3.1 The money market is a key component of thefinancial system as it is the fulcrum of monetaryoperations conducted by the central bank in itspursuit of monetary policy objectives. It is a marketfor short-term funds with maturity ranging fromovernight to one year and includes f inancialinstruments that are deemed to be close substitutesof money. The money market performs three broadfunct ions. One, i t provides an equi l ibrat ingmechanism for demand and supply of short-termfunds. Two, it enables borrowers and lenders of short-term funds to fulfil their borrowing and investmentrequirements at an efficient market clearing price.Three, it provides an avenue for central bankintervention in influencing both quantum and cost ofliquidity in the financial system, thereby transmittingmonetary policy impulses to the real economy. Theobjective of monetary management by the centralbank is to align money market rates with the keypolicy rate. As excessive money market volatilitycould deliver confusing signals about the stance ofmonetary policy, it is critical to ensure orderly marketbehaviour, from the point of view of both monetaryand financial stability. Thus, efficient functioning ofthe money market is important for the effectivenessof monetary policy.

3.2 In order to meet these basic functionsefficiently, money markets have evolved over timespawning new instruments and participants withvarying risk profiles in line with the changes in theoperating procedures of monetary policy. Changes infinancial market structures, macroeconomicobjectives and economic environment have called forshifts in monetary regimes, which, in turn, havenecessitated refinements both in the operatinginstruments and procedures, and in institutionalarrangements by central banks.

3.3 Internationally, following the breakdown ofthe Bretton Woods system, there was a shift fromrule-based frameworks towards discretion in the useof monetary policy instruments, which ultimately ledto the gradual abandonment of exchange ratetargets. Changes in financial structures and financialinnovations also rendered monetary targetingineffective by making the money demand functionsunstable. Accordingly, since the early 1990s, there

has been a shift towards greater exchange rateflexibility and adoption of inflation targeting by somecentral banks partly because of increased capitalmobility, greater financial market integration andrepeated episodes of currency crises. Commensuratewith these changes, central banks have moved awayfrom conventional (direct) instruments of monetarycontrol (working through the quantum channel)towards more use of indirect instruments (operatingthrough the price channel). Accordingly, the use ofreserve requirements and direct credit controls hasbeen gradually de-emphasised, while relying moreon interest rates for signalling the monetary policystance. As central banks have only limited controlover long-term interest rates, the most commonlyadopted strategy has been to exert direct influenceonly on short-term interest rates and permittingmarket expectations to influence long-term interestrates through financial market inter-linkages. Thus,the choice of monetary policy instruments is guidedby the structure of the money market.

3.4 In India, although the ultimate goals ofmonetary policy, viz., growth and price stability, haveremained unchanged over the years, the ReserveBank has modified its operational and intermediateobjectives of monetary policy several times inresponse to changes in the economic and financialenvironment. For instance, in the mid-1980s, theReserve Bank formally adopted monetary targetingwith feedback as a nominal anchor to fight inflation,partly induced by the large scale monetisation of fiscaldeficits. The operating procedure in this regime wasmodulation of bank reserves by varying reserverequirements. In order to meet reserve requirements,banks borrowed primarily from the inter-bank (callmoney) market. Hence, these transactions werereflective of the overall liquidity in the system.Accordingly, the Reserve Bank focussed on the moneymarket, in particular, the call money market by usingvarious direct instruments of monetary control tosignal the policy stance consistent with the overallobjectives of achieving growth and price stability. Asinterest rates were regulated, monetary managementwas undertaken mainly through changes in the cashreserve ratio (CRR), which was used to influenceindirectly the marginal cost of borrowing by havingan initial impact on the call money market. As the

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success of this strategy was crucially dependent onthe stability of the call money market and its inter-linkages with other money market segments, reformssince the late 1980s, along with changes in thereserve maintenance procedures, have aimed atdeveloping various money market segments throughintroduction of new instruments, increasedparticipation and improved liquidity management inthe system.

3.5 Financial sector reforms since the early1990s have provided a strong impetus to thedevelopment of financial markets, which, along withinterest rate deregulation, paved the way forintroduction of market-based monetary policyinstruments. With financial innovations, moneydemand was seen as less stable and thedisequilibrium in money markets got reflected inshort-term interest rates (Mohan, 2006). Accordingly,since the adoption of the multiple indicator approachin 1998, although monetary aggregates continue tobe an important information variable, interest rateshave emerged as the operational instrument of policy– initially the Bank Rate and then the repo/reverserepo rates under the liquidity adjustment facility(LAF) from June 2000. This shift in emphasis frommoney to interest rates has been spurred byincreased financial liberalisation, greater tradeopenness and capital flows, and innovations inpayment and transactions technologies. Such a shiftwas gradual and a logical outcome of measuresimplemented in the reform period since the early1990s (Reddy, 2002). An array of new money marketinstruments such as commercial paper, certificatesof deposit and repos has been introduced in orderto broaden the money market. Furthermore, withincreased sophistication of financial markets, the riskprof i les of f inancial market par t ic ipants alsochanged, necessitating introduction of derivativeinstruments as effective risk management tools.

3.6 The liberalisation of capital controls resultingin increased integration of the Indian economy withthe global economy, however, posed new challengesand dilemmas for monetary and exchange ratemanagement in the 1990s. These developmentscalled for a greater emphasis on orderly conditionsin financial markets for ensuring financial stability.In this phase, the focus of reforms was on introducinginstruments of various maturities in different moneymarket segments and imparting liquidity to theseinstruments by developing a secondary market, and

streamlining the money market operations. Thisresulted in greater control over the liquidity in thesystem and created an efficient mechanism totransmit interest rate signals. Thus, changes in themonetary policy operating procedures necessitatedrefinements in money market microstructure throughintroduction of new instruments and widening ofpar ticipation under a deregulated interest rateenvironment.

3.7 The need for developed and well-integratedmoney market also assumes critical importance asIndia progressively moves towards greater capitalaccount convertibility, as envisaged by the Committeeon Fuller Capital Account Convertibility (FCAC), whichsubmitted its report to the Reserve Bank in July 2006.Better response to such financial flows by variousmarket segments will depend upon the extent ofintegration as well as the development of necessaryinfrastructure. The greater integration of domestic andinternational markets also calls for flexible use ofmonetary policy instruments for modulating domesticliquidity conditions and correcting any seriousmisalignments between short-term and long-terminterest rates.

3.8 Against the above backdrop, this chaptertraces the evolution of monetary policy operatingprocedures in India as necessitated by the changesin the financial market structure, in particular, themoney market, and the risks/challenges arising outof such market orientation of monetary policy.Section I spells out the theoretical underpinnings ofmoney market for monetary pol icy making.International experience on money market operatingprocedures, the evolving practices in l iquiditymanagement operations and the structure of moneymarket are set out in Section II. Section III presentsa brief review of the money market in India in thepre-reform period. Section IV deals with the changesin the Reserve Bank’s l iquidi ty managementoperations commensurate with the shifts in operatingprocedures. Developments in various segments ofthe money market since the mid-1980s are coveredin Section V. It also discusses the Reserve Bank’sproactive role in mitigating various risks to thefinancial system. Section VI identifies the emergingissues in monetary and liquidity management in Indiaand the need for addressing them in future for thesmooth functioning of the money market and theefficient conduct of monetary policy. Section VIIpresents the concluding observations.

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I. ROLE OF THE MONEY MARKET -THEORETICAL UNDERPINNINGS

3.9 There is a general consensus amongacademics and central bankers that monetary policyis best geared to achieve price stability. In somecountries, central banks have additional mandatessuch as ensuring full employment, maximising growthand promoting financial stability. In order to meet theseobjectives, central banks intervene in financialmarkets to ensure that short-term interest rates (andexchange rates) and liquidity are maintained atappropriate levels, consistent with the objectives ofmonetary policy. Thus, monetary policy and financialmarkets are linked intrinsically. It is through thefinancial markets that monetary policy affects the realeconomy. Hence, financial markets are the connectinglink in the transmission mechanism between monetarypolicy and the real economy.

3.10 The relationship between monetary policy andfinancial markets is of mutual inter-dependence.Central banks conduct monetary policy by directly andindirectly influencing financial market prices. Financialmarket prices reflect the expectations of marketparticipants about future economic developments.These expectations, in turn, provide valuableinformation to central banks in setting the optimalcourse of monetary policy in the future.

3.11 Monetary policy affects financial marketsthrough various financial price and quantity channels.The transmission process from monetary policy tofinancial markets and finally to the real economy istypically triggered through the use of monetary policyinstruments (reserve requirements, open marketoperations, policy rates and refinance facilities) forcontrolling the operating targets (like reserve moneyand bank reserves) consistent with intermediatetargets such as money supply, which enablesattainment of final objectives of economic growth andpr ice stabil i ty. Typical ly, the monetary pol icyinstrument is a financial market price, which isdirectly set or closely controlled by the central bank.For most central banks with floating exchange rates,the monetary policy instrument is a short-terminterest rate. Changes in the short-term policy rateprovide signals to financial markets, whereby varioussegments of the f inancial system respond byadjusting their rates of return on various instruments,depending on their sensitivity and the efficacy of thetransmission mechanism. Under fixed exchange rateregimes, a particular exchange rate serves as theinstrument. Similarly, under the monetary targetingregime, the operating target is the quantity of central

bank money in the banking system, which isdetermined by the supply of bank reserves. If allfactors having an impact on output and inflation werecompletely known in advance, it would make nodifference whether the central bank conducts policyby fixing the supply of reserves or by setting aninterest rate (Friedman, 2000b). In fact, thesealternative operating strategies would be similar inimpact. However, since many factors that impact thecentral bank’s policy priorities are unpredictable, thechoice of the operating instrument matters for theeffectiveness of monetary policy.

3.12 The theoretical justification for the conduct ofmonetary policy through interest rates is derived from“the appropriate choice of instrument problem” (Poole,1970). It was demonstrated that if aggregate demandshocks in the economy originate from the goodsmarket (the IS curve), then the optimum policy is totarget monetary aggregates for minimising outputfluctuations. On the other hand, if demand shocksoriginate in the money market (the LM curve), fromthe perspective of monetary policy, targeting interestrates is the appropriate approach. The implicationbeing that as f inancial markets develop withincreasing financial innovations, the demand formoney becomes unstable, rendering monetarytargeting redundant. In other words, with the gradualf inancial sophistication of the economy, thespeculative demand for money dominates thetransaction motive. Hence, most developed countriesoperate through an interest rate target.

3.13 The interest rate channel is the primarymechanism of monetary policy transmission inconventional macroeconomic models where anincrease in nominal interest rates, given some degreeof price stickiness, translates into an increase in thereal rate of interest and the user cost of capital(Exhibit III.1) . These changes, in turn, lead to apostponement in consumption or a reduction ininvestment spending thereby affecting the working ofthe real sector, viz., changing aggregate demand andsupply, and eventually growth and inflation in theeconomy (Kuttner and Mosser, 2002). This is themechanism embodied in conventional specificationsof the “IS” curve, both of the “Old Keynesian” variety(Samuelson and Solow, 1960) and the “New Keynesian”models developed during the 1990s (Rotemberg andWoodford, 1997; Clarida, Gali, and Gertler, 1999).However, the macroeconomic response to policy-induced interest rate changes is considerably largerthan that implied by conventional estimates of theinterest elasticities of consumption and investment

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(Bernanke and Gertler, 1995). This suggests thatmechanisms, other than the interest rate channel, mayalso be at work in the transmission of monetary policy1 .

3.14 Interest rates can influence the monetarypolicymaking process in three dist inct ways(Friedman, 2000a). The first role of interest rates isas an instrument variable that the central bank setsin order to implement its chosen policy. A secondpotential role for interest rates in the monetary policyprocess is again as an instrument variable, but as aninstrument that the central bank varies not forinfluencing output and inflation directly but rather fortargeting the money stock. Finally, most central banksuse short-term interest rate as their monetary policyinstrument variable based on long-term interest ratemovements, which are taken as more of aninformation var iable about potential futuredevelopments. Implicit in this framework, however, isa regular term structure of interest rates wherebypolicy initiatives at the short end are transmittedefficiently to the longer end of the maturity spectrum.This relationship fares better under the assumptionof adaptive expectations (Chow, 1989), while recentempirical evidence suggests that long-term rates arepoor (and biased) predictors of future short-termrates, particularly when expectations are rational(Blinder, 2006).

3.15 Short-term interest rates alone have onlylimited direct effects on the economy. Long-terminterest rates have a stronger impact as theydetermine savings and investment decisions in theeconomy. In order to impact the economy, monetarypolicy impulses must, therefore, be transmitted fromthe money market to the capital market by influencingasset prices such as loan rates, bond rates, exchangerates and stock market valuations. The money marketand the capital market are linked by expectations.Neglecting transaction costs and risk premiums, theexpectations theory of the term structure views thelong-term interest rate as an average of the short-term interest rates expected to prevail till the maturityof the respective instrument. Although current short-term interest rates have some effect on longer-termbond yields, the expectations theory of the termstructure indicates that it is primarily expected futureshort-term interest rates which determine bond yields.In practice, owing to uncertainty about the futureevolution of short-term interest rates and the time-varying risk premiums, the longer the maturity, theweaker the link between current short-term rates andlong-term rates. Therefore, in practice, central bankssometimes find it difficult to guide longer-term interestrates to a level commensurate with what they considerto be the optimal monetary policy stance.

1 The changes in the policy rate, by inducing international interest rate differentials, also have a bearing on exchange rate movements through theuncovered interest rate parity condition.

Source: Adapted from Kuttner and Mosser (2002).

Exhibit III.1: Monetary Policy Transmission through Interest Rate Channel

Monetary Policy Operations (OMO, Reserve Requirements, Refinance)

Change in Reserves

Short-term Interest Rate Monetary Base

Money Supply

Market Interest Rate

Real Interest Rate

Interest Rate Channel

Aggregate Demand

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3.16 Central banks, nevertheless, operate onshort-term policy rates, which under a regular term-structure and a smooth market continuum would beable to influence long-term interest rates. In order toefficiently transmit monetary policy signals to long-term rates, central banks foster development of themoney market. The money market, thus, serves asthe corner-stone of a competitive and efficient systemof market-based intervention by the central bank. Itstimulates an active secondary bond market byreducing the liquidity risk of bonds and other short-term financial instruments and assists financialintermediaries in managing their liquidity risk. It alsoserves as the medium for Government cashmanagement and provides the first l ink in theimplementation of monetary policy. There are threeconditions which are required to be fulfilled fordeveloping a well-functioning money market. Theseare: (i) banks and other financial institutions must becommercially motivated to respond to incentives,actively manage risk and maximise profit; (ii) thecentral bank must shift from direct to indirect methodsof implementing monetary policy; and (ii i) theGovernment must have a good mechanism of cashmanagement, thereby giving the central bank greaterfreedom in setting its operating procedures.

3.17 The central bank’s operating proceduresgreatly influence the stability of the money market aswell as banks’ incentives to actively use the moneymarket to manage risk. In this regard, operatingprocedures need to be designed appropriately topromote market liquidity, stability and encourageactive risk management. The operating proceduresthat particularly influence banks’ risk managementincentives are the reserve maintenance period, thedefinition of liabilities on which reserves are levied,accommodation policy and the accuracy of operationsdesigned to affect market liquidity - that is, theaccuracy with which the central bank can control thedemand for excess reserves in the system.

3.18 Development of liquidity in the inter-bankmarket - the market for short-term lending/borrowingamongst banks - provides the basis for growth andincreased liquidity in the broader money market,including secondary market for Treasury Bills andprivate sector money market instruments. While thecentral bank’s liquidity management operationsencompass discretionary injections or withdrawals ofprimary money from the financial system at its owninitiative, its accommodation policy comprisesoperations to meet the demand for liquidity frommarket participants. Market liquidity management

refers to actions taken by the central bank to managethe overall level of high-powered money and, throughthis, to regulate money market conditions (Box III.1).The regulation of money market conditions focusseson offsetting the demand for excess reserves in orderto avoid large fluctuations in bank reserves causingvolatility in short-term interest rates. Successfulmarket liquidity management requires that the dailylevel of excess reserves in the banking system beclose to the level demanded by banks.

3.19 Theoretically, the speed of transmission ofpolicy signals to financial asset prices improves withderivatives trading as it enables risk sharing acrossthe market as well as reflects the inter-temporaladjustments of financial asset prices to monetarypolicy signals. A financial derivative contract derivesthe future price for the underlying asset on the basisof its current price and interest rates. Accordingly, theefficient pricing of derivatives is contingent upon anactive and liquid market for the underlying asset. Asthe informational content of the market is reflected inprices of derivatives, there is a case for usingderivatives as monetary policy instruments. It is,however, noted that central banks do not usederivative instruments actively for monetary policypurposes as they are normally considered to be riskyand uncertain. Furthermore, the impact of derivativestrading on the real economy remains ambiguous (Grayand Place, 2001). Der ivatives, however, areincreasingly becoming a useful tool for r iskmanagement in financial markets.

3.20 To sum up, the interest rate channel hasemerged as a key channel of monetary policytransmission mechanism. Although the central bankcan directly influence mainly shor t-term rates,effective transmission of policy signals requires aproper term structure of interest rates, which isdependent on market par ticipants’ expectationsabout the future movements in policy rates. A well-functioning money market is, therefore, essential forconducting indirect, market-based monetary policyoperations and for providing the liquidity necessaryfor the market in government securities and privatesector bonds. By careful management of liquidityconditions, the central bank can realise its monetarypolicy objectives and encourage money markettransactions while ensuring stable market conditions.A vital element for conducting effective monetarypolicy is knowledge of Government cash flows,which, like central bank’s open market operations,also affect bank’s reserve balances.

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The money market forms the first and foremost link in thetransmission of monetary policy impulses to the realeconomy. Policy interventions by the central bank alongwith its market operations influence the decisions ofhouseholds and firms through the monetary policytransmission mechanism. The key to this mechanism isthe total claim of the economy on the central bank,commonly known as the monetary base or high-poweredmoney in the economy. Among the constituents of themonetary base, the most important constituent is bankreserves, i.e., the claims that banks hold in the form ofdeposits with the central bank. The banks’ need for thesereserves depends on the overall level of economic activity.This is governed by several factors: (i) banks hold suchreserves in proportion to the volume of deposits in manycountries, known as reserve requirements, which influencetheir ability to extend credit and create deposits, therebylimiting the volume of transactions to be handled by thebank; (ii) bank’s ability to make loans (asset of the bank)depends on its ability to mobilise deposits (liability of thebank) as total assets and liabilities of the bank need tomatch and expand/contract together; and (iii) banks’ needto hold balances at the central bank for settlement of claimswithin the banking system as these transactions are settledthrough the accounts of banks maintained with the centralbank. Therefore, the daily functioning of a modern economyand its financial system creates a demand for central bankreserves which increases along with an expansion inoverall economic activity (Friedman, 2000b).

The central bank’s power to conduct monetary policy stemsfrom its role as a monopolist, as the sole supplier of bankreserves, in the market for bank reserves. The mostcommon procedure by which central banks influence theoutstanding supply of bank reserves is through “openmarket operations” – that is, by buying or sell inggovernment securities in the market. When a central bankbuys (sells) securities, it credits (debits) the reserve accountof the seller (buyer) bank. This increases (decreases) thetotal volume of reserves that the banking system collectivelyholds. Expansion (contraction) of the total volume ofreserves in this way matters because banks can exchangereserves for other remunerative assets. Since reserves earnlow interest, and in many countries remain unremunerated,banks typically would exchange them for some interestbearing asset such as Treasury Bill or other short-term debtinstruments. If the banking system has excess (inadequate)reserves, banks would seek to buy (sell) such instruments.If there is a general increase (decrease) in demand forsecurities, it would result in increase (decline) in securityprices and decline (increase) in interest rates. The resultinglower (higher) interest rates on short-term debt instrumentsmean a reduced (enhanced) opportunity cost of holdinglow interest reserves. Only when market interest rates fall

Box III.1 Role of the Money Market in the Monetary Transmission Mechanism

(rise) to the level at which banks collectively are willing tohold all of the reserves that the central bank has suppliedwill the financial system reach equilibrium. Hence, an“expansionary” (contractionary) open market operationcreates downward (upward) pressure on short-term interestrates not only because the central bank itself is a buyer(seller), but also because it leads banks to buy (sell)securities. In this way, the central bank can easily influenceinterest rates on short-term debt instruments. In thepresence of a regular term structure of interest rates andwithout market segmentation, such policy impulses gettransmitted to the longer end of the maturity spectrum,thereby influencing long-term interest rates, which have abearing on household’s consumption and savings decisionsand hence on aggregate demand.

There are alternative mechanisms of achieving the sameobjective through the imposition of reserve requirementsand central bank lending to banks in the form of refinancefacilities. Lowering (increasing) the reserve requirement,and, therefore, reducing (increasing) the demand forreserves has roughly the same impact as an expansionary(contractionary) open market operation, which increases(decreases) the supply of reserves creating downward(upward) pressure on interest rates. Similarly, another wayin which central banks can influence the supply of reservesis through direct lending of reserves to banks. Centralbanks lend funds to banks at a policy rate, which usuallyacts as the ceiling in the short-term market. Similarly,central banks absorb liquidity at a rate which acts as thefloor for short-term market interest rates. This is important,since injecting liquidity at the ceiling rate would ensurethat banks do not have access to these funds for arbitrageopportunities whereby they borrow from the central bankand deploy these funds in the market to earn higher interestrates. Similarly, liquidity absorption by the central bank hasto be at the floor rate since deployment of funds with thecentral bank is free of credit and other risks. Typically, theobjective of the central bank is to modulate liquidityconditions by pegging short-term interest rates within thiscorridor.

While the above mechanism outlines how central bankscan influence short-term interest rates by adjusting thequantity of bank reserves, the same objective can beachieved by picking on a particular short-term interest rateand then adjusting the supply of reserves commensuratewith that rate. In many countries, this is achieved bytargeting the overnight inter-bank lending rate andadjusting the level of reserves which would keep the inter-bank lending rate at the desired level. Thus, by influencingshort-term interest rates, central banks can influenceoutput and inflation in the economy, the ultimate objectivesof monetary policy.

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II. OPERATING PROCEDURES AND MONEYMARKET - INTERNATIONAL EXPERIENCE

3.21 The objectives, targets and operatingprocedures of monetary policy worldwide havewitnessed considerable shifts in tune with theevolution of monetary theory, central banking regimesand the changing macroeconomic conditions overtime. By the 1970s, most central banks came to acceptprice stability as a key objective of monetary policy -a departure from the earlier prominence given togrowth and employment objectives. In recent years,beyond the traditional growth-inflation trade-off,financial stability has emerged as another keyobjective in the wake of growing financial marketintegration and associated uncertainty and volatilityarising out of contagion. Although a number of centralbanks in developed countries such as the ReserveBank of New Zealand, Reserve Bank of Australia andthe Bank of England have adopted price stability astheir sole objective by adopting an inflation targetingframework, several other countries, viz., the US andJapan continue to pursue dual objectives of pricestability and growth. Similarly, while some emergingmarket economies (EMEs) such as South Africa,Thailand, Korea and Mexico have emphasised solelyprice stability by adopting an inflation targetingframework, some others tend to follow multipleobjectives.

