development of financial markets in india* rakesh mohan · rakesh mohan markets, particularly over...

RBIMonthly Bulletin

June 2007 961

SPEECH

Development ofFinancial Markets

in India

Rakesh Mohan

* Address by Dr. Rakesh Mohan, Deputy Governor, ReserveBank of India at the First Indian-French Financial Forumin Mumbai on May 16, 2007. The assistance of Janak Raj,Jai Chander and Partha Ray in preparing this address isgratefully acknowledged.

I am delighted to have the opportunityof speaking on the issue of development offinancial markets along with Mr. ChristianNoyer, Governor of the Banque de France. He has displayed a deep commitment to thedevelopment of financial markets over theyears and we heard a very thoughtful speechfrom him on this subject at the ReserveBank just two days ago. His approach tofinancial markets is marked by a greatdegree of pragmatism: as we developfinancial markets we need to make sure thatthey serve our needs, and we have to beequally conscious of the risks that they cangenerate if not managed well.

I welcome this opportunity to documentthe development of financial markets inIndia over the past decade and a half. Withacceleration in economic growth in thecountry, the step up in savings andinvestments, and expanded horizons ofmarket participants, along with renewedthinking on fuller capital accountconvertibility, discussion on financialmarket development has assumed a newurgency.

What are the key objectives of financialmarket development? From our point ofview, the basic aim of financial marketdevelopment must be to aid economicgrowth and development. The primary roleof financial markets, broadly interpreted, isto intermediate resources from savers toinvestors, and allocate them in an efficientmanner among competing uses in theeconomy, thereby contributing to growthboth through increased investment andthrough enhanced efficiency in resource use.

The Reserve Bank has taken a proactiverole in the development of financial

Development of FinancialMarkets in India*

Rakesh Mohan

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Development ofFinancial Marketsin India

Rakesh Mohan

markets, particularly over the past decadeand a half of overall economic policyreforms. There has been a completetransformation of the money market, thegovernment securities market, and theforeign exchange market over this period. Development of these markets has beendone in a calibrated, sequenced and carefulmanner in step with those in other marketsin the real economy. The sequencing hasalso been informed by the need to developmarket infrastructure, technology andcapabilities of market participants andfinancial institutions in a consistentmanner. In a low income economy likeours, the cost of downside risk is very high,so the objective of maintaining financialstability has to be constantly kept in viewas we develop financial markets. What Iwould like to do today is to briefly recountthe measures taken to develop variousfinancial markets in India, document theoutcomes and broadly sketch out thedirection of the way forward.

From the point of view of the centralbank, developed financial markets arecritical for effective transmission ofmonetary policy impulses to the rest of theeconomy. Monetary transmission cannottake place without efficient price discovery,particularly with respect to interest ratesand exchange rates. Deep and liquidfinancial markets contribute to efficientprice discovery in various segments of thefinancial market. Well-integrated marketsimprove efficacy of policy impulses byenabling quick transmission of changes inthe central bank’s short-term policy rate tothe entire spectrum of market rates, bothshort and long-term, in the money, thecredit and the bond markets. However,

various benefits emanating from thefunctioning of the financial markets dependcritically upon the resilience of varioussegments of the market to withstand shocksand the strength of the risk managementsystems in place. In view of the critical roleplayed by the financial markets in financingthe growing needs of various sectors of theeconomy, it is important that financialmarkets are developed further and well-integrated.

In recognition of the critical role of thefinancial markets, the initiation of thestructural reforms in the early 1990s inIndia also encompassed a process of phasedand coordinated deregulation andliberalisation of financial markets. Financialmarkets in India in the period before theearly 1990s were marked by administeredinterest rates, quantitative ceilings,statutory pre-emptions, captive market forgovernment securities, excessive relianceon central bank financing, pegged exchangerate, and current and capital accountrestrictions. As a result of various reforms,the financial markets have transited to aregime characterised by market-determinedinterest and exchange rates, price-basedinstruments of monetary policy, currentaccount convertibility, phased capitalaccount liberalisation and an auction-basedsystem in the government securitiesmarket.

Excessive fluctuations and volatility infinancial markets can mask the underlyingvalue and give rise to confusing signals,thereby hindering efficient price discovery.Accordingly, policy efforts have also aimedat ensuring orderly conditions in financialmarkets. Furthermore, deregulation,

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liberalisation, and globalisation of financialmarkets pose several risks to financialstability. Financial markets are oftengoverned by herd behaviour and contagionand excessive competition among financialinstitutions can also lead to a race to thebottom. The East Asian crisis of the 1990ssuggested that global financial markets canexacerbate domestic vulnerabilities.Notwithstanding the conventional wisdomthat financial markets punish deviationsfrom prudent policies, financial markets, attimes, seem to tolerate imprudentbehaviour for a remarkable stretch of time,while reacting pre-maturely at other times(Lipschitz, 2007). In recognition of thesepossible destabilising factors, whileliberalising domestic financial markets inIndia, appropriate prudential safeguardshave also been put in place. Enhancingefficiency, while at the same time avoidinginstability in the system, has been thechallenge for the regulators in India (Reddy,2004). This approach to development andregulation of financial markets has impartedresilience to the financial markets.

From the point of view of the economyas a whole, while developing financialmarkets it is essential to keep in view howsuch development helps overall growth anddevelopment. The price discovery ofinterest rates and exchange rates, and theintegration of such prices across marketshelps in the efficient allocation of resourcesin the real sectors of the economy. Financialintermediaries like banks also gain frombetter determination of interest rates infinancial markets so that they can price theirown products better. Moreover, their ownrisk management can also improve throughthe availability of different varieties of

financial instruments. The access of realsector entities to finance is also assisted bythe appropriate development of thefinancial market and the availability oftransparent information on benchmarkinterest rates and prevailing exchangerates. The approach of the Reserve Bank inthe development of financial markets hasbeen guided by these considerations, whilealso keeping in view the availability ofappropriate skills and capacities forparticipation in financial markets bothamong financial market participants andreal sector entities and individuals.

The Reserve Bank’s approach hastherefore been one of consistentdevelopment of markets while exercisingcaution in favour of maintaining financialstability in the system.

Money Market

The Reserve Bank has accorded primeattention to the development of the moneymarket as it is the key link in thetransmission mechanism of monetarypolicy to financial markets and finally, tothe real economy (Annex I). In the past,development of the money market washindered by a system of administeredinterest rates and lack of proper accountingand risk management systems. With theinitiation of reforms and the transition toindirect, market-based instruments ofmonetary policy in the 1990s, the ReserveBank made conscious efforts to develop anefficient, stable and liquid money marketby creating a favourable policy environmentthrough appropriate institutional changes,instruments, technologies and marketpractices. Accordingly, the call money


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market was developed into primarily aninter-bank market, while encouraging othermarket participants to migrate towardscollateralised segments of the market,thereby increasing overall market integrity.

