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  1. 1. 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
  2. 2. 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
  3. 3. 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
  4. 4. 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
  5. 5. 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
  6. 6. 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
  7. 7. 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
  8. 8. 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
  9. 9. 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
  10. 10. 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
  11. 11. 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
  12. 12. 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
  13. 13. 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
  14. 14. 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
  15. 15. 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
  16. 16. 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

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