Monetary Policy Frameworks

Intermediate Targets

3.22 As central banks could not always directlytarget the ultimate objective, monetary policy focussedon intermediate targets that bear close relationshipwith the final objective. The selection of intermediatetargets is conditional on the channels of monetarypolicy transmission that operate in the economy. Theprocess of rapid disintermediation sparked off by aspate of financial innovations during the 1980s beganto impact the monetary targeting framework (Solans,2003). Accordingly, with money demand becomingunstable, central banks began to modulate aggregatedemand by targeting interest rates. As a result, centralbanks in the US (1992) and Japan (1994-2001)2,among others, adopted inter-bank rates asintermediate targets. Financial liberalisation, however,has reduced the importance of explicit intermediate

targets in several countries, thereby prompting manycentral banks to adopt a multiple indicator approach.Under this approach, many central banks such as theUS Federal Reserve, the European Central Bank andthe Bank of Japan regularly monitor a number ofmacroeconomic indicators such as prices, outputgaps, and developments in asset, credit and otherfinancial markets, which have a bearing on pricestability.

3.23 Some EMEs such as Russia and Chinacontinue to specify intermediate targets in the formof monetary aggregates. Some other countries suchas Indonesia, however, use indicative monetarytargets more as an important information variable,supplementing it with other indicators of developmentsin f inancial markets and the real economy.Furthermore, along with the adoption of inflationtargeting by many EME central banks, there has beenan increasing focus on the interest rate channel ofthe monetary transmission process.

Operating Targets

3.24 The process of monetary policyimplementation is guided mainly by the choice ofoperating targets. Notwithstanding the policyobjectives, the critical issue facing the monetaryauthorities is to strike a balance in the short-runbetween instruments and targets. In recent years, acertain degree of consensus has emerged both in theindustrialised countries and EMEs to use market-oriented instruments, driven mainly by the rapiddevelopment and deepening of various financialmarket segments, the diversification of financialinsti tut ions and the globalisation of f inancialintermediation (Van’t dack,1999).

3.25 With the gradual development andsophistication of money markets in a deregulatedregime, there has been a shift from Keynesian growth-and full-employment-or iented monetary policyoperating on monetary aggregates to an inflation-oriented monetary policy operating on interest rates.With the growing sophistication of markets, thetraditional dir igiste, direct control approach tomonetary policy has become obsolete, while indirectmarket or iented approach has gained greateracceptance (Forssbaeck and Oxelheim, 2003).

2 The Bank of Japan shifted to quantitative easing policy since March 2001 but again decided on March 9, 2006 to change the operating targetfrom the outstanding balances of current accounts at the Bank to the uncollateralised overnight call rate.

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3.26 Among the two operating procedures, viz.,through bank reserves and interest rates, the focushas increasingly shifted towards the latter since theearly 1990s due to the broader changes that tookplace in the economic environment (Borio, 1997). Thetrend reflects the growing role played by interest ratesin the transmission mechanism as markets developin a deregulated environment. The sharper focus oninterest rates as the operating target has gone handin hand with a tendency to move towards targetingshort-term interest rates. As a corollary, the overnightrate has emerged as the most commonly pursuedoperating target in the conduct of monetary policy.Hence, the focus has been concentrated on moneymarkets for transmitting monetary policy signals. Thetargeting of short-term interest rates is fully consistentwith a market oriented approach whereby informationabout the expectations of future movements in interestrates is extracted from the prevailing market rates.

3.27 Although countries differ in terms of thechoice of instruments, they could be broadly classifiedon the basis of their key operating targets (interestrates) (Annex III.1). In the first category are countriessuch as the US, Japan, Canada and Australia, wherethe key operating target is the overnight inter-bankrate although the signalling strategies differ. In thecase of other developed countries such as the ECB,the key policy rate is the tender rate that is applicableto regular operations, mainly, the refinancingoperations. Some central banks, however, in countriessuch as the UK, select overnight market interest ratesas their operating target consistent with the officialBank Rate decided by the MPC. In general, thematurity of such interest rates varies from 1 to 2 weeksbut could range between 1 or 2 days to 1-month.

3.28 The operating target in the case of severalEMEs also is the overnight rate - determined in theinter-bank market for settlement balances (Korea andMalaysia) (Annex III.2). In order to promote financialstability, central banks, being the monopolisticsuppliers of primary liquidity, have endeavoured tosmoothen the movements in the overnight rate with ahigh degree of precision through calibratedmodulation of bank reserves. Central banks havegenerally refrained from strict control of interest ratesas it deters the development of money markets.Allowing the volatility in the overnight rate to absorbtemporary pressure could enable central banks topreserve stability in other money market segments.

3.29 Central banks have used several techniquesin order to contain the interest rate volatility - theaveraging of reserve requirements and use of

standing facilities to define an interest rate corridor.Most of these countries steer the overnight rateswithin a corridor - lower bound (floor) set by thedeposit facility and upper bound (ceiling) representedby the lending facility. These corridors are normallyconsiderably wide, allowing for the significant flexibilityin the movement of both policy and overnight rates(Borio, op.cit). With regard to the frequency of interestrate adjustments, most central banks prefer a policyof small and gradual changes.

Operating Procedures

3.30 The operating procedures of l iquiditymanagement have also changed in response to thechanges in the policy environment amidst financialliberalisation. The literature and the central banks’ ownaccounts attribute five main reasons for reform in theiroperating procedures in the industrial countries duringthe 1980s and the 1990s (Mehran et al., 1996 andForssbaeck and Oxelheim, op cit). First, monetarypolicy instruments were changed to adapt to the newoperational frameworks of the respective monetaryauthor it ies. Second, with f inancial deepeningoccurring more or less entirely outside the centralbanks’ balance sheets, the share of the financialsystem over which monetary authorities had directcontrol was reduced, warranting indirect (price-oriented as opposed to quantity-oriented instruments)ways to control the non-monetary components ofliquidity in the financial system. Third, in the wake ofexpansion, diversification and integration of financialmarkets all over the world, greater interest rateflexibility and narrowing of differentials between ratesof return in different currencies warranted instrumentsthat can impart flexibility to liquidity management interms of the timing, magnitude and accuracy. Fourth,the growing importance of expectations in financialmarkets favoured the adoption of instruments that arebetter suited for signalling the stance of monetarypolicy. Finally, there was a growing urge on the partof central banks to stimulate money market activityand improve monetary policy transmission whileemphasising the separation of monetary andGovernment debt management objectives.

3.31 As a result of the changes in the policyenvironment, the following trends could be observedat the international level, particularly during the 1990s(Borio, op.cit and Van’t dack, op.cit). First, there hasbeen a continuous reduction in reserve requirements.The marked international trend towards reduction inreserve requirements over the last decade reflectsthe conscious policy effort to reduce the tax on

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intermediation with a view to reducing the burden ofinstitutions and generate a level playing field, bothbetween different types of domestic institutions andincreasingly those across national borders. Althoughthe fluctuations in liquidity levels engendered byautonomous factors could be modulated through thebuffer stock property of reserve requirements andthrough active liquidity management by means ofdiscretionary operations3, internationally, the generaldownward trend in reserve ratios has been shiftingthe balance towards liquidity activism. This has alsobeen made possible by the increase in excessmaintenance of reserves whereby banks circumventthe impact of changes in reserve requirements.

3.32 Central banks in EMEs tend to use reserverequirements to offset autonomous influences on bankliquidity more frequently than in developed countries.While reserve requirements play a different role inEMEs than in developed countries, there has been aconvergence towards lower levels whiledeemphasising their role as active instruments ofmonetary control. Thus, in recent years, reserverequirements have been giving way to a more marketoriented approach of impounding liquidity, includingthrough the issue of central bank paper.

3.33 Second, there has been a growing emphasison active liquidity management driven partly by thepressures of increasingly mobile international capitaland decline in reserve requirements. With a view todeveloping money markets by reducing the relianceon accommodation from the central bank and in orderto impart greater flexibility in interest rate adjustments,liquidity management has largely been implementedthrough discretionary operations at the expense ofstanding facilities, particularly since the early 1980s.As a corollary, central banks have widened the rangeof instruments used in their market operations,shortened the maturity of transactions, increased theirfrequency and complemented regular basicrefinancing operations with other f ine-tuningoperations.

3.34 The reliance on market operations rather thanstanding facilities for balancing the market for bankreserves was also necessitated by the need to developmore flexible and less intrusive implementationprocedures. Hence, the main instruments for liquiditymanagement by central banks are discretionarymarket operations. Conversely, standing facilities have

become ‘safety valves’ rather than the keymechanisms for setting the interest rate. They areoperated at the margin in order to bridge temporarymismatches in liquidity. In the case of EMEs also,there has been a movement away from standingfacilities. With the development and integration of newfinancial markets, bank intermediation became lessdominant as households parked a part of their savingsoutside the banking sector. As a result, enterprisesincreasingly started tapping non-bank sources offunding. Consequently, aggregate spending becamesensitive to more than just bank-determined interestrates as policy induced changes in interest rates alsoinfluenced demand through the wealth effect of assetprices. Accordingly, the asset channel of monetarytransmission, which focusses on developing newinstruments and procedures for influencing financialmarket expectations and behaviour, has gained addedimportance.

3.35 Third, among the wide array of monetarypolicy instruments, repos have almost become themain policy tool, which could be considered a majormilestone in the development of money markets.Countries (including EMEs) have preferred reposmore than the outright open market operationsbecause they do not require an underlying market forsecurities and they tend to break the link betweenthe maturity of the paper and that of the transaction.The emergence and subsequent rapid growth ofpr ivate repo markets in recent years, oftenencouraged by the central banks themselves, havespurred the usage of these instruments.

3.36 Most EMEs have assigned repos a major rolein the day-to-day management of bank reserves. Anactive market for repos and reverse repos has beendeveloped in Korea, Mexico and Thailand. Theunderlying eligible assets are mainly government fixedincome securities. In the case of thin markets, centralbanks have responded by widening the range ofeligible securities. The central banks of the US, theECB, the UK, Singapore and Mexico also conductrepo operations involving corporate bonds ascollaterals.

3.37 Besides the rapid growth of domestic repomarkets in recent years, repurchase transactions arenow easily carried out across national borders also.This has been facil i tated by the InternationalSecurities Market Association (ISMA)

4, which plays

3 Discretionary operations include purchase/ sale of securities or more often reverse transactions in domestic or foreign currency.4 Since July 2005, ISMA merged with Primary Market Association to become the International Capital Market Association.

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an important role by establishing uniform tradingprocedures in the international bond markets. This hashelped large banks/other financial institutions to covershort-term liquidity mismatches. Accordingly, theinternational financial system has experienced anincrease in global integration. It is widely believed thatthe growth of the collateralised repo market hasplayed an important role in enhancing the overallstabil i ty of the f inancial system by removingcounterparty risks through funded credit protectionagainst risky transactions in unsecured wholesalefinancial markets (Joshi, 2005).

3.38 Four th , greater f lexibi l i ty in l iquiditymanagement has been accompanied by a greatertransparency in the policy signals relating to desiredinterest rate levels, driven by the broader changes inthe economic and political environment, including thedecline in inflation to relatively low levels, growingemphasis on inflation targeting, greater autonomy andaccountability of central banks and growing influenceof market forces and expectations in the formation ofinterest rates. The main structural factors shapingpolicy implementation are also induced by thechanges in payment and sett lement systems,particularly, the broad-based introduction of real timegross settlement system.

Central Bank Operations

3.39 With regard to market operations, mostcentral banks conduct at least one transaction at aregular interval in order to meet the basic liquidityneeds of the system. The other complementaryoperations that take place are calibrated responsesto day-to-day market condit ions, f ine-tuningoperations providing liquidity over longer horizons (theUS and Japan) and mopping up of excess liquiditywith a view to inducing ex ante liquidity shortage (theUK). The maturity of these operations is usuallyrelatively short for key operations, shorter for day-to-day calibration and longer for other operations.

3.40 In some countries, outright transactions alsoplay a role. For instance, in the US, periodic purchasesand sales of government securities are used aspermanent additions/withdrawals of reserves. InJapan, the central bank regular ly purchasesgovernment bonds to supply the base money. In thecase of EMEs, outright transactions in the secondarymarkets remain important instruments, particularly tooffset structural liquidity surpluses/shortages. Inrecent years, however, there has been an increasingtrend towards allowing greater leeway to market forcesin determining the interest rates. Hence, there is

reluctance to conduct outright transactions in thegovernment securities market.

3.41 Although country practices vary, the operatingprocedures of monetary policy of most central banksare beginning to converge to one of the variants ofthe three-closely related paradigms. The first set ofcentral banks, including the US Federal Reserve,estimate the demand for bank reserves and then carryout open market operations to target short-terminterest rates, especially if their financial markets aredeep enough to transmit changes at the short end tothe longer end of the term structure. A second set ofcentral banks such as in Russia and Mexico estimatemarket liquidity and carry out open market operationsto target bank reserves, while allowing interest ratesto adjust, especially if their credit channels arestrong. In the third category, a growing number ofcentral banks including the European Central Bank(ECB) and a large number of inflation targetersmodulate monetary conditions in terms of both thequantum and price of liquidity through a mix of openmarket operations (OMOs), standing facilities andminimum reserve requirements and changes in thepolicy rate but do not announce pre-set money orinterest rate targets.

3.42 These developments together with thegrowing integration of markets have warrantedaccurate forecasts of liquidity, par ticular ly theautonomous supply of bank reserves and its demandby the banking system. The operations of centralbanks have become critically contingent on theseforecasts. The features of the forecasting process varysignificantly across the countries, reflecting theiroperating frameworks of monetary policy. SeveralEMEs also conduct forecasts on a regular basis withplanning horizons ranging from one day to severalmonths.

3.43 Regarding the number of instruments, countrypractices differ widely. Central banks in countries suchas Canada conduct one or two type of operations atthe most, which are suff icient for l iquiditymanagement, whereas central banks in Japan andthe UK rely on a broad range of operations. The rangeof underlying securities traded and collateral acceptedis broad in Japan and several European countries,including various types of public and private claims.Conversely, in the US, New Zealand and Australia,central banks operate on the basis of public sectorassets.

3.44 The choice of counterpar t ies var iessubstantially across the countries. For instance, in

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the US, the Fed deals only with a restricted group ofprimary dealers. In the UK, each market operationand standing faci l i ty has a specific set ofcounterparties. There is a wide range of counterpartiesin different countries. For instance, only banks act ascounterparties in Mexico, while in Korea apart frombanks, merchant banks, investment/trust companiesand securities companies also act as counterparties.While level playing field considerations may favourmany counterparties, efficiency considerations maycall for a system of primary dealers. If the domesticsecurities markets are not deep, central banksengage in foreign exchange swaps for liquiditymanagement purposes (South Africa and Thailand).

3.45 Most central banks, thus, prefer open marketoperations (OMO) as a tool of monetary policy, whichallow them to adjust market liquidity and influencethe interest rate structure across tenors through anauction mechanism in which market participants areable to bid their preferences. The particular form ofoperations such as outright transactions in eligiblesecurities, repos and sometimes standing deposit/lending faci l i ty, often depend on the specif icmacroeconomic conditions and the existing legalframework of the country.

Government’s Surplus Cash Balances

3.46 Government’s large surplus cash balancesheld with the central bank can have a significantimpact on liquidity in the banking system (andthereby could have a bearing on short-term interestrates) necessitating active management of suchsurplus balances. Accordingly, arrangements whichfacilitate transfer of surplus funds from Government’saccount to deficit participants in the system couldhelp in better management of l iquidity. Sucharrangements not only enable the Governments toearn better returns on the cash balances, but alsomitigate volatility in short-term interest rates andkeep overnight money market rates stable. Thecross-country practices on such arrangements varywidely. For instance, while the cash balances of theCentral Government are auctioned (competitively)on a daily basis in Canada, all government balancesare maintained with their respective central banksin Japan and Italy. In the US and France, a significantworking balance is maintained with their centralbanks while amounts beyond the targeted balanceare invested in the market. Such surplus balanceshave also been effectively used as an instrument ofsterilisation by many central banks. The Governmentof Singapore, for instance, issues government

securities in excess of the fiscal requirements andparks the surplus funds with the Monetary Authorityof Singapore (MAS) as deposits, thus, supplementingits draining operations. Countries such as Malaysia,Thailand and Indonesia have modulated excessliquidity in the financial system by diverting government/public sector deposits from the commercial bankingsystem to the central bank.

3.47 To sum up, some lessons emerge from theinternational experience on liquidity management ofboth developed and emerging market economies.First, with the deepening of financial markets and thegrowth of non-bank intermediaries, central banksneed to increase the market orientation of theirinstruments. A large proportion of reserves is suppliedthrough open market operations with standingfaci l i t ies being l imited to providing marginalaccommodation or emergency finance. Furthermore,high reserve requirements tend to inhibit inter-bankactivity. Similarly, easy and cheap access to centralbank standing facilities impedes proactive liquiditymanagement by banks.

3.48 Second, in view of growing complexities ofmonetary management, monetary policy formulationhas been guided by a number of macroeconomicindicators rather than a single intermediate nominalanchor.

3.49 Third , the growing impor tance and theflexibility of financial market price and its transmissionmechanism in a deregulated environmentnecessitated central banks to focus increasingly oninterest rates rather than bank reserves in liquiditymanagement. Central banks need to ensure smoothtrend in interest rates for several reasons. Forinstance, volatile interest rates can obscure policysignals, while more orderly market conditions promotea rapid and predictable transmission of monetarypolicy impulses. Less volatile interest rates may alsohelp financial institutions to better assess and managetheir market risks. Market participants benefit fromstable rates through stabilisation of expectations,which, in turn, promote the development of a termstructure in the money market.

3.50 Fourth, with reduced market segmentationand the greater ease and speed with which interestrate changes are transmitted across the entire termstructure, central banks need to focus on the veryshort end of the yield curve, where their actions tendto have the maximum impact.

3.51 Fifth, the greater market orientation of thecentral banks’ policy instruments has been associated

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with a preference for flexible instruments. In volatilefinancial conditions, most notably in the EMEs, theflexibility in the design of policy instruments hasemerged as a key consideration.

3.52 Finally , the growing awareness of theimportance of market psychology and expectationshas warranted greater transparency in the conductof monetary policy with special emphasis oncommunication policy for conveying the stance andrationale of policy decisions.

Structure of the Money Market

Instruments

3.53 In view of the rapid changes on account offinancial deregulation and global financial marketsintegration, central banks in several countries havestriven to develop and deepen the money markets byenlarging the ambit of instruments5 and participantsso as to improve the transmission channels ofmonetary policy. The structure of money marketsdetermines the type of instruments that are feasiblefor the conduct of monetary management. Evidenceand experience indicate that preference for market-oriented instruments by the monetary authoritieshelps to promote broader market development(Forssbaeck and Oxelheim, op cit).

3.54 The diminishing role of quantitative controlsand search for alternatives gave rise to three majormarket-or iented instruments, viz., shor t-termsecurities, repurchase operations and swaps. Theseinstruments prompted the central banks to create,stimulate and support the development of marketsparticularly, inter-bank deposit market and short-termsecurities market. In the absence of an efficient inter-bank market, there was a pressing need for the centralbanks to create adequate instruments to absorbliquidity and stimulate the formation of markets foralternative short-term assets. The emergence of theshort-term securities market added a new dimension toliquidity management by central banks. In the absenceof outright transactions in the securities market, theexistence of a liquid securities segment in the moneymarket is often believed to facilitate the central bank’soperations by providing collateral to repurchaseagreements and similar collateralised transactions.

3.55 Among developed countr ies, the moneymarket in the US encompasses a large group of short-

term credit instruments, futures market instrumentsand the Federal Reserve’s discount window (AnnexIII.3). These are generally characterised by a highdegree of safety of principal and are most commonlyissued in units of US $1 million or more. Treasury Billsissued by the US Treasury and the securities issuedby the State and Local Governments have the largestvolume outstanding and constitute the most activesecondary market amongst al l money marketinstruments (MMIs) in the US. A key feature of mostState and local securities is that the interest incomeis generally exempt from federal income taxes, whichmakes them particularly attractive to investors in highincome tax brackets. Non-financial and non-bankfinancial businesses raise funds in the money marketprimarily by issuing commercial paper (CP) - a short-term unsecured promissory note. In recent years, anincreasing number of firms have gained access to thismarket, and issue of CPs has grown at a rapid pace.The outstanding CPs is expected to increase to US $2.17 trillion in 2007. Besides conventional instruments,money market futures and options have also becomepopular in the US money market in the recent period.

3.56 Similarly in the UK, the money market hasemerged as a mechanism for short-term fundingthrough the issuance of money market instrumentsor an active fixed-term cash deposit market. It isprincipally sterling-based but also covers a wide rangeof other currencies. The Government, the bankingsector and industry are among those who raiseresources from the money market through theissuance of Treasury Bills, certificates of deposit(CDs) and bills of exchange (BE)/CPs, respectively.Besides, Acceptances and Local Authority Bills alsoact as MMIs. Commercial bills include bank acceptanceand trade paper. Both overseas and inland trade isfinanced by bank acceptances. Much of the lending inthe market takes place overnight. The bulk (90 per cent)of the MMIs held are CDs and the rest are BEs, TreasuryBills and CPs.

3.57 In the Euro system, during the course of the1990s, repurchase transactions were adopted as amain liquidity management instrument in Denmark(1992), Sweden (1994), Austria (1995), Finland (mid-1990s), Switzerland (1998) and then in the whole Eurosystem since its inception (1999). Several countriessuch as Austria, the Netherlands and Denmark, inthe absence of adequate liquid short-term markets,came to rely on foreign exchange operations

5 Money market instruments facilitate transfer of large sums of money quickly and at a low cost from one economic unit (business,government, banks, non-banks and others) to another for relatively short periods of time.

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(particularly swaps) for liquidity management. In additionto marketable debt instruments, non-marketable debtinstruments and even some equities are eligible for repos.These are of two types, viz., Tier-1 fulfilling uniform euroarea-wide eligibility criteria of ECB and Tier-2, subjectto the eligible criteria specified by the national centralbanks and the ECB.

3.58 In Japan, the most active money marketsegment involves very short-term transactions, whichinclude the borrowing and lending of funds in the callmarket with or without collateral; the sale andpurchase of short-term securities such as CPs, CDsand short-term government bills such as TreasuryBills; and repo transactions with government and/municipal securities, government guaranteed bonds,corporate bonds and foreign government bonds aseligible collaterals. Purchases of shor t-termgovernment bills are used most frequently.

