas very well received by the Non-Resident Indians(NRIs)/ Persons of Indian Origin (PIO).

6.98 In retrospect, India was successful incontaining the contagion effect of the Asian crisis dueto swift policy responses to manage the crisis andfavourable macro economic condition. During theperiod of crisis, India had a low current account deficit,comfortable foreign exchange reserves amounting toimpor t cover of over seven months, a market-determined exchange rate, low level of short-termdebt, and absence of asset price inflation or creditboom. These positive features were the result ofprudent policies pursued over the years notably, capon external commercial borrowings with restrictionson end-use, low exposure of banks to real estate andthe stock market, insulation from large intermediationof overseas capital by the banking sector, closemonitoring of off-balance sheet items and tightlegislative, regulatory and prudential control over non-bank entities. Some capital controls also helped ininsulating the economy from the contagion effect ofthe East Asian crisis. The ultimate result could be seenin terms of low volatility in the exchange rate of theIndian rupee, during the second half of the 1990s,when most of the Asian currencies witnessed highlevel of volatility (Table 6.13).

Phase of Relative Stability with Intermittent Event-Related Volatility: September 1998 - March 2003

6.99 The measures announced by the ReserveBank earlier coupled with the success of the RIBissue, which was subscribed to the tune of US $ 4.2billion, had a stabilising effect on the foreign exchangemarket, resulting in a marked improvement in thesentiment. The rupee remained stable dur ing

September 1998 to May 1999 before coming underpressure during June-October 1999 due to thenervousness in the market induced by heightenedtension on the border. Besides intervention in orderto reduce the temporary demand-supply mismatches,the Reserve Bank on August 23, 1999, indicated itsreadiness to meet fully/par tly foreign exchangerequirements on account of crude oil imports and debtservice payments of the Government.

6.100 The period between April 2000 and March2003 generally remained stable with intermittentperiods of volatility associated with sharp increasein international crude oil pr ices in 1999-2000,successive interest rate increases in industrialcountries, cross-currency movements of the USdollar vis-à-vis other major international currenciesand the sharp reversals of portfolio flows in 2000.The Reserve Bank responded promptly throughmonetary and other measures like variations in theBank Rate, the repo rate, cash reserve requirements,refinance to banks, surcharge on import finance andminimum interest rates on overdue export bills tocurb destabilising speculative activities during theseepisodes of volat i l i ty, whi le al lowing order lycorrections in the exchange rate of the rupee.Financing through India Millennium Deposits (IMDs)was resorted to as a preemptive step in the face ofhardening of wor ld petroleum pr ices and theconsequent possible depletion of India’s foreignexchange reserves. Inflows under the IMDs to thetune of US $ 5.5 billion during October-November2000 helped in easing the market pressure.

6.101 The exchange rate pressure in the aftermathof September 11, 2001 incident in the US was tackledby the Reserve Bank through quick responses interms of a package of measures and liquidityoperations. These measures included: (i) a reiteration

243


by the Reserve Bank to keep interest rates stable withadequate liquidity; (ii) assurance to sell foreignexchange to meet any unusual supply-demand gap;(iii) opening a purchase window for select governmentsecurities on an auction basis; (iv) relaxation in FIIinvestment limits up to the sectoral cap/statutoryceiling; (v) a special financial package for large valueexports of six select products; and (vi) reduction ininterest rates on export credit by one percentage point.

Period with Surge in Capital Flows: 2003-04 onwards

6.102 Excess supply conditions have dominated theforeign exchange market since 2003-04 due to a surgein capital inflows. Large scale purchases by theReserve Bank to absorb excess supplies in the foreignexchange market assuaged the strong upwardpressure on the exchange rate. The Reserve Bankresorted to sterilisation operations to tackle suchflows. Faced with the finite stock of Government ofIndia securities with the Reserve Bank, marketStabilisation scheme (MSS) was introduced in April2004 wherein the Government of India datedsecurities/Treasury Bills were issued to absorbliquidity. As a result, its foreign exchange reservesmore than trebled during the period from US $ 54.1billion at end-March 2002 to US $ 199.2 billion at end-March 2007 - an average increase of US $ 29.0 billionper annum. Foreign exchange reserves stood at US$ 203.1 billion as on April 13, 2007.

6.103 One instance during this period when rupeecame under substantial pressure was on May 17,2004 when it reached Rs. 45.96 per US dollar from

Rs.43.45 per US dollar as at end-March 2004 onaccount of turbulence in the Indian equity marketdue to political uncertainty in the aftermath of generalelection results and rising global oil prices. On thatday, the stock markets in India witnessed a recordfall in price, which triggered the index-based circuitbreaker twice during the day. The index-based circuitbreaker triggered a stoppage of trades in the stockexchange for around two hours. Anticipating thepossibility of a spill-over in the money, governmentsecurities and the foreign exchange markets, theReserve Bank intervened on that day and twoseparate press releases were issued by the ReserveBank indicating (a) the constitution of an InternalTask Force under the Executive Director, FinancialMarket Committee to monitor the developments infinancial markets; and (b) its willingness to provideliquidity (Mohan, 2006d). These announcements hada salutary impact and soon orderly conditions wererestored. In fact, no Reserve Bank liquidity or foreignexchange facilities announced during the day hadto be used.

6.104 A look at the entire period since 1993 whenIndia moved towards market determined exchangerates reveals that the Indian Rupee has generallydepreciated against the dollar during the last 14 years,except during the period 2003 to 2005 when rupeeappreciated on account of general dollar weaknessagainst major currencies. For the period as a whole,1993-94 to 2006-07, the Indian rupee depreciatedagainst dollar by about 30.9 per cent on an annualaverage basis (Table 6.14).

Table 6.14 : Movements of Indian Rupee-US Dollar Exchange Rate : 1993-94 to 2005-06

Year Range Average Appreciation/ Coefficient of Standard(Rs. per US $) Exchange Rate Depreciation (%) Variation (%) Deviation

(Rs. per US $)

1 2 3 4 5 6

1993-94 31.21-31.49 31.37 0.1 1994-95 31.37-31.97 31.40 -0.10 0.3 1995-96 31.37-37.95 33.45 -6.13 5.8 1.931996-97 34.14-35.96 35.50 -5.77 1.3 0.481997-98 35.70-40.36 37.16 -4.47 4.2 1.571998-99 39.48-43.42 42.07 -11.67 2.1 0.901999-00 42.44-43.64 43.33 -2.91 0.7 0.292000-01 43.61-46.89 45.68 -5.14 2.3 1.072001-02 46.56-48.85 47.69 -4.21 1.4 0.672002-03 47.51-49.06 48.40 -1.47 0.9 0.452003-04 43.45-47.46 45.95 5.40 1.6 0.722004-05 43.36-46.46 44.93 2.16 2.3 1.032005-06 43.30-46.33 44.28 1.51 1.5 1.792006-07 43.14-46.97 45.28 -2.45 2.0 0.89


244


6.105 In terms of real effective exchange rates(REER), while the REER (6 currency trade basedindices) appreciated by about 7 per cent, the REER(36 currency trade based indices) recorded anappreciation of above 2 per cent during the period 1993-94 to 2005-06 (Table 6.15).

6.106 An important feature has been the reductionin volatility of rupee exchange rate during last few years.Among all currencies worldwide, which are not on anominal peg, and certainly among all emerging market

economies, the rupee-dollar exchange rate has beenless volatile. The REER of India has been relativelystable compared with other key Asian countries. Thevolatility measured from the effective exchange rates,i.e., 6 currency NEER and REER indices for India, wasalso lower as compared with other countries such asthe US and Japan for recent period (Table 6.16).

6.107 In the context of the behaviour of the exchangerate in the post-liberalisation period, it is worthexploring some related aspects such as the changing

Table 6.15: Trends in External Value of Indian Rupee

36-Currency Trade Based 6-Currency Trade Based

REER % Variation NEER % Variation REER % Variation NEER % Variation

1 2 3 4 5 6 7 8 9

1993-94 100.00 0.0 100.00 0.0 100.00 0.0 100.00 0.01994-95 104.32 4.3 98.91 -1.1 105.71 5.7 96.86 -3.11995-96 98.19 -5.9 91.54 -7.5 101.14 -4.3 88.45 -8.71996-97 96.83 -1.4 89.27 -2.5 100.97 -0.2 86.73 -1.91997-98 100.77 4.1 92.04 3.1 104.24 3.2 87.80 1.21998-99 93.04 -7.7 89.05 -3.2 95.99 -7.9 77.37 -11.91999-00 95.99 3.2 91.02 2.2 97.52 1.6 77.04 -0.42000-01 100.09 4.3 92.12 1.2 102.64 5.3 77.30 0.32001-02 100.86 0.8 91.58 -0.6 102.49 -0.1 75.89 -1.82002-03 98.18 -2.7 89.12 -2.7 97.43 -4.9 71.09 -6.32003-04 99.56 1.4 87.14 -2.2 98.85 1.5 69.75 -1.92004-05 100.09 0.5 87.31 0.2 101.36 2.5 69.26 -0.72005-06 102.34 2.2 89.84 2.9 106.67 5.2 71.41 3.12006-07 P 98.07 -4.2 85.80 -4.5 104.91 -1.6 68.13 -4.6

REER : Real Effective Exchange Rate. NEER : Nominal Effective Exchange Rate. P : Provisional.(+) indicates appreciation and (–) indicates depreciation.Note : Both REER and NEER are bilateral trade weight-based indices with 1993-94 as the base year.Source : Reserve Bank of India.

Table 6.16: Volatility of Exchange Rates in the Global Foreign Exchange Market(Per cent)

Year NEER REER

India US UK Japan Euro China India US UK Japan Euro ChinaArea Area

1 2 3 4 5 6 7 8 9 10 11 12 13

1993-94 1.2 1.0 1.0 2.6 1.8 8.2 1.3 0.8 1.1 2.8 1.9 8.21994-95 1.3 1.4 0.8 2.2 0.9 1.1 2.5 1.3 0.9 2.2 1.1 1.31995-96 2.9 1.5 0.7 3.7 0.7 1.2 2.9 1.5 0.8 3.5 0.9 1.21996-97 1.4 1.2 1.4 1.4 1.0 0.7 1.2 0.7 1.4 1.4 1.1 0.71997-98 1.7 1.3 1.8 3.0 1.5 1.8 1.8 1.4 1.7 2.8 1.7 1.61998-99 1.8 2.0 1.5 4.0 1.6 1.5 1.6 1.4 1.4 4.1 1.7 1.61999-00 1.0 1.3 0.7 2.7 1.1 0.8 1.2 0.8 0.8 2.9 1.3 1.02000-01 1.4 1.8 1.8 2.8 2.4 0.8 1.4 1.0 1.6 2.2 2.4 0.92001-02 1.0 1.1 0.7 2.1 1.2 0.9 1.0 0.7 0.6 2.0 1.6 1.12002-03 1.0 1.4 1.1 1.6 0.8 1.1 1.3 1.0 1.1 1.6 1.2 1.02003-04 1.5 2.2 1.2 1.4 1.5 1.1 1.3 1.6 1.1 1.4 1.7 1.32004-05 1.7 1.7 1.0 1.9 0.9 1.0 1.1 1.2 1.2 1.9 2.0 1.22005-06 1.1 1.4 1.1 1.4 0.9 1.3 1.1 0.9 1.1 1.4 1.0 1.5

Note : Volatility has been calculated by taking the standard deviation of percentage change in monthly REER/NEER indices.Source : IFS, IMF, 2006 and Reserve Bank of India.

245


invoicing pattern of trade, the cross currencymovement and the impact of global imbalances onthe Indian foreign exchange market. In internationaltrade, the pattern of currency invoicing depends on anumber of factors such as historic relationshipsbetween the trading par tners, establishedconventions, the relative bargaining strength of tradingparties, as well as the extent of development of theforeign exchange market. Under a flexible exchange

rate system, the exchange rate developments of majorcurrencies also play an important role. Particularly,the expectation of the exporter/importer about thefuture changes in the exchange rates is a significantconsideration in invoicing of exports/imports, as theinvoiced amounts are received/paid with a lag of someweeks/months after the invoicing is made. Theinvoicing pattern of trade also has implications forexchange rate pass through (Box VI.7). With the

A macroeconomic puzzle of the 1990s observed in severalcountries was the phenomenon of low inflation despiteepisodes of large currency depreciation, implying lowexchange rate pass-through to domestic prices. A largevolume of literature that spawned observed that exchangerate pass-through declined in several developed anddeveloping countries. The literature suggests that someof the important determinants of pass-through are: lowglobal inflation and its lower volatility (Taylor (2000),Choudhri and Hakura (2001) and Gagnon and Ihrig(2004)); volatility of exchange rate; share of import in thedomestic consumption; trade to GDP ratio; compositionof imports; trade distortions from tariffs and quantitativerestrictions (Goldfajn and Werlang (2000), Campa andGoldberg (2004) and Frankel et al (2005)).

The general argument is that lower average inflation andits volatility was an outcome of credible monetary policy.In such an environment, firms believe that monetary policywill be successful in stabilising prices and are less keento alter prices of their products resulting in lower pass-through. The impact of exchange rate volatility on pass-through is less unambiguous. One view is that currenciesof countries with lower exchange rate variability imply astable monetary policy, and consequently, would be chosenas the invoice currency. Hence, the pass-through wouldbe lower. The counter view is that greater exchange ratevolatility implies common and transitory fluctuation, andmakes firms wary of changing prices as they fear losingmarket share. Firms, are therefore, more willing to adjustprofit margins. Increasing share of trade in GDP byincreasing the share of imports in consumption and theparticipation of foreign firms in domestic economy wouldlead to higher pass-through. Pass-through to imports suchas energy, raw materials and food with inelastic and lesscompetitive supply are found to be higher than tomanufacture products, the supply of which is elastic andmore competitive. Thus, change in import compositionwould affect the aggregate pass-through even when thepass-through in individual components remains the same.Trade barriers such as tariffs and quantitative restrictionsact as barrier to arbitrage of goods between countries andhave negative impact on pass-through. Reducing thesebarriers would, thus, lead to higher pass-through.

Box VI.7Invoicing Pattern of Trade and Exchange Rate Pass-Through

These factors underwent significant transformation in the early1990s with economic reforms. Thus, exchange rate pass-through to domestic prices in India would have undergone achange during the post-economic reforms as found in othercountries. A recent study for the period August 1991 to March2005 that estimated the pass-through coefficients found thata 10 per cent change in exchange rate leads to change infinal prices by about 0.6 per cent in short run and 0.9 percent in the long run. The statistical tests on temporal behaviourof pass-through obtained from rolling regressions show that,unlike in case of many countries, there was no evidence ofdecline in pass-through. This was much more evident in thelong-run than in the short-run, and was observed to be theresult of rise in inflation persistence.

Further, pass-through from appreciation was found to behigher than depreciation. In an increasingly open economywhere foreign firms' objective would expectedly be to capturea larger market share, they would be more willing to pass onthe benefit of lower prices from appreciation and avoid passingon the higher prices from depreciation that cause loss ofmarket share. The pass-through was higher for small thanlarge exchange rate changes. This could be explained by theinvoicing of imports in India in US dollars (80-90 per cent)and the presence of menu cost in changing invoice price. Forsmall exchange rate change, it is not worthwhile to changethe invoice price of imports in its own currency due to themenu cost (a fixed cost involved in altering invoice price).Thus, the import price in local currency (domestic prices)would change by the extent of the exchange rate change,i.e., a higher pass-through. The opposite will be the case forlarge exchange rate change, as it would be worthwhile forforeign firms to change the invoice price in their currency inorder to absorb a part of the exchange rate change on importprice in local currency. Invoicing pattern of trade, exchangerate movements and exchange rate pass-through to domesticprices, thus, have implications for exchange rate managementand trade competitiveness.

Reference:

Khundrakpam, J.K. 2007. “Economic Reforms and ExchangeRate Pass-Through to Domestic Prices in India.” BIS WorkingPaper No. 225, February.

246


growing importance of the Indian economy and itsrising share in world trade, it is expected that the Indiancurrency would gain considerable acceptance in future.In fact, the growth of NDF market in rupee, in a way,shows the use of rupee in international transactions.

6.108 Although the invoicing of trade in rupee hasbeen permitted, there has not been any significantgrowth. The substantial share of exports invoiced inrupees during 1990-91 was on account of the practiceof exports invoicing in rupees to bilateral accountcountries (Table 6.17). The subsequent drop in theshare of rupee invoicing could be attr ibuted todiscontinuance of rupee trade consequent uponagreement between the Government of India and theRussian Federation in 1992 to scrap the bilateral tradeand instead invoice trade in US dollar. However, after

disintegration of the USSR, rupee invoicing of exportsis now confined to financing of exports throughrepayment of civilian and non-civilian debt to Russia.The use of rupee invoicing for trade purposes needsto be given due consideration by the importers/exporters as India’s share in world trade in goods andservices expands in future.

6.109 An important feature of the Indian foreignexchange market observed in recent years has beenthe growing correlation between the movement inexchange rate of the Indian rupee and currencies ofthe Asian countries. In the last couple of years, therupee-dollar exchange rate is increasingly gettinglinked to exchange rate of some of the Asiancurrencies such as Japanese yen vis-a-vis US dollar(Table 6.18). This feature of the market could be

Table 6.17: Currency-wise Invoicing of India’s Exports and Imports

(Per cent)

Imports Exports

Currency 1990-91 1994-95 1999-00 2005-06 P 1990-91 1994-95 1999-00 2005-06 P

1 2 3 4 5 6 7 8 9

US Dollar 59.7 73.5 85.8 88.6 57.2 78.8 87.0 85.8Deutsche Mark 7.0 5.9 1.6 0.0 5.1 6.3 1.6 0.0Euro – – 3.3 6.5 – – 3.0 7.6Japanese Yen 4.4 4.4 3.8 2.2 0.1 0.3 0.3 0.5Pound Sterling 3.1 2.5 1.7 1.0 4.5 4.8 3.9 2.8Indian Rupee 7.7 0.4 0.0 0.0 27.7 3.3 0.3 1.9Others 18.1 13.3 3.8 1.7 5.4 6.5 3.9 1.4Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

P : Provisional.Source : Reserve Bank of India.

Table 6.18: Cross Currency Correlation(January 3, 2005 to December 4, 2006)

(Per cent)

Currency Euro Yen GPB AD CaD Yuan INR IRu PRu Ruble SD SLR Baht

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Euro 1.00 Yen 0.54 1.00 GPB 0.95 0.45 1.00 AD 0.68 0.66 0.73 1.00 CaD 0.00 -0.74 0.04 -0.35 1.00 Yuan -0.12 -0.82 -0.02 -0.36 0.90 1.00 INR 0.01 0.68 -0.06 0.39 -0.81 -0.73 1.00 IRu 0.37 -0.02 0.31 0.06 0.25 0.20 -0.16 1.00 PRu 0.04 0.76 -0.09 0.29 -0.83 -0.94 0.71 -0.35 1.00 Ruble 0.70 -0.20 0.72 0.17 0.65 0.60 -0.55 0.75 -0.67 1.00 SD 0.56 -0.28 0.57 0.08 0.69 0.64 -0.53 0.56 -0.67 0.95 1.00 SLR -0.02 0.72 -0.13 0.23 -0.77 -0.90 0.63 -0.23 0.89 -0.66 -0.69 1.00 Baht 0.70 -0.12 0.71 0.19 0.55 0.48 -0.42 0.86 -0.50 0.94 0.94 -0.56 1.00

Note : GPB: Pound Sterling; AD: Australian Dollar; CaD: Canadian Dollar; Yuan: Chinese Yuan;INR: Indian Rupee; IRu: Indonesian Rupiah; Yen : Japanese Yen PRu: Pakistan Rupee;Ruble: Russian Ruble; SD: Singapore Dollar; SLR: Sri Lankan Rupee; Baht: Thai Baht.

247


external demand. The current accounts of China, otherEast Asian EMEs (Indonesia, Malaysia, Taiwan,Thailand) and the two island economies, viz, HongKong and Singapore have recorded large surpluses,especial ly since 1999. Another new sourcecontributing to the global imbalances has been thelarge current account surpluses of oil exportingcountries. The Middle East region recorded currentaccount surplus of 18.1 per cent of GDP in 2006mainly associated with higher oil revenues due to bothhigher prices and some expansion in production. Withthe size of these imbalances becoming large,concerns have been raised regarding its sustainabilityand possible disorderly unwinding. Further historicalepisodes of large and sustained imbalances and theirreversals suggest that a market led realignment ofreal exchange rates can play an important role todemand rebalancing across countries to facilitatesmooth unwinding (IMF, 2007).

6.111 An issue that is of relevance to India in thisregard is the likely response of different nations toglobal imbalances and its impact on the Indian foreignexchange market. India has not contributed eitherpositively or negatively to large current accountdeficit; India’s saving-investments have been by andlarge balanced (Table 6.20); the economy is domesticdemand dr iven and generally India’s policies,including exchange rate are market oriented. Thus,India has been following policies which have not onlyserved it well but also contributed to global stability(Reddy, 2006b). Any large and rapid adjustments inmajor currencies and related interest rates or currentaccounts of trading partners would impact the Indian

Table 6.19: Macroeconomic Parameters of theUnited States

(in per cent, annual average)

Period GDP Current General Saving-growth Account Government Investment

Deficit/ Fiscal gapGDP Balance/

GDP

1 2 3 4 5

1981-1985 3.3 -1.3 -2.9 -1.61986-1990 3.3 -2.4 -2.4 -2.21991-1995 2.5 -1.1 -3.1 -0.91996-2000 4.1 -2.6 -0.2 -2.22001-2005 2.4 -5.0 -3.5 -3.92006 3.3 -6.5 -2.6 –

Source : Bureau of Economic Analysis, US Department ofCommerce; World Development Indicators, World Bank;World Economic Outlook, IMF, various issues.

Table 6.20: Savings-Investment Gap inEmerging Economies

(as % of GDP, annual average)

Country 1981-85 1986-90 1991-95 1996-2000 2001-05

1 2 3 4 5 6

China -0.1 -0.4 1.5 3.2 2.4 *

Hong Kong 3.9 9.8 3.2 1.1 8.6

India -1.5 -2.5 -1.2 -1.1 0.2

Indonesia 2.0 1.5 1.5 5.5 6.7

Korea -1.7 4.1 -1.1 3.7 2.6 *

Malaysia -2.7 7.6 -1.6 13.9 19.7 *

Singapore -2.9 4.6 11.8 16.4 23.6

Thailand -4.4 -1.8 -5.3 6.4 4.5

Note : * Average for four years 2001-04.Data for India pertain to financial year.

Source : World Bank online database, Central StatisticalOrganisation, Government of India.

ascribed to the greater integration of the Asianmarkets led by large trade and capital flows in theregion as well as greater interdependence of financialmarkets within the region. Some kind of a supply chainis emerging from the Asian region with Japan at thetop of the chain supplying high value technologicalproducts. China is the major supplier of intermediateproducts, while India, besides being a supplier ofintellectual capital, is emerging as supplier ofintermediate products. The financial markets,including the foreign exchange market, areincreasingly taking cognisance of the growingintegration of the Indian economy with the rest of theworld, particularly with the Asian region. The crosscurrency impact on the exchange rate of the Indianrupee is observed to be particularly pronounced forJapanese yen and Singapore dollar (Ranjan and Dhal,1999).

6.110 Recognising the growing influence of crosscurrencies on Indian exchange rate, an issue that isof relevance is the impact of potential disorderlyadjustments in the current global imbalances on theexchange rate of major currencies and the secondround impact on the Indian rupee. The current globalimbalances represent the large and increasing currentaccount deficit (CAD) of the US that has beenfinanced by surpluses elsewhere, especially emergingAsia, oil expor ting countr ies and Japan. As apercentage of GDP, the CAD of the US has almostdoubled every 5 years since the early 1990s (Table6.19). In contrast to the US that is dependent on thedomestic demand, growth in Asia and other emergingeconomies since the late 1990s has been led by

248


economy, though the impact on India may be less thanmany other emerging market economies.

6.112 It emerges from the above analysis thatflexibility and pragmatism, rather than adherence tostrict theoretical rules, is the order of the day inexchange rate policy in developing countries. It alsounderscores the need for central banks to keepinstruments/policies in hand for use in difficultsituations. On the whole, the Indian approach toexchange rate management has been described asideal for Asia (Jalan, 2003). India has been able toeffectively withstand periods of volatility in the foreignexchange market associated with several unexpectedexternal and domestic developments (Mohan, 2006a).An important aspect of policy response to thesevarious episodes of volatility has been marketintervention combined with monetary andadministrative measures to meet the threats tofinancial stability, while complementary or parallelrecourse was taken to communications (Reddy,2006e). Some i l lustrations of thoughtfulcommunication include a speech in Goa by the thenDeputy Governor in August 1997 to “talk down therupee”; reassur ing statements on marketdevelopments in the context of Asian crisis combinedwith a package of measures in tranches in 1997 and1998; pre-emptive measures in the mid-1998 in thecontext of crisis in Russia; reassuring statementsissued in the context of Kargil war in 1999; acombination of l iquidity injection, reassur ingstatements along with measures in the context of the9/11; a combination of actions and measures at thetime of sharp downward movement of Indian stockmarkets on May 17, 2004 coinciding with the politicaltransition at the Centre; and to explain the impact ofredemption of the India Millennium Deposits. Goingforward, there will be a continuous need to adopt acombined strategy of liquidity management as wellas exchange rate management for effective monetarymanagement and shor t-term interest ratesmoothening (Mohan, 2006a). Given the importantrole that foreign exchange intervention played duringseveral earlier episodes, it would be useful to examinethe effectiveness of central bank intervention in theforeign exchange market.

VI. ISSUES RELATING TO CENTRAL BANKINTERVENTION IN THE FOREIGN EXCHANGEMARKET

6.113 Official exchange rate intervention refers tosales and purchases of foreign exchange byauthorities in order to affect exchange rates. Globally,

the objective of intervention in the foreign exchangemarket has changed over the years. Under the BrettonWoods system of fixed exchange rates, interventionswere used frequently to maintain the exchange ratewithin the prescribed margins. When the BrettonWoods system broke down in 1971, major industrialcountries discontinued pegging their currencies to theUS dollar, bringing in an era of floating exchange rates.In principle, freely floating exchange rates would ruleout intervention by central banks. The central bankshave, however, often intervened for a variety ofreasons: (i) to influence trend movements in theexchange rates because they perceive long-runequilibrium values to be different from actual values;(ii) to maintain export competitiveness; (iii) to managevolatility to reduce risks in financial markets; and (iv)to protect the currency from speculative attack andcrisis.

6.114 Intervention by most central banks in foreignexchange markets has become necessary is primarilybecause of the impor tance of capital f lows indetermining exchange rate movements as againsttrade balances and economic growth, which wereimportant in the earlier days. In recent times, therehas been a large increase in international capitalmovements. In emerging market economies,particularly, these capital flows are very volatile, andlargely sentiment driven exposing financial marketsto large risks. In order to reduce the risks, authoritiesintervene to curb volatility. Secondly, unlike tradeflows, capital flows in “gross” terms, which affectexchange rate can be several times higher than “net”flows on any day. Therefore, herding becomesunavoidable (Jalan, 2003).

6.115 In 1977, the IMF Executive Board laid downsome guiding principles for intervention policy bycentral banks of member countries. In essence, theseprinciples stated that countries should not manipulatetheir exchange rates to gain unfair competitiveadvantage over others, or to prevent balance ofpayment adjustment, but they should intervene tocounter ‘disorderly market conditions’. It is difficult todefine ‘disorderly market conditions’ but they aregenerally taken to refer to management of exchangerate volatility. While intervention by central banks inthe foreign exchange market has come to be acceptedas being consistent with a fully flexible exchange ratesystem, there is st i l l no consensus on theeffectiveness of central bank intervention.

6.116 Theoretically, intervention is categorised intosterilised and non-sterilised. Sterilised interventionoccurs when the purchase or sale of foreign currency

249


is offset by a corresponding sale or purchase ofdomestic government debt to eliminate the effects ondomestic money supply. Unsterilised interventionoccurs when the authorities purchase or sell foreignexchange, normally against their own currency,without such offsetting actions. There are differingeffects of sterilised and unsterilised intervention onthe net foreign assets (NFA) and net domestic assets(NDA) of the central bank and on money supply (M)(Table 6.21).

6.117 There is near agreement that non-sterilisedintervention directly influences the exchange ratethrough the monetary channel. Any purchase offoreign exchange (i.e., intervention) if left unsterilisedwill impact the monetary base (rises), which, in turn,induces changes in the broader monetary aggregates,interest rates, real demand for goods and assets andultimately the exchange rate (depreciates).

6.118 In so far as ster i l ised intervention isconcerned, the proponents of monetary approachclaim that it is ineffective. The literature, however,identifies three possible channels through which evensterilised intervention would work: (a) por tfoliobalance channel under which domestic and foreignbonds are assumed to be imperfect substitutes, and

intervention, even though ster i l ised, impactsexchange rate by changing the relative supplies ofbonds; (b) signalling channel where ster il isedpurchase of foreign currency will lead to a depreciationof the exchange rate if the foreign currency purchaseis assumed to signal a more expansionary domesticmonetary policy and vice versa12 ; and (c) morerecently, the noise-trading channel, according towhich, a central bank can use sterilised interventionsto induce noise traders to buy or sell currency (Kortian,1995). Even if an intervention has only a temporaryeffect, it can still lead to noise traders assuming thatthe trend has been broken and induce investors totake posit ions in l ine with the central bank’sintentions13 .

6.119 Recognising the fact that non-sterilisedintervention significantly impacts exchange rates,most studies on central bank intervention haveattempted to examine whether sterilised interventionhas had a quantitatively significant effect on theexchange rate, i.e., an effect that is predictable,sizeable, and lasting. It has also been observed thatwhile empirical evidence on the effectiveness ofcentral bank intervention is available in large numbersfor some specific developed countries, the evidenceon foreign exchange intervention in developingcountries, including India is weak14 . Most of theprevious empirical studies have been inconclusive asto the validity of the different transmissionmechanisms (Edison,1993 and Sarno and Taylor,2001). While the “portfolio balance” channel hasreceived little empirical support, the evidence in favourof the “signaling” channel is somewhat moresupportive (Table 6.22).

6.120 In the Indian context, empirical evidence onthe effectiveness of sterilised intervention through theportfolio balance channel has been found to be limitedfor the period April 1996 to March 1999 (Bhaumik andMukhopadhyay, 2000). As regards signaling channel,studies have shown that the Reserve Bank has usedintervention though not very significantly for signalingthe future course of monetary policy (Sahadevan,2002). The use of profitability analysis to gauge thesuccess of intervention has also been inconclusivein the Indian case (Pattanaik and Sahoo, 2001).

Table 6.21 : Effects of Foreign Exchange Intervention

Intervention Effects on Effects on Effects onNFA NDA M

1 2 3 4

Non-sterilised foreignexchange intervention(Purchase) + 0 +

Sterilised foreign exchangeintervention (Purchase) + – 0

Non-sterilised foreign exchangeintervention (Sale) – 0 –

Sterilised foreign exchangeintervention (Sale) – + 0

+ : Positive Impact. – : Negative Impact. 0 : No Impact.NFA : Net foreign assets.NDA : Net domestic assets.M : Money supply.

12 For the signalling channel to be effective, there must be asymmetric information between the market participants and the central bank.

13 For the noise-trading to work successfully, however, the central bank must not only have up to date market intelligence and familiarity withnoise-traders’ reaction functions, but also must be capable of conducting intervention secretly and deftly.

14 The major reason for the lack of empirical evidence for developing countries is that the availability of data on intervention and exchangerate expectations in the case of developing countries is very low (Edison, 1993).

250


6.121 Empir ical evidence in the Indian case,however, suggests that in the present day of managedfloat regime, intervention can serve as a potentinstrument in containing the magnitude of exchangerate volatility of the rupee even though the degree ofinfluence may not be strong (Pattanaik and Sahoo,2001). Studies in the Indian context have observed apositive response of direct intervention activity duringexchange rate volatility, with the intervention activitysubsiding once a re-alignment has taken place (Kohli,2000). Besides, significant asymmetry has been

observed in the volatility response to market pressurewith heightened volatility leading to depreciatingpressure on the rupee (RBI, 2002-03). Thisunderscores the importance of intervention by thecentral bank to manage volatility.

Reserve Bank’s Intervention and Sterilisation

6.122 As observed during the various episodes ofexchange rate volatility in India, the Reserve Bankhas been intervening in the foreign exchange market

Table 6.22: Major Findings of Recent Studies on Central Bank Intervention

Author(s) Major Findings

I. Portfolio balance channel

Frankel (1982)

Danker et al. (1987)

Lewis (1988)

Dominguez Frankel (1993)

II. Signaling channel

Dominguez (1990)

Lindberg (1994)

Kaminsky and Lewis (1996)

Lewis (1995)

Fatum and Hutchison (1999)

III. Noise trading channel

Goodhart and Hesse (1993)

IV. Intervention and profitability

Christopher J Neely (2002)

V. Intervention and volatility

Baillie and Osterberg (1997)

No empirical support for portfolio balance model in a mean-variance optimisation framework.

Mixed evidence on the impact of sterilised intervention.

Limited support for the portfolio balance model.

Intervention variables were observed to have statistically significant explanatory power in aregression for risk premium. This study provides strong support in favour of a significant portfoliobalance effect for the first time though the effect was quite weak.

Provides evidence towards intervention anticipating monetary policy.

Concludes that sterilised interventions might have effects on exchange rates through the signalingchannel though the channel is fragile.

Using a regime switching model, found inconclusive evidence as to whether intervention correctlysignaled changes in monetary policy.

Examined the links between intervention, monetary policy and exchange rates and found evidencethat monetary policy influenced exchange rates.

Observed that dollar support intervention is not related to changes in expectations over thestance of future monetary policy proxied by federal funds futures rate.

Provides some supportive evidence towards impact of intervention on exchange rate via noise-trading channel.

Observed that high frequency evidence disapproves the hypothesis that intervention generatestrading rule profits.

Little support is obtained for the hypothesis that intervention can consistently influence thelevel of the exchange rate. Any significant effect is usually of the ‘leaning against the wind’variety, with dollar purchases depreciating the dollar. Further, intervention tends to increasevolatility rather than ‘calm disorderly markets’, with the effects differing between currenciesand between the buying of US dollars as opposed to the selling of US dollars.

251


to curb volatility arising due to demand-supplymismatch in the domestic foreign exchange market.Sale of dollars in the foreign exchange market isgenerally guided by excess demand conditions thatmay arise due to several factors. Similarly, theReserve Bank purchases dollars from the marketwhen there is an excess supply pressure. There issome evidence of co-movement in demand-supplymismatch proxied by the difference between thepurchase and sale transactions in the merchantsegment of the spot market and intervention by theReserve Bank (Chart VI.10)15 . Thus, the ReserveBank has been prepared to make sales and purchasesof foreign currency in order to curb volatility, even outlumpy demand and supply in the foreign exchangemarket and to smoothen jerky movements, whileallowing the rupee to move in both directions.However, such intervention is generally not governedby any pre-determined target or band around theexchange rate (Jalan, 1999).

6.123 Capital movements have rendered exchangerates significantly more volatile than before. Largecapital inflows have made the central bank more activein the foreign exchange market, forcing the ReserveBank to release rupees for buying dollars. It ispertinent to note that capital flows in the recent period

have been dominated by non-debt creating flowsresulting in an increase in the proportion of non-debtflows (Table 6.23). An analysis of the movement ofexchange rate and net purchases of the Reserve Bankshows that the intervention operation does not

15 A positive correlation of 0.7 is also found in the case of demand-supply mismatch and net RBI purchases.

Table 6.23: India's Capital Flows: Composition(per cent to total)

Annual average

Indicator\Period 1990-91 to 1997-98 to 2003-04 to 2003-04 2004-05 2005-061996-97 2002-03 2005-06

1 2 3 4 5 6 7

1. Non-debt Creating Flows 41.9 58.3 78.1 93.7 54.6 86.1

a) Foreign Direct Investment 15.9 40.2 26.6 25.8 21.4 32.7

b) Portfolio Investment 26.0 18.1 51.5 67.9 33.2 53.7

2. Debt Creating Flows 52.4 34.8 22.1 -6.0 35.2 37.0

a) External Assistance 32.4 2.9 -0.6 -16.5 7.2 7.5

b) External Commercial Borrowings 19.1 18.3 4.8 -17.5 19.4 12.7

c) Short- term Credits -3.1 -0.1 9.8 8.5 13.5 7.3

d) NRI Deposits 21.6 20.6 10.1 21.8 -3.4 11.9

e) Rupee Debt Service -17.7 -6.9 -2.1 -2.2 -1.5 -2.4

3. Other Capital 5.7 6.9 -0.2 12.3 10.2 -23.1*

Total (1 to 3) 100.0 100.0 100.0 100.0 100.0 100.0

* : The negative share of ‘other capital’ during 2005-06 indicates that payments on account of India's investment abroad were more than thecapital inflows through 'non NRI banking channel' and 'other capital'.


252


necessarily influence so much the level of rupee.Empirical analysis, however, reveals that while FIIinvestments have contributed towards increasingvolatility, intervention by the Reserve Bank has beeneffective in reducing volatility in the Indian foreignexchange market16.

6.124 Intervention by the Reserve Bank to neutralisethe impact of excess foreign exchange inflowsresulted in the increase in the foreign currency assets(FCA) continuously. In order to offset the effect ofincrease in FCA on monetary base, the Reserve Bankhas been continuously mopping up the excess liquidityfrom the system through open market operations(Chart VI.11).

6.125 While analysing the impact of sterilisation, itis pertinent to examine whether the contraction of netdomestic assets (NDA) through open market sales tosterilise initial capital flows has exerted pressure oninterest rates, leading in turn, to further capital inflows.

In the Indian case, empirical evidence for the period1995-2004 suggests a unidirectional causality fromchanges in NFA to NDA, and more specifically fromNFA to net Reserve Bank credit to the Centre, withsterilisation coefficient being 0.63, i.e., Rs.100increase in foreign currency purchases from ADsinduces sterilisation operations involving sales ofgovernment securities amounting to Rs.63 from theReserve Bank (RBI, 2003-04). Thus, the ReserveBank, through its sterilisation operations, has beeneffective in offsetting the impact of foreign capitalinf lows and keeping the domestic monetaryaggregates close to the desired trajectory for most ofthe period. It is, however, pertinent to note thatReserve Bank’s intervention in the foreign exchangemarket has been relatively small in terms of volume(less than 1 per cent) during 2005-06 and 2006-07(up to February 2007). The largest gross interventionby the Reserve Bank was in 2003-04 accounting forabout 4 per cent of the turnover in the foreignexchange market (Table 6.24). The extent ofintervention by the Reserve Bank in the foreignexchange market also remains low when compared

Table 6.24 : Extent of RBI Intervention in theForeign Exchange Market

Year RBI Intervention Foreign Exchange Column 2 over 3in Foreign Market Turnover (in per cent)Exchange (US $ billion)

Market(US $ billion)

1 2 3 4

2002-03 45.6 1560 2.9

2003-04 80.4 2118 3.8

2004-05 41.9 2892 1.4

2005-06 22.3 4413 0.5

2006-07 24.5 5734 0.4(up to February 2007)


16 ht = 0.76 - 0.00001Invrt +0.00004FIIt - 0.71Dumt +0.39ε2 t-1 + 0.50ht-1

(2.46)* (-2.00)* (2.17)* (-2.42)* (2.53)* (4.12)*

R–2

= 0.25; DW = 2.19; Wald Stat = 0.77 (prob.:0.38); Log likelihood =-158.99

Note: Figures in the parentheses are the t-statistics.* denotes significance at 5 per cent level.ht = time varying volatility of rupee-dollar exchange rate returnεt = ARCH termInvr = net purchases of the Reserve Bank of IndiaFII = foreign institutional investors’ investmentsDum= Dummy variable to capture the 1997 crises and RBI’s policy stance

0 up to July 1998 and 1 for August 1998 onwards.Sample: June 1995 to June 2006.

253


with other EMEs, suggesting the predominant role ofmarket forces in the determination of the externalvalue of the rupee.

6.126 In general, apart from increased exchangerate flexibility, a number of steps have been taken tomanage the excess capital flows, including a phasedliberalisation of the policy framework in relation tocurrent as well as capital accounts; flexibility tocorporates on prepayment of external commercialborrowings; extension of foreign currency accountfacilities to other residents; allowing banks to liberallyinvest abroad in high quality instruments; liberalisationof norms for overseas investment by corporates andliberalising surrender requirements for exporter. TheAnnual Policy Statement for 2007-08, released onApril 24, 2007 announced a host of measures tol iberal ise overseas investments such as (i)enhancement of the overseas investment limit forIndian companies to 300 per cent of their net worthfrom the existing limit of 200 per cent; (ii) introductionof a revised repor ting framework on overseasinvestments; (iii) enhancing the limit of listed Indiancompanies for portfolio investment abroad in listedoverseas companies to 35 per cent of net worth from25 per cent; (iv) enhancing the aggregate ceiling onoverseas investment by mutual funds to US $ 4 billionfrom US $ 3 billion; (v) allowing prepayment of externalcommercial borrowings (ECBs) up to US $ 400 millionas against the existing limit of US $ 300 million byADs without prior approval of the Reserve Bank; and(vi) enhancing the limit for individuals for anypermitted current or capital account transaction fromUS $ 50,000 to US $ 100,000 per financial year in theliberalised remittance scheme.

6.127 A major instrument of managing capital flowsin India has been sterilisation. After examining thevarious instruments used in India and in othercountries and assessing the trade-offs involved in thechoice of such instruments to deal with the emergingsituation and the extent of their use, the MSS asalluded to earlier was introduced in April 2004 whereinGovernment of India dated securities/Treasury Billsare issued to absorb liquidity. Proceeds of the MSSare immobilised in a separate identifiable cashaccount maintained and operated by the ReserveBank, which is used only for redemption and/orbuyback of MSS securities. The Reserve Bank activelymanages liquidity through open market operations,including market stabilisation scheme, liquidityadjustment facility and cash reserve ratio, and otherpolicy instruments at its disposal flexibly, as and whenthe situation warrants.

