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

Assessment of Reform Measures - Government Securities & Foreign Exchange Markets

Existence of a well-developed government securities market is essential for the pursuit of a market-based monetary policy. Well-developed government securities market is also required to develop a domestic rupee yield curve, which could provide a credible benchmark for pricing of securities in other markets.

The major objective of reforms in the government securities market was to impart liquidity and depth to the market by broadening the investor base and by ensuring market-clearing interest rate mechanism. Keeping this in view, a number of reform measures were initiated in this segment (Box VI.4), which had a positive impact on both the primary and the secondary markets.

After the switchover to auction-based system for issuing securities, the amount of market-based primary issuance of Government securities increased by more than ten-fold from about Rs.12,000 crore in 1991-92 to about Rs.1,40,000 crore in 2001-02. This was accompanied by a sharp decline in primary subscription by the Reserve Bank from 45.9 per cent in 1992-93 to 1.45 per cent in 1993-94 and to mere 0.74 per cent in 1994-95. However, in the recent years, devolvement/private placement on the Reserve Bank was higher at around 30 per cent in 1999-2000 and 25 per cent in 2001-02, essentially reflecting the liquidity management operations undertaken by the Reserve Bank. These securities are, however, offloaded in the market to contain the monetary impact

The switchover to the system of borrowing at market-related rates provided the flexibility to modulate the maturity structure according to the needs. In the initial years of reforms, the maturity structure was shortened to reduce the cost, apart from making the government securities attractive to investors in terms of their tenor. Consequently, the weighted average maturity, which was around 16 years in 1990-91, was reduced to 6.59 years in 1997-98. This, in turn, resulted in significant bunching of redemptions. Consequently, it was considered desirable to elongate the maturity profile of the Government debt. Accordingly, during 1998-99, longer dated securities with tenors of 11, 12, 15 and 20 years were issued. Reflecting this, the weighted average maturity of dated securities went up from 7.71 years in 1998-99 to 14.3 years in 2001-02. The average maturity of the Government debt in India compares favourably with other countries.

Despite the increase in maturity, the average cost of issuance of dated securities declined substantially during 2001-02 to 9.44 per cent from 13.69 per cent in 1996-97.

A policy of reissuance/reopenings through price-based auctions (as opposed to earlier yield-based auctions) introduced in 1999 with a view to improving fungibility amongst the securities and facilitating consolidation of the debt greatly improved market liquidity and helped in the emergence of benchmark securities in the market. The process of passive consolidation itself helped in more or less containing the number of bonds to a level that was prevailing at the end of 1998-99. Of the 25 loans issued (excluding private placements) during 2001-02, 12 were new loans and the remaining were reissues of the existing loans. This ability to ‘reissue’ or ‘reopen’ loans is limited by the maximum outstanding amount that is perceived as ‘manageable’ from the viewpoint of redemption.

As a result of a series of structural and institutional reforms, a deep, wide and vibrant gilt market has emerged. The secondary market turnover of government securities in India has been rising steadily, reflecting increased liquidity in the market and increased trading activity by market participants. Over the 6-year period ended March 2002, turnover increased 12-fold. This sharp increase in turnover, particularly in the last 2 to 3 years, in part, was due to a sustained rally in the Government securities market.

There was a sharp decline in the weighted average interest cost of market borrowings by the Government from 13.75 per cent in 1995-96 to 10.95 per cent in 2000-01 and to 9.44 per cent in 2001-02. Real interest rate on government securities [adjusting for the inflation (WPI)] also declined from 5.7 per cent in 1995-96 to 3.7 per cent in 2000-01 before rising to 5.8 per cent in 2001-02. The sharp fall in yields could be partly attributed to increased liquidity and efficiency of the market.

One of the major objectives of the reforms was the evolution of the yield curve. Up to 1999, the curve was limited to 10 years. Gradually, with the elongation of maturity of Government bond issuance, the yield curve got extended up to 30 years.

Thus, a series of institutional and structural reform measures undertaken in the government securities market since the early 1990s with the objective of creating a deep and liquid market have brought about significant improvements. With the aligning of coupons on government securities with market interest rate, market gradually widened with the participation of several non-bank players. Presently, investor base includes, apart from banks and insurance companies, private corporate sectors, private sector mutual funds, finance companies as also individuals. Recent steps to allow retailing of government securities and introduction of trading in government securities at stock exchanges are expected to give a further impetus to this trend. As a result, the market has become more deep and liquid and the Government is able to mobilise adequate funds from the market. The Reserve Bank’s absorption of primary issues has come down drastically. Even the limited primary purchases taken as private placement/ devolvement are off-loaded in the market. This, in turn, enabled the elimination of automatic monetisation by the Reserve Bank and reduction in statutory pre-emption of banks. These arrangements provided functional autonomy to the Reserve Bank in the conduct of monetary policy.