3.59 In Australia, the list of securities eligible underthe Intra-day Repurchase Agreement Facil i ty(introduced in 1998) has been broadened to coverseveral other instruments. These includecommonwealth government secur it ies (CGS),domestic debt securities and discount instrumentsissued by the central borrowing authorities of Stateand Territory Governments (permitted in 1997), andbank bills and CDs issued by select banks and selectdebt securities of approved supranational institutionsand foreign Governments. At the other end of thespectrum, Canadian MMIs comprise short-term papersof maturity up to 18 months that are issued by theGovernment, banks and corporations and are availablein the US and Canadian dollars. MMIs mainly compriseTreasury Bills and money market strips issued andguaranteed by the Government of Canada. There arealso Government guaranteed CPs, which are short-termpromissory notes issued by the Crown Corporationssuch as Canadian Wheat Board and the FederalBusiness Development Bank. The other MMIs includeTreasury Bills and promissory notes issued by theProvincial Governments, bankers’ acceptances issuedby corporations with an unconditional guarantee of amajor Canadian chartered bank and CPs issued by themajor corporations.

3.60 In several other EMEs such as Russia, SouthAfrica, China, Malaysia and Korea, the main moneymarket instruments are government Treasury Bills,repurchase agreements, bankers’ acceptances, CPsand CDs. In countries such as Thailand and Indonesia,central banks have aimed to expand the range ofinstruments by issuing their own bonds/certificates,viz., Bank of Thailand Bonds and Bank of Indonesia

Certificates. Moreover, in Thailand, other bonds suchas Financial Institution Development Fund Bonds andGovernment Guaranteed State Enterprise Bonds areused for repo operations. Foreign exchange swap isanother instrument that the Bank of Thailand uses toinfluence liquidity conditions in the money market.

Tenor

3.61 In the US, although maturities of MMIs rangefrom one day to one year, the maturity of mostcommon instruments is three months or less. In theUK, the main items in “period money” are borrowedfor 1 and 3 months, but banks may also borrow for aweek or for almost any time up to 12 months. TheCDs issued by the building societies and activelytraded by banks and discount houses have an originalmaturity of less than one year (although some CDshave a maturity of over a year). They are all short-term bearer negotiable debt instruments that areeither issued at a discount or bear a coupon. In thecase of ECB, the maturity of refinancing operationsranges from 1-week to 3-months and for debtsecurities up to 12- months. Japan’s tenor for its repois in the range of 1 week to 6-months. In Canada, thematurity of Treasury Bills ranges from 1-month to 1-year and that of money market STRIPS up to 18months and Government guaranteed CPs from 1-month to 1-year.

3.62 In other countr ies also, money marketinstruments are mostly short-term in nature – withtenor being generally less than a year. In mostcountries, call money transactions and the repurchaseagreements serve as the shorter duration segmentof money markets. The tenor of Treasury Bills is ofnormally 91-day, 182-day and 364-day. MarketStabilisation Bonds in Korea even have 546-daymaturity period. In the case of certain instrumentssuch as negotiable certificates of deposit (NCDs),tenor may be as long as five years also.

Participants

3.63 The major participants in the US money marketare commercial banks, Governments, corporations,Government-sponsored enterprises, money marketmutual funds, futures market exchanges, brokers anddealers and the Fed. Commercial banks are the majorparticipants in the market for federal funds, which arevery short-term, mainly overnight. Banks act asdealers in the money market for over-the-counterinterest rate derivatives, which has grown rapidly inrecent years. The Federal Reserve is also a keyparticipant in the US money market.

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3.64 Another important group of participants in theUS money markets include money market mutualfunds and local Government investment pools. Thesepools, which were virtually non-existent before themid-1970s, have grown to be one of the largestfinancial intermediaries in the US. A distinct featureof the US money market is that there are groups ofprivately owned financial intermediaries sponsored bythe Government who raise the funds and channelthem to farming and housing sectors of the economy.

3.65 In the UK, trading in the money market takesplace on an over-the-counter (OTC) basis for thesame day settlement. The money market attracts awide range of participants such as the Government,banking sector, industry and financial institutions suchas pension funds. The Bank of England and the UKDebt Management Office also make use of the moneymarket on a daily basis to fulfil their official obligations.Participants in the UK inter-bank market comprise thewhole of the banking community (including thediscount houses) and non-bank institutions (such asbuilding societies) and the market is served by anumber of money market brokers.

3.66 In the Euro system, the ECB, national centralbanks, the Governments and the eligible creditinstitutions participate in the money market. Similarly,in Australia, the Central Government, State andTerr itor ial Governments, the Reserve Bank ofAustralia, banks, Government agencies, otherGovernments of the Commonwealth andsupranational institutions are the major participants.In the case of Canada, the participants include bothFederal and Provincial Governments, banks, majorCrown Corporations such as Canadian Wheat Boardand Federal Business Development Bank.

3.67 In Japan, business units of Japanese andnon-Japanese banks located in Japan participate inthe uncollateralised money market to raise funds. Themajor participants in the uncollateralised overnightcall money market are the city banks which have thelargest share as borrowers, while regional banks actas major lenders. The other participants includeinstitutional investors such as investment trusts, trustbanks, regional banks, life insurance companies,specialised money market brokers and Keito6 . Thecounterparties of the Bank of Japan include banks,securities companies, security finance companies andmoney market brokers (Tanshi companies).

3.68 In most other countries, commercial banks,central banks, regional banks, specialised banks,investment and finance companies, merchant bankingcorporations, investment trust companies, insurancecompanies, securities finance corporations, creditinsurance funds and business enterprises are themajor participants in the money market.

III. MONEY MARKET IN INDIA – UP TO THEMID-1980s

3.69 The Indian money market prior to the 1980swas characterised by paucity of instruments, lack ofdepth and dichotomy in the market structure. Themoney market consisted of the inter-bank call market,Treasury Bills, commercial bills and participationcertificates. Historically, the call money market hasconstituted the core of the money market structure inIndia due to lack of other instruments and strictregulations on interest rates and participation.

3.70 In the call/notice money market, overnightmoney and money at short notice (up to a period of14 days) are lent and borrowed without collateral. Thismarket enables banks to bridge their short-termliquidity mismatches arising out of their day-to-dayoperations. The call money market in India was purelyan inter-bank market until 1971 when the erstwhileUnit Trust of India (UTI) and Life InsuranceCorporation (LIC) of India were allowed to participateas lenders. The interest rate in the call money marketwas freely determined by the market till December1973. However, as call money rates increased sharplyto touch 25-30 per cent, the Indian Banks’ Association(IBA) instituted an administered system of interestrates by imposing a ceiling interest rate of 15 per centin December 1973 so as to maintain systemic stabilityand quell any abnormal rise in the call rates. Theceiling was subject to several revisions but there wereseveral instances of violation of the ceiling ratesthrough other means (like buy-back arrangements)during phases of tight liquidity.

3.71 Treasury Bi l ls const i tuted the maininstrument of shor t- term borrowing by theGovernment and served as a convenient gilt-edgedsecurity for the money market. The characteristicsof high liquidity, absence of default risk and negligiblecapital depreciation of Treasury Bills made themanother attract ive instrument for shor t- terminvestment by banks and other financial institutions.

6 Keito is a central financing organisation for financial co-operatives such as small and medium sized businesses, agriculture, forestry, andfishery co-operatives.

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The Reserve Bank, being the banker to theGovernment, issued Treasury Bills at a discount. Theissuance system of Treasury Bills migrated from anauction to tap basis in July 1965 with the rate ofdiscount administratively fixed at 3.5 per cent perannum, which was raised to 4.6 per cent by July 1974and remained at that level in respect of 91-dayTreasury Bills till 1991. There was also a system ofad hoc Treasury Bills from 1955, which were createdby the Central Government in favour of the ReserveBank to automatically restore its cash balances tothe minimum stipulated level, whenever there wasexcess drawdown of cash.

3.72 Par ticipation cer t i f icates (PCs) andcommercial bills (under bills rediscounting scheme)were introduced in the money market in 1970. PCswere utilised mostly by financial institutions to parktheir funds for longer maturities and could not bedeveloped for meeting liquidity mismatches betweenfinancial institutions and/or banks. Under the billsrediscounting scheme, the Reserve Bankrediscounted genuine trade bills at the Bank Rate orat a rate specified by it. The underlying purpose ofdeveloping the bill market was to enable banks andother financial institutions to invest their surplus fundsprofitably by selecting appropriate maturities. Over theyears, the rediscounting facility became restrictive andwas made available on a discretionary basis. The mainfactors inhibiting the development of bill finance werelack of a bill culture, non-availability of stamp papersof required denominations, absence of specialisedcredit information agencies and an active secondarymarket. Both these instruments (par ticipationcertificates and commercial bills), however, did notdevelop and activity in these instruments remainedinsignificant.

3.73 As a result of inadequate depth and liquidityin the organised money market, the sectoral financinggaps (i.e., the requirements of unsatisfied borrowersin the organised financial system) were met by theunorganised market. The interest rate in this segmentwas generally higher than that in the organised marketreflective of the actual market conditions. As bankcredit (both aggregate and sectoral) was the principalfocus of monetary policy making under the creditplanning approach adopted in 1967-68, thisdichotomous nature of the money market served therequirement of monetary management.

3.74 To sum up, the money market during thisperiod could not provide an equilibrating marketmechanism for meeting short-term liquidity needs for

banks. The prevalence of administered structure inthe money market did not permit interest rates toreflect the actual extent of scarcity of funds. Owing tolimited participation, money market liquidity was highlyskewed, characterised by a few dominant lenders anda large number of chronic borrowers. Faced with theseimpediments, together with limited Reserve Bank’srefinance, banks often faced either short-term liquidityproblems for meeting the statutory reserverequirements or remained saddled with excessliquidity. Banks parked surplus funds, in the absenceof alternative instruments, in Treasury Bills beforerediscounting them with the Reserve Bank so as tomeet the cash reserve requirements on an averagebasis dur ing the repor ting per iod. This led tosignificant fluctuations in banks’ investments inTreasury Bills and also their cash balances with theReserve Bank, thereby complicating the task ofmonetary management. Furthermore, in addition tothe rediscounted regular Treasury Bills, the ReserveBank also had to hold the ad hoc Treasury Bills (issuedby the Government of India with a fixed 4.6 per centinterest rate since July 1974) under the system ofautomatic monetisation, thereby constraining theemergence of Treasury Bills as a money marketinstrument. Moreover, the government securitiesmarket was also characterised by administeredinterest rates and captive investor base, which madeopen market operations an ineffective instrument ofmonetary control thereby constraining, to a largeextent, the regular management of short-term liquidityby the Reserve Bank.

IV. EVOLUTION OF RESERVE BANK’S LIQUIDITYMANAGEMENT

3.75 The nascent state of development of themoney market in India and the administered interestrate structure inhibited active liquidity managementoperations of the Reserve Bank. The Reserve Bankregulated market liquidity by essentially operatingthrough direct instruments such as CRR and sector-specific refinance. As monetary policy was largelycontingent on the fiscal stance, monetary operationswere undertaken to neutralise the fiscal impact.Consequently, with the dominance of the quantumchannel in the transmission mechanism, there waslittle scope of signalling monetary policy changesthrough indirect instruments. Therefore, the moneymarket increasingly reflected the spillover impact ofmonetary policy operations through direct instruments.The increasingly unsustainable fiscal conditions, asreflected in macroeconomic imbalances, necessitatedstructural reforms from the early 1990s. Consequently,

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the emphasis on the market paradigm gatheredmomentum, warranting greater use of indirectinstruments for the conduct of monetary policy.Concomitantly, the Reserve Bank refined its operatingprocedures of liquidity management in tandem withthe changing financial landscape. Major developmentsin the liquidity management operations of the ReserveBank and developments of money market have takenplace since the mid-1980s. However, in order toplace these developments in proper perspective, itmay be useful to understand the broad contours ofliquidity management by the Reserve Bank sincethe late 1960s.

3.76 Monetary policy up to the mid-1980s waspredominantly conducted through direct instrumentswith credit budgets for the banks being framed in syncwith monetary budgeting (Mohan, op. cit). This periodwas marked by administered interest rates, creditceilings, directed lending, automatic monetisation ofdeficits and fixed exchange rates. The Indian economyfunctioned essentially as a closed and controlledeconomy with the role of market being virtually non-existent due to the existing structural rigidities in thesystem. In the absence of a formal intermediate target,bank credit - aggregate as well as sectoral – came toserve as a proximate target of monetary policy afterthe adoption of credit planning in 1967-68 (Jalan,2002). The money market was essentially representedby the inter-bank call market, where activity wasmainly driven by the banks’ demand for reserves formeeting their statutory commitments. Furthermore,strong seasonality in demand for money and creditduring agricultural seasons also influenced marketactivity. In the presence of skewed distribution ofliquidity, these factors made the call money rateshighly volatile, necessitating imposition of interest rateceilings. In the absence of stability in the moneymarket, and with planned allocation of credit underan administered structure of interest rates, theReserve Bank had little choice but to conduct itsliquidity management operations through a standardmix of OMOs and changes in the Bank Rate. TheOMOs were conducted through outright transactionsin government securities.

3.77 Although credit planning guided monetarypolicy, the concerns about rising inflation during the1970s and the 1980s attracted a good deal of policyattention. Apart from supply shocks (oil prices andcrop failures), inflation was increasingly believed tobe caused by excessive monetary expansiongenerated by large scale monetisation of fiscal deficitsduring the 1980s. Accordingly, the Reserve Bank

began to pay greater attention to the movements inmonetary aggregates. Against this backdrop, theCommittee to Review the Working of the MonetarySystem (Chairman: Sukhamoy Chakravarty, 1985)recommended a framework of monetary targeting withfeedback. In pursuance of the recommendations ofthis Committee, the Reserve Bank began to target adesirable growth in money supply consistent with atolerable level of inflation and expected output growth(RBI, 1985). Thus, broad money emerged as anintermediate target of monetary policy and theReserve Bank began to formally announce monetarytargets as nominal anchor for inflation.

3.78 The adoption of monetary targetingnecessitated considerable changes in the operatingprocedures of monetary policy. Over the years, theReserve Bank, through its refinancing and openmarket operations, had already succeeded, to a largeextent, in reducing the level of interest rates in generaland the call money rate in particular; albeit by varyingthe ceiling rate (it reached 8.5 per cent by March 1978although it was again raised to 10.0 per cent in April1980). However, the fiscal dominance since the late1970s made the traditional instruments of Bank Rateand OMO less effective. The scope for OMO waslimited as yields were governed by an administeredinterest rate regime, including sale of Treasury Billson tap at a coupon of 4.6 per cent fixed since 1974(Mohan, op. cit). In this scenario, the Reserve Bankbegan to use reserve requirements and creditplanning for modulating monetary and liquidityconditions. As a result, the CRR reached the ceilingof 15 per cent of net demand and time liabilities(NDTL) in July 1989 and the SLR reached the peakof 38.5 per cent in September 1990. The increase inSLR was, however, unable to fully meet the financingrequirements of the Government, thereby leading tomonetary accommodation by the Reserve Bank (RBI,2004a). As monetary financing of fiscal deficits isinflationary beyond a point, an increase in the ReserveBank’s support to the Government was accompaniedby an increase in CRR to rein in monetary expansion.Despite these measures, however, money supplygrowth remained high and contributed to inflation. Thisunderscored the need for monetary-fiscal co-ordination in achieving price stability.

3.79 In tandem with the shifts in operatingprocedures, the proper development of the moneymarket was also emphasised, partly due to thesuccess in lowering the call money rates, albeit,through reductions in interest rate ceilings. TheChakravarty Committee (1985) was the first to make

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comprehensive recommendations for thedevelopment of the Indian money market.Furthermore, the Reserve Bank set up a WorkingGroup on the Money Market (Chairman: Shri N.Vaghul, 1987) to specifically examine various aspectsfor widening and deepening the money market.Following the recommendations of these twocommittees, several new initiatives were undertakenby the Reserve Bank. These included(i) setting up of the Discount and Finance House ofIndia (DFHI) in 1988 to impart liquidity to moneymarket instruments and help the development ofsecondary markets in such instruments; ( i i)introduction of instruments such as CDs (1989) andCPs (1990) and inter-bank participation certificates(with and without risk) (1988) to increase the rangeof instruments; (iii) freeing of call money rates by May1989 to enable price discovery; and (iv) introductionof auctions of 182-day Treasury Bills (November 1986)with a view to moving towards a system of market-determined yields. Although these measures createdthe ground for the development of a proper moneymarket, the efficient functioning of the market washindered by a number of other structural rigidities inthe system such as skewed distribution of liquidity andthe prevalence of administered deposit and lending rates.

3.80 The process of f inancial l iberal isationintroduced in the early 1990s, as part of the overalleconomic reforms programme, led to a structural shiftin the financing paradigm for the Government and thecommercial sectors. The role of the financial systemwas reassessed and the emphasis shifted from amere channelisation to eff icient al location ofresources to sustain the higher growth. With a viewto improving the resource allocation process andfacilitating efficient price discovery in the financialmarkets, the Reserve Bank initiated a multi-prongedstrategy of institutional reforms. The measuresintroduced by the Reserve Bank were aimed atwidening, deepening and integrating var ioussegments of the financial market, especially themoney market, and smoothening the process oftransmission of policy impulses across marketsegments. Major reforms introduced in the financialmarkets were liberalisation of exchange rates in March1993, deregulation of interest rates, abolition of creditceilings (although directed lending continued),introduction of auctions in Treasury Bills (364-dayTreasury Bills in April 1992 and 91-day Treasury Bills

in January 1993), market borrowing of the Governmentthrough the auction route since 1992-93 (gilt yieldsbecame market determined through rising couponrates) and phasing out of automatic monetisation off iscal deficits (fol lowing the signing of theSupplemental Accord in 1997). All these measurespaved the way for increased financial innovations andmarket sophistication which, along with large swingsin capital flows, induced a degree of instability in themoney demand function, thereby limiting the role ofmoney as an intermediate target.

3.81 Various changes in financial market structurenecessitated a major shift in monetary policyoperating framework in India from monetary targetingto a ‘multiple indicator approach’ in 1998. As part ofthis approach, the Reserve Bank started using theinformation content in interest rates and rates of returnin different markets along with currency, credit, fiscalposition, trade, capital flows, inflation rate, exchangerate, refinancing and transactions in foreign exchange,by juxtaposing it with output data for drawing policyperspectives. The success of this approach requiredgreater monetary policy flexibility, especially in viewof market or ientation of policy. Therefore, theemphasis was placed on the money market as thefocal point for the conduct of monetary policy andfostering its integration with other financial marketsas detailed in the subsequent sections.

3.82 In the changed scenario, monetary policy,which largely operated in a closed economyframework till the early 1990s, had to contend withthe dynamics of an open economy. The transition ofeconomic policies in general, and financial sectorpolicies in particular, from a control oriented regimeto a liberalised but regulated regime was reflected inchanges in the approach of monetary management(Mohan, 2004). Accordingly, in line with the increasingmarket orientation of the economy and shift in theoperating framework, the third phase of liquiditymanagement operations began from the second halfof the 1990s with the Reserve Bank moving away fromdirect instruments of monetary control to indirectinstruments. The CRR was brought down from 15 percent of NDTL (during July 1989-April 1993) to 9.5 percent by November 1997 (it reached a low of 4.5 percent in June 2003)7. The SLR was reduced to thestatutory minimum of 25 per cent by October 1997.Under this system, while reserve requirement was the

7 In the light of developments in current macroeconomic, monetary and anticipated liquidity conditions, the Reserve Bank, on March30, 2007, announced to raise CRR by 50 basis points to 6.50 per cent in April 2007.

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principal medium of modulating liquidity on a systemicbasis, banks took recourse to Reserve Bank’srefinance facilities to meet their short-term fundingrequirements. Introduction of reverse repos8 (thencalled repos) in 1992 provided an instrument forabsorption of liquidity from banks having surplusfunds. This, in conjunction with government marketborrowing through auctions since 1992-93, raised theyields on government securities (from 6.5 per cent in1985-86 to 11.5 per cent in 1997-98) and led to theshortening of maturity of the Government debt. Thismarked the beginning of development of a secondarymarket in government securities and the marketdetermination of interest rates. With the objective ofmanaging short-term liquidity and smootheninginterest rates in the call/notice money market, theReserve Bank began absorbing excess liquiditythrough auctions of reverse repos. Furthermore, withexchange rate liberalisation (the rupee became fullyconvertible on the current account in 1994) andopening up of the economy, the exchange rate beganto play an important role in monetary management.In the process, the exchange rate becameendogenous to money, income, prices and interestrates and, with f inancial innovations, thedisequilibrium in money markets begun to be reflectedin short-term interest rates (Mohan, op cit). In view ofthese changes, the call money market became the focalpoint of market intervention by the Reserve Bank.

3.83 The volatility in call rates, however, continued,necessitating some instruments for managing liquidity.Against this backdrop, the Committee on BankingSector Reforms (Narasimham Committee II, 1998)stressed that interest rate movements in the inter-bankcall money market should be orderly and this couldonly be achieved if the Reserve Bank has a presencein the market through short-term reverse repos (asper current terminology). Following the committee’srecommendations, the reverse repos, which were inoperation from 1992, got integrated with the interimliquidity adjustment facility (ILAF) introduced in April1999. The absorption of liquidity continued to be atfixed rate reverse repos. Although absorption ofliquidity was done through a single reverse repo rate,the system of injecting liquidity through various ways,including refinance, continued at interest rates linkedto the Bank Rate, which was reactivated in April 1997.

Under the ILAF, the general refinance facility wasreplaced by a collateralised lending facility (CLF) andadditional collateralised lending facility (ACLF) linkedto the Bank Rate. Similarly, export credit refinance andliquidity support to PDs were also linked to the BankRate. Thus, the reverse repo rate (as floor) and theBank Rate (as the ceiling) provided an informalcorridor in the money market.

3.84 In the light of the experience gained in theoperation of ILAF, an Internal Group set up by theReserve Bank recommended gradual implementationof a full-fledged LAF as suggested by the NarasimhamCommittee (1998). Accordingly, the system of ILAFmigrated to a system of Liquidity Adjustment Facility(LAF) in stages beginning June 2000 (Box III.2). Thefixed rate reverse repo was replaced by variablereverse repo auctions, while ACLF and level II liquiditysupport to PDs was replaced by variable reposauctions, conducted on a daily basis. Consequently,the repo rate replaced the earlier Bank Rate as theceiling of the corridor, thereby enabling injection ofliquidity at a single rate (i.e., repo rate), while the floorcontinued to be the reverse repo rate. This signified amajor change in the operating procedure and liquiditymanagement operations by the Reserve Bank as itfacilitated the transition from direct instruments toindirect (market-based) instruments of monetarymanagement. Furthermore, it has also provided thenecessary f lexibi l i ty to the Reserve Bank inmodulating liquidity (both supply of and demand forfunds) on a daily basis through policy rate changes.This has ensured stability in the call money rates,which have generally remained within the corridor(Chart III.1)9. This, in turn, has promoted the stabilityof short-term interest rates in the money market.

