A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 4 - Financial Sector Reforms

Financial Markets - An Assessment of Reforms

A major objective of reforms in the financial sector was to develop various segments of the financial market, viz., the money market, the Government securities market, the foreign exchange market and the capital market. Another important objective of reforms in financial markets was elimination of segmentation across various markets in order to smoothen the process of transmission of impulses across markets, easing the liquidity management process and making resource allocation process more efficient across the economy. The strategy adopted for meeting these objectives involved removal of restrictions on pricing of assets, building the institutional structure and technological infrastructure, introduction of new instruments, and fine-tuning of the market microstructure. The market development efforts were supported by appropriate changes in the legal framework to remove structural rigidities and improvements in the regulatory design to ensure smooth functioning of markets. Aiming at widening and deepening of financial markets, new players and instruments were introduced. This section assesses the impact of reforms on various market segments in terms of parameters such as liquidity, volatility, efficiency and integration of various segments.

Since the early 1990s, various measures were initiated in all segments of financial markets aimed at improving depth and liquidity in the markets. The reforms also emphasised on improving the transparency and efficiency of the markets. The key reform measures undertaken in different market segments are briefly presented below.

• A ceiling of 10 per cent on call money rates imposed by the Indian Banks Association was withdrawn in 1989.

• Initially, the participation in the call market was gradually widened by including non-banks, such as, financial institutions, non-banking finance companies, primary/satellite dealers, mutual funds, corporates (through primary dealers), etc. The process of transformation of call money market to a pure inter-bank market commenced effective May 2001.

• The 182-day treasury bills were introduced effective November 1986, followed subsequently by phasing out of on-tap treasury bills, introduction of auctioning system in 91-day treasury bills since January 1993, and introduction of 14-day and 364-day treasury bills. The system of ad hoc treasury bills (with a fixed 4.6 per cent interest rate since July 1974), which were issued by the Central Government to the Reserve Bank, was abolished effective April 1997. Currently only the 91-day and 364-day treasury bills exist.

• The Discount and Finance House of India (DFHI) was set up in April 1988, and was allowed to participate in the call/ notice money market both as a borrower and lender commencing from July 1988.

• Several new financial instruments were introduced, such as inter-bank participation certificates (1988), certificates of deposit (June 1989), commercial paper (January 1990) and repos (December 1992).

• Derivative products like forward rate agreements and interest rate swaps were introduced in July 1999 to enable banks, FIs and PDs to hedge interest rate risks.

• A full-fledged Liquidity Adjustment Facility was introduced on June 5, 2000 with a view to modulating short-term liquidity under diverse market conditions.

• With a view to adopting the sound risk management procedures and eliminating counter-party risk, the Clearing Corporation of India Ltd. was set up on February 15, 2002. The CCIL acts as a central counter-party to all trades involving foreign exchange, government securities and other debt instruments routed through it and guarantees their settlement.

• The segment refinance facility for banks is gradually being phased out.

• New auction-based instruments were introduced with varying maturities such as 364-day, 182-day, 91-day and 14-day treasury bills and the zero coupon bond. The auction system was also introduced for Government of India dated securities. An innovative feature of ‘part payment’ was added to the auction of Government of India dated securities.

• In the long-term segment, Floating Rate Bonds (FRBs) benchmarked to the 364-day treasury bill yields and a 10-year loan with embedded call and put options exercisable on or after 5 years from the date of issue were introduced.

• A system of Primary Dealers (PDs) was made operational in March 1996.

• Foreign Institutional Investors (FIIs) were allowed to set up 100 per cent debt funds to invest in Government (Central and State) dated securities in both primary and secondary markets.

• The system of automatic monetisation of budget deficit through ad hoc treasury bills which hampered the development of the market was phased out over a period of three years from 1993-94 to 1996-97 and was replaced by the system of Ways and Means Advances (WMA) with effect from April 1, 1997.

• The Delivery-versus-Payment system (DvP) was introduced in 1995 for the settlement of transactions in Government securities. A screen-based trade reporting system with the use of VSAT communication network complemented by a centralised Subsidiary General Ledger (SGL) accounting system was put in place.

