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Policy-Induced Financial Market Vulnerabilities

There is an unwarranted smugness in the Indian response to the crisis sweeping global financial markets. If Indian institutions are, as of now, unaffected by the turmoil, it is not because of the correctness of Indian policy decisions, but because of intense social pressure which has prevented the authorities from inflicting radical reforms on the financial sector. It is also not entirely correct to claim that the Indian financial system is not exposed to the new and complex instruments, which have been a source of distress in the United States. A number of instruments of securitisation have been introduced in the Indian market; what has protected the system is the institutional structure of banking with over 70 per cent of assets still held by the conservative public sector banks. The explosion in trading in individual stock futures and of commodity futures are two obvious examples that suggest that the Indian financial system is vulnerable because of an inadequate regulatory architecture.

MONEY MARKET REVIEW

Policy-Induced Financial Market Vulnerabilities

EPW Research Foundation

so that large-size banks may operate globally despite the country not enjoying, now or in the foreseeable future, any sizeable amount of current account surplus – a prerequisite for the domestic banks to operate internationally rather successfully.

Therefore, if the Indian financial system

There is an unwarranted smugness in the Indian response to the crisis sweeping global financial markets. If Indian institutions are, as of now, unaffected by the turmoil, it is not because of the correctness of Indian policy decisions, but because of intense social pressure which has prevented the authorities from inflicting radical reforms on the financial sector. It is also not entirely correct to claim that the Indian financial system is not exposed to the new and complex instruments, which have been a source of distress in the United States. A number of instruments of securitisation have been introduced in the Indian market; what has protected the system is the institutional structure of banking with over 70 per cent of assets still held by the conservative public sector banks. The explosion in trading in individual stock futures and of commodity futures are two obvious examples that suggest that the Indian financial system is vulnerable because of an inadequate regulatory architecture.

Piyusha Hukeri drafted the initial note and V P Prasanth compiled the accompanying tables and graphs.

Economic & Political Weekly

EPW
september 27, 2008

R
eacting to the tumultuous global financial crisis unprecedented since the Great Depression of the 1930s, the union finance minister, P Chidambaram, has asserted that the Indian financial system is insulated from the external turmoil, that “a strong regulatory architecture fortified with prudent norms of checks and balances would prevent India’s banks from falling into a tailspin similar to some of their peers in the United States”. In the same context, the Planning Commission deputy chairperson, Montek Singh Ahluwalia, has opined that “we have not been as exposed to these new and innovative instruments, which have been the source of financial distress internationally”.

1 Smugness Indefensible

For a serious student of India’s contemporary financial system, such self-praise smacks of double standards. The authorities were at one point anxious to dilute the public sector character of India’s banking system and achieve full-fledged financial sector liberalisation for a pittance of a World Bank loan. Now, in the midst of the stunning revelations of vulnerabilities of every aspect of the global financial system

  • in institutional structures, in dominance of exotic securitised and derivative products, in appropriateness of risk management and supervisory practices under Basel II norms, and conventional thinking on the sources of financial stress in general, we have the Planning Commission-inspired Raghuram Rajan committee recommending for India various financial sector reforms
  • full capital account liberalisation, entry of foreign institutional investors (FIIs) into currency and interest rate derivatives, reducing government control in financial sector institutions, and allowing more banks and freeing branch banking norms.
  • The finance minister has been in the forefront asking for consolidation of banks has now been insulated from the global turmoil, it is not because of the innate strength of the policy devices pursued by the authorities but because of intense social pressures which have prevented the authorities from inflicting on the system radical financial sector reforms. Over a decade ago in 1997, the authorities had proposed capital account convertibility but better sense prevailed after its adverse consequences got exposed in the Asian crisis of 1997-99. John Williamson, the author of the Washington Consensus, regretted in an article in this journal (EPW, April 12, 2003), that the IMF and other institutions urged “most damagingly a pace of capital account liberalisation that most people agree in retrospect to have been precipitate” (p 1477). High-level of short-term debt was the kingpin in the Asian crisis. India’s short-term debt had remained at a low level of 2 to 7 per cent of total external debt for many years but now it has already jumped to 20 per cent in March 2008.