In line with the objective of wideningand deepening of the money market andimparting greater liquidity to the market forfacilitating efficient price discovery, newinstruments, such as collateralised lendingand borrowing obligations (CBLO), havebeen introduced. Money marketinstruments such as market repo and CBLOhave provided avenues for non-banks tomanage their short-term liquiditymismatches and facilitated thetransformation of the call money marketinto a pure inter-bank market. Furthermore,issuance norms and maturity profiles ofother money market instruments such ascommercial paper (CP) and certificates ofdeposit (CDs) have been modified over timeto encourage wider participation whilestrengthening the transmission of policysignals across the various market segments.The abolition of ad hoc Treasury Bills andintroduction of regular auctions of TreasuryBills paved the way for the emergence of arisk free rate, which has become abenchmark for pricing the other moneymarket instruments. Concomitantly, withthe increased market orientation ofmonetary policy along with greater globalintegration of domestic markets, theReserve Bank’s emphasis has been onsetting prudential limits on borrowing andlending in the call money market,encouraging migration towards thecollateralised segments and developingderivative instruments for hedging marketrisks. This has been complemented by the

institutionalisation of the ClearingCorporation of India Limited (CCIL) as acentral counterparty. The upgradation ofpayment system technologies has alsoenabled market participants to improvetheir asset liability management. All thesemeasures have widened and deepened themoney market in terms of instruments andparticipants, enhanced transparency andimproved the signalling mechanism ofmonetary policy while ensuring financialstability.

These policy initiatives over time haveled to the development of a relatively deep,liquid and vibrant money market in thecountry. Activity in all the segments hasincreased significantly, especially during thelast three years. With the development ofmarket repo and CBLO segments, the callmoney market has been transformed into apure inter-bank market from August 2005. Arecent noteworthy development is thesubstantial migration of money marketactivity from the uncollateralised call moneysegment to the collateralised market repoand CBLO markets. Thus, uncollateralisedovernight transactions are now limited tobanks and primary dealers in the interest offinancial stability (Table 1).

Volatility in call rates has declined overthe years, especially after the introductionof the Liquidity Adjustment Facility (LAF).Under the LAF, the Reserve Bank sets itspolicy rates, i.e., repo and reverse repo ratesand carries out repo/reverse repooperations, thereby providing a corridor forovernight money market rates. Theweighted average overnight rate has largelymoved within the corridor set by LAF rates,barring some occasions, especially in recentmonths (Chart 1).

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The operating framework of monetarypolicy has been the maintenance ofovernight market rates within an interestrate corridor defined by the floor of thereverse repo (absorption) rate and ceiling ofthe repo (injection) rate. During periods ofsystem wide excess liquidity, overnightrates tend to hug the bottom of the corridor,while touching the ceiling during other

periods of liquidity shortage, as might beexpected. Increased volatility in capitalflows, tending to inject excess liquidity intothe system, and in government cashbalances resulting from bunching of taxpayments that suck liquidity out of thesystem, have made the task of liquiditymanagement somewhat more difficult overthe past year. Consequently, volatility in

Table 1: Activity in Money Market Segments

(Rupees crore)

1 2 3 4 5 6 7 8

1997-98 22,709 — — — 22,709 1,500 14,2961998-99 26,500 — — — 26,500 4,770 3,7171999-00 23,161 6,895 — — 30,056 7,014 1,9082000-01 32,157 10,500 — — 42,657 6,751 1,1992001-02 35,144 30,161 — 195 65,500 7,927 9492002-03 29,421 46,960 30 341 76,752 8,268 1,2242003-04 17,191 10,435 515 519 28,660 7,835 3,2122004-05 14,170 17,135 6,697 526 38,528 11,723 6,0522005-06 17,979 21,183 20,039 833 60,034 17,285 27,2982006-07 21,725 33,676 32,390 1,012 88,803 21,478 64,954

# : Turnover is twice the single leg volumes in the case of call money and CBLO to capture borrowing and lendingboth, and four times in case of market repo (outside LAF) to capture the borrowing andlending in the two legs for a repo.

* : Liquidity Adjustment Facility.

Outstanding Amount

CommercialPaper

Certificatesof Deposit

MoneyMarket -

Total(2 to 5)

TermMoneyMarket

CollateralisedBorrowing

and LendingObligation

(CBLO)

MarketRepo

(Outsidethe LAF)*

Call MoneyMarket

Year Average Daily Turnover #


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overnight rates has increased in recentmonths relative to previous years, withovernight rates breaching both ends of thecorridor.

After the adoption of the full-fledgedLAF in June 2000, call rates, in general,witnessed a declining trend up to 2004-05.The institution of LAF has also enabled theReserve Bank to manage liquidity moreefficiently and reduce volatility in call rates.Volatility, measured by the coefficient ofvariation (CV) of call rates, has declinedsignificantly in the current decade ascompared with that in the 1990s (Chart 2),with some increase in 2006-07, as alreadynoted.

The reduction in bid-ask spread in theovernight rates indicates that the Indianmoney market has become reasonably deep,vibrant and liquid. During April 2004-February 2007, the bid-ask spread has variedwithin a range of –0.37 to +1.32 basis pointswith an average of 16 basis points andstandard deviation (SD) of 11 basis points(coefficient of variation being 68.8). Despitea higher degree of variation, however, the

bid-ask spread remained within the 2-SDband around the average during most of theperiod (Chart 3).

As a result of various reform measures,the money market in India has undergonesignificant transformation in terms ofvolume, number of instruments andparticipants and development of riskmanagement practices. In line with theshifts in policy emphasis, various segmentsof the money market have acquired greaterdepth and liquidity. The price discovery process has also improved. The call moneymarket has been transformed into a pureinter-bank market, while other moneymarket instruments such as market repoand CBLO have developed to provideavenues to non-banks for managing theirshort-term liquidity mismatches. Themoney market has also become moreefficient as is reflected in the narrowing ofthe bid-ask spread in overnight rates. Theabolition of ad hoc Treasury Bills andintroduction of Treasury Bills auction haveled to the emergence of a risk free rate,which acts as a benchmark for the pricingof other money market instruments.

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Government Securities Market

The Reserve Bank has actively pursuedthe development of the governmentsecurities market since the early 1990s fora variety of reasons (Annex II). First, withthe Reserve Bank acting as the debt managerto the Government, a well-developed andliquid government securities market isessential to ensure the smooth passage ofGovernment’s market borrowings to financeits deficit. Second, the development of thegovernment securities market is alsonecessary to facilitate the emergence of arisk free rupee yield curve to serve as abenchmark for pricing other debtinstruments. Finally, the governmentsecurities market plays a key role in theeffective transmission of monetary policyimpulses in a deregulated environment.

In order to foster the development ofthe government securities market, it wasimperative to migrate from a regime ofadministered interest rates to a market-oriented system. Accordingly, in the early1990s, the Reserve Bank initiated severalmeasures. First, it introduced the auction

system for issuance of governmentsecurities. While initially only yield-basedmultiple price auctions were conducted,uniform price-based auctions were alsoemployed during uncertain marketconditions and while issuing newinstruments. Second, as the captiveinvestor base was viewed as constrainingthe development of the market, thestatutory prescription for banks ’investments in government and otherapproved securities was scaled down fromthe peak level in February 1992 to thestatutory minimum level of 25 per cent byApril 1997. As a result, the focus shiftedtowards the widening of the investor base.A network of intermediaries in the formof primary dealers was developed for thispurpose. Retail participation has beenpromoted in the primary market (througha system of non-competitive bidding in theauctions) as well as in the secondarymarket (by allowing retail trading in stockexchanges). Simultaneously, the ReserveBank also introduced new instrumentswith innovative features to cater to diversemarket preferences, although the


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experience in this regard has not beenencouraging.

