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  • III MONEY MARKET3.1 The money market is a key component of the has been a shift towards greater exchange ratefinancial system as it is the fulcrum of monetary flexibility and adoption of inflation targeting by someoperations conducted by the central bank in its central banks partly because of increased capitalpursuit of monetary policy objectives. It is a market mobility, greater financial market integration andfor shor t-term funds with maturity ranging from repeated episodes of currency crises. Commensurateover night to one year and includes financial with these changes, central banks have moved awayinstruments that are deemed to be close substitutes from conventional (direct) instruments of monetaryof money. The money market performs three broad control (working through the quantum channel)functions. One, it provides an equilibrating towards more use of indirect instruments (operatingmechanism for demand and supply of short-term through the price channel). Accordingly, the use offunds. Two, it enables borrowers and lenders of short- reserve requirements and direct credit controls hasterm funds to fulfil their borrowing and investment been gradually de-emphasised, while relying morerequirements at an efficient market clearing price. on interest rates for signalling the monetary policyThree, it provides an avenue for central bank stance. As central banks have only limited controlintervention in influencing both quantum and cost of over long-term interest rates, the most commonlyliquidity in the financial system, thereby transmitting adopted strategy has been to exert direct influencemonetary policy impulses to the real economy. The only on short-term interest rates and permittingobjective of monetary management by the central market expectations to influence long-term interestbank is to align money market rates with the key rates through financial market inter-linkages. Thus,policy rate. As excessive money market volatility the choice of monetary policy instruments is guidedcould deliver confusing signals about the stance of by the structure of the money market.monetary policy, it is critical to ensure orderly market 3.4 In India, although the ultimate goals ofbehaviour, from the point of view of both monetary monetary policy, viz., growth and price stability, haveand financial stability. Thus, efficient functioning of remained unchanged over the years, the Reservethe money market is important for the effectiveness Bank has modified its operational and intermediateof monetary policy. objectives of monetar y policy several times in3.2 In order to meet these basic functions response to changes in the economic and financialefficiently, money markets have evolved over time environment. For instance, in the mid-1980s, thespawning new instruments and participants with Reserve Bank formally adopted monetary targetingvarying risk profiles in line with the changes in the with feedback as a nominal anchor to fight inflation,operating procedures of monetary policy. Changes in partly induced by the large scale monetisation of fiscalfinancial mar ket str uctures, macroeconomic deficits. The operating procedure in this regime wasobjectives and economic environment have called for modulation of bank reserves by varying reserveshifts in monetary regimes, which, in turn, have requirements. In order to meet reserve requirements,necessitated refinements both in the operating banks borrowed primarily from the inter-bank (callinstruments and procedures, and in institutional money) market. Hence, these transactions werearrangements by central banks. reflective of the overall liquidity in the system. Accordingly, the Reserve Bank focussed on the money3.3 Internationally, following the breakdown of market, in particular, the call money market by usingthe Bretton Woods system, there was a shift from various direct instruments of monetary control torule-based frameworks towards discretion in the use signal the policy stance consistent with the overallof monetary policy instruments, which ultimately led objectives of achieving growth and price stability. Asto the gradual abandonment of exchange rate interest rates were regulated, monetary managementtargets. Changes in financial structures and financial was undertaken mainly through changes in the cashinnovations also rendered monetar y targeting reserve ratio (CRR), which was used to influenceineffective by making the money demand functions indirectly the marginal cost of borrowing by havingunstable. Accordingly, since the early 1990s, there an initial impact on the call money market. As the
  • REPORT ON CURRENCY AND FINANCEsuccess of this strategy was crucially dependent on streamlining the money market operations. Thisthe stability of the call money market and its inter- resulted in greater control over the liquidity in thelinkages with other money market segments, reforms system and created an efficient mechanism tosince the late 1980s, along with changes in the transmit interest rate signals. Thus, changes in thereserve maintenance procedures, have aimed at monetary policy operating procedures necessitateddeveloping various money market segments through refinements in money market microstructure throughintroduction of new instr uments, increased introduction of new instruments and widening ofparticipation and improved liquidity management in par ticipation under a deregulated interest ratethe system. environment.3.5 Financial sector reforms since the early 3.7 The need for developed and well-integrated1990s have provided a strong impetus to the money market also assumes critical importance asdevelopment of financial markets, which, along with India progressively moves towards greater capitalinterest rate deregulation, paved the way for account convertibility, as envisaged by the Committeeintroduction of mar ket-based monetar y policy on Fuller Capital Account Convertibility (FCAC), whichinstruments. With financial innovations, money submitted its report to the Reserve Bank in July 2006.demand was seen as less stable and the Better response to such financial flows by variousdisequilibrium in money markets got reflected in market segments will depend upon the extent ofshort-term interest rates (Mohan, 2006). Accordingly, integration as well as the development of necessarysince the adoption of the multiple indicator approach infrastructure. The greater integration of domestic andin 1998, although monetary aggregates continue to international markets also calls for flexible use ofbe an important information variable, interest rates monetary policy instruments for modulating domestichave emerged as the operational instrument of policy liquidity conditions and correcting any serious– initially the Bank Rate and then the repo/reverse misalignments between short-term and long-termrepo rates under the liquidity adjustment facility interest rates.(LAF) from June 2000. This shift in emphasis frommoney to interest rates has been spurred by 3.8 Against the above backdrop, this chapterincreased financial liberalisation, greater trade traces the evolution of monetary policy operatingopenness and capital flows, and innovations in procedures in India as necessitated by the changespayment and transactions technologies. Such a shift in the financial market structure, in particular, thewas gradual and a logical outcome of measures money market, and the risks/challenges arising outimplemented in the reform period since the early of such market orientation of monetar y policy.1990s (Reddy, 2002). An array of new money market Section I spells out the theoretical underpinnings ofinstruments such as commercial paper, certificates money mar ket for monetar y policy making.of deposit and repos has been introduced in order International experience on money market operatingto broaden the money market. Furthermore, with procedures, the evolving practices in liquidityincreased sophistication of financial markets, the risk management operations and the structure of moneyprofiles of financial mar ket par ticipants also market are set out in Section II. Section III presentschanged, necessitating introduction of derivative a brief review of the money market in India in theinstruments as effective risk management tools. pre-reform period. Section IV deals with the changes in the Reser ve Bank’s liquidity management3.6 The liberalisation of capital controls resulting operations commensurate with the shifts in operatingin increased integration of the Indian economy with procedures. Developments in various segments ofthe global economy, however, posed new challenges the money market since the mid-1980s are coveredand dilemmas for monetar y and exchange rate in Section V. It also discusses the Reserve Bank’smanagement in the 1990s. These developments proactive role in mitigating various risks to thecalled for a greater emphasis on orderly conditions financial system. Section VI identifies the emergingin financial markets for ensuring financial stability. issues in monetary and liquidity management in IndiaIn this phase, the focus of reforms was on introducing and the need for addressing them in future for theinstruments of various maturities in different money smooth functioning of the money market and themarket segments and imparting liquidity to these efficient conduct of monetary policy. Section VIIinstruments by developing a secondary market, and presents the concluding observations. 68
  • MONEY MARKETI. ROLE OF THE MONEY MARKET - bank money in the banking system, which is THEORETICAL UNDERPINNINGS determined by the supply of bank reserves. If all factors having an impact on output and inflation were3.9 There is a general consensus among completely known in advance, it would make noacademics and central bankers that monetary policy difference whether the central bank conducts policyis best geared to achieve price stability. In some by fixing the supply of reserves or by setting ancountries, central banks have additional mandates interest rate (Friedman, 2000b). In fact, thesesuch as ensuring full employment, maximising growth alternative operating strategies would be similar inand promoting financial stability. In order to meet these impact. However, since many factors that impact theobjectives, central banks intervene in financial central bank’s policy priorities are unpredictable, themarkets to ensure that short-term interest rates (and choice of the operating instrument matters for theexchange rates) and liquidity are maintained at effectiveness of monetary policy.appropriate levels, consistent with the objectives ofmonetary policy. Thus, monetary policy and financial 3.12 The theoretical justification for the conduct ofmarkets are linked intrinsically. It is through the monetary policy through interest rates is derived fromfinancial markets that monetary policy affects the real “the appropriate choice of instrument problem” (Poole,economy. Hence, financial markets are the connecting 1970). It was demonstrated that if aggregate demandlink in the transmission mechanism between monetary shocks in the economy originate from the goodspolicy and the real economy. market (the IS curve), then the optimum policy is to3.10 The relationship between monetary policy and target monetary aggregates for minimising outputfinancial markets is of mutual inter-dependence. fluctuations. On the other hand, if demand shocksCentral banks conduct monetary policy by directly and originate in the money market (the LM curve), fromindirectly influencing financial market prices. Financial the perspective of monetary policy, targeting interestmarket prices reflect the expectations of market rates is the appropriate approach. The implicationparticipants about future economic developments. being that as financial mar kets develop withThese expectations, in tur n, provide valuable increasing financial innovations, the demand forinformation to central banks in setting the optimal money becomes unstable, rendering monetar ycourse of monetary policy in the future. targeting redundant. In other words, with the gradual financial sophistication of the economy, the3.11 Monetary policy affects financial markets speculative demand for money dominates thethrough various financial price and quantity channels. transaction motive. Hence, most developed countriesThe transmission process from monetary policy to operate through an interest rate target.financial markets and finally to the real economy istypically triggered through the use of monetary policy 3.13 The interest rate channel is the primaryinstruments (reserve requirements, open market mechanism of monetar y policy transmission inoperations, policy rates and refinance facilities) for conventional macroeconomic models where ancontrolling the operating targets (like reserve money increase in nominal interest rates, given some degreeand bank reserves) consistent with intermediate of price stickiness, translates into an increase in thetargets such as money supply, which enables real rate of interest and the user cost of capitalattainment of final objectives of economic growth and (Exhibit III.1) . These changes, in turn, lead to apr ice stability. Typically, the monetar y policy postponement in consumption or a reduction ininstrument is a financial market price, which is investment spending thereby affecting the working ofdirectly set or closely controlled by the central bank. the real sector, viz., changing aggregate demand andFor most central banks with floating exchange rates, supply, and eventually growth and inflation in thethe monetar y policy instrument is a shor t-term economy (Kuttner and Mosser, 2002). This is theinterest rate. Changes in the short-term policy rate mechanism embodied in conventional specificationsprovide signals to financial markets, whereby various of the “IS” curve, both of the “Old Keynesian” varietysegments of the financial system respond by (Samuelson and Solow, 1960) and the “New Keynesian”adjusting their rates of return on various instruments, models developed during the 1990s (Rotemberg anddepending on their sensitivity and the efficacy of the Woodford, 1997; Clarida, Gali, and Gertler, 1999).transmission mechanism. Under fixed exchange rate However, the macroeconomic response to policy-regimes, a particular exchange rate serves as the induced interest rate changes is considerably largerinstrument. Similarly, under the monetary targeting than that implied by conventional estimates of theregime, the operating target is the quantity of central interest elasticities of consumption and investment 69
  • REPORT ON CURRENCY AND FINANCE 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 Source: Adapted from Kuttner and Mosser (2002).(Bernanke and Gertler, 1995). This suggests that 3.15 Short-term interest rates alone have onlymechanisms, other than the interest rate channel, may limited direct effects on the economy. Long-termalso be at work in the transmission of monetary policy1 . interest rates have a stronger impact as they3.14 Interest rates can influence the monetary determine savings and investment decisions in thepolicymaking process in three distinct ways economy. In order to impact the economy, monetary(Friedman, 2000a). The first role of interest rates is policy impulses must, therefore, be transmitted fromas an instrument variable that the central bank sets the money market to the capital market by influencingin order to implement its chosen policy. A second asset prices such as loan rates, bond rates, exchangepotential role for interest rates in the monetary policy rates and stock market valuations. The money marketprocess is again as an instrument variable, but as an and the capital market are linked by expectations.instrument that the central bank varies not for Neglecting transaction costs and risk premiums, theinfluencing output and inflation directly but rather for expectations theory of the term structure views thetargeting the money stock. Finally, most central banks long-term interest rate as an average of the short-use short-term interest rate as their monetary policy term interest rates expected to prevail till the maturityinstrument variable based on long-term interest rate of the respective instrument. Although current short-movements, which are taken as more of an term interest rates have some effect on longer-terminfor mation var iable about potential future bond yields, the expectations theory of the termdevelopments. Implicit in this framework, however, is structure indicates that it is primarily expected futurea regular term structure of interest rates whereby short-term interest rates which determine bond yields.policy initiatives at the short end are transmitted In practice, owing to uncertainty about the futureefficiently to the longer end of the maturity spectrum. evolution of short-term interest rates and the time-This relationship fares better under the assumption varying risk premiums, the longer the maturity, theof adaptive expectations (Chow, 1989), while recent weaker the link between current short-term rates andempirical evidence suggests that long-term rates are long-term rates. Therefore, in practice, central bankspoor (and biased) predictors of future short-term sometimes find it difficult to guide longer-term interestrates, particularly when expectations are rational rates to a level commensurate with what they consider(Blinder, 2006). to 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 the uncovered interest rate parity condition. 70
  • MONEY MARKET3.16 Central banks, never theless, operate on refers to actions taken by the central bank to manageshort-term policy rates, which under a regular term- the overall level of high-powered money and, throughstructure and a smooth market continuum would be this, to regulate money market conditions (Box III.1).able to influence long-term interest rates. In order to The regulation of money market conditions focussesefficiently transmit monetary policy signals to long- on offsetting the demand for excess reserves in orderterm rates, central banks foster development of the to avoid large fluctuations in bank reserves causingmoney market. The money market, thus, serves as volatility in short-term interest rates. Successfulthe corner-stone of a competitive and efficient system market liquidity management requires that the dailyof market-based intervention by the central bank. It level of excess reserves in the banking system bestimulates an active secondary bond market by close to the level demanded by banks.reducing the liquidity risk of bonds and other short-term financial instruments and assists financial 3.19 Theoretically, the speed of transmission ofintermediaries in managing their liquidity risk. It also policy signals to financial asset prices improves withser ves as the medium for Gover nment cash derivatives trading as it enables risk sharing acrossmanagement and provides the first link in the the market as well as reflects the inter-temporalimplementation of monetary policy. There are three adjustments of financial asset prices to monetaryconditions which are required to be fulfilled for policy signals. A financial derivative contract derivesdeveloping a well-functioning money market. These the future price for the underlying asset on the basisare: (i) banks and other financial institutions must be of its current price and interest rates. Accordingly, thecommercially motivated to respond to incentives, efficient pricing of derivatives is contingent upon anactively manage risk and maximise profit; (ii) the active and liquid market for the underlying asset. Ascentral bank must shift from direct to indirect methods the informational content of the market is reflected inof implementing monetar y policy; and (iii) the prices of derivatives, there is a case for usingGovernment must have a good mechanism of cash derivatives as monetary policy instruments. It is,management, thereby giving the central bank greater however, noted that central banks do not usefreedom in setting its operating procedures. derivative instruments actively for monetary policy purposes as they are normally considered to be risky3.17 The central bank’s operating procedures and uncertain. Furthermore, the impact of derivativesgreatly influence the stability of the money market as trading on the real economy remains ambiguous (Graywell as banks’ incentives to actively use the moneymarket to manage risk. In this regard, operating and Place, 2001). Der ivatives, however, areprocedures need to be designed appropriately to increasingly becoming a useful tool for r iskpromote market liquidity, stability and encourage management in financial markets.active risk management. The operating procedures 3.20 To sum up, the interest rate channel hasthat particularly influence banks’ risk management emerged as a key channel of monetar y policyincentives are the reserve maintenance period, the transmission mechanism. Although the central bankdefinition of liabilities on which reserves are levied, can directly influence mainly shor t-ter m rates,accommodation policy and the accuracy of operations effective transmission of policy signals requires adesigned to affect market liquidity - that is, the proper term structure of interest rates, which isaccuracy with which the central bank can control the dependent on market par ticipants’ expectationsdemand for excess reserves in the system. about the future movements in policy rates. A well-3.18 Development of liquidity in the inter-bank functioning money market is, therefore, essential formarket - the market for short-term lending/borrowing conducting indirect, market-based monetary policyamongst banks - provides the basis for growth and operations and for providing the liquidity necessaryincreased liquidity in the broader money market, for the market in government securities and privateincluding secondary market for Treasury Bills and sector bonds. By careful management of liquidityprivate sector money market instruments. While the conditions, the central bank can realise its monetarycentral bank’s liquidity management operations policy objectives and encourage money marketencompass discretionary injections or withdrawals of transactions while ensuring stable market conditions.primary money from the financial system at its own A vital element for conducting effective monetaryinitiative, its accommodation policy comprises policy is knowledge of Government cash flows,operations to meet the demand for liquidity from which, like central bank’s open market operations,market participants. Market liquidity management also affect bank’s reserve balances. 71
  • REPORT ON CURRENCY AND FINANCE Box III.1 Role of the Money Market in the Monetary Transmission MechanismThe money market forms the first and foremost link in the (rise) to the level at which banks collectively are willing totransmission of monetary policy impulses to the real hold all of the reserves that the central bank has suppliedeconomy. Policy interventions by the central bank along will the financial system reach equilibrium. Hence, anwith its market operations influence the decisions of “expansionary” (contractionary) open market operationhouseholds and fir ms through the monetar y policy creates downward (upward) pressure on short-term interesttransmission mechanism. The key to this mechanism is rates not only because the central bank itself is a buyerthe total claim of the economy on the central bank, (seller), but also because it leads banks to buy (sell)commonly known as the monetary base or high-powered securities. In this way, the central bank can easily influencemoney in the economy. Among the constituents of the interest rates on short-term debt instruments. In themonetary base, the most important constituent is bank presence of a regular term structure of interest rates andreserves, i.e., the claims that banks hold in the form of without market segmentation, such policy impulses getdeposits with the central bank. The banks’ need for these transmitted to the longer end of the maturity spectrum,reserves depends on the overall level of economic activity. thereby influencing long-term interest rates, which have aThis is governed by several factors: (i) banks hold such bearing on household’s consumption and savings decisionsreserves in proportion to the volume of deposits in many and hence on aggregate demand.countries, known as reserve requirements, which influencetheir ability to extend credit and create deposits, thereby There are alternative mechanisms of achieving the samelimiting the volume of transactions to be handled by the objective through the imposition of reserve requirementsbank; (ii) bank’s ability to make loans (asset of the bank) and central bank lending to banks in the form of refinancedepends on its ability to mobilise deposits (liability of the facilities. Lowering (increasing) the reserve requirement,bank) as total assets and liabilities of the bank need to and, therefore, reducing (increasing) the demand formatch and expand/contract together; and (iii) banks’ need reserves has roughly the same impact as an expansionaryto hold balances at the central bank for settlement of claims (contractionary) open market operation, which increaseswithin the banking system as these transactions are settled (decreases) the supply of reserves creating downwardthrough the accounts of banks maintained with the central (upward) pressure on interest rates. Similarly, another waybank. Therefore, the daily functioning of a modern economy in which central banks can influence the supply of reservesand its financial system creates a demand for central bank is through direct lending of reserves to banks. Centralreserves which increases along with an expansion in banks lend funds to banks at a policy rate, which usuallyoverall economic activity (Friedman, 2000b). acts as the ceiling in the short-term market. Similarly, central banks absorb liquidity at a rate which acts as theThe central bank’s power to conduct monetary policy stems floor for short-term market interest rates. This is important,from its role as a monopolist, as the sole supplier of bank since injecting liquidity at the ceiling rate would ensurereserves, in the market for bank reserves. The most that banks do not have access to these funds for arbitragecommon procedure by which central banks influence the opportunities whereby they borrow from the central bankoutstanding supply of bank reserves is through “open and deploy these funds in the market to earn higher interestmar ket operations” – that is, by buying or selling rates. Similarly, liquidity absorption by the central bank hasgovernment securities in the market. When a central bank to be at the floor rate since deployment of funds with thebuys (sells) securities, it credits (debits) the reserve account central bank is free of credit and other risks. Typically, theof the seller (buyer) bank. This increases (decreases) the objective of the central bank is to modulate liquiditytotal volume of reserves that the banking system collectively conditions by pegging short-term interest rates within thisholds. Expansion (contraction) of the total volume of corridor.reserves in this way matters because banks can exchangereserves for other remunerative assets. Since reserves earn While the above mechanism outlines how central bankslow interest, and in many countries remain unremunerated, can influence short-term interest rates by adjusting thebanks typically would exchange them for some interest quantity of bank reserves, the same objective can bebearing asset such as Treasury Bill or other short-term debt achieved by picking on a particular short-term interest rateinstruments. If the banking system has excess (inadequate) and then adjusting the supply of reserves commensuratereserves, banks would seek to buy (sell) such instruments. with that rate. In many countries, this is achieved byIf there is a general increase (decrease) in demand for targeting the overnight inter-bank lending rate andsecurities, it would result in increase (decline) in security adjusting the level of reserves which would keep the inter-prices and decline (increase) in interest rates. The resulting bank lending rate at the desired level. Thus, by influencinglower (higher) interest rates on short-term debt instruments short-term interest rates, central banks can influencemean a reduced (enhanced) opportunity cost of holding output and inflation in the economy, the ultimate objectiveslow interest reserves. Only when market interest rates fall of monetary policy. 72