3.85 Consider ing the impor tance of guidingmonetary policy operations on a sound basis, theAnnual Policy Statement of April 1999 underlined theneed for developing a short-term operational modelwhich takes into account the behavioural relationshipsamong different segments of the financial system.Under the guidance of a group of eminent academicexper ts, a model was developed and madeoperational in 2002 for forecasting short-term liquidityconditions to facilitate daily liquidity managementoperations of the Reserve Bank.

8 With effect from October 29, 2004, the nomenclature of repo and reverse repo has been interchanged as per international usages.Accordingly, repos now signify injection while reverse repos signify absorption of liquidity.

9 Call rate hardened during the second half of March 2007 as liquidity conditions tightened due to advance tax outflows, year-endconsiderations, sustained credit demand and asymmetric distribution of government securities holdings across banks.

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As part of financial sector reforms initiated in the early1990s, India began to move away from direct instrumentsof monetary control to indirect ones, which, in turn,warranted a mechanism that can accord greater flexibilityand effective liquidity management so as to maintainorderly conditions in the financial markets, particularly inthe wake of surging volatile capital flows. As a corollary,pursuant to the recommendations of the NarasimhamCommittee (1998), the LAF was introduced in stagescommensurate with the specific features of the Indianfinancial system, the level of market development andtechnological advances in the payment and settlementsystems. In the process, the critical issue facing theReserve Bank was to channelise the various sources ofits liquidity through a single comprehensive window at acommon pr ice. Consequently, an inter im l iquidityadjustment facility (ILAF) was introduced in April 1999which enabled the Reserve Bank to modulate marketliquidity on a daily basis and also transmit interest ratesignals to the market.

With the introduction of ILAF, the general refinance facilitywas replaced by a collateralised lending facility (CLF) upto 0.25 per cent of the fortnightly average of outstandingaggregate deposits in 1997-98 for two weeks at the BankRate and an additional collateralised lending facility (ACLF)for an equivalent amount of CLF at the Bank Rate plus 2per cent. A penal rate of 2 per cent was stipulated for anadditional two week period. However, expor t creditrefinance for scheduled commercial banks was retainedand continued to be provided at the Bank Rate.Simultaneously, a provision for liquidity support to PDsagainst collateral of government securities was also madeavailable. The ILAF was intended to ensure that interestrates move within a reasonable range and promote stabilityin the money market. The transition from ILAF to a full-fledged LAF commenced in June 2000 and progressedgradually in three stages. The first stage began from June5, 2000 when LAF was formally introduced with thereplacement of ACLF and level II support to PDs by variablerate repo auctions with same day settlement.

The second stage commenced from May 2001, when CLFand level I liquidity support for banks and PDs was alsoreplaced by variable rate repo auctions. However, someminimum liquidity support to PDs was retained but at aninterest rate linked to variable rate in the daily reposauctions as determined by the Reserve Bank from timeto time. Furthermore during April 2003, the multiplicity ofrates at which liquidity was being injected was rationalisedwith the back-stop interest rate being fixed at the reverserepo cut-off rate of the regular LAF auctions on that day.

Box III.2Liquidity Adjustment Facility

Concomitantly, a back-stop rate was f ixed at 2.0percentage points above the repo cut-off rate in the eventof no reverse repo in the LAF auctions. On days when noreverse repo/repo bids are received/accepted, back-stoprate was decided by the Reserve Bank on an ad hoc basis.Subsequently from March 29, 2004 the reverse repo ratewas scaled down to 6.0 per cent and aligned with theBank Rate under the revised LAF scheme. A single facilityavailable at a single rate was introduced by mergingnormal facility and back stop facility together. Moreoverin April 2004, fixed rate auctions were re-introduced. Witheffect from October 29, 2004, the nomenclature of repoand reverse repo was interchanged as per internationalusage. The repo now indicates injection of liquidity, whilereverse repo stands for absorption of liquidity.

The full computerisation of Public Debt Office (PDO) ofthe Reserve Bank set the third stage of full-fledged LAFand onset of RTGS marked a major leap forward in thisphase. Repo operations today are mainly throughelectronic transfers and the LAF can be operated atdifferent times of the same day. Consequently, the SecondLAF (SLAF) was introduced from November 28, 2005providing the market participants a second window to fine-tune their management of liquidity. Unlike the past LAFoperations, which were conducted in the forenoon between9.30 am and 10.30 am, the SLAF is conducted by receivingbids between 3.00 pm and 3.45 pm. Although the salientfeatures of SLAF and LAF are same, their settlements areconducted separately on a gross basis. Thus, theintroduction of LAF has been a process and the Indianexperience shows that phased rather than a big bangapproach is required for reforms in the financial sector andin monetary management (Mohan, op. cit).

LAF has now emerged as the pr incipal operatinginstrument of monetary policy. It has helped in stabilisingthe regular liquidity cycles and, subsequently, the volatilityof call money rates by allowing banks to fine-tune theirliquidity needs as per the averaging requirements of CRRover the reporting period. This smoothened the liquiditypositions at the beginning and end of the month. Besides,it helped to modulate sudden liquidity shocks engenderedby temporary mismatches induced by outflows/inflows onaccount of Government auctions/redemptions andadvance tax payments. More importantly, the LAF hasemerged as an effective instrument for maintainingorderly conditions in the financial markets in the face ofvolatile capital flows. Thus, the LAF has imparted a much-needed flexibility to the Reserve Bank in modulating theliquidity in the system and steering the desired trajectoryof interest rates in response to evolving market conditions.

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REPORT ON CURRENCY AND FINANCE

3.86 The issue of managing large and persistentcapital flows and synchronicity in monetary policycycles across the globe has added another dimensionto the issue of liquidity management in the Indiancontext in recent years. The period since mid-2002has generally been characterised by surplus liquidityin the system in the wake of large capital inflows andcurrent account surplus (till 2003-04). An enduringchallenge to monetary policy has been to managesuch surplus liquidity so as to keep the call moneyrates stable for overall stability in the market.Accordingly, in order to sterilise the impact of capitalf lows, the Reserve Bank had to operatesimultaneously through the LAF and OMOs (outrighttransactions of dated securities and Treasury Bills).

3.87 The OMOs have been effectively used bythe Reserve Bank since the mid-1990s for sterilisingthe monetary impact of capital flows by offloadingthe stock of government securities to the market(Chart III.2). The net open market sales increasedfrom Rs.10,464 crore in 1996-97 to Rs.53,781 crorein 2002-03. However, repeated recourse to OMOs forsterilisation purposes during this period depleted thestock of government securities held by the ReserveBank from Rs.52,546 crore at end-March 2003 toRs.40,750 crore at end-March 2004, despite theconversion of the available stock of non-marketablespecial securities (of Rs.61,818 crore), created outof past ad hoc and Tap Treasury Bills, into tradablesecurities during the year. Accordingly, the burden ofsterilisation shifted to the LAF, which was essentiallydesigned as a tool of adjusting marginal liquidity. As

a result, the open market sales by the Reserve Bankas a proportion of the accretion of securities to its giltportfolio dropped to about 50 per cent during 2003-04from an average of 90 per cent in the preceding fiveyears following a switch to LAF operations (RBI,2004b).

3.88 Given the finite stock of government securitiesin its portfolio and the legal restrictions on issuing itsown paper, the Reserve Bank felt that instrumentsother than LAF were needed to fulfil the objective ofabsorbing liquidity of a more enduring nature. Thisresulted in the introduction of the market stabilisationscheme (MSS) in Apr i l 2004 as a specialarrangement, following the recommendations of theWorking Group on Instruments of Sterilisation, 2003(Chairperson: Smt. Usha Thorat). Under thisarrangement, the Government issued Treasury Billsand/or dated securities in addition to the normalborrowing requirements for absorbing excess liquidityfrom the system. The ceiling amount, which wasinitially fixed at Rs.60,000 crore was raised toRs.80,000 crore on October 14, 2004 but reduced toRs.70,000 crore on March 24, 2006 and again raisedto Rs.80,000 crore for 2007-08. The MSS proceedsare held in a separate identifiable cash account bythe Government (reflected as equivalent cashbalances held by the Government with the ReserveBank) and are appropriated only for the purpose ofredemption and/or buyback of the Treasury Bills and/or dated securities issued under the MSS. Thus, whileit provided another tool for liquidity management, itwas designed in such a manner that it did not have

Net RBI Credit to the Centre Net Foreign Currency Assets

OMO (Sales)

Chart III.2: Reserve Bank's Open Market Operations

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Chart III.1: LAF Corridor and the Call Rate

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any fiscal impact except to the extent of interestpayment on the outstanding amount under the MSS.The amount absorbed under the MSS, which hadreached Rs.78,906 crore on September 2, 2005,declined to about Rs.32,000 crore in February 2006due to unwinding of nearly Rs.47,000 crore in view ofoverall marginal liquidity which has transited from thesurplus to the deficit mode. As part of unwinding, freshissuances under the MSS were suspended betweenNovember 2005 and April 2006. In several subsequentauctions during 2006-07, only partial amounts wereaccepted under the MSS. Subsequently, the amountabsorbed under the MSS increased again toRs.62,974 crore in March 2007. The MSS has, thus,provided the Reserve Bank the necessary flexibilityto not only absorb liquidity but also to ease liquiditythrough its unwinding, i f necessary. With theintroduction of the MSS, the pressure of sterilisationon LAF has declined considerably and LAF operationshave been able to fine-tune liquidity on a daily basismore effectively (Table 3.1). Thus, the MSSempowered the Reserve Bank to undertake liquidityabsorptions on a more enduring but still temporarybasis and succeeded in restoring LAF to its intendedfunction of daily liquidity management (Mohan, op cit).

3.89 Furthermore, the build up and volatility inGovernment’s cash balances with the Reserve Bankin recent years have significantly impacted the liquidityconditions. The Working Group on Instruments ofSterilisation favoured revisiting the 1997 agreementso that Government’s surpluses with the ReserveBank are not automatically invested and can remainas interest free balances, thereby releasinggovernment secur it ies for fur ther ster i l isationoperations. Accordingly, the arrangement of allowingthe Central Government to invest the surplus fundsin its own paper since 1997 (to give a notional returnon such balances) was discontinued temporarily fromApril 8, 2004. However, following the introduction ofthe MSS, it was partially restored with a ceiling ofRs.10,000 crore in June 2004, which was furtherraised to Rs.20,000 crore in October 2004. While theGovernment’s surplus cash balances may haveenabled the Reserve Bank to sterilise the monetaryimpact of excess liquidity, at times, it has also resultedin sudden transition in liquidity conditions. The buildup of large and unanticipated cash surpluses of theGovernment with the Reserve Bank and its depletionover a short period poses fresh challenges for liquiditymanagement and maintenance of stable conditionsin the money market.

3.90 The dynamics of surplus liquidity in the recentper iod shows that the total surplus l iquidity

Table 3.1: Liquidity Absorptions

(Rupees crore)

Outstanding LAF MSS Centre’s Totalas on Last Friday Surplus with (2 to 4)of month the RBI @

1 2 3 4 5

2004April 73,075 22,851 0 95,926May 72,845 30,701 0 1,03,546June 61,365 37,812 0 99,177July 53,280 46,206 0 99,486August 40,640 51,635 7,943 1,00,218September 19,245 52,255 21,896 93,396October 7,455 55,087 18,381 80,923November 5,825 51,872 26,518 84,215December 2,420 52,608 26,517 81,545

2005January 14,760 54,499 17,274 86,533February 26,575 60,835 15,357 1,02,767March* 19,330 64,211 26,102 1,09,643April 27,650 67,087 6,449 1,01,186May 33,120 69,016 7,974 1,10,110June 9,670 71,681 21,745 1,03,096July 18,895 68,765 16,093 1,03,753August 25,435 76,936 23,562 1,25,933September 24,505 67,328 34,073 1,25,906October 20,840 69,752 21,498 1,12,090November 3,685 64,332 33,302 1,01,319December -27,755 46,112 45,855 64,212#

2006January -20,555 37,280 39,080 55,805February -12,715 31,958 37,013 56,256March* 7,250 29,062 48,828 85,140April 47,805 24,276 5,611 77,692May 57,245 27,817 0 85,062June 42,565 33,295 8,621 84,481July 44,155 38,995 8,770 91,920August 23,985 42,364 26,791 93,140September 1,915 42,064 34,821 78,800October 12,270 40,091 25,868 78,229November 15,995 37,917 31,305 85,217December -31,685 37,314 65,581 71,311

2007January -11,445 39,375 42,494 70,424February 6,940 42,807 53,115 1,02,862March -29,185 62,974 49,992 83,781

@ : Excludes minimum cash balances with the Reserve Bank.* : Data pertain to March 31. # Reflects IMD redemption of about

Rs.32,000 crore.Note : Negative sign in column 2 indicates injection of liquidity through

LAF repo.

(comprising MSS, LAF and Government surplus) inthe system increased to over Rs.1,25,000 crore inAugust 2005. Reflecting such surplus conditions inthe banking system, the call money rate hoveredgenerally around the lower bound of the corridor (i.e.,the reverse repo rate), which (along with the repo rate)has emerged as the main instrument of policy in theshort-run (see Chart III.1). The Bank Rate now serves

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REPORT ON CURRENCY AND FINANCE

Table 3.2: First and Second LAF(Amount in Rupees crore)

Period Average daily Average daily First Average daily Second Share of First LAF in Share of Second LAF inLAF Operations (net) LAF Operations (net) LAF Operations (net) Total LAF (per cent) Total LAF (per cent)

1 2 3 4 5 6

December 2005 -1,452 654 -2,106 64.6 35.4January 2006 15,386 12,938 2,447 72.9 27.1February 2006 13,532 10,850 2,682 74.9 25.1March 2006@ 6,319 5,520 799 54.1 45.9April 2006 -46,088 -18,480 -27,608 41.1 58.9May 2006 -59,505 -29,600 -29,905 49.7 50.3June 2006 -48,611 -25,647 -22,964 52.8 47.2July 2006 -48,027 -26,486 -21,541 55.2 44.8August 2006 -36,326 -21,677 -14,649 59.7 40.3September 2006 -25,862 -12,544 -13,318 47.8 52.2October 2006 -12,262 -5,435 -6,827 44.4 55.6November 2006 -9,937 -1,315 -8,622 13.2 86.8December 2006 1,713 6,548 -4,836 41.6 58.4January 2007 10,738 7,170 3,569 46.8 53.2February 2007 -648 3,211 -3,859 36.4 63.6March 2007 11,858 9,701 2,157 55.5 44.5

@ : Additional LAF conducted on March 31, 2006 has been shown under second LAF.Note: (+) indicates injection of liquidity through LAF repos while (-) indicates absorption of liquidity through LAF reverse repos.

the role of a signalling instrument for the medium-term. Commensurate with these changes, the LAFhas been further refined. Facilitated by the introductionof real time gross settlement (RTGS) system, it has nowbeen possible to operate LAF at different times of thesame day (Second LAF was introduced from November28, 2005) providing market participants a secondwindow to fine-tune the management of liquidity. Theevidence so far suggests active transaction through theSecond LAF during periods of easy liquidity (Table 3.2).

3.91 The surplus liquidity conditions, however, easedto about Rs.55,000 crore by January 2006 following thepressures from redemption of India Millennium Deposits(IMDs) (US $ 7.1 billion or about Rs.32,000 crore onDecember 28-29, 2005). The sustained pick-up in non-food credit (around 30 per cent witnessed since mid-2004), brought the liquidity position from the surplusmode to the deficit mode, leading to injections of liquiditythrough LAF repos during December 2005-February2006 (Chart III.3). To meet their liquidity requirements,banks have been unwinding their excess SLR holdings(from about 13 per cent of NDTL at end-March 2005to about 3 per cent by end-March 2007) above theprescribed minimum of 25 per cent. The depletion ofSLR investments by banks has resulted in call ratesfirming up to the ceiling of the LAF corridor andbeyond, even when reverse repo bids have beenreceived under the LAF and funds have beenabsorbed from the system. This indicates that somebanks overdrew both collateral and cash, therebynecessitating rollovers at the short-end of the market

spectrum leading to pressures on liquidity and interestrates. In this regard, the Government’s decision in theUnion Budget 2006-07 to conver t the entireoutstanding recapitalisation bonds/special securitiesissued to nationalised banks, amounting to Rs. 20,809crore, into tradable, SLR eligible securities couldreduce the pressure on banks seeking appropriatecollaterals.

3.92 In the current phase of monetary tightening,the Reserve Bank has raised the reverse repo rates

Reverse Repo Amount Repo Amount

Call Rate (Right Scale)

Chart III.3: Liquidity Adjustment Facility and the Call Rate

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six times of 25 basis points each since October 2004,which along with the corresponding adjustments inthe repo rate had narrowed down the corridor to 100basis points by April 2005 (which subsequentlyincreased to 175 basis points with the increase in reporate by 25 basis points each on October 31, 2006,January 31, 2007 and March 30, 2007). The ReserveBank has emphasised gradual changes in policy rates,

as large changes in interest rates could be disruptive,particularly in the wake of increased openness of theeconomy and the current stage of development offinancial markets. This approach has been successfulin signalling the market about the need for such pre-emptive actions in order to stabil ise inflationexpectations. Various segments of the financial markethave responded well to the policy signals (Box III.3).

The effectiveness of monetary policy hinges on the abilityof the monetary authority to communicate with the publicin a clear and transparent manner. In this regard, thesignalling of policy assumes key importance as it conveysthe stance of monetary policy. While the signallingmechanisms in developed countries are quite robust, theytend to be weak in emerging market economies,particularly in the wake of market segmentation andabsence of a well-defined transmission mechanism.

Financial markets are typically characterised by asymmetricinformation, where some agents are better informed thanothers, that gets reflected in the problems of moral hazardand adverse selection. Seminal research on the economictheory of information has demonstrated that better-informedagents in a market could credibly “signal” (transmit) theirinformation to less informed agents, so as to avoid some ofthe problems associated with adverse selection and improvethe market outcome (Spence, 1973).

The effectiveness of monetary policy is strongly related tothe signalling of policy, the reason being that importantvariables such as the exchange rate and long-term interestrates reflect expectations about future monetary policy.Central banks usually consider four different types ofsignalling channels, viz., (a) speeches of executives, (b)views about future inflation, (c) changes in policyinstruments and (d) publication of the minutes of policymeetings. In particular, the announcement of an inflationforecast or a monetary conditions index (MCI) is used tosignal central bank’s intentions.

In India, several measures have been initiated in the post-reform per iod to develop indirect instruments fortransmitting policy signals. An important measure was thereactivation of the Bank Rate in April 1997 by initially linkingit to all other rates, including Reserve Bank’s refinancerates. The introduction of fixed rate reverse repo helped increating an informal corridor in the money market with thereverse repo rate as the floor and the Bank Rate as theceiling, which enabled the Reserve Bank to modulate thecall rate within this informal corridor. Subsequently, theintroduction of the Liquidity Adjustment Facility (LAF) fromJune 2000 facilitated the modulation of liquidity conditionsand also short-term interest rates on a daily basis throughthe LAF window, while signalling the medium-term stanceof policy through changes in the Bank Rate.

Box III.3The Interface between Monetary Policy Announcements and Financial Market Behaviour

In the Indian context, some attempts have been made toempir ically examine the interrelationship betweenmonetary policy signals and financial market behaviour ina VAR framework (Bhattacharyya and Sensarma, 2005).Monetary policy signals are proxied by changes in the CRR,the Bank Rate and the LAF reverse repo rate. The impact ofthese signalling instruments of monetary policy is consideredon four segments of the financial market, viz., money market(call money rate), stock market (BSE Sensex), foreignexchange market (3-month forward premia) and thegovernment securities market (yield on 1-year G-sec).

Impulse response analysis is used to study the impact ofa one standard error shock in each policy indicator on thevarious financial market segments. The study reveals thatan increase in the CRR raises the call money rate instantlybecause of the news effect and also over time through theliquidity effect as more resources get impounded causingtightness in liquidity conditions. This is also the case forforward premia and yields on government securities. It hasmore of an instantaneous news impact in the stock marketby depressing the market sentiment.

An increase in the Bank Rate, as the signalling mechanismof policy stance over the medium-term, appears to havean instantaneous effect on call, government securities andforward premia because of the news effect. The long-termimpact, however, gets muted as refinance at the Bank Rateis formula driven and not adequate to have a liquidityimpact. In the stock market, hardening of the Bank Rate isconstrued as restrictive monetary policy, which dampensthe market sentiment.

An increase in the reverse repo rate, as the signallingmechanism of policy stance in the short-term, appears to havean instantaneous effect on call, government securities andforward premia because of the announcement effect andmakes the term-structure steep at the short-end. Like the BankRate, repo rate hike also dampens the market sentiment.

The instantaneous impact of monetary policy signals onmost financial market segments points towards increasingintegration and sophistication of markets. Therefore,increasing reliance on indirect instruments, greater marketintegration and technological innovations prima facie haveimproved the channels of communication between theReserve Bank and the financial market and facilitated theconduct of monetary policy.

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REPORT ON CURRENCY AND FINANCE

A liquid money market is an important pre-requisite for theeffective transmission of monetary policy. In particular, adeep and liquid money market contributes towards a moreeffective propagation of the impulses of central bank policyintervention in financial markets. Besides, pr icedetermination is more efficient in a liquid money market andconveys important information to monetary authorities onmarket expectations. In this context, central banks modulateand fine-tune money market liquidity not only for monetarymanagement but also in their quest for preserving financialstability.

Measures of money market liquidity are based on threedimensions, viz., tightness, depth and resiliency. Tightnessrefers to how far transaction prices diverge from the averagemarket price, i.e., the general costs incurred irrespective ofthe level of market prices. Depth denotes either the volumeof trades possible without affecting prevailing market prices,or the amount of orders in the order books of market makersat any time period. Finally, resiliency refers either to thespeed with which price fluctuations resulting from the tradeare dissipated, or the speed with which imbalances in orderflows are adjusted. Other measures such as the numberand volume of trades, trading frequency, turnover ratio, pricevolatility and the number of market participants are oftenregarded as readily available proxies for market liquidity.

As the buying and selling rates in any market transactionare commonly referred as bid and offer (ask) rates in financialmarket parlance, one of the most frequently used measuresof tightness is the bid-ask spread. The bid-ask spread, i.e.,the differential between the lowest bid quote (the price atwhich a market participant is willing to borrow in the inter-bank market) and the highest ask quote (at which the agentis willing to lend) represents an operational measure of theprice of the agents’ services in the absence of othertransaction costs. Depth is reflected by the maximum sizeof a trade for any given bid-ask spread. The turnover ratio,i.e., the turnover in the money market as a percentage oftotal outstanding money market transactions, also providesan additional measure of the depth of the market. However,a more accurate measure of market depth would take intoaccount advances of both actual and potential transactionsarising out of portfolio adjustments. Finally, while there is noappropriate measure of resiliency, one approach is toexamine the speed of the restoration of normal marketconditions (such as the bid-ask spread and order volume)after transactions are completed. Thus, a relatively moreliquid money market, ceteris paribus, requires less time toexecute a transaction, operates on a narrower bid-askspread, supports higher volumes for a given spread andrequires relatively less time for the restoration of the “normal”bid-ask spread following a high value transaction.