    In matters relating to the domestic operations of banks, it has been a constant tug of war between the authorities’ reform enthusiasm and their responses to social pressures. The government has of late been pursuing a distorted set of priorities – bank consolidation, more foreign capital, larger voting rights in private sectors, etc, while the needs of the period are a strengthening of the institutional spread with an expanded and well-designed professional staff structure. The tug of war between reforms and social pressures is better seen in all aspects of credit delivery arrangements purported to be attempted by banks for the informal sector; the arrangements themselves are consciously done in a halfhearted manner as a matter of rhetoric and publicity. This is true of the 40 per cent priority sector target, the policy of doubling of credit flow in favour of agriculture and small-scale and micro enterprises, placing the responsibility of a larger rural

    MONEY MARKET REVIEW

    credit structure on the shoulders of the microfinance (MFI) movement, and now the introduction of the policy of financial inclusion with compulsory “no-frills” deposit accounts and optional overdraft accounts – all in the face of reductions in the number of rural branches by about 3,500 in the past 12 years and similar curtailment of bank staff to the extent of over 60,000 in rural and semi-urban branches, thus making servicing of the informal sector in every nook and corner of the country that much more difficult.

    Reverting to the claim that the Indian financial system is not exposed to the new and innovative instruments which have been a source of such financial distress in the US, it should be noted that the claim is not entirely true. All such instruments of securitisation have been introduced in the Indian market. What has protected the system nevertheless is the institutional structure of banking with over 70 per cent of bank assets held by the public sector banks, which have a more conservative approach to asset management. The new private sector banks as well as foreign banks in India have indulged in relatively large amounts of securitisation and suffered in the past; there has not been any systemic impact because of their relatively small size. The recent case of many banks indulging in reckless lending for real estate, commodities and against shares stands out.

    Also, in the area of foreign exchange dealings where there is intense competition between foreign and private banks on the one hand, and public sector banks, on the other, there has occurred a serious sign of stress created out of the unmitigated hedging facilities permitted. Prior to April 2007, hedging of forex instruments including

    Table 1: Money Market Operations (RBI’s Daily Data)

    forwards, swaps, and options were permitted mainly against crystallised foreign currency exposures, but after that period, “dynamic hedging” by the residents was facilitated on the basis of declaration of an exposure actually in sight or based on past performance and the contracts could be cancelled and rebooked. But, the most damaging aspect of the newly introduced expansion of hedging facilities, as revealed by the recent corporate turmoil, relates to the small and medium enterprises. The April 2007 policy statement said that,

    In order to enable small and medium enterprises (SMEs) to hedge their foreign exchange exposures, it is proposed to permit them to book forward contracts without underlying exposures or past records of exports and imports. Such contracts may be booked through authorised dealers with whom the SMEs have credit facilities. The SMEs are also permitted to freely cancel and rebook the contracts (p 56, emphasis added).

    In such a free-for-all policy environment, banks and the corporates, obviously handin-glove, have indulged in huge amounts of hedging. The banks appear to have sold contracts to corporates, particularly the SMEs, hardly based on any underlying exposures. While full details of the markto-market (MTM) losses are not available, a reputed forex deal

    er, Jamal Mecklai of

    Borrowing – August 2008

    Mecklai Financial 12 – Services, has placed

    Call Rates 10 –

    the MTM losses of

    8–

    banks and the corporate sector in the 6– range of $ 3 billion to $ 5 billion 4– (Rs 12,000 crore– 2– Rs 20,000 crore). We

    0–

    have a large list of IT companies, banks and corporates facing huge forex losses. These kinds of liberalisation measures without proper checks and balances have an inherent tendency to create stress in the financial markets.