  • MONEY MARKETII. OPERATING PROCEDURES AND MONEY targets in several countries, thereby prompting many MARKET - INTERNATIONAL EXPERIENCE central banks to adopt a multiple indicator approach. Under this approach, many central banks such as the3.21 The objectives, targets and operating US Federal Reserve, the European Central Bank andprocedures of monetary policy worldwide have the Bank of Japan regularly monitor a number ofwitnessed considerable shifts in tune with the macroeconomic indicators such as prices, outputevolution of monetary theory, central banking regimes gaps, and developments in asset, credit and otherand the changing macroeconomic conditions over financial markets, which have a bearing on pricetime. By the 1970s, most central banks came to accept stability.price stability as a key objective of monetary policy -a departure from the earlier prominence given to 3.23 Some EMEs such as Russia and Chinagrowth and employment objectives. In recent years, continue to specify intermediate targets in the formbeyond the traditional growth-inflation trade-off, of monetary aggregates. Some other countries suchfinancial stability has emerged as another key as Indonesia, however, use indicative monetaryobjective in the wake of growing financial market targets more as an important information variable,integration and associated uncertainty and volatility supplementing it with other indicators of developmentsarising out of contagion. Although a number of central in financial mar kets and the real economy.banks in developed countries such as the Reserve Furthermore, along with the adoption of inflationBank of New Zealand, Reserve Bank of Australia and targeting by many EME central banks, there has beenthe Bank of England have adopted price stability as an increasing focus on the interest rate channel oftheir sole objective by adopting an inflation targeting the monetary transmission process.framework, several other countries, viz., the US andJapan continue to pursue dual objectives of pricestability and growth. Similarly, while some emerging Operating Targetsmarket economies (EMEs) such as South Africa, 3.24 The process of monetar y policyThailand, Korea and Mexico have emphasised solely implementation is guided mainly by the choice ofprice stability by adopting an inflation targeting operating targets. Notwithstanding the policyframework, some others tend to follow multiple objectives, the critical issue facing the monetaryobjectives. authorities is to strike a balance in the short-run between instruments and targets. In recent years, aMonetary Policy Frameworks certain degree of consensus has emerged both in theIntermediate Targets industrialised countries and EMEs to use market- oriented instruments, driven mainly by the rapid3.22 As central banks could not always directly development and deepening of various financialtarget the ultimate objective, monetary policy focussed market segments, the diversification of financialon intermediate targets that bear close relationship institutions and the globalisation of financialwith the final objective. The selection of intermediate intermediation (Van’t dack,1999).targets is conditional on the channels of monetarypolicy transmission that operate in the economy. The 3.25 With the gradual development andprocess of rapid disintermediation sparked off by a sophistication of money markets in a deregulatedspate of financial innovations during the 1980s began regime, there has been a shift from Keynesian growth-to impact the monetary targeting framework (Solans, and full-employment-or iented monetar y policy2003). Accordingly, with money demand becoming operating on monetary aggregates to an inflation-unstable, central banks began to modulate aggregate oriented monetary policy operating on interest rates.demand by targeting interest rates. As a result, central With the growing sophistication of markets, the 2banks in the US (1992) and Japan (1994-2001) , traditional dirigiste, direct control approach toamong others, adopted inter-bank rates as monetary policy has become obsolete, while indirectintermediate targets. Financial liberalisation, however, mar ket oriented approach has gained greaterhas reduced the importance of explicit intermediate acceptance (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 target from the outstanding balances of current accounts at the Bank to the uncollateralised overnight call rate. 73
  • REPORT ON CURRENCY AND FINANCE3.26 Among the two operating procedures, viz., standing facilities to define an interest rate corridor.through bank reserves and interest rates, the focus Most of these countries steer the overnight rateshas increasingly shifted towards the latter since the within a corridor - lower bound (floor) set by theearly 1990s due to the broader changes that took deposit facility and upper bound (ceiling) representedplace in the economic environment (Borio, 1997). The by the lending facility. These corridors are normallytrend reflects the growing role played by interest rates considerably wide, allowing for the significant flexibilityin the transmission mechanism as markets develop in the movement of both policy and overnight ratesin a deregulated environment. The sharper focus on (Borio, op.cit). With regard to the frequency of interestinterest rates as the operating target has gone hand rate adjustments, most central banks prefer a policyin hand with a tendency to move towards targeting of small and gradual changes.short-term interest rates. As a corollary, the overnightrate has emerged as the most commonly pursued Operating Proceduresoperating target in the conduct of monetary policy.Hence, the focus has been concentrated on money 3.30 The operating procedures of liquiditymarkets for transmitting monetary policy signals. The management have also changed in response to thetargeting of short-term interest rates is fully consistent changes in the policy environment amidst financialwith a market oriented approach whereby information liberalisation. The literature and the central banks’ ownabout the expectations of future movements in interest accounts attribute five main reasons for reform in theirrates is extracted from the prevailing market rates. operating procedures in the industrial countries during the 1980s and the 1990s (Mehran et al., 1996 and3.27 Although countries differ in terms of the Forssbaeck and Oxelheim, op cit). First, monetarychoice of instruments, they could be broadly classified policy instruments were changed to adapt to the newon the basis of their key operating targets (interest operational frameworks of the respective monetaryrates) (Annex III.1). In the first category are countries author ities. Second, with financial deepeningsuch as the US, Japan, Canada and Australia, where occurring more or less entirely outside the centralthe key operating target is the overnight inter-bank banks’ balance sheets, the share of the financialrate although the signalling strategies differ. In the system over which monetary authorities had directcase of other developed countries such as the ECB, control was reduced, warranting indirect (price-the key policy rate is the tender rate that is applicable oriented as opposed to quantity-oriented instruments)to regular operations, mainly, the refinancing ways to control the non-monetary components ofoperations. Some central banks, however, in countries liquidity in the financial system. Third, in the wake ofsuch as the UK, select overnight market interest rates expansion, diversification and integration of financialas their operating target consistent with the official markets all over the world, greater interest rateBank Rate decided by the MPC. In general, the flexibility and narrowing of differentials between ratesmaturity of such interest rates varies from 1 to 2 weeks of return in different currencies warranted instrumentsbut could range between 1 or 2 days to 1-month. that can impart flexibility to liquidity management in3.28 The operating target in the case of several terms of the timing, magnitude and accuracy. Fourth,EMEs also is the overnight rate - determined in the the growing importance of expectations in financialinter-bank market for settlement balances (Korea and markets favoured the adoption of instruments that areMalaysia) (Annex III.2). In order to promote financial better suited for signalling the stance of monetarystability, central banks, being the monopolistic policy. Finally, there was a growing urge on the partsuppliers of primary liquidity, have endeavoured to of central banks to stimulate money market activitysmoothen the movements in the overnight rate with a and improve monetary policy transmission whilehigh degree of precision through calibrated emphasising the separation of monetar y andmodulation of bank reserves. Central banks have Government debt management objectives.generally refrained from strict control of interest rates 3.31 As a result of the changes in the policyas it deters the development of money markets. environment, the following trends could be observedAllowing the volatility in the overnight rate to absorb at the international level, particularly during the 1990stemporary pressure could enable central banks to (Borio, op.cit and Van’t dack, op.cit). First, there haspreserve stability in other money market segments. been a continuous reduction in reserve requirements.3.29 Central banks have used several techniques The marked international trend towards reduction inin order to contain the interest rate volatility - the reserve requirements over the last decade reflectsaveraging of reser ve requirements and use of the conscious policy effort to reduce the tax on 74
  • MONEY MARKETintermediation with a view to reducing the burden of become ‘safety valves’ rather than the keyinstitutions and generate a level playing field, both mechanisms for setting the interest rate. They arebetween different types of domestic institutions and operated at the margin in order to bridge temporaryincreasingly those across national borders. Although mismatches in liquidity. In the case of EMEs also,the fluctuations in liquidity levels engendered by there has been a movement away from standingautonomous factors could be modulated through the facilities. With the development and integration of newbuffer stock property of reserve requirements and financial markets, bank intermediation became lessthrough active liquidity management by means of dominant as households parked a part of their savingsdiscretionary operations3, internationally, the general outside the banking sector. As a result, enterprisesdownward trend in reserve ratios has been shifting increasingly started tapping non-bank sources ofthe balance towards liquidity activism. This has also funding. Consequently, aggregate spending becamebeen made possible by the increase in excess sensitive to more than just bank-determined interestmaintenance of reserves whereby banks circumvent rates as policy induced changes in interest rates alsothe impact of changes in reserve requirements. influenced demand through the wealth effect of asset prices. Accordingly, the asset channel of monetary3.32 Central banks in EMEs tend to use reserve transmission, which focusses on developing newrequirements to offset autonomous influences on bank instruments and procedures for influencing financialliquidity more frequently than in developed countries. market expectations and behaviour, has gained addedWhile reserve requirements play a different role in importance.EMEs than in developed countries, there has been aconvergence towards lower levels while 3.35 Third, among the wide array of monetarydeemphasising their role as active instruments of policy instruments, repos have almost become themonetary control. Thus, in recent years, reserve main policy tool, which could be considered a majorrequirements have been giving way to a more market milestone in the development of money markets.oriented approach of impounding liquidity, including Countries (including EMEs) have preferred reposthrough the issue of central bank paper. more than the outright open market operations because they do not require an underlying market for3.33 Second, there has been a growing emphasis securities and they tend to break the link betweenon active liquidity management driven partly by the the maturity of the paper and that of the transaction.pressures of increasingly mobile international capital The emergence and subsequent rapid growth ofand decline in reserve requirements. With a view to pr ivate repo mar kets in recent years, oftendeveloping money markets by reducing the reliance encouraged by the central banks themselves, haveon accommodation from the central bank and in order spurred the usage of these instruments.to impart greater flexibility in interest rate adjustments,liquidity management has largely been implemented 3.36 Most EMEs have assigned repos a major rolethrough discretionary operations at the expense of in the day-to-day management of bank reserves. Anstanding facilities, particularly since the early 1980s. active market for repos and reverse repos has beenAs a corollary, central banks have widened the range developed in Korea, Mexico and Thailand. Theof instruments used in their market operations, underlying eligible assets are mainly government fixedshortened the maturity of transactions, increased their income securities. In the case of thin markets, centralfrequency and complemented regular basic banks have responded by widening the range ofrefinancing operations with other fine-tuning eligible securities. The central banks of the US, theoperations. ECB, the UK, Singapore and Mexico also conduct repo operations involving cor porate bonds as3.34 The reliance on market operations rather than collaterals.standing facilities for balancing the market for bankreserves was also necessitated by the need to develop 3.37 Besides the rapid growth of domestic repomore flexible and less intrusive implementation markets in recent years, repurchase transactions areprocedures. Hence, the main instruments for liquidity now easily carried out across national borders also.management by central banks are discretionary This has been facilitated by the Inter national 4market operations. Conversely, standing facilities have Securities Market Association (ISMA) , which plays3 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. 75
  • REPORT ON CURRENCY AND FINANCEan important role by establishing uniform trading reluctance to conduct outright transactions in theprocedures in the international bond markets. This has government securities market.helped large banks/other financial institutions to covershort-term liquidity mismatches. Accordingly, the 3.41 Although country practices vary, the operatinginternational financial system has experienced an procedures of monetary policy of most central banksincrease in global integration. It is widely believed that are beginning to converge to one of the variants ofthe growth of the collateralised repo market has the three-closely related paradigms. The first set ofplayed an important role in enhancing the overall central banks, including the US Federal Reserve,stability of the financial system by removing estimate the demand for bank reserves and then carrycounterparty risks through funded credit protection out open market operations to target short-termagainst risky transactions in unsecured wholesale interest rates, especially if their financial markets arefinancial markets (Joshi, 2005). deep enough to transmit changes at the short end to the longer end of the term structure. A second set of3.38 Four th, greater flexibility in liquidity central banks such as in Russia and Mexico estimatemanagement has been accompanied by a greater market liquidity and carry out open market operationstransparency in the policy signals relating to desired to target bank reserves, while allowing interest ratesinterest rate levels, driven by the broader changes in to adjust, especially if their credit channels arethe economic and political environment, including the strong. In the third category, a growing number ofdecline in inflation to relatively low levels, growing central banks including the European Central Bankemphasis on inflation targeting, greater autonomy and (ECB) and a large number of inflation targetersaccountability of central banks and growing influence modulate monetary conditions in terms of both theof market forces and expectations in the formation of quantum and price of liquidity through a mix of openinterest rates. The main structural factors shaping market operations (OMOs), standing facilities andpolicy implementation are also induced by the minimum reserve requirements and changes in thechanges in payment and settlement systems, policy rate but do not announce pre-set money orparticularly, the broad-based introduction of real time interest rate targets.gross settlement system. 3.42 These developments together with theCentral Bank Operations growing integration of markets have warranted accurate forecasts of liquidity, par ticularly the3.39 With regard to market operations, most autonomous supply of bank reserves and its demandcentral banks conduct at least one transaction at a by the banking system. The operations of centralregular interval in order to meet the basic liquidity banks have become critically contingent on theseneeds of the system. The other complementary forecasts. The features of the forecasting process varyoperations that take place are calibrated responses significantly across the countries, reflecting theirto day-to-day mar ket conditions, fine-tuning operating frameworks of monetary policy. Severaloperations providing liquidity over longer horizons (the EMEs also conduct forecasts on a regular basis withUS and Japan) and mopping up of excess liquidity planning horizons ranging from one day to severalwith a view to inducing ex ante liquidity shortage (the months.UK). The maturity of these operations is usuallyrelatively short for key operations, shorter for day-to- 3.43 Regarding the number of instruments, countryday calibration and longer for other operations. practices differ widely. Central banks in countries such as Canada conduct one or two type of operations at3.40 In some countries, outright transactions also the most, which are sufficient for liquidityplay a role. For instance, in the US, periodic purchases management, whereas central banks in Japan andand sales of government securities are used as the UK rely on a broad range of operations. The rangepermanent additions/withdrawals of reserves. In of underlying securities traded and collateral acceptedJapan, the central bank regular ly purchases is broad in Japan and several European countries,government bonds to supply the base money. In the including various types of public and private claims.case of EMEs, outright transactions in the secondary Conversely, in the US, New Zealand and Australia,markets remain important instruments, particularly to central banks operate on the basis of public sectoroffset structural liquidity surpluses/shortages. In assets.recent years, however, there has been an increasingtrend towards allowing greater leeway to market forces 3.44 The choice of counter par ties var iesin determining the interest rates. Hence, there is substantially across the countries. For instance, in 76
  • MONEY MARKETthe US, the Fed deals only with a restricted group of securities in excess of the fiscal requirements andprimary dealers. In the UK, each market operation parks the surplus funds with the Monetary Authorityand standing facility has a specific set of of Singapore (MAS) as deposits, thus, supplementingcounterparties. There is a wide range of counterparties its draining operations. Countries such as Malaysia,in different countries. For instance, only banks act as Thailand and Indonesia have modulated excesscounterparties in Mexico, while in Korea apart from liquidity in the financial system by diverting government/banks, merchant banks, investment/trust companies public sector deposits from the commercial bankingand securities companies also act as counterparties. system to the central bank.While level playing field considerations may favour 3.47 To sum up, some lessons emerge from themany counterparties, efficiency considerations may international experience on liquidity management ofcall for a system of primary dealers. If the domestic both developed and emerging market economies.securities markets are not deep, central banks First, with the deepening of financial markets and theengage in foreign exchange swaps for liquidity growth of non-bank intermediaries, central banksmanagement purposes (South Africa and Thailand). need to increase the market orientation of their3.45 Most central banks, thus, prefer open market instruments. A large proportion of reserves is suppliedoperations (OMO) as a tool of monetary policy, which through open market operations with standingallow them to adjust market liquidity and influence facilities being limited to providing marginalthe interest rate structure across tenors through an accommodation or emergency finance. Furthermore,auction mechanism in which market participants are high reserve requirements tend to inhibit inter-bankable to bid their preferences. The particular form of activity. Similarly, easy and cheap access to centraloperations such as outright transactions in eligible bank standing facilities impedes proactive liquiditysecurities, repos and sometimes standing deposit/ management by banks.lending facility, often depend on the specific 3.48 Second, in view of growing complexities ofmacroeconomic conditions and the existing legal monetary management, monetary policy formulationframework of the country. has been guided by a number of macroeconomic indicators rather than a single intermediate nominalGovernment’s Surplus Cash Balances anchor.3.46 Government’s large surplus cash balances 3.49 Third, the growing impor tance and theheld with the central bank can have a significant flexibility of financial market price and its transmissionimpact on liquidity in the banking system (and mechanism in a deregulated environmentthereby could have a bearing on short-term interest necessitated central banks to focus increasingly onrates) necessitating active management of such interest rates rather than bank reserves in liquiditysurplus balances. Accordingly, arrangements which management. Central banks need to ensure smoothfacilitate transfer of surplus funds from Government’s trend in interest rates for several reasons. Foraccount to deficit participants in the system could instance, volatile interest rates can obscure policyhelp in better management of liquidity. Such signals, while more orderly market conditions promotearrangements not only enable the Governments to a rapid and predictable transmission of monetaryearn better returns on the cash balances, but also policy impulses. Less volatile interest rates may alsomitigate volatility in short-term interest rates and help financial institutions to better assess and managekeep overnight money market rates stable. The their market risks. Market participants benefit fromcross-country practices on such arrangements vary stable rates through stabilisation of expectations,widely. For instance, while the cash balances of the which, in turn, promote the development of a termCentral Government are auctioned (competitively) structure in the money market.on a daily basis in Canada, all government balances 3.50 Fourth, with reduced market segmentationare maintained with their respective central banks and the greater ease and speed with which interestin Japan and Italy. In the US and France, a significant rate changes are transmitted across the entire termworking balance is maintained with their central structure, central banks need to focus on the verybanks while amounts beyond the targeted balance short end of the yield curve, where their actions tendare invested in the market. Such surplus balances to have the maximum impact.have also been effectively used as an instrument ofsterilisation by many central banks. The Government 3.51 Fifth, the greater market orientation of theof Singapore, for instance, issues government central banks’ policy instruments has been associated 77
  • REPORT ON CURRENCY AND FINANCEwith a preference for flexible instruments. In volatile term credit instruments, futures market instrumentsfinancial conditions, most notably in the EMEs, the and the Federal Reserve’s discount window (Annexflexibility in the design of policy instruments has III.3). These are generally characterised by a highemerged as a key consideration. degree of safety of principal and are most commonly issued in units of US $1 million or more. Treasury Bills3.52 Finally, the growing awareness of the issued by the US Treasury and the securities issuedimportance of market psychology and expectations by the State and Local Governments have the largesthas warranted greater transparency in the conduct volume outstanding and constitute the most activeof monetar y policy with special emphasis on secondar y mar ket amongst all money mar ketcommunication policy for conveying the stance and instruments (MMIs) in the US. A key feature of mostrationale of policy decisions. State and local securities is that the interest income is generally exempt from federal income taxes, whichStructure of the Money Market makes them particularly attractive to investors in highInstruments income tax brackets. Non-financial and non-bank financial businesses raise funds in the money market3.53 In view of the rapid changes on account of primarily by issuing commercial paper (CP) - a short-financial deregulation and global financial markets term unsecured promissory note. In recent years, anintegration, central banks in several countries have increasing number of firms have gained access to thisstriven to develop and deepen the money markets by market, and issue of CPs has grown at a rapid pace.enlarging the ambit of instruments5 and participants The outstanding CPs is expected to increase to US $so as to improve the transmission channels of 2.17 trillion in 2007. Besides conventional instruments,monetary policy. The structure of money markets money market futures and options have also becomedetermines the type of instruments that are feasible popular in the US money market in the recent period.for the conduct of monetary management. Evidenceand experience indicate that preference for market- 3.56 Similarly in the UK, the money market hasoriented instruments by the monetary authorities emerged as a mechanism for short-term fundinghelps to promote broader market development through the issuance of money market instruments(Forssbaeck and Oxelheim, op cit). or an active fixed-term cash deposit market. It is principally sterling-based but also covers a wide range3.54 The diminishing role of quantitative controls of other currencies. The Government, the bankingand search for alternatives gave rise to three major sector and industry are among those who raisemar ket-or iented instr uments, viz., shor t-ter m resources from the money market through thesecurities, repurchase operations and swaps. These issuance of Treasury Bills, certificates of depositinstruments prompted the central banks to create, (CDs) and bills of exchange (BE)/CPs, respectively.stimulate and support the development of markets Besides, Acceptances and Local Authority Bills alsoparticularly, inter-bank deposit market and short-term act as MMIs. Commercial bills include bank acceptancesecurities market. In the absence of an efficient inter- and trade paper. Both overseas and inland trade isbank market, there was a pressing need for the central financed by bank acceptances. Much of the lending inbanks to create adequate instruments to absorb the market takes place overnight. The bulk (90 per cent)liquidity and stimulate the formation of markets for of the MMIs held are CDs and the rest are BEs, Treasuryalternative short-term assets. The emergence of the Bills and CPs.short-term securities market added a new dimension to 3.57 In the Euro system, during the course of theliquidity management by central banks. In the absence 1990s, repurchase transactions were adopted as aof outright transactions in the securities market, the main liquidity management instrument in Denmarkexistence of a liquid securities segment in the money (1992), Sweden (1994), Austria (1995), Finland (mid-market is often believed to facilitate the central bank’s 1990s), Switzerland (1998) and then in the whole Eurooperations by providing collateral to repurchase system since its inception (1999). Several countriesagreements and similar collateralised transactions. such as Austria, the Netherlands and Denmark, in3.55 Among developed countries, the money the absence of adequate liquid short-term markets,market in the US encompasses a large group of short- came to rely on foreign exchange operations5 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. 78