Third, with the discontinuance of theprocess of unconstrained recourse by theGovernment to the Reserve Bank throughautomatic monetisation of deficit andconversion of non-marketable securities tomarketable securities, the Reserve Bankgained more operational freedom. Fourth,in an effort to increase liquidity, the ReserveBank has, since the late 1990s, pursued astrategy of passive consolidation of debt byraising progressively higher share of marketborrowings through re-issuances. This hasresulted in critical mass in key maturities,and is facilitating the emergence of marketbenchmarks. Fifth, improvement in overallmacroeconomic and monetary managementthat has resulted in lower inflation, lowerinflation expectations, and price stabilityhas enabled the elongation of the yieldcurve to maturities upto 30 years. Finally,the Reserve Bank has also undertakenmeasures to strengthen the technologicalinfrastructure for trading and settlement.A screen-based anonymous trading andreporting platform has been introduced inthe form of NDS-OM, which enableselectronic bidding in primary auctions anddisseminates trading information with aminimum time lag. Furthermore, with thesetting up of the Clearing Corporation ofIndia Limited (CCIL), an efficient settlementmechanism has also been institutionalised,which has imparted considerable stabilityto the government securities market.

With the withdrawal from the primarymarket from April 1, 2006 in accordance withthe FRBM (Fiscal Responsibility and BudgetManagement Act) stipulations, the ReserveBank introduced various institutional

changes in the form of revamping andwidening of the coverage of the PrimaryDealer (PD) system to meet the emergingchallenges. Other measures taken to deepenthe market and promote liquidity includeintroduction of ‘when issued’ trading, ‘shortselling’ of government securities and activeconsolidation of government debt throughbuy backs. Various policy initiatives takenby the Reserve Bank over the years to widenand deepen the government securitiesmarket in terms of instruments as well asparticipants have enabled successfulcompletion of market borrowingprogrammes of the Government undervaried circumstances. In particular, a smoothtransition to the post-FRBM phase has beenensured.

The system of automatic monetisationthrough ad hoc Treasury Bills was replacedwith Ways and Means Advances in 1997,because of which the Government resortedto increased market borrowings to financeits deficit. Accordingly, the size of thegovernment securities market has increasedsignificantly over the years (Chart 4).

The investor base for governmentsecurities, which was largely determined bymandated investment requirements beforereforms, has expanded with the voluntaryholding of government securities.Accordingly, the share of commercial bankshas declined from 2004-05 (Chart 5).

The PD system was essentiallyconceived for institutions whose basicinterest is not to hold securities but toparticipate in the primary auctions with theintent to act as market makers in thesecondary market. PDs are responsible forensuring the success of primary auctions.

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The presence of PDs in the governmentsecurities market has brought about anelement of dynamism, both in the primaryand the secondary segments. PDs have beenactively participating in the auctions ofgovernment securities. By providingcontinuous two-way quotes, PDs act asmarket makers in the secondary market.The liquidity in the secondary market, inturn, lends support to the success ofprimary market operations. The PD systemhas facilitated better distribution of primaryauctioned stock while providing betterliquidity in the secondary market (Table 2).

The decline in the share of PDs in theprimary issuances in the recent periodneeds to be seen in the context of increasedbidding interest by insurance companies,particularly in the long dated securities.

One of the key issues in thedevelopment of the market for a better pricediscovery is liquidity of securities. It wasobserved that, of the universe of a largenumber of outstanding securities, only afew securities are actively traded in thesecondary market. The Reserve Bank hasbeen following a policy of passive


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consolidation through re-issuance ofexisting securities with a view to enhancingliquidity in the secondary segment of thegovernment securities market. The share ofre-issuances in the total securities issuedwas 97.7 per cent during 2005-06. Activeconsolidation of government securities hasalso been attempted under the debt buybackscheme introduced in July 2003, which isexpected to be more actively pursued now.

As a result of the developmentalmeasures undertaken, the volume oftransactions has increased manifold overthe past decade (Chart 6).

The significant drop in turnover in2004-05 and 2005-06 could be due to a ‘buyand hold’ tendency of the participants otherthan commercial banks, particularlyinsurance companies, which now hold asubstantial portion of governmentsecurities, particularly those of longermaturities. The decline could also beattributed to the asymmetric response ofinvestors to the interest rate cycle. In theabsence of a facility of short selling ingovernment securities, participantsgenerally refrained from taking positionswhich resulted in volumes drying up in afalling market (Chart 7).

To keep the markets liquid and activeeven during the bearish times, and moreimportantly, to give the participants a toolto better manage their interest rate risk,intra-day short selling in governmentsecurities was permitted among eligible

Table 2: Role of Primary Dealers in theGovernment Securities Market

(Per cent)

Year Share in Share in Share ofPrimary Turnover Government

Subscription (Outright) Securitiesin Total

Assets ofPDs*

1 2 3 4

2001-02 65.0 27.7 79.82002-03 58.5 27.0 83.92003-04 51.5 23.9 82.22004-05 52.9 28.2 71.52005-06 40.4 31.1 60.92006-07 (P) 40.0 26.4 61.0

* : At end-March. P : Provisional.Note: Data exclude devolvement but include MSS and

Non-Competitive Bids.

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participants, viz., scheduled commercialbanks (SCBs) and primary dealers (PDs) inFebruary 2006. Subsequently, the shortpositions were permitted to be carriedbeyond intra-day for a period of five tradingdays, effective January 31, 2007. To furtherimprove the liquidity in the governmentsecurities market, guidelines for trading inwhen issued ‘WI’ market were issued by theReserve Bank in May, 2006. Trading in ‘WI’segment, which commenced in August2006, was initially permitted in reissuedsecurities. It takes place from the date ofannouncement of auction till one day priorto allotment of auctioned securities. Therevised guidelines extending ‘WI’ trading tonew issuances of Central Governmentsecurities on a selective basis were issuedin November 2006.

The Reserve Bank has followed astrategy of elongating the yield curve byissuing a fine blend of long-term securitiesalong with the short-term to suit thepreference of both the issuer and theinvestor. With the issuance of longer termsecurities, the yield curve on governmentsecurities has emerged over a spectrum of

30 years, although the yield curve is notliquid at the longer end of the maturity(Chart 8).

Thus, various measures undertakenhave led to a significant improvement in thefunctioning of the government securitiesmarket. The primary market has attained agreater resilience, benefiting from measurestaken for the development of institutionsand instruments. The functioning of thegovernment securities market since themid-1990s indicates consistent increase inits size in tandem with the growth in marketborrowings of both the Central and the StateGovernments. Introduction of the auctionbased system has improved the pricediscovery process. Reflecting theeffectiveness of various measures todevelop the market, the turnover in thesecondary market has increased manifoldover the years. The establishment ofsettlement and trading infrastructure hasalso led to increased activity in thesecondary market. The holding pattern ofgovernment debt shows some shift frombanks to non-banks, reflecting a progressivediversification of the investor base. The


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yield curve on government securities hasemerged even as it is yet to become liquidat the longer end of the maturity. Thus, thegovernment securities market in India haswitnessed a transition to an increasinglybroad-based market, characterised by anefficient auction process, an activesecondary market and a liquid yield curve. These developments have aided the smoothfinancing of government debt, of both thecentral government and state governments,even when their fiscal deficits were highand rising. This experience has enabled thegreater recourse for state governments tomarket borrowing as mandated by theTwelfth Finance Commission.