    The speculative activities prompted by official blessings are more serious in the case of stock and commodity markets. In the Indian share market, well-meaning experts have brought out how there are two key destabilising elements in its derivative segments. First, all major exchanges of the world (in the United States and Europe in particular) desist from introducing individual stock futures as they are considered highly unsafe and do not serve any justifiable purpose. Despite such a weighty opinion, individual stock futures and options together now constitute over 60 per cent of derivative transactions on the National Stock Exchange (NSE) of India. Secondly, in equity derivatives in the Indian bourses, trades are allowed to be cash settled and not delivery settled, which is totally contrary to the international best practices that we profess to adopt with pride. In the absence of physical delivery, there is no logical conclusion to the futures trade; on the last day, just the cash is exchanged. Because of such a structurally

    Graph A: Trends in Weighted Averages of Call Rates, Repo Rates and Call Money
    26/07 29/07 1/08 4/08 7/08 10/08 13/08 16/08 19/08 22/08 25/08 28/08 the RBI Call Money Volume (Rs ‘000 Crore) (Right axis)

    – 25

    Repo Rates – Outside

  • 20
  • 15
  • 10
  • –5

    –0

    Average August 2008 Average July 2008
    Items for Five Weeks 29 (RF) 22 14 (RF) $ 8 1 (RF) for Four Weeks 25 18 (RF) 11 4 (RF)
    No of working days 27 6 5 5 6 5 24 6 6 6 6
    Call Money
    Weighted average of call rates: 5.98-9.71 5.98-9.67 9.11-9.71 8.68-9.30 8.97-9.35 6.20-9.12 5.60-9.58 8.51-9.58 7.98-8.98 8.49-9.03 5.60-8.70
    per cent (weekly range) per annum (5.98) (8.68) (6.20) (7.98) (5.60)
    Daily averages (Rupees crore) 10,174 10,279 10,307 11,981 10,707 7,469 10,978 164 95 136 254
    Total call market borrowings (957) (793) (648) (316) (166)
    Notice Money
    Weighted average of notice money rates: 6.25-9.88 6.25-9.88 8.56-9.72 8.24-9.48 8.00-9.19 6.51-8.25 6.25-9.10 7.00-9.00 7.50-9.10 7.70-9.07 6.25-8.80
    per cent (weekly range) per annum (6.25) (9.30) (6.51) (8.88) (6.27)
    Daily averages (Rupees crore) 2,996 2,910 3,590 4,913 4,007 4,535 2,915 75,715 2,306 3,933 2,431
    Total notice market borrowings (14,431) (14,529) (13,598) (11,519) (11,132)
    Turnover in term money market 299 238 318 316 522 114 157 164 95 136 254
    (borrowings) $$ (224) (685) (246) (103) (60)

    Data for reporting Fridays (RF) are given within brackets and they are also included in the weekly range/daily averages. $ Thursday data. $$ No of reporting/traded days is fewer than given above.

    september 27, 2008

    MONEY MARKET REVIEW

    weak system, not only has that the size of derivatives market grown phenomenally (larger than the cash market), it has also converted the Indian equity market into the most volatile one in the world. What is more, such speculative activities do not

    Graph B: Spot Quotations for the US Dollar in the Domestic Inter-Bank Market

    49 47 45 43 41 39

    (Daily)
    Working
    Days Aug
    2008
    (Monthly Averages)
    (Jan 2001 to July 2008)

    help the system achieve the primary goals of better liquidity and stability; nor do they facilitate the development of a healthy, stable and dependable primary issue market for the corporates in the manufacturing and infrastructure areas so as to mobilise some parts of project finance.

    As for the commodity markets, the authorities have permitted futures trading in over 80 agricultural commodities (including a few which are temporarily banned) with hardly any distinction in margining for hedging and speculation

    – a simple process of preventing gambling type of dealings. Because of the consequential dominance of speculator- financial interests in futures, the market has expanded over 50fold in the past five years, but has failed to perform its basic function of facilitating hedging, price discovery and price stability, and hence it has also failed to attract farmer participation, though futures trading is being propagated in the name of the farmer.

    These few examples are strong enough to suggest that the Indian financial system does face a situation of vulnerability because of the insufficiency of a strong regulatory architecture. This is certainly true of the capital market segment of the financial system. As for the banking system, the sub-prime crisis and the consequential crisis in the mortgage loans market, which has brought down four leading US financial firms and has catalysed an unthinkable size of government salvage operations (almost equivalent to a trillion dollars) and nationalisation of large firms in that citadel of capitalism. The origin of the ongoing cataclysm should be traced to the sub-prime credit crisis of US banks which

    Economic & Political Weekly

    EPW
    september 27, 2008

    covered loans of over $ 1.3 trillion, a crisis which exposed above all the irrelevance of the so-called international best practices under Basel II norms.