  • MONEY MARKET(particularly swaps) for liquidity management. In addition Certificates. Moreover, in Thailand, other bonds suchto marketable debt instruments, non-marketable debt as Financial Institution Development Fund Bonds andinstruments and even some equities are eligible for repos. Government Guaranteed State Enterprise Bonds areThese are of two types, viz., Tier-1 fulfilling uniform euro used for repo operations. Foreign exchange swap isarea-wide eligibility criteria of ECB and Tier-2, subject another instrument that the Bank of Thailand uses toto the eligible criteria specified by the national central influence liquidity conditions in the money market.banks and the ECB.3.58 In Japan, the most active money market Tenorsegment involves very short-term transactions, which 3.61 In the US, although maturities of MMIs rangeinclude the borrowing and lending of funds in the call from one day to one year, the maturity of mostmarket with or without collateral; the sale and common instruments is three months or less. In thepurchase of short-term securities such as CPs, CDs UK, the main items in “period money” are borrowedand short-term government bills such as Treasury for 1 and 3 months, but banks may also borrow for aBills; and repo transactions with government and/ week or for almost any time up to 12 months. Themunicipal securities, government guaranteed bonds, CDs issued by the building societies and activelycorporate bonds and foreign government bonds as traded by banks and discount houses have an originaleligible collaterals. Purchases of shor t-ter m maturity of less than one year (although some CDsgovernment bills are used most frequently. have a maturity of over a year). They are all short-3.59 In Australia, the list of securities eligible under term bearer negotiable debt instruments that arethe Intra-day Repurchase Agreement Facility either issued at a discount or bear a coupon. In the(introduced in 1998) has been broadened to cover case of ECB, the maturity of refinancing operationsseveral other instr uments. These include ranges from 1-week to 3-months and for debtcommonwealth gover nment secur ities (CGS), securities up to 12- months. Japan’s tenor for its repodomestic debt securities and discount instruments is in the range of 1 week to 6-months. In Canada, theissued by the central borrowing authorities of State maturity of Treasury Bills ranges from 1-month to 1-and Territory Governments (permitted in 1997), and year and that of money market STRIPS up to 18bank bills and CDs issued by select banks and select months and Government guaranteed CPs from 1-debt securities of approved supranational institutions month to 1-year.and foreign Governments. At the other end of the 3.62 In other countries also, money marketspectrum, Canadian MMIs comprise short-term papers instruments are mostly short-term in nature – withof maturity up to 18 months that are issued by the tenor being generally less than a year. In mostGovernment, banks and corporations and are available countries, call money transactions and the repurchasein the US and Canadian dollars. MMIs mainly comprise agreements serve as the shorter duration segmentTreasury Bills and money market strips issued and of money markets. The tenor of Treasury Bills is ofguaranteed by the Government of Canada. There are nor mally 91-day, 182-day and 364-day. Marketalso Government guaranteed CPs, which are short-term Stabilisation Bonds in Korea even have 546-daypromissory notes issued by the Crown Corporations maturity period. In the case of certain instrumentssuch as Canadian Wheat Board and the Federal such as negotiable certificates of deposit (NCDs),Business Development Bank. The other MMIs include tenor may be as long as five years also.Treasury Bills and promissory notes issued by theProvincial Governments, bankers’ acceptances issued Participantsby corporations with an unconditional guarantee of a 3.63 The major participants in the US money marketmajor Canadian chartered bank and CPs issued by the are commercial banks, Governments, corporations,major corporations. Government-sponsored enterprises, money market3.60 In several other EMEs such as Russia, South mutual funds, futures market exchanges, brokers andAfrica, China, Malaysia and Korea, the main money dealers and the Fed. Commercial banks are the majormarket instruments are government Treasury Bills, participants in the market for federal funds, which arerepurchase agreements, bankers’ acceptances, CPs very short-term, mainly overnight. Banks act asand CDs. In countries such as Thailand and Indonesia, dealers in the money market for over-the-countercentral banks have aimed to expand the range of interest rate derivatives, which has grown rapidly ininstruments by issuing their own bonds/certificates, recent years. The Federal Reserve is also a keyviz., Bank of Thailand Bonds and Bank of Indonesia participant in the US money market. 79
  • REPORT ON CURRENCY AND FINANCE3.64 Another important group of participants in the 3.68 In most other countries, commercial banks,US money markets include money market mutual central banks, regional banks, specialised banks,funds and local Government investment pools. These investment and finance companies, merchant bankingpools, which were virtually non-existent before the corporations, investment trust companies, insurancemid-1970s, have grown to be one of the largest companies, securities finance corporations, creditfinancial intermediaries in the US. A distinct feature insurance funds and business enterprises are theof the US money market is that there are groups of major participants in the money market.privately owned financial intermediaries sponsored bythe Government who raise the funds and channel III. MONEY MARKET IN INDIA – UP TO THEthem to farming and housing sectors of the economy. MID-1980s3.65 In the UK, trading in the money market takes 3.69 The Indian money market prior to the 1980splace on an over-the-counter (OTC) basis for the was characterised by paucity of instruments, lack ofsame day settlement. The money market attracts a depth and dichotomy in the market structure. Thewide range of participants such as the Government, money market consisted of the inter-bank call market,banking sector, industry and financial institutions such Treasury Bills, commercial bills and participationas pension funds. The Bank of England and the UK certificates. Historically, the call money market hasDebt Management Office also make use of the money constituted the core of the money market structure inmarket on a daily basis to fulfil their official obligations. India due to lack of other instruments and strictParticipants in the UK inter-bank market comprise the regulations on interest rates and participation.whole of the banking community (including thediscount houses) and non-bank institutions (such as 3.70 In the call/notice money market, overnightbuilding societies) and the market is served by a money and money at short notice (up to a period ofnumber of money market brokers. 14 days) are lent and borrowed without collateral. This market enables banks to bridge their short-term3.66 In the Euro system, the ECB, national central liquidity mismatches arising out of their day-to-daybanks, the Governments and the eligible credit operations. The call money market in India was purelyinstitutions participate in the money market. Similarly, an inter-bank market until 1971 when the erstwhilein Australia, the Central Government, State and Unit Tr ust of India (UTI) and Life InsuranceTerritorial Gover nments, the Reser ve Bank of Corporation (LIC) of India were allowed to participateAustralia, banks, Gover nment agencies, other as lenders. The interest rate in the call money marketGover nments of the Commonwealth and was freely determined by the market till Decembersupranational institutions are the major participants. 1973. However, as call money rates increased sharplyIn the case of Canada, the participants include both to touch 25-30 per cent, the Indian Banks’ AssociationFederal and Provincial Governments, banks, major (IBA) instituted an administered system of interestCrown Corporations such as Canadian Wheat Board rates by imposing a ceiling interest rate of 15 per centand Federal Business Development Bank. in December 1973 so as to maintain systemic stability3.67 In Japan, business units of Japanese and and quell any abnormal rise in the call rates. Thenon-Japanese banks located in Japan participate in ceiling was subject to several revisions but there werethe uncollateralised money market to raise funds. The several instances of violation of the ceiling ratesmajor participants in the uncollateralised overnight through other means (like buy-back arrangements)call money market are the city banks which have the during phases of tight liquidity.largest share as borrowers, while regional banks act 3.71 Treasur y Bills constituted the mainas major lenders. The other participants include instr ument of shor t-ter m borrowing by theinstitutional investors such as investment trusts, trust Government and served as a convenient gilt-edgedbanks, regional banks, life insurance companies, security for the money market. The characteristicsspecialised money market brokers and Keito 6 . The of high liquidity, absence of default risk and negligiblecounterparties of the Bank of Japan include banks, capital depreciation of Treasury Bills made themsecurities companies, security finance companies and another attractive instr ument for shor t-ter mmoney market brokers (Tanshi companies). investment 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, and fishery co-operatives. 80
  • MONEY MARKETThe Reser ve Bank, being the banker to the banks. The prevalence of administered structure inGovernment, issued Treasury Bills at a discount. The the money market did not permit interest rates toissuance system of Treasury Bills migrated from an reflect the actual extent of scarcity of funds. Owing toauction to tap basis in July 1965 with the rate of limited participation, money market liquidity was highlydiscount administratively fixed at 3.5 per cent per skewed, characterised by a few dominant lenders andannum, which was raised to 4.6 per cent by July 1974 a large number of chronic borrowers. Faced with theseand remained at that level in respect of 91-day impediments, together with limited Reserve Bank’sTreasury Bills till 1991. There was also a system of refinance, banks often faced either short-term liquidityad hoc Treasury Bills from 1955, which were created problems for meeting the statutor y reser veby the Central Government in favour of the Reserve requirements or remained saddled with excessBank to automatically restore its cash balances to liquidity. Banks parked surplus funds, in the absencethe minimum stipulated level, whenever there was of alternative instruments, in Treasury Bills beforeexcess drawdown of cash. rediscounting them with the Reserve Bank so as to meet the cash reserve requirements on an average3.72 Par ticipation cer tificates (PCs) and basis dur ing the repor ting period. This led tocommercial bills (under bills rediscounting scheme) significant fluctuations in banks’ investments inwere introduced in the money market in 1970. PCs Treasury Bills and also their cash balances with thewere utilised mostly by financial institutions to park Reserve Bank, thereby complicating the task oftheir funds for longer maturities and could not be monetary management. Furthermore, in addition todeveloped for meeting liquidity mismatches between the rediscounted regular Treasury Bills, the Reservefinancial institutions and/or banks. Under the bills Bank also had to hold the ad hoc Treasury Bills (issuedrediscounting scheme, the Reser ve Bank by the Government of India with a fixed 4.6 per centrediscounted genuine trade bills at the Bank Rate or interest rate since July 1974) under the system ofat a rate specified by it. The underlying purpose of automatic monetisation, thereby constraining thedeveloping the bill market was to enable banks and emergence of Treasury Bills as a money marketother financial institutions to invest their surplus funds instrument. Moreover, the government securitiesprofitably by selecting appropriate maturities. Over the market was also characterised by administeredyears, the rediscounting facility became restrictive and interest rates and captive investor base, which madewas made available on a discretionary basis. The main open market operations an ineffective instrument offactors inhibiting the development of bill finance were monetary control thereby constraining, to a largelack of a bill culture, non-availability of stamp papers extent, the regular management of short-term liquidityof required denominations, absence of specialised by the Reserve Bank.credit information agencies and an active secondarymar ket. Both these instr uments (par ticipation IV. EVOLUTION OF RESERVE BANK’S LIQUIDITYcertificates and commercial bills), however, did not MANAGEMENTdevelop and activity in these instruments remained 3.75 The nascent state of development of theinsignificant. money market in India and the administered interest3.73 As a result of inadequate depth and liquidity rate structure inhibited active liquidity managementin the organised money market, the sectoral financing operations of the Reserve Bank. The Reserve Bankgaps (i.e., the requirements of unsatisfied borrowers regulated market liquidity by essentially operatingin the organised financial system) were met by the through direct instruments such as CRR and sector-unorganised market. The interest rate in this segment specific refinance. As monetary policy was largelywas generally higher than that in the organised market contingent on the fiscal stance, monetary operationsreflective of the actual market conditions. As bank were undertaken to neutralise the fiscal impact.credit (both aggregate and sectoral) was the principal Consequently, with the dominance of the quantumfocus of monetary policy making under the credit channel in the transmission mechanism, there wasplanning approach adopted in 1967-68, this little scope of signalling monetary policy changesdichotomous nature of the money market served the through indirect instruments. Therefore, the moneyrequirement of monetary management. market increasingly reflected the spillover impact of monetary policy operations through direct instruments.3.74 To sum up, the money market during this The increasingly unsustainable fiscal conditions, asperiod could not provide an equilibrating market reflected in macroeconomic imbalances, necessitatedmechanism for meeting short-term liquidity needs for structural reforms from the early 1990s. Consequently, 81
  • REPORT ON CURRENCY AND FINANCEthe emphasis on the market paradigm gathered began to pay greater attention to the movements inmomentum, warranting greater use of indirect monetary aggregates. Against this backdrop, theinstruments for the conduct of monetary policy. Committee to Review the Working of the MonetaryConcomitantly, the Reserve Bank refined its operating System (Chairman: Sukhamoy Chakravarty, 1985)procedures of liquidity management in tandem with recommended a framework of monetary targeting withthe changing financial landscape. Major developments feedback. In pursuance of the recommendations ofin the liquidity management operations of the Reserve this Committee, the Reserve Bank began to target aBank and developments of money market have taken desirable growth in money supply consistent with aplace since the mid-1980s. However, in order to tolerable level of inflation and expected output growthplace these developments in proper perspective, it (RBI, 1985). Thus, broad money emerged as anmay be useful to understand the broad contours of intermediate target of monetary policy and theliquidity management by the Reserve Bank since Reserve Bank began to formally announce monetarythe late 1960s. targets as nominal anchor for inflation.3.76 Monetary policy up to the mid-1980s was 3.78 The adoption of monetar y targetingpredominantly conducted through direct instruments necessitated considerable changes in the operatingwith credit budgets for the banks being framed in sync procedures of monetary policy. Over the years, thewith monetary budgeting (Mohan, op. cit). This period Reserve Bank, through its refinancing and openwas marked by administered interest rates, credit market operations, had already succeeded, to a largeceilings, directed lending, automatic monetisation of extent, in reducing the level of interest rates in generaldeficits and fixed exchange rates. The Indian economy and the call money rate in particular; albeit by varyingfunctioned essentially as a closed and controlled the ceiling rate (it reached 8.5 per cent by March 1978economy with the role of market being virtually non- although it was again raised to 10.0 per cent in Aprilexistent due to the existing structural rigidities in the 1980). However, the fiscal dominance since the latesystem. In the absence of a formal intermediate target, 1970s made the traditional instruments of Bank Ratebank credit - aggregate as well as sectoral – came to and OMO less effective. The scope for OMO wasserve as a proximate target of monetary policy after limited as yields were governed by an administeredthe adoption of credit planning in 1967-68 (Jalan, interest rate regime, including sale of Treasury Bills2002). The money market was essentially represented on tap at a coupon of 4.6 per cent fixed since 1974by the inter-bank call market, where activity was (Mohan, op. cit). In this scenario, the Reserve Bankmainly driven by the banks’ demand for reserves for began to use reser ve requirements and creditmeeting their statutory commitments. Furthermore, planning for modulating monetar y and liquiditystrong seasonality in demand for money and credit conditions. As a result, the CRR reached the ceilingduring agricultural seasons also influenced market of 15 per cent of net demand and time liabilitiesactivity. In the presence of skewed distribution of (NDTL) in July 1989 and the SLR reached the peakliquidity, these factors made the call money rates of 38.5 per cent in September 1990. The increase inhighly volatile, necessitating imposition of interest rate SLR was, however, unable to fully meet the financingceilings. In the absence of stability in the money requirements of the Government, thereby leading tomarket, and with planned allocation of credit under monetary accommodation by the Reserve Bank (RBI,an administered structure of interest rates, the 2004a). As monetary financing of fiscal deficits isReserve Bank had little choice but to conduct its inflationary beyond a point, an increase in the Reserveliquidity management operations through a standard Bank’s support to the Government was accompaniedmix of OMOs and changes in the Bank Rate. The by an increase in CRR to rein in monetary expansion.OMOs were conducted through outright transactions Despite these measures, however, money supplyin government securities. growth remained high and contributed to inflation. This underscored the need for monetar y-fiscal co-3.77 Although credit planning guided monetary ordination in achieving price stability.policy, the concerns about rising inflation during the1970s and the 1980s attracted a good deal of policy 3.79 In tandem with the shifts in operatingattention. Apart from supply shocks (oil prices and procedures, the proper development of the moneycrop failures), inflation was increasingly believed to market was also emphasised, partly due to thebe caused by excessive monetar y expansion success in lowering the call money rates, albeit,generated by large scale monetisation of fiscal deficits through reductions in interest rate ceilings. Theduring the 1980s. Accordingly, the Reserve Bank Chakravarty Committee (1985) was the first to make 82
  • MONEY MARKETcomprehensive recommendations for the in January 1993), market borrowing of the Governmentdevelopment of the Indian money mar ket. through the auction route since 1992-93 (gilt yieldsFurthermore, the Reserve Bank set up a Working became market determined through rising couponGroup on the Money Market (Chairman: Shri N. rates) and phasing out of automatic monetisation ofVaghul, 1987) to specifically examine various aspects fiscal deficits (following the signing of thefor widening and deepening the money market. Supplemental Accord in 1997). All these measuresFollowing the recommendations of these two paved the way for increased financial innovations andcommittees, several new initiatives were undertaken market sophistication which, along with large swingsby the Reser ve Bank. These included in capital flows, induced a degree of instability in the(i) setting up of the Discount and Finance House of money demand function, thereby limiting the role ofIndia (DFHI) in 1988 to impart liquidity to money money as an intermediate target.market instruments and help the development ofsecondar y mar kets in such instr uments; (ii) 3.81 Various changes in financial market structureintroduction of instruments such as CDs (1989) and necessitated a major shift in monetar y policyCPs (1990) and inter-bank participation certificates operating framework in India from monetary targeting(with and without risk) (1988) to increase the range to a ‘multiple indicator approach’ in 1998. As part ofof instruments; (iii) freeing of call money rates by May this approach, the Reserve Bank started using the1989 to enable price discovery; and (iv) introduction information content in interest rates and rates of returnof auctions of 182-day Treasury Bills (November 1986) in different markets along with currency, credit, fiscalwith a view to moving towards a system of market- position, trade, capital flows, inflation rate, exchangedetermined yields. Although these measures created rate, refinancing and transactions in foreign exchange,the ground for the development of a proper money by juxtaposing it with output data for drawing policymarket, the efficient functioning of the market was perspectives. The success of this approach requiredhindered by a number of other structural rigidities in greater monetary policy flexibility, especially in viewthe system such as skewed distribution of liquidity and of market orientation of policy. Therefore, thethe prevalence of administered deposit and lending rates. emphasis was placed on the money market as the focal point for the conduct of monetary policy and3.80 The process of financial liberalisation fostering its integration with other financial marketsintroduced in the early 1990s, as part of the overall as detailed in the subsequent sections.economic reforms programme, led to a structural shiftin the financing paradigm for the Government and the 3.82 In the changed scenario, monetary policy,commercial sectors. The role of the financial system which largely operated in a closed economywas reassessed and the emphasis shifted from a framework till the early 1990s, had to contend withmere channelisation to efficient allocation of the dynamics of an open economy. The transition ofresources to sustain the higher growth. With a view economic policies in general, and financial sectorto improving the resource allocation process and policies in particular, from a control oriented regimefacilitating efficient price discovery in the financial to a liberalised but regulated regime was reflected inmarkets, the Reserve Bank initiated a multi-pronged changes in the approach of monetary managementstrategy of institutional reforms. The measures (Mohan, 2004). Accordingly, in line with the increasingintroduced by the Reserve Bank were aimed at market orientation of the economy and shift in thewidening, deepening and integrating var ious operating framework, the third phase of liquiditysegments of the financial market, especially the management operations began from the second halfmoney market, and smoothening the process of of the 1990s with the Reserve Bank moving away fromtransmission of policy impulses across market direct instruments of monetary control to indirectsegments. Major reforms introduced in the financial instruments. The CRR was brought down from 15 permarkets were liberalisation of exchange rates in March cent of NDTL (during July 1989-April 1993) to 9.5 per1993, deregulation of interest rates, abolition of credit cent by November 1997 (it reached a low of 4.5 perceilings (although directed lending continued), cent in June 2003)7. The SLR was reduced to theintroduction of auctions in Treasury Bills (364-day statutory minimum of 25 per cent by October 1997.Treasury Bills in April 1992 and 91-day Treasury Bills Under this system, while reserve requirement was the7 In the light of developments in current macroeconomic, monetary and anticipated liquidity conditions, the Reserve Bank, on March 30, 2007, announced to raise CRR by 50 basis points to 6.50 per cent in April 2007. 83