Foreign Exchange Market

The Indian foreign exchange market haswitnessed far reaching changes since theearly 1990s following the phased transitionfrom a pegged exchange rate regime to amarket determined exchange rate regime in1993 and the subsequent adoption ofcurrent account convertibility in 1994 andsubstantial liberalisation of capital accounttransactions (Annex III). Market participants

have also been provided with greaterflexibility to undertake foreign exchangeoperations and manage their risks. This hasbeen facilitated through simplification ofprocedures and availability of several newinstruments. There has also been significantimprovement in market infrastructure interms of trading platform and settlementmechanisms. As a result of various reformmeasures, liquidity in the foreign exchangemarket increased by more than five timesbetween 1997-98 and 2006-07 (Table 3).

In relative terms, turnover in the foreignexchange market was 6.6 times the size ofIndia’s balance of payments during 2005-06as compared with 5.4 times in 2000-01(Table 4). With the deepening of the foreignexchange market and increased turnover,income of commercial banks through suchtransactions increased significantly. Profitfrom foreign exchange transactionsaccounted for more than 20 per cent of totalprofit of scheduled commercial banks in thelast 2 years.

Efficiency in the foreign exchangemarket has also improved as reflected in the

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Table 4: Size of the Foreign Exchange Market

(Per cent)

Year Foreign BoP size Col. 2Exchange (US$ billion) over

Market- Col. 3Annual

Turnover(US$ billion)

1 2 3 4

2000-01 1,387 258 5.42001-02 1,422 237 6.02002-03 1,560 267 5.82003-04 2,118 362 5.92004-05 2,892 481 6.02005-06 4,413 664 6.62006-07 6,514 N.A. N.A.

developing countries, which specialise inlabour-intensive and low and intermediatetechnology products, profit margins in thehighly competitive markets are very thinand vulnerable to pricing power by largeretail chains. Consequently, exchange ratevolatility has significant employment,output and distributional consequences.Foreign exchange market conditions haveremained orderly in the post-1993 period,barring occasional periods of volatility(Chart 10). The Indian approach to exchangerate management has been to avoidexcessive volatility. Intervention by theReserve Bank in the foreign exchangemarket, however, has been relatively smallcompared to total turnover in the market.

The exchange rate policy in recent yearshas been guided by the broad principles ofcareful monitoring and management ofexchange rates with flexibility, without afixed target or a pre-announced target or aband, coupled with the ability to intervene,if and when necessary. The overall approachto the management of India’s foreignexchange reserves takes into account thechanging composition of the balance of

decline in bid-ask spreads. The bid-askspread of Rupee/US$ market has almostconverged with that of other majorcurrencies in the international market. Onsome occasions, in fact, the bid-ask spreadof Rupee/US$ market was lower than thatof some major currencies (Chart 9).

The EMEs’ experience, in general, in the1990s has highlighted the growingimportance of capital flows in determiningthe exchange rate movements as againsttrade flows and economic growth in the1980s and before. In the case of most

Year Turnover in US $ billion Share of Spot Turnover in Per cent

Merchant Inter-bank Total Merchant Inter-bank Total

1 2 3 4 5 6 7

1997-98 210 1,096 1,305 57.6 50.3 51.51998-99 246 1,057 1,303 52.9 49.4 50.01999-00 244 898 1,142 62.3 50.8 53.32000-01 269 1,118 1,387 65.2 45.2 49.12001-02 257 1,165 1,422 64.0 39.8 44.12002-03 325 1,236 1,560 57.9 42.7 45.92003-04 491 1,628 2,118 53.1 48.7 49.72004-05 705 2,188 2,892 48.2 50.5 50.02005-06 1,220 3,192 4,413 45.0 52.7 50.62006-07 (P) 1,787 4,727 6,514 46.2 54.2 52.0

P : Provisional.

Table 3: Turnover in the Foreign Exchange Market


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payments and endeavours to reflect the‘liquidity risks’ associated with differenttypes of flows and other requirements.Illustratively, the Indian rupee exhibitedtwo-way movements during 2006-07moving in a range of Rs.43.14–46.97 per USdollar. The rupee initially depreciatedagainst the US dollar during the year,reaching Rs.46.97 on July 19, 2006, reflectinghigher crude oil prices, FII outflows and geo-political risks in the Middle East region. Therupee, however, strengthened thereafter onthe back of moderation in crude oil prices,

revival of FII inflows and weakness of theUS dollar in the international markets. Therupee appreciated further to reach Rs. 40.59 per US dollar on May 7, 2007 due toincreased supply of dollars in the market.Thereafter, however, the rupee depreciatedto Rs. 40.85 per US dollar on May 16, 2007.At this level, the rupee appreciated by 6.7per cent over end-March 2007 and 9.2 percent over end-March 2006. Against the Euro,the rupee appreciated by 4.7 per cent overend-March 2007, but depreciated by 2.4 percent over end-March 2006. The real effective

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exchange rate (REER) of the Indian rupee(six-currency trade-based weights) at 112.2as on April 18, 2007 appreciated by 12.2 percent over the base 1993-94; over 2000-01 theappreciation is by 9.6 per cent (Chart 11).

Apart from the spot segment, the foreignexchange market in India trades inderivatives such as forwards, swaps, andoptions. The typical forward contract is forone month, three months, or six months,with three months being the most common.Forward contracts for longer periods are notas common because of the greatuncertainties involved. A swap transactionin the foreign exchange market is acombination of a spot and a forward in theopposite direction. Foreign exchange swapsaccount for the largest share of the totalderivatives turnover in India, followed byforwards and options (Table 5). Optionshave remained insignificant despite beingin existence for three years. Withrestrictions on the issue of foreign exchangeswaps and options by corporates in India,turnover in these segments (swap andoptions) essentially reflects inter-banktransactions.

With greater opening of the capitalaccount, the forward premia is gettinggradually aligned with the interest ratedifferential reflecting growing marketefficiency. In the post-liberalisation phase,forward premia of the Indian rupee vis-à-visdollar has generally remained high indicatingthat rupee was at a discount to the US dollar.In recent times, however, reflecting the build-up of foreign exchange reserves, the strongcapital flows and the confidence in theIndian economy, forward premia have comedown sharply from the peak reached in1995-96 (Chart 12).

Table 5: Derivatives Turnover in India inNominal/Notional Amounts

(US $ billion)

Product 2000-01 2005-06 2006-07(Up to

November2006)

1 2 3 4

Forward 163 839 734Swap 565 1,344 1,187Options 0 11 * 38

* : Relates to the year September 2005-August 2006 asreporting for options data started in September 2005.

Note : Options denote foreign currency Indian rupeeoptions. Turnover is calculated by taking thedifference between notional outstanding over theprevious year.