• The Negotiated Dealing System (NDS) (Phase I) was operationalised in February 2002 to enable on-line electronic bidding facility in the primary auctions of Central/State Government securities, OMO/LAF auctions, screen-based electronic dealing and reporting of transactions in money market instruments, including repo and to facilitate information on trades with minimal time lag.

• Since timely flow of information is a critical factor in evolving the efficient price discovery mechanism, improvements were brought in transparency of operations and data dissemination.

• A practice of pre-announcing a calendar of treasury bills and government securities auctions to the market was introduced.

• Retail trading in Government securities at select stock exchanges commenced in January 2003.

• The current account was gradually made convertible leading to the acceptance of obligations under Article VIII of the IMF. The exchange rate, which was pegged to a basket of currencies, was made market-determined in a phased manner. Several transactions in the capital account were also gradually liberalised over the years.

• In line with the liberal policy environment of the 1990s, the Foreign Exchange Regulation Act, 1973 (FERA) was replaced by the Foreign Exchange Management Act (FEMA) in 1999.

• Banks were given increased freedom for operating in the forex market. These related to the following: (a) freedom to fix overnight position limit and gap limits approved by RBI, replacing the system of across-the-board or RBI-prescribed limits; (b) freedom to initiate trading position in the overseas market; freedom to borrow (up to 25 per cent of Tier I capital or up to US $ 250 million, whichever is higher) or freely invest funds in the overseas market; (c) freedom to determine the interest rates (subject to a ceiling) and maturity period of Foreign Currency Non-Resident (FCNR) deposits (not exceeding three years); (d) freedom to use derivative products for asset-liability management.

• Corporates were allowed to undertake active hedging operations by resorting to cancellation and rebooking of forward contracts, book forward contracts based on past performance without having to produce documents endorsing a forex exposure, use foreign currency options and variations thereof like range forwards and ratio range forwards. They can access a range of products including Foreign Currency-Rupee Swap to manage longer-term exposures arising out of External Commercial Borrowings

• With the repeal of the Capital Issues (Control) Act, 1947, companies were given freedom to price their issues. The book-building process in the new issue of capital was introduced with a view to further strengthen the price discovery process.

• In the secondary market, the floor-based open outcry trading system was replaced by electronic trading system in all the stock exchanges.

• The account period settlement system was replaced by rolling settlement, thus, reducing the scope for speculation. The rolling settlement cycle was shortened from T+5 to T+3 with effect from April 1, 2002. This process was enabled by a shift to electronic book entry transfer system through depository mechanism.

• The risk management system was made more comprehensive with trading members being subject to margins based on trading volumes and some other parameters and exposure norms based on the capital deposited with the exchange. The mark-to-market margins based on 99 per cent value at risk were introduced to capture the risk profile of trading members.

• The Indian companies were allowed to raise funds from abroad, through American/Global Depository Receipts (ADRs/ GDRs), foreign currency convertible bonds (FCCBs) and external commercial borrowings (ECBs). The Reserve Bank allowed two-way fungibility of ADRs/GDRs in February 2002.

• Foreign institutional investors (FIIs) were allowed to participate in the capital market.

• For strengthening the process of information flows from the listed companies, several measures were introduced:

  1. while sufficient disclosures are mandatory for the companies at the stage of public issue, the listed companies are also required under the listing agreement to make disclosures on a continuing basis;

  2. for ensuring quick flow of information to the public, the decision pertaining to dividend, bonus and right announcements or any material event are now required to be disclosed to the public within 15 minutes of the conclusion of the board meeting in which the decisions are taken;

  3. the accounting practices were streamlined with norms introduced for segment reporting, related party transactions and consolidated balance sheets.

• Insider trading was made a criminal offence. The regulations governing substantial acquisition of shares and takeovers of companies were also introduced aimed at protecting the interests of minority shareholders by making the takeover process more transparent.

• For providing market participants instruments for hedging and risk management, several types of derivative products on equities were introduced. Non-transparent products like ‘badla’ were banned.