Box III.4Market Microstructure: Issues in Money Market Liquidity

On the basis of these criteria, the Indian money marketappears to be a reasonably deep, vibrant and liquid market(based on overnight data on bid-ask spread from April 1,2004 to February 28, 2007). During this period, the bid-ask spread has varied within a range of (-)0.37 to (+)1.32basis points with an average of 16 basis points andstandard deviation (SD) of 11 basis points (coefficient ofvariation is 0.69). Despite a higher degree of variation, thebid-ask spread remained within the 2-SD band around theaverage during most of the period (Chart). Considerablevolatility above the average was witnessed up to December2004. It eased up significantly during the major part of 2005but increased subsequently during the early part of 2006.During 2006-07, while bid-ask spreads ruled below theaverage till August 2006, increase in spreads beyond the2-SD band were noticed during end-December 2006 onaccount of tightness in liquidity due to the impact of thestaggered hike of 0.5 percentage point in the CRR and theadvance tax flows from the banking system. The bid-askspread hardened significantly in March 2007, reflecting tight

liquidity conditions on account of advance tax outflows,year-end considerations and sustained credit demand.However, events such as the blast of July 11, 2006 inMumbai did not have any significant impact on the bid-askspread in the call money market.

Differences in market microstructure can affect marketliquidity considerably. In this regard, evolution of marketstructure is mostly dr iven by the rapid structural,technological and regulatory changes affecting globalfinancial markets. In the Indian context, the gradual shifttowards a collateralised market, phasing out of non-bankparticipants from call money market, reductions in statutoryreserve requirements, introduction of new instruments suchas CBLO, implementation of RTGS and facilitating thetrading through NDS-CALL are some of the factors that havecontributed to the development of a relatively vibrant andliquid money market.

3.93 Despite al l these developments, thebehaviour of call rates, which occasionally breached

the corridor has called for a re-look at the marketmicrostructure (Box III.4). Accordingly, as part of the

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policy strategy of focusing on market microstructure,the Reserve Bank took several initiatives for furtherdeepening the money market along with other marketsegments in order to enhance the effectiveness ofthe rate channel of monetary transmission. A numberof measures were taken by the Reserve Bank toenable the exit of non-bank participants from the callmoney market in a gradual manner. Instruments suchas market repo (repo outside the Reserve Bank’sLAF) and collateralised borrowing and lendingobligation (CBLO) introduced in 2003, through theClear ing Corporation of India Limited (CCIL),enabled smooth migration of non-bank participantsfrom the uncollateralised call money segment to thecollateralised segments. The collateralised marketis now the predominant segment of the moneymarket with a share of around 70 per cent in totalvolume during 2006-07. This also provided analternative avenue for banks to park their surplusfunds beyond one day. Fur thermore, this wasfacilitated by the standardisation of accountingpractices, broad-basing of eligibility criteria in thecollateralised markets, exemption of CBLO from theCRR requirements and anonymity provided by theorder matching systems in the CBLO market.Moreover, minimum maturity period for CPs (October2004) and CDs (April 2005) were shortened from 15days to 7 days. These developments helped in thesmooth transformation of the call money market intoa pure inter-bank market in August 2005.

3.94 Availability of alternative avenues (such asthe market repo and CBLO) for deploying short-termfunds by market participants has also enabled thealignment of other money market rates with theinformal interest rate corridor of reverse repo andrepo rates under the LAF. Accordingly, although thecall rate has at times breached the corridor, theweighted average overnight rate moved largely withinthe informal corridor set by LAF rates (Chart III.4).

3.95 To sum up, various policy initiatives by theReserve Bank in terms of widening of market-basedinstruments and shortening of maturities of variousinstruments have not only helped in promoting marketintegration but also enabled better l iquiditymanagement and transmission of policy signals bythe Reserve Bank. Following the recommendationsof the Technical Group on Money Market (2005), theReserve Bank’s focus on the money market has beenon encouraging the growth of the collateralisedmarket, developing a rupee yield curve and providingavenues for better risk management by marketparticipants.

V. MONEY MARKET DEVELOPMENTS –MID-1980s ONWARDS

3.96 As discussed earlier, the Vaghul WorkingGroup (1987) recommended several measures forwidening and deepening the money market. Some ofthe major recommendations, inter alia, included (i)activating existing instruments and introducing newinstruments to suit the changing requirements ofborrowers and lenders; (ii) freeing interest rates onmoney market instruments; and (iii) creating an activesecondary market through establishing, wherevernecessary, a new set of institutions to impart sufficientliquidity to the system. The Committee on the FinancialSystem, 1991 (Chairman: Shri M. Narasimham)further recommended phased rationalisation of theCRR for the development of the money market.Second generation reforms in the money marketcommenced when the Committee on Banking SectorReforms, 1998 (Chairman: Shri M. Narasimham)recommended measures to facilitate the emergenceof a proper interest rate structure reflecting thedifferences in liquidity, maturity and risk.

3.97 In pursuance of the recommendations of thetwo committees, a comprehensive set of measures wasundertaken by the Reserve Bank to develop themoney market. These included (i) withdrawal ofinterest rate ceilings in the money market; (ii)introduction of auctions in Treasury Bills; (iii) abolitionof ad hoc Treasury Bills; (iv) gradual move away fromthe cash credit system to a loan-based system; (v)relaxation in the issuance restrictions and subscription

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10 Satellite Dealers (SDs) were also allowed to operate in the call/notice money market until they were phased out from May 2002.

Table 3.3: Activity in Money Market Segments

(Rupees crore)

Average Daily Turnover # Outstanding Amount

Year Call Money Market Repo Collateralised Term Money Commercial Certificates ofMarket (Outside the Borrowing and Market Paper Deposit

LAF) LendingObligation

(CBLO)

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1997-98 22,709 – – – 2,806 9,349

1998-99 26,500 – – – 4,514 6,876

1999-00 23,161 6,895 – – 7,014 1,908

2000-01 32,157 10,500 – – 6,751 1,199

2001-02 35,144 30,161 – 195 7,927 949

2002-03 29,421 46,960 30 341 8,268 1,224

2003-04 17,191 10,435 515 519 7,835 3,212

2004-05 14,170 17,135 6,697 526 11,723 6,052

2005-06 17,979 21,183 20,039 833 17,285 27,298

2006-07 21,725 33,676 32,390 1,012 21,314 64,814

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

norms in the case of many money marketinstruments; (vi) introduction of new financialinstruments; (vii) widening of participation in themoney market; and (viii) development of a secondarymarket. All these policy measures have helped indeveloping the money market significantly over theyears as reflected in the volumes and turnover invarious market segments (Table 3.3).

Call/Notice Money Market

3.98 Prior to the mid-1980s, as discussed earlier,the market participants heavily depended on the callmoney market for meeting their funding requirements.However, inherent volatility in the market impededefficient price discovery, thereby hampering theconduct of monetary policy. Against this backdrop, theChakravar ty Committee (1985) recommendedactivation of the Treasury Bills market (with thediscount rate being market related) to reducedependence on the call money market and abolishceilings on the call rate along with permitting moreinstitutional participation to widen the market base.The Vaghul Committee, in view of the continuedexistence of an unaligned overall interest ratestructure, recommended abolition of the ceilinginterest rate on the call money market. However, it

held the view that the call money market shouldcontinue to remain a strictly inter-bank market (barringLIC and the erstwhile UTI which could continue aslenders only) and recommended the setting up of aFinance House of India to impart liquidity to short-term money market instruments.

3.99 The reforms commenced with the setting upof an institution, viz., the Discount and Finance Houseof India (DFHI) in 1988 as a money market institutionto impart liquidity to money market instruments.Interest rate in the call money market was deregulatedwith the withdrawal of the ceiling rate with respect toDFHI from October 1988 and with respect to the callmoney market in May 1989. Although the VaghulCommittee had recommended that call/notice moneyshould be restricted to banks only, the Reserve Bankfavoured the widening of the call/notice money market.In the absence of adequate avenues for deploymentof short-term surpluses by non-bank institutions, alarge number of non-bank participants such as FIs,mutual funds, insurance companies and corporateswere allowed to lend in the call/notice money market,although their operations were required to be routedthrough the PDs from March 199510 . In this context,PDs and banks were permitted to both lend andborrow in the market. The Reserve Bank exempted

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inter-bank liabilities from the maintenance of CRR/SLR (except for the statutory minimum) effective April1997 with a view to imparting stability to the callmoney market.

3.100 The Narsimham Committee (1998), however,noted that the money market continued to remainlopsided, thin and extremely volatile. While the non-bank participation was a source of comfort, it hadnot led to the development of a stable market withdepth and liquidity. The non-bank participants, unlikebanks, were not subjected to reserve requirementsand the call/notice money market was characterisedby predominant lenders and chronic borrowerscausing heavy gyrations in the market. There wasalso over-reliance of banks in the call/notice moneysegment, thereby impeding the development of othersegments of the money market. The Reserve Bankalso did not have any effective presence in themarket and operated with pre-determined lines ofrefinance. As interest rates in other money marketsegments move in tandem with the inter-bank callmoney rate, the volatility in the call segment inhibitedproper risk management and pricing of instruments.Thus, freeing of interest rates did not result in a well-defined yield curve (Box III.5). Furthermore, banks’role in the money market was further impaired bythe health of their own balance sheets, lack ofintegrated treasury management and sound asset-liability management.

3.101 The Narasimham Committee (1998) madeseveral recommendations to further develop themoney market. First, it reiterated the need to makethe call/notice money market a strictly inter-bankmarket, with PDs being the sole exception, as theyperform the key function of equilibrating the callmoney market and are formally treated as banks forthe purpose of inter-bank transactions. Second, itrecommended prudential limits beyond which banksshould not be allowed to rely on the call moneymarket. The access to the call money market shouldonly be for meeting unforeseen fund mismatchesrather than for regular financing needs. Third, theReserve Bank’s operations in the money marketneed to be market-based through LAF repos andreverse repo auctions, which would determine thecorridor for the market. Fourth, non-bank participantscould be provided free access to rediscounting ofbills, CP, CDs, Treasury Bills and money marketmutual funds.

3.102 Following the recommendations of theReserve Bank’s Internal Working Group (1997) and

the Narasimham Committee (1998), steps weretaken to reform the cal l money market bytransforming it into a pure inter-bank market in aphased manner. The corporates, which were allowedto route their transactions through PDs, were phasedout by end-June 2001. The non-banks’ exit wasimplemented in four stages beginning May 2001whereby limits on lending by non-banks wereprogressively reduced along with theoperationalisation of negotiated dealing system(NDS) and CCIL until their complete withdrawal inAugust 2005. In order to create avenues fordeployment of funds by non-banks following theirphased exit from the call money market, several newinstruments were created such as market repos andCBLO. Maturities of other existing instruments suchas CPs and CDs were also gradually shortened inorder to align the maturity structure to facilitate theemergence of a rupee yield curve. The Reserve Bankhas been modulating liquidity conditions throughOMOs ( including LAF), MSS and ref inanceoperations which, along with stipulations of minimumaverage daily reserve maintenance requirements,have imparted stability to the call money market.

3.103 Despite these reforms, however, thebehaviour of banks in the call market has not beenuniform. There are still some banks, such as foreignand new private sector banks, which are chronicborrowers and public sector banks, which are thelenders. Notwithstanding excessive dependence ofsome banks on the call money market, the short-term money markets are characterised by highdegree of stability. The Reserve Bank has instituteda series of prudential measures and placed limitson borrowings and lendings of banks and PDs in thecall/notice market to minimise the default risk andbring about a balanced development of variousmarket segments. In order to improve transparencyand strengthen efficiency in the money market, it wasmade mandatory for all NDS members to report alltheir call/notice money market transactions throughNDS within 15 minutes of conclusion of thetransaction. The Reserve Bank and the marketparticipants have access to this information on afaster frequency and in a more classified manner,which has improved the transparency and the pricediscovery process. Furthermore, a screen-basednegotiated quote-driven system for all dealings inthe call/notice and the term money markets (NDS-CALL), developed by CCIL, was operationalised onSeptember 18, 2006 to br ing about increasedtransparency and better price discovery in thesesegments. Although the dealing on this platform is

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opt ional, 85 banks and 7 PDs have takenmembership of NDS-CALL.

3.104 Various reform measures over the years haveimparted stability to the call money market. It haswitnessed orderly conditions (barring a few episodes

of volatility) and provided the necessary platform forthe Reserve Bank to conduct its monetary policy. Thebehaviour of call rates has, histor ically, beeninfluenced by liquidity conditions in the market. Callrates touched a peak of about 35 per cent in May1992, reflecting tight liquidity on account of high levels

The existence of a wide, deep and liquid money marketis critical for the development of a smooth yield curve,which facilitates the conduct of monetary policy. As moneymarket determines the cost of liquidity and anchors theshort-end of the yield curve, the development of a deepand liquid money market is imperative for the emergenceof a yield curve which would credibly transmit monetarypolicy signals. In this regard, the Reserve Bank has takenseveral measures since the mid-1990s to develop a short-term yield curve with deep liquidity. These are: (i)exempting inter-bank liabilities from the maintenance ofCRR; (ii) operationalising the LAF whereby the reverserepo and repo rates are used as policy instruments tomodulate liquidity conditions and stabilise call rates withinthe LAF corridor; (iii) transforming the call money marketinto a pure inter-bank market by phasing out the non-bank lenders; (iv) developing other market segments withadequate access for non-banks; (v) developing a relativelyvibrant non-RBI repo market; and (vi) developing theCBLO market as yet another instrument of overnightborrowing/lending facility.

Notwithstanding these initiatives, a short-term yield curvewhich is readily amenable for policy purposes is yet toemerge. In this regard, the single largest impediment forthe emergence of a short-term yield curve has been thenon-existence of a vibrant and liquid term-money market,mainly due to the inability of market participants to buildlong-term interest rate expectations, skewed distributionof market liquidity, reduction in the minimum maturityperiod of term deposits of banks, and tendency on thepart of banks to deploy their surplus funds in LAF auctionsrather than in the term money market.

As a result, the yield curve has been flattening in recentyears; it even remained inverted for a very brief period.For instance, the absorpt ion of l iquidi ty throughsterilisation operations had led the call rates and the cut-off yield on 91-day Treasury Bills to edge above the yieldof 364-day Treasury Bills, leading to an inversion of asegment of the yield curve for a few days in October 2003.

The prolonged flattening of the yield curve has, however,been influenced by structural factors such as considerablesoftening of yields due to dismantling of administeredinterest rate regime, favourable inflationary expectationsand excess liquidity in the wake of capital flows. The

Box III.5Development of a Short-Term Yield Curve – Some Issues

moderation in yields has also been suppor ted byrat ional isat ion of smal l savings interest ratesadministered by the Government. The stickiness of thereverse repo/repo rate could also have contributed to theflattened yield curve. Maintaining the reverse repo/reporate at the unchanged level for an extended period oftime could have also led to distor tions in the termstructure of interest rates. This can be understood by thefact that while the 10-year gilt yield declined by 257 basispoints during May 2002 to April 2004, the reverse reporate declined by only 150 basis points while call moneyrates declined by 180 basis points during the same period.These structural factors appeared to have contributed tothe f lattening of the yield curve. Owing to thesedistortions, the Indian yield curve does not fully reflectthe market expectat ions on inf lat ion and growthprospects.

An important objective of money market reforms by theReserve Bank in recent years has been to facilitatetransparency in transact ions in order to reducetransactions cost and improve price discovery. TheClearing Corporation of India Limited (CCIL), by providingfor guaranteed sett lement of al l t rades, ensuresprevent ion of gr id- lock in f inancial t ransact ions.Furthermore, the introduction of CBLO by the CCIL inJanuary 2003 and operationalisation of an order matching(OM) anonymous trading screen has made tradingtransparent and on a real time basis, thereby making themoney market more efficient. In order to further enhancetransparency in the money market, screen-based tradingthrough the NDS-CALL was operationalised in September2006. The full implementation of the real time grosssettlement (RTGS) would further aid this process bycontributing to systemic stability.

Notwithstanding considerable progress, a proper short-term yield curve, which facilitates the transmission ofmonetary policy signals and provides a benchmark forthe pricing of other short-term debt instruments, is yet toemerge fully. In this regard, the constant interactionbetween the Reserve Bank and market par ticipantsthrough frequent meetings, speeches, interviews, pressreleases and publications is progressively expected tomute the surpr ise element of monetary policy andfacilitate the process of formation of market expectations,which would increasingly get captured in the yield curve.

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of statutory pre-emptions and withdrawal of allrefinance facilities, barring export credit refinance.After some softness, call rates again came underpressure to touch 35 per cent in November 1995,partly reflecting turbulence in the foreign exchangemarket. The Reserve Bank supplied liquidity throughrepos and enhanced refinance facilities while reducingthe CRR to stabilise the market. After softening to asingle digit level, the rate hardened again to touch 29per cent in January 1998, reflecting mopping up ofliquidity by the Reserve Bank to ease foreignexchange market pressure. Barring these episodesof volatility, call rates remained generally stable in the1990s. After the adoption of the LAF in June 2000,the call rate eased significantly to a low of 4.5 percent in September 2004, reflecting improved liquidityin the system following increased capital inflows.However, it came under some pressure in December2005 on account of IMD redemptions and increasedto about 7 per cent in February 2007, partly due tomonetary tightening (Chart III.5)11. With the institutionof LAF and consequent improvement in liquiditymanagement by the Reserve Bank, the volatility incall rates has come down significantly compared tothe earlier periods. The mean rate has almost halvedfrom around 11 per cent during April 1993-March 1996to about 6 per cent during April 2000-March 2007.

Volatility, measured by coefficient of variation (CV) ofcall rates, also halved from 0.6 to 0.3 over the sameperiod. Thus, while statutory pre-emptions like CRRand SLR, and reserve maintenance period were themain factors that influenced call rates in the pre-reformperiod, it is the developments in other marketsegments, mainly the foreign exchange and thegovernment securities market along with the ReserveBank’s liquidity management operations that havebeen the main driver of call rates in the post-reformperiod. This signifies increased market integration andimproved liquidity management by the Reserve Bank.

3.105 With the transformation of the call moneymarket into a pure inter-bank market, the turnover inthe call /notice money market has declinedsignificantly. The activity has migrated to otherovernight collateralised market segments such asmarket repo and CBLO. The daily average turnoverin the call money market, which was Rs.35,144 crorein 2001-02, declined to Rs.14,170 crore in 2004-05before increasing again to Rs.21,725 crore during2006-07. The recent rise in call money market turnoverreflects the general tendency of heightened marketactivity following the imbalance between growth inbank credit and bank deposits in recent years againstthe backdrop of sustained pick-up in non-food credit.

Term Money Market

3.106 The term money market is another segmentof the uncollateralised money market. The maturityperiod in this segment ranges from 15 days to oneyear. The term money market has been somewhatdormant in India. It was also a strictly regulated marketup to the late 1980s with the ceiling rates of interest(10.5-11.5 per cent) across the various maturitybuckets. Historically, statutory pre-emptions on inter-bank liabilities, regulated interest rate structure, cashcredit system of financing, high degree of volatility inthe call money rates, availability of sector-specificrefinance, inadequate asset liability management(ALM) discipline among banks and scarcity of moneymarket instruments of varying maturities were citedas the main factors that inhibited the development ofthe term money market.

3.107 In order to activate the term money market,several policy measures were taken by the Reserve

11 Call money rate hardened during the second half of March 2007 (averaging about 20 per cent), reflecting tight liquidity conditions onaccount of advance tax outflows, year-end considerations, sustained credit demand and asymmetric distribution of government securitiesholdings across banks.

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Bank. In pursuance of the Vaghul Working Group’srecommendations, the administered interest ratesystem in this market was dismantled in 1989. In orderto promote this segment, the participation waswidened by allowing select financial institutions in1993 to borrow from the term money market for amaturity period of 3-6 months. Term money of originalmaturity between 15 days and 1 year was exemptedfrom the CRR in August 2001. Furthermore, no limitswere stipulated for transactions in the term moneymarket, unlike under the call/notice money market.

3.108 Despite various reforms, the average dailyturnover in this segment continues to be quite low. Itincreased moderately from Rs.195 crore in 2001-02to Rs.1,012 crore during 2006-07. The factors stillhindering the development of this segment of themoney market include: (i) the inability of participantsto build interest rate expectations over the medium-term due to which there is a tendency on their part tolock themselves in the short-term; (ii) the distributionof liquidity is also skewed with public sector banksoften having surplus funds and foreign banks beingin deficit in respect of short-term resources. Sincethe deficit banks depend heavily on call/notice money,more often, surplus banks exhaust their exposurelimits to them; (i i i ) corporates’ overwhelmingpreference for ‘cash credit’ system rather than ‘loan’generally forces banks to deploy a large amount inthe call/notice money market rather than in the termmoney market to meet sudden demand fromcorporates; (iv) the steady reduction in the minimummaturity period of term deposits offered by banks; and(v) the tendency on the part of banks to deploy theirsurplus funds in LAF auctions rather than in the termmoney market, reflecting risk-averse behaviour.

3.109 It is widely accepted that the banking sectorneeds a deep and liquid term money market formanaging its liquidity as also a smoother rupee yieldcurve. The recent reform measures such as thephasing out of non-banks from the call/notice moneymarket and institution of prudential call/notice moneyexposure limits for banks and PDs are expected toswitch market participants to other market segments.The development of an efficient repo market couldprovide benchmarks to all fixed income segments,including the term money market. In order to improvetransparency, strengthen efficiency and facilitate abetter price discovery process in the term moneymarket, the Technical Group on Money Marketrecommended that term money transactions shouldalso be conducted on a screen-based negotiatedquote driven platform.

Market Repos

3.110 Repo (Repurchase Agreement) instrumentsenable collateralised short-term borrowing throughthe sell ing of debt instruments. Under a repotransaction, the security is sold with an agreement torepurchase it at a pre-determined date and rate.Reverse repo is a mirror image of repo and representsthe acquisition of a security with a simultaneouscommitment to resell.

3.111 In developed financial markets, repurchaseagreements (repos) are recognised as a very usefulmoney market instrument enabl ing smoothadjustment of shor t-term liquidity among variedcategories of market participants such as banks,financial institutions, securities and investment firms.Compared with pure cal l /not ice/term moneytransaction, which is non-collateralised, repo is fullycollateralised by securities, thereby offering greaterflexibility and minimising default risk. Furthermore,repo has several advantages over othercollateralised instruments also. One, while obtainingtitles to securities in other collateralised lendinginstruments is a time-consuming and uncer tainprocess, repo entails instantaneous legal transfer ofownership of the eligible securities. Two, it helps topromote greater integration between the money andthe government securities markets, thereby creatinga more continuous yield curve. Additionally, repo canalso be used to faci l i tate Government’s cashmanagement (Gray, 1998). Central banks all over theworld also use repo as a very powerful and flexiblemoney market instrument for modulating marketliquidity. Since it is a market-based instrument, itserves the purpose of an indirect instrument ofmonetary policy at the short-end of the yield curve.