Government securities are emerging as a benchmark for pricing private debt instruments. This would enable market players to appropriately price the securities.

The foreign exchange market in India is a three-tier structure comprising (a) the Reserve Bank at the apex, (b) Authorised Dealers (ADs) licensed by the Reserve Bank, and (c) customers such as exporters and importers, corporates and other foreign exchange earners. Apart from these main market players, there are foreign exchange money changers who bring buyers and sellers together but are not permitted to deal in foreign exchange on their own account. The ADs are governed by the guidelines framed by the Foreign Exchange Dealers Association of India (FEDAI). Dealings in the foreign exchange market include transactions between ADs and the exporters/ importers and other customers, transactions among ADs themselves, transactions with overseas banks and transactions between ADs and the Reserve Bank.

In line with the liberalisation measures undertaken in other areas, various reform measures were also initiated in the foreign exchange market guided mainly by the recommendations of various high level committees with the main objective of making it more deep and liquid, more vibrant, open and market determined.

The impact of reforms on the forex market could be assessed by examining the behaviour of the market over the period as also the trends in various market growth related parameters.

With the gradual opening of current and capital account transactions in the 1990s, the increasing volume of capital flows had a direct bearing on the stability of the exchange rate. There were intermittent periods of excessive capital inflows followed by episodes of ebbing of capital flows and subsequent recovery in capital inflows. From the viewpoint of examining the impact of external transactions on the exchange rate stability, the 10-year period starting from March 1993 (when the exchange rate became market determined) could be divided into three sub-periods as detailed below.

March 1993-August 1995: Reflecting the positive investor confidence, the Indian economy experienced surges in capital inflows during 1993-94, 1994-95 and the first half of 1995-96, which, coupled with robust export growth, exerted upward pressures on the exchange rate. In the face of these inflows, the Reserve Bank absorbed the excess supplies of foreign exchange. In the process, the nominal exchange rate of the Rupee vis-à-vis the US dollar remained virtually unchanged at around Rs.31.37 per US dollar over the extended period from March 1993 to August 1995.

September 1995-December 1996: The period from September 1995 to February 1996 witnessed large capital inflows. The real appreciation of the Rupee resulting from surges in capital inflows triggered off market expectations and led to a depreciation of the Rupee in the second half of 1995-96, i.e., between September 1995-mid-January 1996. In response to the upheavals, the Reserve Bank intervened in the market to signal that the fundamentals were in place and to ensure that market correction of the overvalued exchange rate was orderly and calibrated. The interventions in the forex market were supported by monetary tightening to prevent speculative attacks. These decisive and timely measures brought stability to the market lasting till mid-January 1996. In the first week of February 1996, another bout of uncertainty led the Rupee to overshoot to Rs.37.95 per US dollar. The monetary and other measures succeeded in restoring orderly conditions and the Rupee traded in a range of Rs.34-35 per US dollar over the period March-June 1996. The Rupee remained range bound during the second half of 1996.

1997 onwards: The foreign exchange market since 1997 had to cope with a number of adverse internal as well as external developments. The important internal developments included the economic sanctions in the aftermath of nuclear tests during May 1998 and the border conflict during May-June 1999. The external developments included, inter alia, the contagion due to the Asian financial crisis and the Russian crisis during 1997-98 and the sharp increase in international crude prices in the period since 1999, especially from May 2000 onwards. Movements in interest rates in the industrialised countries as well as the cross-currency movements of the US dollar vis-à-vis other major international currencies were some of the other external developments impacting the foreign exchange market. These developments created a large degree of uncertainty in the foreign exchange market leading to excess demand, which was reflected in the spot market gap in the merchant segment, increasing from US $ 3.2 billion in 1997-98 to US $ 4.4 billion in 1998-99. The Reserve Bank responded through timely monetary and other measures like variations in the Bank Rate, the repo rate, cash reserve requirements, refinance to banks, surcharge on import finance and minimum interest rates on overdue export bills to curb destabilising speculative activities during these episodes of volatility while allowing an orderly correction in the value of the Rupee. Reappearance of uncertainty in the foreign exchange market between mid-May to mid-August 2000 reflected hardening of international oil prices, successive interest rate increase in industrial countries and the withdrawal of portfolio flows. This resulted in widening of the excess demand gap in the spot segment of merchant transactions and compensating activity built up in the inter-bank segment. Tight monetary measures adopted during May-June 2000 coupled with inflows in respect of the Indian Millennium Deposits during October-November 2000 eased market tightness and brought stability to the foreign exchange market. In the aftermath of September 11, 2001 incident in the US, once again the pressure was felt in the forex market as the Rupee depreciated against the US dollar, but the RBI tackled the situation through quick responses in terms of a package of measures and liquidity operations.