VII. THE WAY FORWARD

6.128 The Indian foreign exchange market hasundergone transformation from a closed and heavilycontrolled setting of the 1970s and the 1980s to amore open and market oriented regime since the mid-1990s. The foreign exchange market, which witnessedderegulation in conjunction with current accountconvertibility and liberalisation of capital controls inmany areas, lent considerable support to the externalsector reform process. The criticality of a well-functioning market with its ability to trade and settletransactions in new products and adapt itself quicklyto the changing regulatory and competit iveenvironment has been demonstrated well in the Indiancontext. The bid-ask spread of rupee/US dollar ratehas almost converged with that of other majorcurrencies in the international market. On someoccasions, in fact, the bid-ask spread of rupee/USdollar rate was lower than that of some majorcurrencies (Mohan, 2007). Contrary to the experienceof many EMEs in this regard, the absence of afunctioning market has never been a constraint inundertaking reforms in India. The Reserve Bankintervenes in the foreign exchange market primarilyto prevent excessive volati l i ty and disorder lyconditions. Such intervention is not motivated by anypre-determined target or band around the exchangerate. The objective is to keep market movementsorderly and ensure that there is no liquidity problemor rumour/panic-induced volatility. India’s approach ofmarket determination of the exchange rate, flexibility,combined with intervention, as felt necessary, hasserved it well so far (Mohan, 2006a).

6.129 Moving forward, fur ther init iat ives fordeveloping the Indian foreign exchange market needto be aligned with the external sector reforms,particularly the move towards (a) further liberalisationof the existing capital controls, for which a freshroadmap has been provided by the Committee onFCAC; (b) reforms in other segments of the financialmarket; and (c) greater integration of the economywith the outside world. These, among other things,would imply that (i) an increasing number of Indiancorporates will become global players; and (ii) moreand more non-resident entities operating in India willbe exposed to risks related to changes in exchangerates and interest rates.

6.130 With the Indian economy progressivelymoving towards fuller capital account convertibility inthe coming years and getting increasingly integratedwith the global economy, the foreign exchange marketis likely to see a significant rise in volumes and liquidity

254


in the spot and derivative segments. With theavailability of a large pool of global capital seekingavenues to participate in economies with high growthpotential, inflows into India are likely to continue inview of its stable macroeconomic conditions andpositive growth outlook. The Indian foreign exchangemarket, therefore, will have to prepare itself to dealwith such large capital inflows. This would need furtherdeepening of the foreign exchange market. A keyissue in managing the capital account is credibilityand consistency in macroeconomic policies and thebuilding up of safety nets in a gradually diminishingmanner to provide comfort to the markets during theperiod of transition from an emerging market to adeveloped market.

Improvement in Market Infrastructure

6.131 Against the backdrop of corporates in Indiagoing global, it is essential that the Indian foreignexchange market is able to provide them with thesame types of products and services as are availablein the major markets overseas. The agenda for thefuture should, therefore, include introduction of moreinstruments, more participants and improved marketinfrastructure in respect of trading and settlement.

6.132 The issues that could dominate the agendafor the next phase of development in the foreignexchange market could be catalogued as:(i) introduction of more derivative products involvingthe rupee and more flexibility to both ‘market makers’and ‘users’ to buy or sell these products; (ii) takingcognisance of the offshore derivative marketsinvolving the rupee and weighing all the options inthis regard (i.e., permitting these products onshoreand permitting onshore entities to participate in theoffshore markets); and (iii) relaxation of the currentrestrictions imposed on the entry of non-residententities in the domestic foreign exchange market,par ticularly the derivatives segment. The mainguiding principles for further liberalisation on theabove lines could be summed up as: (i) entrenchmentof modern risk management systems, proceduresand governance in banks and their corporate clients;( i i ) d iversi f icat ion of customer base withheterogeneous expectations; and (iii) adoption ofaccounting and disclosure norms in respect ofderivatives by banks and their corporate clients,based on international best practices. Carefulassessment will need to be made of the need formaking progress in these issues, their sequencing,and consistency with the need of the real economy,and maintenance of financial stability.

Accounting Standards

6.133 The Indian accounting standards relating toderivatives are still in the process of being developed.Greater clarity is required in the area of derivativeaccounting in the books of corporates as well as bankswith regard to revenue recognition and valuation ofassets and liabilities. It may be, therefore, desirableto have convergence in the accounting standards forboth foreign currency and INR derivatives andbetween on-balance sheet and off-balance sheetitems. There is also a need to eliminate incentives todrive a wedge between on-balance sheet and off-balance sheet items (Gopinath, 2005). Moreover,further liberalisation requires banks to act responsiblyin order to provide confidence to corporate entitiesgoing in for derivative transactions, in addition tocomplying with the regulations. In this context,customer suitability and appropriateness issue hasassumed considerable significance. The recentlyissued guidelines on the transactions in derivativeinstruments in India accord high priority to theobservance of customer suitability and appropriatenessby ‘market makers’. The “appropriateness standard”ensures that banks use the same principles for takingcredit decisions in respect of complex derivativetransactions as they do for non-derivative transactions.Banks are expected to evaluate the purpose of thederivative transactions and make an assessment as towhether it is appropriate to the customer’s needs andlevel of sophistication. Only some banks have anappropriateness policy in place. It is, therefore,important that all banks introduce a customer suitabilityand appropriateness policy.

Relaxation of the Cr iter ia of Under lying forTransactions

6.134 The Annual Policy Statement of the ReserveBank for 2007-08 released in April 2007 announcedseveral measures to expand the range of hedgingtools available to market participants and facilitatedynamic hedging by residents as alluded to earlier.As the foreign exchange market matures, the criteriaof ‘underlying’ could be considered for fur therrelaxation to include economic exposures, i.e.,exposures which may not relate directly to foreignexchange transactions, but are affected bymovements in exchange rates.

Interest Rate Parity

6.135 To encourage interest rate parity in theforward markets, the Committee on Fuller CapitalAccount Convertibility (2006) recommended more

255


flexibility for banks to borrow and lend overseas onboth short-term and long-term basis and to increasethe limits. The Committee further observed that inorder to ensure that banks are not exposed toadditional risks because of their access to foreignmarkets, their access should continue to be alloweddepending upon the strength of their balance sheets.Some other issues that have been highlighted by theCommittee as agenda for future development of theforeign exchange market include (i) permitting FIIsthe facility of cancelling and rebooking all forwardcontracts and other derivatives booked to hedgerupee exposures so as to minimise the influence ofNDF markets abroad; and (ii) introduction of currencyfutures, subject to risks being contained throughproper trading mechanism, design of contracts andregulatory environment. The Annual Policy Statementof the Reserve Bank for 2007-08 proposed the settingup of a Working Group on Currency Futures tosuggest a suitable framework to operationalise theproposal in line with the current legal and regulatoryframework.

Reserve Management

6.136 India’s experience highlights the importanceof managing foreign exchange reserves to take careof unforeseen contingencies, volatile capital flows andother developments, which can affect expectationsadversely. As there is no international “lender of lastresort” to provide additional liquidity at short noticeon acceptable terms, the need for adequate reservesis unlikely to be eliminated or reduced even ifexchange rates are allowed to float freely (Mohan,2006a). Several factors such as vulnerability of thereal sector to shocks, strength of the fiscal andfinancial sectors, current account balance, thechanging composition of capital flows, a medium-termview of growth prospects encompassing businesscycles and the exchange rate regime influence thecomfort level of reserves. In a sense, official reserveshave to reflect the balancing and comforting factorsrelative to external assets and liabilities in the contextof a national balance sheet approach (Reddy, 2006d).Thus, the comfort level of reserves should not beviewed with respect to the current situation alone, butgoing forward should also reckon with the potentialrisks.

Customer Service

6.137 In order to provide adequate foreign exchangefacilities to common persons, it is necessary that awide range of activities are available and that there

exist a number of Authorised Dealers. Accordingly, afew entities were licensed as AD (Category II),permitting them to release/remit foreign exchange for17 non-trade related current account transactions.Existing full-fledged money changers (FFMCs), urbanco-operative banks (UCBs), regional rural banks(RRBs), among others, are eligible for such license.Individuals and small enterprises may not haveadequate access to competitive and efficient servicerelating to foreign exchange transactions. Theexporters, particularly the small exporters, do needbetter advice on hedging their currency exposures inview of the two-way movement of the exchange rate.Banks, therefore, may have to consider devisinghedging products, especially for the small and mediumenterprises (SME) sector.

Implications of Global Imbalances

6.138 A significant risk arises from the large andgrowing global financial imbalances. The speed atwhich the US current account ultimately returnstowards balance, the tr iggers that dr ive thatadjustment, and the way in which the burden ofadjustment is allocated across the rest of the worldhave enormous implications for the global exchangerates. Any disorderly adjustments in major currenciesand rise in interest rates would impact the Indianeconomy, though the impact is not expected to besignificant compared to many other emerging marketeconomies (Reddy, 2006b). Any disorderly adjustmentin global imbalances may have some impact oncorporates, banks and households in India, thoughtheir exposures, in aggregate, to the external sectorare not significant. Nevertheless, there will be a needto be alert to unforeseen domestic and global shocksand proactively manage various risks to the foreignexchange market as they evolve.

Managing Exchange Rate Volatility

6.139 As India progresses towards fuller capitalaccount convertibility, it would have to contend withthe impossible trinity of independent monetary policy,open capital account, and exchange rate regime. Atbest, only two out of the three would be feasible. Witha more open capital account as a ‘given’ if a choice ismade of an ‘anchor’ role for monetary policy, it willhave to be at the expense of exchange rate objective.It needs to be recognised, however, that the impactof exchange rate changes on the real sector issignificantly different for reserve currency countriesand for EMEs such as India. In the reserve currencycountries, which specialise in technology intensive

256


products, the degree of exchange rate pass-throughis low, enabling exporters and importers to ignoretemporary shocks and set stable product prices tomaintain monopolistic positions, despite largecurrency fluctuations. Moreover, mature and well-developed financial markets in these countries havethe wherewithal to absorb the risk associated withexchange rate fluctuations with minimal shocks to thereal sector. On the other hand, for the most ofdeveloping countries, which specialise in labour-intensive and low and intermediate technologyproducts, profit margins in the highly competitivemarkets for these products are very thin andvulnerable to pr icing power by retai l chains.Consequently, exchange rate volatility has significantemployment, output and distributional consequences.In this context, managing exchange rate volatilitywould continue to be an issue requiring attention, evenwhen the exchange rate becomes more flexible.

Greater Inter-linkages of Foreign Exchange Marketwith other Segments

6.140 Cross border f lows to var ious marketsegments, viz., the equity market, the money marketand the government securities market are channelledthrough the foreign exchange market. In a regime offuller capital account convertibility, financial flowsacross borders are expected to rise substantially. Theeffective management of these large inflows andoutf lows wil l depend considerably upon thedevelopment of not only the foreign exchange marketbut also on the efficient functioning of other segmentsof the domestic market. A pre-condition to developproper/meaningful linkages between the foreignexchange and other domestic financial markets is todevelop the term money market and a money marketyield curve. This will improve the efficiency of theforeign exchange market by encouraging interestparity conditions in the forward market. The need forproviding market participants with more instrumentsfor hedging price risk by developing the interest ratefutures market would also arise. Thus, with theopening up of the Indian economy, the linkages ofthe foreign exchange market with other segments ofthe financial market would need to be strengthenedwith better information flows (see also Chapter VIII).

VIII. SUMMING UP

6.141 The Indian foreign exchange market hasoperated in a liberalised environment for more than adecade. A cautious and well-calibrated approach wasfollowed while liberalising the foreign exchange market

with an emphasis on the need to safeguard againstpotential financial instability that could arise due toexcessive speculation. The focus was on graduallydismantling controls and providing an enablingenvironment to all entities engaged in externaltransactions. The approach to liberalisation adoptedby the Reserve Bank has been characterised bygreater transparency, data monitoring and informationdissemination and to move away from micromanagement of foreign exchange transactions tomacro management of foreign exchange flows. Theemphasis has been to ensure that proceduralformalities are minimised so that individuals are ableto conduct hassle free current account transactionsand exporters and other users of the market are ableto concentrate on their core activities rather thanengage in avoidable paper work. With a view tomaintaining the integrity of the market, strong know-your-customer (KYC)/anti-money laundering (AML)guidelines have also been put in place.

6.142 Banks have been given significant autonomyto undertake foreign exchange operations. In orderto deepen the foreign exchange market, severalproducts have been introduced and new players havebeen allowed to enter the market. Full convertibilityon the current account and extensive liberalisation ofthe capital account have resulted in large increase intransactions in foreign currency. These have alsoenabled the corporates to hedge various types of risksassociated with foreign currency transactions. Theimpact of these reform initiatives is clearly discerniblein terms of depth and efficiency of the market.

6.143 Exchange rate regimes do influence theregulatory framework when it comes to the issue ofproviding operational freedom to market participantsin respect of their foreign exchange market operations.Notwithstanding a move towards greater exchangerate flexibility by most EMEs, almost all central banksin EMEs actively participate in their foreign exchangemarkets to maintain orderly conditions. While the useof risk management instruments is encouraged bymany emerging markets for hedging genuineexposures linked to real and financial flows, theiroverall approach towards risk management hasremained cautious with an emphasis on the need tosafeguard against potential financial instability arisingdue to excessive speculation in the foreign exchangemarket.

6.144 In the coming years, the challenge for theReserve Bank would be to further build up on thestrength of the foreign exchange market and carryforward the reform initiatives, while simultaneously

257


ensuring that orderly conditions prevail in the foreignexchange market. Besides, with the Indian economymoving towards further capital account liberalisation,the development of a well-integrated foreign exchangemarket also becomes important as it is through thismarket that cross-border financial inflows and outflowsare channelled to other markets. Development of the

foreign exchange market also need to be co-ordinatedwith the capital account liberalisation. Reforms in thefinancial markets is a dynamic process and need tobe harmonised with the evolving macroeconomicdevelopments and the level of maturity of participatingfinancial institutions and other segments of thefinancial market.

7.1 The capital market fosters economic growthin various ways such as by augmenting the quantumof savings and capital formation and through efficientallocation of capital, which, in turn, raises theproductivity of investment. It also enhances theefficiency of a financial system as diverse competitorsvie with each other for financial resources. Further, itadds to the financial deepening of the economy byenlarging the financial sector and promoting the useof innovative, sophisticated and cost-effective financialinstruments, which ultimately reduce the cost ofcapital. Well-functioning capital markets also imposediscipline on firms to perform (Beck et al., 2000;Bandiera et al., 2000). Equity and debt markets canalso diffuse stress on the banking sector bydiversifying credit risk across the economy.

7.2 Although the capital market in India has a longhistory, during the most part, it remained on theperiphery of the financial system. Various reformsundertaken since the early 1990s by the Securitiesand Exchange Board of India (SEBI) and theGovernment have brought about a signif icantstructural transformation in the Indian capital market.As a result, the Indian equity market has becomemodern and transparent. However, its role in capitalformation continues to be limited. The pr ivatecorporate debt market is active mainly in the form ofprivate placements, while the public issue market forcorporate debt is yet to pick up. It is the primary equityand debt markets that link the issuers of securitiesand investors and provide resources for capitalformation. In some advanced countries, especially theUS, the new issue market has been quite successfulin f inancing new companies and spurr ing thedevelopment of new technology companies. A growingeconomy requires r isk capital and long-termresources in the form of debt for enabling thecorporates to choose an appropriate mix of debt andequity. Long-term resources are also important forfinancing infrastructure projects. Therefore, in orderto sustain India’s high growth path, the capital marketneeds to play a major role. The significance of a well-functioning domestic capital market has alsoincreased as banks need to raise necessary capitalfrom the market to sustain their growing operations.

7.3 This chapter is divided into four sections.Section I begins by discussing the role of the stock

market in financing economic growth. This is followedby a brief overview of measures initiated to reformthe capital market since the early 1990s. It thenassesses the impact of various reform measures onthe efficiency and stability parameters such as size,l iquidity, transaction cost and volati l i ty. Theperformance has been assessed against internationalbest standards, wherever possible. In this section, abrief discussion is also presented on the stock pricesand wealth effect from the point of view of its impacton aggregate demand. Section II discusses the needfor developing the private corporate bond market forpromoting growth and creating multiple financingchannels. It presents the evolution of the debt marketin India from the mid-1980s onwards, and variousfactors affecting its growth. It then presentsexperiences of other countries in developing theprivate corporate debt market. Section III suggestsmeasures to enhance the role of the primary capitalmarket in general and the private corporate debtmarket in particular. The last section sets out theconcluding observations.

I. EQUITY MARKET

Role of the Stock Market in Financing EconomicGrowth

7.4 A growing body of empirical research showsthat stock market development matters for growth asaccess to external capital al lows f inancial lyconstrained firms to expand. It is argued that countrieswith better-developed financial systems, especiallythose with liquid stock exchanges, tend to grow faster.On the other hand, Singh (1997) argues that stockmarket expansion is not a necessary naturalprogression of a country’s financial development andstock market development may not help in achievingquicker industr ial isation and faster long-termeconomic growth in most of the developing countriesbecause of several reasons. First, because of inherentvolatility and arbitrariness of the stock market, theresulting pricing process is a poor guide to efficientinvestment allocation. Second, in the wake ofunfavourable economic shocks, the interactionsbetween the stock and currency markets mayexacerbate macroeconomic instability and reducelong-term economic growth. Third, stock market

EQUITY AND CORPORATEDEBT MARKETVII

development is likely to undermine the role of existingbanking systems in developing countries, which havenot been without merit in several countries, not leastin highly successful East Asian economies.

7.5 A study on f inancial development andeconomic growth suggests that stock markets andfinancial intermediaries have grown hand-in-hand inthe emerging market economies, which is popularlyattributed to ‘complementarity hypothesis’. Someother studies also find that the levels of bankingdevelopment and stock market liquidity exert a positiveinfluence on economic growth. Levine and Zervos(1998) provide information on the independent impactof stock markets and banks on economic growth,capital accumulation and productivity in their cross-country study. They find that the initial level of stockmarket liquidity and the initial level of bankingdevelopment are both positively and significantlycorrelated with future rates of economic growth,capital accumulation and productivity growth evenafter controlling for a few initial social, economic andpolitical factors. These results do not lend muchsupport to models that emphasise the tensionsbetween bank-based and market-based systems asthey suggest that stock markets provide differentfinancial functions from those provided by banks.However, Levine and Zervos do not find that stockmarket size, measured by market capitalisationdivided by GDP, is robustly correlated with growth.This implies that simply listing on a stock exchangedoes not necessarily foster resource allocation.Instead, it is the ability to trade ownership of theeconomy’s productive technologies that influencesresource allocation and growth (Levine, 2003). Similarresults were obtained by Beck and Levine (2003) byusing panel techniques. Industry level studies havealso found a positive relationship between financialdevelopment and growth (Rajan and Zingales, 1998),but an increase in f inancial developmentdispropor tionately boosts the growth of thosecompanies that are naturally heavy users of externalfinance. Using firm-level data, Demirguc-Kunt andMaksimovic (1998) show that the proportion of firmsthat grow at rates exceeding the rate at which eachfirm can grow with only retained earnings and short-term borrowing is positively associated with stockmarket liquidity (and banking system size). Thus, thereis ample literature supporting the role of financialdevelopment and the stock market in economic growthby easing external financing constraints.

7.6 Histor ical ly, different kinds of f inancialintermediaries have existed in the Indian financialsystem. Banks f inanced only working capital

requirements of corporates. As the capital market wasunderdeveloped, a number of development financeinstitutions (DFIs) were set up at the all-India and theState levels to meet the long-term requirement offunds. As the stock market played a limited role in theearly stages, the relationship between the stockmarket and the real economy in India has not beenwidely examined. Most of the earlier empirical studiesfocused on banks’ role in financial deepening anddevelopment. More recent work suggests that thefunctional relationship between stock marketdevelopment and economic growth is weak in theIndian context (Nagaishi, 1999). On the contrary, Shahand Thomas (1997) argue that the stock market inIndia is more efficient than the banking system andhence an efficient capital market would contribute tolong-term growth through efficient allocation andutilisation of resources. A revisit of this issue has foundthat both the banking sector and the stock marketpromote growth in the Indian economy and that theycomplement each other. However, the significance ofthe banking sector in economic development is muchmore important than the stock market, which hashitherto played only a limited role. The analysis foundthat economic growth also leads to stock marketdevelopment. There is, thus, bi-directional relationshipbetween stock market development and economicgrowth. These findings are, broadly, in sync with the‘complementary hypothesis’ (Box VII.1).

Recent Developments in the Indian Equity Market

7.7 The Indian equity market has witnessed aseries of reforms since the early 1990s. The reformshave been implemented in a gradual and sequentialmanner, based on international best practices,modified to suit the country’s needs. The reformmeasures were aimed at (i) creating growth-enablinginstitutions; (ii) boosting competitive conditions in theequity market through improved price discoverymechanism; (iii) putting in place an appropriateregulatory framework; (iv) reducing the transactioncosts; and (v) reducing information asymmetry,thereby boosting the investor confidence. Thesemeasures were expected to increase the role of theequity market in resource mobilisation by enhancingthe corporate sector’s access to large resourcesthrough a variety of marketable securities.

7.8 Institutional development was at the core ofthe reform process. The Securities and ExchangeBoard of India, which was initially set up in April 1988as a non-statutory body, was given statutory powersin January 1992 for regulating the securities markets.

259

EQUITY AND CORPORATE DEBT MARKET

260


SEBI was given the twin mandate of protectinginvestors’ interests and ensur ing the order lydevelopment of the capital market.

7.9 The most significant reform in respect of theprimary capital market was the introduction of freepricing. The Capital Issues (Control) Act, 1947 wasrepealed in 1992 paving the way for market forces inthe determination of pricing of issues and allocationof resources for competing uses. The issuers ofsecurities were allowed to raise capital from themarket without requiring any consent from anyauthority for either making the issue or pricing it.Restrictions on rights and bonus issues were alsoremoved. All companies are now able to price issuesbased on market conditions.

7.10 Without seeking to control the freedom of theissuers to enter the market and freely price their issues,the norms for public issues were made stringent in April1996 to prevent fraudulent companies from accessingthe market. Issuers of capital are now required todisclose information on various aspects such as trackrecord of profitability, risk factors, etc. As a result,there has been an improvement in the standards ofdisclosure in the offer documents for the public andrights issues and easier accessibility of informationto the investors. The improvement in disclosure

standards has enhanced transparency, therebyimproving the level of investor protection.

7.11 Issuers also have the option of raisingresources through fixed price mechanism or the bookbuilding process. Book-building is a process by whichdemand for the securities proposed to be issued isbuilt-up and the price for securities is assessed fordetermination of the quantum of such securities tobe issued. Book building was introduced to improvethe transparency in pricing of the scrips and determineproper market price for shares.

7.12 Trading infrastructure in the stock exchanges hasbeen modernised by replacing the open outcry systemwith on-line screen based electronic trading. This hasimproved the liquidity in the Indian capital market andled to better price discovery. The trading and settlementcycles were initially shortened from 14 days to 7 days.Subsequently, to enhance the efficiency of thesecondary market, rolling settlement was introducedon a T+5 basis. With effect from April 1, 2002, thesettlement cycle for all listed securities was shortenedto T+3 and further to T+2 from April 1, 2003. Shorteningof settlement cycles helped in reducing risks associatedwith unsettled trades due to market fluctuations.

7.13 The setting up of the National Stock Exchangeof India Ltd. (NSE) as an electronic trading platform set

In order to establish the relationship of various componentsof the financial sector, viz., banking sector and stockmarket, with economic growth in India, regressiontechnique has been used. As the monthly GDP series isnot available, seasonally adjusted monthly index ofindustr ial production (IIP) was used as a proxy foreconomic activity. Before carrying out the regressionanalysis using ordinary least square (OLS), the monthlydata were adjusted for seasonality and then the variableswere log transformed. As an indicator of the capital marketdevelopment, market capital isation (MCAP) as apercentage of GDP, which measures the size of the market,and value traded ratio (VTR), which reflects the liquidityof the market, have been used. For the banking sector,bank credit (BCR) as a percentage of GDP has been takenas a measure of banking sector development. The periodof the analysis was from April 1995 to June 2006.

It is found that both the stock market and the banking sectorabet the level of economic activity in the country (equation1). However, the relationship between stock market andeconomic activity is not strong as the coefficients of stockmarket activity, viz., MCAP and VTR, though significant,are very small. On the other hand, bank credit plays a very

Box VII.1Does Stock Market Promote Economic Growth in India?

significant role. This confirms the bank-dominated financialsystem in India.

LIIP =1.27 + 0.02 LMCAP + 0.02 LVTR + 0.43 LBCR + 0.47 AR(1) - (Equation 1)

(16.9) (2.2) (5.0) (34.4) (6.0)

Adjusted R2 = 0.99; F-statistics = 3240.7; DW Statistics =2.24

(Figures in parentheses represent t-statistics.)

It is also found that both the banking sector and theeconomic growth promote stock market activity in India(equation 2).

LMCAP = -9.01 + 1.25 LIIP + 1.32 LBCR + 0.89 AR(1) - (Equation 2)

(-3.2) (2.7) (4.7) (25.9)

Adjusted R2 = 0.97; F-statistics = 904.6; DW Statistics =2.28

(Figures in parentheses represent t-statistics.)

References:

Shah, A., and Susan Thomas. 1997. “Securities Markets:Towards Greater Efficiency.” India Development Report,Oxford University Press.

Nagaishi, M. 1999. “Stock Market Development andEconomic Growth: Dubious Relationship.” Economic andPolitical Weekly, July 17.

261


a benchmark of operating efficiency for other stockexchanges in the country. The establishment ofNational Securities Depository Ltd. (NSDL) in 1996and Central Depository Services (India) Ltd. (CSDL)in 1999 has enabled paper less trading in theexchanges. This has also facilitated instantaneouselectronic transfer of securities and eliminated therisks to the investors arising from bad deliveries inthe market, delays in share transfer, fake and forgedshares and loss of scrips. The electronic fund transfer(EFT) facility combined with dematerialisation ofshares created a conducive environment for reducingthe settlement cycle in stock markets.

7.14 The improvement in clearing and settlementsystem has brought a substantial reduction intransaction costs. Several measures were alsoundertaken to enhance the safety and integrity of themarket. These include capital requirements, tradingand exposure limits, daily margins comprising mark-to-market margins and VaR based margins. Trade/settlement guarantee fund has also been set up toensure smooth settlement of transactions in case ofdefault by any member.

7.15 Trading in derivatives such as stock indexfutures, stock index options and futures and optionsin individual stocks was introduced to provide hedgingoptions to the investors and to improve ‘pr icediscovery’ mechanism in the market.

7.16 Another significant reform has been a movetowards corporatisation and demutualisation of stockexchanges. Stock exchanges all over the world havebeen traditionally formed as ‘mutual’ organisations.The trading members not only provide brokingservices, but also own, control and manage suchexchanges for their mutual benefit. In India, NSE wasset up as a demutualised corporate body, whereownership, management and trading rights are inhands of three different sets of groups from itsinception. The Stock Exchange, Mumbai, one of thetwo premier exchanges in the country, has since beencorporatised and demutualised and renamed as theBombay Stock Exchange Ltd. (BSE).

7.17 The stock exchanges have put in place asystem for redressal of investor grievances for mattersrelating to trading members and companies. Theyensure that critical and price-sensitive informationreaching the exchange is made available to all classesof investor at the same point of time. Further, to protectthe interests of investors, the Investor Protection Fund(IPF) has also been set up by the stock exchanges.The exchanges maintain an IPF to take care of

investor claims, which may arise out of non-settlementof obligations by the trading member, who has beendeclared a defaulter, in respect of trades executedon the exchange. Measures of investor protection thathave been put in place over the reform period haveled to increased confidence among investors. TheWorld Bank in its survey of ‘Doing Business’ hasworked out an investor protection index, whichmeasures the strength of minority shareholdersagainst directors’ misuse of corporate assets for his/her personal gain (World Bank, 2006). The index isthe average of the disclosure index, director liabilityindex, and shareholder suits index. The index rangesfrom 1 to 10, with higher values indicating betterinvestor protection. Based on this index, India faresbetter than a large number of economies, includingeven some of the developed ones such as Franceand Germany (Chart VII.1).

7.18 Corporate Governance has emerged as animportant tool for protection of shareholders. Thecorporate governance framework in India has evolvedover a period of time since the setting up of the KumarMangalam Birla Committee by SEBI. According to theEconomic Intelligence Unit Survey of 2003, corporategovernance across the countries, India was rated thethird best country to have good corporate governancecode after Singapore and Hong Kong. India has areasonably well-designed regulatory framework forthe issuance and trading of securities, and disclosuresby the issuers with strong focus on corporategovernance standards.

262


7.19 To improve the availability of information toinvestors, all listed companies are required to publishunaudited financial results on a quarterly basis. Toenhance the level of continuous disclosure by thelisted companies, SEBI amended the l ist ingagreement to incorporate segment reporting, relatedparty disclosures, consolidated financial results andconsolidated f inancial statements. The l ist ingagreement between the stock exchanges and thecompanies has been strengthened from time to timeto enhance corporate governance standards.

7.20 Another important development of the reformprocess was the opening up of mutual funds industryto the private sector in 1992, which earlier was themonopoly of the Unit Trust of India (UTI) and mutualfunds set up by public sector financial institutions.

7.21 Since 1992, foreign institutional investors(FIIs) were permitted to invest in all types ofsecurities, including corporate debt and governmentsecurities in stages and subject to limits. Further, theIndian corporate sector was allowed to accessinternational capital markets through AmericanDepository Receipts (ADRs), Global DepositoryReceipts (GDRs), Foreign Currency Convertible Bonds(FCCBs) and External Commercial Borrowings (ECBs).Eligible foreign companies have been permitted toraise money from domestic capital markets throughissue of Indian Depository Receipts (IDRs).

7.22 Regulations governing substantial acquisitionof shares and takeovers of companies have also beenput in place. These are aimed at making the takeoverprocess more transparent and to protect the interestsof minority shareholders.

7.23 Besides strengthening the institutional designof the markets, the reforms have also brought aboutan increase in the number of service providers whoadd value to the market. The most significantdevelopment in this respect has been the setting upof credit rating agencies. By assigning ratings to debtinstruments and by continuous monitoring anddissemination of the ratings, they help in improvingthe quality of information. At present, four credit ratingagencies are operating in India. Besides, two otherservice providers, viz., registrars to issue and sharetransfer agents, have also grown in number, whichhelp in spreading the services easily and atcompetitive prices.

7.24 The regulatory ambit has been widened intune with the emerging needs and developments inthe equity markets. Apart from stock exchanges,various intermediaries such as mutual funds, stock

brokers and sub-brokers, merchant bankers, portfoliomanagers, registrars to an issue, share transferagents, underwriters, debentures trustees, bankersto an issue, custodian of securities, venture capitalfunds and issuers have been brought under the SEBI’sregulatory purview.

Impact of Reforms on the Equity Market

7.25 The Indian equity market has witnessed asignificant improvement, since the reform processbegan in the early 1990s, in terms of var iousparameters such as size of the market, liquidity,transparency, stability and efficiency. The changes inregulatory and governance framework have broughtabout an improvement in investor confidence.

7.26 The most commonly used indicator of stockmarket development is the size of the market,measured by stock market capitalisation (the valueof listed shares on the country’s exchanges) to GDPratio. This ratio has improved significantly in Indiain recent years (Char t VII.2). Apar t from newlistings, the ratio may go up because of rise in stockprices. While during 1994-95 to 1999-00, 3,434initial public offers (IPOs) amounting to Rs.37,626crore were floated, during 2000-01 to 2005-06, 250IPOs amounting to Rs.43,290 crore were floated. In2006-07, 75 IPOs amounting to Rs.27,524 croreentered the market. The size of the market isinfluenced by several factors, including improvementin macroeconomic fundamentals, changes infinancial technology and increase in institutional

263


efficiency. A cross-country study has identified thatin the case of India, the equity market size hasexpanded mostly because of change in financialtechnology, followed by change in macroeconomicfundamentals, while change in institutional efficiencyhad no impact on the market size (Li, 2007).

7.27 While the size of the Indian equity market stillremains much smaller than many advanced economiessuch as the US, UK, Australia and Japan, it issignificantly higher than many other emerging marketeconomies, including Brazil and Mexico (Chart VII.3).

7.28 The turnover ratio (TOR), which equals thetotal value of shares traded on a country’s stockexchange divided by stock market capitalisation, isa commonly used measure of trading activity orliquidity in the stock markets. The turnover ratiomeasures trading relative to the size of the market.All things equal, therefore, differences in tradingfrictions will influence the turnover ratio. Anotherrelated variable is the value traded ratio (VTR), whichequals the total value of domestic stocks traded ondomestic exchanges as a share of GDP. This ratiomeasures trading relative to the size of the economy.Both TOR and VTR have improved significantly ascompared to the early 1990s (Table 7.1). These ratiostouched high levels between 1996-97 and 2000-01.This, however, largely reflected the impact of sharprise in stock prices due to the IT boom. The priceeffect may lead to an increase in the liquidity ratiosby boosting the value of stock transactions evenwithout a rise in the number of transactions or a fall

in transaction costs. Fur ther, l iquidity may beconcentrated among larger stocks.

7.29 The turnover ratio exhibits substantial cross-country variations (Chart VII.4). The turnover ratio ofNSE in 2005 was lower than that in NASDAQ, Korea,Japan, China and Thailand, but significantly higherthan that of Singapore, Hong Kong, and Mexico stockexchanges. Automation of trading in stock exchangeshas increased the number of trades and the number

Table 7.1: Liquidity in the Stock Market in India(Per cent)

Year Turnover Ratio Value Traded Ratio

1 2 3

1990-91 32.7 6.3

1991-92 20.3 11.0

1992-93 20.0 6.1

1993-94 21.1 9.8

1994-95 14.7 6.9

1995-96 20.5 9.9

1996-97 85.8 30.6

1997-98 98.0 38.0

1998-99 126.5 41.7

1999-00 167.0 78.1

2000-01 409.3 111.3

2001-02 134.0 36.0

2002-03 162.9 37.9

2003-04 133.4 57.9

2004-05 97.7 53.1

2005-06 78.9 66.9

2006-07 81.8 70.7

264


of shares traded per day, which, in turn, has helpedin lowering transaction costs. The spread of tradingterminals across the country has also aided in givingaccess to investors in the stock market. The openingof the Indian equity market to foreign institutionalinvestors (FIIs) and growth in assets of mutual fundsmight have also contributed to the increased liquidityin the Indian stock exchanges.

7.30 Apart from the frequency of trading, liquiditycan also be measured by frictionless trading, proxiedby the transaction cost. Transaction costs are of twotypes – direct and indirect. Direct costs arise fromcosts incurred while transacting a trade such as fees,commissions, taxes, etc. These costs are directlyobservable in the market. In addition, there are‘indirect’ costs that are not directly observable but canbe derived from the speed and efficiency of executionof trades. These can be captured by estimating ‘impactcost’ or cost of executing a transaction on a stockexchange, which var ies with the size of thetransaction. A liquid market is one where transactioncosts (indirect) are low. The impact cost for purchaseor sale of Rs.50 lakh of the Nifty portfolio droppedsteadily and sharply from a level of 0.12 per cent in2002 to 0.08 per cent in 2006, while in the case ofpurchase or sale of Rs.25 lakh of the Nifty Juniorportfolio, the impact cost dropped from a level of 0.41per cent in 2002 to 0.16 per cent in 2006 (Chart VII.5).Besides, even in terms of direct costs that theparticipants have to pay as fee to the broker and theexchange, and the securities transaction tax, the

charges in India are among the lowest in the world(Government of India, 2005-06). As per the SEBI-NCAER Survey of Indian Investors, 2003, there hasbeen a substantial reduction in transaction cost in theIndian securities market, which declined from a levelof more than 4.75 per cent in 1994 to 0.60 per centin 1999, close to the global best level of 0.45 percent. Further, the Indian equity market had the thirdlowest transaction cost after the US and Hong Kong.As compared with some of the developed andemerging markets, transaction costs for institutionalinvestors on the Indian stock exchanges are also oneof the lowest.

7.31 In all developed markets, stock marketsprovide mechanisms for hedging. Derivatives haveincreasingly gained popularity as instruments of riskmanagement. By locking-in asset prices, derivativeproducts enable market participants to partially or fullytransfer price risks. Equity derivatives were introducedin India in 2000. Since then, India has been able tobuild a modern and transparent derivatives market ina relatively short period of time. The turnover inderivative market has also risen sharply, though alarge part of the trading is concentrated in single stockfutures (Chart VII.6). In several other countries, it isindex futures and options, which are the most popularderivative products. The number of stocks on whichindividual stock derivatives are traded has gone upsteadily from 31 in 2001 to 117 at present, which hashelped in percolating liquidity and market efficiencydown to a wide range of stocks.

265


Table 7.3: Volatility in Select World Stock Markets

Year US UK Hong Kong Singapore Malaysia Brazil Mexico Japan India

1 2 3 4 5 6 7 8 9 10

1992 0.6 1.0 1.4 0.9 0.8 7.0 1.6 – 3.31993 0.5 0.6 1.4 0.8 1.1 3.4 1.3 1.2 1.81994 0.6 0.8 1.9 1.3 1.8 3.9 1.8 0.9 1.41995 0.5 0.6 1.3 1.0 1.1 3.4 2.3 1.2 1.31996 0.7 0.6 1.1 0.8 0.8 1.4 1.2 0.8 1.51997 1.1 1.0 2.5 1.5 2.4 3.0 1.8 0.4 1.61998 1.3 1.3 2.8 2.5 3.2 3.5 2.3 1.4 1.91999 1.1 1.1 1.7 1.5 1.8 2.9 1.9 1.2 1.82000 1.4 1.2 2.0 1.5 1.4 2.0 2.2 1.4 2.22001 1.4 1.4 1.8 1.5 1.3 2.1 1.5 1.6 1.72002 1.6 1.7 1.2 1.0 0.8 1.9 1.4 1.4 1.12003 1.1 1.2 1.1 1.2 0.7 2.1 1.1 1.4 1.22004 0.7 0.7 1.0 0.8 0.7 1.8 0.9 1.0 1.62005 0.7 0.6 0.7 0.6 0.5 1.6 1.1 0.8 1.1

Source : Handbook of Statistics on the Indian Securities Market, 2006, SEBI.

7.32 According to the World Federation of StockExchanges, NSE was the leader in the trading ofsingle stock futures in 2006, while in the tradingof index futures, NSE was at the fourth position(Table 7.2).

were able to contain the impact of volatile movementin stock prices on May 17, 2004 and May 22, 2006without any disruption in financial markets.

7.34 The Indian equity market, however, has beensomewhat more volatile as compared with some othermarkets such as the US, Singapore and Malaysia(Table 7.3).

7.35 Significant improvement has also taken placein clearing and settlement mechanism in India. Outof a score of 100, the settlement benchmark, which

Table 7.2: Top Five Equity DerivativeExchanges in the world - 2006

A. Single Stock Futures Contracts

Exchange No. of contracts Rank

National Stock Exchange, India 100,430,505 1

Jakarta Stock Exchange, Indonesia 69,663,332 2

Eurex 35,589,089 3

Euronext.liffe 29,515,726 4

BME Spanish Exchange 21,120,621 5

B. Stock Index Futures Contracts

Exchange No. of contracts Rank

Chicago Mercantile Exchange 470,180,198 1

Eurex 270,134,951 2

Euronext.liffe 72,135,006 3

National Stock Exchange, India 70,286,258 4

Korea Stock Exchange 46,562,881 5

Source : World Federation of Exchanges.

7.33 The Indian stock markets have also becomeless volatile due to the strengthening of the marketdesign. This is reflected in sharp decline in thevolatility in stock prices (Chart VII.7). The robustnessof the r isk management practices at the stockexchange level was also evident as the exchanges

266


Table 7.4: Share of Various Instruments in Gross Financial Savings of the Household Sector in India(Per cent)

Period Currency Bank and Insurance, PF, Units of Claims on Shares andnon-bank deposits Trade debt UTI Government Debentures@

1970-71 to 1979-80 13.9 48.6 31.3 0.5 4.2 1.5

1980-81 to 1989-90 11.9 45.0 25.9 2.2 11.1 3.9

1990-91 to 1994-95 10.8 39.6 25.5 6.6 8.1 9.4

1995-96 to 1999-00 9.7 43.4 30.5 0.9 10.8 4.7

2000-01 to 2005-06 8.9 40.9 29.0 -0.8 18.8 3.2

@ : Includes investment in shares and debentures of credit/non-credit societies, public sector bonds and investment in mutual funds (other thanUTI).

Note : Gross financial savings data for the year 2004-05 are on new base, i.e., 1999-2000.Source : Handbook of Statistics on the Indian Economy, 2005-06, RBI.

provides a means of tracking the evolution ofsettlement performance over a period of time,improved from 8.3 in 1994 to 93.1 in 2004. Thesafekeeping benchmark, which provides the efficiencyof a market in terms of collection of dividend andinterest, protection of rights in the event of a corporateaction, improved from 71.8 in 1994 to 91.8 in 2004.The operational risk benchmark that takes intoconsideration the settlement and safekeepingbenchmarks and other operational factors such as thelevel of compliance with G30 recommendations, thecomplexity and effectiveness of the regulatory andlegal structure of the market, and counterparty risk,improved from 28.0 out of 100 in 1994 to 67.2 in 2004(NSE, 2005).

7.36 Despite significant improvement in trading andsettlement infrastructure, risk management system,liquidity and containment of volatility, the role of theIndian capital market (equity and debt) has remainedless significant as is reflected in the savings in theform of capital market instruments and resourcesraised by the corporates. Savings of the householdsector in the form of shares and debentures and unitsof mutual funds have remained at a low level, barringthe period from 1990-91 to 1994-95, when they wererelatively high. It is also significant to note that theshare of savings in capital market instruments(shares, debentures and units of mutual funds) during2000-01 to 2005-06 was lower than that in the 1980sand 1990s (Table 7.4).

7.37 The opening up of the mutual funds sector tothe private sector brought about an element ofcompetition. The mutual fund industry recovered fromthe adverse impact of the UTI imbroglio and hasbegun to attract substantial funds. The growingpopularity of mutual funds is clearly evident from theincrease in net funds mobilised (net of redemptions)

by them (Chart VII.8). The buoyancy in stock marketsduring last two years enabled mutual funds to attractfresh inflow of funds. Although the share of equity-oriented schemes increased significantly in recentyears, most of the funds mobilised by mutual fundswere through liquid/money market schemes, whichremain attractive for parking of funds by largeinvestors with a short-term perspective.

7.38 As a result of large mobilisation of funds androbust stock markets, the assets under managementof mutual funds increased sharply during last twoyears (Chart VII.9).

7.39 Despite significant fund mobilisation in therecent years, the penetration of the mutual fundsindustry in India remains fairly low as compared with

267


even some of the emerging market economies(Chart VII.10).

