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 - Money Market

The money market forms an important part of the financial system by providing an avenue for equilibrating the surplus funds of lenders and the requirements of borrowers for short periods ranging from overnight up to a year. It also provides a focal point for central bank’s intervention for influencing the liquidity in the financial system and thereby transmitting the monetary policy impulses.

Traditionally, the money market in India comprised mainly the call money market. Although other money market segments, viz., commercial bills market and inter-corporate deposits market have been in existence for a long time, there has not been much activity in these segments. Therefore, for assessing the impact of reforms on the money market the focus is mainly on the call money market. The impact of reforms is assessed in terms of behaviour of the call money market and the market growth related parameters, including those instruments, which were introduced in the 1990s.

The call money market, which deals in overnight funds, is a key segment of the money market in India. Funds for 2-14 days are termed as notice money. Various reform measures initiated in this segment have resulted in more orderly conditions and increased liquidity.

In the initial phase of money market reforms in the late 1980s, considerable volatility was noticed in the call rate, resulting primarily from a free call money market while interest rates in other segments of the money market remained regulated. As a result, any fluctuation in the liquidity conditions impinged on the call money market.

The call money market during the 1990s witnessed orderly conditions barring a few episodes of volatility. The call rates first came under pressure in May 1992 when they touched a peak of 35.3 per cent, essentially reflecting liquidity tightness due to high levels of statutory preemptions and withdrawal of all refinance facilities except for export credit refinance. After witnessing tranquil conditions during July 1992-December 1994, the call money market came under pressure again during 1995-96. The call rate touched a peak of around 35.0 per cent in November 1995, largely mirroring turbulence in the foreign exchange market. To stabilise the market, the Reserve Bank injected liquidity through reverse repos, enhanced banks’ refinance facilities against Government securities and reduced the CRR. The call rate softened to a single digit level thereafter till December 1997. However, the call rate hardened again and touched a high of around 29 per cent, in January 1998, reflecting the mopping up of money market liquidity by the Reserve Bank to squelch the pressure in the foreign exchange market. During 1999-2000, the inter-bank call money rates ruled steady within a narrow range, excepting few bouts of volatility, primarily attributable to the unanticipated demand for reserves by commercial banks.

Thus, excepting a few episodes of volatility, conditions in the call money market remained stable in the 1990s. The full-fledged Liquidity Adjustment Facility (LAF), which was introduced on June 5, 2000, with a view to modulating short-term liquidity under diverse market conditions, has emerged as an effective instrument to provide a corridor for the overnight call rate movement. This has resulted in stability and orderly market conditions through clear signalling. The LAF combined with strategic open market operations (OMOs) has since been used to signal the monetary stance by removing shortfalls and excesses of liquidity in the system so as to keep the short-term interest rates reasonably stable.

The level of weighted average call money borrowing rates declined from around 7.5 per cent in April 2001 to 5.7 per cent in February 2003. The LAF has also enabled a reduction in the volatility in call rates (measured by coefficient of variation) from 85.7 per cent during 1997-98 to 7.6 per cent during 2002-03 so far (April to February).

The call/notice money market essentially serves the purpose of equilibrating the short-term liquidity position of banks and other participants. The turnover in the call/notice money market depends on the amount of surplus funds available with some participants and the requirements of funds by some other participants. Over the years, the number of participants in the market has gradually increased to include banks and Primary Dealers both as lenders and borrowers, and select mutual funds, insurance companies, development financial institutions and corporates through Primary Dealers (as lenders).

The supply of and demand for funds in the market arise on account of

1. compliance with cash reserve requirement of banks as mandated by the Reserve Bank,

2. as a funding source to build up assets,

3. temporary surpluses that are available with lenders,

4. foreign exchange flows and

5. seasonal factors such as festival, election, harvesting, advance tax payments, etc.