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As a result of various measures, theIndian foreign exchange market has evolvedinto a relatively mature market over a periodof time with increase in depth and liquidity.The turnover in the market has increasedover the years. With the gradual opening upof the capital account, the forward premiaare getting increasingly aligned with theinterest rate differential. There is alsoevidence of enhanced efficiency in theforeign exchange market as is reflected inlow bid-ask spreads.

The gradual development of the foreignexchange market has helped in smoothimplementation of current accountconvertibility and the phased and gradualopening of the capital account. Theavailability of derivatives is also helpingdomestic entities and foreign investors intheir risk management. This approach hashelped India in being able to maintainfinancial stability right through the periodof economic reforms and liberalisationleading to continuing opening of theeconomy, despite a great degree of volatilityin international markets, particularly duringthe 1990s.

Financial Market Integration

The success of a monetary policytransmission framework, which relies onindirect instruments of monetarymanagement such as interest rates, iscontingent upon the extent and speed withwhich changes in the central bank’s policyrate are transmitted to the spectrum ofmarket interest rates and exchange rate inthe economy and onwards to the real sector.Changes in the central banks’ policy ratescan, through variations in domestic moneymarket interest rates, impact the exchangerates, which, in turn, impact the realeconomy. Similarly, movement in policyinterest rates can influence other assetmarkets such as equity and property prices,further strengthening monetarytransmission. If markets are weaklyintegrated, the central bank’s interest ratesignals will not have the desired impact onother short and long-term interest rates, theexchange rate and other asset prices. In sucha scenario, the central bank would need toact in various segments of the market toachieve the desired objectives. In brief, the

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greater the degree of integration acrossmarket segments, the stronger is thetransmission of monetary policy to thespectrum of financial markets and on to thereal economy. By enabling dispersion ofshocks and risks to a particular segmentacross all markets, well-integrated marketsalso contribute to financial stability.

Financial market reforms in India haveenabled a greater integration of varioussegments of the financial market, reducingarbitrage opportunities, achieving higher

level of efficiency in market operation ofintermediaries and increasing efficacy ofmonetary policy in the economy. Growingintegration of financial markets beginning2000 could be gauged from crosscorrelation among various market interestrates. The correlation structure of interestrates reveals several notable features ofintegration of specific market segments(Table 6).

First, in the money market segment,there is evidence of stronger correlation

RREPO Call TB91 TB364 Yield10 CDs CPs FR1 FR3 FR6 EXCH LBSES

1 2 3 4 5 6 7 8 9 10 11 12 13

(April 1993 to March 2000)

RREPO 1.00Call 0.35 1.00TB91 0.44 0.61 1.00TB364 0.32 0.40 0.90 1.00Yield10 0.04 0.46 0.57 0.49 1.00CDs 0.30 0.32 0.45 0.41 0.38 1.00CPs 0.39 0.54 0.81 0.75 0.57 0.71 1.00FR1 0.27 0.80 0.45 0.33 0.46 0.47 0.63 1.00FR3 0.28 0.68 0.47 0.32 0.56 0.58 0.65 0.97 1.00FR6 0.30 0.61 0.48 0.36 0.60 0.62 0.68 0.91 0.98 1.00EXCH 0.03 –0.04 –0.23 –0.38 –0.06 –0.19 –0.31 –0.25 0.12 0.13 1.00LBSES –0.37 –0.10 –0.24 –0.34 –0.05 –0.40 –0.28 –0.32 –0.28 –0.30 0.35 1.00

(April 2000 to December 2006)

RREPO 1.00Call 0.86 1.00TB91 0.86 0.95 1.00TB364 0.84 0.92 0.99 1.00Yield10 0.78 0.88 0.96 0.98 1.00CDs 0.78 0.90 0.94 0.93 0.93 1.00CPs 0.81 0.90 0.96 0.94 0.92 0.95 1.00FR1 0.58 0.62 0.57 0.52 0.50 0.60 0.67 1.00FR3 0.60 0.61 0.60 0.54 0.52 0.63 0.71 0.98 1.00FR6 0.61 0.62 0.61 0.55 0.54 0.66 0.74 0.95 0.99 1.00EXCH 0.29 0.20 0.14 0.08 0.04 0.24 0.28 0.60 0.66 0.70 1.00LBSES –0.26 –0.23 –0.20 –0.15 –0.11 –0.27 –0.31 –0.57 –0.64 –0.68 –0.69 1.00

TB91 : 91-day Treasury Bills rate. RREPO : Reverse repo rate.Yield10 : 10-year government securities yield. CPs : Commercial paper rate.Call : Inter-bank call money rate (weighted average). TB364 : 364-day Treasury Bills rate.FR1 : 1-month forward exchange premia. CDs : Certificates of deposit rate.FR6 : 6-month forward exchange premia. FR3 : 3-month forward premia.LBSES : Natural logarithm of BSE Sensex. EXCH : Exchange rate of Indian rupee per US dollar.Note : Correlations are based on monthly data.

Table 6: Correlation Among Major Financial Markets


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among interest rates in the more recentperiod 2000-06 than the earlier period 1993-2000, suggesting the impact of policyinitiatives undertaken for financialdeepening. The enhanced correlationamong interest rates also indicatesimprovement in efficiency in the operationsof financial intermediaries trading indifferent instruments. Second, the highcorrelation between risk free and liquidinstruments such as Treasury Bills, whichserve as benchmark instruments, and othermarket instruments such as certificates ofdeposit and commercial papers and forwardexchange premia, underlines the efficiencyof the price discovery process. Third, thesharp improvement in correlation betweenthe reverse repo rate and money marketrates in the recent period implies enhancedeffectiveness of monetary policytransmission. Fourth, the high degree ofcorrelation between long-term governmentbond yield and short-term Treasury Billsrate indicates the significance of term-structure of interest rates in financialmarkets. Fifth, the correlation betweeninterest rates in money markets and three-month forward premia was significantly

high, indicating relatively high horizontalintegration. Integration of the foreignexchange market with the money marketand the government securities market hasfacilitated closer co-ordination of monetaryand external sector management. Theimpact of foreign exchange marketintervention can be carefully coordinatedwith monetary management encompassingconstant monitoring of the supply ofbanking system liquidity and an active useof open market operations to adjustliquidity conditions. Sixth, the equitymarket appears to be segmented withrelatively low and negative correlation withmoney market segments.

A growing integration between themoney, the gilt and the foreign exchangemarket segments was also discernible in theconvergence of financial prices, within andamong various segments and co-movementin interest rates (Chart 13).

The degree of integration of the foreignexchange market with other markets islargely determined by the degree ofopenness. One of the indicators of foreignmarket integration is the differential in

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covered interest rates1. In the Indiancontext, the forward price of the rupee isnot essentially determined by the interestrate differentials, but it is also significantlyinfluenced by: (a) supply and demand offorward US dollars; (b) interest differentialsand expectations of future interest rates;and (c) expectations of future US dollar-rupee exchange rate. Empirical evidencesupports this view, as the three monthforward premia (FP3) has less than perfectco-movement with interest rate differential(between 91-day treasury bill rate and three-month LIBOR), indicative of the timevarying nature of the risk premium. Theinter-linkage becomes stronger when theinterest rate differential is based on themonthly average call money rate and one-month LIBOR (Chart 14). The relationshipimproves still further, when the differencebetween the CP rate in India and the

3-month US dollar LIBOR rate is consideredfor interest parity assessments. Thedeviation of the forward premia from theinterest parity condition appears toincrease during volatile conditions in thespot segment of the foreign exchangemarket.