3.112 Since forward trading in securities wasgenerally prohibited in India, repos were permittedunder regulated conditions in terms of participantsand instruments. Reforms in this market haveencompassed both institutions and instruments. Bothbanks and non-banks were allowed in the market. Allgovernment securities and PSU bonds were eligiblefor repos till April 1988. Between April 1988 and mid-June 1992, only inter-bank repos were allowed in allgovernment secur it ies. Double ready forwardtransactions were part of the repos market throughoutthis period. Subsequent to the irregularities insecurities transactions that surfaced in April 1992,repos were banned in all securities, except TreasuryBills, while double ready forward transactions wereprohibited altogether. Repos were permitted onlyamong banks and PDs. In order to reactivate the repos

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market, the Reserve Bank gradually extended reposfacility to all Central Government dated securities,Treasury Bills and State Government securities. It ismandatory to actually hold the securities in theportfolio before undertaking repo operations. In orderto activate the repo market and promote transparency,the Reserve Bank introduced regulatory safeguardssuch as delivery versus payments (DvP) systemduring 1995-96. The Reserve Bank allowed all non-bank entities maintaining subsidiary general ledger(SGL) account to participate in this money marketsegment. Furthermore, non-bank financial companies,mutual funds, housing finance companies andinsurance companies not holding SGL accounts werealso allowed by the Reserve Bank to undertake repotransactions from March 2003, through their “giltaccounts” maintained with custodians. With theincreasing use of repos in the wake of phased exit ofnon-banks from the call money market, the ReserveBank issued comprehensive uniform accountingguidelines as well as documentation policy in March2003. Moreover, the DvP III mode of settlement ingovernment securities (which involves settlement ofsecurities and funds on a net basis) in April 2004facilitated the introduction of rollover of repo transactionsin government securities and provided flexibility tomarket participants in managing their collaterals.

3.113 The operationalisation of the NegotiatedDealing System (NDS) and the Clearing Corporationof India Ltd. (CCIL) combined with prudential limitson borrowing and lending in the call/notice market forbanks also helped in the development of market repos.Reflecting this, the average daily turnover of repotransactions (other than the Reserve Bank) increasedsharply from Rs.11,311 crore during April 2001 to Rs.42,252 crore in June 2006 in line with the phasingout of non-banks from the call/notice money market -a process which was completed by August 2005.Subsequently, the turnover in this segment becamesubdued. In this segment, mutual funds and someforeign banks are the major providers of funds, whilesome foreign banks, private sector banks and primarydealers are the major borrowers.

Collateralised Borrowing and Lending Obligations(CBLO)

3.114 The CBLOs were operationalised as a moneymarket instrument by the CCIL on January 20, 2003.The product was introduced with the objective ofproviding an alternative avenue for managing short-term liquidity to the market participants who wererestricted and/or phased out of the call money market.The market was quick to reap the benefits of

anonymous trading system. Mutual funds andcooperative banks were the main beneficiaries of thisscheme. The anonymous, order-driven and onlinematching system was a milestone in the Indian debtmarket.

3.115 With the transformation of the call moneymarket into a pure inter-bank market (with PDs) sinceAugust 2005 and imposition of prudential limits onborrowing/lending by banks and PDs in the call moneymarket, the activity has migrated to the CBLO segmentas it enables market participants to manage their short-term liquidity. Accordingly, the average daily turnover inthe CBLO segment increased from Rs.515 crore in2003-04 to Rs.32,390 crore during 2006-07. Theincrease in turnover could be attributed partly to theincrease in the number of participants from 30 in July2003 to 153 by March 2007. The composition of marketparticipants has undergone changes with mutual fundsand insurance companies emerging as the majorlenders in the CBLO market, while nationalised banks,PDs and non-financial companies as the majorborrowers during 2006-07. Thus, the CBLO and themarket repo (the collateralised segment) have nowemerged as the predominant money market segmentswith a combined share of nearly 70 per cent of the totalturnover in 2006-07.

3.116 As borrowings in the CBLO segment are fullycollateralised, the rates in this segment are expectedto be comparable with the repo rates. The movementsin the daily average rates in the overnight call, therepo and the CBLO markets for the period fromJanuary 2003 to March 2007 show that CBLO ratesmoved between the call and the repo rates up toNovember 2003 due to a l imited number ofparticipants. From November 2003, the CBLO rateshave aligned with the repo rates on account ofincrease in the number of par t icipants. Thetransparent nature and real time basis of deals in theCBLO segment have helped in enhancing efficiencyof the money market.

Treasury Bills

3.117 In India, prior to the institution of reforms, the91-day Treasury Bil ls were sold on tap at anadministered rate of discount, which was fixed at 4.6per cent from July 1974. They, however, could notemerge as a useful money market instrument due tothe administered nature of interest rates, whichreflected the perspective of the issuer rather than thebuyer. A reform process in this segment started withthe introduction of 182-day Treasury Bills fromNovember 1986. This was followed by the phasing

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out of tap Treasury Bills and an introduction ofauctioning system in 91-day Treasury Bills. Theinstitution of DFHI as a money market institution alongwith other steps taken to develop the market createdthe ground for the emergence of 91-day Treasury Billsas an important market segment. Treasury Bills with364-day maturity were introduced in April 1992 andtendered through auction-determined rates ofdiscount. Subsequently, 91-day Treasury Bills wereintroduced on an auction basis in January 1993. Therewas also a system of 91-day ad hoc Treasury Bills,which were issued by the Central Government to theReserve Bank with a de jure objective of bridgingtemporary mismatches. De facto, however, they turnedout to be a permanent source of meeting CentralGovernment’s resource requirement throughmonetisation of fiscal deficit. A major reform occurredin April 1997, when the system of ad hoc TreasuryBills was abolished and 14-day intermediate TreasuryBills and auction bills were introduced to enable bettercash management by the Government and to providealternative avenues of investments to the StateGovernments and some foreign central banks. Thus,Treasury Bills of different tenors were introduced toconsolidate the market for imparting liquidity, whileyields were made market determined through auctionsfor their use as a benchmark for other short-termmarket instruments.

3.118 The Reserve Bank now auctions 91-dayTreasury Bills on a weekly basis and 182-day TreasuryBills (re-introduced in April 2005) and 364-dayTreasury Bills on a fortnightly basis on behalf of theCentral Government. Treasury Bills market being atthe heart of money market development, the ReserveBank has been paying special attention to this marketsegment. The amounts earmarked for auctions arepre-announced and bids received from non-competitive bidders have been kept outside thenotified amount since April 1998. The dates ofpayment are synchronised on the following Friday afterthe auctions with a view to providing fungible stock ofvarying maturities and to activate the secondarymarket in Treasury Bills. To impart liquidity to TreasuryBills and also to enable investors to acquire thesebills in between the auctions, primary dealers (PDs)quote their bid daily and offer discount rates.

3.119 In view of the limited stock of governmentsecurities with the Reserve Bank, which constrainedoutright OMOs for sterilisation purposes, TreasuryBills were made eligible for issuance under the MSS.The notified amount of Treasury Bills issued underthe MSS has varied during the year keeping in view

the prevailing liquidity conditions. The primary marketyields of Treasury Bills edged higher during 2005-06mirroring the liquidity conditions as well as movementsin LAF rates. The hardening of primary yields sinceSeptember 2005 mainly reflects liquidity tighteningdue to festival demand for cash, quarterly advancetax outflows and IMD redemption on December 29,2005 and strong credit demand (Chart III.6). Thus,Treasury Bills have not only served the Governmentin their cash management, but have also beeneffectively used for sterilisation purposes under theMSS. The persistent use of these instruments forsterilisation, however, could undermine their role asbenchmarks for other money market instruments.

3.120 The Reserve Bank has been modifying thenotified amounts for auctioning of Treasury Bills intune with the evolving liquidity conditions. Reflectingthe relatively tight liquidity conditions during 2006-07, the bid-cover ratios have generally declined,especially in respect of 91-day and 182-day TreasuryBills (Table 3.4).

Commercial Paper

3.121 Commercial Paper (CP) is issued in the formof a promissory note sold directly by the issuers toinvestors, or else placed by the borrowers throughagents such as merchant banks and security houses.When it is issued by corporate borrowers directly toinvestors in the money market and by the process ofsecuritisation, the intermediation function of the bankis obviated. CP was introduced in India in January

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1990, in pursuance of the Vaghul Committee’srecommendations, in order to enable highly rated non-bank corporate borrowers to diversify their sourcesof shor t-term borrowings and also provide anadditional instrument to investors. CP could carry aninterest rate coupon but is generally sold at a discount.Since CP is freely transferable, banks, financialinstitutions, insurance companies and others are ableto invest their short-term surplus funds in a highlyliquid instrument at attractive rates of return.

3.122 The terms and conditions relating to issuingCPs such as eligibility, maturity periods and modesof issue have been gradually relaxed over the yearsby the Reserve Bank. The minimum tenor has beenbrought down to seven days (by October 2004) instages and the minimum size of individual issue aswell as individual investment has also been reducedto Rs. 5 lakh with a view to aligning it with other moneymarket instruments. The limit of CP issuance was first

carved out of the maximum permissible bank finance(MPBF) limit and subsequently only to its cash creditportion. A major reform to impart a measure ofindependence to the CP market took place when the“stand-by” facility of the restoration of the cash creditlimit and guaranteeing funds to the issuer on maturityof the paper was withdrawn in October 1994. As thereduction in the cash credit portion of the MPBFimpeded the development of the CP market, theissuance of CP was delinked from the cash credit limitin October 1997. It was converted into a “stand alone”product from October 2000 so as to enable the issuersof the services sector to meet short-term workingcapital requirements. Banks were allowed to fixworking capital limits after taking into account theresource pattern of the companies’ finances, includingCPs. Corporates, PDs and al l-India f inancialinstitutions (FIs) under specified stipulations havebeen permitted to raise short-term resources by theReserve Bank through the issue of CPs. There is no

Table 3.4: Treasury Bills – Primary Market

Month Notified Amount Average Implicit Yield at Minimum Cut-off Price Average Bid-Cover Ratio*(Rupees crore) (Per cent)

91-day 182-day 364-day 91-day 182-day 364-day

1 2 3 4 5 6 7 8

2005-06April 19,000 5.17 5.36 5.62 4.03 4.48 2.54May 15,000 5.19 5.35 5.58 3.30 3.37 2.29June 18,500 5.29 5.37 5.61 1.54 2.42 1.81July 11,500 5.46 5.67 5.81 1.21 1.79 1.68August 21,000 5.23 5.42 5.63 3.07 2.68 2.54September 23,000 5.24 5.37 5.70 1.52 1.45 1.61October 15,000 5.50 5.71 5.84 1.69 1.53 3.44November 11,000 5.76 5.85 5.96 2.12 1.92 2.30December 5,000 5.89 6.00 6.09 3.07 2.97 2.36January 5,000 6.25 6.22 6.21 2.86 2.83 2.72February 5,000 6.63 6.74 6.78 3.04 2.07 2.71March 6,500 6.51 6.66 6.66 4.17 3.43 3.36

2006-07April 5,000 5.52 5.87 5.98 5.57 4.96 2.02May 18,500 5.70 6.07 6.34 1.88 1.84 1.69June 15,000 6.14 6.64 6.77 1.63 1.35 2.11July 16,500 6.42 6.75 7.03 1.82 1.55 3.12August 19,000 6.41 6.70 6.96 2.03 2.71 3.48September 15,000 6.51 6.76 6.91 1.35 1.80 2.92October 15,000 6.63 6.84 6.95 1.31 1.20 2.02November 18,500 6.65 6.92 6.99 1.33 1.22 2.49December 15,000 7.01 7.27 7.09 1.19 1.29 3.34January 19,000 7.28 7.45 7.39 1.02 1.35 1.74February 15,000 7.72 7.67 7.79 2.48 2.56 3.16March 15,000 7.68 7.98 7.90 2.08 2.15 3.87

* : Ratio of competitive bids amount received (BR) to notified amount (NA).Note : 1. 182-day Treasury Bills were re-introduced with effect from April 6, 2005.

2. Notified amount is inclusive of issuances under the MSS.

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lock-in period for CPs. Furthermore, guidelines wereissued permitt ing investments in CPs only indematerialised form effective June 30, 2001 whichhas enabled a reduction in the transaction cost. Inorder to rationalise and standardise, whereverpossible, various aspects of processing, settlementand documentation of CP issuance, several measureswere under taken with a view to achieving thesettlement on a T+1 basis. For further deepening themarket, the Reserve Bank issued draft guidelines onsecuritisation of standard assets on April 4, 2005.Accordingly, the reporting of CP issuance by issuingand paying agents (IPAs) on NDS platformcommenced effective April 16, 2005. The FCACobserved that CPs being short-term instruments, anyunlimited opening up of issuance could haveimplications for short-term debt flows. It, therefore,recommended for prudential limits even under fullconvertibility.

3.123 The issuance of CP has generally beenobserved to be inversely related to call money rates.Activity in the CP market reflects the state of marketliquidity as its issuances tend to rise amidst ampleliquidity conditions when companies can raise fundsthrough CPs at an effective rate of discount lower thanthe lending rate of banks. Banks also prefer investingin CPs during credit downswing as the CP rate worksout higher than the call rate. Thus, the averageoutstanding amount of CPs declined from Rs.2,280crore during 1993-94 to Rs.442 crore during 1995-96amidst tight liquidity but moved up to Rs.17,285 croreduring 2005-06. It increased further to Rs.21,314 croreduring 2006-07. Leasing and finance companiescontinue to be the predominant issuers of CPs.Discount rates on CPs have firmed up in line with theincreases in policy rates during 2005-06 and 2006-07(Chart III.7).

Certificates of Deposit

3.124 In order to widen the range of money marketinstruments and provide greater f lexibi l i ty toinvestors for deploying their short-term surplusfunds, certificates of deposit (CDs) were introducedin June 1989. They are essentially securitised short-term time deposits issued by banks and all-Indiafinancial institutions during periods of tight liquidity,at relatively higher discount rates as compared toterm deposits. The guidelines concerning CDs havealso been relaxed over time. These include (i) freeingof CDs from interest rate regulation in 1992; (ii)lowering the minimum maturity period of CDs issuedby banks to 7 days (April 2005) with a view to aligning

the minimum tenor for CPs and CDs asrecommended by the Narasimham Committee(1998); (iii) permitting select all-India financialinstitutions to issue CDs for a maturity period of 1 to3 years; (iv) abolishing limits to CD issuances as acertain proportion of average fortnightly outstandingaggregate deposits effective October 16, 1993 witha view to enabling it as a market determinedinstrument; (v) reducing the minimum issuance sizefrom Rs. 1 crore in 1989 to Rs. 1 lakh in June 2002;(vi) withdrawal of restriction on minimum period fortransferability with a view to providing flexibility anddepth to the secondary market activity; (vii) requiringbanks and FIs to issue CDs only in dematerialisedform, effective June 30, 2002, in order to impart moretransparency and encourage secondary market; and(viii) permitting banks in October 2002 to issuefloating rate CDs as a coupon bearing instrumentso as to promote flexible pricing in this instrument.The FCAC Committee recommended for prudentiall imits on opening up CDs even under ful lconvertibility.

3.125 Activity in the CD market also mirrors liquidityconditions but unlike CPs, the CD issuances by banksand FIs pick up during periods of tight liquidity. Forinstance, the average outstanding amount of CDs rosefrom Rs.8,266 crore during 1992-93 to Rs.14,045crore during 1995-96. It further increased to Rs.21,503crore in June 1996 reflecting the credit pick-up.Another phase of tight liquidity during the East Asiancrisis led to increased market activity in this segment.

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Subsequently, the outstanding amount declined toRs.949 crore during 2001-02, reflecting the state ofeasy liquidity on account of large capital inflows. Theaverage outstanding amount of CDs increased againto Rs.64,814 crore during 2006-07 as banks continuedto supplement their efforts at deposit mobilisation inorder to support the sustained credit demand. Interestrates on CDs softened in recent years in line withother money market instruments, although there wassome hardening during 2006-07 (Chart III.8).

Volatility in Money Market Segments

3.126 An analysis of the trends in interest ratesacross the various instruments in the money marketbrings out the following salient features. First, since theintroduction of reforms, all money market rates havewitnessed considerable softening commensurate withthe progressive reduction in inflation, reflecting lowerinflation expectations. Softening of interest rates hasalso been on account of several other factors such asthe deepening of the market through establishment ofappropriate market intermediaries, increase in thenumber of participants, prevalence of comfortableliquidity conditions arising out of large capital inflowsand a distinct policy preference for a softer interestrate regime. The volatility in call money rates hasreduced after the introduction of LAF and the settingup of an informal corridor of reverse repo and repo rates(Table 3.5). The stability in the overnight money marketwas further facilitated by introduction of new instrumentssuch as market repo and CBLO. Increased stability in

Table 3.5: Volatility in Money Market Rates

April 1993- April 1996- April 2000-Item March 1996 March 2000 March 2007

1 2 3 4

Call MoneyAverage (Per cent) 11.1 8.0 6.3SD 6.7 3.7 1.9CV 0.6 0.5 0.3

Commercial PaperAverage (Per cent) 13.4 11.7 7.8SD 2.6 2.2 1.8CV 0.2 0.2 0.2

Certificates of DepositAverage (Per cent) 12.2 11.6 6.9SD 2.2 2.4 1.7CV 0.2 0.2 0.2

Term Money @Average (Per cent) – – 6.5SD – – 1.4CV – – 0.2

Market Repo*Average (Per cent) – – 5.4SD – – 1.1CV – – 0.2

CBLO*Average (Per cent) – – 5.3SD – – 1.1CV – – 0.2

@ : For the period May 2001 to March 2007.* : For the period April 2004-March 2007.SD : Standard Deviation. CV : Coefficient of Variation.Note: Calculated on monthly average data.

call rates and various other reforms have also imparteda degree of stability to other market instruments suchas CPs and CDs. The lower volatility is in consonancewith the Reserve Bank’s emphasis on financial stabilityas a key consideration of monetary policy.

Interest Rate Derivatives

3.127 Interest rate deregulation has made financialmarket operations relatively efficient and cost effectivebut has also exposed market participants to variousrisks. This necessitated introduction of derivativeinstruments to manage these r isks throughunbundling of risks. The derivative contracts can betraded either over-the-counter (OTC) or in stockexchanges (exchange-traded). OTC contracts aretraded directly between two eligible parties, with orwithout the use of an intermediary and without goingthrough the stock exchanges. On the other hand,exchange-traded (ET) derivatives are transacted instock exchanges as standardised products throughscreen-based trading.

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3.128 Derivative trading in India witnessed someactivity from July 1999 when the Reserve Bankallowed scheduled commercial banks (excludingRegional Rural Banks), PDs and all-India financialinstitutions to undertake Forward Rate Agreements(FRA)/Interest Rate Swaps (IRS) for managinginterest rate risks in their balance sheets. In order towiden the market, mutual funds were allowed toparticipate for the purpose of hedging their ownbalance sheet risks from November 1999. The use of‘interest rate implied in the foreign exchange forwardmarket’ as a benchmark, in addition to the domesticmoney and debt market rates, was permitted fromApril 2000. The activity gathered momentum afterexchange-traded derivatives by way of futures wereintroduced in Mumbai Stock Exchange (BSE) andNational Stock Exchange (NSE) from June 2000.

3.129 Initially, banks/PDs/FIs were permitted toundertake different kinds of plain vanilla products suchas FRAs/IRS with tenors ranging from one month toone year. The Foreign Exchange Management Act(FEMA), 2000 permitted banks to provide r iskmanagement tools such as swaps, options, caps,collars and FRAs to clients to hedge interest rate riskarising out of foreign currency liabilities. Even thoughthe derivative transactions have grown significantlyin recent years, the market is essentially one of vanillaproducts. Active participants in the market are alsolimited, mainly some foreign and private sector banks,PDs and all-India financial institutions. The ReserveBank allowed banks and PDs to transact in exchangetraded interest rate futures (IRFs) from June 2003to hedge their interest rate risk effectively. While PDswere allowed to hold trading as well as hedgingpositions in IRFs, banks were allowed only to hedgetheir underlying government securities [in availablefor sale (AFS) /held for trading (HFT) categorypor t fol ios] through IRFs. The National StockExchange (NSE) introduced futures on a notional 10-year government security, a 3-month Treasury Billrate and a 10-year government zero coupon in June2003. Activity in the IRF market has, however, notpicked up because of valuation problems as alsobecause banks have been allowed only to hedge butnot to trade.

3.130 Innovations in OTC derivatives have beenlimited due to several structural shor tcomings,including lack of clear accounting and disclosurestandards, lack of adequate knowledge of uses andrisks inherent in derivative transactions, particularlythose involving complex structures, legaluncertainties surrounding the use of OTC derivatives

and uncertainties about regulations with regard tocertain complex products. To address these issues,the Reserve Bank constituted a number of workinggroups.

3.131 The Working Group on Rupee Derivatives(Chairman: Shri Jaspal Bindra), which submitted itsReport in January 2003, was set up to suggest themodalities for introducing derivatives having explicitoption features such as caps/collars/floors in therupee derivative segment and also the norms forcapital adequacy, exposure limits, swap position,asset liability management, internal control and otherrisk management methods for these derivatives.Recognising the ambiguity regarding the legality ofthe OTC derivative contracts as the main factorinhibit ing their growth, the Group proposedappropriate amendments in the Reserve Bank of IndiaAct, 1934 to provide legality to OTC derivatives.Accordingly, the Union Budget, 2005-06 proposed totake measures to provide clear legal validity to suchcontracts. The Reserve Bank of India Act, 1934 hassince been amended, which now provides legalsanctity to OTC derivatives if at least one of the partiesto the transaction is the Reserve Bank or any agencyfalling under its regulatory purview.

3.132 The Internal Working Group on RupeeInterest Rate Der ivatives (Chairman: Shr i G.Padmanabhan) recommended the harmonisation ofregulations between OTC interest rate derivativesand ET interest rate der ivat ives. I t alsorecommended that banks that have adequateinternal risk management and control systems anda robust operational framework be permitted to holdtrading positions in the interest rate futures (IRF)market. The Securities and Exchange Board of India(SEBI) revisited the issue pertaining to introductionof new futures contracts in consultation with theFixed Income Money Market and Der ivat ivesAssociation of India (FIMMDA) and permitted tradingof interest rate futures contract on an underlying 10-year coupon-bearing notional bond from January 5,2004. The Reserve Bank released comprehensivedraft guidelines in December 2006 on derivativescovering broad generic principles for undertakingderivative transactions, management of risk andsound corporate governance requirements.

3.133 Reflecting these measures, the rupeederivative market has grown significantly. FRAs/IRStransactions, in terms of outstanding notional principalamount, rose from Rs.4,249 crore in March 2000 toRs.21,94,637 crore at end-March 2006.