  • REPORT ON CURRENCY AND FINANCEprincipal medium of modulating liquidity on a systemic Under the ILAF, the general refinance facility wasbasis, banks took recourse to Reser ve Bank’s replaced by a collateralised lending facility (CLF) andrefinance facilities to meet their short-term funding additional collateralised lending facility (ACLF) linkedrequirements. Introduction of reverse repos 8 (then to the Bank Rate. Similarly, export credit refinance andcalled repos) in 1992 provided an instrument for liquidity support to PDs were also linked to the Bankabsorption of liquidity from banks having surplus Rate. Thus, the reverse repo rate (as floor) and thefunds. This, in conjunction with government market Bank Rate (as the ceiling) provided an informalborrowing through auctions since 1992-93, raised the corridor in the money market.yields on government securities (from 6.5 per cent in1985-86 to 11.5 per cent in 1997-98) and led to the 3.84 In the light of the experience gained in theshortening of maturity of the Government debt. This operation of ILAF, an Internal Group set up by themarked the beginning of development of a secondary Reserve Bank recommended gradual implementationmarket in government securities and the market of a full-fledged LAF as suggested by the Narasimhamdetermination of interest rates. With the objective of Committee (1998). Accordingly, the system of ILAFmanaging shor t-term liquidity and smoothening migrated to a system of Liquidity Adjustment Facilityinterest rates in the call/notice money market, the (LAF) in stages beginning June 2000 (Box III.2). TheReserve Bank began absorbing excess liquidity fixed rate reverse repo was replaced by variablethrough auctions of reverse repos. Furthermore, with reverse repo auctions, while ACLF and level II liquidityexchange rate liberalisation (the rupee became fully support to PDs was replaced by variable reposconvertible on the current account in 1994) and auctions, conducted on a daily basis. Consequently,opening up of the economy, the exchange rate began the repo rate replaced the earlier Bank Rate as theto play an important role in monetary management. ceiling of the corridor, thereby enabling injection ofIn the process, the exchange rate became liquidity at a single rate (i.e., repo rate), while the floorendogenous to money, income, prices and interest continued to be the reverse repo rate. This signified arates and, with financial innovations, the major change in the operating procedure and liquiditydisequilibrium in money markets begun to be reflected management operations by the Reserve Bank as itin short-term interest rates (Mohan, op cit). In view of facilitated the transition from direct instruments tothese changes, the call money market became the focal indirect (market-based) instruments of monetarypoint of market intervention by the Reserve Bank. management. Furthermore, it has also provided the necessar y flexibility to the Reser ve Bank in3.83 The volatility in call rates, however, continued, modulating liquidity (both supply of and demand fornecessitating some instruments for managing liquidity. funds) on a daily basis through policy rate changes.Against this backdrop, the Committee on Banking This has ensured stability in the call money rates,Sector Reforms (Narasimham Committee II, 1998) which have generally remained within the corridorstressed that interest rate movements in the inter-bank 9 (Chart III.1) . This, in turn, has promoted the stabilitycall money market should be orderly and this could of short-term interest rates in the money market.only be achieved if the Reserve Bank has a presencein the market through short-term reverse repos (as 3.85 Consider ing the impor tance of guidingper current terminology). Following the committee’s monetary policy operations on a sound basis, therecommendations, the reverse repos, which were in Annual Policy Statement of April 1999 underlined theoperation from 1992, got integrated with the interim need for developing a short-term operational modelliquidity adjustment facility (ILAF) introduced in April which takes into account the behavioural relationships1999. The absorption of liquidity continued to be at among different segments of the financial system.fixed rate reverse repos. Although absorption of Under the guidance of a group of eminent academicliquidity was done through a single reverse repo rate, exper ts, a model was developed and madethe system of injecting liquidity through various ways, operational in 2002 for forecasting short-term liquidityincluding refinance, continued at interest rates linked conditions to facilitate daily liquidity managementto the Bank Rate, which was reactivated in April 1997. operations 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-end considerations, sustained credit demand and asymmetric distribution of government securities holdings across banks. 84
  • MONEY MARKET Box III.2 Liquidity Adjustment Facility As part of financial sector reforms initiated in the early Concomitantly, a back-stop rate was fixed at 2.01990s, India began to move away from direct instruments percentage points above the repo cut-off rate in the eventof monetary control to indirect ones, which, in turn, of no reverse repo in the LAF auctions. On days when nowarranted a mechanism that can accord greater flexibility reverse repo/repo bids are received/accepted, back-stopand effective liquidity management so as to maintain rate was decided by the Reserve Bank on an ad hoc basis.orderly conditions in the financial markets, particularly in Subsequently from March 29, 2004 the reverse repo ratethe wake of surging volatile capital flows. As a corollary, was scaled down to 6.0 per cent and aligned with thepursuant to the recommendations of the Narasimham Bank Rate under the revised LAF scheme. A single facilityCommittee (1998), the LAF was introduced in stages available at a single rate was introduced by mergingcommensurate with the specific features of the Indian normal facility and back stop facility together. Moreoverfinancial system, the level of market development and in April 2004, fixed rate auctions were re-introduced. Withtechnological advances in the payment and settlement effect from October 29, 2004, the nomenclature of reposystems. In the process, the critical issue facing the and reverse repo was interchanged as per internationalReserve Bank was to channelise the various sources of usage. The repo now indicates injection of liquidity, whileits liquidity through a single comprehensive window at a reverse repo stands for absorption of liquidity.common pr ice. Consequently, an inter im liquidity The full computerisation of Public Debt Office (PDO) ofadjustment facility (ILAF) was introduced in April 1999 the Reserve Bank set the third stage of full-fledged LAFwhich enabled the Reserve Bank to modulate market and onset of RTGS marked a major leap forward in thisliquidity on a daily basis and also transmit interest rate phase. Repo operations today are mainly throughsignals to the market. electronic transfers and the LAF can be operated atWith the introduction of ILAF, the general refinance facility different times of the same day. Consequently, the Secondwas replaced by a collateralised lending facility (CLF) up LAF (SLAF) was introduced from November 28, 2005to 0.25 per cent of the fortnightly average of outstanding providing the market participants a second window to fine-aggregate deposits in 1997-98 for two weeks at the Bank tune their management of liquidity. Unlike the past LAFRate and an additional collateralised lending facility (ACLF) operations, which were conducted in the forenoon betweenfor an equivalent amount of CLF at the Bank Rate plus 2 9.30 am and 10.30 am, the SLAF is conducted by receivingper cent. A penal rate of 2 per cent was stipulated for an bids between 3.00 pm and 3.45 pm. Although the salientadditional two week period. However, expor t credit features of SLAF and LAF are same, their settlements arerefinance for scheduled commercial banks was retained conducted separately on a gross basis. Thus, theand continued to be provided at the Bank Rate. introduction of LAF has been a process and the IndianSimultaneously, a provision for liquidity support to PDs experience shows that phased rather than a big bangagainst collateral of government securities was also made approach is required for reforms in the financial sector andavailable. The ILAF was intended to ensure that interest in monetary management (Mohan, op. cit).rates move within a reasonable range and promote stability LAF has now emerged as the pr incipal operatingin the money market. The transition from ILAF to a full- instrument of monetary policy. It has helped in stabilisingfledged LAF commenced in June 2000 and progressed the regular liquidity cycles and, subsequently, the volatilitygradually in three stages. The first stage began from June of call money rates by allowing banks to fine-tune their5, 2000 when LAF was formally introduced with the liquidity needs as per the averaging requirements of CRRreplacement of ACLF and level II support to PDs by variable over the reporting period. This smoothened the liquidityrate repo auctions with same day settlement. positions at the beginning and end of the month. Besides,The second stage commenced from May 2001, when CLF it helped to modulate sudden liquidity shocks engenderedand level I liquidity support for banks and PDs was also by temporary mismatches induced by outflows/inflows onreplaced by variable rate repo auctions. However, some account of Gover nment auctions/redemptions andminimum liquidity support to PDs was retained but at an advance tax payments. More importantly, the LAF hasinterest rate linked to variable rate in the daily repos emerged as an effective instrument for maintainingauctions as determined by the Reserve Bank from time orderly conditions in the financial markets in the face ofto time. Furthermore during April 2003, the multiplicity of volatile capital flows. Thus, the LAF has imparted a much-rates at which liquidity was being injected was rationalised needed flexibility to the Reserve Bank in modulating thewith the back-stop interest rate being fixed at the reverse liquidity in the system and steering the desired trajectoryrepo cut-off rate of the regular LAF auctions on that day. of interest rates in response to evolving market conditions. 85
  • REPORT ON CURRENCY AND FINANCE Chart III.1: LAF Corridor and the Call Rate Chart III.2: Reserve Banks Open Market Operations Rupees crore Per cent 19-Aug-01 23-Aug-04 05-Jun-00 11-Jan-01 27-Mar-02 10-Jun-03 16-Jan-04 31-Mar-05 14-Jun-06 20-Jan-07 02-Nov-02 06-Nov-05 Net RBI Credit to the Centre Net Foreign Currency Assets Call Rate Reverse Repo Rate Repo Rate OMO (Sales)3.86 The issue of managing large and persistent a result, the open market sales by the Reserve Bankcapital flows and synchronicity in monetary policy as a proportion of the accretion of securities to its giltcycles across the globe has added another dimension portfolio dropped to about 50 per cent during 2003-04to the issue of liquidity management in the Indian from an average of 90 per cent in the preceding fivecontext in recent years. The period since mid-2002 years following a switch to LAF operations (RBI,has generally been characterised by surplus liquidity 2004b).in the system in the wake of large capital inflows and 3.88 Given the finite stock of government securitiescurrent account surplus (till 2003-04). An enduring in its portfolio and the legal restrictions on issuing itschallenge to monetary policy has been to manage own paper, the Reserve Bank felt that instrumentssuch surplus liquidity so as to keep the call money other than LAF were needed to fulfil the objective ofrates stable for overall stability in the market. absorbing liquidity of a more enduring nature. ThisAccordingly, in order to sterilise the impact of capital resulted in the introduction of the market stabilisationflows, the Reser ve Bank had to operate scheme (MSS) in Apr il 2004 as a specialsimultaneously through the LAF and OMOs (outright arrangement, following the recommendations of thetransactions of dated securities and Treasury Bills). Working Group on Instruments of Sterilisation, 20033.87 The OMOs have been effectively used by (Chair person: Smt. Usha Thorat). Under thisthe Reserve Bank since the mid-1990s for sterilising arrangement, the Government issued Treasury Billsthe monetary impact of capital flows by offloading and/or dated securities in addition to the normalthe stock of government securities to the market borrowing requirements for absorbing excess liquidity(Chart III.2). The net open market sales increased from the system. The ceiling amount, which wasfrom Rs.10,464 crore in 1996-97 to Rs.53,781 crore initially fixed at Rs.60,000 crore was raised toin 2002-03. However, repeated recourse to OMOs for Rs.80,000 crore on October 14, 2004 but reduced tosterilisation purposes during this period depleted the Rs.70,000 crore on March 24, 2006 and again raisedstock of government securities held by the Reserve to Rs.80,000 crore for 2007-08. The MSS proceedsBank from Rs.52,546 crore at end-March 2003 to are held in a separate identifiable cash account byRs.40,750 crore at end-March 2004, despite the the Gover nment (reflected as equivalent cashconversion of the available stock of non-marketable balances held by the Government with the Reservespecial securities (of Rs.61,818 crore), created out Bank) and are appropriated only for the purpose ofof past ad hoc and Tap Treasury Bills, into tradable redemption and/or buyback of the Treasury Bills and/securities during the year. Accordingly, the burden of or dated securities issued under the MSS. Thus, whilesterilisation shifted to the LAF, which was essentially it provided another tool for liquidity management, itdesigned as a tool of adjusting marginal liquidity. As was designed in such a manner that it did not have 86
  • MONEY MARKETany fiscal impact except to the extent of interest Table 3.1: Liquidity Absorptionspayment on the outstanding amount under the MSS. (Rupees crore)The amount absorbed under the MSS, which hadreached Rs.78,906 crore on September 2, 2005, Outstanding LAF MSS Centre’s Totaldeclined to about Rs.32,000 crore in February 2006 as on Last Friday Surplus with (2 to 4) of month the RBI @due to unwinding of nearly Rs.47,000 crore in view ofoverall marginal liquidity which has transited from the 1 2 3 4 5surplus to the deficit mode. As part of unwinding, fresh 2004issuances under the MSS were suspended between April 73,075 22,851 0 95,926 May 72,845 30,701 0 1,03,546November 2005 and April 2006. In several subsequent June 61,365 37,812 0 99,177auctions during 2006-07, only partial amounts were July 53,280 46,206 0 99,486accepted under the MSS. Subsequently, the amount August 40,640 51,635 7,943 1,00,218absorbed under the MSS increased again to September 19,245 52,255 21,896 93,396 October 7,455 55,087 18,381 80,923Rs.62,974 crore in March 2007. The MSS has, thus, November 5,825 51,872 26,518 84,215provided the Reserve Bank the necessary flexibility December 2,420 52,608 26,517 81,545to not only absorb liquidity but also to ease liquidity 2005through its unwinding, if necessar y. With the January 14,760 54,499 17,274 86,533introduction of the MSS, the pressure of sterilisation February 26,575 60,835 15,357 1,02,767 March* 19,330 64,211 26,102 1,09,643on LAF has declined considerably and LAF operations April 27,650 67,087 6,449 1,01,186have been able to fine-tune liquidity on a daily basis May 33,120 69,016 7,974 1,10,110more effectively (Table 3.1). Thus, the MSS June 9,670 71,681 21,745 1,03,096empowered the Reserve Bank to undertake liquidity July 18,895 68,765 16,093 1,03,753 August 25,435 76,936 23,562 1,25,933absorptions on a more enduring but still temporary September 24,505 67,328 34,073 1,25,906basis and succeeded in restoring LAF to its intended October 20,840 69,752 21,498 1,12,090function of daily liquidity management (Mohan, op cit). November 3,685 64,332 33,302 1,01,319 December -27,755 46,112 45,855 64,212#3.89 Furthermore, the build up and volatility in 2006Government’s cash balances with the Reserve Bank January -20,555 37,280 39,080 55,805in recent years have significantly impacted the liquidity February -12,715 31,958 37,013 56,256conditions. The Working Group on Instruments of March* 7,250 29,062 48,828 85,140 April 47,805 24,276 5,611 77,692Sterilisation favoured revisiting the 1997 agreement May 57,245 27,817 0 85,062so that Government’s surpluses with the Reserve June 42,565 33,295 8,621 84,481Bank are not automatically invested and can remain July 44,155 38,995 8,770 91,920 August 23,985 42,364 26,791 93,140as interest free balances, thereby releasing September 1,915 42,064 34,821 78,800gover nment secur ities for fur ther sterilisation October 12,270 40,091 25,868 78,229operations. Accordingly, the arrangement of allowing November 15,995 37,917 31,305 85,217the Central Government to invest the surplus funds December -31,685 37,314 65,581 71,311in its own paper since 1997 (to give a notional return 2007on such balances) was discontinued temporarily from January -11,445 39,375 42,494 70,424 February 6,940 42,807 53,115 1,02,862April 8, 2004. However, following the introduction of March -29,185 62,974 49,992 83,781the MSS, it was partially restored with a ceiling ofRs.10,000 crore in June 2004, which was further @ : Excludes minimum cash balances with the Reserve Bank. * : Data pertain to March 31. # Reflects IMD redemption of aboutraised to Rs.20,000 crore in October 2004. While the Rs.32,000 crore.Government’s surplus cash balances may have Note : Negative sign in column 2 indicates injection of liquidity throughenabled the Reserve Bank to sterilise the monetary LAF repo.impact of excess liquidity, at times, it has also resultedin sudden transition in liquidity conditions. The build (comprising MSS, LAF and Government surplus) inup of large and unanticipated cash surpluses of the the system increased to over Rs.1,25,000 crore inGovernment with the Reserve Bank and its depletion August 2005. Reflecting such surplus conditions inover a short period poses fresh challenges for liquidity the banking system, the call money rate hoveredmanagement and maintenance of stable conditions generally around the lower bound of the corridor (i.e.,in the money market. the reverse repo rate), which (along with the repo rate)3.90 The dynamics of surplus liquidity in the recent has emerged as the main instrument of policy in theper iod shows that the total sur plus liquidity short-run (see Chart III.1). The Bank Rate now serves 87
  • REPORT ON CURRENCY AND FINANCEthe role of a signalling instrument for the medium- Chart III.3: Liquidity Adjustment Facility and the Call Rateterm. 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 second Rupees crore Per centwindow 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 on 26-Jul-02 03-Apr-02 21-Apr-04 09-Oct-00 29-Nov-01 08-Nov-02 02-Aug-04 11-Nov-04 24-Apr-06 05-Jun-00 09-Feb-01 20-Jun-01 21-Feb-03 23-Sep-03 13-Jun-03 06-Jan-04 24-Feb-05 23-Sep-05 10-Jun-05 04-Jan-06 01-Aug-06 13-Nov-06 27-Feb-07December 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 liquidity Reverse Repo Amount Repo Amountthrough LAF repos during December 2005-February Call Rate (Right Scale)2006 (Chart III.3). To meet their liquidity requirements,banks have been unwinding their excess SLR holdings spectrum leading to pressures on liquidity and interest(from about 13 per cent of NDTL at end-March 2005 rates. In this regard, the Government’s decision in theto about 3 per cent by end-March 2007) above the Union Budget 2006-07 to conver t the entireprescribed minimum of 25 per cent. The depletion of outstanding recapitalisation bonds/special securitiesSLR investments by banks has resulted in call rates issued to nationalised banks, amounting to Rs. 20,809firming up to the ceiling of the LAF corridor and crore, into tradable, SLR eligible securities couldbeyond, even when reverse repo bids have been reduce the pressure on banks seeking appropriatereceived under the LAF and funds have been collaterals.absorbed from the system. This indicates that somebanks overdrew both collateral and cash, thereby 3.92 In the current phase of monetary tightening,necessitating rollovers at the short-end of the market the Reserve Bank has raised the reverse repo rates 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 in LAF Operations (net) LAF Operations (net) LAF Operations (net) Total LAF (per cent) Total LAF (per cent)1 2 3 4 5 6December 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. 88
  • MONEY MARKETsix times of 25 basis points each since October 2004, as large changes in interest rates could be disruptive,which along with the corresponding adjustments in particularly in the wake of increased openness of thethe repo rate had narrowed down the corridor to 100 economy and the current stage of development ofbasis points by April 2005 (which subsequently financial markets. This approach has been successfulincreased to 175 basis points with the increase in repo in signalling the market about the need for such pre-rate by 25 basis points each on October 31, 2006, emptive actions in order to stabilise inflationJanuary 31, 2007 and March 30, 2007). The Reserve expectations. Various segments of the financial marketBank has emphasised gradual changes in policy rates, have responded well to the policy signals (Box III.3). Box III.3 The Interface between Monetary Policy Announcements and Financial Market BehaviourThe effectiveness of monetary policy hinges on the ability In the Indian context, some attempts have been made toof the monetary authority to communicate with the public empir ically examine the interrelationship betweenin a clear and transparent manner. In this regard, the monetary policy signals and financial market behaviour insignalling of policy assumes key importance as it conveys a VAR framework (Bhattacharyya and Sensarma, 2005).the stance of monetar y policy. While the signalling Monetary policy signals are proxied by changes in the CRR,mechanisms in developed countries are quite robust, they the Bank Rate and the LAF reverse repo rate. The impact oftend to be weak in emerging mar ket economies, these signalling instruments of monetary policy is consideredparticularly in the wake of market segmentation and on four segments of the financial market, viz., money marketabsence of a well-defined transmission mechanism. (call money rate), stock market (BSE Sensex), foreignFinancial markets are typically characterised by asymmetric exchange market (3-month forward premia) and theinformation, where some agents are better informed than government securities market (yield on 1-year G-sec).others, that gets reflected in the problems of moral hazard Impulse response analysis is used to study the impact ofand adverse selection. Seminal research on the economic a one standard error shock in each policy indicator on thetheory of information has demonstrated that better-informed various financial market segments. The study reveals thatagents in a market could credibly “signal” (transmit) their an increase in the CRR raises the call money rate instantlyinformation to less informed agents, so as to avoid some of because of the news effect and also over time through thethe problems associated with adverse selection and improve liquidity effect as more resources get impounded causingthe market outcome (Spence, 1973). tightness in liquidity conditions. This is also the case for forward premia and yields on government securities. It hasThe effectiveness of monetary policy is strongly related to more of an instantaneous news impact in the stock marketthe signalling of policy, the reason being that important by depressing the market sentiment.variables such as the exchange rate and long-term interestrates reflect expectations about future monetary policy. An increase in the Bank Rate, as the signalling mechanismCentral banks usually consider four different types of of policy stance over the medium-term, appears to havesignalling channels, viz., (a) speeches of executives, (b) an instantaneous effect on call, government securities andviews about future inflation, (c) changes in policy forward premia because of the news effect. The long-terminstruments and (d) publication of the minutes of policy impact, however, gets muted as refinance at the Bank Ratemeetings. In particular, the announcement of an inflation is formula driven and not adequate to have a liquidityforecast or a monetary conditions index (MCI) is used to impact. In the stock market, hardening of the Bank Rate issignal central bank’s intentions. construed as restrictive monetary policy, which dampens the market sentiment.In India, several measures have been initiated in the post-refor m per iod to develop indirect instr uments for An increase in the reverse repo rate, as the signallingtransmitting policy signals. An important measure was the mechanism of policy stance in the short-term, appears to havereactivation of the Bank Rate in April 1997 by initially linking an instantaneous effect on call, government securities andit to all other rates, including Reserve Bank’s refinance forward premia because of the announcement effect andrates. The introduction of fixed rate reverse repo helped in makes the term-structure steep at the short-end. Like the Bankcreating an informal corridor in the money market with the Rate, repo rate hike also dampens the market sentiment.reverse repo rate as the floor and the Bank Rate as the The instantaneous impact of monetary policy signals onceiling, which enabled the Reserve Bank to modulate the most financial market segments points towards increasingcall rate within this informal corridor. Subsequently, the integration and sophistication of markets. Therefore,introduction of the Liquidity Adjustment Facility (LAF) from increasing reliance on indirect instruments, greater marketJune 2000 facilitated the modulation of liquidity conditions integration and technological innovations prima facie haveand also short-term interest rates on a daily basis through improved the channels of communication between thethe LAF window, while signalling the medium-term stance Reserve Bank and the financial market and facilitated theof policy through changes in the Bank Rate. conduct of monetary policy. 89
  • REPORT ON CURRENCY AND FINANCE3.93 Despite all these developments, the the corridor has called for a re-look at the marketbehaviour of call rates, which occasionally breached microstructure (Box III.4). Accordingly, as part of the Box III.4 Market Microstructure: Issues in Money Market LiquidityA liquid money market is an important pre-requisite for the On the basis of these criteria, the Indian money marketeffective transmission of monetary policy. In particular, a appears to be a reasonably deep, vibrant and liquid marketdeep and liquid money market contributes towards a more (based on overnight data on bid-ask spread from April 1,effective propagation of the impulses of central bank policy 2004 to February 28, 2007). During this period, the bid-inter vention in financial markets. Besides, price ask spread has varied within a range of (-)0.37 to (+)1.32determination is more efficient in a liquid money market and basis points with an average of 16 basis points andconveys important information to monetary authorities on standard deviation (SD) of 11 basis points (coefficient ofmarket expectations. In this context, central banks modulate variation is 0.69). Despite a higher degree of variation, theand fine-tune money market liquidity not only for monetary bid-ask spread remained within the 2-SD band around themanagement but also in their quest for preserving financial average during most of the period (Chart). Considerablestability. volatility above the average was witnessed up to December 2004. It eased up significantly during the major part of 2005Measures of money market liquidity are based on three but increased subsequently during the early part of 2006.dimensions, viz., tightness, depth and resiliency. Tightness During 2006-07, while bid-ask spreads ruled below therefers to how far transaction prices diverge from the average average till August 2006, increase in spreads beyond themarket price, i.e., the general costs incurred irrespective of 2-SD band were noticed during end-December 2006 onthe level of market prices. Depth denotes either the volume account of tightness in liquidity due to the impact of theof trades possible without affecting prevailing market prices, staggered hike of 0.5 percentage point in the CRR and theor the amount of orders in the order books of market makers advance tax flows from the banking system. The bid-askat any time period. Finally, resiliency refers either to the spread hardened significantly in March 2007, reflecting tightspeed with which price fluctuations resulting from the tradeare dissipated, or the speed with which imbalances in order Chart: Bid Ask Spread in the Call Money Marketflows are adjusted. Other measures such as the numberand volume of trades, trading frequency, turnover ratio, pricevolatility and the number of market participants are often Per centregarded 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 measures 20-May-04 02-Jul-04 06-Nov-04 15-Dec-04 16-May-05 21-Jun-05 29-Jul-05 19-Nov-05 24-Dec-05 25-May-06 29-Jun-06 23-Nov-06 29-Dec-06 01-Apr-04 13-Aug-04 27-Sep-04 05-Sep-05 18-Apr-06 19-Jan-05 25-Feb-05 06-Apr-05 07-Feb-07 11-Oct-05 31-Jan-06 08-Mar-06 03-Aug-06 08-Sept-06 16-Oct-06of 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 agent Bid-Ask Spread Mean Mean+2SD Mean-2SDis willing to lend) represents an operational measure of the Source: Reutersprice of the agents’ services in the absence of othertransaction costs. Depth is reflected by the maximum size liquidity conditions on account of advance tax outflows,of a trade for any given bid-ask spread. The turnover ratio, year-end considerations and sustained credit demand.i.e., the turnover in the money market as a percentage of However, events such as the blast of July 11, 2006 intotal outstanding money market transactions, also provides Mumbai did not have any significant impact on the bid-askan additional measure of the depth of the market. However, spread in the call money market.a more accurate measure of market depth would take into Differences in market microstructure can affect marketaccount advances of both actual and potential transactions liquidity considerably. In this regard, evolution of marketarising out of portfolio adjustments. Finally, while there is no structure is mostly driven by the rapid structural,appropriate measure of resiliency, one approach is to technological and regulatory changes affecting globalexamine the speed of the restoration of normal market financial markets. In the Indian context, the gradual shiftconditions (such as the bid-ask spread and order volume) towards a collateralised market, phasing out of non-bankafter transactions are completed. Thus, a relatively more participants from call money market, reductions in statutoryliquid money market, ceteris paribus, requires less time to reserve requirements, introduction of new instruments suchexecute a transaction, operates on a narrower bid-ask as CBLO, implementation of RTGS and facilitating thespread, supports higher volumes for a given spread and trading through NDS-CALL are some of the factors that haverequires relatively less time for the restoration of the “normal” contributed to the development of a relatively vibrant andbid-ask spread following a high value transaction. liquid money market. 90