From the monetary policy perspective,there has been convergence among marketsegments, with a significant decline in thespread of market interest rates over thereverse repo rate (Table 7). The spread wasthe lowest for the inter-bank call money ratefollowed by rates on Treasury Bills,certificates of deposit, commercial paperand 10-year government bond yield. Thebenefit of financial market developmentpercolating to the real sector is also evidentfrom the moderation in the spread ofcommercial paper over the policy rate. The

1 The Covered Interest Parity (CIP) implies that the rates of return on homogenous financial instruments that aredenominated in same currency, but traded domestically as well as offshore must be equal under efficient market conditions,provided exchange controls do not exist and country risk premium is similar in two markets. The CIP implies that yieldon foreign investment that is covered in forward markets equals the yield on domestic investment. The interest differentialis offset by premium or discount on the forward rate. The absence of covered interest differential indicates that there aresome impediments to financial integration, attributable to some element of market imperfection, transaction costs,market liquidity conditions, margin requirements, taxation and market entry exit conditions.


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Table 8: Depth of Financial Markets in India – Average Daily Turnover

(Rupees crore)

Year Money Market* Government Foreign Exchange Equity Market** EquitySecurities Market Market # (Cash Segment) Derivatives

at NSE

1 2 3 4 5 6

1991-92@ 6,579 391 — 469 —2000-01 42,657 2,802 21,198 9,308 112001-02 65,500 6,252 23,173 3,310 4102002-03 76,752 7,067 24,207 3,711 1,7522003-04 28,660 8,445 30,714 6,309 8,3882004-05 38,528 4,826 39,952 6,556 10,1072005-06 60,034 3,643 56,391 9,504 19,2202006-07 88,803 4,863 83,984 11,760 29,803

* : Includes the call money, the notice money, the term money, the CBLO and the repo markets.** : Includes both BSE and NSE turnover. # : Inter-bank turnover only.@ : Data for G-Sec and equity market relate to 1995-96.— : Not available.Source: Reserve Bank of India; The Bombay Stock Exchange, Mumbai; and The National Stock Exchange of India Limited.

Table 7: Interest Rate Spread over theReverse Repo Rate

(Per cent)

Item April 1993 - April 1993 - April 2000 -Sept 2006 March 2000 Sept 2006

1 2 3 4

Call money Rate 1.75 2.98 0.43

Certificates ofDeposit Rate 3.33 5.43 1.07

CommercialPaper Rate 4.01 6.09 1.78

91-day TreasuryBill Rate 1.71 2.90 0.42

364-day TreasuryBill Rate 2.13 4.18 0.75

10-year Yield onG-Sec 3.50 6.21 1.84

narrowing of the spread between the policyrate and other market rates suggests theincreasing efficiency of the transmissionmechanism of monetary policy.

Thus, integration among various marketsegments has grown, especially in the recentperiod. This is reflected in the increase inthe depth of the markets and highercorrelation among interest rates in various

market segments. Growing integrationamong various financial market segmentswas accompanied by lower volatility ofinterest rates. The narrowing of the interestrate spread over the reverse repo rate reflectsan improvement in the monetary policytransmission channel and greater financialmarket integration.

We can also note the gradual increasein depth of all segments of financial marketsin India over the years, including in theequity market, though the average dailytransaction volumes are the highest in theforex and money markets (Table 8).

Summing Up

The Reserve Bank has taken a keeninterest in the development of the money,the government securities and the foreignexchange markets in view of their criticalrole in overall growth and development ofthe economy and particularly in thetransmission mechanism of monetary

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policy. The approach has been one ofsimultaneous movement on several fronts,graduated and calibrated, with an emphasison institutional and infrastructuraldevelopment and improvements in marketmicrostructure. The pace of reforms wascontingent upon putting in placeappropriate systems and procedures,technologies and market practices.Initiatives taken by the Reserve Bank havebrought about a significant transformationof various segments of the financial market. These developments, by improving thedepth and liquidity in domestic financialmarkets, have contributed to better pricediscovery of interest rates and exchangerates, which, in turn, have led to greaterefficiency in resource allocation in theeconomy. The increase in size and depth offinancial markets has paved the way forflexible use of indirect instruments. Greaterdepth and liquidity and freedom to marketparticipants have also strengthened theintegration of various segments of thefinancial market. Increased integration notonly leads to more efficient dispersal ofrisks across the spectrum but also increasesthe efficacy of monetary policy impulses.Evidence suggests that growing integrationof various financial market segments inIndia has been accompanied by lowervolatility of interest rates.

While financial markets have certainlybecome more developed over the years, weare quite conscious of the fact thatdevelopment of financial markets is anongoing process and there is still some wayto go before the markets are fullydeveloped and integrated. Initiatives tofurther deepen and widen the varioussegments of the financial market will,

therefore, need to be pursued in themonths and years ahead. Financial marketswill have to play an even more important rolein future to sustain the current growthmomentum being experienced by theIndian economy but their development willneed to continue to be in step withcorresponding real sector developments.Further development and integration ofvarious segments is also important in thecontext of envisaged move towards fullercapital account convertibility. Accordingly,in the Annual Policy Statement for the year2007-08 released on April 24, 2007, severalmeasures are being initiated to furtherdevelop the financial markets.

A number of initiatives have beenannounced for further development of thegovernment securities market. With a viewto helping investors to plan theirinvestments in advance and, in turn, toavoid undue liquidity pressure in thesystem, the operational modalities forintroduction of an indicative calendar forstate government borrowing are beingfinalised. A ‘Non-Competitive BiddingScheme’ in the auctions of StateDevelopment Loans (SDLs) would beintroduced in the financial year 2007-08.The modalities for operationalisation of thescheme are being finalised. Reissuance ofSDLs has been favoured with a view tobuilding up a critical mass and therebyimproving the secondary market liquidityof such securities. The Reserve Bank is inconsultation with the State Governments tointroduce a system of reissuances.

With a view to simplifying themethodology for pricing of floating ratebonds (FRBs) in the secondary market, it isproposed to use the average cut-off yield on


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182-day Treasury Bills, instead of the yieldon 364-day Treasury Bills as a benchmarkrate for the FRBs to be issued in future.The modalities for undertaking activeconsolidation of Central Governmentsecurities have already been finalised inconsultation with the Government ofIndia.

As the economy develops and financialmarkets become more sophisticated, marketparticipants need better access to riskmanagement mechanisms. Thus, interestrate derivatives need to be developedfurther. Accordingly, the Reserve Bank hasrecently issued comprehensive guidelinesin respect of interest rate derivatives,incorporating the broad regulatoryframework for undertaking derivativetransactions. In respect of OTC derivativetransactions, it has become necessary tohave a mechanism for transparent captureand dissemination of trade information aswell as an efficient post-trade processinginfrastructure to address some of theattendant risks. To begin with, the CCIL isbeing advised to start a trade reportingplatform for Rupee Interest Rate Swaps(IRS). This reporting module would befunctional by August 31, 2007 and willthereafter be available to all marketparticipants.