7.40 Resource mobilisation from the primary capitalmarket by way of public issues, which touched thepeak during 1994-95, declined in subsequent years(Chart VII.11). Although resource mobilisation pickedup during the period from 2003-04 to 2005-06,resource mobilisation as per cent of GDP and grossdomestic capital formation (GDCF) in 2005-06 waslower than that in 1990-91 (Chart VII.12). This wasdespite the fact that the industrial sector has remained

buoyant for the last 3 years and has witnessed largecapacity additions.

7.41 The size of the primary market in Indiaremains much smaller than many advancedeconomies such as Hong Kong, Australia, the UK,the US and Singapore, as also emerging marketeconomies such as Thailand, Malaysia, Brazil and thePhilippines (Chart VII.13).

7.42 The relative decline in the public issuessegment could be attributed to four main factors:

268


(i) tightening of entry and disclosure norms; (ii) increasedreliance by corporates on internal generation offunds; (iii) corporates raising resources from theinternational capital markets; and (iv) emergence ofthe private placement market.

7.43 In the early 1990s, the liberalisation of theindustrial sector and free pricing of capital issues ledto an increased number of companies tapping theprimary capital market to mobilise resources. Severalcorporates charged a high premium not justified bytheir fundamentals. Also, several companies vanishedafter raising resources from the capital market. SEBI,therefore, strengthened the norms for public issueswhile retaining the freedom of the issuers to enterthe new issues market and to freely price their issues.The disclosure standards were also strengthened forcompanies coming out with public issues for improvingthe levels of investor protection. Strict disclosurenorms and entry point restrictions prescribed by SEBImade it difficult for most new companies without anestablished track record to access the public issuesmarket. Whereas this helped to improve the qualityof paper coming into the market, it contributed to adecline in the number of issues and the amountmobilised from the market. This period also coincidedwith slackening of investment activity across varioussectors. In particular, the pace of private investmentoriginating from the private corporate sector lostmomentum in the second half of the 1990s on accountof factors such as reduced savings from this sectorand lack of public investment in infrastructure. Thedampening of investment climate also resulted in a

Table 7.5: Pattern of Sources of Funds forIndian Corporates

(Per cent to total)

Item 1985-86 1990-91 1995-96 2000-01to to to to

1989-90 1994-95 1999-2000 2004-05

1. Internal Sources 31.9 29.9 37.1 60.7

2. External Sources 68.1 70.1 62.9 39.3of which:a) Equity capital 7.2 18.8 13.0 9.9b) Borrowings 37.9 32.7 35.9 11.5

of which:(i) Debentures 11.0 7.1 5.6 -1.3(ii) From Banks 13.6 8.2 12.3 18.4(iii) From FIs 8.7 10.3 9.0 -1.8

c) Trade dues & other 22.8 18.4 13.7 17.3current liabilities

Total 100.0 100.0 100.0 100.0

Memo:(i) Share of Capital Market 18.2 26.0 18.6 8.6

Related Instruments(Debentures and EquityCapital)

(ii) Share of Financial 22.2 18.3 21.3 16.6Intermediaries(Borrowings fromBanks and FIs)

(iii) Debt-Equity Ratio 88.4 85.5 65.2 61.6

Note : Data pertain to a sample of non-government non-financialpublic limited companies.

Source : Article on “Finances of Public Limited Companies”, RBI Bulletin(various issues).

drastic fall in the number of companies accessing theprimary capital market for funds. The slowdown inactivity in the primary market could also be attributedto the subdued conditions in the secondary market.

7.44 During the second half of the 1990s andthereafter, the pattern of financing of investments bythe Indian corporate sector also underwent asignificant change. Corporates came to rely heavilyon internal sources of funds, constituting 60.7 per centof total funds during 2000-01 to 2004-05 as against29.9 per cent during 1990-91 to 1994-95. Amongexternal sources, however, while share of equitycapital, borrowings by way of debentures and fromFIs declined sharply, that of borrowings from banksincreased significantly (Table 7.5).

7.45 Indian corporates were allowed to raise fundsfrom the international capital markets by way of ADRs/GDRs, FCCBs and external commercial borrowingsin the early 1990s. This widened the financing choicesavailable to corporates, enabling them to raise largeresources from the international capital markets,especially in the recent period (Chart VII.14).

269


7.46 International equity issuances by Indiancompanies increased sharply between 2000 and 2005and were significantly higher than those by corporatesin several other emerging markets (Chart VII.15).

7.47 The private placement market also emergedin the mid-1990s. The convenience and flexibility ofissuance made this segment attractive for companies.Mid-sized companies wishing to issue long-term debtsecurities at fixed rates of interest preferred the privateplacement market. Some of these companies mightbe new entrants in the market, which would not have

been able to float public issues in the absence of atrack record of past performance. However, at times,even large-sized companies also prefer to issuesecurities in the private placement market. A majoradvantage of private placement is tailor-made deals,which suit the requirements of both the parties. Manycompanies may also prefer private placements if theywish to raise funds quickly. The resources raisedthrough the private placement market, which amountedto Rs.13,361 crore in 1995-96, increased to Rs.96,369crore in 2005-06 (as detailed in section III). Currently,the size of the private placement market is estimatedto be more than three times of the public issuesmarket (Chart VII.16). Although the private placementmarket is cost-effective and less time-consuming, itlacks transparency. It also deprives retail investor fromparticipating in the capital market.

7.48 The available data on the shareholding patternin India between 2001 and 2005 suggest that promoterscontinue to hold a large portion in the equity of thecompanies. In fact, the share of promoters increasedmarginally over the period. The share of equity heldby FIIs/NRIs also increased. On the other hand, theshare of equity held by mutual funds, banks/FIs andIndian public declined (Chart VII.17). Concentratedownership prevents the broad distribution of gains fromthe equity market development. Concentration ofownership among promoters and corporate bodies(through cross-holdings) also has implications for thefunctioning of the corporate governance frameworkand protection of rights of minority shareholders.

270


7.49 To sum up, the Indian capital market hasbecome modern in terms of market infrastructure andtrading and settlement practices. The capital markethas also become a much safer place than it was beforethe reform process began. The secondary capitalmarket in India has also become deep and liquid. Therehas also been a reduction in transaction costs andsignificant improvement in efficiency and transparency.However, the role of the domestic capital market incapital formation in the country, both directly andindirectly through mutual funds, continues to be lesssignificant. The public issues segment of the capitalmarket, in particular, has remained small. Rather, it hasshrunk over the last 15 years.

Asset Prices and Wealth Effect

7.50 Apart from playing a vital role in the growthprocess through mobilisation of resources andimproved allocative efficiency, the stock market alsopromotes economic growth indirectly through its effecton consumption and hence aggregate demand. Inrecent years, financial balance sheets of economicagents have deepened on account of increase infinancial assets and liabilities relative to income andan increase in the holding of assets whose returnsare directly linked to the market. Market-linked assetsin the form of real estate and equities have becomeimpor tant arguments in the wealth function ofhouseholds and firms. The tendency of a greatershare of wealth to be held in market-linked assetshas increased the sensitivity of spending decisions.Price movements in these assets, therefore, may lead

more directly to changes in consumption withattendant implications for monetary policy.

7.51 Empirical studies have shown that large pricechanges may have substantial wealth effects onconsumption and savings. Ludwig and Slok (2002)estimated panel data from 16 OECD countries andconcluded that there is a significant long run impactof stock market wealth on private consumption. Theyhave singled out five channels of transmission fromchanges in stock market wealth to changes inconsumption. One, if the value of consumers’ stockholding increases and consumers realise their gains,then consumption will increase. This is known asrealised wealth effect. Two, increase in stock pricescan also have an expectations effect where the valueof stocks in pension accounts and other locked-inaccounts increases. The consumers may not realisethese gains but they result in higher presentconsumption on expectation that income and wealthwill be higher in future. This is termed as unrealisedwealth effect. Three, increase in stock market pricesincreases the value of investor portfolio. Borrowingagainst the value of this portfolio, in turn, allows theconsumer to increase consumption. This is calledliquidity constraints effect. Four, an increase in stockprices may lead to higher consumption for stock optionowners as a result of increase in value of stock options.This increase may be independent of whether thegains have been realised or unrealised. This is termedas stock option value effect. Five, consumption ofhouseholds, who do not participate in the stockmarket, may be indirectly affected by changes in stockmarket prices. Asset prices contain information aboutfuture movements in real variables (Christoffersen andSlok, 2000). Hence, a decline in stock prices leads toincreased uncertainty about future income, i.e.,decrease in consumer confidence and, therefore,decline in durable consumption (Romer, 1990). Thisis an indirect effect.

7.52 The impact of changes in stock prices onconsumption was found to be bigger in economies withmarket-based financial systems than in economieswith bank-based financial systems. Further, this impactfrom stock markets to consumption has increased overtime for both sets of countries. While the effect ofhousing prices on consumption is ambiguous, thewealth effect has become more important over time.

7.53 Effect of stock prices on consumption appearsto be strongest in the US, where most estimates pointto an elasticity of consumption spending relative tonet stock market wealth in the range of 0.03 to 0.07.In contrast, studies have not found any significantimpact of stock prices on private consumption in

271


France and Italy. In Canada, Germany, Japan, theNetherlands and the United Kingdom, the effects aresignificant but smaller than in the United States. Thisis reflective of the smaller share of stock ownershiprelative to other financial assets in these countries,as well as more concentrated distribution of stockownership across households in continental Europeas compared with the US. The effect of changes inreal property prices on consumption was found to bemuch stronger in European Union countries. Risingreal property prices can affect consumption not onlythrough higher realised home values but also by thehouseholds’ ability to refinance a mortgage or go forreverse mortgages (IMF, 2000). However, in the Indiancontext, the wealth effect is limited as the householdsector holds a very small share of its savings in stocks,i.e., about 5 per cent in 2005-06. As householdsdiversify their portfolios in equities, the asset pricechannel of monetary transmission could strengthenas wealth effect becomes more important.

II. PRIVATE CORPORATE DEBT MARKET

7.54 The private corporate debt market provides analternative means of long-term resources (alternativeto financing by banks and financial institutions) tocorporates. The size and growth of private corporatedebt market depends upon several factors, includingfinancing patterns of companies. Among market-basedsources of financing, while the equity markets havebeen largely developed, the corporate bond marketsin most emerging market economies (EMEs) haveremained relatively underdeveloped. This has been theresult of dominance of the banking system combinedwith the weaknesses in market infrastructure andinherent complexities. However, credit squeezefollowing the Asian financial crisis in the mid-1990sdrew attention of policy makers to the importance ofmultiple financing channels in an economy. Alternativesources of finance, apart from banks, need to beactively developed to suppor t higher levels ofinvestment and economic growth. The development ofcorporate debt market has, therefore, become the primeconcern of regulators in developing countries.

7.55 As in several other EMEs, corporates in Indiahave traditionally relied heavily on borrowings frombanks and financial institutions (FIs) to finance theirinvestments. Equity financing was also used, butlargely during periods of surging equity prices.However, bond issuances by companies have remainedlimited in size and scope. Given the huge fundingrequirements, especially for long-term infrastructureprojects, the private corporate debt market has a crucialrole to play and needs to be nurtured.

Significance of the Corporate Debt Market

7.56 In any country, companies face different typesof f inancing choices at different stages ofdevelopment. Reflecting the varied supplies ofdifferent types of capital and their costs, regulatorypolicies and financial innovations, the financingpatterns of firms vary geographically and temporally.Some studies have observed that while developedcountries rely more on market-based sources offinance, the developing countries rely more on bank-based sources. The development of a corporate bondmarket, for direct financing of the capital requirementsof corporates by investors assumes paramountimportance, particularly in a liberalised financialsystem (Sakakibara, 2001). From the perspective ofdeveloping countries, a liquid corporate bond marketcan play a critical role in supporting economicdevelopment as it supplements the banking systemto meet the requirements of the corporate sector forlong-term capital investment and asset creation. Itprovides a stable source of finance when the equitymarket is volatile. Further, with the decline in the roleof specialised financial institutions, there is anincreasing realisation of the need for a well-developedcorporate debt market as an alternative source offinance. Corporate bond markets can also help firmsreduce their overall cost of capital by allowing themto tailor their asset and liability profiles to reduce therisk of maturity and currency mismatches. A privatecorporate bond market is important for nurturing acredit culture and market discipline. The existence ofa well-functioning bond market can lead to the efficientpricing of credit risk as expectations of all bond marketparticipants are incorporated into bond prices.

7.57 In many Asian economies, banks havetraditionally been performing the role of financialintermediation. The East Asian cr isis of 1997underscored the limitations of weak banking systems.The primary role of a banking system is to create andmaintain liquidity that is needed to finance productionwithin a short-term horizon. The crisis showed thatover-reliance on bank lending for debt financingexposes an economy to the risk of a failure of thebanking system. Banking systems, therefore, cannotbe the sole source of long-term investment capitalwithout making an economy vulnerable to externalshocks. In times of financial distress, when bankingsector becomes vulnerable, the corporate bondmarkets act as a buffer and reduce macroeconomicvulnerability to shocks and systemic risk throughdiversification of credit and investment risks. Bycontributing to a more diverse financial system, a bondmarket can promote financial stability. A bond market

272


may also help the banking system in diff icultconditions by allowing banks to recapitalise theirbalance sheets through securitisation (IOSCO, 2002).

7.58 The available economic literature suggeststhat meeting the demand for long-term funds bycorporates, especially in developing economiesrequires multiple financing channels such as theequity market, the debt market, banks and otherfinancial institutions. Indirect financing by banks anddirect financing by bonds also improve firms’ capitalstructures. From a broader sense of macroeconomicstability and growth, the complementary nature ofbank financing and direct financing by the market infinancing corporates is desirable. It has beenestablished that they indeed play a complementary rolein the emerging market economies (Takagi, 2001).

7.59 Apart from providing a channel for financinginvestments, the corporate bond markets alsocontribute towards portfolio diversification for holdersof long-term funds. Effective asset managementrequires a balance of asset alternatives. In view ofthe underdeveloped state of the corporate bondmarkets, there would be an overweight position ingovernment securit ies and even equities. Theexistence of a well-functioning corporate bond marketwidens the array of asset choices for long-terminvestors such as pension funds and insurancecompanies and allows them to better manage thematurity structure of their balance sheets.

7.60 The financial structure of corporates hasimplications for monetary policy. Bond markets givean assessment of expected interest rates through theterm structure of interest rates. The shape of the yieldcurve provides useful information about marketexpectations of future interest rates and inflation rates.Bond der ivatives can also provide impor tantinformation about the prevailing uncertainty aboutfuture interest rates. Such information gives importantclues on whether market expectations deviate too farfrom central banks’ own evaluation of the currentcircumstances. In other words, bond markets canprovide relevant information about risks to pricestability. In situations when banks may adopt anoligopolistic pricing behaviour, the dynamic response ofmonetary policy changes works mainly through the bondmarket. Further, when the banking sector is impaired,as in Thailand in 1997, a change in policy interest ratecan still have some effect through the change inbehaviour and issuing costs for corporate bonds.

State of the Corporate Debt Market in India

7.61 In India, banks and FIs have traditionally beenthe most important external sources of finance for the

corporate sector. India has traditionally been apredominantly bank-based system. This picture isgenerally characteristic of most Asian economies. Thesecond half of the 1980s saw some activity in primarybond issuances, but these were largely by the PSUs.The period of ‘debenture boom’ in the late 1980s,however, proved to be short-lived. The corporatesrelied more on banks for meeting short-term workingcapital requirements and DFIs for financing long-terminvestment. However, with the conversion of two largeDFIs into banks, a gap has appeared for long-termfinance. Commercial banks have managed to fill thisgap, but only to an extent as there are asset-liabilitymismatch issues for banks in providing longer-maturity credit. The problems associated with thediminishing role of DFIs appeared less severe as thisperiod coincided with a decline in the reliance of thecorporates on external financing. However, thissituation may change in future.

7.62 In the 1990s, the equity market in Indiawitnessed a series of reforms, which helped in bringingit on par with international standards. However, thecorporate debt market has not been able to developdue to lack of market infrastructure and a comprehensiveregulatory framework. For a variety of reasons, theissuers resorted to ‘private placement’ of bonds asopposed to ‘public issues’ of bonds. The issuances ofbonds to the public have declined sharply since the early1990s. From an annual average of Rs.7,513 croreraised by way of public debt issues during 1990-95,the mobilisation fell to Rs.5,526 crore during 1995-2000 and further to Rs.4,433 crore during 2000-05(Chart VII.18). The decline is expected to be much

273


sharper in real terms, i.e., adjusted for rise in inflation.In contrast, the mobilisation of funds by privateplacement of debt increased sharply from an averageof Rs.33,638 crore during 1995-2000 to Rs.69,928crore during 2000-05. In 2005-06, the mobilisation offunds by public issue of debt shrank to a measly sumof Rs.245 crore, while the resources raised by way ofprivate placement of debt swelled to Rs.96,369 crore.The share of resources raised by private placementsin total debt issues correspondingly increased from 69.1per cent in 1995-96 to 99.8 per cent in 2005-06. Thistrend continued in 2006-07.

7.63 The emergence of private placement markethas provided an easier alternative to the corporates

In private placement, resources are raised privatelythrough arrangers (merchant banking intermediaries) whoplace securities with a limited number of investors suchas financial institutions, corporates and high net worthindividuals. Under Section 81 of the Companies Act, 1956,a private placement is defined as ‘an issue of shares orof convertible securities by a company to a select groupof persons’. An offer of securities to more than 50 personsis deemed to be a public issue under the Act.

Corporates access the private placement market becauseof its certain inherent advantages. First, it is a cost andtime-effective method of raising funds. Second, it can bestructured to meet the needs of the entrepreneurs. Third,private placement does not require detailed complianceof formalities as required in public or rights issues. Theprivate placement market was not regulated until May2004. In view of the mushrooming growth of the marketand the risk posed by it, SEBI prescribed that the listingof all debt securities, irrespective of the mode of issuance,i.e., whether issued on a private placement basis orthrough public/rights issue, shall be done through aseparate listing agreement. The Reserve Bank also issuedguidelines to the financial intermediaries under its purviewon investments in non-SLR securities including, private

placement. In June 2001, boards of banks were advisedto lay down policy and prudential limits on investments inbonds and debentures, including cap on unrated issuesand on a private placement basis. The policy laid downby banks should prescribe stringent appraisal of issues,especially by non-borrower customers, provide for aninternal system of rating, stipulate entry-level minimumratings/quality standards and put in place proper riskmanagement systems.

The private placement market in India, which shot intoprominence in the early 1990s, has grown sharply inrecent years. The resource mobilisation by way of privateplacements increased from Rs.13,361 crore in 1995-96to Rs.96,369 crore in 2005-06, recording an averageannual growth of over 25 per cent during the decade(Chart A). The private placement market remained largelyconfined to financial companies and central PSUs andstate-level undertakings. These institutions togetheraccounted for over 75 per cent share in resourcemobilisation by private placements. The resources raisedby non-government non-financial companies remainedcomparatively insignificant (Char t B). Most of theresources from the market are raised by way of debt, witha majority of issues carrying ‘AAA’ or ‘AA’ rating.

Box VII.2Private Placement Market in India

to raise funds (Box VII.2). Although the privateplacement market provides a cost effective and timesaving mechanism for raising resources, the unbridledgrowth of this market has raised some concerns. Thequality of issues and extent of transparency in theprivate placement deals remain areas of concern eventhough privately placed issues by listed companiesare now required to be listed and also subject tonecessary disclosures. In the case of public issues,all the issues coming to the market are screened fortheir quality and the investors rely on ratings and otherpublic information for evaluation of risk. Such ascreening mechanism is missing in the case of privateplacements. This increases the risk associated with

274


privately placed securities. Fur ther, the privateplacement market appears to be growing at theexpense of the public issues market, which has somedistinct advantages in the form of wider participationby the investors and, thus, diversification of the risk.

7.64 The size of the Indian corporate debt marketis very small in comparison with not only developedmarkets, but also some of the emerging marketeconomies in Asia such as Malaysia, Thailand andChina (Table 7.6).

7.65 In view of the dominance of the privateplacement segment, most of the corporate debt issuesin India do not find a way into the secondary marketdue to limited transparency in both primary andsecondary markets. Liquidity is also constrained onaccount of small size of issues. For instance, theaverage size of issue of privately placed bonds in2005-06 worked out to around Rs.90 crore, less thanhalf of an average size of an equity issue. Out of nearly1,000 bond issues in the private placement market,only around 3 per cent of the issues were of the sizeof more than Rs.500 crore. Some companies enteredthe market more than 100 times in a single year toraise funds through small tranches. As a result, thesecondary market for corporate debt is characterisedby poor liquidity and trading is confined largely to thetop 5 or 10 bond papers (Bose and Coondoo, 2003).The government bond market has become reasonablyliquid, while the trading in private corporate debt

securities has remained insignificant (Table 7.7).Typically, the turnover ratios differ widely forgovernment and corporate debt securities across theworld. The turnover ratios for Asian corporate bondmarkets are a small fraction of those for governmentbond markets reflecting low levels of liquidity. Liquiditydifferences for government and corporate bondmarkets are expected because corporate debt issuesare more heterogeneous and smaller in size thangovernment bond issues. Even in the US, the turnoverratio for corporate bonds was less than 2 per cent in2004 as compared with turnover ratio of more than30 per cent for government bonds (BIS, 2006).

7.66 Development of the domestic corporate debtmarket in India is constrained by a number of factors- low issuance leading to illiquidity in the secondarymarket, narrow investor base, inadequate creditassessment skills, high costs of issuance, lack oftransparency in trades, non-standardised instruments,comprehensive regulatory framework andunderdevelopment of securitisation products. Themarket suffers from deficiencies in products,participants and institutional framework. This isdespite the fact that India is fairly well placed insofaras pre-requisites for the development of the corporatebond market are concerned (Mohan, 2004b). Thereis a reasonably well-developed government securitiesmarket, which generally precedes the developmentof the market for corporate debt securities. The majorstock exchanges have trading platforms for thetransactions in debt securities. The infrastructure alsoexists for clearing and settlement. The ClearingCorporation of India Limited (CCIL) has beensuccessfully settling trades in government bonds,foreign exchange and other money marketinstruments. The experience with the depositorysystem has been satisfactory. The presence ofmultiple rating agencies meets the requirement of anassessment framework for bond quality.

Table 7.6: Size of Domestic Corporate Debt Marketand other Sources of Local Currency Funding

(As at end-2004)(As per cent of GDP)

Country Corporate Government Domesticbonds bonds credit

outstanding outstanding

1 2 3 4

US 128.8 42.5 89.0Korea 49.3 23.7 104.2Japan 41.7 117.2 146.9Malaysia 38.8 36.1 113.9Hong Kong 35.8 5.0 148.9New Zealand 27.8 19.9 245.5Australia 27.1 13.8 185.4Singapore 18.6 27.6 70.1Thailand 18.3 18.5 84.9China 10.6 18.0 154.4India 3.3 29.9 60.2Indonesia 2.4 15.2 42.6Philippines 0.2 21.8 49.8

Source : Bank for International Settlements, 2006.

Table 7.7: Turnover of Debt Securities(Rs. crore)

Year Government Bonds* Corporate Bonds

2000-01 5,72,145 14,4862001-02 12,11,945 19,5862002-03 13,78,158 35,8762003-04 16,83,711 41,7602004-05 11,60,632 37,3122005-06 8,81,652 24,6022006-07 (April-Feb.) 9,71,414 12,099

*: Outright transactions in government securities.Source : RBI; National Stock Exchange of India Limited.

275


7.67 With the intent of the development of thecorporate bond market along sound lines, someinitiatives were taken by the SEBI in the past fewyears. These measures largely aimed at improvingdisclosures in respect of privately placed debt issues.In view of the immediate need to design a suitableframework for the corporate debt market, it wasannounced in the Union Budget 2005-06 that a HighLevel Expert Committee on Corporate Bonds andSecuritisation would be set up to look into the legal,regulatory, tax and mortgage design issues for thedevelopment of the corporate bond market. The HighLevel Committee (Chairman: Dr. R. H. Patil), whichsubmitted its report in December 2005, looked intothe factors inhibiting the development of an activecorporate debt market in India and made severalsuggestions for developing the market infrastructurefor development of primary as well as secondarycorporate bond market (Box VII.3).

7.68 At the current time, when India is endeavoringto sustain its high growth rate, it is necessary thatfinancing constraints in any form are removed andalternative financing channels are developed in asystematic manner for supplementing traditionalbank credit. The problem of ‘missing’ corporate bondmarket, however, is not unique to India alone.Predominantly bank-dominated financial systems inmost Asian economies faced this situation. ManyAsian economies woke up to meet this challenge inthe wake of the Asian financial crisis. During lessthan a decade, the domestic bond markets of manyAsian economies have undergone signif icanttransformation. In the case of India, however, thesmall size of the private corporate debt market hasshrunk further. This trend needs to be reversed soon.India could learn from the experiences of countriesthat have undertaken the process of reforming theirdomestic corporate bond markets.

Lessons from Experiences of other Countries

7.69 The corporate bond markets have developedat a different pace in different countries across theglobe. While the local environment shaped thedevelopments in a major way in most economies,there were certain common elements of reform thataimed at removing various bottlenecks impeding thegrowth of this segment. It is difficult to find muchuniformity in the various features of the corporatebond market across the countries. This is partlybecause of the complex nature of bond contracts andvariations in market practices across countries. Thesize of the corporate bond market also differs widely

across the countries, with the US and Japan havinglarge markets, followed by Korea, China and Australia(refer to Table 7.6). Corporates would have limitedincentive to tap bond markets when banks are willingto lend at low spreads. Even among developedeconomies, the dominance of the banking sector inEurope and correspondingly small size of thecorporate bond market is in sharp contrast to the USwhere corporate debt market plays a bigger role incorporate financing than banks. The European bondmarkets have, however, grown in size after theintroduction of euro in 1999. The US is perhaps theonly country with a bigger market for corporate bondsas compared with domestic credit market. The sizeof the US corporate bond market is almost as big asits equity market. While the corporate bond market inthe US has existed for a long time, Canada, Japanand most European countr ies have seen theircorporate bond markets developing in more recentdecades (IMF, 2005). The size of an economy, thelevel of its development and state of financialarchitecture are some of the key determinants of thesize of the corporate bond market. Although the USexperience with corporate bond markets could serveas a useful model for Asian economies striving todevelop domestic bond markets, they may find itdifficult to emulate the US experience on account ofdifferences in the level of financial development andexperience. Even in the US, the corporate bondmarkets evolved over a long period of time due to acombination of regulatory intervention and marketforces.

7.70 The growth of the corporate bond market inseveral countries, including the US and Korea, wasspurred by increased availability of structuredfinancial products such as mortgage and asset-backed securities. In the US, mortgage backedsecurities accounted for 26 per cent of the totaloutstanding debt in 2004, while the corporate debtsecur it ies accounted for 23 per cent of theoutstanding debt (Chart VII.19). In a pure corporatedebt market, only large companies can access themarket. The availability of structured productsprovides an al ternat ive way of addressing afundamental limitation of the corporate bond market,namely the gap between the credit quality of bondsthat investors would like to hold and the actual creditquality of potential borrowers (Gyntelberg andRemolana, 2006).

7.71 After the 1997 Asian crisis, several Asianeconomies have implemented measures to developtheir local corporate bond markets to create multiple

276


The key recommendations of the High Level ExpertCommittee on Corporate Debt and Securitisation, whichsubmitted its report in December 2005, are summed upbelow:

Corporate Debt Market

Primary Market

1. The stamp duty on debt instruments be made uniformacross all the States and linked to the tenor of securities.

2. To increase the issuer base, the time and cost forpublic issuance and the disclosure and listingrequirements for private placements be reduced andmade simpler. Banks be allowed to issue bonds ofmaturities of 5 year and above for ALM purpose, inaddition to infrastructure sector bonds.

3. A suitable framework for market making be put in place.4. The disclosure requirements be substantially abridged

for listed companies. For unlisted companies, ratingrationale should form the basis of listing. Companiesthat wish to make a public issue should be subjectedto stringent disclosure requirements. The privatelyplaced bonds should be listed within 7 days from thedate of allotment, as in the case of public issues.

5. The role of debenture trustees should bestrengthened. SEBI should encourage developmentof professional debenture trustee companies.

6. To reduce the relative cost of participation in the corporatebond market, the tax deduction at source (TDS) rule forcorporate bonds should be brought at par with thegovernment securities. Companies should pay interestand redemption amounts to the depository, which wouldthen pass them on to the investors through ECS/warrants.

7. For widening investor base, the scope of investment byprovident/pension/gratuity funds and insurancecompanies in corporate bonds should be enhanced.Retail investors should be encouraged to participate inthe market through stock exchanges and mutual funds.

8. To create large floating stocks, the number of freshissuances by a given corporate in a given time periodshould be limited. Any new issue should preferablybe a reissue so that there are large stocks in any givenissue and issuers should be encouraged toconsolidate various existing issues into a few largeissues, which can then serve as benchmarks.

9. A centralised database of all bonds issued bycorporates be created. Enabling regulations for settingup platforms for non-competit ive bidding andelectronic bidding process for primary issuance ofbonds should be created.

Secondary Market1. The regulatory framework for a transparent and efficient

secondary market for corporate bonds should be put inplace by SEBI in a phased manner. To begin with, a tradereporting system for capturing information related to

Box VII.3Recommendations of the High Level Expert Committee on Corporate Debt and Securitisation

trading in corporate bonds and disseminating on a realtime basis should be created. The market participantsshould report details of each transaction within a specifiedtime period to the trade reporting system.

2. The clearing and settlement of trades should meetthe standards set by IOSCO and global best practices.The clearing and settlement system should migratewithin a reasonable timeframe from gross settlementto net settlement. The clearing and settlementagencies should be given access to the RTGS system.For improving secondary market trading, repos incorporate bonds be allowed.

3. An online order matching platform for corporate bondsshould be set up by the stock exchanges or jointly byregulated institutions such as banks, financialinstitutions, mutual funds, insurance companies, etc.In the final stage of development, the trade reportingsystem could migrate to STP-enabled order matchingsystem and net settlement.

4. The Committee also recommended: (i) reduction inshut period for corporate bonds; (ii) application ofuniform coupon conventions such as, 30/360 daycount convention as fol lowed for governmentsecurities; (iii) reduction in minimum market lot fromRs.10 lakh to Rs.1 lakh, and (iv) introduction ofexchange traded interest rate derivative products.

Securitised Debt Market1. A consensus should evolve on the affordable rates

and levels of stamp duty on debt assignment, pass-through certificates (PTCs) and security receipts(SRs) across States.

2. An explicit tax pass-through treatment to securitisationSPVs / Trust SPVs should be provided. Wholesaleinvestors should be permitted to invest in and holdunits of a close-ended passively managed mutual fundwhose sole objective is to invest its funds in securitisedpaper. There should be no withholding tax on interestpaid by the borrowers to the securitisation trust andon distributions made by the securitisation trust to itsPTCs and/or SR holders.

3. PTCs and other securities issued by securitisationSPVs / Trust SPVs should be notified as “securities”under SCRA.

4. Large-sized NBFCs and non-NBFCs corporate bodiesestablished in India may be permitted to invest in SRsas QIBs. Private equity funds registered with SEBI asventure capital funds (VCFs) may also be permittedto invest in SRs within the limits that are applied forinvestment by VCFs into corporate bonds.

5. The Committee also recommended: (i) introduction ofcredit enhancement mechanism for corporate bonds; (ii)creation of specialised debt funds to cater to the needsof the infrastructure sector; and (iii) fiscal support, liketax benefits, bond insurance and credit enhancement,for municipal bonds and infrastructure SPVs.

277


financing channels. The primary markets for corporatebonds in Asia have grown significantly in size.However, this growth in some cases has been drivenmainly by quasi-Government issuers or issues withsome kind of credit guarantee (BIS, 2006). Thecorporate debt markets are being accessed primarilyby large firms as investors can easily assess theircredit quality based on publicly available information.In Asian countries such as Malaysia and Korea, theprimary corporate bond market is dominated byissues carrying ratings of single-A or above, with alarge proportion of debt papers having triple-A ratings.

7.72 In some countries, the pick-up in corporatebond issuances was a direct fallout of credit squeezefollowing the Asian crisis. In these bank-dominatedfinancial systems, there were several inherentconstraints on the development of bond markets,requiring efforts by the regulatory authorities. MostAsian economies are sti l l grappling with thedevelopment of local corporate bond markets.Nonetheless, a number of cr itical issues haveemerged from the experiences with developing bondmarkets in some countries (Box VII.4). These are setout below:

i. The issue of appropriate trading systems forcorporate bond markets has been a subject ofdebate among securities market regulators.Across the world, the trading systems for bondmarkets are primarily OTC-type. There have,however, been some effor ts by severaleconomies to move beyond traditional trading via

telephone to screen-based electronic tradingplatform. Trading frameworks in several countrieshave different features (Annex I). Most countriesare experimenting with both OTC and exchange-based framework utilising the virtues of bothtypes of systems to achieve optimal results.

ii. The reforms for fostering the growth of an activesecondary market also included creation ofmarket-making obligations and introduction of arepo facility so that dealers can borrow securitiesto cover their short positions.

iii. An important element of reform in most countrieshas been the building of a liquid governmentbenchmark yield curve, which required increasingthe size of the government bond market andextension of yield curve for longer term securitiesdepending upon the market demand. Issuanceof calendar for auctions in advance also formedpart of the reforms.

iv. Most countries took steps for expanding theissuer and investor base. The growing presenceof institutional investors played a big role in thegrowth of local bond markets such as Chile andMalaysia. Some countries such as Singapore andAustralia actively encouraged foreign investorsand issuers.

v. A number of East Asian markets have introducedtax incentives to encourage greater investorparticipation. This is based on the realisation thatexcessive taxes discourage local and foreignparticipation in local debt markets and impede acountry’s investment growth and, thus, canrestrain bond market development. Incentiveswere applied in a variety of ways such as taxexemptions on interest income earned oninfrastructure bonds and removal of withholdingtax. There is, however, divergence of opinion onthe use of tax incentives for promoting a marketsegment. While most Asian governments wantto speed up development of their debt markets,studies show that they need to balancedevelopment plans with existing market maturity,fiscal priorities, and the possible trade-relateddistortions tax incentives can cause.

vi. Lack of appropriate hedging instruments hasconstrained the development of secondarymarket in several economies. The experience ofrelatively developed markets shows that a vibranthedging market and adequate l iquidityenhancement facilities helped in improving theliquidity of the secondary market.

278


Korea

Korea had an underdeveloped local government bond market till 1997as the Government was running a surplus, but a developed marketfor corporate bonds, which had come up in the early 1970s. However,a majority of Korean corporate bond issues had guarantees fromcommercial banks. The experience of Korea shows that too muchGovernment intervention (either in exchange rate or implicit or explicitguarantees) results in serious distortion of markets. Since the currencycrisis, the corporate bond market in Korea grew remarkably fast asthe companies had to substitute bank lending by bond issues andlarge quantities of asset-backed securities (ABSs) had to be issuedin the process of financial restructuring. Reflecting this, the totaloutstanding volume of bonds doubled to 93.1 per cent of GDP atend-2004 from 46.1 per cent of GDP at end-1997 (BIS, 2006).Although the bond market in Korea grew fast, it followed boom-bustcycle due to collapse of one of its leading corporate houses. Theauthorities, therefore, had to intervene from time to time to stabilisethe market. The Korean experience is important in that corporateswere able to replace bonds guaranteed by banks with bonds withoutbank guarantees. As a result, corporate bonds in Korea increasinglyreflected corporate credit risk rather than credit risk of banks. Koreaintroduced mark-to-market accounting on bond funds as it promotestransparency and enhances market liquidity. Two private pricingagencies provide bond valuations in Korea.

Malaysia

Malaysia succeeded in giving a boost to its corporate bond marketby reducing impediments and enhancing coordination. The NationalBond Market Committee, which consolidated regulatory responsibilityunder one umbrella, brought about a reduction in approval processfor corporate issuance from 9-12 months to 14 days. In order toenhance cost-effectiveness and efficiency, the Malaysian authoritiesalso computerised several processes and made some others online,to speed up securities tendering, reduce settlement risk, promotetransparency of information and more efficient trading. Securitieslending and borrowing programme was introduced via real-time grosssettlement system. The Malaysian bond market also benefited fromregional cooperation in East Asia. The growth of Malaysia’s corporatebond market was spurred by the increasing presence of institutionalinvestors, such as pension funds, unit trust funds and insurancecompanies on the one hand and increasing demand from the privatesector for innovative forms of finance, on the other. Malaysia promotedits indigenous Islamic bond market through the Malaysia InternationalIslamic Financial Centre initiative, which abolished withholding taxeson interest income earned on multilateral-issued bonds. The Islamicbond market now accounts for almost one-third of the private debtsecurities market (BIS, 2006). It is significant to note that the corporateand government bond markets in Malaysia share the sameinfrastructure, dealers, reporting system and RTGS system, thus,taking advantage of the economies of scale in infrastructure like dealernetworks, reporting and settlement.

Singapore

Singapore has one of the more developed debt markets in Asia.Despite the small size of economy, the authorities made attempts toattract non-resident issuers in both local and foreign currencies toenhance the size and depth of the corporate bond market. Singaporetook various steps to encourage foreign investors and issuers, whichincluded removal of restrictions on Singapore-based financial

Box VII.4Development of Corporate Bond Market – Experiences of Select Economies

institutions trading with non-financial institutions, and on trading ofinterest rate swaps (IRS), asset swaps, cross-currency swaps andoptions. Issue of bonds was also encouraged by streamlining ofprospectus requirements. Under a debenture issuance programme,an issuer in Singapore can make multiple offers of separate tranchesof debentures, by issuing a base prospectus that is applicable for theentire programme and by lodging a brief pricing statement forsubsequent offers under the programme. The validity of the baseprospectus has been extended from six months from the date of initialregistration to 24 months. Financial institutions offering continuouslyissued structured notes have been exempted from the requirementto lodge and register a pricing statement as there were practicaldifficulties for the issuer of these notes in lodging a pricing statementbefore such an offer. These streamlined disclosure requirements haveensured that proper risk and product disclosures are made availableto investors. There has been a sharp surge in foreign entities issuingSingapore dollar-denominated bonds. Local institutions, particularlyquasi-government entities, were also encouraged to issue bonds. InSingapore, key issues that were designated as benchmarks wereaugmented by re-opening these issues and buying back others. Thiswas done based on market feedback about minimum issue size thatis needed for active trading. Therefore, issues that were smaller insize were bought back to concentrate liquidity in the larger issues.For faster processing of applications, an internet based facility wascreated for primary dealers to submit bids. An electronic tradingplatform, which publishes details of transactions on a real time basis,also helped in improving the transparency of the yield curve.Singapore introduced investor tax exemptions on interest incomederived from infrastructure bonds to diversify the range of attractivedebt products. Singapore experimented with a short-term interestrate futures contract and a five-year futures contract in governmentsecurities in 2001, but the response was poor. Market participants inSingapore exhibited a preference for the IRS market.

Australia

A well-functioning corporate bond market has emerged in Australiaover last one decade due to a combination of factors such as strongeconomic growth leading to demand for funds, reduction ingovernment’s borrowing requirements, thereby easing competitionfor investible funds and introduction of a compulsory retirementsavings system in the early 1990s that expanded the pool of funds.The growth of corporate bond market in Australia is also attributableto its openness to foreign issuers and investors. To enable theseinvestors and issuers to hedge against currency risk, Australiadeveloped liquid markets in currency swaps. Australia also removedinterest withholding tax on foreign investment.

Thailand

The regulatory authorities in Thailand have been actively promotingtheir local bond market. Thailand implemented a no tax policy onspecial purpose vehicle (SPV) transfers for marketable securities topromote investor liquidity and lower financing costs. The BondElectronic Exchange of Thailand recently set up an electronic tradingplatform to facilitate trade and reduce transaction costs.

Reference:

Bank for International Settlements. 2006. ‘‘Developing Corporate BondMarkets in Asia.’’ BIS Papers No.26, February.

279


vii. The growth of the corporate bond markets acrossthe world has been propelled by the emergenceof structured debt products like asset-securitiseddebt, credit-linked debt, equity-linked debt,conver tible debt, etc. due to increasedsophistication and risk appetite on the part of theinvestors. Securitisation acts as a risk transfermechanism that could work to the advantage ofboth banks and investors. In Singapore, structureddebt made up almost 60 per cent of totalSingapore-dollar debt issuances in 2004 (BIS,2006). Access for small and medium enterprises(SMEs) has been created through asset-backedsecurities, which has been successful in Japan andKorea. In many countries, however, this market isnot fully developed, either because it needscomplicated legal infrastructure or the creditenvironment does not enable securitisation.

7.73 There have also been initiatives at the cross-country level. In the Asian region, the Asian BondFund (ABF) is an important initiative developed bythe EMEAP1 group that aims at broadening anddeepening the domestic bond markets in Asia. ABF1,which was launched in June 2003, pooled US$ 1billion in reserves from 11 central banks and investedin a basket of US dollar denominated bonds issuedby Asian sovereign and quasi-sovereign issuers inEMEAP economies. ABF2, launched in July 2005,extends the ABF concept to bonds denominated inlocal currencies and comprises nine componentfunds - a Pan-Asian Bond Index Fund and eightsingle market funds. The EMEAP group has pooleda total of US$ 2 billion. The setting up of ABF enablesbringing together Asian economies, which will enableintra-regional debt flows that can then be usefullyabsorbed in the region (Mohan, 2006a).

III. THE WAY FORWARD

7.74 The stock markets in India have becomemodern and are comparable to the best in the worldin terms of market infrastructure, trading andsettlement practices and risk management systems.However, given the size of the Indian economy, thecapital raised from the securities market has remainedquite small, notwithstanding some spurt in issues inrecent years. In fact, in relation to GDP and GDCF,the size of the public issue segment has shrunksomewhat in comparison with the position in 1991.

Stock markets in several EMEs are growing fast. Acontinuing increase in the savings rate of householdssuggests that there is no supply constraint in termsof financial resources that could be channeled intothe equity market. After the exuberance of the stockmarket in the mid-1990s and its decline thereafter, alarge number of individual investors took flight tosafety in bank deposits, safe retirement instrumentsand insurance (Mohan, 2004a). Households in Indiahave increasingly tended to prefer savings in the formof safe and contractual instruments as opposed tocapital market based instruments. Although retailinvestors have started showing some increasedinterest in the equity market in recent years, there isa need to increase their participation further. Thesuccess of all the recent public issues also suggeststhat investors are willing to invest in the equity market.However, corporates, by and large, tend to financetheir investment activities through alternative sources,which have inhibited the growth of the market. Largeand well-known corporates in India have tended toprefer international capital markets. Huge resourceshave also been raised by way of debt issues from theprivate placement market, which is less cumbersome,fast and economical. However, this segment lackstransparency and appears to be growing at theexpense of the public issues segment. Lack ofsufficient capital market activity has hindered theprocess of diversification of investment from fixedincome instruments to equity-based instruments bythe households.