    The fetishness with which the Indian authorities have applied Basel II norms to banking will call for a rethink. For normal banking operations, they have proved to be highly expensive and cumbersome and besides they have grossly diverted the attention of the banking system from its social orientation; the formal financial institutions have been as a result hard put to address the credit needs of the poor. It was in this context of the working of the financial markets that are characterised as markedly different from other markets, that Joseph Stiglitz came out clearly to assert that globalisation could have devastating effects on developing countries and especially the poor within those countries (Joseph E Stiglitz (2002): Globalisation and Its Discontents, W W Norton & Company).

    The use of global standards of regulatory architecture but with a narrow banking spread without a relationship banking which are far out of line with their social relevance vis-à-vis, say, engineers and scientists. That apart, within financial operations, the current upheaval is providing telling lessons for developing countries like India to be extremely cautious in aping the globalised financial architecture.

    First, the safety and security of banking business in India are better ensured by strengthening the character of social ownership, encouraging commercial competition within social mores, and insisting on professional management and adoption of modern sophisticated technology and accounting practices. Second, in the adoption of exotic instruments of financial dealings – securitisation, derivatives and short-selling – the original objectives of ensuring liquidity for the base instruments have to be scrupulously kept in view. In commodity derivatives or forex derivatives, hedging should be treated as the primary purpose. All these secondary market dealings should have a well- defined sustainable limit which should not be allowed to be crossed.

    strategy is sure to

    Table 2: Weighted Averages of Daily Call/Notice Rates in Per Cent Per Annum: prevent the spread Simple Statistical Characteristics

    Month/Week Simple Standard Coefficient of Simple Standard Coefficient of of financial inter-Mean * Deviation Variation Mean * Deviation Variation (in %)$ (in %)$

    mediation region-

    Call Money Notice Money **

    ally, functionally

    July 2008 and across differ-All four weeks 8.57 0.98 11.48 8.10 0.96 11.89

    ent size classes 25 9.28 0.55 5.94 8.63 1.09 12.69

    18 (RF)* 8.70 0.42 4.85 8.24 0.71 8.58

    of assets.

    11 8.90 0.21 2.31 8.25 0.59 7.16

    The smug reac

    4 (RF)* 7.31 1.31 17.89 7.37 1.25 17.01

    tion to the most

    August 2008

    explosive develop-

    All five weeks 8.90 0.90 10.07 8.53 1.00 11.69ment in the global 29 (RF)* 8.59 1.40 16.26 8.25 1.32 16.02

    financial system 22 9.45 0.22 2.36 9.26 0.43 4.61

    with sharp lessons 14 9.07 0.25 2.71 9.01 0.67 7.44

    8 9.19 0.13 1.38 8.57 0.52 6.06

    for developing

    1 (RF)* 8.20 1.16 14.18 7.25 0.90 12.37

    countries, with the

    ** Separate reportings began on March 15, 2005. * Including data for reporting Fridays (RF). authorities suggest-$ Based on original unrounded figures.

    Source: RBI.

    ing that everything

    Table 3: Comparison of Call, Overnight CBLO and Repo Rates

    is fine with our

    Week Ending Weighted Average Rates (in %) Daily Average Volumes (Rs Crore) system, is truly Call Overnight CBLO Repo Call Overnight CBLO Repo

    4-Jul-08 7.34 5.87 6.25 11,137 29,084 10,459

    indefensible. The

    11-Jul-08 9.01 8.43 8.56 16,556 23,936 7,326

    globalisation of the

    18-Jul-08 8.95 8.26 8.44 14,530 20,354 7,910

    financial markets

    25-Jul-08 9.44 8.51 8.71 15,754 17,533 6,615

    has created mani

    1-Aug-08 8.21 7.62 7.85 10,686 27,236 11,279

    fold distortions the

    8-Aug-08 9.20 8.95 9.00 14,047 24,151 9,863

    world over, includ

    14-Aug-08 9.24 8.76 8.85 14,929 22,167 9,765

    ing in the remuner

    22-Aug-08 9.61 8.81 9.05 13,861 18,990 9,730

    ation packages for

    29-Aug-08 8.46 8.07 8.05 12,704 24,480 12,531 company executives Source: Clearing Corporation of India.