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(ii) Interest Rate Swaps

3.134 In the interest rate swap market, apart fromincrease in volumes, the market also witnessedemergence of interest rate benchmarks such asMumbai Inter-Bank Offered Rate (MIBOR), theMumbai Inter-Bank Forward Offered Rate (MIFOR)(which is a combination of the MIBOR and forwardpremium) and other multiple benchmarks, whichessentially have linkages to the movement in overseasinterest rates. MIBOR linked short-term paper up to365 days, with/without daily call/put options, hasemerged as an important instrument which enablestop rated corporates to raise funds from non-bankentities, particularly from mutual funds.

3.135 Overnight Index Swaps (OIS) help inmanaging interest rate risk by converting fixed ratereceivables to floating and vice versa without takingcredit risk as this tool is built on a notional principal.Banks can use this instrument to effectively managetheir liquidity by converting their fixed term depositsinto floating rate. This instrument is also used for assetliability management and as a positioning tool forputting on carry trades. MIFOR swaps, on the otherhand, are used to hedge interest rate risk as well ascurrency risk by an entity which has exposure toforeign currency borrowing by taking an oppositeposition in MIFOR swap.

3.136 The 5-year OIS yields rose considerably fromaround 4.70 per cent in the beginning of January 2004to about 7.90 per cent on March 28, 2007. The OIScurve steepened during the period from January 2004to October 2004 with spreads between 1 year and 5year tenors increasing from 26 basis points (bps) to140 bps, but later flattened to reach 22 bps byDecember 8, 2006. Inversion of the curve wasobserved with the spread turning negativeintermittently between the last week of December

2006 to third week of March 2007. OIS yields arepositively correlated to the government securities (G-Sec) yields. For most part of 2004, OIS curve wasabove the G-sec curve as it priced in expectations ofa turnaround in interest rate cycle. In the absence ofshort selling, G-Sec markets were unable to pricethese expectations effectively. Subsequently, as G-Sec markets reacted to the rising interest ratescenario, the G-Sec yields edged above the OIS curve(Chart III.9). The OIS curve remaining below the G-Sec curve for a sustained period of time was probablya reflection of the liquidity conditions as swap curvesnormally stay above the Treasury curve. Thus, duringsituations of tight liquidity, the OIS - G-Sec spreadtends to be narrow.

MIFOR (Mumbai Inter-Bank Forward Offered Rate)Swaps

3.137 The yields on MIFOR swaps have risen duringthe last three years in line with the general increasein interest rates. The 5-year MIFOR swap rateincreased from 3.85 per cent at the beginning ofJanuary 2004 to 8.16 per cent on March 28, 2007.The MIFOR curve flattened with the 1-year to 5-yearspreads steadily declining from a high of 200 bps inthe beginning of January 2004 before turning negativefrom December 2006 to March 2007, it touched (-)119 bps on March 28, 2007. The MIFOR curve hasremained consistently below the G-Sec curve duringlast three years except from June to August 2004.This was mainly for the reason that MIFOR curve isinfluenced largely by the implied rupee interest ratesin the forward premia, which, in the absence ofcovered interest parity, tend to diverge from interestrate differential. Between mid-November 2006 and thethird week of March 2007, the MIFOR curve wasabove the G-Sec curve. Five-year MIFOR was above

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G-Sec of corresponding tenor by 53 bps as onJanuary 29, 2007 and 28 bps as on February 12,2007, as forward premia moved up sharply during thisperiod (Chart III.10).

Monetary Policy and Swap Rates

3.138 Swap rates generally move in tandem withG-sec yields. Accordingly, whenever there was a hikein the policy rate, all swap rates, viz., OIS and MIFORgenerally reacted similarly (Chart III.11). The onlyexception was on October 25, 2005, when swap ratesdid not react to the hike in reverse repo rate by 25bps to 5.25 per cent. This was mainly due to marketparticipants refraining from taking firm positions sincethe Bank Rate was left unchanged. Furthermore, themarket did not perceive the hike in the repo rate by

25 bps on October 31, 2006 as tightening of monetarypolicy stance as the reverse repo rate was leftunchanged.

3.139 While the introduction of new instruments,including derivatives, has deepened the moneymarket, the market is still not mature enough forcomplex products. With ful ler capital accountconver tibility the market par ticipants would beexposed to cer tain risks. Therefore, the fur therdevelopment of hedging instruments such as interestrate futures assumes critical importance. Effective riskmanagement by market participants also calls foraccess initially to a liquid IRF market and eventuallyto an interest rate options market, which, in turn,would increase liquidity in the government securitiesmarket. As demand for complex derivate productsgrows over time, there would be a need for banks tolay down appropriate policies for marketing suchproducts to their clients and put in place a mechanismfor close monitoring and stricter regulations.

Other Money Market Segments

(a) Inter-Bank Participation Certificates (IBPCs)

3.140 As an additional instrument for modulatingshort-term liquidity within the banking system, it wasdecided, in principle, to introduce two types ofparticipation certificates (PCs) in October 1988 - oneon risk sharing basis and the other without riskshar ing. These were made str ict ly inter-bankinstruments confined to scheduled commercial banks,excluding regional rural banks. PCs, however, havenot been used widely so far. These instruments areused only to obviate short-term liquidity problems bysome banks by parting with standard assets. At times,these assets are also used to equilibrate prioritysector norms by banks.

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Chart III.10: MIFOR SWAP and G-Sec Yields

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Chart III.11: Monetary Policy and Swap Rates

G-Sec OIS MIFOR Reverse Repo Rate

Per

cen

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105

MONEY MARKET

(b) Money Market Mutual Funds (MMMFs)

3.141 Money market mutual funds were introducedin India in April 1991 to provide an additional short-term avenue to investors and to bring money marketinstruments within the reach of individuals. A detailedscheme of MMMFs was announced by the ReserveBank in April 1992. The portfolio of MMMFs consistsof short-term money market instruments. Investmentsin such funds provide an opportunity to investors toobtain a yield close to short-term money market ratescoupled with adequate liquidity. The Reserve Bankhas made several modifications in the scheme tomake it more flexible and attractive to banks andfinancial institutions. In October 1997, MMMFs werepermitted to invest in rated corporate bonds anddebentures with a residual maturity of up to one year,within the ceiling existing for CPs. The minimum lock-in period was also reduced gradually to 15 days,making the scheme more attractive to investors.

Market Integration

3.142 The success of monetary policy depends onthe speed of adjustment in money market rates inresponse to changes in the policy rates for effectivetransmission of monetary policy impulses to theeconomy. This, in turn, depends on the developmentand integration of various market segments. In linewith the progress of financial sector reforms in India,various segments of the money market are gettingincreasingly integrated as reflected in the close co-movement of rates in various segments. The structureof returns across markets has shown greaterconvergence after the introduction of LAF,differentiated by matur ity, l iquidity and r isk ofinstruments (Chart III.12).

3.143 Strengthening of linkages amongst marketsegments suggests greater operational efficiency ofmarkets as well as the conduct of monetary policy.On the flip side, however, increased integration hasresulted in increased contagion as turbulenceor iginating in one market segment is swift lytransmitted across all segments. Recent experienceof financial market operations in various countriessuggests that market integration tends to strengthenduring episodes of volatility, pointing to a swiftertransmission of market pressures from one segmentto another. This imposes additional constraints on themanagement of market conditions necessitatingsimultaneous policy actions in various marketsegments to limit contagion in the presence ofasymmetric integration of markets. The monetary

policy reaction has been in terms of a combination ofinstruments, including regulatory action, to ensure therapid restoration of stability in financial markets. Inthis regard, the Reserve Bank has been able tomaintain orderly market conditions in recent yearsamidst heightened volatility in international financialmarkets (see also Chapter VIII).

Risk Management

3.144 The money market is characterised by variousrisks, viz., default risk, interest rate risk, exchangerate risk and settlement risk. Given the increasingmarket orientation of monetary policy in India, greaterflexibility provided to banks and the focus on interestrates as the main policy instrument, sound riskmanagement is critical for orderly market behaviourand overall financial stability. Accordingly, the ReserveBank has been laying greater emphasis on developingefficient r isk management practices by marketparticipants.

3.145 A potential source of default risk in the moneymarket emanates from the uncollateralised nature ofthe call money market. In this market, transactionsare traditionally undertaken over the counter throughtelephonic deals, which lack standardisation andguarantee of settlement against default. This problemhas been addressed by mandatory reporting of thedeals by the participants in an electronic platform.Moreover, a screen based quote driven system (NDS-CALL) has been developed by the CCIL on behalf ofthe Reserve Bank for greater transparency and price

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Chart III.12: Money Market Rates

Call Rate Yield on 91-day Treasury Bill

CP Rate CD Rate

Per

cen

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106

REPORT ON CURRENCY AND FINANCE

discovery in the call/notice and the term moneymarkets. Furthermore, as large recourse to theuncollateralised money market segment carries apotential risk of systemic instability arising out ofdefaults, prudential limits have been placed on callmoney exposures of banks and PDs. Moreover, non-bank participants with a distinctly different maturityprofile of sources and uses of funds have beenallowed to migrate from the call money segment tothe collateralised segments (market repos andCBLOs). The shift ing of non-banks to thecollateralised segment has enhanced financialstability by reducing systemic risks. Besides, it hasalso promoted better asset-liability management onthe part of banks. Cumulatively, these measures haveresulted in the dominance of the collateralisedsegment in the overnight money market.

3.146 In view of the growing inter-linkages betweenthe money and the foreign exchange markets on theone hand, and greater integration of the domesticmarket with global markets on the other, it isnecessary that the market participants appropriatelyhedge the risks in their balance sheets emanatingfrom movements in both international interest ratesand exchange rates. In this regard, the Reserve Bankhas introduced derivative instruments such as FRAs/IRS/IRFs for hedging exposures. Although derivativesfacil itate r isk management, they, being highlyleveraged, are more volatile than the underlyingassets. This calls for monitoring and regulation ofspeculative derivative positions. The Reserve Bank,therefore, has been emphasising monitoring andregulation of derivative transactions.

3.147 The institutionalisation of a central counterpartyin the form of Clearing Corporation of India (CCIL) from2002, which guarantees settlement of transactions, hasfacilitated the mitigation of settlement risks andprevention of gridlock in the financial system arisingout of bunching of transactions. The introduction ofRTGS has further mitigated the settlement risk andthe occurrence of gridlock.

VI. THE WAY FORWARD

3.148 Wide-ranging reforms have been undertakento develop the money market and strengthen its rolein the transmission mechanism of monetary policy.Three major considerations that have guidedrationalisation of the structure in the money marketare: (i) ensuring balanced development of variousconstituents of the money market, especially thegrowth of the collateralised market vis-a-vis theuncollateralised market; (ii) preserving integrity and

transparency of the money market by ensuring betterdisclosure of information; and (iii) rationalising variousclasses of par ticipants across different marketsegments in order to strengthen the efficacy of theLAF of the Reserve Bank. As a result of various reformmeasures, the money market in India has undergonesignificant transformation in terms of volume, numberof instruments and participants, and adoption of riskmanagement practices. There are, however, still anumber of concerns as well as issues that need to beaddressed to enable it to play a more effective role,especially in the wake of move towards fuller capitalaccount convertibility. These issues broadly relate tomarket development and liquidity management.

Market Development

Greater Flexibility for Participants in the Call MoneyMarket

3.149 In view of the transformation of the call moneymarket into a pure inter-bank market, there is a needto consider greater flexibility to banks and PDs toborrow or lend in this market, provided they have putin place appropriate risk management systems whichwould address the asset-liability mismatches in theirbalance sheets. In this context, banks have alreadystarted operating in an environment that requiresgreater harmonisation between sources anddeployment of funds for asset-liability management(ALM) purposes. Direct regulation in the form ofprudential limits on borrowing and lending eventuallywould need to graduate to a system, where such limitsare taken care of by banks’ own internal systems ofALM framework. This would correct large mismatchesbetween sources and uses of funds by banks andthereby help the Reserve Bank in the properassessment of market conditions for the conduct ofits liquidity management operations. There is also, atthe same time, a greater need for closely monitoringthe movements of call money rates.

Extension of the Repo Market

3.150 It has been the endeavour of the ReserveBank to develop the repo market not only for easingpressure from the uncollateralised call money marketbut also to facilitate the emergence of a short-termrupee yield curve for pricing fixed income securities.At present, only Central and State Governmentssecurities are eligible for market repo. However, StateGovernment securities do not have wider acceptabilityas there are hardly any repo operations based onthem. As the fixed income money market has beenoverwhelmingly dependent upon Central Government

107

MONEY MARKET

securities, there is a need to consider broad-basingthe pool of eligible securities. In this context, fullydematerialised corporate bonds with internationallyaccepted accounting practices could eventually beconsidered as eligible collaterals. The developmentof a proper settlement system for such instrumentswould be a prior necessity for progress in thisprocess. There is also a need to exercise caution toensure that only highly rated instruments qualify forsuch a facility. This is critical from the point of view ofpreserving market integrity. In future, the growth ofmarket repo will be driven by the “short selling” activityin the government securities market as a repoedsecurity can now be delivered up to five days in viewof the recent changes in the regulations governingshort sales.

Development of a Vibrant Term Money Market

3.151 The term money market has not developedfor several reasons, as discussed in detail earlier. Oneof the major reasons for this is that market participantshave been unable to take a long-term view of interestrates despite availability of Treasury Bills of varyingmaturities and a reasonably developed swap market.In order to enable market participants to take a long-term view on interest rates, it is imperative that theALM framework is strengthened and greater flexibilityis allowed to the personnel managing treasuryoperations in banks. The skewness in liquidity in themoney market in terms of chronic lenders andborrowers would get corrected as banks developbetter ALM systems. The development of the termmoney market is vital for strengthening properlinkages between the foreign exchange market andthe domestic currency market, which, in turn, wouldprovide an impetus to the derivative segment.

Relook at Inter-Bank Participation Certificates

3.152 Inter-Bank Participation Certificates, whichcan be used for evening out short-term liquiditymismatches by banks, were introduced in October1988 in order to infuse greater degree of flexibility intheir credit portfolios. In view of rapid credit growth inrecent years, interest in IBPCs has again arisen. Inthis context, since considerable time has elapsedsince the guidelines on the scheme of IBPCs wereissued, the IBPC scheme with respect to duration,quantum in terms of the proportion to the loan amount,eligible participants and transferability of IBPCs needsa thorough review. Depending on the results of sucha review, extending the use of this instrument couldalso facilitate the asset liability management by banks,

improve day-to-day liquidity management and helpdevelop a market for credit risk transfer instrumentsbetween banks.

Issues Pertaining to CP

3.153 Despite the de-linking of issuance from fund-based working capital l imits and completedematerialisation of CP issuances, the CP marketcontinues to lack the desired level of activity. In termsof extant guidelines, only companies rated P-1 or P-2by CRISIL or such equivalent rating by other agencies,can issue CP. As the market attains a reasonable levelof maturity while the rating criterion may continue,the requirement of rating for issuing CP could be mademore flexible so that a more structured market isavailable to investors depending on their risk appetite.

Futures on Policy Linked Interest Rates

3.154 Going forward, an Indian variant of the FederalFunds Futures on interest rates linked to the ReserveBank’s key policy rates may emerge. Trading in thefutures market would reveal important informationabout market expectation on the future course ofmonetary policy. For instance, the trading of theFederal Funds Futures provides key information tothe Federal Open Market Committee (FOMC) in theUS in formulating its monetary policy.

Promoting Financial Stability

3.155 Default risk in the money market has thepotential to create a contagion in the financial marketsand, therefore, needs to be mitigated. In this regard,experiences of developed economies show thatgenerally the self-regulatory organisations (SROs)regulate activities of participants in the money marketin terms of their capital adequacy and conduct ofbusiness. Also, default resolution in most of thesemarkets is undertaken through the Contract Law andthe Bankruptcy Law. In view of internationalexperience, there may be a case for empowering asuitable self-regulatory organisation appropriately toact as a catalyst for the development of marketmicrostructure.

3.156 One of the fundamental forces that couldcontribute to more organic integration across varioussegments of the financial market is the technologicalupgradation of the payment and settlement system.The accomplishment of virtual Public Debt Office(PDO) and Deposit Accounts Department (DAD) atthe Reserve Bank, coupled with the operationalisationof the centralised funds management system (CFMS)

108

REPORT ON CURRENCY AND FINANCE

in a relatively low CRR regime should foster greaterintegration of various segments of the domesticmarket. While these developments could enhancethe efficiency of the financial market, there is alsothe r isk of faster t ransmission of contagion.Therefore, risk containment in the new environmentwould be a major challenge for the Reserve Bankand it would have to remain flexible in the deploymentof its instruments while simultaneously interveningin various market segments in order to strengthenfinancial stability.

Liquidity Management

3.157 Although significant progress has been madein refining the liquidity management practices in India,several new challenges have emerged. First, duringperiods of abundant liquidity, the LAF windowbecomes a first resort for parking surplus funds bybanks. Second, the Reserve Bank has developed theMSS as a sterilisation mechanism for arresting theliquidity impact of foreign exchange inflows of a moreenduring nature, while the LAF continues to be usedfor managing liquidity at the margin. There is, however,no way of knowing ex-ante whether the liquiditysituation is temporary or permanent. Furthermore, theMSS remains immobilised for the entire period of itsmaturity. There is, therefore, a need to explore furtherinstruments/options to under take l iquiditymanagement, particularly in the context of a move tofuller capital account convertibility. Third, the ReserveBank may not be in a position to conduct sterilisationoperations indefinitely as its inventory of Governmentpaper is limited. There is also a limit on MSSissuances. Fur thermore, the Reserve Bank haswithdrawn from pr imary market auctions ofGovernment paper from April 1, 2006 in terms ofprovisions of the Fiscal Responsibility and BudgetManagement (FRBM) Act, 2003. Fourth, the absenceof a vibrant corporate debt market continues toimpede further refinements in liquidity managementin terms of eligible instruments as collaterals. In thiscontext, it may be noted that State DevelopmentLoans, which are treated as eligible securities forcollaterals under LAF operations effective April 3,2007, have widened the collateral base for LAF. Fifth,as many banks are now operating close to theprescribed levels of SLR securities, in case of liquiditytightness, banks may find it difficult to approach theLAF window in the absence of sufficient collateral

securities. Sixth, while the Reserve Bank now holdsLAF auctions twice on each working day to facilitateintra-day liquidity, a moral hazard issue arises assome market par ticipants may not be activelymanaging their own liquidity in the wake of theReserve Bank’s market operations.

3.158 The above issues need to be addressed,especially in the wake of a progressive move to fullercapital account convertibility. First, there is a need tofur ther refine the system of assessing liquidityconditions, which calls for an improved framework ofliquidity forecasting. The short span within whichliquidity conditions have been changing by a largeamount has posed a major challenge for targetingshort-term interest rates. The understanding of thefiscal position and the Government’s cash balancesas also the timing and extent of capital inflowsassumes added significance. In this context, theremay be a need to consider the regular release ofinformation on Government cash balances held withthe Reserve Bank. Second, progressively moreweightage needs to be given to movements ininternational interest rates in view of increased capitalmobility. Third, destabilising large and sudden capitalflows call for more flexible and swift monetary policyresponses through small and gradual changes inpolicy rates, as has been practised in recent years,as large changes can be disruptive. Fourth, openmarket operations (OMOs), apart from being used formodulating liquidity conditions, could also be used tocorrect any serious distortions in the yield curve.Finally, while the Reserve Bank has progressivelydeemphasised the use of reserve requirements asan instrument of monetary policy, given the presentstate of market development, it is necessary to retainthe flexibility of using reserve requirements, as andwhen necessary12.

VII. SUMMING UP

3.159 Since the early 1990s, the money market hasundergone a significant transformation in terms ofinstruments, par t icipants and technologicalinfrastructure. Various reform measures have resultedin a relatively deep, liquid and vibrant money market.The transformation has been facilitated by theReserve Bank’s policy initiatives as also by a shift inthe monetary policy operating procedures fromadministered and direct to indirect market-based

12 The provisions of Section 3 of the Reserve Bank of India (Amendment) Act, 2006 came into force effective April 1, 2007, which provide thenecessary flexibility to the Reserve Bank in the use of the CRR.

109

MONEY MARKET

instruments of monetary management. The changesin the money market structure and monetary policyoperating procedures in India have been broadly instep with the international experience and bestpractices.

3.160 Along with the shifts in the operatingprocedures of monetary policy, the l iquiditymanagement operations of the Reserve Bank havealso been fine-tuned to enhance the effectiveness ofmonetary policy signalling. The increasing financialinnovations in the wake of greater openness of theeconomy necessitated the transition from monetarytargeting to a multiple indicator approach with greateremphasis on rate channels for monetary policyformulation. Accordingly, short-term interest rateshave emerged as a key instrument of monetary policysince the introduction of LAF, which has become theprincipal mechanism of modulating liquidity conditionson a daily basis.

3.161 In line with the shifts in policy emphasis,various segments of the money market have beendeveloped. The call money market was transformedinto a pure inter-bank market, while other moneymarket instruments such as market repo and CBLOwere developed to provide avenues to non-banks formanaging their short-term liquidity mismatches.Furthermore, issuance norms and maturity profilesof other money market instruments such as CPs andCDs were aligned for effective transmission of policyintent across various segments. The abolition of adhoc Treasury Bills and introduction of Treasury Billsauction have led to the emergence of a risk free rate,which acts as a benchmark for pricing other moneymarket instruments. The increased market orientationof monetary policy and greater integration of domesticmarkets with global financial markets, however, havenecessitated the development of an institutionalframework for appropriate risk management practices.

Accordingly, the Reserve Bank’s emphasis has beenon encouraging migration towards the collateralisedsegments and developing derivatives for hedgingmarket risks. This has been complemented by theinstitutionalisation of CCIL as a central counterpartyto mitigate the settlement risk. The upgradation ofpayment technologies has further enabled marketpar t icipants to improve their asset l iabi l i tymanagement. Cumulatively, these measures havehelped in containing volatility in the money market,thereby improving the signalling mechanism ofmonetary policy while ensuring financial stability.

3.162 Notwithstanding the considerable progressmade so far, there is a need to develop the moneymarket further, particularly in the context of a movetowards fuller capital account convertibility. Furtherdevelopment of the money market calls for better ALMpractices by banks and other market participants,which would enable banks to evolve appropriateprudential limits on their call money exposures fromtheir internal control systems. In order to develop theterm money market, participants need to take a long-term view on interest rates. Furthermore, there is aneed to expand the eligible set of underlying collateralsecurities for repo transactions. This would not onlyfacilitate liquidity management but also promote thedevelopment of underlying debt instruments. Finally,liquidity forecasting techniques need to be furtherrefined for proper assessment of liquidity conditionsby the Reserve Bank. This would facilitate finerchanges in the operating procedures of liquiditymanagement and enable the Reserve Bank to flexiblymeet the emerging challenges. As thesedevelopments take place, it needs to be understoodthat monetary management in India will continue tobe conducted in an intermediate regime that will haveto respond creatively and carefully to the emergingand evolving monetary and macroeconomicconditions, both domestic and global.

110

REPORT ON CURRENCY AND FINANCE

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& g

row

th p

rosp

ects

,m

oney

& c

redi

t con

ditio

ns.