7.75 India is now one of the fastest growingeconomies in the world and is endeavoring to stepup the growth rate. Limited availability of adequatelong-term resources could adversely affect India’sinfrastructure development. Banks have been able tofill the void created by the conversion of two majorDFIs into banks, but only to some extent.Infrastructure financing requirements are large andcould not be expected to be met by the banking sectoralone. Banks already appear to have significantexposure to long-term funds. They may, therefore, notbe in a position to fund long-term projects in future tothe extent they have been able to do in recent years.Inadequate long-term resources could, therefore, actas a constraint on India’s future growth prospects. Inthe absence of a well-functioning debt market, evenlarge corporates fund their requirements from thebanking system, limiting the availability of bank funds

1 Executives' Meeting of East Asia and Pacific Central Banks (EMEAP) group comprises 11 central banks and monetary authoritiesfrom Australia, China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, New Zealand, the Philippines, Singapore and Thailand.

280


for small and medium enterprises and other sectors.This also raises the cost of borrowings for them. Thus,development of the capital market, in general, andthe debt market, in particular, is crucial from the pointof view of reducing corporate sector’s reliance on thebanking system so as to enable it to focus more onlending to small and medium enterprises, andagriculture and allied activities.

7.76 Given the importance of the capital market forsustaining the growth and enhancing the financialstability, it may be necessary to identify the factorsthat inhibit its growth and introduce reforms that areneeded for strengthening the role of the capitalmarket.

Time and Cost of Issuance

7.77 The time and cost of raising funds from thedomestic capital market are key considerations forfloating public issues. The time taken for approval ofpublic issues should be reasonably short. If the timeperiod for raising resources is long, it can hamperthe financing opportunities and raise the financingcost for issuers. In some countries, a ceiling isimposed on the maximum number of days for grantingapprovals. Generally, the upper ceiling is 30 days. Forinstance, it is 14 days in the case of corporate bondissues in Malaysia (BIS, 2006). It takes less than amonth for floating a GDR/ADR issue. In India, the timelimit for granting approval for a public issue is 21 daysafter filing the completed document. However, it maytake a company around 6 months to float a publicissue. The cost of a public issue in India is alsoestimated to be higher than other countries. Asrecommended by the High Level Expert Committee onCorporate Bonds and Securitisation, the time and costof public issuances need to be reduced.

Institutional Investors

7.78 Institutional investors play an important rolein the development of the market by providing depthand liquidity. As “informed” traders, they also help inimproving the corporate governance practices ofcompanies. In Chile, for example, institutionalinvestors played a key role in the development of theprivate pension industry, which, in turn, had afavourable impact on the development of the domesticcapital markets. In India, even though the contractualsaving institutions such as pension/provident fundsand insurance companies are the ‘natural’ holders oflong-term sources of funds, their funds are mostlydeployed in government securities partly because ofits risk free feature and partly because the corporate

debt market is not yet developed. For the samereasons, banks too find gilts more attractive thanilliquid corporate debt paper. As a result, they are alsonot able to generate sufficiently high returns on theirinvestments. Mutual funds, on the other hand, areheavily oriented towards liquid and money marketschemes. For generating adequate supply of fundsto meet the financing needs of corporates, it isnecessary to relax the investment limits for pensionfunds’ investments in corporate securities. The growthof pension funds is likely to continue, leading toincreased demand for high-quality fixed-incomeassets. It is, therefore, important that the demand forfunds exists to absorb increased supply of funds. Thetwo forces, to some extent, would reinforce each otherwith supply creating its own demand.

7.79 The change over from ‘defined benefit’ to‘defined contribution’ architecture for pension funds,resulting in, among other things, the risk of investmentbeing borne by the beneficiaries and not by theiremployers makes it desirable that the pool ofinvestments is invested and managed on professionallines against proper long-term investment andperformance benchmarks. As has been the caseglobally, such funds need to be allowed to invest apart of their assets in equities within, of course,cer tain prudent l imits. Par t icipation of fundsrepresenting long-term savings in the economy suchas superannuation funds in equity and long-termcorporate debt would be desirable for several reasons,including: (a) to withstand short-term volatility due tolonger time horizon; (b) opportunity to benefit from long-term outlook and performance of the Indian economy;and (c) facilitating better price discovery as well as theoverall development of the capital market in India.

7.80 Greater participation of domestic institutionalinvestors could also act as a counterweight to foreigninstitutional investors and thereby enhance stabilityof the market, especially during periods of volatility.As long-term holders of funds, these institutionalinvestors can provide a long-term view as opposed toforeign institutional investors who normally take a short-term view on the market. The challenge in this regard isto set up appropriate regulatory framework that wouldenhance governance, including accountability, mandateappropriate disclosure and ensure separation ofadministration from asset management.

Transparency and Corporate Governance

7.81 The enabling environment must also providereasonably high standards of corporate governance,accounting and auditing and financial disclosures at

281


regular intervals. As part of the broader set of reformsaimed at improving the functioning of the securitiesmarket, the SEBI has taken several measures toimprove information flows from the listed companieswith a view to enhancing the efficiency of the market.It has also been the endeavour of the SEBI to improvecorporate governance practices for the l istedcompanies to infuse a sense of discipline andaccountability in the Indian corporate sector bystrengthening standards of disclosure andtransparency. However, corporate governance is anevolving process and the standards need to be revisedfrom time to time in keeping with internationaldevelopments in this regard. According to thecorporate governance assessment for India donejointly by IMF and the World Bank as part of the Reporton Observance of Standards and Codes, there areseveral OECD corporate governance principles thatare not fully observed in India. The Report noted thatenforcement and implementation of laws andregulations continue to remain important challenges(World Bank, 2004). For developing the debt market,many emerging markets in Asia have also improvedtheir bankruptcy procedures to strengthen thecreditors’ right to protection and facilitate the processof corporate debt restructuring (Luengnaruemitchaiand Ong, 2005). For example, revised bankruptcyprocedures have been introduced in Thailand, Koreaand Malaysia.

Penetration of Mutual Funds

7.82 Mutual funds are an important vehicle for retailinvestors in several countries. Despite a significantgrowth in the number of schemes and assets undermanagement of mutual funds in India in recent years,their level of penetration remains l imited incomparison with other countries. This is reflected inthe small size of assets managed by them (amountingto less than 5 per cent of GDP as against 70 per centin the US, 61 per cent in France and 37 per cent inBrazil) and small share of household savings in unitsof mutual funds. Resource mobilisation by mutualfunds through equity-oriented schemes, in particular,has remained small, notwithstanding some increaseduring past two years (Chart VII.8). There is, therefore,need to enhance mutual fund penetration in thecountry to attract a larger share of household savingsin financial assets.

Reliable and Liquid Yield Curve

7.83 Among various reforms needed for promotingthe secondary market trading in corporate bonds,

perhaps the most important factor is the existence ofa reliable and liquid benchmark government securitiesyield curve. Even though the government securitiesmarket has seen a range of reforms in both theprimary and secondary segments and a surge inissuances as well trading volumes, a stable andsmooth sovereign yield curve, especially at the longerend of maturity is yet to emerge in India. If the yieldcurve derived from benchmark issues is to bereflective of an efficient risk free rate of return, therehas to be sufficient liquidity in the governmentsecurities market. The number of actively tradedgovernment securities is very low as compared withthe total number of securities outstanding. On a dailybasis, hardly 10-12 securities are traded, of whichonly four or five securities trade actively. In theabsence of active trading, the yield curve is kinkymaking pricing of securities difficult (Mohan, 2006a).However, the recent permission of short-selling ingovernment securities should help in this regard.

Trading and Settlement Infrastructure for the DebtMarket

7.84 A well-organised debt market would meanmore informed transactions and at fairer prices. Forthe secondary markets to function efficiently, thetrading and settlement infrastructure has to besufficiently developed. Even though both the BSE andthe NSE offer an order-driven trading platform fortrading in corporate debt paper, the trading volumesremain low. It may be added that the corporate bonds,even in some developed markets, face the problemof illiquidity as they are held till maturity. Also, theyare mostly traded in OTC markets, although many ofthem are listed on stock exchanges. A depositorysystem exists for issuance and transfer of securitiesin demat form and to facilitate trading, the stamp dutyfor trading in debt instruments in demat form has beenabolished. However, unlike in the case of equities, theclearing house/corporation does not bear the counter-party risk for debt instruments. Thus, even for debttransactions taking place through the trading platformof stock exchanges, the settlement takes place directlybetween the participants.

Debt Derivative Products

7.85 A well-developed corporate bond market cannotexist without a well-functioning market in derivatives inwhich interest rate risk is readily hedged. Derivativemarkets help in improving the liquidity of the underlyingcash market. Derivative products generally have hugedemand in mature markets as they provide investors

282


with a wide range of investment products andinstruments for managing their risks. The experiencewith fixed income derivative products in India, on thewhole, has not been encouraging. Thus, in order toattract sophisticated investors to promote liquidity, it isimperative to develop appropriate hedging tools.

Market Making for Debt Instruments

7.86 There is an important role that ‘market making’can play in the development of the corporate bondmarket. Market making has been actively used indeveloping the government as well as corporate bondmarkets in several countries by creating a network ofdealers which provide two-way quotes by activelyusing repo markets. In some countries, the corporatesthemselves provide this facility by standing ready tobuy and sell their bonds. In this way, they make marketfor their own bond issues and solve the ‘illiquidity’problem. In view of illiquid secondary market, marketmaking, at least in the initial stages, can go a longway in creating liquidity and attracting investors to thebond market.

Product Standardisation

7.87 Corporate bond papers are generally notstandardised contracts as they carry along a slew offeatures. These include: (i) coupons linked to variousreference rates; (ii) embedded options like call, put,convertibility and other options; (iii) different types ofcollateral; and (iv) other covenants. This makes itdifficult to accurately price the credit risk associatedwith the bond. Standardisation of bond contracts couldcontribute to a better assessment of credit risk byinvestors.

IV. SUMMING UP

7.88 Sound development of various segments ofthe capital market is a pre-requisite for a well-functioning financial system. The equity market inIndia has been modernised over the past 15 yearsand is now comparable with the internationalmarkets. There has been a visible improvement intrading and sett lement infrastructure, r iskmanagement systems and levels of transparency.These improvements have brought about a reductionin the transaction costs and led to improvement inliquidity. However, the size of the public issuesegment has remained small as corporates havetended to prefer the international capital market andthe private placement market. This has affected thegrowth of the public issues market and led to under-

participation by the investors in the capital market.The corporate bond market, in par ticular, hasremained underdeveloped, possibly due to theabsence of a reliable and liquid yield curve, long timetaken for floating an issue, high cost of issuance andlack of l iquidity in the secondary market. Thepromotion of a vibrant corporate bond market isessential for meeting the demand for long-termfunds, especially for infrastructure requirements.

7.89 The development of any market requiresremoval of bottlenecks on supply as well as demandside, while putt ing in place alongside soundinstitutional and legal framework. In India, higheconomic growth has created ample demand forfunds from the corporate sector which is reflected insharp growth in bank credit and increased resourcemobilisation from the international equity market andthe private placement market. Encouraging businessoutlook and congenial investment climate havecreated stimulus for companies to undertake capacityexpansion. On the supply side too, rising incomelevels and savings would require alternativeinvestment options, including equity and corporatedebt. The need, therefore, is to ensure that the capitalmarket is well positioned to take advantage of thesefavourable factors.

7.90 There is a need to ensure that the corporatesare able to raise resources from the capital market ina timely and cost-effective manner. The need is alsofelt to develop strong domestic institutional investors,which would serve many purposes. As the marketevolution is an ongoing process, the Indian equitymarket would have to continuously strive to keep upto the international standards. In particular, corporategovernance practices need to be strengthened furtherto raise the confidence level of a common investor.This would also enhance flow of institutional moneyto equities.

7.91 Learning from the experience of developingthe government securities market, the developmentof the corporate debt market needs to proceed in ameasured manner with well thought out sequencing(Mohan, 2006a). Such development also requirescooperation of and coordination with the key players.The initial steps towards developing the corporatebond market based on the recommendations of theHigh Level Expert Committee on Corporate Bondsand Securitisation have already been initiated. TheUnion Budget for 2006-07 had proposed to create asingle unified exchange-traded market for corporatebonds. As a first step towards creation of a UnifiedExchange Traded Bond Market, the SEBI has initiated

283


steps to establish a system to capture all informationrelated to trading in corporate bonds as accuratelyand as close to execution as possible through anauthor ised repor ting platform. The marketdevelopment process for bonds in India is likely to bea gradual process as has been experienced in othercountries. For step by step development of thecorporate bond market, it is necessary to lay downthe broad objectives, which may include, (i) buildinga liquid government securities benchmark yield curvefor appropriate pricing of debt instruments; (ii) promotingthe growth of an active secondary market for spot andderivative transactions; and (iii) providing encouragementto issuers and investors to participate in the bondmarket. All these objectives are mutually reinforcing.The reform process wil l be faci l i tated by acomprehensive regulatory framework. For the abovescheme of things to yield the desired results, theregulators as well as market participants have to playa proactive role. The next phase of development mayinvolve the setting up of a corporate debt tradingplatform, which enables efficient price discovery andreliable clearing and settlement, in a gradual manner.Concerted efforts by all concerned to expedite theprocess would enable the emergence of a vibrantcorporate bond market in India.

7.92 The development of f inancial markets,especially the government securities market, isimportant for the entire debt market as it serves as abenchmark for pricing other debt market instruments,thereby aiding the monetary transmission processacross the yield curve (Mohan, 2006b). Therefore,efforts have been made in India to broaden anddeepen the government securities market so as toenable the process of efficient price discovery in

respect of interest rates. While developing the privatecorporate debt market, the experience gained fromdeveloping the government securities market shouldprove useful. It has been seen in the case ofgovernment securities market that there are difficultiesin creating liquidity in bond markets. Liquidity ingovernment secur it ies market has remainedconcentrated in a few securities. The yield curve hasemerged but it is not liquid at the longer end of themarket. Even at the shorter end of the debt market,though several instruments have been introduced,liquidity remains low and banks remain the majorinvestors. The corporate debt market would require alarge number of investors and large sized issues tofunction effectively. Development of the the corporatedebt market is bound to be time-consuming as thesize of issuances would increase gradually alongsidean expansion in the investor base. In the governmentsecurities market, the problem of small size of issueshas been tackled through consolidation of issues. Inthe case of corporate bonds, this aspect may have tobe addressed by bringing about more discipline inissuances and by following consolidation through re-issuances. Taking a cue from the role played byprimary dealers in the development of the governmentsecurities market, there may be a need for a similarinstitutional framework in the corporate debt market.Institutional innovations such as housing mortgageproducts would also play an important role. Therefinements in the trading framework can aid inefficient price discovery. The counterparty guaranteefor settlement of trades by the clearing corporationwould reduce counterparty and settlement risks,thereby promoting secondary market trading incorporate bonds.

284


Annex VII.1: Characteristics of Trading Frameworks for Corporate Bonds

Country

Australia

France

Germany

Hong Kong

India

Japan

Malaysia

Singapore

Thailand

UK

US

Trading Venue

OTC Market

Australian Stock Exchange

Yieldbroker

Euronext

OTC market

Frankfurt Stock Exchange

OTC market

Stock Exchange of Hong Kong

Bloomberg

OTC; Stock Exchanges

Stock Exchanges

OTC Market; ATS

OTC Market

Kuala Lumpur StockExchange (KLSE)

SGX-ST

OTC Market

OTC Market; BondElectronic Exchnage

London Stock Exchange

ATS

OTC Market

Multi-dealer ATS

Inter-dealer broker ATS

Single dealer trading system

ATSs

Auction-ATS

NYSE’s Automated BondSystem

Trade Execution

Bilateral

Cross-matching; Order-driven

Bilateral

Cross-matching; Auto-matching; Order-driven

Bilateral

Order-driven

Bilateral

Cross-matching; Auto-matching; Order-driven

Multi-dealer auction

Bilateral; Order-driven

Auction

Bilateral; Multi-dealer

Bilateral

Order-driven


Bilateral

Bilateral; Order-driven

Market maker

Multi-dealer; Order-driven

Bilateral

—

Order-driven

Automated limit order book

Cross-matching

One-sided


Direct Participants

Dealers; Institutions

ASX Broker Partcipants

Dealers

Exchange members

Dealer institutions

Exchange participants

Dealer-to-dealer

Dealers (exchangeparticipants)

Dealer-to-dealer

Participants; Trading members

Authorised intermediaries

Dealer-to-client; Multi-dealer

Dealers

Exchange members

Dealer-to-dealer; Institutionsand retail through dealers

Dealers; Institutional investors;Retail investors

Dealers, Institutions

Exchange members

Dealers; Fund manager;Investment firms

Dealer-to-institution; Dealer-to-dealer


Dealer-to-dealer; Dealer-to-institutions


Dealer-to-institution; Retail andinstitutions through dealers

Dealers; Institutions

NYSE members

Electronic or byPhone

Electronic; Phone

Electronic

Electronic

Electronic

Electronic; Phone

Floor trading; Electronic

Phone

Electronic

Electronic

Phone; Electronic

Electronic

Electronic; Phone

Electronic; Phone

Electronic

Electronic

Electronic; Phone

Electronic; Phone

Electronic; Phone

Electronic

Electronic; Phone

Electronic

By phone

Electronic

Electronic

Electronic

Electronic

Source: 1. International Organisation for Securities Commission (IOSCO);2. Bank for International Settlements (BIS).

8.1 Integration of financial markets is a process ofunifying markets and enabling convergence of risk-adjusted returns on the assets of similar maturity acrossthe markets. The process of integration is facilitated byan unimpeded access of participants to various marketsegments. Financial markets all over the world havewitnessed growing integration within as well as acrossboundaries, spurred by deregulation, globalisation andadvances in information technology. Central banks invarious parts of the world have made concerted effortsto develop financial markets, especially after theexperience of several financial crises in the 1990s. Asmay be expected, financial markets tend to be betterintegrated in developed countries. At the same time,deregulation in emerging market economies (EMEs)has led to removal of restrictions on pricing of variousfinancial assets, which is one of the pre-requisites formarket integration. Capital has become more mobileacross national boundaries as nations are increasinglyrelying on savings of other nations to supplement thedomestic savings. Technological developments inelectronic payment and communication systems havesubstantially reduced the arbitrage opportunities acrossfinancial centres, thereby aiding the cross bordermobility of funds. Changes in the operating frameworkof monetary policy, with a shift in emphasis fromquantitative controls to price-based instruments suchas the short-term policy interest rate, brought aboutchanges in the term structure of interest rates. Thishas contributed to the integration of various financialmarket segments. Harmonisation of prudentialregulations in line with international best practices, byenabling competitive pricing of products, has alsostrengthened the market integration process.

8.2 Integrated financial markets assume vitalimportance for several reasons. First, integrated marketsserve as a conduit for authorities to transmit importantprice signals (Reddy, 2003). Second, efficient andintegrated financial markets constitute an importantvehicle for promoting domestic savings, investment andconsequently economic growth (Mohan, 2005). Third,financial market integration fosters the necessarycondition for a country’s financial sector to emerge asan international or a regional financial centre (Reddy,2003). Fourth, financial market integration, by enhancingcompetition and efficiency of intermediaries in theiroperations and allocation of resources, contributes to

financial stability (Trichet, 2005). Fifth, integrated marketslead to innovations and cost effective intermediation,thereby improving access to financial services formembers of the public, institutions and companies alike(Giannetti et al., 2002). Sixth, integrated financial marketsinduce market discipline and informational efficiency.Seventh, market integration promotes the adoption ofmodern technology and payment systems to achievecost effective financial intermediation services.

8.3 An important objective of reforms in India hasbeen to integrate the various segments of the financialmarket for bringing about a transformation in thestructure of markets, reducing arbitrage opportunities,achieving higher level of efficiency in market operationof intermediaries and increasing efficacy of monetarypolicy in the economy (Reddy, 1999, 2005d). Efficientallocation of funds across the financial sector anduniformity in the pricing of various financial productsthrough greater inter-linkages of financial markets hasbeen the basic emphasis of monetary policy (Mohan,2005). In the domestic sphere, integration of marketshas been pursued through strengthening competition,financial deepening with innovative instruments,easing of restrictions on flows or transactions,lowering of transaction costs and enhancing liquidity.Financial markets in India have also increasinglyintegrated with the global financial system as a resultof cal ibrated and gradual capital accountl iberal isat ion in keeping with the under lyingmacroeconomic developments, the state of readinessof the domestic financial system and the dynamics ofinternational financial markets (Reddy, 2005a).

8.4 In the above backdrop, this chapter examinesin detail the various aspects of integration of financialmarkets within the country as well as with internationalfinancial markets. The chapter is organised in sixsections. Section I provides a brief review of the conceptof financial integration along with a discussion onmeasurement issues. The policy measures enablingfinancial market integration in India are discussed inSection II. Empirical analysis of domestic financialmarket integration is presented in Section III. Integrationof domestic financial markets with international as wellas regional financial markets is set out in Section IV.Section V suggests some measures for fur therstrengthening the integration process of the markets.Concluding observations are set out in Section VI.

FINANCIAL MARKET INTEGRATIONVIII

286


I. CONCEPT AND DIMENSIONS OF FINANCIALMARKET INTEGRATION

8.5 Financial market integration encompasses acomplex interplay of various factors such as policyinitiatives, structure and growth of financialintermediaries/markets, organic linkages among marketparticipants and the preference of savers and investorsfor financial instruments. While assessing the integrationof financial markets, it may be useful to keep in view theheterogeneity of markets, dimensions of integration,measurement issues and perceived benefits and risksof integration.

Heterogeneity of Markets

8.6 Various financial market segments are notuniform as they trade in a variety of instruments, whichdiffer in terms of risk and liquidity. First, some marketsegments are national, whereas others are internationalin nature, depending on where financial transactionsoccur among participants within a country’s geographicboundary or across the border. Generally, money andcredit market segments involving participation of banksand other financial institutions operating within acountry’s boundary are national in character. On theother hand, foreign exchange markets dealing withcross-border transactions and stock markets with cross-listings of securities and participation of foreigninstitutional investors are international in nature.Second, financial markets differ in terms of depth andliquidity. For instance, money market instruments aremore liquid, while bonds in the capital markets are lessliquid. Third, financial markets differ in terms ofeconomic nature of instruments catering to variousneeds of economic agents. For instance, a distinctioncan be made between saving, investment, credit andderivative instruments. Fourth, financial markets aredifferentiated in terms of risk profile of instruments suchas government bonds, which do not involve default andcredit risks, and corporate bonds, which are relativelymore risky in nature. Integration of market segments,thus, reflects an investor’s attitude towards risk and thetrade-off between risk and return on assets. Fifth,market participants in different financial markets couldbe different such as banks, non-bank financialinstitutions, including mutual funds, insurancecompanies, mortgage institutions and specialised long-term financial institutions.

8.7 Financial market integration at the theoreticallevel has been postulated in several ways. The mostpopular economic principles of financial integrationinclude the law of one price, term structure of interestrates, parity conditions such as purchasing power parity,

covered and uncovered interest parity conditions, capitalasset price model, arbitrage price theory and Black-Scholes’ principle of pricing derivatives (Box VIII.1).

Dimensions of Financial Market Integration

8.8 Broadly, financial market integration occursin three dimensions, nationally, regionally and globally(Reddy, 2002 and BIS, 2006). From an alternativeperspective, financial market integration could takeplace horizontally and vertically. In the horizontalintegration, inter-linkages occur among domesticfinancial market segments, while vertical integrationoccurs between domestic markets and international/regional financial markets (USAID, 1998).

8.9 Domestic financial market integration entailshorizontal linkages of various segments, reflectingportfolio diversification by savers, investors andintermediaries. Under horizontal integration, marketinterest rates typically revolve around a basic referencerate, which is defined as the price of a short-term low-risk financial instrument in a competitive and liquidmarket. It typically provides the basic liquidity for theformal financial system and central banks often use itto gauge the tightness of monetary policy. Domesticmarkets may be closely integrated becauseintermediaries operate simultaneously in variousmarket segments; for instance, commercial banksoperate in both the saving (deposit) and loan markets.

8.10 Global integration refers to the opening up ofdomestic markets and institutions to the free cross-border flow of capital and financial services by removingbarriers such as capital controls and withholding taxes.A deeper dimension of global integration entailsremoving obstacles to movement of people, technologyand market participants across border (BIS, 2006).Global integration is promoted through harmonisationof national standards and laws, either through theadoption of commonly agreed minimum standards orthe mutual recognition of standards (Reddy, 2005c).

8.11 Regional financial integration occurs due to tiesbetween a given region and the major financial centreserving that region. Economic integration might beeasier to achieve at a regional level due to networkexternalities and the tendency of market makers toconcentrate in certain geographical centres. Gravitymodels, which take into account the economic sizesand distance between two countries, explain bilateraltrade and investment flows. Furthermore, regionalfinancial integration can be an important means ofdeveloping local financial markets, for instance, throughpeer pressure to strengthen institutions and upgradelocal practices (BIS, 2006).

287

FINANCIAL MARKET INTEGRATION

The law of one price (LOOP), pioneered by Augustin Cournot(1927) and Alfred Marshall (1930), constitutes the fundamentalprinciple underlying financial market integration. According tothe LOOP, in the absence of administrative and informationalbarriers, risk-adjusted returns on identical assets should becomparable across markets. While the LOOP provides ageneralised framework for financial market integration, financeliterature provides alternative principles, which establishoperational linkages among different financial market segments.

First, the term structure of interest rates, deriving fromparadigms of unbiased expectations, liquidity preference, andmarket segmentation, establishes integration across thematurity spectrum, i.e., short, medium and long ends of thefinancial market (Blinder, 2004). Usually, the term structureis applied to a particular instrument such as the risk freegovernment securities. In the monetary economics literature,it is recognised that the term structure of interest rate containsuseful information about future paths of inflation and growth,which characterise the objective function of policy in mostcountries. Second, the capital asset pricing model (CAPM)of Nobel laureate, William Sharpe (1964) is used widely forvaluing systematic risk to financial assets. The CAPMestablishes linkage between market instruments and risk freeinstruments such as government securities. The CAPMenvisages a simplified world with no taxes and transaction

Box VIII.1Theory of Financial Market Integration

costs, and identical investors. In such a world, super-efficientportfolio must be the market portfolio (Tobin, 1958). Allinvestors will hold the market portfolio; leveraging or de-leveraging would be driven by the risk-free asset in order toachieve a desired level of risk and return. Third, the Black-Scholes’ principle of option pricing postulates linkage betweenderivative products on the one hand, and cash/spot marketof underlying assets on the other. The often quoted put-callparity principle in finance theory states that in the absence ofarbitrage opportunities, a derivative instrument can bereplicated in terms of spot price of an underlying asset,coupled with some borrowing or lending activity. The forward-spot parity relation is used widely for analysing linkagesbetween foreign exchange forwards and the money marketinstruments.

Beyond economic and financial principles, financial marketsintegration could also occur due to information efficiency aseconomic agents form expectations about the future courseof policy and real sector developments. For instance, even iftransactions between residents and non-residents andbetween markets and intermediaries remain incomplete orlimited due to regulatory barriers, participants could formexpectation that such restrictions would not continue for longwith a shift in policy regime towards greater opening andliberalisation of markets over time.

Measures of Financial Integration

8.12 The progress of domestic, global and regionalfinancial integration could be measured using anumber of approaches. Generally, these measures aredivided into three categories: institutional/regulatorymeasures, quantity and price based measures. Froma policy perspective, specific indicators of financialintegration could be classified into de jure and de factomeasures. The existence of legal restrictions on tradeand capital flows across border as well as marketsegments is the most frequently used de jureindicators. However, these indicators have severalshortcomings as restrictions may not be binding, orthey are not respected because capital flows wouldnot exist somehow. They may not cover a specificaspect of all possible impediments to financialintegration (Prasad et al., 2006). Moreover, in practice,de jure indicators adopting a dichotomous scheme ofthe existence or absence of restrictions may not revealactual degree of openness of countries to capital flows.

8.13 De facto indicators of financial integration areusually based either on prices or quantities. Thecommonly used price based measures for gaugingprice equalisation and convergence of marketsegments include cross-market spreads, correlations

among various interest rates, tests of common trend inthe term structure of interest rates and volatilitytransmission. From a policy perspective, interest ratespreads between the official short-term rate and abenchmark short-term market instrument on the onehand, and various other market interest rates on theother, are used for measuring price convergence andeffectiveness of policy. Price-related measures alsoinclude covered and uncovered interest rate parity aswell as asset price correlations between countries. Thereare, however, serious practical problems in using pricesto measure global or regional financial integration,particularly in emerging markets. This is because pricesmay move together because of a common external factoror because of similar macroeconomic fundamentals andnot because of market integration. Moreover, prices maybe affected by differences in currency, credit andliquidity risks, implying different price movements evenif there is a substantial degree of financial integration(Prasad et al., 2006).

8.14 Liquidity and turnover data are used asquantitative indicators for measuring inter-linkagesamong domestic financial market segments. Forglobal integration, capital flows indicate whether acountry is becoming more or less financially integratedover time. In this context, gross capital flows are a

288


The benefits and costs of financial integration can be viewedfrom the perspective of sovereigns, individuals, corporates,and financial institutions. In the hierarchy, domestic financialmarket integration comes first, followed by global and regionalintegration (Sundarajan et al., 2003). Unlike internationalintegration, the benefits of domestic financial integration arehardly contested. Domestic financial markets constitute acritical pillar of a market-based economy as they mobilisesavings, allocate risk, absorb external financial shocks, fostergood governance through market-based incentives andcontribute to more stable investment financing and, thus,higher economic growth, lower macroeconomic volatility andgreater financial stability (Mohan, 2005). The development oflocal financial markets also reduces the risks associated withexcessive reliance on foreign capital, including currency andmaturity mismatches (Prasad et al., 2003). Domesticintegration provides an effective channel for the transmissionof policy impulses (Pétursson, 2001; Bhoi and Dhal, 1998).

The benefits of global integration depend on size, composition,and quality of capital flows. Global financial integration involvesdirect and indirect or collateral benefits (Prasad et al,. 2006).Analytical arguments supporting financial openness revolvearound main considerations such as the benefits ofinternational risk sharing for consumption smoothing, thepositive impact of capital flows on domestic investment andgrowth, enhanced macroeconomic discipline and increasedefficiency as well as greater stability of the domestic financialsystem associated with financial openness (Agenor, 2001).International financial integration could positively affect totalfactor productivity (Levine, 2001). Financial openness mayincrease the depth and breadth of domestic financial marketsand lead to an increase in the degree of efficiency of thefinancial intermediation process by lowering costs andexcessive profits associated with monopolistic and cartelisedmarkets, thereby lowering the cost of investment andimproving the resource allocation (Levine, 1996; Caprio andHonhan, 1999). Empirical studies on international integrationoffer mixed perspectives on the benefits of financial integration.The cumulative growth performance of emerging markets,

Box VIII.2Benefits and Risks of Financial Integration

excluding China and India, appears less spectacular thanusually perceived under globalisation (Prasad et al., 2006).

Financial market integration also poses some risks andentails costs. A major risk is that of contagion, which wasevident in the case of East Asian crisis. There are twochannels through which the contagion normally works. One,the real channel, which relates to potential for ‘domino effects’through real exposures on participants operating in othersegments. Two, the information channel which relates tocontagious withdrawals due to lack of accurate and timelyinformation. Increased domestic and international integrationaccentuates the risk of contagion as problems in one marketsegment are likely to be transmitted to other markets withthe potential to cause systemic instability.

In the context of globalisation, potential costs include thehigh degree of concentration of capital flows, misallocationof flows, which may hamper their growth effects andexacerbate domestic distortions; the loss of macroeconomicstability; the pro-cyclical nature of short-term capital flowsand the risk of abrupt reversals; a high degree of volatility ofcapital flows, which relates in part to herding and contagioneffects; and risks associated with foreign bank penetration(Dadush, Dasgupta and Ratha; 2000). Most studies find thatdirect investment tends to be less volatile than other formsof capital flows (Chuhan et al., 1996; Brewer and Nollen,2000; Sarno and Taylor, 1999). Volatility of capital flowstranslates into exchange rate instability (under flexibleexchange rate) or large fluctuations in official reserves (undera pegged exchange rate regime) and sometimes currencycrises as was observed in the East Asian crisis. For instance,nominal exchange rate volatility may hamper expansion ofexports if appropriate hedging techniques are not availableto exporters. Large capital inflows could also lead to rapidmonetary expansion (due to the difficulty and cost ofpursuing aggressive sterilisation policies), inflationarypressures (resulting from the effect of capital inflows ondomestic spending), real exchange rate appreciation andwidening of current account deficits.

better measure than net flows because the latter mayunderestimate the degree of integration of thosecountries with similarly large inflows and outflows. Onelimitation of capital flows, as an indicator of how fastfinancial integration is proceeding, is that they areinfluenced by changes in short-term market conditionsand can fluctuate sharply. Stock measures, based onthe accumulation of gross capital flows after takinginto account valuation effects, are less affected byshort-term market conditions. These measures arepreferred generally for emerging market economies.A more direct measure of financial openness is basedon the estimated gross stocks of foreign assets andliabilities as a share of GDP. The stock data is a better

indicator of integration since it is less volatile and isless prone to measurement error, assuming that sucherrors are not correlated over time (Prasad et al., 2003).

Benefits and Risks of Financial Integration

8.15 Though financial integration provides severalbenefits, it also involves various risks. The benefits andcosts of financial market integration depend on the degreeof domestic financial market integration, internationalfinancial integration and financial development.Evaluating the benefits and risks of financial marketintegration is a complex issue, in particular, in aneconomy with open capital account (Box VIII.2).

289


8.16 In recent years, there appears to be somerethinking about financial globalisation based on theexperience of various crises in the late 1990s andthe current global imbalances (Reddy, 2005b). Owingto contagion effects, some economists have viewedincreasing capital account l iberal isation andunfettered capital flows as a serious impediment toglobal financial stability (Rodrik, 1998; Bhagwati,1998; and Stiglitz, 2002). Others argue that increasedcapital account openness has largely proven essentialfor countries aiming to upgrade from lower to middle-income status (Prasad et al., 2006). In order to benefitfrom international capital inflows, host countriesneed to pursue sound macroeconomic policies,develop strong institutions and adopt an appropriateregulatory framework for the stability of financialsystems and sustained economic progress (Reddy,2003 and 2005).

8.17 There is growing realisation that unlike tradeintegration, where benefits to all countries aredemonstrable, in the case of financial integration, a‘threshold’ in terms of preparedness and resilienceof the economy is important for a country to get fullbenefits (Kose et al., 2006). A judgemental view needsto be taken whether and when a country has reachedthe ‘threshold’. The nature of optimal integration ishighly country-specific and contextual. Financialintegration needs to be approached cautiously,preferably within the framework of a plausibleroadmap that is drawn up embodying the country-specific context and institutional features. On balance,there appears to be a greater advantage in well-managed and appropriate integration into the globalprocess, which implies not large-scale but moreeffective interventions by the authorities. In fact,markets do not and cannot exist in a vacuum, i.e.,without some externally imposed rules and such orderis a result of public policy (Reddy, 2006b). Thus, witha view to enhancing financial sector efficiency, it isnecessary not only to foster competition amonginstitutions but also to develop a system that facilitatestransparent and symmetric dissemination of maximuminformation to the markets.

II. POLICY MEASURES ENABLING MARKETINTEGRATION IN INDIA

8.18 Until the early 1990s, India’s financial sectorwas tightly controlled. Interest rates in all marketsegments were administered. The flow of fundsbetween various market segments was restricted byextensive micro-regulations. There were alsorestrictions on participants operating in different

market segments. Banks remained captivesubscribers to government securities under statutoryarrangements. The secondary market of governmentsecurities was dormant. In the equity market, newequity issues were governed by several complexregulations and restrictions. The secondary markettrading of such equities lacked transparency anddepth. The foreign exchange market remainedextremely shallow as most transactions weregoverned by inflexible and low limits under exchangeregulation and prior approval requirements. Theexchange rate was linked to a basket of currencies.Although the financial sector grew considerably in theregulated environment, it could not achieve thedesired level of efficiency. Compartmentalisation ofactivities of different types of financial intermediarieseliminated the scope for competition among existingfinancial intermediaries (Mohan, 2004b).

8.19 Financial markets reform initiated in the early1990s focused on removal of structural bottlenecks,introduction of new players/instruments, free pricingof f inancial assets, relaxation of quantitat iverestrictions, improvement in trading, clearing andsettlement practices and greater transparency(Mohan, 2004b, 2006). Other policy initiatives in themoney, the foreign exchange, the governmentsecurities and the equity markets were aimed atstrengthening institutions, greater transparency,encouraging good market practices, effective paymentand settlement mechanism, rationalised tax structuresand enabling legislative framework. Dismantling ofvarious price and non-price controls in the financialsystem has facilitated the integration of financialmarkets. While various measures initiated to developthe markets have been delineated in the respectivechapters, some measures, in particular, facilitated theintegration of markets (Box VIII.3).

III. DOMESTIC FINANCIAL MARKETINTEGRATION IN INDIA

8.20 Broadly, India’s domestic financial marketcomprises the money market, the credit market, thegovernment securities market, the equity market, thecorporate debt market and the foreign exchangemarket, each of which has been addressed at lengthin the previous chapters. The channels of integrationamong various market segments differ. For instance,the Indian money and the foreign exchange marketsare intrinsically linked in view of the presence ofcommercial banks’ and the short-term nature of bothmarkets. The linkage is established through variouschannels such as banks borrowing in overseas

290


Box VIII.3Measures Enabling Financial Market Integration in India

Broadly, integration of financial markets in India has been facilitatedby various measures in the form of free pricing, widening ofparticipation base in markets, introduction of new instruments andimprovements in payment and settlement infrastructure.

Free Pricing

• Free pricing in financial markets was facilitated by variousmeasures. These include, inter alia, freedom to banks to decideinterest rate on deposits and credit; withdrawal of a ceiling of 10per cent on call money rate imposed by the Indian Banks’Association in 1989; replacement of administered interest rateson government securities by an auction system; abolition of thesystem of ad hoc Treasury Bills in April 1997 and replacementby the system of Ways and Means Advances (WMAs) with effectfrom April 1, 1997; shift in the exchange rate regime from a single-currency fixed-exchange rate system to a market-determinedfloating exchange rate regime; gradual liberalisation of the capitalaccount in line with the recommendations of the Committee onCapital Account Convertibility (Chairman: Shri S. S. Tarapore)(see Chapter VI on Foreign Exchange Market); and freedom tobanks to determine interest rates (subject to a ceiling) andmaturity period of Foreign Currency Non-Resident (FCNR)deposits (not exceeding three years); and to use derivativeproducts for hedging risk.

• In the capital market, the Capital Issues (Control) Act, 1947 wasrepealed. The introduction of the book-building process in thenew issue market strengthened the price discovery process.

Widening Participation

• Enhanced presence of foreign banks, in line with India’scommitment to the World Trade Organisation under GATS,strengthened domestic and international markets inter-linkages,apart from increasing competition.

• Initially, the participation in the call market was gradually widenedby including non-banks such as financial institutions, non-bankingfinancial companies, primary/satellite dealers, mutual funds andcorporates (through primary dealers). The process oftransformation of the call money market into a pure inter-bankmarket, which commenced from May 2001, was completed inAugust 2005.

• Foreign Institutional Investors (FIIs) were allowed to participatein the Indian equity market and set up 100 per cent debt funds toinvest in government (Central and State) dated securities in boththe primary and secondary markets. This provided a major thrustto the integration of domestic markets with international markets.

• The linkage between the domestic foreign exchange market andthe overseas market (vertical integration) was facilitated byallowing banks/authorised dealers (ADs) to borrow and investfunds abroad (subject to certain limits), and to lend in foreigncurrency to companies in India for any productive purpose, givingthem the choice to economise on interest cost and exchangerisk. Exporters also have the ability to substitute rupee credit forforeign currency credit.

• Indian companies were permitted to raise resources from abroad,through American/Global Depository Receipts (ADRs/ GDRs),foreign currency convertible bonds (FCCBs) and externalcommercial borrowings (ECBs), thus, facilitating integration ofdomestic capital market with international capital market. TheReserve Bank allowed two-way fungibility of ADRs/GDRs inFebruary 2002.

• Corporates were allowed to undertake active hedgingoperations by resorting to cancellation and rebooking of forwardcontracts, booking forward contracts based on pastperformance, using foreign currency options and forwards, andaccessing foreign currency-rupee swap to manage longer-termexposures arising out of external commercial borrowings.

• Integration of the credit market and the equity market wasstrengthened by application of capital adequacy norms andallowing public sector banks to raise capital from the equitymarket up to 49 per cent of their paid-up capital.

New Instruments

• Repurchase agreement (repo) was introduced as a tool of short-term liquidity adjustment. The liquidity adjustment facility (LAF)is open to banks and primary dealers. The LAF has emerged asa tool for both liquidity management and also signalling devicefor interest rates in the overnight market. Several new financialinstruments such as inter-bank participation certificates (1988),certificates of deposit (June 1989), commercial paper (January1990) and repos (December 1992) were introduced. Collateralisedborrowing and lending obligation (CBLO) and market repos havealso emerged as money market instruments.

• New auction-based instruments were introduced for 364-day,182-day, 91-day and 14-day Treasury Bills, the zero coupon bondand government of India dated securities. In the long-termsegment, Floating Rate Bonds (FRBs) benchmarked to the 364-day Treasury Bills yields and a 10-year loan with embedded calland put options exercisable on or after 5 years from the date ofissue were introduced.

• Derivative products such as forward rate agreements andinterest rate swaps were introduced in July 1999 to enablebanks, FIs and PDs to hedge interest rate risks. A rupee-foreigncurrency swap market was developed. ADs in the foreignexchange market were permitted to use cross-currency options,interest rate and currency swaps, caps/collars and forward rateagreements (FRAs) in the international foreign exchangemarket, thereby facilitating the deepening of the market andenabling participants to diversify their risk.

Institutional Measures

• Institutions such as Discount and Finance House of India(DFHI), Securities Trading Corporation of India (STCI) and PDswere allowed to participate in more than one market, thusstrengthening the market inter-linkages.

• The Clearing Corporation of India Ltd. (CCIL) was set up toact as a central counter-party to all trades involving foreignexchange, government securities and other debt instrumentsrouted through it and to guarantee their settlement.