Over the years, a few banks tended to be overly exposed to the call/notice money market. Such banks relied excessively on the call money market for carrying out banking operations and long-term asset creation. The Narasimham Committee II recommended that there must be clearly defined prudent limits beyond which banks should not be allowed to rely on the call/notice money market and that access to this market should essentially be for meeting unforeseen mismatches and not as regular means of financing banks’ lending operations. With the progressive regulations, asset liability management system was put in place, which kept the mismatches in cash flows in the 1-28 days bucket under check. As part of streamlining the Liquidity Adjustment Facility and improving the transmission channel of monetary policy, the phasing out of non-bank participants from the call money market commenced from May 2001. Furthermore, recognising that building up of substantial exposure to the call/notice money market relative to the balance-sheet size by some participants on a continuous basis has the potential not only for default and the consequent systemic instability but also impeding other segments of the money market, participants are now operating within limits on both lending and borrowing operations. Thus, the call/notice money market is evolving as a pure inter-bank market with ALM discipline for participants and prudential limits for borrowing and lending.

With the establishment of the Clearing Corporation and the enhanced liquidity in the repo market both in Government and non-Government securities, it is envisaged that eventually both the call market and the repo market combined with other money market instruments, would constitute an integrated market for equilibrating short-term funds for both banks and non-banks.

During the first half of the 1990s, volumes in the call money market at Mumbai remained more or less steady. However, the turnover increased sharply and fluctuated widely during the last few years. The average daily turnover rose from Rs.23,221 crore in 1999-2000 to Rs.30,320 crore in 2000-01 and further to Rs.35,144 crore in 2001-02, before falling to Rs.29,857 crore in 2002-03 so far (up to February 2003). The turnover in the call/notice market should also be seen alongside the repo amount accepted by the Reserve Bank on a daily basis where one can observe substantial volatility. LAF has been effective in reducing the volatility in the call/notice money market.

Commercial Paper (CP) was introduced as a money market instrument in January 1990 with a view to enabling corporates to diversify their sourcing of short-term borrowings as well as for providing investors with an additional instrument for investment. It was made broad-based with the lowering of the minimum issue size to Rs.5 lakh and the widening in the maturity period from 91 days-6 months to 15 days-1 year in July 2000 to make it compatible with instruments of comparable maturities. The Indian CP market is driven by swings in bank liquidity. Banks prefer investing in CPs, especially in times of easy liquidity as they can park funds at interest rates higher than call rates and at the same time avoid higher transaction costs associated with bank loans. The effective discount rate of CP usually lies between representative money market rate and the bank lending rate. On the other hand, companies are able to raise funds through CPs at a lower rate than the lending rates of banks under easy liquidity conditions. The amount of CPs outstanding increased significantly from Rs.577 crore in March 1993 to a high of Rs.4,511 crore in August 1994 accompanied by a decline in the average discount rate from 15.9 per cent to 10.5 per cent during this period. As the call rates firmed up, the average discount rate touched a peak of 20.2 per cent in April 1996 with the concomitant decline in outstanding amount to Rs.71 crore. The subsequent easing of liquidity conditions and institution of a series of reforms including dematerialisation of issuances and alignment of minimum maturity period boosted the CP market taking the outstanding amount to Rs.7,622 crore in February 2003.

Certificates of Deposit (CDs) were introduced in 1989 as a money market instrument to mobilise large value deposits. CDs were freed from the interest rate regulation in 1992, thus, providing banks with an option to meet their liquidity needs through CDs issued at a premium during tight phases of liquidity. Thus, in its early stages of development, as and when the market faced tight liquidity conditions, banks found CDs as an appropriate instrument to raise funds, thereby taking the outstanding amount of CDs from Rs.2,000 crore in July 1990 to Rs.12,557 crore in July 1993. However, as liquidity conditions eased, the CDs outstanding amount declined to Rs.5,218 crore in July 1994. A credit pick-up again spurted the outstanding amount of CDs to a historical peak of Rs.21,503 crore in June 1996. Another phase of liquidity tightness during the South East Asian crisis in the fourth quarter of 1997-98 led to a pick-up in the CDs issuances. The subsequent easing of liquidity conditions enabled banks to reduce borrowing through CDs leading to a decline in the outstanding amount of CDs to Rs.1,212 crore in January 2003. Interest rates on CDs softened in the recent period in line with other short-term interest rates.

