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

Money Market Structure

Money markets perform the crucial role of providing a conduit for equilibrating short-term demand for and supply of funds, thereby facilitating the conduct of monetary policy. The money market instruments mainly comprise:

1. call money,

2. certificates of deposit,

3. treasury bills,

4. other short-term government securities transactions, such as, repos,

5. bankers' acceptances/commercial bills,

6. commercial paper, and

7. inter-corporate funds.

While inter-bank money markets and central bank lending via repo operations or discounting provide liquidity for banks, private non-bank money market instruments, such as, commercial bills and commercial paper provide liquidity to the commercial sector. Unlike in developed economies where money markets are promoted by financial intermediaries out of efficiency considerations, in India, as in many other developing countries, the evolution of the money market and its structure has been integrated into the overall deregulation process of the financial sector.

In 1985, the Chakravarty Committee first underlined the need to develop money market instruments in India, while in 1987 the Working Group on the Money Market (Chairman: Shri N. Vaghul) laid the blueprint for the institution of money markets. The Reserve Bank has gradually developed money markets through a five-pronged effort. First, interest rate ceilings on inter-bank call/notice money (10.0 per cent), inter-bank term money (10.5-11.5 per cent), rediscounting of commercial bills (12.5 per cent) and inter-bank participation without risk (12.5 per cent) were withdrawn effective May 1, 1989. Secondly, several financial innovations in terms of money market instruments, such as, auctions of Treasury Bills (beginning with the introduction of 182-day Treasury Bills effective November 1986), certificates of deposit (June 1989), commercial paper (January 1990) and RBI repos (December 1992) were introduced. Thirdly, barriers to entry were gradually eased by-

1. increasing the number of players (beginning with the Discount and Finance House of India (DFHI) in April 1988 followed by primary and satellite dealers and money market mutual funds),

2. relaxing both issuance restrictions and subscription norms in respect of money market instruments and allowing determination of yields based on demand and supply of such paper, and

3. enabling market evaluation of associated risks, by withdrawing regulatory restrictions, such as, bank guarantees in respect of CPs.

4. Fourthly, the development of markets for short-term funds at market determined interest rates has been fostered by a gradual switch from a cash credit system to a loan-based system, shifting the onus of cash management from banks to borrowers and phasing out the 4.6 per cent 91-day tap Treasury bills, which in the past provided an avenue for investing short-term funds.

5. Finally, institutional development has been carried out to facilitate inter-linkages between the money market and the foreign exchange market, especially after a market-based exchange rate system was put in place in March 1993.

The changes in the money market structure need to be seen in the context of a gradual shift from a regime of administered interest rates to a market-based pricing of assets and liabilities. The development of money markets in India in the last 3-4 years has been facilitated by three major factors. First, the limiting of almost automatic funding of the government, largely realised with the replacement of ad hoc Treasury bills (which bore a fixed coupon rate of 4.6 per cent per annum from July 1974, implying a negative real interest rate for most part of the period) by ways and means advances (WMA) at interest rates linked to the Bank Rate and the development of the government securities market, discussed later in the chapter, permitting a gradual de-emphasis on cash reserve ratio as a monetary policy instrument. Secondly, the development of an array of instruments of indirect monetary control, such as, the Bank Rate (re-activated in April 1997), the strategy of combining auctions, private placements and open market operations in government paper (put in place in 1998-99) and the liquidity adjustment facility (LAF) (instituted in June 2000). Thirdly, the enabling institutional framework was introduced in the form of primary and satellite dealers and money market mutual funds. The monetary authority uses money markets to adjust primary liquidity in the domestic economy and monetary policy is often, in turn, shaped by developments in the money and the foreign exchange markets.

The overnight inter-bank call money market, in which banks trade positions to maintain cash reserves, is the key segment of the money market in India. It is basically an 'over the counter' (OTC) market without the intermediation of brokers. Participation has been gradually widened to include other financial institutions, primary/satellite dealers, mutual funds and other participants in the bills rediscounting market and corporates (through primary dealers) besides banks, LIC and UTI. While banks and primary dealers are allowed two-way operations, other non-bank entities can only participate as lenders. As per the announced policies, once the repo market develops, the call money market would be made into a pure inter-bank market, including primary dealers.