  • MONEY MARKETpolicy strategy of focusing on market microstructure, Chart III.4: Overnight Interest Ratesthe 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 such Per centas market repo (repo outside the Reserve Bank’sLAF) and collateralised borrowing and lendingobligation (CBLO) introduced in 2003, through theClear ing Cor poration of India Limited (CCIL),enabled smooth migration of non-bank participantsfrom the uncollateralised call money segment to thecollateralised segments. The collateralised market Apr-04 Jun-04 Aug-04 Oct-04 Dec-04 Feb-05 Apr-05 Jun-05 Aug-05 Oct-05 Dec-05 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07is now the predominant segment of the moneymarket with a share of around 70 per cent in totalvolume during 2006-07. This also provided an Market Repo (Non-RBI) Reverse Repoalternative avenue for banks to park their surplus Average Call Money CBLO Repofunds beyond one day. Fur ther more, this wasfacilitated by the standardisation of accountingpractices, broad-basing of eligibility criteria in the V. MONEY MARKET DEVELOPMENTS –collateralised markets, exemption of CBLO from the MID-1980s ONWARDSCRR requirements and anonymity provided by theorder matching systems in the CBLO mar ket. 3.96 As discussed earlier, the Vaghul WorkingMoreover, minimum maturity period for CPs (October Group (1987) recommended several measures for2004) and CDs (April 2005) were shortened from 15 widening and deepening the money market. Some ofdays to 7 days. These developments helped in the the major recommendations, inter alia, included (i)smooth transformation of the call money market into activating existing instruments and introducing newa pure inter-bank market in August 2005. instruments to suit the changing requirements of borrowers and lenders; (ii) freeing interest rates on3.94 Availability of alternative avenues (such as money market instruments; and (iii) creating an activethe market repo and CBLO) for deploying short-term secondary market through establishing, whereverfunds by market participants has also enabled the necessary, a new set of institutions to impart sufficientalignment of other money market rates with the liquidity to the system. The Committee on the Financialinformal interest rate corridor of reverse repo and System, 1991 (Chairman: Shri M. Narasimham)repo rates under the LAF. Accordingly, although the further recommended phased rationalisation of thecall rate has at times breached the corridor, the CRR for the development of the money market.weighted average overnight rate moved largely within Second generation reforms in the money marketthe informal corridor set by LAF rates (Chart III.4). commenced when the Committee on Banking Sector Reforms, 1998 (Chairman: Shri M. Narasimham)3.95 To sum up, various policy initiatives by the recommended measures to facilitate the emergenceReserve Bank in terms of widening of market-based of a proper interest rate structure reflecting theinstruments and shortening of maturities of various differences in liquidity, maturity and risk.instruments have not only helped in promoting marketintegration but also enabled better liquidity 3.97 In pursuance of the recommendations of themanagement and transmission of policy signals by two committees, a comprehensive set of measures wasthe Reserve Bank. Following the recommendations undertaken by the Reserve Bank to develop theof the Technical Group on Money Market (2005), the money market. These included (i) withdrawal ofReserve Bank’s focus on the money market has been interest rate ceilings in the money market; (ii)on encouraging the growth of the collateralised introduction of auctions in Treasury Bills; (iii) abolitionmarket, developing a rupee yield curve and providing of ad hoc Treasury Bills; (iv) gradual move away fromavenues for better risk management by market the cash credit system to a loan-based system; (v)participants. relaxation in the issuance restrictions and subscription 91
  • REPORT ON CURRENCY AND FINANCE Table 3.3: Activity in Money Market Segments (Rupees crore) Average Daily Turnover # Outstanding AmountYear Call Money Market Repo Collateralised Term Money Commercial Certificates of Market (Outside the Borrowing and Market Paper Deposit LAF) Lending Obligation (CBLO)1 2 3 4 5 6 71997-98 22,709 – – – 2,806 9,3491998-99 26,500 – – – 4,514 6,8761999-00 23,161 6,895 – – 7,014 1,9082000-01 32,157 10,500 – – 6,751 1,1992001-02 35,144 30,161 – 195 7,927 9492002-03 29,421 46,960 30 341 8,268 1,2242003-04 17,191 10,435 515 519 7,835 3,2122004-05 14,170 17,135 6,697 526 11,723 6,0522005-06 17,979 21,183 20,039 833 17,285 27,2982006-07 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 of market repo (outside LAF) to capture the borrowing and lending in the two legs of a repo.nor ms in the case of many money mar ket held the view that the call money market shouldinstr uments; (vi) introduction of new financial continue to remain a strictly inter-bank market (barringinstruments; (vii) widening of participation in the LIC and the erstwhile UTI which could continue asmoney market; and (viii) development of a secondary lenders only) and recommended the setting up of amarket. All these policy measures have helped in Finance House of India to impart liquidity to short-developing the money market significantly over the term money market instruments.years as reflected in the volumes and turnover in 3.99 The reforms commenced with the setting upvarious market segments (Table 3.3). of an institution, viz., the Discount and Finance House of India (DFHI) in 1988 as a money market institutionCall/Notice Money Market to impart liquidity to money market instruments.3.98 Prior to the mid-1980s, as discussed earlier, Interest rate in the call money market was deregulatedthe market participants heavily depended on the call with the withdrawal of the ceiling rate with respect tomoney market for meeting their funding requirements. DFHI from October 1988 and with respect to the callHowever, inherent volatility in the market impeded money market in May 1989. Although the Vaghulefficient price discovery, thereby hampering the Committee had recommended that call/notice moneyconduct of monetary policy. Against this backdrop, the should be restricted to banks only, the Reserve BankChakravar ty Committee (1985) recommended favoured the widening of the call/notice money market.activation of the Treasury Bills market (with the In the absence of adequate avenues for deploymentdiscount rate being market related) to reduce of short-term surpluses by non-bank institutions, adependence on the call money market and abolish large number of non-bank participants such as FIs,ceilings on the call rate along with permitting more mutual funds, insurance companies and corporatesinstitutional participation to widen the market base. were allowed to lend in the call/notice money market,The Vaghul Committee, in view of the continued although their operations were required to be routedexistence of an unaligned overall interest rate through the PDs from March 199510 . In this context,structure, recommended abolition of the ceiling PDs and banks were permitted to both lend andinterest rate on the call money market. However, it borrow in the market. The Reserve Bank exempted10 Satellite Dealers (SDs) were also allowed to operate in the call/notice money market until they were phased out from May 2002. 92
  • MONEY MARKETinter-bank liabilities from the maintenance of CRR/ the Narasimham Committee (1998), steps wereSLR (except for the statutory minimum) effective April taken to refor m the call money mar ket by1997 with a view to imparting stability to the call transforming it into a pure inter-bank market in amoney market. phased manner. The corporates, which were allowed to route their transactions through PDs, were phased3.100 The Narsimham Committee (1998), however, out by end-June 2001. The non-banks’ exit wasnoted that the money market continued to remain implemented in four stages beginning May 2001lopsided, thin and extremely volatile. While the non- whereby limits on lending by non-banks werebank participation was a source of comfort, it had progressively reduced along with thenot led to the development of a stable market with operationalisation of negotiated dealing systemdepth and liquidity. The non-bank participants, unlike (NDS) and CCIL until their complete withdrawal inbanks, were not subjected to reserve requirements August 2005. In order to create avenues forand the call/notice money market was characterised deployment of funds by non-banks following theirby predominant lenders and chronic borrowers phased exit from the call money market, several newcausing heavy gyrations in the market. There was instruments were created such as market repos andalso over-reliance of banks in the call/notice money CBLO. Maturities of other existing instruments suchsegment, thereby impeding the development of other as CPs and CDs were also gradually shortened insegments of the money market. The Reserve Bank order to align the maturity structure to facilitate thealso did not have any effective presence in the emergence of a rupee yield curve. The Reserve Bankmarket and operated with pre-determined lines of has been modulating liquidity conditions throughrefinance. As interest rates in other money market OMOs (including LAF), MSS and refinancesegments move in tandem with the inter-bank call operations which, along with stipulations of minimummoney rate, the volatility in the call segment inhibited average daily reserve maintenance requirements,proper risk management and pricing of instruments. have imparted stability to the call money market.Thus, freeing of interest rates did not result in a well-defined yield curve (Box III.5). Furthermore, banks’ 3.103 Despite these refor ms, however, therole in the money market was further impaired by behaviour of banks in the call market has not beenthe health of their own balance sheets, lack of uniform. There are still some banks, such as foreignintegrated treasury management and sound asset- and new private sector banks, which are chronicliability management. borrowers and public sector banks, which are the lenders. Notwithstanding excessive dependence of3.101 The Narasimham Committee (1998) made some banks on the call money market, the short-several recommendations to further develop the term money markets are characterised by highmoney market. First, it reiterated the need to make degree of stability. The Reserve Bank has institutedthe call/notice money market a strictly inter-bank a series of prudential measures and placed limitsmarket, with PDs being the sole exception, as they on borrowings and lendings of banks and PDs in theperform the key function of equilibrating the call call/notice market to minimise the default risk andmoney market and are formally treated as banks for bring about a balanced development of variousthe purpose of inter-bank transactions. Second, it market segments. In order to improve transparencyrecommended prudential limits beyond which banks and strengthen efficiency in the money market, it wasshould not be allowed to rely on the call money made mandatory for all NDS members to report allmarket. The access to the call money market should their call/notice money market transactions throughonly be for meeting unforeseen fund mismatches NDS within 15 minutes of conclusion of therather than for regular financing needs. Third, the transaction. The Reser ve Bank and the marketReserve Bank’s operations in the money market participants have access to this information on aneed to be market-based through LAF repos and faster frequency and in a more classified manner,reverse repo auctions, which would determine the which has improved the transparency and the pricecorridor for the market. Fourth, non-bank participants discovery process. Furthermore, a screen-basedcould be provided free access to rediscounting of negotiated quote-driven system for all dealings inbills, CP, CDs, Treasury Bills and money market the call/notice and the term money markets (NDS-mutual funds. CALL), developed by CCIL, was operationalised on September 18, 2006 to br ing about increased3.102 Following the recommendations of the transparency and better price discovery in theseReserve Bank’s Internal Working Group (1997) and segments. Although the dealing on this platform is 93
  • REPORT ON CURRENCY AND FINANCE Box III.5 Development of a Short-Term Yield Curve – Some IssuesThe existence of a wide, deep and liquid money market moderation in yields has also been suppor ted byis critical for the development of a smooth yield curve, rationalisation of small savings interest rateswhich facilitates the conduct of monetary policy. As money administered by the Government. The stickiness of themarket determines the cost of liquidity and anchors the reverse repo/repo rate could also have contributed to theshort-end of the yield curve, the development of a deep flattened yield curve. Maintaining the reverse repo/repoand liquid money market is imperative for the emergence rate at the unchanged level for an extended period ofof a yield curve which would credibly transmit monetary time could have also led to distor tions in the termpolicy signals. In this regard, the Reserve Bank has taken structure of interest rates. This can be understood by theseveral measures since the mid-1990s to develop a short- fact that while the 10-year gilt yield declined by 257 basisterm yield cur ve with deep liquidity. These are: (i) points during May 2002 to April 2004, the reverse repoexempting inter-bank liabilities from the maintenance of rate declined by only 150 basis points while call moneyCRR; (ii) operationalising the LAF whereby the reverse rates declined by 180 basis points during the same period.repo and repo rates are used as policy instruments to These structural factors appeared to have contributed tomodulate liquidity conditions and stabilise call rates within the flattening of the yield cur ve. Owing to thesethe LAF corridor; (iii) transforming the call money market distortions, the Indian yield curve does not fully reflectinto a pure inter-bank market by phasing out the non- the mar ket expectations on inflation and growthbank lenders; (iv) developing other market segments with prospects.adequate access for non-banks; (v) developing a relatively An important objective of money market reforms by thevibrant non-RBI repo market; and (vi) developing the Reserve Bank in recent years has been to facilitateCBLO market as yet another instrument of overnight transparency in transactions in order to reduceborrowing/lending facility. transactions cost and improve price discovery. TheNotwithstanding these initiatives, a short-term yield curve Clearing Corporation of India Limited (CCIL), by providingwhich is readily amenable for policy purposes is yet to for guaranteed settlement of all trades, ensuresemerge. In this regard, the single largest impediment for prevention of gr id-lock in financial transactions.the emergence of a short-term yield curve has been the Furthermore, the introduction of CBLO by the CCIL innon-existence of a vibrant and liquid term-money market, January 2003 and operationalisation of an order matchingmainly due to the inability of market participants to build (OM) anonymous trading screen has made tradinglong-term interest rate expectations, skewed distribution transparent and on a real time basis, thereby making theof market liquidity, reduction in the minimum maturity money market more efficient. In order to further enhanceperiod of term deposits of banks, and tendency on the transparency in the money market, screen-based tradingpart of banks to deploy their surplus funds in LAF auctions through the NDS-CALL was operationalised in Septemberrather than in the term money market. 2006. The full implementation of the real time gross settlement (RTGS) would further aid this process byAs a result, the yield curve has been flattening in recent contributing to systemic stability.years; it even remained inverted for a very brief period.For instance, the absor ption of liquidity through Notwithstanding considerable progress, a proper short-sterilisation operations had led the call rates and the cut- term yield curve, which facilitates the transmission ofoff yield on 91-day Treasury Bills to edge above the yield monetary policy signals and provides a benchmark forof 364-day Treasury Bills, leading to an inversion of a the pricing of other short-term debt instruments, is yet tosegment of the yield curve for a few days in October 2003. emerge fully. In this regard, the constant interaction between the Reserve Bank and market par ticipantsThe prolonged flattening of the yield curve has, however, through frequent meetings, speeches, interviews, pressbeen influenced by structural factors such as considerable releases and publications is progressively expected tosoftening of yields due to dismantling of administered mute the sur prise element of monetar y policy andinterest rate regime, favourable inflationary expectations facilitate the process of formation of market expectations,and excess liquidity in the wake of capital flows. The which would increasingly get captured in the yield curve.optional, 85 banks and 7 PDs have taken of volatility) and provided the necessary platform formembership of NDS-CALL. the Reserve Bank to conduct its monetary policy. The behaviour of call rates has, histor ically, been3.104 Various reform measures over the years have influenced by liquidity conditions in the market. Callimparted stability to the call money market. It has rates touched a peak of about 35 per cent in Maywitnessed orderly conditions (barring a few episodes 1992, reflecting tight liquidity on account of high levels 94
  • MONEY MARKETof statutory pre-emptions and withdrawal of all Volatility, measured by coefficient of variation (CV) ofrefinance facilities, barring export credit refinance. call rates, also halved from 0.6 to 0.3 over the sameAfter some softness, call rates again came under period. Thus, while statutory pre-emptions like CRRpressure to touch 35 per cent in November 1995, and SLR, and reserve maintenance period were thepartly reflecting turbulence in the foreign exchange main factors that influenced call rates in the pre-reformmarket. The Reserve Bank supplied liquidity through period, it is the developments in other marketrepos and enhanced refinance facilities while reducing segments, mainly the foreign exchange and thethe CRR to stabilise the market. After softening to a government securities market along with the Reservesingle digit level, the rate hardened again to touch 29 Bank’s liquidity management operations that haveper cent in January 1998, reflecting mopping up of been the main driver of call rates in the post-reformliquidity by the Reser ve Bank to ease foreign period. This signifies increased market integration andexchange market pressure. Barring these episodes improved liquidity management by the Reserve Bank.of volatility, call rates remained generally stable in the1990s. After the adoption of the LAF in June 2000, 3.105 With the transformation of the call moneythe call rate eased significantly to a low of 4.5 per market into a pure inter-bank market, the turnover incent in September 2004, reflecting improved liquidity the call/notice money mar ket has declinedin the system following increased capital inflows. significantly. The activity has migrated to otherHowever, it came under some pressure in December overnight collateralised market segments such as2005 on account of IMD redemptions and increased market repo and CBLO. The daily average turnoverto about 7 per cent in February 2007, partly due to in the call money market, which was Rs.35,144 crore 11monetary tightening (Chart III.5) . With the institution in 2001-02, declined to Rs.14,170 crore in 2004-05of LAF and consequent improvement in liquidity before increasing again to Rs.21,725 crore duringmanagement by the Reserve Bank, the volatility in 2006-07. The recent rise in call money market turnovercall rates has come down significantly compared to reflects the general tendency of heightened marketthe earlier periods. The mean rate has almost halved activity following the imbalance between growth infrom around 11 per cent during April 1993-March 1996 bank credit and bank deposits in recent years againstto about 6 per cent during April 2000-March 2007. the backdrop of sustained pick-up in non-food credit. Chart III.5: Call Money Rate Term Money Market 3.106 The term money market is another segment of the uncollateralised money market. The maturity period in this segment ranges from 15 days to one year. The term money market has been somewhat dormant in India. It was also a strictly regulated market up to the late 1980s with the ceiling rates of interest (10.5-11.5 per cent) across the various maturity Per cent buckets. Historically, statutory pre-emptions on inter- bank liabilities, regulated interest rate structure, cash credit system of financing, high degree of volatility in the call money rates, availability of sector-specific refinance, inadequate asset liability management (ALM) discipline among banks and scarcity of money market instruments of varying maturities were cited as the main factors that inhibited the development of the term money market. Jul-83 Jan-60 Dec-63 Nov-67 Oct-71 Sep-75 Aug-79 Jun-87 May-91 Apr-95 Mar-99 Feb-03 Jan-07 3.107 In order to activate the term money market, several policy measures were taken by the Reserve11 Call money rate hardened during the second half of March 2007 (averaging about 20 per cent), reflecting tight liquidity conditions on account of advance tax outflows, year-end considerations, sustained credit demand and asymmetric distribution of government securities holdings across banks. 95
  • REPORT ON CURRENCY AND FINANCEBank. In pursuance of the Vaghul Working Group’s Market Reposrecommendations, the administered interest rate 3.110 Repo (Repurchase Agreement) instrumentssystem in this market was dismantled in 1989. In order enable collateralised short-term borrowing throughto promote this segment, the par ticipation was the selling of debt instruments. Under a repowidened by allowing select financial institutions in transaction, the security is sold with an agreement to1993 to borrow from the term money market for a repurchase it at a pre-determined date and rate.maturity period of 3-6 months. Term money of original Reverse repo is a mirror image of repo and representsmaturity between 15 days and 1 year was exempted the acquisition of a security with a simultaneousfrom the CRR in August 2001. Furthermore, no limits commitment to resell.were stipulated for transactions in the term moneymarket, unlike under the call/notice money market. 3.111 In developed financial markets, repurchase agreements (repos) are recognised as a very useful3.108 Despite various reforms, the average daily money mar ket instr ument enabling smoothturnover in this segment continues to be quite low. It adjustment of shor t-term liquidity among variedincreased moderately from Rs.195 crore in 2001-02 categories of market participants such as banks,to Rs.1,012 crore during 2006-07. The factors still financial institutions, securities and investment firms.hindering the development of this segment of the Compared with pure call/notice/ter m moneymoney market include: (i) the inability of participants transaction, which is non-collateralised, repo is fullyto build interest rate expectations over the medium- collateralised by securities, thereby offering greaterterm due to which there is a tendency on their part to flexibility and minimising default risk. Furthermore,lock themselves in the short-term; (ii) the distribution repo has several advantages over otherof liquidity is also skewed with public sector banks collateralised instruments also. One, while obtainingoften having surplus funds and foreign banks being titles to securities in other collateralised lendingin deficit in respect of short-term resources. Since instruments is a time-consuming and uncer tainthe deficit banks depend heavily on call/notice money, process, repo entails instantaneous legal transfer ofmore often, surplus banks exhaust their exposure ownership of the eligible securities. Two, it helps tolimits to them; (iii) cor porates’ overwhelming promote greater integration between the money andpreference for ‘cash credit’ system rather than ‘loan’ the government securities markets, thereby creatinggenerally forces banks to deploy a large amount in a more continuous yield curve. Additionally, repo canthe call/notice money market rather than in the term also be used to facilitate Gover nment’s cashmoney mar ket to meet sudden demand from management (Gray, 1998). Central banks all over thecorporates; (iv) the steady reduction in the minimum world also use repo as a very powerful and flexiblematurity period of term deposits offered by banks; and money market instrument for modulating market(v) the tendency on the part of banks to deploy their liquidity. Since it is a market-based instrument, itsurplus funds in LAF auctions rather than in the term serves the purpose of an indirect instrument ofmoney market, reflecting risk-averse behaviour. monetary policy at the short-end of the yield curve.3.109 It is widely accepted that the banking sector 3.112 Since forward trading in securities wasneeds a deep and liquid term money market for generally prohibited in India, repos were permittedmanaging its liquidity as also a smoother rupee yield under regulated conditions in terms of participantscurve. The recent reform measures such as the and instruments. Refor ms in this market havephasing out of non-banks from the call/notice money encompassed both institutions and instruments. Bothmarket and institution of prudential call/notice money banks and non-banks were allowed in the market. Allexposure limits for banks and PDs are expected to government securities and PSU bonds were eligibleswitch market participants to other market segments. for repos till April 1988. Between April 1988 and mid-The development of an efficient repo market could June 1992, only inter-bank repos were allowed in allprovide benchmarks to all fixed income segments, gover nment secur ities. Double ready forwardincluding the term money market. In order to improve transactions were part of the repos market throughouttransparency, strengthen efficiency and facilitate a this period. Subsequent to the irregularities inbetter price discovery process in the term money securities transactions that surfaced in April 1992,market, the Technical Group on Money Market repos were banned in all securities, except Treasuryrecommended that term money transactions should Bills, while double ready forward transactions werealso be conducted on a screen-based negotiated prohibited altogether. Repos were permitted onlyquote driven platform. among banks and PDs. In order to reactivate the repos 96