An anonymous order driven system fortrading in Interest Rate Derivatives (IRDs)was introduced on exchanges in 2003. Bankswere allowed to hedge the risk in theirunderlying investment portfolio whilePrimary Dealers (PDs) were also permittedas market-makers. Since then, theGovernment securities market hasundergone numerous developmental

changes, including the introduction of shortselling and when-issued markets.Recognising the need for a robust interestrate futures market as an effectiveinstrument for management of interest raterisk, a Working Group is being set up to gointo all the relevant issues and to suggestmeasures to facilitate the development ofthe interest rate futures market.

As the capital account is graduallyopened further the Reserve Bank has takenseveral initiatives to provide a moreconducive environment for the conduct offoreign exchange business. The primeconcern has been to provide prompt andefficient customer service by progressivelyliberalising foreign exchange relatedtransactions, removing restrictions andsimplifying procedures. Concomitantly,powers have been delegated to authoriseddealers with a view to improving ease oftransactions for the common person.Keeping in view the recommendations ofthe Committee on Fuller Capital AccountConvertibility (CFCAC), several measureshave been proposed in the Annual PolicyStatement towards liberalisation of foreignexchange facilities.

In order to provide greater flexibility toIndian companies for investments abroadand to rationalise the existing facilities, itis proposed (a) to enhance the overseasinvestment limit (total financialcommitments) for Indian companies fromthe existing limit of 200 per cent of theirnet worth to 300 per cent of their networth, as per the last audited balance sheet;and (b) to reckon the amount of guaranteeat 100 per cent of the amount instead ofthe current conversion factor of 50 per cent

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for determining the total financialcommitments.

At present, listed Indian companieshave a separate limit of 25 per cent of networth for portfolio investment abroad inlisted overseas companies. It has beendecided to enhance this limit to 35 per centof net worth. At present, the aggregateceiling on overseas investment by mutualfunds is US $ 3 billion. With a view toproviding greater opportunity to mutualfunds for investment overseas, it isproposed to increase the ceiling to US $ 4billion.

In order to further liberalise theremittance scheme for individuals, thepresent limit of US$ 50,000 is beingenhanced to US$ 100,000 per financial yearfor any permitted current or capital accounttransaction or a combination of both.

The basic principle for accessingdomestic foreign exchange markets ishedging of underlying foreign exchangeexposures. In keeping with the evolutionof the foreign exchange market and theincrease in depth and volumes, a range ofhedging instruments have been permittedto market participants including foreignexchange forwards, swaps and options, butmainly against crystallised foreign currencyexposures. However, it has now beendecided to expand the range of hedgingtools available to the market participants asalso to facilitate dynamic hedging by theresidents in respect of other economicexposures. This will include hedging ofprice risk faced by domestic producers ofnon-ferrous metals, users of aviationturbine fuel, and others facing similar

systemic international price risk. In orderto facilitate dynamic hedging of foreignexchange exposures of exporters andimporters of goods and services, it isproposed to enhance this limit to 75 percent from 50 per cent earlier.

Similarly, small and mediumenterprises (SMEs) are being permitted tohedge their foreign exchange exposures. They will be allowed to book forwardcontracts without underlying exposuresor past records of exports and imports.Furthermore, resident individuals arebeing enabled to manage/hedge theirforeign exchange exposures, includinganticipated exposures up to an annuallimit of US $ 100,000, which can befreely cancelled and rebooked.

In view of the increasing exposure ofIndian entities to foreign currency risk, ithas also been decided to set up a WorkingGroup on Currency Futures to study theinternational experience and suggest asuitable framework to operationalise theproposal, in line with the current legal andregulatory framework.

These initiatives can be seen within theoverall context of the financial sectordevelopment in the country, particularly, inthe money market, government securitiesmarket and the foreign exchange market.As we gain experience, with theimplementation of these initiatives, we canexpect a continuing process of financialmarket development that aids the overalldevelopment process. Similar efforts arebeing undertaken by the Government andthe securities regulator, the Securities andExchange Board of India along with the


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Reserve Bank in activating the corporatedebt market. As has been experiencedelsewhere, among the various financialmarkets, the corporate debt market isindeed the most difficult to develop for avariety of reasons. Our experience withdevelopment of the government securitiesmarket suggests that a great deal of detailedwork will need to be undertaken over aperiod of time to put in place an appropriatemarket micro infrastructure, tradingplatforms, technology and clearing andsettlement systems, along with furtherdevelopment of both issuers and buyers.The expansion of the pension fund andinsurance industries will progressivelyresult in the presence of a larger financialinvestor base, which will help in the overallexpansion of financial markets and inparticular the corporate debt market.

References:

Lipschitz, Leslie. 2007. “Wising Up aboutFinance.” Finance and Development, 44(1),March.

Mohan, Rakesh. 2004. “Financial SectorReforms in India: Policies and PerformanceAnalysis.” RBI Bulletin, October.

——. 2005. “Globalisation, FinancialMarkets and the Operation of MonetaryPolicy in India.” BIS Papers No 23.

——. 2006. “Monetary Policy and ExchangeRate Frameworks: The Indian Experience.”RBI Bulletin, June.

——. 2007. “Monetary Policy Transmissionin India.” RBI Bulletin, April.

Reddy, Y.V. 2004. “Financial Stability: IndianExperience.” RBI Bulletin, July.

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The Reserve Bank has been makingefforts to develop a repo market outside theLAF for bank and nonbank participants, soas to provide a stable collateralised fundingalternative with a view to promoting smoothtransformation of the call/notice moneymarket into a pure inter-bank market and fordeepening the underlying governmentsecurities market. Thus, the following newinstruments have been introduced.

Collateralised Borrowing andLending Obligation (CBLO)

● Developed by the Clearing Corporationof India Limited and introduced onJanuary 20, 2003, it is a discountedinstrument available in electronic bookentry form for the maturity periodranging from one day to ninety days(can be made available up to one yearas per RBI guidelines).

● In order to enable the market participantsto borrow and lend funds, CCIL providesthe Dealing System through IndianFinancial Network (INFINET), a closeduser group to the Members of theNegotiated Dealing System (NDS) whomaintain Current account with ReserveBank and through Internet for otherentities who do not maintain Currentaccount with Reserve Bank.

● Membership (including AssociateMembership) of CBLO segment isextended to banks, financial institutions,insurance companies, mutual funds,primary dealers, NBFCs, non-GovernmentProvident Funds, Corporates, etc.

● Eligible securities are Central Governmentsecurities including Treasury Bills.

● Borrowing limits for members is fixedby CCIL at the beginning of the daytaking into account the securitiesdeposited by borrowers in their CSGLaccount with CCIL. The securities aresubjected to necessary hair-cut aftermarking them to market.

● Auction market is available only to NDSMembers for overnight borrowing andsettlement on T+0 basis. At the end ofthe auction market session, CCILinitiates auction matching processbased on Uniform Yield principle.

● CCIL assumes the role of the centralcounter party through the process ofnovation and guarantees settlement oftransactions in CBLO.

● Automated value-free transfer ofsecurities between market participantsand the CCIL was introduced during2004-05.

● Members can reckon unencumberedsecurities for SLR calculations.

● The operations in CBLO are exemptedfrom cash reserve requirement (CRR).