With interest rate deregulation and the consequent flexibility in the market-determined rates, the associated risk factor for market participants also increased. This necessitated the development of derivative products for hedging risks by participants. Accordingly, banks and financial institutions were allowed in July 1999 to adopt risk management tools such as forward rate agreements (FRAs) and interest rate swaps (IRS) for their balance sheet management and hedging of interest rate risks by using the implied rates from any market segment such as money, debt or foreign exchange segment, for their own benchmarking.

The market has developed with successive rounds of interest rate deregulation in the economy. The notional principal amount under FRA/IRS contract moved up from Rs.2,065 crore during the fortnight ended January 14, 2000 to Rs.1,92,170 crore by January 24, 2003.

Repo (Repurchase Agreement) instruments enable collateralised short-term borrowing through sale operations in debt instruments. Under a repo transaction, the holder of securities sells them to an investor with an agreement to repurchase it at a predetermined date and rate. Reverse repo is a mirror image of repo, and represents acquiring of the debt securities with a simultaneous commitment to resell.

The Reserve Bank has been emphasising expansion and diversification of the repo market under regulated conditions so that repos become very active in enabling smooth adjustment of liquidity in the system. The essential reason to promote the repos as against the call/notice money market is the collateralised nature of the former. It is mandatory to actually hold the securities in the portfolio before undertaking repo operations. To further develop and widen the repos market, the Reserve Bank introduced regulatory safeguards such as delivery versus payments (DvP) system in April 1999. The operationalisation of the Negotiated Dealing System (NDS) and the Clearing Corporation of India Ltd. (CCIL) combined with placement of prudential limits on borrowing and lending in the call/notice market for banks are also expected to provide further boost to this market. The phase-out process of non-banks from the call/notice money market as also laying down of prudential restrictions on exposure limits of banks and PDs to this uncollaterialised market segment is being followed up with the concomitant development of the repo market. Thus, the supply of funds of non-banks to the repo market picked up in the recent months. While the turnover in the call/notice money declined, the turnover in the repo market (outside RBI) increased from Rs.11,311 crore in April 2001 to Rs.27,712 crore in May 2001, when the non-bank phasing out process commenced. The turnover further moved up to Rs.34,503 crore in November 2002.

To sum up, the money market in India, which traditionally consisted largely of call/notice money market, now comprises many other instruments such as CP, CDs, Repos and FRAs/IRS. Various reform measures have helped in improving the depth and efficiency of the money market operations. The operationalisation of the LAF has provided an informal corridor for overnight call money borrowing rate, which has further imparted stability and flexibility in the interest rate structure and to the market. The other money market instruments such as, CP and CDs have also been developed through alignment in maturity (with deposit instruments like term deposits) and easing of issuance norms. With the proper development of other money market segments, non-banks have been able to smoothly switch over from the call/notice money market to the other segments.

Though significant progress has been made through initiation of various reforms, there are several issues, which need to be addressed. While the overnight market is reasonably developed, the term-money market is yet to develop necessitating large rollover of short-term funds in the overnight market. This is mainly on account of the inability of participants to form appropriate interest rate expectations in the medium-term due to which there is a tendency on their part to lock themselves into short-term period. Besides, the absence of a proper yield curve at the shorter end of the market also renders pricing of intra-fortnight money difficult. Furthermore, corporates’ overwhelming preference for "cash" credit rather than for "loan" credit generally forces banks to deploy a large amount in the call/notice money market rather than in the term money market.

Another issue relates to the avenues available to deploy short-term funds to non-bank corporates. A critical issue in transforming the call/notice money market to a pure inter-bank market is the availability of some other avenue for short-term funds for non-bank participants. The commercial bill market at the present stage continues to be limited especially as few participants are willing to bear the concomitant risk of default. Thus, the repo trade at this stage offers a quick medium for developing a market for short-term funds especially as the transactions are collateralised in the case of non-banks. While the Reserve Bank has taken several steps to develop a repo market for non-bank participants, a vibrant repo market is, however, yet to develop. There is also a need to develop uniform accounting and documentation procedures in this regard. Besides, there is a need to explore the possibility of expanding an array of repo-able instruments in terms of both the type of paper and the investment category.