  • MONEY MARKETmarket, the Reserve Bank gradually extended repos anonymous trading system. Mutual funds andfacility to all Central Government dated securities, cooperative banks were the main beneficiaries of thisTreasury Bills and State Government securities. It is scheme. The anonymous, order-driven and onlinemandatory to actually hold the securities in the matching system was a milestone in the Indian debtportfolio before undertaking repo operations. In order market.to activate the repo market and promote transparency, 3.115 With the transformation of the call moneythe Reserve Bank introduced regulatory safeguards market into a pure inter-bank market (with PDs) sincesuch as delivery versus payments (DvP) system August 2005 and imposition of prudential limits onduring 1995-96. The Reserve Bank allowed all non- borrowing/lending by banks and PDs in the call moneybank entities maintaining subsidiary general ledger market, the activity has migrated to the CBLO segment(SGL) account to participate in this money market as it enables market participants to manage their short-segment. Furthermore, non-bank financial companies, term liquidity. Accordingly, the average daily turnover inmutual funds, housing finance companies andinsurance companies not holding SGL accounts were the CBLO segment increased from Rs.515 crore inalso allowed by the Reserve Bank to undertake repo 2003-04 to Rs.32,390 crore during 2006-07. Thetransactions from March 2003, through their “gilt increase in turnover could be attributed partly to theaccounts” maintained with custodians. With the increase in the number of participants from 30 in Julyincreasing use of repos in the wake of phased exit of 2003 to 153 by March 2007. The composition of marketnon-banks from the call money market, the Reserve participants has undergone changes with mutual fundsBank issued comprehensive uniform accounting and insurance companies emerging as the majorguidelines as well as documentation policy in March lenders in the CBLO market, while nationalised banks,2003. Moreover, the DvP III mode of settlement in PDs and non-financial companies as the majorgovernment securities (which involves settlement of borrowers during 2006-07. Thus, the CBLO and thesecurities and funds on a net basis) in April 2004 market repo (the collateralised segment) have nowfacilitated the introduction of rollover of repo transactions emerged as the predominant money market segmentsin government securities and provided flexibility to with a combined share of nearly 70 per cent of the totalmarket participants in managing their collaterals. turnover in 2006-07.3.113 The operationalisation of the Negotiated 3.116 As borrowings in the CBLO segment are fullyDealing System (NDS) and the Clearing Corporation collateralised, the rates in this segment are expectedof India Ltd. (CCIL) combined with prudential limits to be comparable with the repo rates. The movementson borrowing and lending in the call/notice market for in the daily average rates in the overnight call, thebanks also helped in the development of market repos. repo and the CBLO markets for the period fromReflecting this, the average daily turnover of repo January 2003 to March 2007 show that CBLO ratestransactions (other than the Reserve Bank) increased moved between the call and the repo rates up tosharply from Rs.11,311 crore during April 2001 to Rs. November 2003 due to a limited number of42,252 crore in June 2006 in line with the phasing participants. From November 2003, the CBLO ratesout of non-banks from the call/notice money market - have aligned with the repo rates on account ofa process which was completed by August 2005. increase in the number of par ticipants. TheSubsequently, the turnover in this segment became transparent nature and real time basis of deals in thesubdued. In this segment, mutual funds and some CBLO segment have helped in enhancing efficiencyforeign banks are the major providers of funds, while of the money market.some foreign banks, private sector banks and primarydealers are the major borrowers. Treasury Bills 3.117 In India, prior to the institution of reforms, theCollateralised Borrowing and Lending Obligations 91-day Treasur y Bills were sold on tap at an(CBLO) administered rate of discount, which was fixed at 4.63.114 The CBLOs were operationalised as a money per cent from July 1974. They, however, could notmarket instrument by the CCIL on January 20, 2003. emerge as a useful money market instrument due toThe product was introduced with the objective of the administered nature of interest rates, whichproviding an alternative avenue for managing short- reflected the perspective of the issuer rather than theterm liquidity to the market participants who were buyer. A reform process in this segment started withrestricted and/or phased out of the call money market. the introduction of 182-day Treasury Bills fromThe mar ket was quick to reap the benefits of November 1986. This was followed by the phasing 97
  • REPORT ON CURRENCY AND FINANCEout of tap Treasury Bills and an introduction of the prevailing liquidity conditions. The primary marketauctioning system in 91-day Treasury Bills. The yields of Treasury Bills edged higher during 2005-06institution of DFHI as a money market institution along mirroring the liquidity conditions as well as movementswith other steps taken to develop the market created in LAF rates. The hardening of primary yields sincethe ground for the emergence of 91-day Treasury Bills September 2005 mainly reflects liquidity tighteningas an important market segment. Treasury Bills with due to festival demand for cash, quarterly advance364-day maturity were introduced in April 1992 and tax outflows and IMD redemption on December 29,tendered through auction-deter mined rates of 2005 and strong credit demand (Chart III.6). Thus,discount. Subsequently, 91-day Treasury Bills were Treasury Bills have not only served the Governmentintroduced on an auction basis in January 1993. There in their cash management, but have also beenwas also a system of 91-day ad hoc Treasury Bills, effectively used for sterilisation purposes under thewhich were issued by the Central Government to the MSS. The persistent use of these instruments forReserve Bank with a de jure objective of bridging sterilisation, however, could undermine their role astemporary mismatches. De facto, however, they turned benchmarks for other money market instruments.out to be a permanent source of meeting Central 3.120 The Reserve Bank has been modifying theGover nment’s resource requirement through notified amounts for auctioning of Treasury Bills inmonetisation of fiscal deficit. A major reform occurred tune with the evolving liquidity conditions. Reflectingin April 1997, when the system of ad hoc Treasury the relatively tight liquidity conditions during 2006-Bills was abolished and 14-day intermediate Treasury 07, the bid-cover ratios have generally declined,Bills and auction bills were introduced to enable better especially in respect of 91-day and 182-day Treasurycash management by the Government and to provide Bills (Table 3.4).alternative avenues of investments to the StateGovernments and some foreign central banks. Thus,Treasury Bills of different tenors were introduced to Commercial Paperconsolidate the market for imparting liquidity, while 3.121 Commercial Paper (CP) is issued in the formyields were made market determined through auctions of a promissory note sold directly by the issuers tofor their use as a benchmark for other short-term investors, or else placed by the borrowers throughmarket instruments. agents such as merchant banks and security houses. When it is issued by corporate borrowers directly to3.118 The Reserve Bank now auctions 91-day investors in the money market and by the process ofTreasury Bills on a weekly basis and 182-day Treasury securitisation, the intermediation function of the bankBills (re-introduced in April 2005) and 364-day is obviated. CP was introduced in India in JanuaryTreasury Bills on a fortnightly basis on behalf of theCentral Government. Treasury Bills market being atthe heart of money market development, the Reserve Chart III.6: Yields on Treasury BillsBank 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 after Per centthe 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 government 03-Apr-02 27-Apr-05 24-Jul-02 15-Oct-03 15-Sep-04 19-Jul-06 28-Feb-07 25-Jun-03 04-Feb-04 05-Jan-05 02-May-01 20-Aug-01 12-Dec-01 13-Nov-02 05-Mar-03 26-May-04 17-Aug-05 07-Dec-05 29-Mar-06 08-Nov-06securities with the Reserve Bank, which constrainedoutright OMOs for sterilisation purposes, TreasuryBills were made eligible for issuance under the MSS. Date of AuctionThe notified amount of Treasury Bills issued under 364-day 91-day Reverse Repo Ratethe MSS has varied during the year keeping in view 98
  • MONEY MARKET Table 3.4: Treasury Bills – Primary MarketMonth 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-day1 2 3 4 5 6 7 82005-06April 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 3.362006-07April 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.1990, in pursuance of the Vaghul Committee’s carved out of the maximum permissible bank financerecommendations, in order to enable highly rated non- (MPBF) limit and subsequently only to its cash creditbank corporate borrowers to diversify their sources portion. A major reform to impart a measure ofof shor t-ter m borrowings and also provide an independence to the CP market took place when theadditional instrument to investors. CP could carry an “stand-by” facility of the restoration of the cash creditinterest rate coupon but is generally sold at a discount. limit and guaranteeing funds to the issuer on maturitySince CP is freely transferable, banks, financial of the paper was withdrawn in October 1994. As theinstitutions, insurance companies and others are able reduction in the cash credit portion of the MPBFto invest their short-term surplus funds in a highly impeded the development of the CP market, theliquid instrument at attractive rates of return. issuance of CP was delinked from the cash credit limit in October 1997. It was converted into a “stand alone”3.122 The terms and conditions relating to issuing product from October 2000 so as to enable the issuersCPs such as eligibility, maturity periods and modes of the services sector to meet short-term workingof issue have been gradually relaxed over the years capital requirements. Banks were allowed to fixby the Reserve Bank. The minimum tenor has been working capital limits after taking into account thebrought down to seven days (by October 2004) in resource pattern of the companies’ finances, includingstages and the minimum size of individual issue as CPs. Cor porates, PDs and all-India financialwell as individual investment has also been reduced institutions (FIs) under specified stipulations haveto Rs. 5 lakh with a view to aligning it with other money been permitted to raise short-term resources by themarket instruments. The limit of CP issuance was first Reserve Bank through the issue of CPs. There is no 99
  • REPORT ON CURRENCY AND FINANCElock-in period for CPs. Furthermore, guidelines were Chart III.7: Commercial Paperissued per mitting 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 measures Rupees crorewere under taken with a view to achieving the Per centsettlement 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 platfor mcommenced effective April 16, 2005. The FCACobserved that CPs being short-term instruments, anyunlimited opening up of issuance could have 15-Jul-94 15-Jul-99 15-Jul-04 15-Apr-93 15-Apr-98 15-Apr-03 30-Nov-93 28-Feb-95 15-Oct-95 31-May-96 15-Jan-97 31-Aug-97 30-Nov-98 29-Feb-00 15-Oct-00 31-May-01 15-Jan-02 31-Aug-02 30-Nov-03 28-Feb-05 15-Oct-05 31-May-06 15-Jan-07implications for short-term debt flows. It, therefore,recommended for prudential limits even under fullconvertibility. Outstanding Amount Average Discount Rate (right scale)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 market the minimum tenor for CPs and CDs asliquidity as its issuances tend to rise amidst ample recommended by the Narasimham Committeeliquidity conditions when companies can raise funds (1998); (iii) permitting select all-India financialthrough CPs at an effective rate of discount lower than institutions to issue CDs for a maturity period of 1 tothe lending rate of banks. Banks also prefer investing 3 years; (iv) abolishing limits to CD issuances as ain CPs during credit downswing as the CP rate works certain proportion of average fortnightly outstandingout higher than the call rate. Thus, the average aggregate deposits effective October 16, 1993 withoutstanding amount of CPs declined from Rs.2,280 a view to enabling it as a mar ket deter minedcrore during 1993-94 to Rs.442 crore during 1995-96 instrument; (v) reducing the minimum issuance sizeamidst tight liquidity but moved up to Rs.17,285 crore from Rs. 1 crore in 1989 to Rs. 1 lakh in June 2002;during 2005-06. It increased further to Rs.21,314 crore (vi) withdrawal of restriction on minimum period forduring 2006-07. Leasing and finance companies transferability with a view to providing flexibility andcontinue to be the predominant issuers of CPs. depth to the secondary market activity; (vii) requiringDiscount rates on CPs have firmed up in line with the banks and FIs to issue CDs only in dematerialisedincreases in policy rates during 2005-06 and 2006-07 form, effective June 30, 2002, in order to impart more(Chart III.7). transparency and encourage secondary market; and (viii) permitting banks in October 2002 to issueCertificates of Deposit floating rate CDs as a coupon bearing instrument so as to promote flexible pricing in this instrument.3.124 In order to widen the range of money market The FCAC Committee recommended for prudentialinstr uments and provide greater flexibility to limits on opening up CDs even under fullinvestors for deploying their shor t-term surplus convertibility.funds, certificates of deposit (CDs) were introducedin June 1989. They are essentially securitised short- 3.125 Activity in the CD market also mirrors liquidityterm time deposits issued by banks and all-India conditions but unlike CPs, the CD issuances by banksfinancial institutions during periods of tight liquidity, and FIs pick up during periods of tight liquidity. Forat relatively higher discount rates as compared to instance, the average outstanding amount of CDs roseterm deposits. The guidelines concerning CDs have from Rs.8,266 crore during 1992-93 to Rs.14,045also been relaxed over time. These include (i) freeing crore during 1995-96. It further increased to Rs.21,503of CDs from interest rate regulation in 1992; (ii) crore in June 1996 reflecting the credit pick-up.lowering the minimum maturity period of CDs issued Another phase of tight liquidity during the East Asianby banks to 7 days (April 2005) with a view to aligning crisis led to increased market activity in this segment. 100
  • MONEY MARKET Table 3.5: Volatility in Money Market Rates Chart III.8: Certificates of Deposit April 1993- April 1996- April 2000- Item March 1996 March 2000 March 2007 1 2 3 4 Call Money Average (Per cent) 11.1 8.0 6.3 Rupees crore SD 6.7 3.7 1.9 Per cent CV 0.6 0.5 0.3 Commercial Paper Average (Per cent) 13.4 11.7 7.8 SD 2.6 2.2 1.8 CV 0.2 0.2 0.2 Certificates of Deposit Average (Per cent) 12.2 11.6 6.9 SD 2.2 2.4 1.7 CV 0.2 0.2 0.2 02-Apr-93 25-Apr-97 29-Oct-93 21-Jul-95 16-Feb-96 27-Sep-96 06-Oct-00 19-Jun-98 15-Jan-99 13-Aug-99 10-Mar-00 28-Jun-02 24-Jan-03 22-Aug-03 19-Mar-04 15-Oct-04 07-Jul-06 02-Feb-07 27-May-94 23-Dec-94 21-Nov-97 04-May-01 30-Nov-01 13-May-05 09-Dec-05 Term Money @ Average (Per cent) – – 6.5 SD – – 1.4 Outstanding Amount Average Discount Rate (right scale) CV – – 0.2 Market Repo* Average (Per cent) – – 5.4Subsequently, the outstanding amount declined to SD – – 1.1Rs.949 crore during 2001-02, reflecting the state of CV – – 0.2easy liquidity on account of large capital inflows. The CBLO*average outstanding amount of CDs increased again Average (Per cent) – – 5.3 SD – – 1.1to Rs.64,814 crore during 2006-07 as banks continued CV – – 0.2to supplement their efforts at deposit mobilisation in @ : For the period May 2001 to March 2007.order to support the sustained credit demand. Interest * : For the period April 2004-March 2007.rates on CDs softened in recent years in line with SD : Standard Deviation. CV : Coefficient of Variation.other money market instruments, although there was Note: Calculated on monthly average data.some hardening during 2006-07 (Chart III.8). call rates and various other reforms have also impartedVolatility in Money Market Segments a degree of stability to other market instruments such as CPs and CDs. The lower volatility is in consonance3.126 An analysis of the trends in interest rates with the Reserve Bank’s emphasis on financial stabilityacross the various instruments in the money market as a key consideration of monetary policy.brings out the following salient features. First, since theintroduction of reforms, all money market rates have Interest Rate Derivativeswitnessed considerable softening commensurate withthe progressive reduction in inflation, reflecting lower 3.127 Interest rate deregulation has made financialinflation expectations. Softening of interest rates has market operations relatively efficient and cost effectivealso been on account of several other factors such as but has also exposed market participants to variousthe deepening of the market through establishment of risks. This necessitated introduction of derivativeappropriate market intermediaries, increase in the instr uments to manage these r isks throughnumber of participants, prevalence of comfortable unbundling of risks. The derivative contracts can beliquidity conditions arising out of large capital inflows traded either over-the-counter (OTC) or in stockand a distinct policy preference for a softer interest exchanges (exchange-traded). OTC contracts arerate regime. The volatility in call money rates has traded directly between two eligible parties, with orreduced after the introduction of LAF and the setting without the use of an intermediary and without goingup of an informal corridor of reverse repo and repo rates through the stock exchanges. On the other hand,(Table 3.5). The stability in the overnight money market exchange-traded (ET) derivatives are transacted inwas further facilitated by introduction of new instruments stock exchanges as standardised products throughsuch as market repo and CBLO. Increased stability in screen-based trading. 101
  • REPORT ON CURRENCY AND FINANCE3.128 Derivative trading in India witnessed some and uncertainties about regulations with regard toactivity from July 1999 when the Reserve Bank certain complex products. To address these issues,allowed scheduled commercial banks (excluding the Reserve Bank constituted a number of workingRegional Rural Banks), PDs and all-India financial groups.institutions to undertake Forward Rate Agreements(FRA)/Interest Rate Swaps (IRS) for managing 3.131 The Working Group on Rupee Derivativesinterest rate risks in their balance sheets. In order to (Chairman: Shri Jaspal Bindra), which submitted itswiden the market, mutual funds were allowed to Report in January 2003, was set up to suggest theparticipate for the purpose of hedging their own modalities for introducing derivatives having explicitbalance sheet risks from November 1999. The use of option features such as caps/collars/floors in the‘interest rate implied in the foreign exchange forward rupee derivative segment and also the norms formarket’ as a benchmark, in addition to the domestic capital adequacy, exposure limits, swap position,money and debt market rates, was permitted from asset liability management, internal control and otherApril 2000. The activity gathered momentum after risk management methods for these derivatives.exchange-traded derivatives by way of futures were Recognising the ambiguity regarding the legality ofintroduced in Mumbai Stock Exchange (BSE) and the OTC derivative contracts as the main factorNational Stock Exchange (NSE) from June 2000. inhibiting their growth, the Group proposed appropriate amendments in the Reserve Bank of India3.129 Initially, banks/PDs/FIs were permitted to Act, 1934 to provide legality to OTC derivatives.undertake different kinds of plain vanilla products such Accordingly, the Union Budget, 2005-06 proposed toas FRAs/IRS with tenors ranging from one month to take measures to provide clear legal validity to suchone year. The Foreign Exchange Management Act contracts. The Reserve Bank of India Act, 1934 has(FEMA), 2000 permitted banks to provide risk since been amended, which now provides legalmanagement tools such as swaps, options, caps, sanctity to OTC derivatives if at least one of the partiescollars and FRAs to clients to hedge interest rate risk to the transaction is the Reserve Bank or any agencyarising out of foreign currency liabilities. Even though falling under its regulatory purview.the derivative transactions have grown significantlyin recent years, the market is essentially one of vanilla 3.132 The Inter nal Wor king Group on Rupeeproducts. Active participants in the market are also Interest Rate Der ivatives (Chair man: Shr i G.limited, mainly some foreign and private sector banks, Padmanabhan) recommended the harmonisation ofPDs and all-India financial institutions. The Reserve regulations between OTC interest rate derivativesBank allowed banks and PDs to transact in exchange and ET interest rate der ivatives. It alsotraded interest rate futures (IRFs) from June 2003 recommended that banks that have adequateto hedge their interest rate risk effectively. While PDs internal risk management and control systems andwere allowed to hold trading as well as hedging a robust operational framework be permitted to holdpositions in IRFs, banks were allowed only to hedge trading positions in the interest rate futures (IRF)their underlying government securities [in available market. The Securities and Exchange Board of Indiafor sale (AFS) /held for trading (HFT) category (SEBI) revisited the issue pertaining to introductionpor tfolios] through IRFs. The National Stock of new futures contracts in consultation with theExchange (NSE) introduced futures on a notional 10- Fixed Income Money Mar ket and Der ivativesyear government security, a 3-month Treasury Bill Association of India (FIMMDA) and permitted tradingrate and a 10-year government zero coupon in June of interest rate futures contract on an underlying 10-2003. Activity in the IRF market has, however, not year coupon-bearing notional bond from January 5,picked up because of valuation problems as also 2004. The Reserve Bank released comprehensivebecause banks have been allowed only to hedge but draft guidelines in December 2006 on derivativesnot to trade. covering broad generic principles for undertaking derivative transactions, management of risk and3.130 Innovations in OTC derivatives have been sound corporate governance requirements.limited due to several structural shor tcomings,including lack of clear accounting and disclosure 3.133 Reflecting these measures, the r upeestandards, lack of adequate knowledge of uses and derivative market has grown significantly. FRAs/IRSrisks inherent in derivative transactions, particularly transactions, in terms of outstanding notional principalthose involving complex str uctures, legal amount, rose from Rs.4,249 crore in March 2000 touncertainties surrounding the use of OTC derivatives Rs.21,94,637 crore at end-March 2006. 102
  • MONEY MARKET(ii) Interest Rate Swaps 2006 to third week of March 2007. OIS yields are3.134 In the interest rate swap market, apart from positively correlated to the government securities (G-increase in volumes, the market also witnessed Sec) yields. For most part of 2004, OIS curve wasemergence of interest rate benchmarks such as above the G-sec curve as it priced in expectations ofMumbai Inter-Bank Offered Rate (MIBOR), the a turnaround in interest rate cycle. In the absence ofMumbai Inter-Bank Forward Offered Rate (MIFOR) short selling, G-Sec markets were unable to price(which is a combination of the MIBOR and forward these expectations effectively. Subsequently, as G-premium) and other multiple benchmarks, which Sec markets reacted to the rising interest rateessentially have linkages to the movement in overseas scenario, the G-Sec yields edged above the OIS curveinterest rates. MIBOR linked short-term paper up to (Chart III.9). The OIS curve remaining below the G-365 days, with/without daily call/put options, has Sec curve for a sustained period of time was probablyemerged as an important instrument which enables a reflection of the liquidity conditions as swap curvestop rated corporates to raise funds from non-bank normally stay above the Treasury curve. Thus, duringentities, particularly from mutual funds. situations of tight liquidity, the OIS - G-Sec spread tends to be narrow.3.135 Over night Index Swaps (OIS) help inmanaging interest rate risk by converting fixed ratereceivables to floating and vice versa without taking MIFOR (Mumbai Inter-Bank Forward Offered Rate)credit risk as this tool is built on a notional principal. SwapsBanks can use this instrument to effectively manage 3.137 The yields on MIFOR swaps have risen duringtheir liquidity by converting their fixed term deposits the last three years in line with the general increaseinto floating rate. This instrument is also used for asset in interest rates. The 5-year MIFOR swap rateliability management and as a positioning tool for increased from 3.85 per cent at the beginning ofputting on carry trades. MIFOR swaps, on the other January 2004 to 8.16 per cent on March 28, 2007.hand, are used to hedge interest rate risk as well as The MIFOR curve flattened with the 1-year to 5-yearcurrency risk by an entity which has exposure to spreads steadily declining from a high of 200 bps inforeign currency borrowing by taking an opposite the beginning of January 2004 before turning negativeposition in MIFOR swap. from December 2006 to March 2007, it touched (-)3.136 The 5-year OIS yields rose considerably from 119 bps on March 28, 2007. The MIFOR curve hasaround 4.70 per cent in the beginning of January 2004 remained consistently below the G-Sec curve duringto about 7.90 per cent on March 28, 2007. The OIS last three years except from June to August 2004.curve steepened during the period from January 2004 This was mainly for the reason that MIFOR curve isto October 2004 with spreads between 1 year and 5 influenced largely by the implied rupee interest ratesyear tenors increasing from 26 basis points (bps) to in the forward premia, which, in the absence of140 bps, but later flattened to reach 22 bps by covered interest parity, tend to diverge from interestDecember 8, 2006. Inversion of the curve was rate differential. Between mid-November 2006 and theobser ved with the spread tur ning negative third week of March 2007, the MIFOR curve wasintermittently between the last week of December above the G-Sec curve. Five-year MIFOR was above Chart III.9: OIS and G-Sec Yields OIS Yields G-Sec and OIS Yields Per cent Per cent 26-Dec-04 21-Dec-05 16-Dec-06 27-Sep-04 17-Sep-06 01-Jan-04 31-Mar-04 29-Jun-04 26-Mar-05 22-Sep-05 24-Jun-05 21-Mar-06 19-Jun-06 16-Mar-07 17-Sep-06 01-Jan-04 31-Mar-04 27-Sep-04 29-Jun-04 26-Dec-04 26-Mar-05 22-Sep-05 24-Jun-05 21-Dec-05 21-Mar-06 19-Jun-06 16-Dec-06 16-Mar-07 1-year 2-year 5-year G-Sec OIS 103