Market Repo

● To broaden the repo market, the ReserveBank enabled non-banking financialcompanies, mutual funds, housingfinance companies and insurancecompanies not holding SGL accounts toundertake repo transactions with effect

Annex I:Money Market Instruments for Liquidity Management


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from March 3, 2003. These entities werepermitted to access the repo marketthrough their ‘gilt accounts’ maintainedwith the custodians.

● Subsequently, non-scheduled urban co-operative banks and listed companieswith gilt accounts with scheduledcommercial banks were allowed toparticipate.

● Necessary precautions were built intothe system to ensure ‘delivery versuspayment’ (DvP) and transparency, whilerestricting the repos to Governmentsecurities only.

● Rollover of repo transactions inGovernment securities was facilitatedwith the enabling of DvP III mode of

settlement in government securitieswhich involves settlement of securitiesand funds on a net basis, effective April2, 2004. This provided significantflexibility to market participants inmanaging their collateral.

Some Assessments

● CBLO and market repo helped inaligning short-term money market ratesto the LAF corridor.

● Mutual funds and insurance companiesare generally the main supplier of fundswhile banks, primary dealers andcorporates are the major borrowers inthe repo market outside the LAF.

Source: Mohan (2007).

Annex I:Money Market Instruments for Liquidity Management (Concld.)

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● Administered interest rates ongovernment securities were replaced byan auction system for price discovery.

● Automatic monetisation of fiscal deficitthrough the issue of ad hoc TreasuryBills was phased out.

● Primary Dealers were introduced asmarket makers in the governmentsecurities market.

● For ensuring transparency in the tradingof government securities, Deliveryversus Payment settlement system wasintroduced.

● Repurchase agreement (repo) wasintroduced as a tool of short-termliquidity adjustment. Subsequently, theLAF was introduced.

● LAF operates through repo and reverserepo auctions and provide a corridor forshort-term interest rate. LAF hasemerged as the tool for both liquiditymanagement and also signalling devicefor interest rates in the overnightmarket. The Second LAF (SLAF) wasintroduced in November 2005.

● Market Stabilisation Scheme has beenintroduced, which has expanded theinstruments available to the ReserveBank for managing the enduring surplusliquidity in the system.

● Effective April 1, 2006, RBI haswithdrawn from participating inprimary market auctions of governmentpaper.

● Banks have been permitted toundertake primary dealer businesswhile primary dealers are being allowedto diversify their business.

● Short sales in government securities isbeing permitted in a calibrated mannerwhile guidelines for ‘when issued’market have been issued recently.

● The Banking Regulation Act, 1949 hasbeen amended recently whereby thefloor rate of 25 per cent for SLR has beenremoved.

Increase in Instruments in theGovernment Securities Market

● 91-day Treasury bill was introduced formanaging liquidity and benchmarking.Zero Coupon Bonds, Floating RateBonds, Capital Indexed Bonds wereissued and exchange traded interest ratefutures were introduced. OTC interestrate derivatives like IRS/ FRAs wereintroduced.

● Outright sale of central governmentdated security that are not owned havebeen permitted, subject to the samebeing covered by outright purchase fromthe secondary market within the sametrading day subject to certainconditions.

● Repo status has been granted to stategovernment securities in order toimprove secondary market liquidity.

Annex II:Reforms in the Government Securities Market – Institutional Measures


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Enabling Measures

● Foreign Institutional Investors wereallowed to invest in governmentsecurities subject to certain limits.

● Introduction of automated screen-basedtrading in government securities throughNegotiated Dealing System.

● Setting up of risk-free payments andsettlement system in governmentsecurities through Clearing Corporationof India Limited.

● Phased introduction of Real Time GrossSettlement System.

● Introduction of trading in governmentsecurities on stock exchanges forpromoting retailing in such securities,permitting non-banks to participate inrepo market.

● Recent measures include introductionof NDS-OM and T+1 settlementnorms.


Annex II:Reforms in the Government Securities Market – Institutional Measures (Concld.)

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● Evolution of exchange rate regime froma single-currency fixed-exchange ratesystem to fixing the value of rupeeagainst a basket of currencies andfurther to market-determined floatingexchange rate regime.

● Adoption of convertibility of rupee forcurrent account transactions withacceptance of Article VIII of the Articlesof Agreement of the IMF. De facto fullcapital account convertibility for nonresidents and calibrated liberalisation oftransactions undertaken for capitalaccount purposes in the case of residents.

Institutional Framework

● Replacement of the earlier ForeignExchange Regulation Act (FERA), 1973by the market friendly Foreign ExchangeManagement Act, 1999. Delegation ofconsiderable powers by Reserve Bank toAuthorised Dealers to release foreignexchange for a variety of purposes.

Increase in Instruments in theForeign Exchange Market

● Development of rupee-foreign currencyswap market.

● Introduction of additional hedginginstruments, such as, foreign currency-rupee options. Authorised dealerspermitted to use innovative products likecross-currency options, interest rateswaps (IRS) and currency swaps, caps/collars and forward rate agreements(FRAs) in the international forex market.

Liberalisation Measures

● Authorised dealers permitted to initiatetrading positions, borrow and invest inoverseas market subject to certainspecifications and ratification byrespective banks’ boards. Banks are alsopermitted to fix interest rates on non-resident deposits, subject to certainspecifications, use derivative productsfor asset-liability management and fixovernight open position limits and gaplimits in the foreign exchange market,subject to ratification by Reserve Bank.

● Permission to various participants in theforeign exchange market, includingexporters, Indians investing abroad,FIIs, to avail forward cover and enterinto swap transactions without anylimit subject to genuine underlying exposure.

● FIIs and NRIs permitted to trade inexchange-traded derivative contractssubject to certain conditions.

● Foreign exchange earners permitted toretain up to 100 per cent of their foreignexchange earnings in their ExchangeEarners’ Foreign Currency accounts.Residents are permitted to remit up toUS $ 1,00,000 per financial year.

● Borrowers eligible for accessing ECBscan avail of an additional US $ 250million with average maturity of morethan 10 years under the approval route.Prepayment of ECB up to US $ 300million without prior approval of theReserve Bank.

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● The existing limit of US $ 2 billion oninvestments in government securitiesby foreign institutional investors (FIIs)enhanced in phases to US $ 3.2 billionby March 31, 2007.

● The extant ceiling of overseasinvestment by mutual funds of US $ 2billion is enhanced to US $ 3 billion.

● Importers to be permitted to bookforward contracts for their customsduty component of imports.

● FIIs to be allowed to rebook a part ofthe cancelled forward contracts.

● Forward contracts booked by exportersand importers in excess of 50 per cent

of the eligible limit to be on deliverablebasis and cannot be cancelled.

● Authorised dealer banks to bepermitted to issue guarantees/letters ofcredit for import of services up to US $100,000 for securing a directcontractual liability arising out of acontract between a resident and a non-resident.

● Lock-in period for sale proceeds of theimmovable property credited to the NROaccount to be eliminated, provided theamount being remitted in any financialyear does not exceed US $ one million.


Annex III:Reforms in the Foreign Exchange Market – Exchange Rate Regime (Concld.)

development of financial markets in india* rakesh mohan · rakesh mohan markets, particularly over...

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