Technology, Payment and Settlement Infrastructure

• The Delivery-versus-Payment system (DvP), the NegotiatedDealing System (NDS) and subsequently, the advancedNegotiated Dealing System – Order Matching (NDS-OM)trading module and the real time gross settlement system(RTGS) have brought about immense benefits in facilitatingtransactions and improving the settlement process, whichhave helped in the integration of markets.

• In the equity market, the floor-based open outcry tradingsystem was replaced by electronic trading system in all thestock exchanges.

291


markets, providing hedging facilities to corporates,accepting foreign currency deposits and acting asconduit for making payments for overseas merchanttransactions. The linkage between the call money andthe government securities markets exists, as at times,large positions in government securities are fundedthrough short-term borrowings. The foreign exchangemarket and the equity markets are linked through theoperations of foreign institutional investors. Theemerging linkages among the money, the governmentsecurities and the foreign exchange markets have attimes necessitated the use of short-term monetarymeasures by the Reserve Bank for meeting demand-supply mismatches to curb volatility.

Phases of Market Integration in India

8.21 Various segments of financial markets havebecome better integrated in the reform period,especially from the mid-1990s (Chart VIII.1). Asreforms in the financial markets progressed, linkagesamongst various segments of market and betweendomestic and international markets improved. For thepurpose of analysis, financial market linkages couldbe divided into two distinct phases. The first phaserefers to the early transition period of the 1990s andthe second phase is the period of relative stability inthe financial markets from 2000 onwards.

8.22 In the first phase, domestic financial marketswitnessed modest integration. Financial markets, ingeneral, lacked depth as measured by the turnoverin various market segments (Table 8.1). Domesticfinancial markets during this phase witnessed easingof various restr ictions, which created enabling

conditions for increased inter-linkages amongstmarket segments. The institution of a market-basedexchange rate mechanism in March 1993 andtransition to current account convertibility in August1994 facilitated inter-linkages between the money andthe foreign exchange markets. Since the beginningof second half of the 1990s, some episodes of volatilitywere witnessed in the money and the foreignexchange markets, which underscored the gradualintegration of the domestic money market and theforeign exchange market.

8.23 Financial markets in India felt the initialimpulses of the contagion from financial crises in

Table 8.1: Depth of Financial Markets in India - Average Daily Turnover(Rupees crore)

Year Money Government Foreign Exchange Equity Market** Equity DerivativesMarket* Securities Market Market # (Cash Segment) at NSE

1 2 3 4 5 6

1991-92*** 6,579 391 – 469 –2000-01 40,923 2,802 21,198 9,308 112001-02 65,500 6,252 23,173 3,310 4102002-03 76,722 7,067 24,207 3,711 1,7522003-04 28,146 8,445 30,714 6,309 8,3882004-05 31,832 4,826 39,952 6,556 10,1072005-06 39,997 3,643 56,391 9,504 19,2202006-07 56,413 4,863 83,894 11,760 29,803

* : Including the call money, the notice money, the term money and the repo markets. The turnover in the CBLO segment was Rs.6,698 crorein 2004-05, Rs. 20,040 crore in 2005-06 and Rs. 32,390 crore in 2006-07. ** : Includes both BSE and NSE turnover.*** : Data for the government securities market and the equity market pertain to 1995-96. # : Inter-bank turnover only. – : Not available.Source : Reserve Bank of India; Bombay Stock Exchange Limited; and National Stock Exchange of India Limited.

292


the East Asian countries, which erupted in thesecond half of 1997-98. Pressures from contagionre-emerged in the mid-November 1997, following theweakening of the sentiment in response to financialcrisis spreading to hit South Korea and far off LatinAmer ican markets. The East Asian cr is isnecessitated policy action by the Reserve Bank tomitigate excess demand conditions in the foreignexchange market. It also moved to siphon off excessliquidity from the system in order to reduce the scopefor arbitrage between the easy money market andthe volati le foreign exchange market. Foreigncurrency operations were undertaken in the thirdquarter of 1997-98 to curb volatility in the exchangerate. This helped in maintaining stability in theexchange rate of the rupee, but resulted in reducedmoney market support to the government borrowing,leading to an increase in the Centre’s monetiseddeficit. The Reserve Bank tightened its monetarypolicy stance by raising the CRR and the Bank Rate,thus, substituting cheap discretionary liquidity withexpensive discretionary liquidity. A host of monetarypolicy actions were taken to tighten liquidity inNovember and December 1997 and January 1998.1

Monetary policy tightening measures in the wake ofEast Asian crisis led to hardening of domesticinterest rates across various segments in the moneymarket and the government securities market,especially at the short-end. Restoration of stabilityin the domestic financial markets in the second halfof 1998, especially in the foreign exchange market,led the Reserve Bank to ease some of the monetarypolicy tightening measures under taken earlier.Several banks reduced their lending and depositrates in response to the Bank Rate cut as also inline with seasonal trends.

8.24 The second phase, beginning 2000 onwards,reflects the period of broad stability in financialmarkets with intermittent episodes of volatility. Theprocess of financial market integration was morepronounced during this phase. A growing integrationbetween the money, the gilt and the foreign exchangemarket segments was visible in the convergence offinancial prices, within and among various segmentsand co-movement in interest rates. The capitalmarket exhibited generally isolated behaviour fromthe other segments of domestic financial markets.However, there was a clear indication of growing

cross-border integration as the domestic stockmarkets declined sharply in line with the sharpdecline in international technology stock drivenexchanges in 2001. On several other occasions also,the Indian equity markets tended to move in tandemwith major international stock markets.

8.25 Growing integration of financial marketsbeginning 2000 could be gauged from crosscorrelation among various market interest rates. Thecorrelation structure of interest rates reveals severalnotable features of integration of specific marketsegments (Table 8.2). First, in the money marketsegment, there is evidence of stronger correlationamong interest rates in the more recent period 2000-06 than the earlier period 1993-2000, suggesting theimpact of policy initiatives undertaken for financialdeepening. The enhanced correlation among interestrates also indicates improvement in efficiency in theoperations of financial intermediaries trading indifferent instruments. Second, the high correlationbetween risk free and liquid instruments such asTreasury Bil ls, which serve as benchmarkinstruments, and other market instruments such ascertificates of deposit (CDs) and commercial papers(CPs) and forward exchange premia, underlines theefficiency of the price discovery process. Third, thesharp improvement in correlation between the reverserepo rate and money market rates in the recent periodimplies enhanced effectiveness of monetary policytransmission. Fourth, the high degree of correlationbetween long-term government bond yield and short-term Treasury Bills rate indicates the significance ofterm-structure of interest rates in financial markets.Fifth, the correlation between interest rates in moneymarkets and three-month forward premia wassignificantly high, indicating relatively high horizontalintegration. Integration of the foreign exchange marketwith the money market and the governmentsecurities market has facilitated closer co-ordinationof monetary and exchange rate policies. Theconsequences of foreign exchange marketintervention are kept in mind in monetarymanagement which includes constant monitoring ofthe supply of banking system liquidity and an activeuse of open market operations to adjust liquidityconditions. Sixth, the equity market appears to besegmented with relat ively low and negat ivecorrelation with money market segments.

1 See Chapter VI for details.

293


Segment-wise Integration

Integration of the Government Securities Market

8.26 The existence of a well-developed governmentsecurities market is a pre-requisite for a market-basedmonetary policy and for facilitating financial marketintegration. The government securities market is alsorequired to develop a domestic rupee yield curve,which could provide a credible benchmark for pricingof securities in other markets. The governmentsecurities market is increasingly getting integratedwith other market segments as is reflected in the closeco-movement of interest rates. As alluded to earlier,a high degree of correlation between long-termgovernment bond yields and short-term Treasury Billsrates in recent years demonstrates the significance

of the term-structure of interest rates in the financialmarket. Furthermore, the movement of 3-month rupeeinterest rate implied from the forward premia has alsomoved largely in tandem with the 91-day Treasury Billsrate, barring the redemption phase of Resurgent IndiaBond when the forward premia turned negative,implying a reasonable level of integration of thegovernment securities market with the foreignexchange market (Chart VIII.2).

8.27 As indicated earlier, the efficiency of monetarypolicy also hinges on how effectively impulses aretransmitted across various financial markets, whichin turn, is incidental upon the level of marketintegration. An improvement in the transmission ofimpulses was reflected in the sharp moderation in the

Table 8.2: Correlation Among Major Financial Markets

(April 1993 to March 2000)

Instrument RREPO Call TB91 TB364 Yield10 CDs CPs FR1 FR3 FR6 EXCH LBSES

1 2 3 4 5 6 7 8 9 10 11 12 13

RREPO 1.00Call 0.35 1.00TB91 0.44 0.61 1.00TB364 0.32 0.40 0.90 1.00Yield10 0.04 0.46 0.57 0.49 1.00CDs 0.30 0.32 0.45 0.41 0.38 1.00CPs 0.39 0.54 0.81 0.75 0.57 0.71 1.00FR1 0.27 0.80 0.45 0.33 0.46 0.47 0.63 1.00FR3 0.28 0.68 0.47 0.32 0.56 0.58 0.65 0.97 1.00FR6 0.30 0.61 0.48 0.36 0.60 0.62 0.68 0.91 0.98 1.00EXCH 0.03 -0.04 -0.23 -0.38 -0.06 -0.19 -0.31 -0.25 0.12 0.13 1.00LBSES -0.37 -0.10 -0.24 -0.34 -0.05 -0.40 -0.28 -0.32 -0.28 -0.30 0.35 1.00

(April 2000 to March 2007)

RREPO 1.00Call 0.77 1.00TB91 0.85 0.88 1.00TB364 0.83 0.85 0.99 1.00Yield10 0.79 0.79 0.96 0.98 1.00CDs 0.75 0.88 0.93 0.92 0.89 1.00CPs 0.80 0.85 0.96 0.94 0.92 0.95 1.00FR1 0.57 0.64 0.58 0.52 0.51 0.61 0.66 1.00FR3 0.59 0.58 0.60 0.54 0.54 0.62 0.70 0.97 1.00FR6 0.60 0.56 0.60 0.55 0.56 0.63 0.71 0.93 0.99 1.00EXCH 0.27 0.06 0.08 0.04 0.06 0.14 0.21 0.51 0.61 0.66 1.00LBSES -0.19 0.01 -0.07 -0.05 -0.11 -0.06 -0.13 -0.39 -0.50 -0.56 -0.69 1.00

TB91 : 91-day Treasury Bills rate. RREPO : Reverse repo rate.Yield10 : 10-year government securities yield. Call : Inter-bank call money rate (weighted average).CPs : Commercial paper rate. TB364 : 364-day Treasury Bills rate.FR1 : 1-month forward exchange premia. CDs : Certificates of deposit rate.FR6 : 6-month forward exchange premia. FR3 : 3-month forward premia.LBSES : Natural logarithm of BSE Sensex. EXCH : Exchange rate of Indian rupee per US dollar.Note : Based on monthly data.

294


term premium in the government securities market,especially the narrowing down of the spread on 10-year government bond yield and Treasury Billsinstruments in the recent period (Chart VIII.3). Sincelong-term interest rates account for a premium chargeon liquidity risk and various uncertainties relating tomacroeconomic fundamentals such as inflation andgrowth, the flattening of the yield curve or narrowingof spread between long-term and short-term interestrates points towards a stronger economy and stablefinancial environment.

8.28 For effective market integration, it is essentialthat there exists a deep secondary market forgovernment securities, which provides a benchmarkfor valuation of other market instruments, and theturnover of the instruments in both primary andsecondary markets is fairly large. The turnover in thesecondary segment of government securities market,indicating the depth of this market segment, inter alia,is influenced by some key factors such as monetarypolicy stance, banks’ SLR holding and credit demandby the private sector. This was evident in the rise inturnover in the secondary market for governmentsecurities, fuelled by banks’ excess SLR holdingduring the period of softening interest rates. In therecent period, following the tightening of policy stanceand rise in credit demand, banks have reduced SLRholdings close to the prescribed limit. Reduction involumes in the secondary segment of governmentsecurities in the second half of 2006 was mostly dueto rise in interest rates apart from demand side factors.The secondary market turnover has, thus, declinedin the recent period (Chart VIII.4). This trend, ifpersists for long, could affect the depth and yield inthis segment and consequently pose some challengesfor effective market integration. International evidencesuggests that banks tend to rebalance their portfolioand reduce their holding of government securitieswhen interest rates rise. For instance, in the US, thepropor tion of government secur it ies held bycommercial banks in total US government securitiesdeclined to 1.6 per cent in 2005 from 5.3 per cent in2003 when the interest rates rose following increase

295


in the Federal Funds Rate from 1.25 per cent in 2003to 5.0 per cent in 20052 .

Integration of the Credit Market

8.29 The integration of the credit market with othermoney market segments has become morepronounced in recent years. Sustained credit demandhas led to higher demand for funds, exerting somepressure on liquidity. This was reflected in the declinein banks’ investment in government securities andhigher activity in all the money market segments suchas inter-bank call money, collateralised borrowing andlending obligation (CBLO) and market repo rates. Totalvolume in these three markets increased fromRs.16,132 crore in March 2005 to Rs.35,024 crore inMarch 2006 and further to Rs.38,484 crore in February2007. Banks also resorted to increased issuances inthe CDs market to meet their liquidity requirements.Outstanding CDs increased from Rs.12,078 crore inMarch 2005 to Rs.43,568 crore in March 2006 andfurther to Rs.77,971 crore by March 2, 2007.

8.30 In the context of credit market integration withother markets, particularly, the benchmark governmentsecurities, there is evidence of high correlation betweenthe commercial paper rate and the Treasury Bills rate.Also, the AAA rated 5-year corporate bond yield andgovernment securities yield of corresponding maturityshow high co-movement (Chart VIII.5). However, thespread of the AAA rated 5-year corporate bond yieldover government securities yield of correspondingmaturity has increased in the recent period. Undercompetitive market condition, the market rate should beequal to risk free rate plus a risk premium3 . Though asimple regression model confirmed the unitary elasticityresponse of the corporate bond rate to governmentsecurities yield, the model was subject to auto-correlatederrors, implying some imperfection in the corporate debtmarket. Furthermore, in an alternative specification usingweekly data, it was found that the AAA rated 5-yearcorporate bond spread over the risk free 91-day TreasuryBills rate could be significantly determined by the termspread, i.e., the spread of 5-year government securitiesyield over 91-day Treasury Bills rate, and default premia(AAA rated 5-year corporate bond yield less AB rated 5-

year corporate bond yield), besides the persistence incorporate bond spread (its own lagged terms). Thus, arising spread between the corporate bond yield and thebenchmark risk free government bond yield suggeststhat the corporate debt market continues to lackadequate depth and liquidity. As indicated by the HighLevel Expert Committee on Corporate Bonds andSecuritisation, 2005 (Chairman: Dr. R. H. Patil), thecorporate debt market, which is at a nascent stage ofdevelopment, needs to be strengthened, inter alia, interms of investor base and enhanced liquidity throughconsolidation of the issuance process by creating largefloating stocks.

Integration of the Foreign Exchange Market

8.31 The degree of integration of the foreignexchange market with other markets is largelydetermined by the degree of openness. At thecornerstone of the international finance, integrationthrough foreign exchange market is characterised withthe Purchasing Power Parity (PPP) doctrine and thethree international interest parity conditions, viz., theCovered Interest Parity (CIP), the Uncovered Interest

2 Source: Federal Reserve Bank of New York, the US. Also, www.bondmarkets.com

3 For a sample period of April 2003 to February 2007, applying a regression of AAA rated 5-year corporate bond yield upon 5-year governmentsecurities yield, the following estimates were found:Corporate Bond Yield = 0.40 + 1.05 G-sec Yield

(1.50) (25.50)R–2

= 0.94, DW = 0.34.Figures in parentheses are estimated t-values. The unity restriction on the coefficient of G-sec yield could not be rejected.

296


Parity (UIP) and the Real Interest Parity (RIP).According to the PPP, in the absence of restrictions oncross border movements of goods and services andassuming no transactions costs, commodity pricesexpressed in any single currency should be the sameall over the world. In other words, the path of the nominalexchange rate should be guided by the developmentsin the domestic prices of goods and services vis-à-visprices of the major trading partners. The behaviour ofthe Real Effective Exchange Rate (REER) could,therefore, indicate whether the nominal exchange ratemoves as per the principle of PPP. The simplestapproach to test PPP is just a test of stationarity of theREER, i.e., to see whether deviations from the PPPare temporary and whether over time the REER revertsto some mean or equilibrium, usually the benchmarklevel at 100, subject to a base year. In India, the 36-currency REER did not show any sustained appreciationor depreciation over longer horizon during the April1993-December 2006 (Chart VIII.6). During this period,it hovered around the mean at 99.2, which was closeto the benchmark level. A formal unit root test alsosuggests that the broad-based REER is stationary, thus,supporting the purchasing power parity in the long-run.

8.32 According to the Covered Interest Parity (CIP),the rates of return on homogenous financialinstruments that are denominated in same currency,but traded domestically or offshore must be equalunder efficient market conditions, provided exchangecontrols do not exist and country risk premium issimilar in two markets. The CIP implies that yield onforeign investment that is covered in forward marketsequals the yield on domestic investment. The interestdifferential is offset by premium or discount on theforward rate. The absence of covered interestdifferential indicates that there are some impedimentsto financial integration, attributable to some element

of market imperfection, transaction costs, marketliquidity conditions, margin requirements, taxation andmarket entry-exit conditions. In the Indian context, theforward price of the rupee is not essentially determinedby the interest rate differentials, but it is alsosignificantly influenced by: (a) supply and demand offorward US dollars; (b) interest rate differentials andexpectations of future interest rates; and (c)expectations of future US dollar-rupee exchange rate.Empirical evidence supports this view, as three monthforward premia has less than perfect co-movementwith interest rate differential (between 91-day treasurybill rate and three-month LIBOR), indicative of the timevarying nature of the risk premium. Inter-linkagebecomes stronger when the interest rate differentialis based on the monthly average call money rate andone-month LIBOR (Chart VIII.7). The relationship

297


improves still further, when the difference betweencommercial paper (CP) rate in India and the 3-monthUS dollar LIBOR rate is considered for interest parityassessments. The deviation of the forward premiumfrom the interest parity condition appears to increaseduring volatile conditions in the spot segment of theforeign exchange market.

8.33 The Uncovered Interest Rate Parity (UIP)implies that ex-ante, expected home currency returnson foreign bonds or deposits in excess of domesticdeposits of equal maturity and default risk should bezero. The currency composition of the asset holdingsis, therefore, irrelevant in determining relative returns.The prevalence of UIP also implies that the cost offinancing for domestic firms in domestic and foreignmarkets would be the same. Operating throughrational expectations, the UIP suggests that expectedchanges in the nominal exchange rates shouldapproximate the interest rate differentials. In the Indiancontext, though empir ical studies confirm theexistence of CIP, they dispute the existence of UIP.Usually, if CIP holds, UIP will also hold if investorsare risk-neutral and form their expectations rationally,so that expected depreciation of home currencyequals the forward discount (Box VIII.4).

Stock Market Integration

8.34 As alluded to earlier, the equity market hasrelatively low and negative correlation with othermarket segments (Table 8.2). The low correlation ofthe equity market with r isk free instruments isindicative of greater volatility of stock returns andthe existence of large equity risk premium. The largerisk premium occurs when equity price movementscannot be rationalised with standard inter-temporalopt imisat ion models of macroeconomicfundamentals such as consumption and savings(Mehra and Prescott, 1985). This could be onaccount of different participants in the equity andother financial markets. For instance, the commonparticipation by banks in the money, the government,the foreign exchange and the credit markets ensuresfairly high correlation among these segments. Theexposure of banks to the capital market remainslimited on account of restrictions due to prudentialregulation. A major reason for the surge in equityprices could be due to demand-supply mismatchesfor equity securities. In fact, a large proportion ofequities is held by promoters and institutionalinvestors as detailed in Chapter VII. The supply ofsecurities for retail investors could possibly belagging behind their demand. Equity prices, however,

have relatively higher correlation with the forwardexchange rate than other market interest rates. Thisis because portfolio investors, mainly, the FIIs, areallowed to hedge their exposure in the foreignexchange market through the forward market.

Integration and Stability of Markets

8.35 Financial markets integration process couldbe smooth or volati le depending on the r isksassociated with different instruments. When financialintegration occurs in a smooth manner, it promotesefficiency in allocation of resources and stability ofthe financial system. On the contrary, volatility inducedintegration fuels speculation and underminescompetitive price discovery process, with adverseconsequences for resource allocation. In the Indiancontext, empirical evidence shows that growingintegration among financial market segments hasbeen accompanied by lower volatility in interest rates(Table 8.3). Barr ing the stock market, varioussegments of financial markets, in general, witnessedsignificantly lower volatility (measured by standarddeviation) during April 2000 to March 2007 than theearlier period April 1993 to March 2000. The cross-section volatility of market interest rates has alsodeclined, suggesting the convergence of interest ratesdue to effective management of l iquidity andincreasing depth of financial markets.

8.36 The reduction in volatility in the money marketsegment, in particular, coincided with the introductionof the full-fledged liquidity adjustment facility (LAF)in 2000-01. The operation of the LAF has generallymanaged to keep the overnight rate, i.e., the callmoney rate in the corridor of reverse repo rate andrepo rate (Chart VIII.8). The gradual phasing out ofnon-banks from the call money market has led todevelopment of collateralised markets such as therepo market and the CBLO. The migration to thecollateralised segments has also reduced the volatilityin the overnight money market rates as availability ofalternative avenues for mobilising short-term fundshas enabled market rates to align with the informalinterest rate corridor of repo and reverse repo rateunder the LAF.

Financial Market Integration and Monetary Policy

8.37 Developed and integrated financial marketsare pre-requisites for effective and credibletransmission of monetary policy impulses. Thesuccess of a monetary policy transmission frameworkthat relies on indirect instruments of monetary

298


4 The estimated CIP equations are as follows: FR3 = 1.70 + 0.45 ID1 + 0.25 ID1(-1) + 0.17 ID1(-2)

(4.8) (6.4) (3.2) (2.5) DW = 0.3 R–2

= 0.47

FR3 = 1.08 + 1.08 ID2 (1.7) (6.7) DW = 0.3 R

–2 = 0.22

where FR3 is 3-month forward premia, ID1 is interest rate differential between the call money rate and the 1-month LIBOR and ID2 is the interestrate differential between the 91-day Treasury Bills rate and the 3-month LIBOR. Figures in parentheses are estimated t-values.

The estimated UIP equation is as follows:DEPX = -0.06 - 0.04 FR3 (t-3)

(0.4) (1.5) DW = 1.5 R–2

= 0.01

where DEPX is actual exchange rate depreciation under the assumption of rational expectations. Figures in parentheses are estimated t-values.

In the context of a country’s international financialintegration, an important issue is the degree of foreignexchange market efficiency, which can be examinedthrough empirical evaluation of ‘covered interest parity(CIP)’ and ‘uncovered parity (UIP)’ hypotheses. The interestparity hypothesis is important from a policy perspective(Blinder, 2004). First, the CIP reflects information efficiencyof the foreign exchange market. Deviations from CIP canarise because of imperfect integration with overseasmarkets. Second, the UIP could be attr ibuted toeffectiveness of sterilised foreign exchange marketintervention by central banks as well as that of interestrate defence of the exchange rate. To the extent that UIPis valid, official intervention cannot successfully changethe prevailing spot exchange rate relative to the expectedfuture spot rate, unless the authorities allow interest ratesto change (Isard, 1995). It may, however, be added thatthere are other channels (for instance, the signallingchannel) through which sterilised intervention may still beeffective. Similarly, the interest rate defence of the exchangerate rests on possible deviations from UIP; otherwise, anyattempts by the monetary authority to increase interest ratesto defend the exchange rate would be offset exactly byexpected currency depreciation. Policy-exploitable deviationsfrom UIP are, therefore, a necessary condition for an interestrate defence (Flood and Rose, 2002).

From a cross-country perspective, empirical literaturegenerally supports the CIP. As regards the UIP, theliterature in general does not support it, though resultscould vary across currency, time horizon and countries(Isard, 1995; Fama, 1984; Froot and Thaler, 1990;Wadhwani, 1999; Chinn and Meredith, 2002; Bekaert etal., 2002; and Flood and Rose, 2002). The failure of UIPis attributable, inter alia, to time-varying risk premium,deviations from rational expectations (since tests of UIPinvolve a joint test of efficient market hypothesis andrational expectations), transaction costs, and endogenousmonetary policy (Wadhwani, 1999; Kim and Roubini, 2000;and Meredith and Ma, 2002).

Box VIII.4Foreign Exchange Market Efficiency

In the Indian context, empirical evidence covering the periodApril 1993 to early 1998 finds some support for CIP but notfor UIP (Bhoi and Dhal, 1998; and Joshi and Saggar, 1998).Deriving from theoretical and empirical insights from cross-country studies, Pattnaik, Kapur and Dhal (2003) adopted arigorous empirical analysis of parity conditions in the Indiancontext during April 1993 to March 2002. The study reiteratedthat the overall evidence in favour of market efficiencyappears to be inconclusive. While CIP appears to hold onan average, the evidence for UIP comes from the absenceof any predictable significant excess foreign exchangemarket returns. In view of significant ongoing liberalisationof the capital account in the subsequent period, it wasattempted to examine afresh the interest parity conditionsfor India. Accordingly, interest parity conditions for the rupeevis-à-vis the US dollar using monthly data over the periodApril 1993 to September 2006 with regard to 3-month forwardpremia were examined. For interest rate differential, twoalternative measures of domestic interest rate (call moneyrate and 91-day Treasury Bills rate) have been used; for theforeign interest rate, 1-month and 3-month LIBOR were used.The results were more or less in line with previous studies4 .Deviations from UIP could not only be due to presence oftime varying risk premium but also due to surges in privatecapital flows (RBI, 2001). Although non-residents have beenincreasingly permitted to invest in the Indian markets,restrictions on borrowing and investing by residents in theoverseas markets remained for most of the sample periodof this study. Moreover, even with regard to non-residents,the major players, viz., the foreign institutional investors (FIIs)are more focused on the equity markets. Furthermore,central bank intervention in the market and administrativemeasures can also affect market behaviour. All these factorscan cause deviations from UIP in the short-horizon, but overtime there remains a tendency for the exchange ratemovements to be consistent with UIP and stable realexchange rate. The average level of interest rate differentialspoints the right way in forecasting long-run currencychanges, even though the short-run correlation usuallypoints the wrong way in forecasting near-term exchange ratechanges (Froot and Thaler, 1990).

299


management such as interest rates is contingent uponthe extent and speed with which changes in the centralbank’s policy rate are transmitted to the spectrum ofmarket interest rates and exchange rate in theeconomy and onward to the real sector (Mohan,2007). Deviations between money market rates andthe policy interest rate, in particular, have at least twoadverse effects. First, they weaken the monetarypolicy transmission mechanism and introduce anelement of uncertainty. Greater the influence thecentral bank has over interest rate levels, the easierit is for it to manage demand in the economy and attainits objective of low inflation and sustained growth(Petursson, 2001). Second, a large spread entailinga mismatch between inter-bank rates and the centralbank’s policy rate could lead to inefficiencies in thefinancial intermediation process. In the Indian context,there has been convergence among market segments,with a significant decline in the spread of marketinterest rates over the reverse repo rate (Table 8.4).The spread was the lowest for the inter-bank callmoney rate followed by rates on Treasury Bills,

certificates of deposit, commercial paper and 10-yeargovernment bond yield. The benefit of financialmarkets development percolating to the private sectorwas also evident from the moderation in spread ofcommercial paper over the policy rate. The narrowingof the spread between the policy rate and other marketrates suggests the increasing efficiency of thetransmission mechanism of monetary policy.

8.38 Besides correlation measure, more formaland robust approach to market integration analysisentails an investigation of causal relationship amongvarious interest rates. The causal relationship betweenreverse repo rate and market interest rates, inparticular, highlights the importance of monetarytransmission in influencing the term structure ofinterest rates. Empirical analysis of Granger causality

Table 8.3: Financial Market Volatility

Rate Apr-1993 Apr-1993 Apr-2000to to to

Mar-2007 Mar-2000 Mar-2007

1 2 3 4

Call money rate 4.30 5.38 1.90

Reverse repo rate 1.27 1.14 1.32

Treasury Bills rate (91 days) 2.29 1.93 1.46

Treasury Bills rate (364 days) 2.57 1.56 1.66

Certificates of deposit rate 3.17 2.36 1.66

Commercial paper rate 3.30 2.50 1.99

Yield on 10-year governmentsecurities 2.77 0.99 1.78

Exchange rate (Rs./US$) 5.96 4.62 1.61

Forward exchange premium 4.69 5.99 1.91(1 month)



BSE SENSEX (index volatility) 2582 685 3194(annualised index (32.94) (32.44) (33.36)return volatility)

Cross-section volatility* 3.88 4.08 2.53

Note : 1. Volatility is measured in terms of standard deviation.2. Data for 10-year government securities yield are available

since April 1996, while data for 1-month forward exchangepremia are available from June 1995.

* :Standard deviation of all of the above interest rates and forwardpremia.

Table 8.4: Interest Rate Spread over theReverse Repo Rate

(Percentage point)

Interest Rate Apr-1993 Apr-1993 Apr-2000to to to

Mar-2007 Mar-2000 Mar-2007

1 2 3 4

Call Money Rate 1.78 2.98 0.58

Certificates of Deposit Rate 3.31 5.43 1.19

Commercial Paper Rate 3.99 6.09 1.89

91-day Treasury Bills Rate 1.69 2.90 0.48

364-day Treasury Bills Rate 2.48 4.18 0.79

10-year Yield on GovernmentSecurities 3.42 6.21 1.83

300


reveals certain important features of transmissionmechanism in the Indian context5. First, lagsassociated with the transmission of policy impulsesto market rates are aligned with the term structure ofinstruments; short-term rates exhibit relatively lowerlags than medium and longer maturity instruments tothe changes in policy rates. Second, the reverse reporate has uni-directional causal effect on short-end ofthe financial market, including call money rate and91-day Treasury Bills rate. In the medium-to-longerterm horizon, 10-year Government bond yield has abi-directional causal association with the reverse reporate. This could be attributed to the feedback betweenpolicies and markets, since at the longer end, financialmarkets contain useful information about investmentactivity and economic agents’ expectations aboutinflation and growth prospects.

Dynamics of Market Inter-linkages

8.39 As alluded to earlier, market integration couldbe attributable to liquidity, term structure, credit marketconditions, exchange rate and macroeconomicfundamentals. Empirical results reveal that themarket integration process is influenced by liquidity,safety and risk, external market developments,private sector growth, credit requirements andmacroeconomic developments such as growth andinflation outlook implied by the long-term bond yield

6.

First, short-term liquidity impact on the inter-bankcall money rate is mainly influenced by foreignexchange market developments reflected in themovement of forward exchange rate and fiscal policyinduced effect at the short-end of the market throughchanges in the benchmark 91-day Treasury Bills rate.Second, the rate on 91-day Treasury Bi l ls isinfluenced by the 10-year government securitiesyield and private sector credit condition throughchanges in the commercial paper rate, while foreignexchange market development and liquidity exertsome influence in the shor t-run. Third, forwardexchange premia is driven by arbitrage condition,with the inter-bank call money market being the key

driver, though some modest impact was due todevelopments in the private sector (commercialpaper) and long-term fundamentals (10-yeargovernment bond yield). Fourth, for the privatesector, commercial paper is driven by long-termgovernment securities yield in the medium to longerterm horizon, while liquidity, risk premium and foreignexchange market condition have modest impact inthe shor t-run. Fi f th, the commercial paperrepresenting developments in productive activitiesand credit requirements by the private sector has asubstantially larger impact than liquidity, foreignexchange market and risk premium. Moreover, anextension of the above multivariate vector auto-regression(VAR) model to a structural representationreveals that financial market integration in the mediumto longer term horizon is induced by the long-termyield on government securities and the commercialpaper rate, at t r ibutable to macroeconomicdevelopments such as medium-term inf lat ionoutlook and real sector developments in the privatesector.

8.40 To sum up, integration among various marketsegments has grown, especially in the recent period.This was reflected in an increase in the depth of themarkets and higher correlation among interest ratesin various market segments. Growing integrationamong various financial market segments wasaccompanied by lower volatility of interest rates. Thenarrowing of the interest rate spread over the reverserepo rate reflects an improvement in the monetarypolicy transmission channel and greater financialmarket integration. Financial market integrationreflects a dynamic interaction among var iousparameters such as liquidity, safety and risk, foreignexchange market development, private sector activity,and macroeconomic fundamentals. Alternatively,financial integration exhibits interaction amongfinancial intermediaries, the Government, the privatesector and the external sector. In respect of specificmarket segments, it was found that the reverse reporate has one-way causal effect with the short-end of

5 Granger causality tests were conducted for the period April 1993 to September 2006 by estimating a vector error correction model (VEC) bytaking the following variables: reverse repo rate, 91-day Treasury Bills rate, 364-day Treasury Bills rate and 10-year Government securitiesyield. The order of the VAR model was chosen to be two months lag based on the Schwarz Criterion.

6 An unrestricted vector auto-regression model was estimated to analyse financial market inter-linkages in terms of interaction among fivevariables such as the inter-bank call money rate, the 91-day Treasury Bills rate, the three-month forward premia, the commercial paper rateand the 10-year government bond yield. From an alternative perspective, such multivariate dynamics demonstrate the underlying financialand real linkages arising from interaction among intermediaries, the Government, the external sector, the private sector and macroeconomicdevelopments. The model was estimated using monthly data for the period April 1993 to September 2006. The order of the VAR was found tobe 9-month lag, based on the Likelihood Ratio test. The forecast error variance decomposition analysis of the VAR model was used forexplaining the variation of one variable in terms of variation in other variables in the system.

301


the financial markets, i.e., money market, while withthe 10-year government bond yield, a two-way causalrelation exists, implying a feedback between policyand markets at the longer end. In the foreign exchangemarket, the PPP doctrine has been held in theabsence of any sustained appreciation/depreciation ofthe REER. The equity market has a relatively lowinteraction with other market segments, which isreflected in the existence of a large equity risk premium.

IV. INDIA’S INTERNATIONAL FINANCIALINTEGRATION

8.41 Development of financial markets is requiredfor the purpose of not only realising the hidden savingpotential and effective monetary policy, but also forexpanding the economy’s role and participation in theprocess of globalisation and regional integration. Withgrowing openness, global factors come to play agreater role in domestic policy formulation, leadingto greater financial market integration (Reddy, 2006b).With growing financial globalisation, it is importantfor emerging market economies such as India todevelop financial markets to manage the r isksassociated with large capital flows. In a globalisedworld, the importance of a strong and well-regulatedfinancial sector can hardly be overemphasised to dealwith capital flows that can be very large and couldreverse very quickly. The Report of the Committeeon Fuller Capital Account Conver tibil i ty, 2006(Chairman: Shri S.S. Tarapore) observed that in orderto make a move towards the fuller capital accountconvertibility, it needs to be ensured that differentmarket segments are not only well-developed but alsothat they are well-integrated.

Global and Regional Trends

8.42 Globalisation has manifested itself in a newform of trade and financial inter-dependence amongindustr ial, developing and emerging marketeconomies. Developing and emerging economies,which earlier relied mainly on primary commodityexports, have emerged as the leading countries inmanufacturing and services trade. Though in absoluteterms, industrial countries continue to account for thebulk of global trade, their share has declined in recentyears, leading to a rise in the share of developingand emerging market economies led by China andcountries in the East and South East Asia. Thespreading out of the production process acrosscountries, with companies increasingly finding itprofitable to allocate different links of the value chainacross a range of countries, has been accompanied

by increased market integration. Thus, in terms oftrade openness, developing and emerging marketeconomies surpassed advanced economies (Table8.5). Across income groups, trade openness of lowand middle-income countries has increased at a fasterrate than high-income countries.

8.43 The major trend in the global economy todayalongside globalisation is growing regionalisation. Inthis context, the issue whether the process ofglobalisation and the growing regionalismcomplement each other or the growing regionalism isdetrimental to globalisation has become a subject ofintense discussion for policy makers and academics.Some believe that globalisation is nothing but agreater integration of economies nationally, regionallyand worldwide. For others, since the regionalintegration process remains concentrated exclusivelyin certain countries, doubts arise whether suchexclusivity throws up building blocks or stumblingblocks on the road to global economic integration.Despite these alternative perspectives, theregionalisation process has accelerated since the mid-1980s with varying features and scale in differentregions. According to the World Trade Organisation(WTO), by March 2007, there were 194 regional tradearrangements as compared with only 24 agreementsin 1986 and 66 agreements in 1996. According to theWorld Investment Report, 2006 of the United NationsConference on Trade and Development, internationalinvestment agreements (IIAs) have increasedsubstantially. At the global level, total number of IIAswas close to 5,500 at the end of 2005, comprising2,495 bilateral investment treaties (BITs), 2,758double taxation treaties (DTTs) and 232 otherinternational agreements that contain investmentprovisions. The total number of BITs amongdeveloping countries increased sharply from 42 in1990 to 644 by the end of 2005, while the number of

Table 8.5: Global Trade Openness(Exports plus Imports as percent of GDP)

Category 1980s 1990s 2000s 2006

1 2 3 4 5

World 37.1 41.4 52.7 60.8Advanced Economies 38.3 40.5 49.3 56.5Developing and Emerging Economies 33.6 46.2 65.0 73.4Low Income Economies 22.9 33.6 43.0 50.0 *Middle Income Economies 35.4 49.4 61.1 67.0 *High Income Economies 38.1 40.0 46.1 45.2 #

* : Data for 2004. # : Data for 2003.Source : World Economic Outlook, April 2007, IMF and World

Development Indicators, 2006, World Bank.

302


Table 8.8: Gross Foreign Assets and Liabilities

(US $ trillion)

Period Global Industrial Developing and EmergingEconomies Emerging Asia

Economies

1 2 3 4 5

1980-84 7.9 6.1 1.9 0.5 (67.5) (74.5) (52.8) (53.7)1985-89 16.4 13.5 2.9 1.2 (97.7) (107.7) (68.4) (102.2)1990-94 29.0 24.0 5.1 2.6 (120.2) (127.1) (95.9) (141.6)1995-99 50.7 42.1 8.7 4.5 (170.1) (183.0) (126.9) (162.7)2000-04 86.0 73.8 12.2 6.2 (250.0) (280.5) (150.6) (179.3)

Note : Figures in brackets represent percentage to GDP.Source : Lane and Ferretti (2006), On-line Database, IMF.

DTTs rose from 105 to 399, and other IIAs from 17 to86 during the same period. Asian countries areparticularly engaged as parties to approximately 40per cent of all BITs, 35 per cent of DTTs and 39 percent of other IIAs.

8.44 The East and South East Asian economies,in particular, have achieved significant integration dueto liberalisation of foreign trade and foreign directinvestment (FDI) regimes within the frameworks ofGATT/WTO and several bilateral regional cooperationagreements. The changing production structure alongwith the various policy measures in the form of tariffreductions and liberalisation of investment norms haveplayed an important role in improving the trade amongthe regions (Table 8.6). The resulting expansion oftrade and FDI has become the engine of economicgrowth and development in the region.

8.45 In the sphere of finance, the traditionalpostulate that the capital flows from the capital surplusdeveloped countries to the capital scarce developingcountries, seems to have been disproved in recentyears (Reddy, 2006b). Today, the world is confrontedwith the puzzle of capital flowing uphill that is, fromthe developing to the developed countries (Prasad etal., 2006). The world’s largest economy, the UnitedStates, currently runs a current account deficit,financed to a substantial extent by surplus savings orcapital exports from the developing and emergingmarket economies (Table 8.7). With rising incomesand increasingly open policies, developing andemerging market economies have become asignificant source of foreign direct investment, banklending and official development assistance (ODA)to other developing countries.

8.46 Trade and financial openness share morethan a complementary relationship. In absoluteterms, the level of integration of different countrygroups into global financial markets is measured as

the sum of gross international financial assets andliabilities (Prasad et al., 2006). While trade opennessat global level increased from an average of 37 percent of GDP during the 1980s to 61 per cent of GDPin 2006, financial openness, measured by grossforeign assets and liabilities as per cent to GDP,witnessed almost a four-fold increase from 68 percent in the early 1980s to 250 per cent during 2000-04. Though the level of integration into globalfinancial markets is clearly the largest for developedcountr ies, emerging market economies haveaccounted for the bulk of integration experienced bythe developing economies block (Table 8.8).

8.47 Global capital flows to developing and emergingmarket economies have seen a boom-bust cyclical

Table 8.6: Intra-regional Trade Share in Asia

(Per cent)

Reporter/Partner 1990 1995 2000 2005

1 2 3 4 5

Asia 47.0 54.9 54.8 58.7East Asia 30.2 37.1 38.1 42.6ASEAN+3 29.4 37.6 37.3 39.2Southeast Asia 18.8 24.0 24.7 28.1ASEAN 18.8 24.0 24.7 28.1SAARC 2.7 3.9 3.9 4.8South Asia 2.1 3.8 3.6 4.7

Source : Asia Regional Integration Centre, ADB.

Table 8.7: Global Current Account Balance

(US $ billion)

Period/Year World Advanced United Developing ChinaEconomies States & Emerging

Economies

1 2 3 4 5 6

1980s -68 -41 -78 -27 -11990s -85 -4 -122 -81 122000 -182 -268 -415 86 212001 -174 -213 -389 39 172002 -152 -229 -472 77 352003 -73 -221 -528 148 462004 -43 -255 -665 213 692005 -45 -473 -792 428 161

2006 -19 -563 -857 544 239 *

* : IMF Staff estimate.Source :World Economic Outlook, Online Database, April 2007, IMF.

303


pattern, typically reflecting a part of a larger process ofdevelopment of the global economy (Chart VIII.9).Lending and other forms of capital flows have tended tosurge when technological changes improvecommunications, growth is buoyant, trade is expanding,financial innovation is rapid and the political climate issupportive (World Bank, 2000). The underlying surge incapital flows to developing and emerging marketeconomies in recent years is led by the strong demandfor emerging market debt and equities, supported bysharp improvement in fundamentals in many EMEs andinvestors’ search for higher yields in an environmentwhere long-term interest rates remain low in majorindustrial countries (World Bank, 2006).

