MONEY AND FOREIGN EXCHANGE MARKETS

MONEY AND FOREIGN EXCHANGE MARKETS The Indian financial sector may be viewed as comprising the money, foreign exchange, capital, credit, debt, insurance, and derivatives markets. For India's monetary policy, "call/notice" money and "repo transactions" are most critical. Call/notice money consists of overnight money and money at short notice (i.e., up to 14 days). In the heavily regulated system of nationalized banking, directed credit, and the automatic monetization of government deficits that prevailed in India throughout the 1970s and 1980s, it was inevitable that this market remained narrow and undeveloped. Rate ceilings were also frequent in those days of volatile call money rates. The Chakravarty Committee (1985) and the Vaghul Committee (1987) suggested several measures for developing the Indian money market. Following these suggestions, extensive attempts were made to increase the number of money market participants. Currently India has two major types of entities participating in the call/notice market: (1) Banks (commercial and cooperative) and primary dealers acting as market makers. These are allowed to lend as well as to borrow; their total number is 112; and (2) All-India financial institutions, mutual funds, and insurance companies. These are permitted to operate as lenders only, and their number is 53. The average daily turnover in this market is now Rs. 12,000 crores (1 billion = 100 crores).

The Indian call/notice money market departs from international practice in not being a pure interbank market. The ease of transacting in the call/notice segment, especially the absence of documentation, has attracted non-bank participants, who often favor this funding channel over the repo channel. The fact that the call money rates are usually higher than the repo rate reinforces this tendency, non-bank institutions operating as lenders only. The strong presence of non-bank participants in the call/notice segment impedes the establishment of a risk-free short-term yield curve. Limits on non-bank activity in this segment have been imposed since May 2001.

Repo transaction represent an important stage in the evolution of the Indian money market, distinguished by the introduction of repos/ready forward contracts by the Reserve Bank of India in December 1992. A repo is essentially the sale of a security against immediate funds with a promise to repurchase the same at a predetermined date and price. The future repurchase price reflects the repo interest rate adjusted for the coupon interest earned on the security during the period of the repo. The repo interest rate is usually lower than the interbank loan rate, since the former represents collateralized lending against a high-grade security.

A stable framework for the repo system in India emerged by 1997, with two types of operations: interbank repos ( covering banks, primary dealers, and select financial institutions); and Reserve Bank of India repos. In a typical interbank repo, the seller (a bank) might be attempting to meet an anticipated cash reserve ratio shortfall, while the buyer (also a bank) may be bridging a potential statutory liquidity ratio default. Banks also resort to repos as a hedge against interest rate volatility. The Reserve Bank of India uses repo operations for dayto-day liquidity management via the so-called liquidity adjustment facility.

Foreign Exchange Market

The foreign exchange regime in India has undergone a number of vicissitudes since the collapse of the Bretton Woods Agreement in the early 1970s. In 1975 India's rupee was de-linked from Britain's pound sterling, and a managed exchange regime was put in place, based on a currency basket. In 1978 banks were allowed to engage in strictly controlled trading in foreign exchange. Following the balance of payments crisis in 1991, moves toward a greater role for markets in exchange rate determination were introduced in a series of important stages. The culmination of this process was marked by the rupee being made fully convertible on the current account on 20 August 1994, thereby paving the way for India to subscribe to Article VIII of the International Monetary Fund (IMF). Subsequent developments in the foreign exchange market have been driven by the recommendations of the Expert Group on Foreign Exchange Markets in India (1995) and the Committee on Capital Account Convertibility (1997).

Currently the Indian foreign exchange market is made up of three major segments: authorized dealers, numbering about one hundred, mainly foreign banks and large domestic banks; customers including foreign institutional investors, large domestic public sector units, and corporates; and the Reserve Bank of India.

Major transactions in the foreign exchange market arise from current account transactions of the balance of payments (imports, exports, and invisibles) as well as capital account transactions relating to foreign direct investment, portfolio investments (including American and Global Depository Receipts), external commercial borrowings and amortization, nonresident Indian deposits, external aid, and (since 1996) debt service repayments of the Indian government and the Indian Oil Corporation.

The forward market is an active segment of the foreign exchange market, with contracts permitted up to one year. The bulk of forward contracts, however, range from one-week to three-month maturity, with rollovers quite common. Since 1996 a number of far-reaching changes have been made in the foreign exchange market.

Two questions often raised in the context of the Indian foreign exchange market are about the prospects of capital account convertibility and the appropriate level of foreign exchange reserves. The Tarapore Committee (1997) laid out a detailed road map toward the goal of full convertibility over the three-year period from 1997 to 2000. Subsequent events, especially the Asian crisis, has made the Reserve Bank of India adopt a much more cautious stance.

The level of foreign exchange reserves in India in July 2004 was about $120 billion, and fears had been expressed by unofficial commentators that this level was excessively high. The Reserve Bank of India itself seems inclined to follow the rather loose guidelines set out under the so-called Guidotti Rule, or "liquidity at risk" factor, which relates reserve-adequacy to the foreseeable risks of financial crises, capital risk, and exchange market pressures that a country might face. Based on this consideration, the official line of the Reserve Bank of India seems to be that the current level of Indian reserves is adequate without being excessive.

Financial Markets and Monetary Policy

Since 1991 a two-way process was at work in India's financial markets, marked by the progressive removal of barriers to the flow of international funds, and the rolling back of rate and quantity restrictions in the various segments of the financial markets. Together, these have brought Indian financial markets closer to one another, as well as to their global counterparts. This has had fundamental consequences for the operation of Indian monetary policy. In particular, the maintenance of such increasing integration of India's financial markets has become an important monetary policy objective. The key guidepost of this market-oriented approach is a flexible multiple indicator (based on interest rates on a variety of financial assets together with some other macroeconomic variables) with open market operations as the major operating lever of monetary stimuli, and with the bank rate and the repo rate playing crucial roles as signaling devices.

To illustrate the current working of India's monetary policy, in a situation of excess demand for dollars in the foreign exchange market, leading to a surge in forward premia on expectations of rupee depreciation, if money market rates are lower than the forward premia, arbitrage opportunities exist for shifting funds from the money market (especially the call/notice segment), the government securities market, and the capital market. The Reserve Bank of India in these circumstances, could, of course, follow a passive wait-and-watch policy, allowing call rates to rise above the forward premia, and thus letting equilibrium restore itself. More likely, it may intervene actively in the foreign exchange market by selling dollars, depleting its reserves, encouraging nonresident Indian deposits (e.g., by reducing reserve requirements on such deposits), and discouraging exporters from delaying repatriation of proceeds.

Dilip M. Nachane

See alsoCapital Market ; Debt Markets ; Monetary Policy since 1991

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