Project on Indian Financial Market - Module: 3
Financial Market Integration
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Integration of Domestic Markets

The money market, the government securities market, the capital market and the forex market constitute the important segments of the financial system, besides the market for credit involving banks, non-banks and all India financial institutions. Integration of these markets is reflected in the movements in the term structure of interest rates, the term structure of forward premia, the behaviour of asset prices and their returns in relation to the range of interest rates, despite the limited degree of openness in the capital account and imperfect asset substitutability in India. The extent of integration between the domestic and foreign markets can be evaluated more directly through the interest parity conditions.

The gradual integration of domestic financial markets, both within themselves and with the foreign exchange market, could be studied by analysing the trends in the turnover and prices of domestic financial markets and the foreign exchange market. Analyses of volatility spillovers - i.e., whether disturbances in one market get transmitted to other markets - could also be useful in assessing the integration of markets.

The Indian money and foreign exchange markets have become intrinsically linked to each other, especially in view of the commercial banks having a dominant presence in both the markets. The linkage between the call money market and the foreign exchange market, which existed in the past as banks were permitted to maintain nostro account surpluses or overdrafts to some extent, has strengthened in the recent years, particularly after the permission to borrow or lend up to 15 per cent of Tier-I capital overseas. The linkage between the call market and the forex market is found to be more pronounced during episodes of volatile exchange market conditions. This fact is clearly discernible in the second half of the 'nineties. A detailed account of yearly developments of integration of markets -especially money and foreign exchange markets -is provided subsequently in this module. It would be, however, necessary to note at this juncture that while the hike in call rates during volatile forex market conditions partly resulted from the introduction of monetary measures to tighten the liquidity conditions in the face of disorderly developments in the market, to some extent it also reflected the short positions taken by market agents in domestic currency against long positions in the US dollars in anticipation of higher profits through depreciation of the rupee. Furthermore, volatility in the call money market, as may be seen from Table 5.1, reflects the significant adjustment that occurs in the money market in response to liquidity changes and gaps in the foreign exchange market. Excess demand conditions in the foreign exchange market and the attendant depreciation of the domestic currency affect bank liquidity. Unsure of the extent of depreciation, exporters often delay repatriation of proceeds, while importers rush for cover. So long as money market rates are lower than the rates implied by the forward premia, arbitrage opportunities exist between the money and foreign exchange markets. Banks could fund foreign currency positions by withdrawing from the inter-bank call money market and liquidating excess investments in government securities over and above the statutory liquidity ratio, thereby hiking interest rates in the call and the government securities markets. Banks without a retail base, which fund their assets largely through the inter-bank call money market, are especially squeezed as they face higher borrowing costs along with a sharp increase in the demand for foreign currency. During prolonged volatile conditions, banks begin to liquidate investments in commercial paper (CP), typically issued at sub-PLR levels. As the credit is often a first charge for retail banks, the need for mobilisation of funds, initially through high cost certificates of deposit (CDs) and thereafter through high cost retail deposits, contributes to upward pressures on interest rates, initially at the short end and thereafter across the spectrum.

The yield and volume in the Government securities market have also witnessed increased volatility as measured by the standard deviation (SD), which has generally tended to fluctuate over time at both long and short-ends of the market. In the Indian context, it is observed that policy induced effects are readily transmitted across different markets in the short run; for instance, relaxation of the monetary policy stance have been quick to find its way into the yields on Treasury bills. However, a similar correspondence between the yield on dated securities and money market conditions became visible only after the first half of 1996, the period which coincides with institutional development in the money and the government securities markets. At the shorter end of the market, the movement of monthly average short-term interest rate for the period from May 1996 to September 2000 reveals that they are generally more volatile as compared to the long-term interest rates. The relative rigidity of the long term interest rates and the falling trend in the spread between the 10-year yield and the 91-day Treasury bill rate indicate that the long-term inflation expectations and real interest rate in the economy may be stable. Besides, the higher volatility at the short end of the Government securities market has also been generally associated with relatively lower trading volumes.

The Reserve Bank's monetary strategy of maintaining orderly conditions in the foreign exchange market involves pre-emptive as well as remedial responses. Pre-emptive measures attempt to augment supply in the foreign exchange market by depleting reserves, encouraging nonresident deposit mobilisation by reducing reserve requirements on such deposits and discouraging exporters from withholding proceeds by raising costs of export credit. Demand is attended to be contained by raising domestic interest rates, especially short-term, above the interest rates implied by the forward premia by substituting low cost discretionary liquidity with high cost discretionary liquidity, usually by raising reserve requirements on domestic deposits and/or cutting refinance facilities available to banks and funding the resultant liquidity gap through refinance at a higher Bank Rate or through high cost reverse repos, backed by increases in the repo rate to discourage speculative positions in the foreign exchange market. This could be buttressed by raising the cost of import finance. The remedial measures attempt to limit the impact of foreign exchange market volatility on the economic activity. Accepting private placements/devolvement of government debt at times of tight liquidity in order to offload them at times of easy liquidity and reversing monetary tightening measures to reduce the cost of discretionary liquidity and thereby reducing interest rates are an integral part of this strategy.

The Indian stock market has undergone a significant transformation in the 'nineties as described in Module 2. Apart from changes in the fundamental factors, information asymmetries and the associated constraints to efficient price discovery remain at the heart of the volatile movements in stock prices. The extent of stock price volatility is also influenced by the extent of integration between the domestic and international capital markets as well as the regulatory framework governing the stock market. In India, two most important factors which had a significant bearing on the behaviour of stock prices during the 'nineties were net investments by FIIs and trends in the international stock exchanges, especially NASDAQ. Stock market volatility has tended to decline in recent years, with the coefficient of variation (CV) in the BSE Sensex working out to 17.51 per cent during 1995-96 to 1999-2000. Asset price bubbles entail significant risks in the form of higher inflation when the bubble grows in size and in the form of financial instability and lost output when the bubble bursts. Monetary and fiscal authorities, therefore, closely watch the asset market developments. The positive wealth effect resulting from bull runs could impart a first round of risk to inflation. If the bull run is prolonged, a second round of pressure on prices may result from subsequent upward wage revisions. Since financial assets are used as collaterals, asset booms may also give rise to large credit expansion. When domestic supply fails to respond to the rising demand, it could give rise to higher external current account deficit. The asset price cycles may follow. When the asset prices collapse, firms may face severe financing constraints as a result of declining value of their collaterals, making lenders reluctant to lend at a scale they do when asset prices are rising. Recognising these alternative complexities emanating from asset market bubbles, information on asset prices is being increasingly used as a critical input for the conduct of public policies.