8.48 A key feature of global financial integrationduring the past three decades is the shift in thecomposition of capital flows to developing andemerging market economies. First, private sectorflows have outpaced official flows due to increasingliberalisation. Second, a shift has occurred in termsof components, from the dominance of debt flows inthe 1970s and the 1980s to foreign direct investment(FDI) and portfolio flows since the 1990s (Table 8.9).FDI flows have been determined by several push andpull factors, including strong global growth, softinterest rates in home countr ies, a generalimprovement in emerging market economies’ risks,greater business and consumer confidence, risingcorporate profitabil i ty, large scale corporaterestructuring, sharp recovery of asset prices andrising commodity prices. Trade and FDI openness hasencouraged domestic institutional and governance

reforms promoting trade and investment further. Thehope of better risk sharing, more efficient allocationof capital, more productive investment and ultimatelyhigher standards of living for all have also propelledthe drive for stronger regional connections of financialsystems across the world. In terms of overall financialflows, Asia has benefited from the surge in net capitalflows to emerging markets in recent years.

8.49 In any approach to the policies relating to thefinancial integration, it may be useful to consider bothquantitative and qualitative factors in such flows(Reddy, 2003). An important parameter of quality ofcapital flows relates to volatility of such flows. In thisregard, cross-country evidence on volatility of capitalflows over the period 1985-2004 shows that FDIinflows to developing and emerging economies havebeen relatively stable as compared with other typesof capital flows (Table 8.10). For instance, portfolioflows exhibited sharp variations, declining from thepeak of US $ 30 billion on an average during the 1993-97 to US $ 7 billion during 1998-2002, following aseries of crises in the South East Asia, the LatinAmerica, Russia, Argentina and Turkey.

Indian Context

8.50 As a result of policy measures undertakensince the early 1990s, India’s trade and financialintegration has grown with the global economy. Thisis evident from the significant increase in variousindicators of openness since the onset of reforms(Table 8.11). In terms of overall trade openness duringthe 1990s, the Indian economy was relatively lessdependent on external demand as compared withselect emerging market economies. However, India’strade openness was higher than some of theadvanced economies, including the US.

8.51 The increasing openness of the Indianeconomy to the external sector in recent years

Table 8.9: Capital Flows to Developing andEmerging Economies

(Per cent to total)

Period FDI Portfolio Debt Grants

1 2 3 4 5

1970s 14.9 0.0 71.8 13.31980s 16.4 0.3 65.7 17.61990s 41.5 7.0 37.4 14.22000-06 62.9 8.1 16.8 12.3

Note : 1. Data are period averages.2. Based on data on net capital flows.

Source : Global Development Finance 2006, World Bank.

304


1990-91). Since 2004-05, China has emerged as thethird major export destination for India after the USand the UAE. China has now become the largestsource of imports for India, relegating the US to thesecond position. India’s exports to China surged to7.4 per cent of India’s total non-oil exports (0.3 percent in 1991-92). Similarly, India’s imports from Chinaaccounted for 10.3 per cent of India’s total non-oilimports, a sharp increase from 0.2 per cent in 1991-92. This reflects growing trade relations between thetwo countries. A similar trend was noticeable vis-à-vis the ASEAN-5 (Singapore, Thailand, Malaysia,Indonesia and the Philippines). In recognition of thegrowing importance of Asian countries in India’sforeign trade, a series of nominal and real effectiveexchange rate indices released by the Reserve Bankwere revised a couple of years ago to include Chineserenminbi and Hong Kong dollar in the weightingscheme. With Japan already a part of the indices, therepresentation of Asian economies has increased tothree in the six-country real effective exchange rateindex. There has been an ongoing transformation inthe composition of production and trade as thecomparative advantage of many Asian economiescontinues to change in an environment of growingregional co-operation (Box VIII.5). In par ticular,economies with relatively high wage costs are shiftingtowards higher value-added products, including services.

8.52 In tandem with trade openness, India’s capitalaccount has witnessed a structural transformationsince the early 1990s, with a shift in the compositionfrom official flows to market-oriented private sectorflows (Table 8.12). After independence, during the firstthree decades, trade balance was financed by capitalaccount balance comprising mainly the official flows.During the 1980s, the dependence on official flowsmoderated sharply with private debt flows in the formof external commercial borrowing and non-residentIndian (NRI) deposits emerging as the keycomponents of the capital account.

8.53 Following the shift in emphasis from debt tonon-debt flows in the reform period, foreign investmentcomprising direct investment and portfolio flowsemerged as predominant component of capitalaccount. India’s FDI openness, as measured by FDIstock to GDP ratio, increased ten-fold from 0.5 percent in 1990 to 5.8 per cent in 2005. However, this isstill much lower than other emerging countries in Asia,including China (Table 8.13).

8.54 India has emerged as a major destination forglobal portfolio equity flows since the late 1990s. Onan average, India’s share was 24 per cent of total

Table 8.10: Volatility of Capital Flows (1985-2004)

Category FDI Equity Debt FDI andEquity

1 2 3 4 5

All Countries

Mean 0.85 0.98 0.76 0.80Median 0.77 0.98 0.66 0.75

Advanced economies

Mean 0.92 0.99 0.64 0.84Median 0.87 0.98 0.64 0.77

Emerging markets

Mean 0.75 1.07 0.85 0.71Median 0.76 1.00 0.67 0.66

Other Developing

Mean 0.89 0.65 0.80 0.87Median 0.77 0.70 0.70 0.77

Note : Volatility is measured by co-efficient of variation basedon data for the period 1985-2004.

Source : Kose et al., 2006.

Table 8.11: Select Indicators of India's Openness

(Per cent to GDP)

Year Merchandise Trade in Gross CapitalTrade* Goods and Transactions

Services# @

1 2 3 4

1990-91 14.6 17.2 12.11995-96 21.5 25.7 12.52000-01 22.5 29.2 21.62001-02 21.1 27.6 16.32002-03 23.3 30.7 16.12003-04 24.3 35.5 22.42004-05 29.3 40.4 24.22005-06 32.5 44.8 32.4

* : Merchandise exports plus imports as percentage to GDP atcurrent market prices.

# : Exports of goods and services plus imports of goods andservices as percentage to GDP at current market prices.

@ : Capital account receipts plus payments as percentage to GDPat current market prices.


characterises its expanding economic relationshipswith the rest of Asia. In recent years, the Asianeconomies are emerging as major trading partnersof India. Emerging Asian economies including China,Hong Kong, Indonesia, Korea, Malaysia, thePhilippines, Singapore and Thailand accounted for asignificant 24.1 per cent share in India’s total non-oilexports in 2005-06 (9.7 per cent in 1990-91) and 27.8per cent of India’s non-oil imports (11.5 per cent in

305


After the South East Asian crisis of 1997, the geographic scopeof cooperation initiatives is expanding across sub-regions ofAsia. East Asian economies have embarked on variousinitiatives for regional monetary and financial cooperation. Themajor initiatives for regional cooperation in Asia includeASEAN+3, Chiang Mai Initiative, Executives’ Meeting of EastAsia- Pacific Central Banks (EMEAP), Asian Bond MarketInitiative and Asian Bond Fund. The countries of ASEAN –Brunei Darussalam, Cambodia, Indonesia, Laos, Malaysia,Myanmar, the Philippines, Singapore, Thailand and Vietnam –and India have entered into a Framework Agreement oncomprehensive economic cooperation. The ASEAN hasembarked on a process to expand economic cooperation withits neighbours in the north, namely China, Japan and SouthKorea (ASEAN+3). As far as India’s association with ASEANcommunity is concerned, currently India is not a full-fledgedpart of the ASEAN network but holds a regular summit with theASEAN. However, in the years ahead, it is envisaged thatASEAN+3+3 network1 would help India to share and cooperateon various financial issues as the present network of ASEAN+3has been consistently engaging in economic policy dialogue ofunprecedented scope and depth.

Another instance of central banking cooperation in Asia existsin the form of reciprocal currency or swap arrangements underthe Chiang Mai Initiative2 . The ASEAN Swap Arrangement(ASA) was created primarily to provide liquidity support tocountries experiencing balance of payments difficulties. TheFinance Ministers of ASEAN+3 announced this initiative in May2000 with the intention to cooperate in four major areas, viz.,monitoring capital flows, regional surveillance, swap networksand training personnel.

A more explicit central banking cooperation has been existingin the form of EMEAP since 19913. The ongoing work of EMEAPseeks to further strengthen policy analysis and advice withinthe region and encourage co-operation with respect tooperational and institutional central banking issues. EMEAPcentral banks have actively coordinated on issues relating tofinancial markets, banking supervision and payment andsettlement systems. The Asian Bond Fund (ABF) initiative ofthe EMEAP Group has been one of the major initiatives aimedat broadening and deepening the domestic and regional bondmarkets in Asia. The initiative has been in the form of ABF1and ABF2. In the near term, the ABF2 Initiative is expected tohelp raise investor awareness and interest in Asian bonds by

Box VIII.5Initiatives on Regional Integration in Asia

providing innovative, low-cost and efficient products in the formof passively managed bond funds. More and more similar kindsof index-driven private bond funds are rapidly emerging in Asia.At present, India does not contribute in the ABF. The informalmeeting organised by Asia Cooperation Dialogue (ACD) is,however, attended by participant central banks including India,to discuss promotion of supply of Asian Bonds. The Governmentof India has given a commitment on participation in the ABF2to the tune of US$ 1 billion.

SEANZA and SEACEN4 are the oldest initiatives in central bank

cooperation in Asia. The SEANZA, formed in 1956, promotescooperation among central banks by conducting intensivetraining courses for higher central banking executive positionswith the objective to build up knowledge of central banking andfoster technical cooperation among central banks in the SEANZAregion. The SEACEN provides a forum for member central bankgovernors to be familiar with each other and to gain deeperunderstanding of the economic conditions of the individualSEACEN countries. It initiates and facilitates co-operation inresearch and training relating to the policy and operationalaspects of central banking, i.e., monetary policy, bankingsupervision and payments and settlement systems.

Asian Clearing Union (ACU), an arrangement of central bankingcooperation, is successfully functioning since 1974 for multilateralsettlement of payments for promoting trade and monetarycooperation among the member countries5. Since 1989, the ACUhas also included a currency swap arrangement among itsoperational objectives. The SAARCFINANCE, established inSeptember 1998 is a regional network of the SAARC CentralBank Governors and Finance Secretaries which aims atstrengthening the SAARC with specific emphasis on internationalfinance and monetary issues6. India has been very activelyparticipating in SAARCFINANCE activities.

The clearest evidence of Asian countries’ desire to forge closereconomic relationships is the proliferation of Free TradeAgreements (FTAs). By 2006, there were more than 30 FTAsunder negotiation in East Asia alone. Increasingly, theseagreements are also deeper, extending to areas beyond justtariff reduction. An example is the recently signed India-Singapore comprehensive economic cooperation agreement,which covers not only trade in goods, but also services,investments and cooperation in technology, education, airservices and human resources.

1 India, Australia and New Zealand are included in ASEAN+3+3.2 Under this Initiative, the total resources available are currently estimated to be around US$ 75 billion (up from less than US$ 40 billion in May

2005), reflecting the renegotiation of most Bilateral Swap Agreements (BSAs).3 Members are the central banks of Australia, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore

and Thailand.4

The SEANZA refers to South East Asia, New Zealand and Australia. The SEACEN refers to South East Asia Central Banks.5 At present, its membership includes eight members including India, Islamic Republic of Iran, Nepal, Pakistan and Sri Lanka being the founder

members (Myanmar, Bangladesh and Bhutan joined later).6 SAARCFINANCE members are India, Pakistan, Sri Lanka, Bangladesh, Bhutan, Maldives and Nepal. It is a permanent body, which got formal

recognition of SAARC at the 11th SAARC Summit, held in Kathmandu, Nepal in January 2002.

306


Table 8.13: FDI Openness : Select Countries

(Per cent to GDP)

Country 1990 1997 2003 2004 2005

1 2 3 4 5 6

China 5.4 17.1 16.2 14.9 14.3Hong Kong 59.4 143.6 239.2 275.2 299.9India 0.5 2.5 5.2 5.7 5.8Indonesia 7.7 14.6 5.0 7.0 7.7Korea 2.0 3.0 9.0 9.2 8.0Malaysia 23.4 42.3 40.4 37.2 36.5Pakistan 3.6 14.1 8.7 8.8 8.8Philippines 7.4 10.2 15.2 14.9 14.4Singapore 82.6 78.4 160.2 156.2 158.6Sri Lanka 8.5 12.2 11.2 11.3 10.4Thailand 9.7 8.8 33.3 32.9 33.5

Note : FDI openness is measured in terms of FDI stock aspercentage of GDP

Source : On-line FDI Database, United Nations Conference onTrade and Development (UNCTAD).

Table 8.12: India’s Trade and Capital Accounts

(US $ million)

Period Trade Current Capital Major Components of Capital Account

Balance Account Account External Foreign Commercial NRI Deposits

Balance Balance Assistance Investment Borrowing

1 2 3 4 5 6 7 8

(Annual Average)

1950s -489 -265 126 106 29 0 01960s -938 -831 845 852 48 0 01970s -1,303 -29 615 662 37 114 851980s -7,363 -4,414 3,932 1,487 349 1,044 1,1351990s -10,356 -4,368 7,822 1,515 3,390 1,778 1,3282000s -22,331 1,584 16,290 -71 12,010 1,080 2,2532003-06 -33,087 809 23,402 346 17,036 1,820 1,822

Source: Reserve Bank of India.

portfolio flows to all developing countries during 1999-2005 (Chart VIII.10). The geographical sources ofportfolio investment inflows show a country’s globaland regional financial linkages. The IMF CoordinatedPortfolio Investments database 2005 showed that themajor source of India’s portfolio investment stock wasthe US (33.4 per cent), followed by Mauritius (32.6per cent), Luxembourg (9.3 per cent), the UK (8.6per cent), Spain (3.2 per cent) and Singapore (2.8per cent).

8.55 Financial market integration has assumedadded significance in the recent period as capital hasbecome more mobile across countries with reductionin capital controls and improvement in technologicalinfrastructure. This is reflected in increasing co-movements in interest rates, bond yields and stock

indices. The bond yield differential in Asia hasnarrowed down in an environment of improvedmacroeconomic fundamentals and lower inflation inthese economies. Evidence from pr ice-basedmeasures of financial integration suggests increasingfinancial markets integration in Asia.

8.56 Stock markets in Emerging Asia show a highdegree of correlation with several countries in theregion, barring China (Table 8.14). In the region,Japan, Hong Kong and Singapore are the maindr ivers. The Indian stock market showed highcorrelation with Asian stock markets, barring Chinaand Korea. Moreover, correlation of India’s stockmarket with Japan, Hong Kong and Singapore was

307


Table 8.14: Regional Stock Market Return Correlation

Country China Hong Kong India Indonesia Japan Korea Malaysia Philippines Singapore Thailand

1 2 3 4 5 6 7 8 9 10 11

China 1.00Hong Kong 0.48 1.00India 0.46 0.93 1.00Indonesia 0.26 0.87 0.80 1.00Japan 0.41 0.86 0.86 0.72 1.00Korea -0.03 0.44 0.45 0.57 0.60 1.00Malaysia 0.26 0.65 0.56 0.81 0.57 0.70 1.00Philippines 0.26 0.87 0.80 0.86 0.78 0.43 0.58 1.00Singapore 0.30 0.93 0.85 0.91 0.85 0.65 0.74 0.92 1.00Thailand 0.53 0.64 0.65 0.61 0.52 0.36 0.66 0.44 0.59 1.00

Note : Based on monthly data for the period 2003-2005.Source : Regional Integration Database, Asian Development Bank.

7 An empirical exercise was carried out using Johansen's co-integration analysis, which showed that stock indices could be integrated withinthe vector error correction model framework involving five-day lag order. In the bi-variate framework, stock indices could be positivelycorrelated. In the multivariate framework, using daily data during January 2000-September 2006, it was found that the cointegrating vectorcould be characterised with opposite sign of the coefficients of global and regional stock indices.

higher than with some of the other Asian countriesincluding, China, Korea, Malaysia and Thailand.

8.57 The international linkage of India’s stock markethas been enhanced with listing of Indian companies insome of major stock exchanges. In the US NASDAQ,12 major Indian companies are listed. These companiesaccount for about 20 per cent weight in the BSE Sensex.In the London Stock Exchange, 50 companies includingeight major companies in the BSE Sensex and theothers in BSE 200 are listed. Empirical evidencesuggests that movements in the BSE Sensex arepositively correlated with the indices in the US, theUK. In a multivariate framework, co-integrationanalysis involving the BSE Sensex, the major stock

markets such as the US, the UK and Japan andregional stocks suggested the existence ofopportunities for portfolio diversification by investors,particularly, foreign investors operating in the regionalas well as global markets7.

8.58 In general, money and bond market segmentsin Asia showed lower degree of correlation ascompared with stock markets. Within countries, bondand money market correlation was negative in manycountr ies, implying that these markets remainsegmented in the region (Tables 8.15 and 8.16). TheIndian money market showed high correlation withIndonesia, but modest correlation with Hong Kong,Korea and Thailand. India’s money market correlation

Table 8.15: Regional Money Market Correlation

Country China Hong Kong India Indonesia Japan Korea Malaysia Philippines Singapore Thailand

1 2 3 4 5 6 7 8 9 10 11

China 1.00Hong Kong -0.43 1.00India -0.24 0.55 1.00Indonesia -0.28 0.47 0.81 1.00Japan 0.02 0.10 -0.01 -0.04 1.00Korea 0.01 -0.08 0.50 0.77 -0.22 1.00Malaysia -0.15 0.18 0.41 0.47 0.09 0.39 1.00Philippines -0.13 -0.28 -0.46 -0.12 0.07 0.04 -0.10 1.00Singapore -0.30 0.80 0.26 0.06 0.29 -0.49 -0.02 -0.31 1.00Thailand -0.44 0.90 0.50 0.38 0.27 -0.22 0.13 -0.24 0.92 1.00

Note : Based on monthly data for the period 2003-2005. Money market rates refer to inter-bank segment.Source : Regional Integration Database, Asian Development Bank.

308


Table 8.16: Regional Bond Market Correlation

Country Hong Kong India Indonesia Japan Korea Malaysia Philippines Singapore Thailand

1 2 3 4 5 6 7 8 9 10

Hong Kong 1.00India -0.49 1.00Indonesia 0.43 0.17 1.00Japan 0.30 -0.04 0.21 1.00Korea 0.59 -0.33 0.57 -0.12 1.00Malaysia -0.05 -0.30 -0.38 0.56 -0.34 1.00Philippines -0.48 0.15 -0.48 0.22 -0.75 0.53 1.00Singapore 0.66 -0.73 0.11 0.32 0.37 0.25 -0.31 1.00Thailand 0.09 0.39 0.55 0.53 0.19 0.18 0.03 -0.04 1.00

Note : Based on monthly data for the period 2003-2005. Bond market rates are yields for domestic 10-year sovereign bonds.Source : Regional Integration Database, Asian Development Bank.

with Singapore was positive but low, while it remainednear zero with Japan and negative with the Philippinesand China. The integration of India’s money and bondmarkets with Asian countries, in the absence of flowsacross markets, could be attributable, inter alia, torelative strength of India’s financial markets, commonparticipation of foreign institutional investors in theregion, emergence of several dedicated funds forinvestment in India floated by international investorsin the Asian region and the existence of offshore marketfor non-deliverable forwards, especially in Japan andsome of the emerging Asian economies.

8.59 To sum up, past two decades have witnessedrapid increase in the pace of globalisation, led bygrowing participation of developing and emergingeconomies. Financial integration has outpaced tradeintegration. Cross-border flows of real and financialcapital have increased sharply, reflecting the declinein the degree of home bias in capital markets.Regional integration in Asia has improved significantlydue to liberalisation measures, formation of severalregional cooperation agreements and strongereconomic activity in the region. The sharp increasein intra-regional trade indicates that regionaleconomies are better integrated. Regional financialintegration is manifested in the price co-movementsin the stock, the money and the bond markets. Stockmarkets in the Asian region are better correlated thanthe bond and the money markets.

8.60 India’s integration with the world economy hasincreased significantly in terms of trade openness andfinancial integration. Tariff liberalisation and removalof non-tariff barriers have contributed to India’s tradeintegration at global and regional levels. India’s capitalaccount has witnessed a structural transformationduring the reform period with cross-border non-debt

creating private capital flows, emerging as a majorcomponent. India is now a major destination for globalportfolio equity flows suggesting growing confidenceof foreign investors in the Indian economy andfinancial markets.

8.61 At the regional level, India’s trade links withAsia are growing at a rapid pace, spurred by tradelinks with China and South-East Asian countries.Also, India’s financial integration with the Asianregion has occurred through the linkage of regionalstock markets and through modest correlation ofbond and money markets.

V. THE WAY FORWARD

8.62 Integrated financial markets are a key elementin the transmission process and hence for the smoothconduct of monetary policy. Financial integration alsoleads to a better diversification of risks and makes apositive contribution to financial stability by improvingthe capacity of economies to absorb shocks. On theother hand, fully integrated financial markets alsopave the way for shocks to propagate more quicklyamong market participants, which could necessitateappropriate safeguards. To mitigate the risks andmaximise benefits from financial integration, it isimperative that the financial markets are developedfur ther. Enhanced co-operation among variousregulatory authorities is also important for ensuringeffective corrective action in an increasingly integratedenvironment. Further, it is necessary to establishfurther linkages amongst the various components offinancial infrastructure – the trading, payment,clearing, settlement and custodian systems.

8.63 As internat ional exper ience suggests,integration of the four major segments of the financial

309


market in India, viz., the money, the foreignexchange, the government securities and the creditmarket segments depends on the conditions suchas (i) the ability of market participants to buy andsell (including short-sale) a wide array of cashinstruments, subject to applicable restrictions suchas those required under mandated capital charge;(ii) the ability of market participants to lend andborrow funds as also securities; (iii) the ability ofmarket participants to trade in derivative instrumentsin foreign exchange, interest rate and credit; and (iv)the ability of market participants to arbitrage betweencash and derivatives instruments. Developments inthese areas will have to be calibrated with those inoverall market development, insti tut ionalsophistication, evolving needs of the real economyand capacity of market participants. Furthermore, foremergence of an integrated yield curve to serve asa benchmark for pricing of all cash and derivativeinstruments, it is essential that, apar t from thegovernment securities market, there should be (a) aterm money market; (b) an interest rate futuresmarket; and (c) an interest rate swap market.

8.64 Financial markets in India have come a longway and are gett ing increasingly integrateddomestically and globally. Reform measures in termsof free pricing, removal of barriers to flows andbroad-based participation have yielded results interms of fairly high degree of integration of the moneymarket, the government securities market and theforeign exchange market, although in varyingdegrees. The money market and the foreignexchange market are reasonably well integrated,which is reflected in the high correlation coefficientsbetween various money market rates and forwardpremia. The inter-linkage between the domesticmoney and international markets has also increasedas is reflected in the increasing impor tance ofinterest rate differentials in the determination offorward premia. In general, the interest ratedifferential between the domestic money andinternational markets motivates market participantsto shift funds between the markets. Thus, interestarbitrage links the domestic and international moneymarkets and the forward markets.

8.65 The domestic credit market is also gettingincreasingly integrated with the international capitalmarket as large and creditworthy borrowers havebeen raising large resources by way of externalcommercial borrowings. Such corporates are,therefore, less constrained by domestic creditconditions. Raising of resources by banks, the major

players in the credit market, by way of externalcommercial borrowings, albeit within limits, has alsointegrated the domestic and international creditmarkets. The money market and the governmentsecurities market are also integrated as changes inmoney market rates are quickly transmitted togovernment securities yields. The linkage betweenthe money market and the credit market also existseven as some stickiness has been observed in thelending interest rate structure. The inter-linkagesbetween the credit market and the bond market arealso growing through asset securitisation by banks.However, the inter-linkages between the equitymarket on the one hand, and the money, the foreignexchange and the government securities markets onthe other, are still weak. The term money market andthe private corporate debt market are missing linksin the Indian financial markets. There is not muchactivity in the public issue segment of the corporatedebt market, despite avai labi l i ty of goodinfrastructure, a vibrant equity market and areasonably developed government securities market.In the corporate debt market, the issuers prefer thepr ivate placement segment, which lackstransparency and deprives the retail investor fromparticipating in the debt market. While the need is tofurther deepen and widen the various segments,which would facilitate better inter-linkages amongthem, some specific measures that could strengthenthe integration process among various marketsegments are detailed below.

Term Money Market

8.66 A developed term money market is necessaryfor the development of a money market yield curve.This, in turn, would facilitate the development of thederivative market and the integration of the foreignexchange market and the domestic currency market.Given the critical role the term money market can playin the development of other segments, concertedefforts need to be made to develop the term moneymarket in India.

Domestic Institutional Investors

8.67 Although integration of the equity market withother segments has to emerge from the marketoriented process, the need is felt to enhance the roleof various domestic institutional investors such asbanks, pension and provident funds in the equitymarket, subject to certain prudential limits as detailedin Chapter VII. This would help in facilitating better

310


inter-l inkages of the equity market with othersegments, apar t from developing domesticinstitutional investors as a counterweight to FIIs.

Promoting Secondary Markets for various Instruments.

8.68 For effective financial market integration, itis essential that there exist secondary segments fortrading of various instruments to provide liquidity andenable efficient r isk pr icing in var ious marketsegments. The secondary segment is nearly absentfor financial instruments such as certificates ofdeposit (CDs), commercial paper (CP) and corporatebonds. For instance, CDs are issued by banks duringperiods of tight liquidity at relatively higher interestrates (as compared with term deposits). Due tohigher interest rate on CDs, subscribers find itprofitable to hold CDs till maturity. As a result, thesecondary market for CDs has been slow to develop.Similarly, the market for CP is driven by the demandfor this instrument mainly by mutual funds whoseassets under management have increased manifoldin recent years. The price of CP usually rangesbetween some representative money market rate andthe scheduled commercial bank’s lending rate,representing the opportunity cost of funds. Mutualfunds hold CP till maturity, leading to a subduedsecondary segment for such instruments. In mostinternational markets, the CP is issued on a short-term basis with a rollover facility. This facility,however, is not allowed in the Indian CP market. Thesecondary market turnover for non-governmentcorporate debt securities has remained insignificant.For instance, the secondary market turnover for non-government corporate debt securities accounted forabout two per cent of total turnover for the debtmarket in the National Stock Exchange of India Ltd.Concerted efforts, therefore, need to be made todevelop the secondary markets, wherever they donot exist. The need is to widen the investor base sothat divergent views emerge, which would help increating liquid secondary markets. The need is alsofelt to incentivise market participants to acquire skillsso that they are able to take a forward looking viewof emerging macroeconomic scenario and are, thus,encouraged to trade.

Private Corporate Debt Market

8.69 Though corporate bond yields exhibit co-movement with yields on benchmark governmentsecurities, empirical evidence suppor ts marketimperfection affecting price development in the

corporate bond segment, which is the leasttransparent and illiquid segment of the financialmarket. As mentioned earlier, the corporate bondmarket also lacks a secondary segment. The issuesrelating to the development of the corporate bondmarket have been addressed comprehensively bythe High Level Committee on Corporate Bond Marketand Securitisation (Chairman: Dr. R. H. Patil). In orderto develop and integrate the corporate bond marketwith other markets, corporate bonds have to becomereally tradable instruments. For this purpose, anelevated and significant level of reforms will beneeded on the basis of recommendations of the HighLevel Committee and other measures as detailed inChapter VII.

Key Role of Government Securities Market in FinancialMarket Integration

8.70 The government securities market holds thekey to better integrated financial markets. Interestrates in government securities serve as a risk freebenchmark for the purpose of asset valuation in othermarkets. Thus, well-functioning and deep governmentsecurities market is a necessary condition forintegration of financial markets. In the governmentsecurities market, turnover in the secondary segmenthas declined in the recent period. While this could betermed as a cyclical development reflecting banks’por tfolio rebalancing through reduction of SLRholdings to stipulated levels in an environment of highcredit demand and rising interest rates, it is critical torecognise that the persistence of such a trend couldpose r isks to the price discovery process andintegration of financial markets. Efforts to sustain theturnover in this segment warrant the formulation of aclear strategy. Turnover in this segment is dominatedby Central Government securities. Initiatives topromote trading in other securities, particularly, StateGovernment securities, could be helpful for marketdevelopment. To impart liquidity to the governmentsecurities market, the investor base also needs to bewidened. There is also a need to consider variousother measures as detailed in Chapter VI.

Securitisation

8.71 Securitisation is gaining acceptance as oneof the fastest growing and most innovative forms ofasset financing in the global capital market. Assetsecur it isation could play an impor tant role inpromoting integration of the credit market and the debtmarket in India. Securitisation increases the numberof debt instruments in the market. In the case of

311


securitisation, the price of a securitised instrumentwould tend to converge with the price of a bond.Securitisation, by creating marketability, generatesliquidity in the otherwise illiquid portfolio of loan assetsof lenders. It also furthers the growth of the bondmarket by providing investment avenues to investorssuit ing their r isk-return profi les. It, therefore,complements the bond market. In the Indian context,the securitisation market has witnessed a significantgrowth in recent years. This, therefore, should help infurthering the development of the bond market. Theinternational experience shows that the creditappraisal and documentation process in the handsof the loan originator could be lax, which, in turn, couldlead to loss of investor confidence in such instruments.Since securitisation essentially involves repackagingof a pool of a large number of relatively small-sizedloan receivables, any reassessment by the market ofcredit risk of the pool has the potential to causevolatility in prices. Therefore, care would need to betaken to ensure that appropriate credit appraisal anddocumentation process is followed at the time oforigination of loans.

Derivatives Market

8.72 Financial derivatives have played a major rolein the development of financial markets and theirintegration across several economies, especially indeveloped countr ies, in the last two decades.Derivatives serve to achieve a more complete financialsystem because previously fixed combinations of therisk properties of loans and financial assets can bebundled and unbundled into new synthetic assets. Forinstance, structured products or synthetic derivativescould be created by adding elementary assets orunderlying assets such as bonds, stocks (or equities)and borrowing and lending instruments with acombination of derivative products such as put andcall options. Repackaging risk properties in this waycan provide a more perfect match between aninvestor’s risk preferences and the effective risk ofthe portfolio or cash-flow. Derivatives allow individualrisk elements of an asset to be priced and tradedindividually, thus, ensuring an efficient price systemin the asset markets. In the Indian context, derivativeinstruments are available in the foreign exchangemarket, the money market and the equity market. Inthe foreign exchange market, the instruments areavailable in the form of currency forwards, swaps andforward rate agreements (FRAs) and rupee options.Though some of the derivative instruments haverecorded growth in recent years, the derivative

markets continue to face various rigidities on accountof (i) lack of credible term money benchmark; (ii) lackof significant participation by large players such aspublic sector banks, mutual funds and insurancecompanies; (iii) absence of cash market for floatingrate bonds; and (iv) lack of transparency in price andvolume information. It would be desirable to addressthese issues in future for the development of thederivatives market in India. Thus, the widening ofpar t icipation and enhancing the depth of thederivatives market by allowing several products couldcontribute to greater inter-linkages amongst thevarious financial market segments.

8.73 Since its emergence in the early 2000, theinterest rate swap market in India has grownsignificantly both in terms of volumes and participants.In the absence of a term money market, choice of atransparent benchmark for the floating rate in swapdeals has all along been an issue. Much like whathappened under similar conditions in some otheremerging countries, the market devised the so-calledMIFOR swaps that use a synthetic benchmark moneymarket rate, derived from LIBOR and the US $/Rupeeforward margin. Impressive growth of the interest rateswap market notwithstanding, the r isk freegovernment securities yield curve and the swapcurves are not integrated at present. The swap curveshave often traded below the government securitiescurve. Volatility of swap rates in response to changesin short-term rates, has, at times, been higher thanyields on government securities. Some policy actionsthat would result in integration of the governmentsecurities yield and swap rates include progressivereduction in SLR, more flexibility with regard to shortsale, securities financing arrangements and more openregime in respect of arbitrage between the curves.

Technology Platform

8.74 Integration of financial markets is greatlyenhanced with an integrated payment, clearing andsettlement infrastructure. The Reserve Bank has beenworking closely with market participants to improvethe infrastructure of financial markets. Payment andsettlement systems, which constitute the backboneof the financial economy, aim at minimising thesystemic risk. The payment system influences thespeed, financial r isk, reliability and the cost ofdomestic and international transactions. With thesignificant improvements in payment and settlementsystems, depth and liquidity of various segments ofthe financial market have improved. Nevertheless, itis to be recognised that not all trading is done through

312


the technology platform introduced and over-the-counter (OTC) trading continues. There is, therefore,need to enhance participation through the technologyplatform. The widening of par ticipation throughtechnology platform would reduce the settlement cycleand contribute to faster integration of markets.

Appropriate Risk Management Strategies

8.75 Greater international f inancial marketintegration exposes domestic markets to certain risksand contagion. For instance, global f inancialimbalances, growing sophistication of financial marketparticipants and the proliferation of complex andhighly leveraged financial instruments, including creditder ivatives and structured products such ascollateralised debt obligations, could heighten volatilityin the f inancial markets. Thus, with growinginternational integration, there would be a need to bevigilant about the risk profile of financial intermediariesand their vulnerability to abrupt market price shocks.This under l ines the need for appropr iate r iskmanagement strategies as also greater coordinationand information sharing among central banks toprevent the transmission of adverse developmentsabroad to the domestic economy and markets.

VI. SUMMING UP

8.76 Domestic financial market integration in Indiahas been largely facilitated by wide-ranging financialsector reforms introduced since the early 1990s.Financial markets in India have acquired greater depthand liquidity. In the process, various market segmentshave also become better integrated over the years. Ahigh degree of correlation between the long-termgovernment bond yield and the short-term TreasuryBills rate indicates the significance of the term-structure of interest rates in financial markets.Integration of the foreign exchange market with themoney and the government securities markets hasfacilitated liquidity management by the Reserve Bank.However, the equity market has relatively lowcorrelation with other market segments. A sharp

improvement in correlation between the reverse reporate and money market rates in recent years impliesenhanced effectiveness of the monetary policytransmission mechanism.

8.77 A key feature of global financial integrationduring the past three decades has reflected in theshift in the composition of capital flows to developingand emerging market economies, especially fromofficial to private flows. Regional integration hasserved as a major catalyst to the global integrationprocess during the past two decades. East and SouthEast Asian economies, in particular, have achievedsubstantial integration. Apart from Asia’s growingintegration with the rest of the world, increasingintegration within Asia also reflects the growing intra-regional trade and financial flows. Evidence fromprice-based measures suggests that financial marketintegration in Asia has been increasing. The stockmarkets in Asia are more integrated than the moneyand the bond markets. In the region, Japan, HongKong and Singapore serve as the nodal centres forother stock markets.

8.78 There is evidence of India’s growinginternational integration through trade and crossborder capital flows. India’s trade and financial linkswith Asia are also growing amidst recent initiativestaken to promote regional cooperation. Emerging Asiahas become the ‘growth centre’ of the world due toshifting of production base to the region. This is likelyto stimulate greater financial integration in the region.India’s financial integration within the region and withthe international f inancial markets is l ikely toincrease in future in view of its robust growthprospects. However, if benefits are to be maximisedfrom a more integrated economy, the need is topursue efforts towards a greater sophistication offinancial markets and financial market instrumentsthat allow risks to be shared more broadly and capitalto flow into the most productive sectors. There wouldalso be a need to constantly review the r iskmanagement practices so that financial institutionsand financial markets continue to remain resilient toadverse external developments.

OVERALL ASSESSMENTIX

9.1 Deep and liquid financial markets play a keyrole in allocating resources in an efficient manneramong competing uses in an economy, therebycontributing to productivity gains and higher economicgrowth. Absence of well-developed domestic financialmarkets can lead to mispricing of risks, misallocationof resources and higher intermediation costs. Thiscould, in turn, lead to a preference for physical assetsover financial assets, preference for foreign currencydenominated assets vis-à-vis domestic currencydenominated assets, credit and investment booms,matur ity mismatches, overdependence uponinternational financial markets, currency mismatches,and excessive external debt culminating in periodiccrises. In view of the critical role played by the financialmarkets in financing the growing needs of varioussectors of the economy, it is important that financialmarkets are fully developed and well-integrated.

9.2 Deep and liquid financial markets contributeto efficient price discovery in various segments of thefinancial market. Well-integrated markets improveeff icacy of policy impulses by enabling quicktransmission of changes in the central bank’s short-term policy rate to the entire spectrum of market rates,both short and long-term, in the money, the creditand the bond markets. Market integration, throughinterest parity conditions, also links the foreignexchange market with other segments of the market.Thus, changes in the central banks’ policy rates can,through variations in domestic money market interestrates, impact the exchange rates, which, in turn,impact the real economy. Similarly, movement inpolicy interest rates can influence other asset marketssuch as equity and proper ty pr ices, fur therstrengthening the monetary transmission. In case,markets are weakly integrated, the central bank’sinterest rate signals will not have the desired impacton other short and long-term interest rates, theexchange rate and other asset prices. In such ascenario, the central bank would need to act in varioussegments of the market to achieve the desiredobjectives. In br ief, the greater the degree ofintegration across market segments, the stronger isthe transmission of monetary policy to the spectrumof financial markets and on to the real economy. Byenabling dispersion of shocks and risks to a particularsegment across all markets, well-integrated markets

can also contribute to financial stability. Given the keyrole of expectations, financial markets help in inter-temporal dispersal of risks through derivative markets.However, various benefits emanating from theworking of the financial markets depend critically uponthe resilience of various segments of the market towithstand shocks and the strength of the r iskmanagement systems in place.

9.3 In recognition of the critical role of the financialmarkets, the onset of the structural reforms in theearly 1990s in India also encompassed a process oftheir phased and coordinated deregulation andliberalisation. Financial markets in India in the periodbefore the early 1990s were marked by administeredinterest rates, quantitative ceilings, statutory pre-emptions, captive market for government securities,excessive reliance on central bank financing, peggedexchange rate, and current and capital accountrestrictions. The reforms have enabled the transitionto a regime characterised by market-determinedinterest and exchange rates, price-based instrumentsof monetary policy, current account convertibility,substantial capital account liberalisation and vibrantgovernment securities and capital markets. Variousreform measures have improved the depth andliquidity of several segments, while also leading totheir increased integration. Enhanced integration offinancial markets allows risks to be shared morebroadly and facilitates the flow of capital to theproductive sectors. These developments have, in turn,facilitated the implementation of monetary policy whilemeeting the financing needs of the various sectorsof the economy, and providing a conduciveenvironment for under taking foreign exchangetransactions.

9.4 Deregulation, liberalisation and globalisationof financial markets pose several risks to financialstability. The East Asian crises of the 1990s as wellas the developments in Turkey and Iceland during2006 indicate that global financial markets canexacerbate domestic vulnerabilities. In view of thesepossible destabilising factors from cross-borderdevelopments, liberalisation of domestic financialmarkets in India has been accompanied withprudential safeguards. This approach to developmentand regulation of financial markets has imparted

314


resilience to the financial markets, vividly reflected intheir ability to withstand exogenous shocks such asfinancial crises in Asia, Brazil and Russia, 9/11terrorist attacks in the US, border tensions, sanctionsimposed in the aftermath of nuclear tests, politicaluncertainties, and the current oil shock.

9.5 The earlier chapters in this Report have dweltat length with the phased process of transformationof the var ious f inancial market segments, anassessment of the outcome, and the road ahead. Asdocumented in the preceding chapters, the phasedand the sequenced approach to reforms since theearly 1990s has led to substantial improvement indepth, l iquidity and integration of the var ioussegments of the f inancial market. Thesedevelopments have (i) improved price discovery andenabled the switch from direct, quantitat iveinstruments to more efficient price-based indirectinstruments of monetary policy; (ii) strengthenedmonetary transmission; and (ii i) enhanced thecapacity of the domestic f inancial markets towithstand exogenous shocks. Nonetheless, it isrecognised that domestic financial markets need todevelop further, especially in order to support therecent acceleration in the growth momentum of theIndian economy. Financial markets would also needto be developed and integrated further in the contextof the envisaged move towards fuller capital accountconvertibility, developing a diversified financialsystem, and maximising gains and minimising costsof financial integration. This concluding chapterattempts to summarise the key findings of the analysiscontained in the preceding chapters, noting both theprogress made so far and the road ahead.

MONEY MARKET

9.6 The Reserve Bank has accorded pr imeattention to the development of the money market asit is the key link in the transmission mechanism ofmonetary policy to financial markets and finally, tothe real economy. In the past, development of themoney market was hindered by the system ofadministered interest rates, directed credit, and lackof proper accounting and risk management systems.With the onset of reforms and the transition to indirect,market-based instruments of monetary policy in the1990s, the Reserve Bank made conscious efforts todevelop an efficient, stable and liquid money marketby creating favourable policy environment throughappropriate institutional changes, instruments,technologies and market practices. These policyinitiatives over time have led to the development of a

relatively deep, liquid and vibrant money market inthe country.

9.7 In line with the transition in the operatingprocedures of monetary policy, the l iquiditymanagement operations of the Reserve Bank havebeen fine-tuned to impart greater flexibility andenhance the signalling effectiveness of the monetarypolicy stance. Under the monetary targeting regimeadopted between the mid-1980s and the second halfof the 1990s, bank reserves became the operatingtarget in the conduct of monetary policy. In thismechanism, reserve requirements played a dominantrole in the liquidity management operations of theReserve Bank. Subsequently, the introduction offinancial sector reforms in the early 1990s placedgreater emphasis on the market mechanism. Thiscalled for the dismantling of the administered interestrate structure and reactivation of the indirectinstruments of monetary policy, which, in turn,necessitated the active development of the moneymarket. Concomitantly, the increasing financialinnovations in the wake of greater openness of theeconomy necessitated the transition from monetarytargeting to a multiple indicator approach in 1998 withgreater reliance on rate channels for monetary policyformulation. Accordingly, short-term interest rateshave emerged as a key instrument of monetary policy.

9.8 Beginning June 2000, the liquidity adjustmentfacility (LAF), with daily repo and reverse repooperations, has emerged as the principal tool ofliquidity management. However, in view of sustainedand large capital flows, well in excess of the currentaccount deficit, money markets have been mostlycharacterised by surplus liquidity conditions. In orderto insulate domestic monetary conditions from theimpact of large capital flows, the LAF window wasaugmented with the issuances under the marketstabilisation scheme (MSS) in April 2004 to absorbliquidity of relatively more enduring nature along withthe flexible use of the cash reserve ratio. Liquiditymanagement has turned out to be more complex inthe recent period on account of greater variation inmarket liquidity not only on account of pressuresemanating from large external flows, but also due tolarge variations in cash balances of the Government.These developments in the liquidity conditions havenecessitated a judicious use of various instrumentsby the Reserve Bank.