  • REPORT ON CURRENCY AND FINANCE Chart III.10: MIFOR SWAP and G-Sec Yields MIFOR SWAP Yields MIFOR and G-Sec Yields Per cent Per cent 26-Dec-04 21-Dec-05 16-Dec-06 31-Mar-04 27-Sep-04 17-Sep-06 16-Mar-07 01-Jan-04 29-Jun-04 26-Mar-05 22-Sep-05 24-Jun-05 21-Mar-06 19-Jun-06 17-Sep-06 01-Jan-04 31-Mar-04 27-Sep-04 26-Dec-04 16-Dec-06 29-Jun-04 26-Mar-05 22-Sep-05 21-Dec-05 24-Jun-05 21-Mar-06 19-Jun-06 16-Mar-07 1-year 2-year 5-year G-Sec MIFORG-Sec of corresponding tenor by 53 bps as on 25 bps on October 31, 2006 as tightening of monetaryJanuary 29, 2007 and 28 bps as on February 12, policy stance as the reverse repo rate was left2007, as forward premia moved up sharply during this unchanged.period (Chart III.10). 3.139 While the introduction of new instruments, including derivatives, has deepened the moneyMonetary Policy and Swap Rates market, the market is still not mature enough for3.138 Swap rates generally move in tandem with complex products. With fuller capital accountG-sec yields. Accordingly, whenever there was a hike conver tibility the market par ticipants would bein the policy rate, all swap rates, viz., OIS and MIFOR exposed to cer tain risks. Therefore, the fur thergenerally reacted similarly (Chart III.11). The only development of hedging instruments such as interestexception was on October 25, 2005, when swap rates rate futures assumes critical importance. Effective riskdid not react to the hike in reverse repo rate by 25 management by market participants also calls forbps to 5.25 per cent. This was mainly due to market access initially to a liquid IRF market and eventuallyparticipants refraining from taking firm positions since to an interest rate options market, which, in turn,the Bank Rate was left unchanged. Furthermore, the would increase liquidity in the government securitiesmarket did not perceive the hike in the repo rate by market. As demand for complex derivate products grows over time, there would be a need for banks to Chart III.11: Monetary Policy and Swap Rates lay down appropriate policies for marketing such products to their clients and put in place a mechanism for close monitoring and stricter regulations. Other Money Market Segments (a) Inter-Bank Participation Certificates (IBPCs) 3.140 As an additional instrument for modulating short-term liquidity within the banking system, it was Per cent decided, in principle, to introduce two types of participation certificates (PCs) in October 1988 - one on risk sharing basis and the other without risk shar ing. These were made str ictly inter-bank instruments confined to scheduled commercial banks, excluding regional rural banks. PCs, however, have not been used widely so far. These instruments are 01-Jan-04 27-Sep-04 22-Sep-05 17-Sep-06 31-Mar-04 26-Dec-04 16-Dec-06 29-Jun-04 26-Mar-05 21-Dec-05 24-Jun-05 21-Mar-06 19-Jun-06 16-Mar-07 used only to obviate short-term liquidity problems by some banks by parting with standard assets. At times, G-Sec OIS MIFOR Reverse Repo Rate these assets are also used to equilibrate priority sector norms by banks. 104
  • MONEY MARKET(b) Money Market Mutual Funds (MMMFs) Chart III.12: Money Market Rates3.141 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. Investments Per centin 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 and Apr-93 Jul-94 Oct-95 Jan-97 Apr-98 Jul-99 Oct-00 Jan-02 Apr-03 Jul-04 Oct-05 Jan-07debentures 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, Call Rate Yield on 91-day Treasury Billmaking the scheme more attractive to investors. CP Rate CD RateMarket Integration policy reaction has been in terms of a combination of instruments, including regulatory action, to ensure the3.142 The success of monetary policy depends on rapid restoration of stability in financial markets. Inthe speed of adjustment in money market rates in this regard, the Reserve Bank has been able toresponse to changes in the policy rates for effective maintain orderly market conditions in recent yearstransmission of monetary policy impulses to the amidst heightened volatility in international financialeconomy. This, in turn, depends on the development markets (see also Chapter VIII).and integration of various market segments. In linewith the progress of financial sector reforms in India,various segments of the money market are getting Risk Managementincreasingly integrated as reflected in the close co- 3.144 The money market is characterised by variousmovement of rates in various segments. The structure risks, viz., default risk, interest rate risk, exchangeof retur ns across markets has shown greater rate risk and settlement risk. Given the increasingconvergence after the introduction of LAF, market orientation of monetary policy in India, greaterdifferentiated by maturity, liquidity and risk of flexibility provided to banks and the focus on interestinstruments (Chart III.12). rates as the main policy instrument, sound risk management is critical for orderly market behaviour3.143 Strengthening of linkages amongst market and overall financial stability. Accordingly, the Reservesegments suggests greater operational efficiency of Bank has been laying greater emphasis on developingmarkets as well as the conduct of monetary policy. efficient risk management practices by marketOn the flip side, however, increased integration has participants.resulted in increased contagion as turbulenceor iginating in one mar ket segment is swiftly 3.145 A potential source of default risk in the moneytransmitted across all segments. Recent experience market emanates from the uncollateralised nature ofof financial market operations in various countries the call money market. In this market, transactionssuggests that market integration tends to strengthen are traditionally undertaken over the counter throughduring episodes of volatility, pointing to a swifter telephonic deals, which lack standardisation andtransmission of market pressures from one segment guarantee of settlement against default. This problemto another. This imposes additional constraints on the has been addressed by mandatory reporting of themanagement of market conditions necessitating deals by the participants in an electronic platform.simultaneous policy actions in various market Moreover, a screen based quote driven system (NDS-segments to limit contagion in the presence of CALL) has been developed by the CCIL on behalf ofasymmetric integration of markets. The monetary the Reserve Bank for greater transparency and price 105
  • REPORT ON CURRENCY AND FINANCEdiscovery in the call/notice and the term money transparency of the money market by ensuring bettermarkets. Furthermore, as large recourse to the disclosure of information; and (iii) rationalising variousuncollateralised money market segment carries a classes of par ticipants across different marketpotential risk of systemic instability arising out of segments in order to strengthen the efficacy of thedefaults, prudential limits have been placed on call LAF of the Reserve Bank. As a result of various reformmoney exposures of banks and PDs. Moreover, non- measures, the money market in India has undergonebank participants with a distinctly different maturity significant transformation in terms of volume, numberprofile of sources and uses of funds have been of instruments and participants, and adoption of riskallowed to migrate from the call money segment to management practices. There are, however, still athe collateralised segments (market repos and number of concerns as well as issues that need to beCBLOs). The shifting of non-banks to the addressed to enable it to play a more effective role,collateralised segment has enhanced financial especially in the wake of move towards fuller capitalstability by reducing systemic risks. Besides, it has account convertibility. These issues broadly relate toalso promoted better asset-liability management on market development and liquidity management.the part of banks. Cumulatively, these measures haveresulted in the dominance of the collateralised Market Developmentsegment in the overnight money market. Greater Flexibility for Participants in the Call Money3.146 In view of the growing inter-linkages between Marketthe money and the foreign exchange markets on theone hand, and greater integration of the domestic 3.149 In view of the transformation of the call moneymarket with global markets on the other, it is market into a pure inter-bank market, there is a neednecessary that the market participants appropriately to consider greater flexibility to banks and PDs tohedge the risks in their balance sheets emanating borrow or lend in this market, provided they have putfrom movements in both international interest rates in place appropriate risk management systems whichand exchange rates. In this regard, the Reserve Bank would address the asset-liability mismatches in theirhas introduced derivative instruments such as FRAs/ balance sheets. In this context, banks have alreadyIRS/IRFs for hedging exposures. Although derivatives started operating in an environment that requiresfacilitate risk management, they, being highly greater har monisation between sources andleveraged, are more volatile than the underlying deployment of funds for asset-liability managementassets. This calls for monitoring and regulation of (ALM) purposes. Direct regulation in the form ofspeculative derivative positions. The Reserve Bank, prudential limits on borrowing and lending eventuallytherefore, has been emphasising monitoring and would need to graduate to a system, where such limitsregulation of derivative transactions. are taken care of by banks’ own internal systems of ALM framework. This would correct large mismatches3.147 The institutionalisation of a central counterparty between sources and uses of funds by banks andin the form of Clearing Corporation of India (CCIL) from thereby help the Reser ve Bank in the proper2002, which guarantees settlement of transactions, has assessment of market conditions for the conduct offacilitated the mitigation of settlement risks and its liquidity management operations. There is also, atprevention of gridlock in the financial system arising the same time, a greater need for closely monitoringout of bunching of transactions. The introduction of the movements of call money rates.RTGS has further mitigated the settlement risk andthe occurrence of gridlock. Extension of the Repo Market 3.150 It has been the endeavour of the ReserveVI. THE WAY FORWARD Bank to develop the repo market not only for easing3.148 Wide-ranging reforms have been undertaken pressure from the uncollateralised call money marketto develop the money market and strengthen its role but also to facilitate the emergence of a short-termin the transmission mechanism of monetary policy. rupee yield curve for pricing fixed income securities.Three major considerations that have guided At present, only Central and State Governmentsrationalisation of the structure in the money market securities are eligible for market repo. However, Stateare: (i) ensuring balanced development of various Government securities do not have wider acceptabilityconstituents of the money market, especially the as there are hardly any repo operations based ongrowth of the collateralised market vis-a-vis the them. As the fixed income money market has beenuncollateralised market; (ii) preserving integrity and overwhelmingly dependent upon Central Government 106
  • MONEY MARKETsecurities, there is a need to consider broad-basing improve day-to-day liquidity management and helpthe pool of eligible securities. In this context, fully develop a market for credit risk transfer instrumentsdematerialised corporate bonds with internationally between banks.accepted accounting practices could eventually beconsidered as eligible collaterals. The development Issues Pertaining to CPof a proper settlement system for such instrumentswould be a prior necessity for progress in this 3.153 Despite the de-linking of issuance from fund-process. There is also a need to exercise caution to based wor king capital limits and completeensure that only highly rated instruments qualify for dematerialisation of CP issuances, the CP marketsuch a facility. This is critical from the point of view of continues to lack the desired level of activity. In termspreserving market integrity. In future, the growth of of extant guidelines, only companies rated P-1 or P-2market repo will be driven by the “short selling” activity by CRISIL or such equivalent rating by other agencies,in the government securities market as a repoed can issue CP. As the market attains a reasonable levelsecurity can now be delivered up to five days in view of maturity while the rating criterion may continue,of the recent changes in the regulations governing the requirement of rating for issuing CP could be madeshort sales. more flexible so that a more structured market is available to investors depending on their risk appetite.Development of a Vibrant Term Money Market Futures on Policy Linked Interest Rates3.151 The term money market has not developedfor several reasons, as discussed in detail earlier. One 3.154 Going forward, an Indian variant of the Federalof the major reasons for this is that market participants Funds Futures on interest rates linked to the Reservehave been unable to take a long-term view of interest Bank’s key policy rates may emerge. Trading in therates despite availability of Treasury Bills of varying futures market would reveal important informationmaturities and a reasonably developed swap market. about market expectation on the future course ofIn order to enable market participants to take a long- monetary policy. For instance, the trading of theterm view on interest rates, it is imperative that the Federal Funds Futures provides key information toALM framework is strengthened and greater flexibility the Federal Open Market Committee (FOMC) in theis allowed to the personnel managing treasury US in formulating its monetary policy.operations in banks. The skewness in liquidity in themoney market in terms of chronic lenders and Promoting Financial Stabilityborrowers would get corrected as banks develop 3.155 Default risk in the money market has thebetter ALM systems. The development of the term potential to create a contagion in the financial marketsmoney market is vital for strengthening proper and, therefore, needs to be mitigated. In this regard,linkages between the foreign exchange market and experiences of developed economies show thatthe domestic currency market, which, in turn, would generally the self-regulatory organisations (SROs)provide an impetus to the derivative segment. regulate activities of participants in the money market in terms of their capital adequacy and conduct ofRelook at Inter-Bank Participation Certificates business. Also, default resolution in most of these3.152 Inter-Bank Participation Certificates, which markets is undertaken through the Contract Law andcan be used for evening out short-term liquidity the Bankr uptcy Law. In view of inter nationalmismatches by banks, were introduced in October experience, there may be a case for empowering a1988 in order to infuse greater degree of flexibility in suitable self-regulatory organisation appropriately totheir credit portfolios. In view of rapid credit growth in act as a catalyst for the development of marketrecent years, interest in IBPCs has again arisen. In microstructure.this context, since considerable time has elapsed 3.156 One of the fundamental forces that couldsince the guidelines on the scheme of IBPCs were contribute to more organic integration across variousissued, the IBPC scheme with respect to duration, segments of the financial market is the technologicalquantum in terms of the proportion to the loan amount, upgradation of the payment and settlement system.eligible participants and transferability of IBPCs needs The accomplishment of virtual Public Debt Officea thorough review. Depending on the results of such (PDO) and Deposit Accounts Department (DAD) ata review, extending the use of this instrument could the Reserve Bank, coupled with the operationalisationalso facilitate the asset liability management by banks, of the centralised funds management system (CFMS) 107
  • REPORT ON CURRENCY AND FINANCEin a relatively low CRR regime should foster greater securities. Sixth, while the Reserve Bank now holdsintegration of various segments of the domestic LAF auctions twice on each working day to facilitatemarket. While these developments could enhance intra-day liquidity, a moral hazard issue arises asthe efficiency of the financial market, there is also some market par ticipants may not be activelythe r isk of faster transmission of contagion. managing their own liquidity in the wake of theTherefore, risk containment in the new environment Reserve Bank’s market operations.would be a major challenge for the Reserve Bankand it would have to remain flexible in the deployment 3.158 The above issues need to be addressed,of its instruments while simultaneously intervening especially in the wake of a progressive move to fullerin various market segments in order to strengthen capital account convertibility. First, there is a need tofinancial stability. fur ther refine the system of assessing liquidity conditions, which calls for an improved framework ofLiquidity Management liquidity forecasting. The short span within which liquidity conditions have been changing by a large3.157 Although significant progress has been made amount has posed a major challenge for targetingin refining the liquidity management practices in India, short-term interest rates. The understanding of theseveral new challenges have emerged. First, during fiscal position and the Government’s cash balancesperiods of abundant liquidity, the LAF window as also the timing and extent of capital inflowsbecomes a first resort for parking surplus funds by assumes added significance. In this context, therebanks. Second, the Reserve Bank has developed the may be a need to consider the regular release ofMSS as a sterilisation mechanism for arresting the information on Government cash balances held withliquidity impact of foreign exchange inflows of a more the Reserve Bank. Second, progressively moreenduring nature, while the LAF continues to be used weightage needs to be given to movements infor managing liquidity at the margin. There is, however, international interest rates in view of increased capitalno way of knowing ex-ante whether the liquidity mobility. Third, destabilising large and sudden capitalsituation is temporary or permanent. Furthermore, the flows call for more flexible and swift monetary policyMSS remains immobilised for the entire period of its responses through small and gradual changes inmaturity. There is, therefore, a need to explore further policy rates, as has been practised in recent years,instr uments/options to under take liquidity as large changes can be disruptive. Fourth, openmanagement, particularly in the context of a move to market operations (OMOs), apart from being used forfuller capital account convertibility. Third, the Reserve modulating liquidity conditions, could also be used toBank may not be in a position to conduct sterilisation correct any serious distortions in the yield curve.operations indefinitely as its inventory of Government Finally, while the Reserve Bank has progressivelypaper is limited. There is also a limit on MSS deemphasised the use of reserve requirements asissuances. Fur thermore, the Reserve Bank has an instrument of monetary policy, given the presentwithdrawn from pr imar y mar ket auctions of state of market development, it is necessary to retainGovernment paper from April 1, 2006 in terms of the flexibility of using reserve requirements, as andprovisions of the Fiscal Responsibility and Budget when necessary12.Management (FRBM) Act, 2003. Fourth, the absenceof a vibrant corporate debt market continues to VII. SUMMING UPimpede further refinements in liquidity managementin terms of eligible instruments as collaterals. In this 3.159 Since the early 1990s, the money market hascontext, it may be noted that State Development undergone a significant transformation in terms ofLoans, which are treated as eligible securities for instr uments, par ticipants and technologicalcollaterals under LAF operations effective April 3, infrastructure. Various reform measures have resulted2007, have widened the collateral base for LAF. Fifth, in a relatively deep, liquid and vibrant money market.as many banks are now operating close to the The transfor mation has been facilitated by theprescribed levels of SLR securities, in case of liquidity Reserve Bank’s policy initiatives as also by a shift intightness, banks may find it difficult to approach the the monetary policy operating procedures fromLAF window in the absence of sufficient collateral administered and direct to indirect market-based12 The provisions of Section 3 of the Reserve Bank of India (Amendment) Act, 2006 came into force effective April 1, 2007, which provide the necessary flexibility to the Reserve Bank in the use of the CRR. 108
  • MONEY MARKETinstruments of monetary management. The changes Accordingly, the Reserve Bank’s emphasis has beenin the money market structure and monetary policy on encouraging migration towards the collateralisedoperating procedures in India have been broadly in segments and developing derivatives for hedgingstep with the international experience and best market risks. This has been complemented by thepractices. institutionalisation of CCIL as a central counterparty to mitigate the settlement risk. The upgradation of3.160 Along with the shifts in the operating payment technologies has further enabled marketprocedures of monetar y policy, the liquidity par ticipants to improve their asset liabilitymanagement operations of the Reserve Bank have management. Cumulatively, these measures havealso been fine-tuned to enhance the effectiveness of helped in containing volatility in the money market,monetary policy signalling. The increasing financial thereby improving the signalling mechanism ofinnovations in the wake of greater openness of the monetary policy while ensuring financial stability.economy necessitated the transition from monetarytargeting to a multiple indicator approach with greater 3.162 Notwithstanding the considerable progressemphasis on rate channels for monetary policy made so far, there is a need to develop the moneyformulation. Accordingly, short-term interest rates market further, particularly in the context of a movehave emerged as a key instrument of monetary policy towards fuller capital account convertibility. Furthersince the introduction of LAF, which has become the development of the money market calls for better ALMprincipal mechanism of modulating liquidity conditions practices by banks and other market participants,on a daily basis. which would enable banks to evolve appropriate prudential limits on their call money exposures from3.161 In line with the shifts in policy emphasis, their internal control systems. In order to develop thevarious segments of the money market have been term money market, participants need to take a long-developed. The call money market was transformed term view on interest rates. Furthermore, there is ainto a pure inter-bank market, while other money need to expand the eligible set of underlying collateralmarket instruments such as market repo and CBLO securities for repo transactions. This would not onlywere developed to provide avenues to non-banks for facilitate liquidity management but also promote themanaging their shor t-term liquidity mismatches. development of underlying debt instruments. Finally,Furthermore, issuance norms and maturity profiles liquidity forecasting techniques need to be furtherof other money market instruments such as CPs and refined for proper assessment of liquidity conditionsCDs were aligned for effective transmission of policy by the Reserve Bank. This would facilitate finerintent across various segments. The abolition of ad changes in the operating procedures of liquidityhoc Treasury Bills and introduction of Treasury Bills management and enable the Reserve Bank to flexiblyauction have led to the emergence of a risk free rate, meet the emerging challenges. As thesewhich acts as a benchmark for pricing other money developments take place, it needs to be understoodmarket instruments. The increased market orientation that monetary management in India will continue toof monetary policy and greater integration of domestic be conducted in an intermediate regime that will havemarkets with global financial markets, however, have to respond creatively and carefully to the emergingnecessitated the development of an institutional and evolving monetar y and macroeconomicframework for appropriate risk management practices. conditions, both domestic and global. 109
  • ANNEX III.1: Operating Procedures of Liquidity Management in Developed Countries Country Objective Intermediate / Key Policy Indicators Key Instruments of Discretionary Liquidity Frequency Eligible Counterparties Eligible Collateral Operating of Market Target CRR OMO Repo Standing Others Operations Facilities 1 2 3 4 5 6 7 8 9 10 11 12 USA To promote Federal funds Multiple indicators of Yes Yes Yes Yes Daily Primary dealers Direct obligations of the Govt. or those maximum rate current & prospective fully guranteed by Federal Govt. sustainable economic developments. agencies & corporate bonds. output, employment & stable prices UK Price stability Overnight market Monetary and credit aggregates, Yes* Yes Yes Yes One per week Eligible UK banks, building UK and EEA Govt. & major international interest rate developments in interest rates, etc. plus one per societies & securities dealers. organisations’ bonds (Sterling and Euro). consistent with month (long- Bank Rate term repos) ECB Price stability, No official Money & broad assessment of Yes Yes Yes Yes One per week Credit institutions meeting certain Both marketable & non-marketable high level of operating outlook for price developments & plus one per operational requirements, mutual private & public instruments. employment, target@ the risks to price stability using month on a funds, corporations, insurance balanced & financial & other economic regular basis companies & other institutional sustainable indicators. investors. development Japan Price stability & to Overnight call Overall economic & financial Yes Yes Yes Yes More than Major players: domestically licensed Both public debts such as JGBs & contribute to the money rate indicators- wholesale prices, one per day banks, foreign banks and securities private debts such as CPs & bank loans.110 sound corporate service prices & money companies & money market development of stock. brokers. national economy Australia Mainly price Cash rate Inflation & growth prospects, Yes Yes Yes Daily Any member of Reserve Bank Commonwealth govt. securities, stability besides, money & credit conditions. Information & Transfer System- large domestic debt securities & discount maintenance of domestic banks, few large non- bank instruments issued by State & territorial full employment, financial institutions & local branches Govt., bank bills & CDs issued by select REPORT ON CURRENCY AND FINANCE economic of some global banks. banks, securities of supranational & prosperity & foreign Govt. agencies having Govt. welfare gurantee. New Zealand Price stability Official cash GDP, output gap, business cycle Yes Yes Yes Daily Those parties who have entered Govt. securities rate indicators. Master Repurchase Agreement with the Reserve Bank. Canada Low and stable Overnight rate Output gap & wide range of Yes Yes Twice a day Primary dealers Securities issued & guaranteed by the inflation indicators in various markets. Govt. of Canada & the provincial Govt., bankers’ acceptances, promissory notes, CPs, short-term muncipal paper, corporate & muncipal bonds with minimum issuer credit ratings. * : Voluntary reserves averaging scheme with reserves remunerated at the Bank Rate provided on average they fall within + or - 1% of targets set by scheme. @ : The ECB sets three key interest rates for the euro area, which determine the stance of the ECB’s monetary policy. These include interest rates on the main refinancing operations, the marginal lending facility and the deposit facility. Source: Websites of respective central banks and Hawkins. J (2005).