The call money market is influenced by liquidity conditions (mainly governed by deposit mobilisation, capital flows and the Reserve Bank's operations affecting banks' reserve requirements on the supply side and tax outflows, government borrowing programme, non-food credit off-take and seasonal fluctuations, such as, large currency drawals during the festival season on the demand side). At times of easy liquidity, call rates tend to hover around the Reserve Bank's repo rate, which provides a ready avenue for parking short-term surplus funds. During periods of tight liquidity, call rates tend to move up towards the Bank Rate and more recently the Reserve Bank's reverse repo rate (and sometimes beyond) as the Reserve Bank modulates liquidity in pursuit of monetary stability. Besides, there are other influences, such as,-

1. the reserve requirement prescriptions (and stipulations regarding average reserve maintenance),

2. the investment policy of non-bank participants in the call market which are among the large suppliers of funds in the call market, and

3. the asymmetries of the call money market, with few lenders and chronic borrowers.

The annual turnover in the call money market at Mumbai which amounted to Rs.16,44,790 crore in 1991-92 and Rs.15,45,160 crore in 1996-97 moved up in more recent years. For example, the daily turnover increased to Rs.33,882 crore during 1999-2000 from Rs.25,956 crore during 1998-99. The average interest in the call money market during last four years tended to move up from 7.8 per cent in 1996-97 to 9.0 per cent during 1999-2000. However, volatility tended to move downwards (Table 4.1).

The term money market in India is still not developed, with the daily turnover amounting to Rs.951 crore - Rs.1,489 crore during March 2000, up from Rs.23 crore - Rs.967 crore during March 1999. Select financial institutions (IDBI, ICICI, IFCI, IIBI, SIDBI, EXIM Bank, NABARD, IDFC and NHB) are permitted to borrow from the term money market for 3-6 months maturity, within stipulated limits for each institution. Banks were exempted from the maintenance of CRR and SLR on inter-bank liabilities to facilitate the development of the term money market in April 1997, subject to the condition that effective CRR and SLR on total demand and time liabilities would not be less than 3 per cent and 25 per cent, respectively.

Repo is a money market instrument, which enables collateralised short-term borrowing and lending through sale/purchase operations in debt instruments. Under a repo transaction, a holder of securities sells them to an investor with an agreement to repurchase at a pre-determined date and rate. In the case of a repo, the forward clean price of the bonds is set in advance at a level which is different from the spot clean price by adjusting the difference between repo interest and coupon earned on the security. Repo is also called a ready forward transaction as it is a means of funding by selling a security held on a spot (ready) basis and repurchasing the same on a forward basis. Reverse repo is a mirror image of repo as in the case of former, securities are acquired with a simultaneous commitment to resell.

Subsequent to the irregularities in securities transactions, repos were initially allowed in the Central Government Treasury bills and dated securities created by converting some of the Treasury bills. In order to activate the repos market essentially to be an equilibrating force between the money market and the Government securities market, the Reserve Bank gradually extended repos facility to all Central Government dated securities and Treasury bills of all maturities. Recently, while the State Government securities were made eligible for repos, the Reserve Bank also allowed all non-banking entities, maintaining SGL and current account with its Mumbai office, to undertake repos (including reverse repos). Furthermore, it has been decided to make PSU bonds and private corporate securities eligible for repos to broaden the repos market.

The Reserve Bank also undertakes repo/ reverse repo operations with PDs and scheduled commercial banks, as part of its open market operations. It also provides liquidity support to SDs and 100 per cent gilt mutual funds through reverse repos. There is no limit on the tenor of repos. The Reserve Bank initially conducted repo operations for a period of 14 days. Since November, 1996, the Reserve Bank has been conducting 3-4 day repo auctions, synchronizing with working day and weekend liquidity conditions, in order to modulate short-term liquidity. With the introduction of Liquidity Adjustment Facility (LAF) from June 5, 2000, the Reserve Bank has been injecting liquidity into the system through reverse repos and absorbing liquidity from the system through repos on a daily basis. These operations are conducted on all working days except on Saturdays, through uniform price auctions and are restricted to scheduled commercial banks and PDs. This is apart from the liquidity support extended by the Reserve Bank to PDs through refinance/reverse repo facility at a fixed price.

Repos help to manage liquidity conditions at the short-end of the market spectrum. Repos have often been used to provide banks an avenue to park funds generated by capital inflows to provide a floor to the call money market. During times of foreign exchange market volatility, repos have been used to prevent speculative activity as the funds tend to flow from the money market to the foreign exchange market. For instance, a fixed rate repo auction system was instituted in November 1997 with a view to ensuring an effective floor for the short-term interest rates in order to ward off the spread of contagion during the South-East Asian crisis. The repo rates were reduced with the return of capital flows, which imparted stability to the foreign exchange market.