9.9 In line with the objective of widening anddeepening the money market and imparting greaterliquidity to the market for facilitating efficient pricediscovery, new instruments, such as collateralised

315

OVERALL ASSESSMENT

lending and borrowing obligation (CBLO), have beenintroduced. Money market instruments such asmarket repo and CBLO have provided avenues fornon-banks to manage their shor t-term liquiditymismatches and facilitated the transformation of thecall money market into a pure inter-bank market.Furthermore, issuance norms and maturity profilesof other money market instruments such ascommercial paper (CP) and certificates of deposit(CDs) have been modified over time to encouragewider par t icipation while strengthening thetransmission of policy signals across the variousmarket segments. The abolition of ad hoc TreasuryBills and introduction of auction Treasury Bills pavedthe way for the emergence of a risk free rate, whichhas become a benchmark for pricing other moneymarket instruments. Concomitantly, with the increasedmarket orientation of monetary policy along withgreater global integration of domestic markets, theReserve Bank’s emphasis has been on settingprudential limits on borrowing and lending in the callmoney market, encouraging migration towards thecollateralised segments and developing derivativeinstruments for hedging market risks. This has beencomplemented by the institutionalisation of theClearing Corporation of India Limited (CCIL) as acentral counterparty. The upgradation of paymentsystem technologies has also enabled marketpar t ic ipants to improve their asset l iabi l i tymanagement. Cumulatively, these measures havewidened and deepened the money market in termsof instruments and par t ic ipants, enhancedtransparency and improved the signal l ingmechanism of monetary policy while ensur ingfinancial stability.

9.10 In the emerging scenario of increasingintegration of domestic and international markets,several issues have come to the fore. First, theabsence of a developed term money market is one ofthe important gaps in the development of domesticfinancial markets. This is affecting the developmentof a money market yield curve, and, in turn, thedevelopment of the der ivative market and theintegration of the foreign exchange market and thedomestic currency market. Accordingly, greater effortswould be required to expedite the development of theterm money market in the country, given the criticalrole of this market in the development of othersegments. Well-developed term money market would,inter alia, contribute to the emergence of deep andvibrant markets for interest rate derivatives andprovide useful inputs of market expectations for theconduct of monetary policy.

9.11 Second, in view of the transformation of thecall money market into a pure inter-bank market, theremay be a need to provide greater flexibility to banksand PDs to borrow or lend in this market, dependingupon the robustness of the r isk managementpractices being followed by them. Prudential limits onborrowing and lending in the inter-bank market couldbe replaced, in stages, by a system where such limitsare taken care of by the banks' own internal ALMframework. Third, in view of sustained credit demandin recent years, there has been some revival ofinterest in Inter-Bank Par ticipation Cer tificates(IBPCs). IBPCs, by enabling banks to even out theirshort-term liquidity mismatches, provide greaterdegree of flexibility in banks' credit por tfolios.Accordingly, the IBPC scheme needs a thoroughreview to improve asset liability management andliquidity management. This will also help in developinga market for credit risk transfer instruments.

9.12 Fourth, the Reserve Bank in its operationswould have to progressively give somewhat moreweightage than hitherto to international interest ratesin view of increased capital mobility. Fifth, potentiallydestabilising large and sudden capital flows may callfor more flexible and swift monetary policy responses.Sixth, open market operations (OMO), apart frombeing used for modulating liquidity conditions, couldalso be used to correct any serious distortions in theyield curve. Seventh, although the Reserve Bank hasprogressively de-emphasised reserve requirementsas an instrument of monetary policy, given the presentstate of market development, it may be necessary tokeep the option of f lexible use of reserverequirements. Finally, as the banking system ismoving to maintenance of SLR securities close to theprescribed minimum levels, liquidity provision wouldbecome more difficult unless the instrument set iswidened to facilitate market participants to even outliquidity mismatches (Mohan, 2006a).

CREDIT MARKET

9.13 In India, credit markets have, historically,played a key role in allocating savings towardsproductive purposes. There has been a profoundtransformation of the credit market since the early1990s. Prior to initiation of financial sector reforms,credit institutions operated under a regulatoryframework character ised by barr iers to entry,administered interest rates, pre-emption of resourcesthrough high statutory liquidity ratio (SLR) and cashreserve ratio (CRR), and allocation of resourcesthrough mechanisms such as maximum permissible

316


bank finance (MPBF) and selective credit controls.Credit institutions suffered from several inefficienciessuch as high intermediation cost, low profitability andhigh non-performing assets (NPAs). Against thisbackdrop, financial sector reforms were initiated inthe early 1990s in a phased manner to move awayfrom a financially repressed regime to a liberalisedregime through measures such as deregulation ofinterest rates, entry of new private sector banks,enhanced presence of foreign banks, reduction instatutory pre-emptions, introduction of prudentialnorms, strengthening of accounting standards anddisclosure norms, and permitting banks to raisecapital from the market. These measures havesubjected the f inancial insti tut ions to marketdiscipline, enhanced competition, and providedproductivity and efficiency gains. The reforms havealso strengthened banks’ risk assessment techniques,thereby increasing the role of interest rates inallocating resources while simultaneously enhancingthe transmission of monetary impulses.

9.14 Although a wide range of credit institutionsoperate in the country, the relative significance ofbanks, already the predominant players in the creditmarket, has increased further due to conversion oftwo major development finance institutions (DFIs) intobanks. In this context, it is noteworthy that, afterwitnessing some deceleration in the late 1990s, creditextended by banks has expanded rapidly beginning2002-03. Robust macroeconomic performance,revival of investment demand, moderation in interestrates and decline in NPAs appear to have contributedto rapid credit expansion. A welcome developmenthas been large credit expansion to the agriculturesector in the last few years, reflecting the impact ofvarious policy measures. The trend of decelerationin credit to agriculture during the 1990s has, thus,been reversed. As a result, credit intensity of theagriculture sector (credit to agriculture as percentageof sectoral GDP) has increased in recent years. Onthe other hand, growth in credit to industry duringthe 1990s and the current decade so far has beensomewhat lower than that in the 1980s. This couldbe attributed partly to alternative avenues of financingavailable to industry such as external commercialborrowings and domestic and international capitalmarkets. Internal generation of funds, facilitated bystrong corporate profitability, has also improvedsignificantly in recent years. At the same time, therehas been a sharp increase in medium and long-termbank credit to industry, which is largely for the projectrelated activity. This suggests that banks are fillingthe gap created by conversion/merger of two DFIs

into banks. Credit growth to the SSI sector, whichdecelerated sharply during 1999-2004, also pickedup from 2004-05. Credit intensity of the industrialsector, on the whole, has increased in the currentdecade so far (up to 2005-06). A key factor underlyingthe rapid expansion of credit since 2002-03 has beenthe emergence of demand for housing and personalloans, facilitated by benign interest rate environment,fiscal benefits, increase in income levels and growingcompetition in the banking sector. Total householdcredit now constitutes almost one-fourth of total bankcredit. In view of growing volume of retail credit, theinterest rate channel of monetary policy is likely tohave a greater influence on private consumption andeconomic activity in the country.

9.15 Cross-country experience shows that periodsof rapid credit expansion can lead to future financialfragilities. Although the Indian banking sector is robustin view of high level of capital adequacy and low levelof NPAs, the Reserve Bank, in the face of rapid creditgrowth, has consistently emphasised di l igentmonitoring of the health of loan portfolios of creditinstitutions. It has also pro-actively tightened riskweights and provisioning requirements, especially inthe case of sectors that have witnessed high growth.Notwithstanding the current phase of high creditgrowth, credit penetration in India remains low evenin comparision with several other EMEs. Viewed in aholistic perspective, it is difficult to arrive at a clearjudgment as to what rate of credit growth is too highin relation to potential growth (Mohan, 2007a). TheReserve Bank has, therefore, re-emphasised theimpor tance of credit quali ty for secur ingmacroeconomic and, in particular, financial stabilitywhile simultaneously pursuing greater creditpenetration and financial inclusion.

9.16 Notwithstanding some acceleration of growthin credit to the agricultural sector in recent years,inadequate access to credit in rural areas remains acause of concern. In this context, reliable access tocredit at reasonable rates is more important than thecost of credit. Revival of rural co-operative creditinstitutions through legal and institutional reforms willhelp in improving the flow of credit to the rural sectorand increasing credit penetration. Extension of micro-finance in unbanked areas on a greater scale, theuse of services of business faci l i tators/correspondents and imparting financial education willalso help in bringing a higher proportion of ruralpopulation within the fold of formal credit institutions.

9.17 With the ongoing l iberal isation andderegulation of the financial system, large corporates

317

OVERALL ASSESSMENT

are able to draw upon several sources of funds suchas external commercial borrowings, ADRs/GDRs anddomestic capital markets, apart from bank credit, tofund their business requirements. In contrast, smalland medium enterprises (SMEs) continue to dependheavily on the banking sector to meet their financingneeds. However, given the role played by SMEs ingeneration of output and employment in the economy,banks need to upgrade their r isk assessmenttechniques to meet the growing requirements ofSMEs. Hitherto, the absence of credit history hasbeen one of the major factors restricting the flow ofcredit to SMEs. The Credit Information Act, 2005 hasbeen enacted and the rules and regulationsthereunder have also been notified. This will facilitatethe formation of credit information companies in thecountry. This, in turn, will improve the quality of credit,reduce the transaction cost and improve the flow ofcredit to the SME sector. Independent rating ofborrowers wil l also help in minimising theasymmetries in information that restrict lending tothe SME sector.

9.18 Although banks have been given the freedomto determine their lending rates, the principlesfollowed by banks in fixing their Benchmark PrimeLending Rate (BPLR) are viewed as opaque. Apredominant and growing proportion – over eighty percent – of the commercial banks’ loan portfolio is atsub-BPLR rates. Competition has turned the pricingof a significant proportion of loans far out of alignmentwith the BPLR and in a non-transparent manner(Mohan, 2007b). The BPLR has ceased to be areference rate, thereby hindering an assessment ofthe efficacy of monetary transmission. There is apublic perception that banks’ r isk assessmentprocesses are less than appropriate and that there isunderpricing of credit for corporates, while there couldbe overpricing of lending to agriculture and SSIs.Lending below the BPLR has several implications. Inparticular, the fixation of BPLR continues to be morearbitrary than rule-based. Therefore, the concept ofarriving at the BPLR needs to be looked into with aview to making it more transparent.

9.19 In the current situation of high creditexpansion, banks have been unwinding their surplusinvestments in SLR securities, over and above theprescribed minimum. This unwinding is approachingthe prescribed minimum of 25 per cent. Depositmobilisation would, thus, be critical, especially in viewof growing credit needs that are likely to emanatefrom the ongoing financial deepening. Therefore,banks need to make sustained efforts for mobilisingstable retail deposits by extending banking facilities

and widening their deposit base to support the creditdemand in a sustainable manner.


9.20 The Reserve Bank has actively pursued thedevelopment of the government securities marketsince the early 1990s for a variety of reasons. First,with the Reserve Bank acting as the debt managerto the Government, a well-developed and liquidgovernment securities market is essential to ensurethe smooth passage of Government’s marketborrowings to f inance its deficit. Second, thedevelopment of the government securities market isalso necessary to facilitate the emergence of a riskfree rupee yield curve to serve as a benchmark forpr icing other debt instruments. Finally, thegovernment securities market plays a key role in theeffective transmission of monetary policy impulsesin a deregulated environment.

9.21 In order to foster the development of thegovernment securities market, primacy was accordedto migrate from a regime of administered interest ratesto a market-oriented system. Accordingly, in the early1990s, the Reserve Bank initiated several measures.First, it introduced the auction system for issuanceof government securities. While initially only yieldbased multiple price auctions were conducted,uniform price based auctions were also employedduring uncertain market conditions and while issuingnew instruments. Second, as the captive investorbase was viewed as constraining the development ofthe market, the statutory prescription for banks’investments in government and other approvedsecurities was scaled down from the peak level inFebruary 1992 to the statutory minimum level of 25per cent by April 1997. As a result, the focus shiftedtowards the widening of the investor base. A networkof intermediaries in the form of primary dealers wasdeveloped for this purpose. Retail participation hasbeen promoted in the primary market (through asystem of non-competitive bidding in the auctions)as well as in the secondary market (by allowing retailtrading in stock exchanges). Simultaneously, theReserve Bank also introduced new instruments withinnovative features to cater to diverse marketpreferences, although the success in this regard hasbeen limited.

9.22 Third, with the discontinuance of the processof unconstrained recourse by the Government fromthe Reserve Bank through automatic monetisation ofdeficit and conversion of non-marketable securitiesto marketable securities, the Reserve Bank gained

318


more operational freedom. Fourth, in an effort toincrease liquidity, the Reserve Bank has, since thelate 1990s, pursued a strategy of passiveconsolidation of debt by raising progressively highershare of market borrowings through re-issuances.This has resulted in critical mass in key maturities,and is faci l i tat ing the emergence of marketbenchmarks. Finally, the Reserve Bank is alsoundertaking measures to strengthen the technologicalinfrastructure for trading and settlement. A screen-based anonymous trading and reporting platform hasbeen introduced in the form of NDS-OM, whichenables electronic bidding in primary auctions anddisseminates trading information with a minimum timelag. Furthermore, with the setting up of CCIL, anefficient settlement mechanism has also beeninstitutionalised, which has imparted considerablestability to the government securities market.

9.23 With the withdrawal from the primary marketfrom April 2006 in accordance with the stipulationsunder the FRBM Act, the Reserve Bank introducedthe necessary institutional changes in the form ofrevamping and widening of the coverage of the PDsystem to meet the emerging challenges. Othermeasures taken to deepen the market and promoteliquidity include introduction of ‘when issued’ trading,‘short selling’ of government securities and activeconsolidation of government debt through buybacks.

9.24 Various policy initiatives taken by the ReserveBank over the years to widen and deepen thegovernment securities market in terms of instrumentsas well as participants have enabled successfulcompletion of market borrowing programmes of theGovernment under var ied circumstances. Inparticular, a smooth transition to the post-FRBMphase has been ensured. Turnover in the secondarymarket for government securities has increasedsubstantially indicating the effectiveness of variousmeasures taken to improve liquidity in key maturities.The issuance of long-term securities has enabled thedevelopment of the yield curve across 30-yearmaturity, although it is not liquid and active at thelonger end of the maturity. With the widening ofinvestor base, the holding pattern of government debthas diversified. The government securities market isgetting increasingly integrated with the domesticmoney market as well as international interest rates.

9.25 The evolving economic conditions and movetowards fuller capital account convertibility, however,necessitate fur ther fine-tuning of the operatingframework so as to ensure smooth debt managementoperations. There are certain issues which need to

be addressed for making the government securitiesmarket more vibrant and also to meet the debtmanagement objectives in an efficient manner. In theabsence of instruments to allow market participantsto take a forward looking view on interest rates,turnover in the secondary market has been observedto rise during the falling interest rate cycle, but declineduring the rising interest rate cycle. In this context,introduction of intra-day ‘short selling’, followed by thepermision for short selling up to five trading days aresteps in the right direction. Liquidity could be improvedfur ther through active consolidation of existingsecurities, phased increase in marked-to-marketportfolio of banks and early introduction of STRIPS.In view of the restriction on the Reserve Bank’ssubscription to Central Government securities in theprimary market under the FRBM Act, it is crucial todiversify the investor base further. The investor basealso needs to be widened in view of the possibility ofreduction in the captive investor base resulting fromany scaling down of the SLR from the present level;the floor of SLR has been removed by the BankingRegulation (Amendment) Act, 2007 which is deemedto have come into force on January 23, 2007. Anydecision in this regard will of course depend on overallmacroeconomic and monetary conditions. StateGovernment securities are relatively illiquid, whichaffects the cost of borrowing for the StateGovernments. Some of the measures taken forimproving liquidity of Central Government securitiesmay need to be considered for State Governmentsecurities as well.


9.26 The Indian foreign exchange market haswitnessed far reaching changes since the early 1990s,following the phased transition from a pegged exchangerate regime to a market determined exchange rateregime in 1993 and the subsequent adoption of currentaccount convertibility in 1994. Market participants havebeen provided with greater flexibility to undertakeforeign exchange operations and manage their risks.This has been facilitated through simplification ofprocedures and availability of several new instruments.There has also been significant improvement in marketinfrastructure in terms of trading platform andsettlement mechanisms. As a result, depth andliquidity of the market have improved significantly overthe years. Efficiency in the foreign exchange markethas also improved as is reflected in low bid-offerspreads. With the gradual opening up of the capitalaccount, forward premia is getting increasingly alignedwith the interest rate differential.

319

OVERALL ASSESSMENT

9.27 The foreign exchange market conditions haveremained orderly in the post-1993 period, barringoccasional periods of volatility. The Indian approachto exchange rate management has been to avoidexcessive volatility. This has contributed to stabilityin the market. Intervention by the Reserve Bank inthe foreign exchange market, though effective, hasbeen relatively small compared to total turnover inthe market. The EMEs’ experience, in general, in the1990s has highlighted the growing importance ofcapital flows in determining the exchange ratemovements as against trade flows and economicgrowth in the 1980s and before. In the case of mostdeveloping countries, which specialise in labour-intensive and low and intermediate technologyproducts, profit margins in the highly competitivemarkets are very thin and vulnerable to pricing powerby large retail chains. Consequently, exchange ratevolatility has significant employment, output anddistr ibutional consequences (Mohan, 2004).Managing exchange rate volatility would, thus,continue to require attention in EMEs such as India.

9.28 Capital flows received by India since 1993-94have generally remained well above the currentaccount deficit. The foreign exchange market has,therefore, been characterised by excess supplyconditions during the most part of the post-reformperiod. Consistent with the policy framework withregard to exchange rate management and foreignexchange reserves, the Reserve Bank has purchasedexcess supplies from the market. The expansionaryimpact of such purchases on monetary aggregatesand domestic economy has been neutralised, interalia, through increased exchange rate flexibility,phased liberalisation of the policy framework inrelation to current as well as capital accounts,flexibility to corporates to prepay external commercialborrowings, extension of foreign currency accountfacilities to residents, allowing banks to liberally investabroad in high quality instruments, and liberalisingsurrender requirements for exporters (Reddy, 2007a).These measures have been supplemented with thesterilisation operations in the form of open marketoperations, repo operations under the LAF,modulation in the cash reserve ratio, and innovationssuch as market stabilisation scheme. This approachto management of capital flows has been successfulso far in maintaining macroeconomic and financialstability while minimising the impact of volatility incapital flows and exchange rate on the domesticeconomy. The challenges to monetary and liquiditymanagement are likely to intensify in the years aheadfrom the ongoing process of capital account

liberalisation and the further integration of the Indianeconomy with the global economy. Globaldevelopments are expected to play an increasinglyimportant role in determining the conduct of monetaryand exchange rate policies, calling for hard choicesin terms of goals and instruments.

9.29 Moving forward, further initiatives towardsdeveloping the Indian foreign exchange market needto be aligned with the external sector reforms,particularly the move towards further liberalisation ofcapital controls, for which a fresh roadmap has beenprovided by the Committee on Fuller Capital AccountConvertibility (FCAC).The agenda for the futureshould, therefore, include introduction of moreinstruments, particularly derivative products, wideningof participants base, commensurate regulations alongwith the entrenchment of modern risk managementsystems and improved customer service. Reforms inthe foreign exchange market will also have to beharmonised with the evolving macroeconomicenvironment as well as the development of othersegments of the financial market, particularly themoney, the equity and the government securitiesmarkets. They will also have to be harmonised withthe evolving needs of the real economy.


9.30 The Indian equity market has witnessed asignificant improvement since the reform processbegan in the early 1990s and is now comparable withthe best international markets. There has been avisible improvement in trading and settlementinfrastructure, risk management systems, efficiencyand levels of transparency in the equity market. Thetransaction cost has declined and volatility has alsobeen contained. Nevertheless, the role of the Indiancapital market, equity as well as debt, in domesticeconomic activity continues to be relatively lesssignificant. Savings of the household sector in the formof shares and debentures and units of mutual fundsremain at relatively low levels, reflecting households’preference for safe and contractual instruments asopposed to capital market based instruments. The sizeof the public issues segment has remained small ascorporates have tended to prefer the internationalcapital market and the private placement market,apart from relying on internal sources and bank credit.The corporate bond market, in par ticular, hasremained underdeveloped, reflecting a variety offactors such as absence of a reliable and liquid yieldcurve, high cost of issuance and lack of liquidity inthe secondary market.

320


9.31 A growing economy like India requires riskcapital and long-term resources for enabling thecorporates to choose an appropriate mix of debt andequity. Acceleration in economic growth has createdlarge demand for funds by the corporate sector.Encouraging business outlook and congenialinvestment climate have encouraged companies toundertake capacity expansion. Long-term resourcesare particularly important for financing infrastructureprojects. A well-functioning domestic capital marketis also necessary to enable the banking sector to raisenecessary capital from the market to sustain itsgrowing operations. Furthermore, a well-functioningbond market can be an effective channel of monetarytransmission in case the banking sector is impairedor in situations when banks adopt an oligopolisticpricing behaviour. On supply side too, rising incomelevels and savings would require alternativeinvestment options, including equity and corporatedebt. Therefore, in order to sustain India’s high growth,the capital market would have to play a major role.

9.32 Prospective reforms in the equity market needto focus on developing strong domestic institutionalinvestors, adherence to international best practicesin corporate governance and reduction in time andcost for floating public issues. Promoters continue tohold a large portion of equity in the companies.Concentrated ownership prevents the broaddistr ibution of gains from the equity marketdevelopment, with implications for the functioning ofthe corporate governance framework and protectionof rights of minority shareholders.

9.33 There is very little activity in the public issuesegment of the private corporate debt market. Keepingin view the proposals made in the Union Budget, 2006-07 and the recommendations made by the High LevelExper t Committee on Corporate Bonds andSecuritisation, the SEBI has recently initiated stepsto capture timely information relating to trading incorporate bonds by establishing trade reportingplatforms at the BSE and the NSE. The next phase ofdevelopment would involve the setting up of acorporate debt trading platform, which is expected tocontribute to efficient price discovery and reliableclearing and settlement mechanism. The marketdevelopment process for bonds in India is likely to bea gradual process as has been experienced in othercountries. In this context, the experience gained fromdeveloping the government securities market shouldprove useful. The corporate debt market would requirea large number of investors and large sized issues tofunction effectively. As in the case of governmentsecurities market, the problem of small size of issues

will have to be addressed by bringing about morediscipline in issuances and consolidation through re-issuances. The role played by market players suchas primary dealers in developing the governmentsecurities market may need to be replicated throughan appropriate institutional framework in the corporatebond market. Counterparty guarantee for settlementof trades to reduce counterparty and settlement riskswould promote secondary market activity in corporatebonds. Macroeconomic stability would also aid theprocess of market development. Increased availabilityof structured financial products such as mortgage andasset-backed securities can also encourage thedevelopment of the corporate bond market byaddressing its fundamental limitation, namely, the gapbetween the credit quality of bonds that investorswould like to hold and the actual credit quality ofpotential borrowers.

9.34 An underdeveloped corporate bond marketresults in excessive reliance of the corporate sectoron bank credit, which reduces supply of funds to smalland medium enterprises, and also creates a gap ininsti tut ional f inance for long-term financingrequirements. Strong and deep domestic capitalmarkets will be essential to sustain investment andgrowth that has been witnessed since 2003-04.

SUMMING UP

9.35 The Reserve Bank, like other central banks,has taken a keen interest in the development of themoney, the credit, the government securities and theforeign exchange markets in view of their critical rolein the transmission mechanism of monetary policy.The approach has been one of simultaneousmovement on several f ronts, graduated andcalibrated, with an emphasis on institutional andinfrastructural development and improvements inmarket microstructure. The pace of reforms wascontingent upon putting in place appropriate systemsand procedures, technologies and market practices.There has been close co-ordination between theReserve Bank and the Government, as also withother regulators, which helped in orderly and smoothdevelopment of the various segments of the financialmarket in India. The Reserve Bank has also engagedin refining the operating procedures and instrumentsas also r isk management systems, incomerecognition and provisioning, and disclosure andaccounting standards in line with international bestpractices with a view to fostering the seamlessintegration of Indian financial markets with globalmarkets (Mohan, 2007b).

321

OVERALL ASSESSMENT

9.36 Initiatives taken by the Reserve Bank and otherregulatory authorities have brought about a significanttransformation in the working of various segments ofthe financial market. Domestic financial markets havetransited from a highly administered system – markedby administered interest rates, credit controls andexchange control – to a system dominated by market-determined interest rates and exchange rate and price-based instruments of monetary policy. Thesedevelopments, by improving the depth and liquidity inthe domestic financial markets, have contributed tobetter price discovery of interest rates and exchangerates, which, in turn, have led to greater efficiency inresource allocation in the economy. The increase insize and depth of financial markets has paved the wayfor flexible use of indirect instruments. Greater depthand liquidity and freedom to market participants havealso increased integration of the various segments ofthe financial market. Increased integration not onlyleads to more efficient dispersal of risks across thespectrum but also increases the efficacy of monetarypolicy impulses. In a world of integrated financialmarkets, monetary policy operates not only throughthe conventional interest rate channel but also throughthe exchange rate and other asset prices channels,thereby strengthening the impact of monetary policyon the real economy and inflation. Evidence suggeststhat growing integration of various financial marketsegments in India has been accompanied by lowervolatility of interest rates.

9.37 Development of financial markets is an ongoingprocess. Initiatives to further deepen and widen thevarious segments of the financial market will, therefore,need to be pursued in the period ahead. Financialmarkets will have to play an even more important rolein future to sustain the current growth momentum beingexperienced by the Indian economy. Large investmentneeds of the growing economy will depend heavily uponthe ability of the financial markets to raise resourcesfrom savers and allocate them efficiently for the mostproductive uses. Further development and integrationof various segments is also important in the context ofenvisaged move towards fuller capital accountconvertibility. As the Report of the Committee on FullerCapital Account Convertibility (2006) observed, anycountry intending to introduce fuller capital accountconvertibility needs to ensure that different marketsegments are not only well-developed but also well-integrated. Accordingly, development of the term moneymarket, greater flexibility in the use of derivatives inthe foreign exchange market, development of thecorporate bond market and creation of secondarymarkets in several instruments such as certificates of

deposit and commercial paper are some of the aspectsof market development that would need to be givendue attention for imparting more depth and liquidity tothe domestic financial markets.

9.38 As a result of various policy initiatives, thefinancial sector in India is no longer a constraint ongrowth, though further improvements need to takeplace. However, without further development in termsof physical infrastructure and improvement in supplyelasticities in the real sector, the financial sector caneven misallocate resources, potentially generatebubbles and possibly amplify the risks. Hence, reformsin the financial sector have complementarity with thepace and process of reforms in the real sector in India(Reddy, 2007b).

9.39 Concomitantly, with growing liberalisation,deregulation and integration with global financialmarkets, policy initiatives have ensured that domesticfinancial markets and market participants are in aposition to absorb unanticipated and large shocks thatcan emanate from global developments so thatfinancial stability is maintained in the country whilesuppor ting the growth. The Indian exper iencedemonstrates that development of markets is anarduous and time-consuming task that requiresconscious policy actions and effective implementation.Financial markets have to be created, nurtured andmonitored on a continuous basis, before they startfunctioning autonomously (Mohan, 2006c). To sustainthe growth momentum witnessed since 2003-04, it isimperative that domestic savings rise further to meetthe growing investment needs of the economy. Thedemand for funds, including long-term funds, is likelyto remain high, particularly in view of relatively lowcredit penetration in the economy. Against thisbackdrop, calibrated policy initiatives to deepen andwiden the various segments of the financial marketwould need to be pursued on an ongoing basis sothat domestic financial markets can effectivelymobilise domestic savings and allocate them amongcompeting uses while also enhancing thetransmission of monetary policy impulses to the restof the economy.

9.40 Growing integration of domestic financialmarkets with international financial markets acrossthe globe also poses the threat of contagion. In therecent past, financial markets, globally, have beenmarked by abundant liquidity conditions, elevatedasset prices, and low long-term interest rates. Thesearch for yield has resulted in large external flowsinto emerging market economies over the past fewyears leading, inter alia, to the problem of monetary

322


management. Risk spreads and measures of volatilityhave also declined to quite low levels. Thesedevelopments in financial markets can be partlyattributed to greater macroeconomic stability – stableoutput growth accompanied by low and stable inflation– since the 1990s compared with the 1970s and the1980s. The decline in volatility in the internationalfinancial markets in the recent period, however, neednot necessarily suggest absence of risk. While thefinancial system may have become more efficient inrisk-bearing, it is taking more risks than before, whichhave the potential to expose the system to largesystemic shocks (Rajan, 2005). Accordingly, thecurrent conditions of financial market tranquillity inan environment of ample global liquidity and large andgrowing global macroeconomic imbalances haveraised concerns as to whether financial markets arepricing in risk appropriately.

9.41 The re-pricing of risks can trigger massiveadjustments in portfolio holdings of global investorsand this can lead to sharp swings in capital flows outof r iskier assets in emerging economies withimplications for foreign exchange markets and otherdomestic financial segments, as was clearly evident

during the recent global equity markets meltdownduring May-June 2006 and again in February/March2007. Thus, policymakers as well as financial marketparticipants would have to contend with the swingsin the financial markets on an even greater scale infuture than hitherto. Against this backdrop, whilefocusing on improving the capacity of the financialsystem to withstand shocks, central banks would needto stand prepared to make appropriate monetarypolicy adjustments if changes in the financialconditions threaten the achievement of the goals ofprice stability and sustainable economic growth(Geithner, 2007).

9.42 Issues of financial stability are, thus, likely toassume even greater importance in future, especiallyfor emerging economies. In India, large segments ofeconomic agents may not have adequate resilienceto withstand volatility in financial markets. TheReserve Bank’s policies are, therefore, vigilant to anyindications of volatility in currency and money markets(RBI, 2007). The policy initiatives to deepen and widenthe financial markets further to reap efficiency gains willneed to be pursued while ensuring macroeconomic andfinancial stability in the economy.

I

SELECT REFERENCES

I. THEME OF THE REPORT

Bagehot, Walter. 1873. “A Description of the Money Market.” Lombard Street, Richard Irvin Inc.

Gambhir, N., and M. Goel. 2003. “Foreign Exchange Derivatives Market in India - Status and Prospects.”in Derivatives Markets In India, Invest India (ed.) Susan Thomas, Tata McGraw-Hill.

Government of India. 2007. High Powered Expert Committee Report on Making Mumbai An InternationalFinancial Centre, April.

King, Robert G., and Ross Levine. 1993. “Finance and Growth : Schumpeter Might be Right.” TheQuarterly Journal of Economics, 108(3).

Levine, Ross, and Sara Zervos. 1996. “Stock Market Development and Long-Run Growth.” World BankEconomic Review, Vol. 10.

Levine, Ross. 1997. “Financial Development and Economic Growth: Views and Agenda.” Journal ofEconomic Literature, 35(2).

Lipschitz, Leslie. 2007. “Wising Up about Finance.” Finance and Development, 44(1), March.

McKinnon, R. 1973. “Money and Capital in Economic Development.” The Brookings Institution,Washington, D.C.

Mishkin, Frederic S. 2006. “The Next Great Globalisation: How Disadvantaged Nations Can HarnessTheir Financial Systems to Get Rich.” New Jersey : Princeton University Press.

Mohan, Rakesh. 2004. “Challenges to Monetary Policy in A Global Context.” RBI Bulletin, January.

——. 2006a. “Coping with Liquidity Management: A Practitioner’s View.” RBI Bulletin, April.

——. 2006b. “Monetary Policy and Exchange Rate Frameworks: The Indian Experience.” RBI Bulletin, June.

——. 2006c. “Economic Growth, Financial Deepening and Financial Inclusion.” RBI Bulletin, November.

——. 2007. “Development of Financial Markets in India.” Speech Delivered at the first Indian-FrenchFinancial Forum in Mumbai, May 16.

Rajan, Raghuram G., and Luigi Zingales. 1998. “Financial Dependence and Growth.” American EconomicReview, 88 (3).

——. 2003. Saving Capitalism from Capitalists, Crown Business, New York.

Rato, Rodrigode. 2006. “The Growing Integration of the Financial Sector and the Broader Economy:Challenges for Policy Makers.” Speech at the Colegio de Economistas Madrid, Spain, November 23.

Reddy, Y.V. 2000. Monetary and Financial Sector Reforms in India: A Central Banker’s Perspective.UBS Publishers’ Distributors Pvt. Ltd.

——. 2004. “Financial Stability: Indian Experience.” RBI Bulletin, July.

——. 2005. “Implications of Global Financial Imbalances for the Emerging Market Economies.” RBIBulletin, December.

Reserve Bank of India. 2006. Report of the Committee on Fuller Capital Account Convertibility (Chairman:S.S.Tarapore), July.

Robinson, Joan. 1952. “The Generalization of the General Theory.” in The Rate of Interest and OtherEssays, London : McMillan.

Schumpeter, Joseph E. 1912. A Theory of Economic Development. New York : Oxford University Press.

II

Shaw, E. 1973. Financial Deepening in Economic Development. New York : Oxford University Press.

World Bank. 2006. The Road to Robust East Asian Financial Markets, September.

III. MONEY MARKET

Bandt, D. O. 1999. “A Cross Country Comparison of Market Structures in European Banking.” EuropeanCentral Bank Working Paper, No.7, September.

Bernanke, Ben, and M. Gertler. 1995. “Inside the Black Box: The Credit Channel of Monetary PolicyTransmission.” Journal of Economic Perspectives, 9(4): 27-48.

Bhattacharyya, I., and R. Sensarma. 2005. “Signalling Instruments of Monetary Policy: The IndianExperience.” Journal of Quantitative Economics, 3(2):180-196.

Blenck D, et al. 2001. “The Main Features of the Monetary Policy Frameworks of Bank of Japan, theFederal Reserve and the Euro System”, BIS Paper, No. 9.

Blinder, A. S. 2006. “Monetary Policy Today: Sixteen Questions and about Twelve Answers.” in CentralBanks in the 21st Century, (eds.) S. Fernandez de Lis and F. Restoy, Banco de Espana, 31-72.

Borio, Claudio E.V. 1997. “The Implementation of Monetary Policy in Industrialised Countries: A Survey.”BIS Economic Papers, No.47, July.

Clarida, R., J. Gali, and M. Gertler. 1999. “The Science of Monetary Policy: A New Keynesian Perspective.”Journal of Economic Literature, 37(4): 1661-1707.

Chow, G. 1989. “Rational versus Adaptive Expectations in Present Value Models.” Review of Economicsand Statistics, 71(3):376-384. August.

Forssbaeck, J., and L. Oxelheim. 2003. “Money Markets and Politics - A Study of European FinancialIntegration and Monetary Policy Options.” Edward Elgar, Cheltenham.

Friedman, B.M. 2000a. “The Role of Interest Rates in Federal Reserve Policymaking.” NBER WorkingPaper No. 8047, December.

——. 2000b. Monetary Policy, NBER Working Paper No. 8057, December.

Government of India. 1998. Report of the Committee on Banking Sector Reforms (Chairman: M.Narasimham).

Gray, S. 1998. ‘‘Repo of Government Securities.’’ Handbooks in Central Banking, No. 16, CCBS, Bankof England.

Gray, S., and J. Place. 1999. ‘‘Repo of Government Securities.’’ Handbooks in Central Banking, No. 17,CCBS, Bank of England.

Hawkins, J. 2005. “Globalisation and Monetary Operations in Emerging Economies.” BIS Paper, No. 23, May.

Jalan, Bimal. 2002. “Research and Policy Developments in Money, Finance and the External Sector.” inMacroeconomics and Monetary Policy: Issues for a Reforming Economy (eds.) M. S. Ahluwalia,Y. V. Reddy and S. S. Tarapore, New Delhi: Oxford University Press.

Joshi, H. 2005. “The Interbank Money Market in India: Evidence on Volatility, Efficacy of RegulatoryInitiatives and Implications for Interest Rate Targeting.” RBI Occasional Papers, 25 (1, 2 and 3,Summer, Monsoon and Winter 2004).

Kuttner, K. N. and P. C. Mosser. 2002. “The Monetary Transmission Mechanism: Some Answers andFurther Questions.” Economic Policy Review, Federal Reserve Bank of New York, May.

III

Maeda, E., B. Fujiwara, and A. Mineshima Taniguchi. 2005. “Japan’s Open Market Operations underthe Quantitative Easing Policy.” Bank of Japan Working Paper, No.05-E-3, April.

Mehran, Hassanali, Laurens, Bernard, Quintyn, Marc. (eds.). 1996. Interest Rate Liberalisation andMoney Market Development: Selected Country Experiences, International Monetary Fund,Washington D.C.

Mohan, Rakesh. 2004. “Challenges to Monetary Policy in a Globalising Context.” RBI Bulletin, March.

——. 2006. “Coping with Liquidity Management in India: A Practitioner’s View.” RBI Bulletin, April.

Poole, W. 1970. “Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model.”The Quarterly Journal of Economics, 84(2):197-216, May.

Reddy, Y.V. 1999. “Development of Money Market in India.” Address at the Fifth J.V. Somayajulu MemorialLecture at Madras, February.

——. 2002. “Monetary and Financial Sector Reforms in India: A Practitioner’s Perspective.” RBI Bulletin, May.

Reserve Bank of India. 1985. Report of the Committee to Review the Working of the Monetary System(Chairman: Sukhomoy Chakravarty).

——. 1987. Report of the Working Group on the Money Market (Chairman: N. Vaghul).

——. 1991. Report of the Committee on the Financial System. (Chairman: M. Narasimham).

——. 2003a. Report of the Working Group on Call Money Market, RBI.

——. 2003b. Report of the Working Group on Instruments of Sterilisation (Chairperson: Ms. Usha Thorat).

——. 2004a. Report on Currency and Finance, 2003-04.

——. 2004b. Annual Report, 2003-04.

——. 2005. Report of the Technical Group on Money Market, May .

——. 2006. Report of the Committee on Fuller Capital Account Convertibility (Chairman: S. S. Tarapore).

Rotemberg, J. J., and M. Woodford. 1997. ‘‘An Optimization- Based Econometric Framework for theEvaluation of Monetary Policy.” in NBER Macroeconomics Annual 1997, (eds.) Bernanke Ben andJ.J. Rotemberg. Cambridge: MIT Press.

Samuelson, P. A., and R. M. Solow. 1960. “Analytical Aspects of Anti-inflation Policy.” American EconomicReview, 50(5):177-194.

Solans, E. D. 2003. “Financial Innovations and Monetary Policy.” the 38th SEACEN Governors Conferenceand 22nd Meeting of SEACEN Board of Governors on Structural Change and Growth Prospects inAsia – Challenges to Central Banking. Manila, February.

Spence, M.1973. “Job Market Signalling.” The Quarterly Journal of Economics, 87(3), August.

Van’t dack, J. 1999. “Implementing Monetary Policy in Emerging Market Economies: An Overview ofIssues.” BIS Policy Papers, (5): 3-72. March.

IV. CREDIT MARKET

Banerjee, Abhijit V., Shawn Cole, and Esther Duflo. 2003. “Bank Financing in India.” MIT, October.

Barth, James R., Gerard Caprio Jr., and Ross Levine. 2002. “Financial Regulation and Performance:Cross Country Evidence.” in Banking, Financial Integration, and International Crisis (eds.), LeonardoHernandez and Klaus Schmidt-Hebbel, Central Bank of Chile, Santiago.

IV

Beck, Thorsten, Asli Demirguc-Kunt, and Maria Soledad Martinez Peria. 2005. “Reaching out: Accessto and Use of Banking Services Across Countries.” World Bank Policy Research Working PaperNo. 3754, October.

Bernanke, Ben, and M. Gertler. 1995. “Inside the Black Box: the Credit Channel of Monetary PolicyTransmission.” NBER Working Paper, No. 5146.

Bernanke, Ben, and A. Blinder. 1988. “Credit, Money and Aggregate Demand.” American Economic Review(AEA Papers and Proceedings), Vol. 78.

Bernanke, Ben, and Simon Gilchrist. 1999. “The Financial Accelerator in a Quantitative Business CycleFramework.” in Handbook of Macroeconomics, Vol.1C, (ed.) John Taylor and Michael Woodford(Amsterdam: North-Holand).

Bernanke, Ben. 2002. “Asset Price Bubbles and Monetary Policy.” BIS Review, 59.

BIS. 2003. Credit Risk Transfer, Committee on the Global Financial System, January.

——. 2006a. Quarterly Review, Bank for International Settlements, June.

——. 2006b. Committee on the Global Financial System, Housing Finance in the Global Financial Market.Working Group Report, No.26.

Caprio, Gerard, and Daniela Klingebiel. 2003. “Episodes of Systemic and Borderline Financial Crises.”The World Bank, Washington.

Diamond, D.W. 1984. “Financial Intermediation and Delegated Monitoring.” Review of Economic Studies,Vol. 51:393-414.

Gertler, Mark, and Simon Gilchrist. 1993. “The Role of Credit Market Imperfections in the MonetaryTransmission Mechanism: Arguments and Evidence.” Finance and Economics, Discussion Series93-5, Board of Governors of the Federal Reserve System. U.S.

——. 1994. “Monetary Policy, Business Cycles, and the Behaviour of Small Manufacturing Firms.” TheQuarterly Journal of Economics, 109(2):309-40. May.

Gourinchas, Pierre-Oliver, Valdes Rodrigo, and Landerretche Oscar. 2000. “Lending Booms: Some StylizedFacts.” MIT, February.

Hernandez, L., and Landerretche Oscar. 2002. “Capital Inflows, Credit Booms and MacroeconomicVulnerability: The Cross-country Experience.” in Banking Financial Integration and InternationalCrises, Central Bank of Chile, Santiago.

Hilbers, Paul, Inci Otker-Robe, Ceyla Pazarbasioglu, and Gudrun Johnsen. 2005. “Assessing and ManagingRapid Credit Growth and the Role of Supervisory and Prudential policies.” IMF Working Paper,WP/05/151, July.

IMF. 2002. Monetary and Financial Statistics Manual.

——. 2004. World Economic Outlook, April.

——. 2006: Global Financial Stability Report, September.

Joshi, H. 2006. “Identifying Asset Price Bubbles in the Housing Market in India – Preliminary Evidence.”RBI Occasional Papers, 27 (1 and 2): 182.

Levine, R. 2004. “Finance and Growth: Theory and Evidence.” NBER Working Paper, No. 10766.

Lindgren, Carl-Johan, Gillian Garcia, and Matthew Saal. 1996. Bank Soundness and MacroeconomicPolicy, IMF, Washington.

V

Mishkin, Frederic S. 1995. “Symposium on the Monetary Transmission Mechanism.” The Journal ofEconomic Perspectives, 9 (4) (Autumn).

Mohan, Rakesh. 2003. “Transforming Indian Banks: In Search for a Better Tomorrow.” RBI Bulletin, January.