GD

P, o

utpu

t ga

p, b

usin

ess

cycl

ein

dica

tors

.

Out

put

gap

&

wid

e ra

nge

ofin

dica

tors

in v

ario

us m

arke

ts.

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes*

Yes

Yes

Freq

uenc

yof

Mar

ket

Ope

ratio

ns

Elig

ible

Cou

nter

part

ies

Elig

ible

Col

late

ral

12

34

56

78

910

1112

Cou

ntry

Obj

ectiv

eIn

term

edia

te /

Ope

ratin

gTa

rget

Key

Pol

icy

Indi

cato

rsK

ey In

stru

men

ts o

f D

iscr

etio

nary

Liq

uidi

ty

CR

RO

MO

Rep

oS

tand

ing

Faci

litie

sO

ther

s

111

MONEY MARKET

AN

NE

X II

I.2:

Op

erat

ing

Pro

ced

ure

s o

f L

iqu

idit

y M

anag

emen

t in

Em

erg

ing

Mar

ket

Eco

no

mie

s

Freq

uenc

yof

Mar

ket

Ope

ratio

ns

Elig

ible

Cou

nter

part

ies

Elig

ible

Col

late

ral

12

34

56

78

910

11 12

Cou

ntry

Obj

ectiv

eIn

term

edia

te /

Ope

ratin

gTa

rget

Key

Pol

icy

Indi

cato

rsK

ey In

stru

men

ts o

f D

iscr

etio

nary

Liq

uidi

ty

CR

RO

MO

Rep

oS

tand

ing

Faci

litie

sO

ther

s

* : P

ositi

on re

port

ed a

s of

200

3.#

: Rep

o/re

vers

e re

po u

nder

Liq

uidi

ty A

djus

tmen

t Fac

ility

.So

urce

: Web

site

s of

res

pect

ive

Cen

tral b

anks

and

Haw

kins

. J (

2005

).

Dai

ly &

wee

kly

Dai

ly

Dai

ly

1 o

r 2 p

erw

eek

Twic

e a

day-

Rep

o

Dai

ly

Dai

ly

Twic

e a

day

Wee

kly

Twic

e a

day

For l

oans

: fin

anci

ally

sou

nd c

redi

tin

stitu

tions

com

plyi

ng w

ith t

here

gula

tory

req

uire

men

ts a

ndha

ving

acc

ount

s i

n 22

Ban

k of

Rus

sia

regi

onal

bra

nche

s.Fo

r dep

osits

: ban

ks, s

ettle

men

t non

-ba

nk c

redi

t ins

titut

ions

con

duct

ing

depo

sit a

nd le

ndin

g op

erat

ions

.

Ban

king

inst

itutio

ns, w

hich

hav

esi

gned

IS

DA

/ISM

A a

gree

men

t.

21 c

omm

erci

al b

anks

& b

ills

finan

ce c

ompa

nies

.

LAF:

ban

ks a

nd p

rimar

y de

aler

sM

SS:

bank

s,

prim

ary

deal

ers,

all-I

ndia

fina

ncia

l ins

titut

ions

&ot

hers

.

Prim

ary

deal

ers,

com

mer

cial

bank

s, fi

nanc

e co

mpa

nies

,fin

ance

& s

ecur

ities

com

pani

es &

spec

ialis

ed fi

nanc

ial i

nstit

utio

ns.

Prim

ary

deal

ers

Bank

s, m

erch

ant b

anks

, inve

stm

ent

trust

and

sec

uritie

s co

mpa

nies

.

Pri

mar

y de

aler

s,

seco

ndar

yde

aler

s -

bank

s, m

erch

ant b

anks

& s

tock

bro

king

firm

s (in

the

case

of re

po o

nly

PD

s).

Ban

k of

R

ussi

a Lo

mba

rd

List

of

Sec

uriti

es,

prom

isso

ry n

otes

and

rig

hts

of c

laim

und

er lo

an a

gree

men

ts, F

eder

al&

Reg

iona

l Gov

t. bo

nds,

Ban

k of

Rus

sia

& c

redi

t in

stitu

tions

' bo

nds,

mor

tgag

eba

cked

bon

ds, r

esid

ent c

orpo

rate

bon

ds,

bond

s of

in

tern

atio

nal

finan

cial

orga

nisa

tions

.

All C

entra

l gov

t. se

curit

ies,

Res

erve

Ban

kB

ills

& la

nd b

ank

bills

.

Elig

ible

bill

s, b

anke

rs’ a

ccep

tanc

es, t

rade

acce

ptan

ces

&

prom

isor

y no

tes

colla

tera

lised

aga

inst

T-b

ills.

Cen

tral

Go

vt.

Sec

uri

ties

& S

tate

Dev

elop

men

t Lo

ans.

Pub

lic d

ebt

secu

ritie

s -

Gov

t. bo

nds,

T-bi

lls,

FID

F bo

nds

& G

ovt.

guar

ante

edS

tate

ent

erpr

ise

bond

s &

BO

T bo

nds.

Gov

t. se

curit

ies

for

repo

Cre

dit s

ecur

ities

(inc

ludi

ng b

ills e

ligib

le fo

rdi

scou

nt),

Tr

easu

ry

bond

s,

Gov

t.gu

aran

teed

bon

ds,

mar

ket

stab

lisat

ion

bond

s &

land

dev

elop

men

t bon

ds.

Sin

gapo

re g

ovt.

secu

ritie

s - T

-bill

s,bo

nds

and

non-

mar

keta

ble

SG

S b

onds

.

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes#

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Rus

sia

Sou

th A

frica

Mex

ico

Chi

na

Indi

a

Thai

land

Indo

nesi

a

Mal

aysi

a

Kore

a*

Sin

gapo

re

Sta

bilit

y of

curr

ency

&se

ttlem

ent

syst

em

Pric

e st

abili

ty

Pric

e st

abili

ty

Sta

bilit

y of

the

curr

ency

&th

ereb

y pr

omot

eec

onom

ic g

row

th

Gro

wth

, pric

ean

d fin

anci

alst

abili

ty

Pric

e st

abili

ty

Pric

e st

abili

ty

Mon

etar

y &

finan

cial

sta

bilit

yfo

r gr

owth

Pric

e st

abili

ty

Pric

e st

abili

ty a

sa

soun

d ba

sis

for

sust

aina

ble

econ

omic

gro

wth

Mon

etar

y ba

se

Rep

urch

ase

rate

Ban

k re

serv

es

Mon

ey s

uppl

y/ex

cess

res

erve

s

Ove

rnig

ht r

ate

Rep

urch

ase

rate

(14-

day)

Ban

k In

done

sia

Rat

e

Ove

rnig

htin

tere

st r

ate

Ove

rnig

ht c

all

rate

Wei

ghte

dex

chan

ge r

ate

Mul

tiple

indi

cato

rs- m

oney

, cre

dit,

inte

rnat

iona

l int

eres

t ra

tes,

yie

ldcu

rve,

out

put

gap,

ass

et p

rices

,B

OP

pos

ition

, exc

hang

e ra

te, e

tc.

Mon

ey &

mon

etar

y ba

se,

infla

tion

indi

cato

rs,

empl

oym

ent,

exch

ange

rat

e &

Bal

ance

of

Paym

ents

.

Mul

tiple

indi

cato

rs: b

road

mon

ey,

inte

rest

rate

s, d

ata

on c

urre

ncy,

cred

it, fi

scal

pos

ition

, tra

de,

capi

tal f

low

s, in

flatio

n ra

te,

exch

ange

rate

, oup

ut d

ata,

etc

.

Fore

cast

s fo

r in

flatio

n, e

cono

mic

grow

th, m

onet

ary

aggr

egat

es &

deve

lopm

ents

in e

cono

mic

&fin

anci

al s

ecto

r.

Rea

l int

eres

t rat

es, i

nfla

tion

&in

flatio

n in

dica

tors

, ass

et p

rices

,cr

edit,

mon

ey &

pot

entia

l out

put.

Indi

cato

rs o

f fut

ure

infla

tion.

Inte

rest

rat

es &

for

war

d fo

rex

rate

s.

Ban

k of

Rus

sia

Bon

ds&

cur

renc

ysw

aps

Fore

ign

curr

ency

swap

s

Pol

icy

orie

nted

finan

cial

bon

ds&

cen

tral

ban

kbo

nds

Mar

ket

Sta

bilis

atio

nSc

hem

e

Issu

ance

of

Ban

k of

Tha

iland

Bon

ds &

fore

ign

curre

ncy

swap

s

Ban

k of

Indo

nesi

aC

ertif

icat

es

Ban

k N

egar

aB

ills

Liqu

idity

adju

stm

ent

loan

s an

d in

tra-

day

over

draf

ts

Fore

x sw

aps

&re

vers

e sw

aps

112

REPORT ON CURRENCY AND FINANCE

ANNEX III.3: Structure of Money Markets

Country

1

USA

Instruments

2

Federal Funds

Discount window

Certificates of Deposit

Negotiable Certificates of Deposit

Eurodollar CDs

Eurodollar Time Deposits

Repurchase Agreements

Treasury Bills

Municipal Notes

Commercial Paper

Bankers’ Acceptances

Government-SponsoredEnterprise Securities· Discount Notes· Bonds

Shares in Money Market Instruments· Money market mutual funds· Local Government Investment Pools

Futures Contracts

Options

Interest Rate Swaps

Tenor

3

Mostly overnight(there are also long-term forfew weeks)

Usually overnight

Mostly 1-12 months(some have 5 years or more)

1-12 months

Mostly 3-6 months(some have long-term)

Overnight, 1-week,1-6 months & longer

Short-term: overnight or a few daysLonger-term: 1, 2, 3-weeks & 1, 2, 3,6-months.

4, 13 & 26-weeks(52-weeks bill suspended in 2001)

30-days to 1-year

Mostly 270-daysAverage 30-days

Up to 270-days.

30 to 360-daysMore than 1-year

Less than 90-daysAverage: 318-days(1-1044 days)

3-months

Exercise at strike price on or before pre-arranged expiration date.

Exchange of interest streames over thelives of underlying debt issues.

Major Participants

4

Banks & other depository institutions.

Banks & other depository institutions*

Banks (money centre banks & largeregional banks)*

Well capitalised banks.

Banks (foreign branches of US banks orforeign banks located abroad)*. Theseare sold to brokers, investment banks,institutional investors, & largecorporations.

Banks*

Banks, securities dealers, non-financialcorporations & Governments (principalparticipants).

US Government & primary dealers.

State/ Local Governments.

Non-financial & financial businesses(corporations & foreign Governments)*.

Non-financial & financial businesses(firms involved in imports & exports)*.

Farm Credit System, Federal Home LoanBank System & Federal NationalMortgage Association*.

Money market mutual funds & LocalGovernment Investment Pools.

Dealers & banks*

Dealers, banks & non-banks

Dealers, banks & non-banks

* Principal borrower.

113

MONEY MARKET

ANNEX III.3: Structure of Money Markets (Contd.)

Reserves Averaging

Standing Lending & Deposit Facilities

OMOs: Repurchase Agreements(Gilts, HM Government non-sterlingmarketable debt, Sterling Treasury Bills,Bank of England Euro Bills & Euro notes,eligible bank & local authority bills, Sterlingdenominated securities issued byEuropean Economic Area, CentralGovernments & International institutions).

Treasury Bills

Bills of Exchange.

Certificates of Deposit

Commercial Paper· Bank Acceptance· Trade Paper

Main refinancing operations

Long-term refinancing operations (Tier-1& Tier-2 assets)

Fine-tuning/structural reverse transactions(Tier-1 & Tier-2 assets)

Fine-tuning/structural outright purchase(Only Tier-1 assets)

Fine-tuning foreign exchange swap

Marginal lending facility(Tier-1 & Tier-2assets)

Structural issuance of debt securities

Deposit facility

Call money marketShort-term securities:· Commercial Paper· Certificates of Deposit· Treasury Bills

1-month between MPC decision dates

Overnight

1-week at Bank Rate;3, 6, 9, 12-months at market rates

Upto 1-year (Some have maturity over1-year)

1-week

3-months

Non-standardised

Non-standardised

Non-standardised

Overnight

Less than 12-months

Overnight

43 banks & building societies

More than 60 UK banks & buildingsocieties

43 UK banks, building societies &securities dealers.

Issued by the Government.

Issued by banks.

Issued by building societies & traded bybanks & discount houses.

Issued by Industry

Traders

Counterparties: eligible credit institutions.

Eligible credit institutions.

Eligible credit institutions.

Eligible credit institutions.

Eligible credit institutions.

Eligible credit institutions.

UK

ECB@

Japan

@ Source : Blenck D, et al. (2001).

Country

1

Instruments

2

Tenor

3

Major Participants

4

114

REPORT ON CURRENCY AND FINANCE

ANNEX III.3: Structure of Money Markets (Contd.)

Repurchase Agreements(Eligible collateral: Government bonds/bills, Government guranteed bonds,municipal bonds, & foreign Governmentbonds, commercial bills, corporate bonds& asset backed securities)

Non-collateralised market

Outright transactionsGovernment Securities:· Treasury Notes· Treasury Bonds· Treasury Indexed Bonds

Semi-Government Securities:· Semi-Government Promissory Notes· Semi-Government Bonds· Semi-Government Indexed Bonds

Repurchase AgreementsGovernment Securities:· Treasury Notes· Treasury Bonds· Treasury Indexed Bonds

Semi-Government securities:· Semi-Government Promissory Notes· Semi-Government Bonds· Semi-Government Indexed Bonds

Domestic Securities

Accepted Bills of Exchange

Negotiable Certificates of Deposit

Treasury Bills

Money Market Strips

Government Guaranteed CommercialPaper

Treasury Bills & Promissory Notes

Bankers’ Acceptances

Commercial Paper

1-week to 6-months

Of less than 18-monthsOf less than 18-months

Of less than 18-monthsOf less than 18-monthsOf less than 18-months

1-month to 1-year

Up to 18-months

1-month to 1-year

1-month to 1-year

1-month to 1-year

1-month to 1-year

Counterparties: Banks, securitiescompanies, securities financecompanies, money market brokers(Tanshi companies).

City banks (borrowers), regional banks(lenders), investment trusts, trustbanks, regional banks, Keito , l i feinsurance companies, specialisedmoney market brokers.

Issued by Commonwealth Governments.

Issued by State Government & TerritoryCentral Borrowing Authorities.

Issued by Commonwealth Governments.

Issued by State Government & TerritoryCentral Borrowing Authorities

Issued by the foreign Sovereigns,Supranationals & Government AgencySecurities.

Issued by eligible banks.

Issued by eligible banks.

Issued by the Government of Canada.

Issued by the Government of Canada.

Issued by the Crown Corporations suchas Canadian Wheat Board, FederalBusiness Development Bank, etc.

Issued by the Provincial Governments

Issued by the corporations (with anunconditional guarantee of a majorCanadian chartered bank)

Major corporations.

Australia

Canada

Country

1

Instruments

2

Tenor

3

Major Participants

4

115

MONEY MARKET

ANNEX III.3: Structure of Money Markets (Contd.)

Refinancing Mechanisms:· Intra-day loans· Overnight loans· Lombard loans· Loans against collateral (Promissory

Notes) & guarantees

Repo operations:· Government Bonds· Federal Government Bills· Bank of Russia Bonds

Securities accepted as Collateral for Bankof Russia loans:· Regional Government Bonds· Credit institutions’ bonds· Mortgage backed bonds· Resident corporate bonds· Bonds of international financial

institutions

Currency swaps.

Deposit operations:· Deposit operations at fixed rates· Deposit operations at auction rates

Inter-bank lending instruments:Repurchase Agreements or outright basis(OMOs) :· Government Securities· Negotiable Certificates of Deposit· Commercial Paper

Discount WindowEligible bills:· Bankers’ Acceptances· Trade Acceptances· Promissory Notes

Call Money

Notice Money

Term Money

1-working day7 or 14-days

Up to 180-days

Overnight, 3 & 6-months6-months3 to 6-months

Daily (with overnight & 1-week)Weekly (4-weeks & 3-months)

1, 7, 20, 30, 60, 90 & 120-days.

Overnight

2 to 14-days

15-days to 1-year

Financially sound credit institutionscomplying with the regulatoryrequirements.

Credit institutions having account in 22Bank of Russia regional branches

Banks, settlement non-bank creditinstitutions & non bank credit institutionsconducting deposit & lending operations.

Participants in OMOs: Central Bank, largedomestic commercial banks & otherfinancial institutions approved by PBC.

Participants in inter-bank market: Allauthorised commercial banks, trust &investment corporations, financial leasingcompanies, finance companies ofbusiness conglomerates, urban credit co-operatives, & rural credit co-operatives,securities companies, insurancecompanies, & financing intermediaries.

Scheduled commercial banks (excludingRRBs), co-operative banks, primary deal-ers (PDs), & till August 5, 2005 select all-India FIs, insurance companies & mutualfunds.

Banks, all-India financial institutions &PDs.

Russia

China

India #

# :Year in parentheses denote the year of introduction of the instrument.

Country

1

Instruments

2

Tenor

3

Major Participants

4

116

REPORT ON CURRENCY AND FINANCE

ANNEX III.3: Structure of Money Markets (Contd.)

Certificates of Deposit (1989)

Commercial Paper (1990)

Forward Rate Agreements/Interest Rate Swaps (1999)

Bills Rediscounting

Repurchase Agreements (1992)

· Market Repo

· RBI Repo (LAF)

Treasury Bills

Inter-bank ParticipationCertificates (1988)

CBLO (2003)

Repurchase Operations:· Government Bonds· Treasury Bills· Financial Institution Development Fund

(FIDF) Bonds· Government Guaranteed State

Enterprises’ Bonds

Bilateral Repurchase Operations

Bank of Thailand (BOT) Bonds

Foreign Exchange Swaps

Minimum 7-days

Minimum 7-days

Contracts are available for maturitiesupto 10-years.

1-day to 1-year

1-day*

91, 182 & 364-days

91 to 180-days

1-day to 1-year

1, 7, 14-days, 1, 2, 3 & 6-months

14-day

12-months or less.

Overnight up to 1-year(Typically concentrated on the short ends-up to 3-month)

Scheduled commercial banks (excludingRRBs & Local Area Banks) & select all-India financial institutions.Corporates, all-India financial institutions& PDs.

Scheduled commercial banks, PDs & all-India financial institutions.

Banks, PDs, select all-India financial in-stitutions, insurance companies & mutualfunds.

Banks, PDs, all-India financial institutions,insurance companies, mutual funds &listed corporates.

Banks and PDs.

Banks, PDs, financial institutions & othernon-bank entities.

Scheduled commercial banks.

Scheduled commercial banks, Co-operative banks, PDs, select all-Indiafinancial institutions, insurancecompanies, mutual funds & othercorporates.

60 members: commercial banks, financecompanies, finance & securitiescompanies, & specialised financialinstitutions, FIDF.

Bilateral primary dealers.

Commercial banks, specialised financialinstitutions, finance companies, finance& securities companies, Governmentpension fund, provident funds, mutualfunds, social security office, life & non-life insurance companies & otherinstitutions having current account at BOT.

Both onshore & offshore commercialbanks.

Thailand

* : The Reserve Bank retains the option to conduct longer term repo under the LAF depending on market conditions and other relevant factors.

Country

1

Instruments

2

Tenor

3

Major Participants

4

117

MONEY MARKET

ANNEX III.3: Structure of Money Markets (Contd.)

End-of-day Liquidity Window

Bank of Indonesia Certificates (SBI)

Fasilitas Bank Indonesia (FASBI) depositfacility.SBI Repurchase Agreements-phased outin Aug, 2005 & replaced by Fine-TuneExpansion (FTE)

SWBI or Wadiah Certificate (SBI usingSharia principles)

Malaysian Government Securities

Treasury Bills

Repurchase Agreements (Repos)(The securities normally used in repotransactions are Malaysian GovernmentSecurities, Bankers’ Acceptances &Negotiable Certificates of Deposits,Treasury Bills, Cagamas Bonds, CentralBank Certificates, other trade bills, etc.)

Bank Negara Bills

Bank Negara Monetary Notes

Direct borrowing

Negotiable Certificates of Deposit

Bankers’ Acceptances

Call money

Repo(Securities eligible for OMOs: GovernmentBond, Government Guaranteed Bonds &land development bonds)

Commercial banks, finance companies,finance & securities companies &specialised financial institutions.

Banks

Security institutions, banking system &the employees’ provident fund.

Commercial banks, discount houses,principal dealers & finance companies.

Commercial banks, merchant banks,finance companies & discount houses.

Business enterprises, banks, discounthouses, statutory authorities, savings &pension funds, the Government & indi-viduals.

Commercial banks & merchant banks

Commercial banks, specialised banks,regional banks, investment & financecompanies, merchant bankingcorporations, investment trust companies,insurance companies, the KoreaSecurities Finance Corporation, theCredit Insurance Fund & foreign bankbranches in Korea.

Select financial institutions.

Overnight

1- month & 3-months

1 to 14-days

1 to 14-days

91, 182, 364-days

Overnight to a few months

1-year

Up to 3-years

Up to 6-months (average: 20-30 days)

In multiples of 3-months, up to 5-years

30 to 200-days

Overnight, 3, 5, 7, 9, 11& 15-days loans.

15 to 91-days.

Indonesia

Malaysia

Korea

Country

1

Instruments

2

Tenor

3

Major Participants

4

118

REPORT ON CURRENCY AND FINANCE

ANNEX III.3: Structure of Money Markets (Concld.)

364-days

14-2 years & 546-days

Not more than 1-month

Close of business day.

91-days & 182-days.

Up to 3-years.

Up to 3-months & in some cases longer.

1 to 7-days.

28 to 56-days.

3-month to 15 years with 3-month &1-year benchmarks for T-Bills & 2, 5, 7,10 & 15-year benchmark for bonds.

Overnight.

Select financial institutions.

Applicant banks

Select commercial banks, special banks,local banks & foreign banks.

Banks.

Eligible non-finance companies,investment & finance companies &merchant banking corporations.

Primary dealers.

Banks, mining houses, pension funds,insurance companies, commercialcompanies, municipal authorities, publiccorporations & individuals

Merchant banks & commercial banks.

Reserve Bank & other financialinstitutions.

Banks.

Primary dealers, secondary dealerscovering banks, merchant banks, & stockbroking firms, finance companies,insurance companies, corporations &individuals. (In the case of the repo, onlyPDs).

Banks.

Treasury Bills

Market Stablisation Bonds.

Liquidity adjustment loans.

Intraday overdrafts.

Negotiable Certificates of Deposit

Commercial Paper.

Treasury Bills

Negotiable Certificates of Deposit.

Bankers’ Acceptances.

Repurchase Agreements.

Reserve Bank Debentures.

Foreign Currency Swaps.

Repos/reverse repos

Singapore Government Securities.

End-of-day Liquidity Facility.

Forex Swaps & Reverse swaps.

Source: Websites of respective central banks.

South Africa

Singapore

Country

1

Instruments

2

Tenor

3

Major Participants

4