  • ANNEX III.2: Operating Procedures of Liquidity Management in Emerging Market Economies Country Objective Intermediate / Key Policy Indicators Key Instruments of Discretionary Liquidity Frequency Eligible Counterparties Eligible Collateral Operating of Market Target CRR OMO Repo Standing Others Operations Facilities 1 2 3 4 5 6 7 8 9 10 11 12 Russia Stability of Monetary base Yes Yes Yes Bank of Daily & For loans: financially sound credit Bank of Russia Lombard List of currency & Russia Bonds weekly institutions complying with the Securities, promissory notes and rights settlement & currency regulatory requirements and of claim under loan agreements, Federal system swaps having accounts in 22 Bank of & Regional Govt. bonds, Bank of Russia Russia regional branches. & credit institutions bonds, mortgage For deposits: banks, settlement non- backed bonds, resident corporate bonds, bank credit institutions conducting bonds of international financial deposit and lending operations. organisations. South Africa Price stability Repurchase rate Multiple indicators- money, credit, Yes Yes Yes Yes Foreign Daily Banking institutions, which have All Central govt. securities, Reserve Bank international interest rates, yield currency signed ISDA/ISMA agreement. Bills & land bank bills. curve, output gap, asset prices, swaps BOP position, exchange rate, etc. Mexico Price stability Bank reserves Money & monetary base, Yes Yes Yes Yes Daily inflation indicators, employment, exchange rate & Balance of Payments. China Stability of the Money supply/ Yes Yes Yes Yes Policy oriented 1 or 2 per 21 commercial banks & bills Eligible bills, bankers’ acceptances, trade currency & excess reserves financial bonds week finance companies. acceptances & promisory notes thereby promote & central bank collateralised against T-bills. economic growth bonds111 India Growth, price Overnight rate Multiple indicators: broad money, Yes Yes Yes# Yes Market Twice a day- LAF: banks and primary dealers Central Govt. Securities & State and financial interest rates, data on currency, Stabilisation Repo MSS: banks, primary dealers, Development Loans. stability credit, fiscal position, trade, Scheme all-India financial institutions & MONEY MARKET capital flows, inflation rate, others. exchange rate, ouput data, etc. Thailand Price stability Repurchase rate Yes Yes Yes Yes Issuance of Daily Primary dealers, commercial Public debt securities - Govt. bonds, (14-day) Bank of Thailand banks, finance companies, T-bills, FIDF bonds & Govt. guaranteed Bonds & foreign finance & securities companies & State enterprise bonds & BOT bonds. currency swaps specialised financial institutions. Indonesia Price stability Bank Indonesia Forecasts for inflation, economic Yes Yes Yes Yes Bank of Daily Rate growth, monetary aggregates & Indonesia developments in economic & Certificates financial sector. Malaysia Monetary & Overnight Real interest rates, inflation & Yes Yes Yes Yes Bank Negara Twice a day Primary dealers Govt. securities for repo financial stability interest rate inflation indicators, asset prices, Bills for growth credit, money & potential output. Korea* Price stability Overnight call Indicators of future inflation. Yes Yes Yes Yes Liquidity Weekly Banks, merchant banks, investment Credit securities (including bills eligible for rate adjustment trust and securities companies. discount), Treasury bonds, Govt. loans and intra- guaranteed bonds, market stablisation day overdrafts bonds & land development bonds. Singapore Price stability as Weighted Interest rates & forward forex Yes Yes Yes Yes Forex swaps & Twice a day Primary dealers, secondary Singapore govt. securities - T-bills, a sound basis for exchange rate rates. reverse swaps dealers - banks, merchant banks bonds and non-marketable SGS bonds. sustainable & stock broking firms (in the case economic growth of repo only PDs). * : Position reported as of 2003. # : Repo/reverse repo under Liquidity Adjustment Facility. Source: Websites of respective Central banks and Hawkins. J (2005).
  • REPORT ON CURRENCY AND FINANCE ANNEX III.3: Structure of Money MarketsCountry Instruments Tenor Major Participants1 2 3 4USA Federal Funds Mostly overnight Banks & other depository institutions. (there are also long-term for few weeks) Discount window Usually overnight Banks & other depository institutions* Certificates of Deposit Mostly 1-12 months Banks (money centre banks & large (some have 5 years or more) regional banks)* Negotiable Certificates of Deposit 1-12 months Well capitalised banks. Eurodollar CDs Mostly 3-6 months Banks (foreign branches of US banks or (some have long-term) foreign banks located abroad)*. These are sold to brokers, investment banks, institutional investors, & large corporations. Eurodollar Time Deposits Overnight, 1-week, Banks* 1-6 months & longer Repurchase Agreements Short-term: overnight or a few days Banks, securities dealers, non-financial Longer-term: 1, 2, 3-weeks & 1, 2, 3, corporations & Governments (principal 6-months. participants). Treasury Bills 4, 13 & 26-weeks US Government & primary dealers. (52-weeks bill suspended in 2001) Municipal Notes 30-days to 1-year State/ Local Governments. Commercial Paper Mostly 270-days Non-financial & financial businesses Average 30-days (corporations & foreign Governments)*. Bankers’ Acceptances Up to 270-days. Non-financial & financial businesses (firms involved in imports & exports)*. Government-Sponsored Enterprise Securities Farm Credit System, Federal Home Loan · Discount Notes 30 to 360-days Bank System & Federal National · Bonds More than 1-year Mortgage Association*. Shares in Money Market Instruments · Money market mutual funds Less than 90-days Money market mutual funds & Local · Local Government Investment Pools Average: 318-days Government Investment Pools. (1-1044 days) Futures Contracts 3-months Dealers & banks* Options Exercise at strike price on or before pre- Dealers, banks & non-banks arranged expiration date. Interest Rate Swaps Exchange of interest streames over the Dealers, banks & non-banks lives of underlying debt issues.* Principal borrower. 112
  • MONEY MARKET ANNEX III.3: Structure of Money Markets (Contd.)Country Instruments Tenor Major Participants1 2 3 4UK Reserves Averaging 1-month between MPC decision dates 43 banks & building societies Standing Lending & Deposit Facilities Overnight More than 60 UK banks & building societies OMOs: Repurchase Agreements 1-week at Bank Rate; 43 UK banks, building societies & (Gilts, HM Government non-sterling 3, 6, 9, 12-months at market rates securities dealers. marketable debt, Sterling Treasury Bills, Bank of England Euro Bills & Euro notes, eligible bank & local authority bills, Sterling denominated securities issued by European Economic Area, Central Governments & International institutions). Treasury Bills Issued by the Government. Bills of Exchange. Issued by banks. Certificates of Deposit Upto 1-year (Some have maturity over Issued by building societies & traded by 1-year) banks & discount houses. Commercial Paper Issued by Industry · Bank Acceptance · Trade Paper TradersECB@ Main refinancing operations 1-week Counterparties: eligible credit institutions. Long-term refinancing operations (Tier-1 3-months & Tier-2 assets) Fine-tuning/structural reverse transactions Non-standardised Eligible credit institutions. (Tier-1 & Tier-2 assets) Fine-tuning/structural outright purchase Non-standardised (Only Tier-1 assets) Fine-tuning foreign exchange swap Non-standardised Eligible credit institutions. Marginal lending facility(Tier-1 & Tier-2 Overnight Eligible credit institutions. assets) Structural issuance of debt securities Less than 12-months Eligible credit institutions. Deposit facility Overnight Eligible credit institutions.Japan Call money market Short-term securities: · Commercial Paper · Certificates of Deposit · Treasury Bills@ Source : Blenck D, et al. (2001). 113
  • REPORT ON CURRENCY AND FINANCE ANNEX III.3: Structure of Money Markets (Contd.)Country Instruments Tenor Major Participants1 2 3 4 Repurchase Agreements 1-week to 6-months Counterpar ties: Banks, securities (Eligible collateral: Government bonds/ companies, securities finance bills, Government guranteed bonds, companies, money market brokers municipal bonds, & foreign Government (Tanshi companies). bonds, commercial bills, corporate bonds & asset backed securities) Non-collateralised market City banks (borrowers), regional banks (lenders), investment tr usts, trust banks, regional banks, Keito, life insurance companies, specialised money market brokers.Australia Outright transactions Government Securities: Issued by Commonwealth Governments. · Treasury Notes · Treasury Bonds Of less than 18-months · Treasury Indexed Bonds Of less than 18-months Semi-Government Securities: Issued by State Government & Territory · Semi-Government Promissory Notes Of less than 18-months Central Borrowing Authorities. · Semi-Government Bonds Of less than 18-months · Semi-Government Indexed Bonds Of less than 18-months Repurchase Agreements Issued by Commonwealth Governments. Government Securities: · Treasury Notes · Treasury Bonds · Treasury Indexed Bonds Semi-Government securities: Issued by State Government & Territory · Semi-Government Promissory Notes Central Borrowing Authorities · Semi-Government Bonds · Semi-Government Indexed Bonds Domestic Securities Issued by the foreign Sovereigns, Supranationals & Government Agency Securities. Accepted Bills of Exchange Issued by eligible banks. Negotiable Certificates of Deposit Issued by eligible banks.Canada Treasury Bills 1-month to 1-year Issued by the Government of Canada. Money Market Strips Up to 18-months Issued by the Government of Canada. Government Guaranteed Commercial 1-month to 1-year Issued by the Crown Corporations such Paper as Canadian Wheat Board, Federal Business Development Bank, etc. Treasury Bills & Promissory Notes 1-month to 1-year Issued by the Provincial Governments Bankers’ Acceptances 1-month to 1-year Issued by the corporations (with an unconditional guarantee of a major Canadian chartered bank) Commercial Paper 1-month to 1-year Major corporations. 114
  • MONEY MARKET ANNEX III.3: Structure of Money Markets (Contd.)Country Instruments Tenor Major Participants1 2 3 4Russia Refinancing Mechanisms: · Intra-day loans Financially sound credit institutions · Overnight loans 1-working day complying with the regulatory · Lombard loans 7 or 14-days requirements. · Loans against collateral (Promissory Notes) & guarantees Up to 180-days Credit institutions having account in 22 Bank of Russia regional branches Repo operations: · Government Bonds Overnight, 3 & 6-months · Federal Government Bills 6-months · Bank of Russia Bonds 3 to 6-months Securities accepted as Collateral for Bank of 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 Daily (with overnight & 1-week) Banks, settlement non-bank credit · Deposit operations at auction rates Weekly (4-weeks & 3-months) institutions & non bank credit institutions conducting deposit & lending operations.China Inter-bank lending instruments: 1, 7, 20, 30, 60, 90 & 120-days. Repurchase Agreements or outright basis (OMOs) : Participants in OMOs: Central Bank, large · Government Securities domestic commercial banks & other · Negotiable Certificates of Deposit financial institutions approved by PBC. · Commercial Paper Participants in inter-bank market: All Discount Window authorised commercial banks, trust & Eligible bills: investment corporations, financial leasing · Bankers’ Acceptances companies, finance companies of · Trade Acceptances business conglomerates, urban credit co- · Promissory Notes operatives, & rural credit co-operatives, securities companies, insurance companies, & financing intermediaries.India # Call Money Overnight Scheduled commercial banks (excluding RRBs), co-operative banks, primary deal- Notice Money 2 to 14-days ers (PDs), & till August 5, 2005 select all- India FIs, insurance companies & mutual funds. Term Money 15-days to 1-year Banks, all-India financial institutions & PDs.# : Year in parentheses denote the year of introduction of the instrument. 115
  • REPORT ON CURRENCY AND FINANCE ANNEX III.3: Structure of Money Markets (Contd.)Country Instruments Tenor Major Participants1 2 3 4 Certificates of Deposit (1989) Minimum 7-days Scheduled commercial banks (excluding RRBs & Local Area Banks) & select all- India financial institutions. Commercial Paper (1990) Minimum 7-days Corporates, all-India financial institutions & PDs. Forward Rate Agreements/ Contracts are available for maturities Scheduled commercial banks, PDs & all- Interest Rate Swaps (1999) upto 10-years. India financial institutions. Bills Rediscounting Banks, PDs, select all-India financial in- stitutions, insurance companies & mutual funds. Repurchase Agreements (1992) · Market Repo 1-day to 1-year Banks, PDs, all-India financial institutions, insurance companies, mutual funds & listed corporates. · RBI Repo (LAF) 1-day* Banks and PDs. Treasury Bills 91, 182 & 364-days Banks, PDs, financial institutions & other non-bank entities. Inter-bank Participation 91 to 180-days Scheduled commercial banks. Certificates (1988) CBLO (2003) 1-day to 1-year Scheduled commercial banks, Co- operative banks, PDs, select all-India financial institutions, insurance companies, mutual funds & other corporates.Thailand Repurchase Operations: 1, 7, 14-days, 1, 2, 3 & 6-months 60 members: commercial banks, finance · Government Bonds companies, finance & securities · Treasury Bills companies, & specialised financial · Financial Institution Development Fund institutions, FIDF. (FIDF) Bonds · Government Guaranteed State Enterprises’ Bonds Bilateral Repurchase Operations 14-day Bilateral primary dealers. Bank of Thailand (BOT) Bonds 12-months or less. Commercial banks, specialised financial institutions, finance companies, finance & securities companies, Government pension fund, provident funds, mutual funds, social security office, life & non- life insurance companies & other institutions having current account at BOT. Foreign Exchange Swaps Overnight up to 1-year Both onshore & offshore commercial (Typically concentrated on the short ends- banks. up to 3-month)* : The Reserve Bank retains the option to conduct longer term repo under the LAF depending on market conditions and other relevant factors. 116
  • MONEY MARKET ANNEX III.3: Structure of Money Markets (Contd.)Country Instruments Tenor Major Participants1 2 3 4 End-of-day Liquidity Window Overnight Commercial banks, finance companies, finance & securities companies & specialised financial institutions.Indonesia Bank of Indonesia Certificates (SBI) 1- month & 3-months Fasilitas Bank Indonesia (FASBI) deposit 1 to 14-days Banks facility. SBI Repurchase Agreements-phased out 1 to 14-days in Aug, 2005 & replaced by Fine-Tune Expansion (FTE) SWBI or Wadiah Certificate (SBI using Sharia principles)Malaysia Malaysian Government Securities Security institutions, banking system & the employees’ provident fund. Treasury Bills 91, 182, 364-days Commercial banks, discount houses, principal dealers & finance companies. Repurchase Agreements (Repos) Overnight to a few months Commercial banks, merchant banks, (The securities normally used in repo finance companies & discount houses. transactions are Malaysian Government Securities, Bankers’ Acceptances & Negotiable Certificates of Deposits, Treasury Bills, Cagamas Bonds, Central Bank Certificates, other trade bills, etc.) Bank Negara Bills 1-year Bank Negara Monetary Notes Up to 3-years Direct borrowing Up to 6-months (average: 20-30 days) Negotiable Certificates of Deposit In multiples of 3-months, up to 5-years Business enterprises, banks, discount houses, statutory authorities, savings & pension funds, the Government & indi- viduals. Bankers’ Acceptances 30 to 200-days Commercial banks & merchant banksKorea Call money Overnight, 3, 5, 7, 9, 11& 15-days loans. Commercial banks, specialised banks, regional banks, investment & finance companies, merchant banking corporations, investment trust companies, insurance companies, the Korea Securities Finance Corporation, the Credit Insurance Fund & foreign bank branches in Korea. Repo 15 to 91-days. Select financial institutions. (Securities eligible for OMOs: Government Bond, Government Guaranteed Bonds & land development bonds) 117
  • REPORT ON CURRENCY AND FINANCE ANNEX III.3: Structure of Money Markets (Concld.)Country Instruments Tenor Major Participants1 2 3 4 Treasury Bills 364-days Market Stablisation Bonds. 14-2 years & 546-days Select financial institutions. Liquidity adjustment loans. Not more than 1-month Applicant banks Intraday overdrafts. Close of business day. Select commercial banks, special banks, local banks & foreign banks. Negotiable Certificates of Deposit Banks. Commercial Paper. Eligible non-finance companies, investment & finance companies & merchant banking corporations.South Africa Treasury Bills 91-days & 182-days. Primary dealers. Negotiable Certificates of Deposit. Up to 3-years. Banks, mining houses, pension funds, insurance companies, commercial companies, municipal authorities, public corporations & individuals Bankers’ Acceptances. Up to 3-months & in some cases longer. Merchant banks & commercial banks. Repurchase Agreements. 1 to 7-days. Reserve Bank & other financial institutions. Reserve Bank Debentures. 28 to 56-days. Banks. Foreign Currency Swaps.Singapore Repos/reverse repos Primary dealers, secondary dealers covering banks, merchant banks, & stock Singapore Government Securities. 3-month to 15 years with 3-month & broking firms, finance companies, 1-year benchmarks for T-Bills & 2, 5, 7, insurance companies, corporations & 10 & 15-year benchmark for bonds. individuals. (In the case of the repo, only PDs). End-of-day Liquidity Facility. Overnight. Banks. Forex Swaps & Reverse swaps.Source: Websites of respective central banks. 118