——. 2005. “Some Apparent Puzzles for Contemporary Monetary Policy.” RBI Bulletin, December.

——. 2006a. “Financial Sector Reforms and Monetary Policy: The Indian Experience.” RBI Bulletin, July.

——. 2006b. “Economic Growth, Financial Deepening and Financial Inclusion.” RBI Bulletin, 1305-1320.November.

——. 2006c. “Reforms, Productivity and Efficiency in Banking: The Indian Experience.” RBI Bulletin,279-293. March.

Mohanty, M.S., Gert Schnabel, and Pablo Gracia-Luna. 2006. “Banks and Aggregate Credit: What isNew?”, BIS Papers, No.28, August.

NSSO. 2006a. Household Assets and Liabilities as on 30.06.2002, All India Debt and Investment Survey,59th Round, Report No.500, National Sample Survey Organisation, Government of India.

——. 2006b. Household Indebtedness in India as on 30.06.2002, All India Debt and Investment Survey,59th Round, Report No.501, National Sample Survey Organisation, Government of India.

Ottens, Daniel, Edwin Lambregts, and Steven Poelhekke. 2005. “Credit Boom in Emerging MarketEconomies: A Recipe for Banking Crisis?.” DNB Working Papers, Netherlands Central Bank.

Pandit, B. L., Ajit Mittal, Mohua Roy, and Saibal Ghosh. 2006. “Transmission of Monetary Policy and theBank Lending Channel: Analysis and Evidence for India.” DRG Study No. 25, Reserve Bank ofIndia, Mumbai.

Rajan, Raghuram G., and L. Zingales. 1988. “Financial Dependence and Growth.” American EconomicReview, 88, June.

Reddy, Y.V. 2004. “Credit Policy, Systems and Culture.” RBI Bulletin, March.

——. 2006a. “Credit Counseling: An Indian Perspective.” RBI Bulletin, 1117-1120. October.

——. 2006b and c. “The Role of Financial Education: The Indian Case.” RBI Bulletin, 1131-1135. October.

——. 2006d. “Rural Banking: Review and Prospects.” RBI Bulletin, January.

Reserve Bank of India. 1998. Working Group on Money Supply: Analytics and Methodology of Compilation(Chairman: Dr. Y.V. Reddy), June.

——. 2003. Report of the Working Group on Introduction of Credit Derivatives in India (Convenor: B.Mahapatra), Mumbai, March.

——. 2004. Report of the Working Group on Flow of Credit to the SSI sector (Chairman: Dr. A. S. Ganguly),Mumbai, September.

——. 2006. Handbook of Statistics on the Indian Economy 2005-06.

——. Report on Currency and Finance, Various Issues.

——. Report on Trend and Progress of Banking in India, Various Issues.

——. Annual Report, Various Issues.

——. Basic Statistical Returns, Various Volumes.

VI

Rozhkov, Dmitriy. 2006. “On the Way to a World-Class Banking Sector.” in India Goes Global: Its ExpandingRole in the World Economy, (eds.) Catriona Purfield and Jerald Schiff. IMF.

Singh, Manmohan. 2006. Address at the Second Agriculture Summit, New Delhi, October 18.

Ueda Kazuo. 2003. “On Credit Risk Transfer Instruments and Central Banks”. 18th Annual GeneralMeeting, Tokyo, April.

V. GOVERNMENT SECURITIES MARKET

Abbink, Klaus, Jordi Brandts, and Paul Pezanis-Christou. 2002. “Auctions for Government Securities:A Laboratory Comparison of Uniform, Discriminatory and Spanish Designs.” November.www.nottingham.ac.uk/.

Asian Development Bank. 2005 and 2006. Asia Bond Monitor.

Back, K., and J.P. Zender. 1993. “Auctions for Divisible Goods with Endogenous Supply.” The Review ofFinancial Studies, 6(4): 733-764.

Bank of England.1999. “Government Debt Structure and Monetary Conditions.” Quarterly Bulletin, November.

Bank for International Settlements.1999. “How Should We Design Deep and Liquid Markets? The Casefor Government Securities.” Committee on Global Financial System, Basel, October.

——. 2001a. “The Changing Shape of Fixed Income Markets: A Collection of Studies by Central BankEconomists.” Monetary and Economic Department.

——. 2001b. International Organisation of Securities Commissions and Technical Committee of theInternational Organisation of Securities Commissions - Recommendations for SecuritiesSettlement Systems.

Bank Negara Malaysia. 2005. Annual Report.

Bank of Thailand. “Private Repurchase Market.” Market Research and Development Team, FinancialMarkets and Reserve Management http://www.bot.or.th.

Bedlord, Margaret E. 1978.“The Federal Reserve and the Government Securities Market.” EconomicReview, April.

Borio, Claudio. 2004. “Market Distress and Vanishing Liquidity: Anatomy and Policy Options.” BISWorking Paper No. 158, July.

Chabchitrchaidol, Akkharaphol, and Orawan Permpoon. 2002. “Development of the Thai Bond Market.”BIS Papers No. 11, June-July.

Chrystal, A., A. Haldane, and J. Proudman.1999.“Government Debt Structure and Monetary Conditions.”Quarterly Bulletin, Bank of England, November.

Commonwealth of Australia. 2002. “Review of Commonwealth Government Securities Market.”Discussion Paper, October.

Dato, Salleh Harun. 2002. “The Development of Debt Markets in Malaysia.” BIS Papers No. 11, June-July.

Department of Treasury. 1992. Joint Report on the Government Securities Market. US GovernmentPrinting Office, Washington D. C.

Doi, Takero, and Takeo Hoshi. 2002. “Paying for the FILP.” NBER Working Paper No.W9385, December.

G-20. 2004. Workshop on Developing Strong Domestic Financial Markets, April.

VII

Gordy, M.B. 1999. “Hedging Winner’s Curse with Multiple Bids: Evidence from the Portuguese TreasuryBill Auction.” The Review of Economics and Statistics, 81(3): 448-465.

Goswami, G., T.H. Noe, and M.J. Rebello. 1996. “Collusion in Uniform-Price Auctions: ExperimentalEvidence and Implications for Treasury Auctions.” The Review of Financial Studies, 9(3): 757-785.

Guorong, Jiang, and Robert McCauley. 2004. “Asian Local Currency Bond Markets.” BIS QuarterlyReview.

Harris, L. 1990. “Liquidity, Trading Rules and Electronic Trading Systems.” Monograph Series in Financeand Economics, No 4. Stern School of Business, New York University.

Hattori, Masazumi, Koji Koyama, and Tatsuya Yonetani. 2001. “Analysis of Credit Spread in Japan’sCorporate Bond Market.” BIS Papers. No. 5.

Herring, R.J., and N. Chatusripitak. 2000. “The Case of the Missing Market: The Bond Market and Whyit Matters for Financial Development.” ADB Institute Working Paper No.11.

Hirose, Masato, Tokeshi Murakami, and Yutaro Oku. 2004. “Development of Asia Bond Market andBusiness Opportunities.” NRI Papers, Nomura Research Institute.

IMF. 2001. Developing Government Bond Markets: A Handbook, Washington D.C.

IMF-World Bank. 2002. Guidelines for Public Debt Management: Accompanying Document, November.

Jadhav, Narendra. 2006. “Evolution of Financial Markets in India.” Monetary Policy, Financial Stabilityand Central Banking in India, New Delhi: Macmillan India Limited.

Kim, Yongbeom, S. M. Irene Ho, and Mark St Giles. 2003. “Developing Institutional Investors in People’sRepublic of China.” World Bank Country Study Paper.

Kim, Yun-Hwan, and M. Suleik. 2001. “Overviews of the Government Bond Markets in Selected AsianDeveloping Countries.” in Government Bond Market Development (ed.) Kim Yun-Hwan. Manila: ADB.

Korean Government Bond Market, Current Status and Future agenda, http://www.bex.or.th.

Krstic, Borko, and Srdan Marinkovic.1997. “Yield Curve and Interest Rate Risk.” Economics andOrganisation, 1(5).

Laganá, Marco, Martin Peøina, Isabel Von Köppen-Mertes, and Avinash Persaud. 2006. “Implicationsfor Liquidity from Innovation and Transparency in the European Corporate Bond Market.” ECBOccasional Paper No. 50.

Malvey, P.F., C.M. Archibald, and S.T. Flynn.1997. “Uniform-Price Auctions: Evaluation of the TreasuryExperiment.” Office of Market Finance, U.S.Treasury, Washington D.C.

McCauley, M. Robert, and Eli Remolona. 2000. “Special Feature: Size and Liquidity of GovernmentBond Market.” BIS Quarterly Review.

McCauley, M. Robert, 2006. “Consolidating the Public Debt Markets of Asia.” BIS Papers No. 30.

Mihaljek, Dubravko, Michela Scatigna, and Agustin Villar. 2002. “Recent Trends in Bond Markets.” BISPapers No. 11, June-July.

Ministry of Finance of Japan. 2006. Guide to Japanese Government Bonds, http://www.mof.go.jp.

Mohan, Rakesh. 2004. “A Decade of Reforms in Government Securities Market in India and the RoadAhead.” RBI Bulletin, November.

——. 2006. “Recent Trends in the Indian Debt Market and Current Initiatives.” RBI Bulletin, April.

VIII

Mohanty, M. S. 2001. “Improving Liquidity in Government Bond Markets: What Can be Done?” BISPapers No.11.

Mu, Huaipeng. 2006. “The Development of China’s Bond Market.” BIS Papers No. 26.

Nyborg, K.G., K. Rydqvist, and S. Sundaresan. 2002. “Bidder Behaviour in Multi-Unit Auctions: Evidencefrom Swedish Treasury Auctions.” Journal of Political Economy, 110 (2): 394-424.

Peter, McCray. 1997. “Australia’s Experience with Indexed Bonds.” Paper presented at the InvestorForum, New York.

Pongpen, Ruengvirayudh, and Sakkapop Panyanukul. 2006. “Developing Corporate Bond Market inAsia.” BIS Papers No. 26.

Reddy, Y. V. 2000. “Managing Public Debt and Promoting Debt Markets in India.” RBI Bulletin, October.

——. 2002. “Developing Bond Markets in Emerging Economies: Issues and Indian Experience.” RBIBulletin, April.

Reserve Bank of India. Annual Report, Various Issues.

——. 1996. “A Review of Internal Debt Management Policy and Operations for the period ended March1995.” RBI Bulletin, November.

——. 2000. Report on Currency and Finance, 1999-2000.

——. 2002. Report of the Working Group for Suggesting Operational and Prudential Guidelines onSTRIPS (Separately Traded Registered Interest and Principal of Securities), August.

——. 2003. Report on Currency and Finance, 2001-02.

——. 2004a. Discussion Paper on Capital Indexed Bonds, May.

——. 2004b. Report of Working Group on Screen Based Trading In Government Securities (Chairman:Dr. R.H.Patil), Mumbai, November.

——. 2005. Report of the Internal Technical Group on Central Government Securities Market, Mumbai, July.

——. 2006a. Report on Currency and Finance, 2004-05.

——. 2006b. Report of the Committee on Fuller Capital Account Convertibility (Chairman: S.S.Tarapore), July.

Ric, Battellino. 2004. “Recent Developments in Asian Bond Markets.” Talk to the 17th AustralasianFinance and Banking Conference, Sydney.

Roberto, Blanco. 2001. “The Euro-Area Government Securities Markets. Recent Developments andImplications for Market Functioning.” Paper prepared for the BIS Autumn Central Bank Economist’sMeeting.

Seongtae, Lee. 2006. “Recent Developments in Korean Bond Market.” BIS Papers No. 30.

Shen, Pu. 1995. “Benefits and Limitations of Inflation Indexed Treasury Bonds.” Federal Reserve Bankof Kansas City, Economic Review, Third Quarter.

Tomita, Toshiki. 2002. “The Need for Redefining Japan’s Government Debt Management Policy.” NRIPapers, Nomura Research Institute.

Toshiro, Muto. 2004. “Japan’s Payment and Settlement System and the Bank of Japan.” Minutes ofthe Meeting Commemorating the 20th Anniversary of the Centre for Financial IndustryInformation Systems.

IX

UK, Debt Management Office. 2005. Government Securities: A Guide to ‘gilts’.

Wang, J.J.D., and J.P. Zender. 2002. “Auctioning Divisible Goods.” Economic Theory, 19(4): 673-705.

Wilson, R.1979. “Auctions of Shares.” Quarterly Journal of Economics, 93 (4): 675-679.

Yun, Hwan Kim. 2001. (ed.) Government Bond Market Development in Asia. Asian Development Bank,Manila.

VI. FOREIGN EXCHANGE MARKET

Almekinders, G.J., and C.W.S. Eijffinger. 1994. “The Ineffectiveness of Central Bank Intervention.” Centerfor Economic Research, No.94101.

Baillie, R., and W.P. Osterberg. 1997. “Why Do Central Banks Intervene?” Journal of International Moneyand Finance, 16(6): 909-19.

Bank for International Settlements. 2004. Triennial Central Bank Survey on Foreign Exchange andDerivatives Market Activity.

Becker, T., and A. Sy. 2005. “Were Bid-ask Spreads in the Foreign Exchange Market Excessive duringthe Asian Crisis?” IMF Working Paper 05/34, International Monetary Fund.

Behera, H.K., V. Narasimhan, and K.N. Murty. 2006. “Relationship Between Exchange Rate Volatilityand Central Bank Intervention: An Empirical Analysis for India.” Paper presented at IGIDR SixthAnnual Conference on Money and Finance in the Indian Economy.

Bhaumik, S.K., and H. Mukhopadhyay. 2000. “RBI’s Intervention in Foreign Exchange Market-AnEconometric Analysis.” Economic and Political Weekly, 35(5).

Bjonnes, H.G., and D. Rime. 2004. “Dealer Behavior and Trading Systems in Foreign Exchange Markets.”Journal of Financial Economics, September.

Bonser-Neal, C. 1996. “Does Central Bank Intervention Stabilize Foreign Exchange Rates?” FederalReserve Bank of Kansas City Economic Review, First Quarter.

Canales-Kriljenko, J.I. 2004. “Foreign Exchange Market Organisation in Selected Developing andTransition Economies: Evidence from a Survey.” IMF Working Paper No. 4.

Cornell, W.B. 1978. “Determinants of the Bid-ask Spread on Forward Foreign Exchange ContractsUnder Floating Exchange Rates.” Journal of International Business Studies, Vol. 9:33-41.

Danker, D.J., R.A. Has, D.W. Hendrson, S. Sysmansky, and R. Tryon. 1987. “Small Empirical Models ofExchange Market Intervention: Applications to Germany, Japan, and Canada.” Journal of PolicyModeling, Vol. 9:143-173.

Dominguez, K.M., and A.J. Frenkel. 1993. “Does Foreign Exchange Intervention Matter? The PortfolioBalance Effect.” American Economic Review, 83(5).

Dominguez, K.M. 1990. “Market Responses to Coordinated Central Bank Intervention.” CarnegieRochester Conference Series on Public Policy, Vol. 32:121-164.

Dominguez, K.M. 1998. “Central Bank Intervention and Exchange Rate Volatility.” Journal of InternationalMoney and Finance, Vol.17:161-190.

Edison, H.J. 1993. “The Effectiveness of Central Bank Intervention: A Survey of the Literature after1982.” Princeton Special Papers in International Economics, No. 18, July.

X

Executives’ Meeting of East Asia Pacific Central Banks and Monetary Authorities (EMEAP). 2001.“Experience and Practical Issues Concerning Foreign Exchange Operations.” EMEAP Study onExchange Rate Regimes, June.

——. 2001. “Foreign Exchange Settlement Risk in the East Asia-Pacific Region.” Report prepared bythe EMEAP Working Group on Payments and Settlement Systems, December.

Fane, G. 2000. “Capital Mobility, Exchange Rates and Economic Crises.” London: EE Publication.

Fatum, R., and M. Hutchison. 2003. “Is Sterilised Foreign Exchange Intervention Effective After All? AnEvent Study Approach.” The Economic Journal, Vol. 113: 390-411.

——. 1999. “Is Intervention a Signal of Future Monetary Policy? Evidence from the Federal FundsFutures Market.” Journal of Money, Credit, and Banking, Vol. 31:54-69.

Frankel, J. A. 1982. “In Search of the Exchange Rate Premium: A Six Currency Test Assuming Mean-variance Optimization.” Journal of International Money and Finance, Vol. 1: 255-274.

Ghosh, A. 1992. “Is it Signaling? Exchange Intervention and Dollar-DM Rate.” Journal of InternationalEconomics, Vol.12: 201-220.

Goodhart, C.A.E., and T. Hesse. 1993. “Central Bank Foreign Exchange Intervention Assessed inContinuous Time.” Journal of International Money and Finance, Vol. 12: 368-389.

Gopinath, S. 2005. “Recent Developments in Foreign Exchange, Money and G-Sec Markets: Accountand Outlook.” RBI Bulletin, September.

Government of India. 1993. The High Level Committee on Balance of Payments (Chairman: Dr. C.Rangarajan), Ministry of Finance, New Delhi.

——. 2006. India’s External Debt: A Status Report. New Delhi, August.

Hartmann, P. 1999. “Trading Volumes and Transaction Costs in the Foreign Exchange Market – Evidencefrom Daily Dollar-Yen Spot Data.” Journal of Banking and Finance, Vol. 23: 801-824.

International Monetary Fund. 2007 “World Economic Outlook.” April.

Jacobson, L.R., 1983. “Calculations of Profitability for U.S. Dollar-Deutsche Mark Intervention.” StaffStudies 131. Board of Governors of the Federal Reserve System, Washington, D.C. September.

Jalan, Bimal. 1999. “International Financial Architecture: Developing Countries Perspective.” RBI Bulletin,October.

——. 2003. “Exchange Rate Management: An Emerging Consensus?.” RBI Bulletin, September.

Jorion, P. 1996. “Risk and Turnover in the Foreign Exchange Market.” in The Microstructure of ForeignExchange Markets (eds.) Frankel, J.A., G. Galli and A. Giovannimi, London: The University ofChicago Press, 19-40.

Joshi, H., and M. Saggar. 1998. “Excess Returns, Risk Premia and Efficiency of the Foreign ExchangeMarket: Indian Experience in Post Liberalisation Period.” RBI Occasional Papers, Vol. 19: 129-152.

Jurgenson, P. 1983. “Report of the Working Group on Exchange Market Intervention.” Washington,D.C., U.S. Dept. of the Treasury, March.

Kaminsky, L.G., and K. Lewis. 1996. “Does Foreign Exchange Intervention Signal Future MonetaryPolicy?” Journal of Monetary Economics, Vol. 37: 285–312.

Khundrakpam, J.K. 2007. “Economic Reforms and Exchange Rate Pass-through to Domestic Prices inIndia.” BIS Working Paper No. 225, February.

XI

Kletzer, K., and R. Kohli. 2000. “Exchange Rate Dynamics with Financial Repression: A Test of ExchangeRate Models for India.” ICRIER Working Paper 52, March.

Kohli, R. 2000. “Real Exchange Rate Stabilisation and Managed Floating: Exchange Rate Policy inIndia.” 1993-99, ICRIER Working Paper 59, October.

Kortian, T.K. 1995. “Modern Approaches to Asset Price Formation: A Survey of the Recent TheoreticalLiterature.” Research Discussion Paper, Reserve Bank of Australia, WP 9501.

Lewis, K.K. 1995. “Are Foreign Exchange Market Intervention and Monetary Policy Related and Does itReally Matter?” Journal of Business, Vol. 68: 185-214.

——. 1988. “Testing the Portfolio Balance Model: A Multi-lateral Approach.” Journal of InternationalEconomics, Vol. 24: 109-127.

Lindberg, H. 1994. “The Effects of Sterilised Interventions Through the Signalling Channel, Sweden1986-1990.” Sveriges Riksbank Working Paper 19.

Lipscomb, L. 2005. “An Overview of Non-Deliverable Foreign Exchange Forward Markets.” Bank ofInternational Settlements, May.

Ma, G., C. Ho, and R.N. McCauley. 2004. “The Markets for Non-Deliverable Forwards in AsianCurrencies.” BIS Quarterly Review, June.

Mc Kenzie, M. 2004. “An Empirical Examination of the Relation between Central Bank Intervention andExchange Rate Volatility: Some Australian Evidence.” Australian Economic Papers, Vol. 43:59-74.

Mohan, Rakesh. 2004. “Challenges to Monetary Policy in a Global Context.” RBI Bulletin, January.

——. 2004. “Financial Sector Reforms in India: Policies and Performance Analysis.” RBI Bulletin, October.

——. 2005. “Some Apparent Puzzles for Contemporary Monetary Policy.” RBI Bulletin, December.

——. 2006a. “Monetary Policy and Exchange Rate Frameworks: The Indian Experience.” RBI Bulletin, June.

——. 2006b. “Monetary and Financial Policy Responses to Global Imbalances.” RBI Bulletin, December.

——. 2006c. “Financial Sector Reforms and Monetary Policy: The Indian Experience.” RBI Bulletin, July.

——. 2006d. “Avian Influenza Pandemic: Preparedness within the Financial Sector.” RBI Bulletin, August.

——. 2007. “Development of Financial Markets in India.” Speech delivered at the First Indian-FrenchFinancial Forum, Mumbai, May.

Mussa, M. 1981. “The Role of Official Intervention.” Group of Thirty Occasional Papers No.6, New York.

Neely, C. J. 2002. “The Temporal Pattern of Trading Rule Returns and Central Bank Intervention:Intervention Does Not Generate Technical Trading Rule Profits.” Working Papers 2000-018, FederalReserve Bank of St. Louis.

Obstfeld, M. 1990. “The Effectiveness of Foreign Exchange Intervention-Recent Experience: 1985-1988.” in International Policy Coordination and Exchange Rate Fluctuations (eds.) W.H. Branson,J.A. Frankel and M. Goldstein, Chicago: U. Chicago press.

Pattanaik, S., and S. Sahoo. 2001. “The Effectiveness of Intervention in India: An Empirical Assessment.”RBI Occasional Papers, Vol. 22, June.

Ranade, A., and G. Kapur. 2003. “Appreciating Rupee: Changing Paradigm?.” Economic and PoliticalWeekly, February.

XII

Ranjan, R., and S.C. Dhal. 1999. “Testing for the Impact of Cross-Currency Volatility on the IndianRupee.” RBI Occasional Papers, 35(5). RBI, Mumbai.

Reddy, Y.V. 1997. “Exchange Rate Management: Dilemmas.” RBI Bulletin, April.

——. 2003. “Global Economy and Financial Markets.” RBI Bulletin, October.

——. 2005. “Indian Economy: Current Status and Select Issues.” RBI Bulletin, February.

——. 2006a. “Financial Sector Reform and Financial Stability.” RBI Bulletin, March.

——. 2006b. “Global Imbalances: An Indian Perspective.” RBI Bulletin, June.

——. 2006c. “India in Emerging Asia.” RBI Bulletin, June.

——. 2006d. “Foreign Exchange Reserves: New Realities and Options.” RBI Bulletin, October.

——. 2006e. “Central Bank Communications: Some Random Thoughts.” RBI Bulletin, February.

——. 2007. “Point of View: Converting a Tiger.” Finance and Development, International Monetary Fund,Vol. 44, March.

Reserve Bank of India. 2006. Report of the Committee on Fuller Capital Account Convertibility (Chairman:S.S. Tarapore).

——. 1995. Report of the Expert Group on Foreign Exchange Markets in India (Chairman: O.P. Sodhani),June.

——. 1997. Report of the Committee on Capital Account Convertibility (Chairman: S.S. Tarapore).

——. 2000. Report on Currency and Finance. 1999-00.



——. 2005. Report of the Internal Technical Group on Foreign Exchange Markets.

Rogoff, K. 1984. “On the Effects of Sterilized Intervention: An Analysis of Weekly Data.” Journal ofMonetary Economics, Vol. 14: 133–150.

Sahadevan, K. 2002. “Foreign Exchange Intervention and Future Monetary Policy: Some EmpiricalEvidence on Signaling Hypothesis.” ICFAI Journal of Applied Finance, Vol. 8.

Sarno, L., and M. Taylor. 2001. “Official Intervention In The Foreign Exchange Market: Is It Effectiveand, If So, How Does It Work?.” Journal of Economic Literature, Vol. 39: 839-868.

Sharma, A.K., and A. Mitra. 2006. “What Drives Forward Premia in the Indian Foreign Exchange Market?”RBI Occasional Papers, 27 (1 and 2).

Tauchen, G., and M. Pitts. 1983. “The Price Variability-Volume Relationship in Speculative Markets.”Econometrica, Vol. 51:485-505.

Taylor, D. 1982. “Official Intervention in the Foreign Exchange Market or Bet Against the Central Bank.”The Journal of Political Economy, Vol. 90: 356-368.

Udeshi, K.J. 2004. “Development of Forex Markets in India: Review and Prospects.” RBI Bulletin, September.

Unnikrishnan, N.K., and P.R. Ravi Mohan. 2001. “Exchange Rate Dynamics: An Indian Perspective.”RBI Occasional Papers, June.

XIII

VII. EQUITY AND CORPORATE DEBT MARKET

Allen, F., R. Chakrabarti, De, Sankar, Qian, Jun, and Meijun Qian. 2006. “Financing Firms in India.”World Bank Policy Research Working Paper, 3975, August.

Allen, F., and D. Gale. 1999. Comparing Financial Systems. Cambridge: MIT Press.

Bandiera, Oriana, Gerard Caprio, Patrick Honohan, and Fabrio Schiantarselli. 2000. “Does FinancialReform Raise or Reduce Savings?” Review of Economics and Statistics, 82(2): 239-63.

Bank for International Settlements. 2006. “Developing Corporate Bond Markets in Asia.” BIS Papers,No. 26, February.

Beck, Thorsten, Ross Levine, and Narsan Loayzo. 2000. “Finance and the Sources of Growth.” Journalof Financial Economics, 58 (1&2): 261-300.

Beck, Thorsten, and Ross Levine. 2003. “Stock Markets, Banks and Growth: Panel Evidence.” Journalof Banking and Finance, September.

Bose, Sushismita, and Dipankor Coondoo. 2003. “A Study of Indian Corporate Bond Market.” Moneyand Finance, ICRA Bulletin, January-March.

Cho, Y. 1986. “Inefficiencies from Financial Liberalisation in the Absence of Well-Functioning EquityMarkets.” Journal of Money, Credit, and Banking, 18 (2): 191-199.

——. 1999. “Indian Capital Markets: Recent Development and Policy Issues.” Songang University,Working Paper No. 99-01.

Christoffersen, P., and T. Slok. 2000. “Do Asset Prices in Transition Countries Contain InformationAbout Future Economic Activity?” IMF Working Paper, WP/00/103, June.

Demirguc-Kunt, Asli, and Vojislav Maksimovic. 1998. “Law, Finance and Firm Growth.” Journal of Finance,53(6): 2107-37, December.

Endo, Tadashi. 2004. “Debt Market Development in Emerging Economies: Major Issues and Challenges.”World Bank Seminar in Colombo, June 9.

Fratzscher, Oliver. 2006. “Emerging Derivative Markets in Asia.” Chapter for EAP Flagship on AsianFinancial Market Development, The World Bank, March.

Government of India. Economic Survey, Various Issues.

Gyntelberg, J., and Eli M. Remolana. 2006. “Securitisation in Asia and the Pacific: Implications forLiquidity and Credit Risks.” BIS Quarterly Review, 65-75, June.

International Monetary Fund. 2000. World Economic Outlook, May.

——. 2005. Global Financial Stability Report, April.

IOSCO. 2002. “The Development of Corporate Bond Markets in Emerging Market Countries.” May.

Levine, Ross, and Sara Zervos. 1998. “Stock Markets, Banks, and Economic Growth.” AmericanEconomic Review, 88(3):537-58, June.

Levine, Ross. 1997. “Financial Development and Economic Growth: Views and Agenda.” Journal ofEconomic Literature, 35(2):688-726, June.

——. 2003. “More on Finance and Growth: More Finance, More Growth?” Federal Reserve Bank of St.Louis. 31-46, July/August.

XIV

Li, Kai. 2007. “The Growth of Equity Market Size and Trading Activity: An International Study.” Journalof Empirical Finance, Vol. 14: 59-90.

Ludwig, A., and T. Slok. 2002. “The Impact of Changes in Stock Prices and House Prices on Consumptionin OECD countries.” IMF Working Paper, WP/02/1, January.

Luengnaruemitchai, P., and Li Lian Ong. 2005. “An Anatomy of Corporate Bond Markets: GrowingPains and Knowledge Gains.” IMF Working Paper, WP/05/152, July.

Mckinsey. 2006. “Accelerating India’s Growth Through Financial System Reforms.” May.

Mohan, Rakesh. 2004a. “Financing for Industrial Growth.” RBI Bulletin, March.

——. 2004b. “Debt Markets in India – Issues and Prospects.” RBI Bulletin, December.

——. 2006a. “Recent Trends in the Indian Debt Market and Current Initiatives.” RBI Bulletin, April.

——. 2006b. “Financial Sector Reforms and Monetary Policy: The Indian Experience.” RBI Bulletin, July.

Nagaishi, M. 1999. “Stock Market Development and Economic Growth: Dubious Relationship.” Economicand Political Weekly, 17-23, July.

Nagaraj, R. 1996. “Indian Capital Market Growth: Trends, Explanations and Evidences.” Economic andPolitical Weekly, Vol.33:14-20, March.

National Stock Exchange of India Ltd. 2005. “Indian Securities Market – A Review.” Volume VIII.

——. 2006. NSE Fact Book.

Patil, R. H. 2004. “Corporate Debt Market: New Beginnings.” Economic and Political Weekly, March 20,1237-1246.

——. 2005. Report of the High Level Expert Committee on Corporate Debt and Securitisation, December.

Purfield, Catriona, Hiroko Oura, Charles F. Kramer, and Andreas Jobst. 2006. “Asian Equity Markets:Growth, Opportunities, and Challenges.” IMF Working Paper, WP/06/266, December.

Rajan, Raghuram. G., and L. Zingales. 1998. “Financial Dependence and Growth.” American EconomicReview, Vol. 88: 559-586.

Reddy, Y.V. 2005. “Banks and Corporates as Partners in Progress.” RBI Bulletin, November.

——. 2002. “Developing Bond Markets in Emerging Economies: Issues and Indian Experience.” RBIBulletin, April.

Reserve Bank of India. 2004. Report on Currency and Finance, 2003-04.

——. 2006. Handbook of Statistics on the Indian Economy, 2005-06.

Romer, C. 1990. “The Great Crash and the Onset of the Great Depression.” Quarterly Journal ofEconomics, Vol. 105: 597-624.

Rousseau, Peter L., and Paul Wachtel. 2000. “Equity Markets and Growth: Cross-country Evidence onTiming and Outcomes, 1980-1995.” Journal of Banking and Finance, 24(12): 1933-57, December.

Sakakibara, Eisuke. 2001. “A Brief Overview: Creation of Asian Bond Market.” in Bond MarketDevelopment in Asia, Proceedings of Round Table on Capital Market Reforms in Asia, AsianDevelopment Bank Institute.

Securities and Exchange Board of India. 2003. SEBI-NCAER Survey of Indian Investors, March.

——. 2006. Handbook of Statistics on the Indian Securities Market, December.

XV

Shah, Ajay. 1995. “The Indian IPO Market: Empirical Facts - Technical Report.” Centre for MonitoringIndian Economy, June.

Shah, A., and Susan Thomas. 1997. “Securities Markets : Towards Greater Efficiency.” India DevelopmentReport, Oxford University Press.

Singh, A. 1995. “Corporate Financial Patterns in Industrialising Economies.” Technical Paper, InternationalFinance Corporation, Washington, D.C.

——. 1997. “Financial Liberalisation, Stock Markets and Economic Development.” The Economic Journal,107(442): 771-782, May.

Society for Capital Market Research and Development. 2005. “Indian Household Investors Survey –The Changing Market Environment, Investors’ Preferences, Problems, Policy Issues.” June.

Takagi, Shinji. 2001. “Developing a Viable Corporate Bond Market under a Bank-Dominated System –Analytical Issues and Policy Implications.” in Bond Market Development in Asia, Proceedings ofRound Table on Capital Market Reforms in Asia, Asian Development Bank Institute.

The World Bank. 2004. Report on the Observance of Standards and Codes (ROSC) - CorporateGovernance Country Assessment: India. Working Paper No. 2004/04/01.

The World Bank. 2006a. Global Development Finance, Washington D.C.

——. 2006b. Doing Business 2007 : How to Reform, September.

World Federation of Exchanges. www.fibv.org.

VIII. FINANCIAL MARKET INTEGRATION

Agenor, P. R. 2001. “Benefits and Costs of International Financial Integration.” Paper for the Conferenceon Financial Globalisation: Issues and Challenges for Small States. Saint Kitts. March 27-28.

Bank for International Settlements. 2006. “Regional Financial Integration in Emerging Markets: Trendsand Policy Challenges.” Unpublished Paper.

Bekaert, Geert, Min Wei and Yuhang Xing. 2002. “Uncovered Interest Parity and the Term Structure”.NBER Working Paper 8795.

Bhagwati, Jagdish. 1998. “The Capital Myth: The Difference between Trade in Widgets and Trade inDollars.” Foreign Affairs, Vol. 77: 7-12.

Bhoi, B. K., and S. C. Dhal. 1998. “Integration of Financial Markets in India: An Empirical Evaluation.”RBI Occasional Papers, 19(4). December.

Blinder, A.S. 2004. “The Quiet Revolution: Central Banking Goes Modern.” London: York University Press.

Brewer, T. L., and S. Nollen. 2000. “Direct Investment and Portfolio Flows to Developing Countries.”World Bank.

Caprio, Gerard, and Patrick Honhan. 1999. “Restoring Banking Stability: Beyond Supervised CapitalMarkets.” Brookings Paper on Economic Activity, Vol.1:143-80.

Chinn. M. D. and Meredith G. 2002. “Testing Uncovered Interest Parity at Short and Long Horizonsduring the Post-Bretton Woods Era’. Working Paper, University of California.

Chuhan, P., G. Perez-Quiros, and H. Popper. 1996. “International Capital Flows: Do Short-term Investmentand Direct Investment Differ?” PRE Working Paper No. 1669, World Bank.

XVI

Cournot, Augustin. 1927. Researches into the Mathematical Principles of the Theory of Wealth. trans.by Nathaniel T. Bacon. New York: Macmillan.

Dadush, U., D. Dasgupta, and D. Ratha. 2000. “The Role of Short-term Debt in Recent Crises.” Financeand Development, Vol. 37:54-57.

Fama, Eugene, F. 1984. “Forward and Spot Exchange Rates.” Journal of Monetary Economics, Vol. 14.

Flood, Robert, P., and Andrew K. Rose. 2002. “Uncovered Interest Parity in Crisis.” IMF Staff Papers, 49(2).

Froot, Kenneth, A., and H. Richarh Thaler. 1990. “Anomalies: Foreign Exchange.” Journal of EconomicPerspectives, 49(3).

Giannetti, M. Guiso, L. Jappelli, M. Padula, and M. Pagano. 2002. “Financial Market Integration, CorporateFinancing and Economic Growth.” European Commission.

Government of India. 2005. Report of High Level Expert Committee on Corporate Bonds andSecuritisation (Chairman: Dr. R.H. Patil).

Isard, Peter. 1995. Exchange Rate Economics, Cambridge University Press.

Joshi, H., and M. Saggar. 1998. “Excess Returns, Risk-Premia and Efficiency of the Foreign ExchangeMarket: Indian Experience in the Post Liberalisation Period.” RBI Occasional Papers, 19(2), June.

Kim, Soyoung, and Nouriel Roubini. 2000. “Exchange Rate Anomalies in the Industrial Countries: ASolution with a Structural VAR Approach.” Journal of Monetary Economics, Vol. 45.

Kose, M. A., E. Prasad, K. Rogoff, and Shang-Jin Wei. 2006. “Financial Globalisation: A Reappraisal.”IMF Working Paper, WP/06/189.

Lane, P.R. and G. M.M. Ferretti. 2006. “The External Wealth of Nations: Revised and Extended Estimatesof Foreign Assets and Liabilities 1970-2004. IMF Working Paper No. 69.

Levine, Ross. 1996. “Foreign Banks, Financial Development and Economic Growth.” InternationalFinancial Markets. (ed.) by Claude E. Barfield. Washington DC: American Enterprise Institute Press.

Levine, Ross. 2001. “International Financial Integration and Economic Growth.” Review of InternationalEconomics, Vol. 9.

Marshall, Alfred. 1930. Principles of Economics: An Introductory Volume. 8th ed. London: Macmillan.

Mehra, R., and E.C. Prescott. 1985. “The Equity Premium: A Puzzle.” Journal of Monetary Economics, 15(2).

Meredith, Guy, and Yue Ma. 2002. “The Forward Premium Puzzle Revisited.” IMF Working Paper.

Mohan, Rakesh. 2004a. “Challenges to Monetary Policy in a Globalising Context.” RBI Bulletin, January.

——. 2004b. “Financial Sector Reforms in India: Policies and Performance Analysis.” RBI Bulletin, October.

——. 2005. “Globalisation, Financial Markets and the Operation of Monetary Policy in India.” BIS PapersNo 23.

——. 2006. “Monetary Policy and Exchange Rate Frameworks: The Indian Experience.” RBI Bulletin, June.

——. 2007. “Monetary Policy Transmission in India.” RBI Bulletin, April.

Pattnaik, R. K., Muneesh Kapur, and S, C. Dhal. 2003. “Exchange Rate Policy and Management: TheIndian Experience.” Economic and Political Weekly, May 31.

Prasad, Eswar, K. Rogoff, Shang-Jin Wei and A. Kose. 2003. “Effects of Financial Globalisation onDeveloping Countries: Some New Evidence.” IMF Occasional Paper 220.

——. 2006. “The Macroeconomic Implications of Financial Globalisation.” Journal of Economic Literature.

XVII

Pétursson, T G. 2001. ‘‘The Transmission Mechanism of Monetary Policy: Analysing the Financial MarketPass-Through.” Working Papers No. 14. Central Bank of Iceland.

Reddy, Y. V. 1999. “Financial Sector Reforms: Review and Prospects.” RBI Bulletin, January.

——. 2002. “Dimensions of Financial Development, Market Reforms and Integration: The IndianExperience.” In Macroeconomics and Monetary Policy: Issues for a Reforming Economy, (eds.)M.S. Ahluwalia, Bimal Jalan and S. S. Tarapore, New Delhi : Oxford University Press.

——. 2003. “The Global Economy and Financial Markets: Outlook, Risks and Policy Responses.” RBIBulletin, October.

——. 2005a. “Overcoming Challenges in a Globalised Economy.” RBI Bulletin, July.

——. 2005b. “Implications of Global Financial Imbalances for the Emerging Market Economies”. RBIBulletin, December.

——. 2005c. “Globalisation of Monetary Policy and Indian Experience.” RBI Bulletin, July.

——. 2005d. “Annual Policy Statement for the year 2005-06.” Reserve Bank of India, April.

——. 2006a. “Reforming India’s Financial Sector: Changing Dimensions and Emerging Issues.” RBIBulletin, June.

——. 2006b. “Globalisation, Money and Finance: Uncertainties and Dilemmas.” RBI Bulletin, October.

Reserve Bank of India. 2001. Report on Currency and Finance, 1999-2000.

——. 2006. Report of the Committee on Fuller Capital Account Convertibility (Chairman: S. S. Tarapore),Mumbai.

Rodrik, Dani. 1998. “Who Needs Capital Account Convertibility?’’ Harvard University, Mimeo.

Sarno, Lucio, and Mark P. Taylor. 1999. “Hot Money, Accounting Labels and the Permanence of CapitalFlows to Developing Countries: An Empirical Investigation.” Journal of Development Economics,Vol. 59: 337-64.

Sharpe, William F. 1964. “Capital Asset Prices: A Theory of Market Equilibrium under Conditions ofRisk.” Journal of Finance, 19 (3).

Stiglitz, Joseph. 2002. Globalisation and its Discontents. New York: Norton.

Sundararajan, V., Cem Karacadag, and Jennifer Elliott. 2003. “Financial Market Development: Sequencingof Reforms to Ensure Stability.” Fifth Annual Financial Markets and Development Conference,Organized by the Brookings Institution, the International Monetary Fund, and the World Bank.

Tobin J. 1958. “Estimation of Relationship for Limited Dependent Variables.” Econometrica, January.

Trichet, J.C. 2005. “European Financial Integration.” Speech delivered at 10th Symposium on Finance,Banking, and Insurance, University of Karlsruhe, Karlsruhe, December 16.

United Nations Conference on Trade and Development. 2006. “World Investment Report.”

United States Agency for International Development. 1998. “Financial Markets Development.” USAIDPolicy Paper.

Wadhwani, Sushil. 1999. “Currency Puzzles.” Lecture Given at the London School of Economics.September.

World Bank. 2000. Global Development Finance. New York.

——. 2006. Global Development Finance. New York.

XVIII

IX. OVERALL ASSESSMENT

Geithner, Timothy F. 2007. “Liquidity and Financial Markets.” BIS Review, Vol.19.

Lipschitz, Leslie. 2007. “Wising Up about Finance.” Finance and Development, 44(1). March.

Mohan, Rakesh. 2004. “Challenges to Monetary Policy in a Globalising Context.” RBI Bulletin, January.

——. 2006a. “Coping with Liquidity Management: A Practitioner’s View.” RBI Bulletin, April.

——. 2006b. “Evolution of Central Banking in India.” RBI Bulletin, June.

——. 2006c. “Monetary Policy and Exchange Rate Frameworks: The Indian Experience.” RBI Bulletin,June.

——. 2007a. “Current Challenges to Monetary Policy Making in India.” RBI Bulletin, March.

——. 2007b. “Monetary Policy Transmission in India.” Paper presented at the BIS’ Deputy Governor’sMeeting on “Transmission Mechanisms for Monetary Policy in Emerging Market Economies –What is New?” RBI Bulletin, April.

Rajan, Raghuram G., 2005. “Has Financial Development Made the World Riskier?” NBER WorkingPaper 11278.

Reddy, Y.V. 2004. “Financial Stability: Indian Experience.” RBI Bulletin, July.

——. 2007a. “Point of View: Converting a Tiger.” Finance and Development, 44(1), March.

——. 2007b. “Globalisation and Monetary Policy: Some Emerging Issues.” RBI Bulletin, April.

Reserve Bank of India. 2006. Report of the Committee on Fuller Capital Account Convertibility.(Chairman: S. S. Tarapore).

——. 2007. “Third Quarter Review of the Annual Statement on Monetary Policy for the year 2006-07.”January.