    MONEY MARKET REVIEW

    Finally, in the whole policy discourse now on the expected role of the financial system in India, what is neglected is the imperative of institution-building which is the fountainhead of the supply-leading approach to credit delivery for agriculture, micro and small enterprises and for other informal sectors adopted following bank nationalisation. In fact, it is not realised that a good part of the risk management issues – credit risk and operational risk – also can be taken care of if we have a fairly decentralised institutional structure with the spread of the branch network across the country, professionally well-manned, such that “lenders have sufficient knowledge about borrowers” and information asymmetry giving rise to moral hazard and adverse selection is avoided. In our perception, the presence of information asymmetry and the issues of moral hazard and adverse selection are exaggerated But, as industrial growth showed some the middle of the month, apprehensions improvement, the sentiments turned cau-expressed by some government officials tious and the yields firmed up. Further, in that inflation would cross 13 per cent

    Table 4: Auctions of 91-Day Treasury Bills (Amount in rupees crore)

    Date of Notified Bids Tendered Bids Accepted Subscription Cut-off Cut-off Amount
    Auction Amount Devolved Price Yeild Outstanding
    No Face Value No Face Value on PDs (Rupees) Rate on the Date
    (Amount) (Amount) (Amount) (%) of Issue
    (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
    2007
    August 01 2,000.00 96 4,932.00 55 2,000.00 0.00 98.41 6.48 70,997.00
    (1) (200.00) (1) (200.00) [98.43] [6.40]
    August 08 2,000.00 84 4,295.00 27 2,000.00 0.00 98.39 6.56 73,497.00
    (2) (2,500.00) (2) (2,500.00) [98.41] [6.48]
    August 14 2,000.00 92 3,450.47 59 2,000.00 0.00 98.35 6.73 72,397.00
    (2) (303.00) (2) (303.00) [98.37] [6.65]
    August 22 2,000.00 78 3,990.50 10 2,000.00 0.00 98.33 6.81 72,896.00
    (4) (2,050.00) (4) (2050.00) [98.34] [6.77]
    August 29 3,500.00 102 7,552.50 24 3,500.00 0.00 98.26 7.10 73,596.00
    (2) (550.00) (2) (550.00) [98.28] [7.02]
    2008
    July 30 3,000 130 9,274.83 60 3,000.00 0.00 97.72 9.36 56,432.00
    (2) (800.00) (2) (800.00) [97.73] [9.32]
    August 6 3,000 122 7,893.64 73 3,000.00 0.00 97.75 9.23 56,434.00
    (6) (2,639.10) (5) (2,638.10) [97.76] [9.19]
    August 13 3,000 112 (4) 9,177.67 (2,150.00) 52 (4) 3,000.00 (2,150.00) 0.00 97.77 [97.78] 9.15 [9.11] 57,834.00

    August 20 3,000 100 8,778.52 20 3,000.00 0.00 97.77 9.15 55,834.00

    insofar as the functioning of commercial

    (1) (2,000.00) (1) (2,000.00) [97.77] [9.15]

    and cooperative banks in developing

    August 27 2,000 79 6,721.82 28 2,000.00 0.00 97.79 9.06 58,439.00 economies like that of India are concerned. (4) (1,608.09) (4) (1,608.09) [97.79] [9.06]

    Unlike in advanced market economies where banks operate as wholesale financial intermediaries, banks in developing countries adopt branch banking combined with relationship banking under which

    Figures in parentheses in cols 3 to 6 represent numbers and amounts of non-competitive bids which are not included in the total. Figures in the square brackets under cols 8 and 9 represent weighted average price and respective yield.

    Table 5: Auctions of 182-Day Treasury Bills (Amount in rupees crore)

    Date of Notified Bids Tendered Bids Accepted Subscription Cut-off Cut-off Amount Auction Amount Devolved Price Yield Outstanding No Face Value No Face Value on PDs (Rupees) Rate on the Date (Amount) (Amount) (Amount) (%) of Issue

    bank managers, if they function profes-2007 August 08 1,500.00 81 1,985.00 46 1,500.00 0.00 96.50 7.27 25,641.00

    sionally, have a reasonably good knowl

    (1) (500.00) (1) (500.00) [96.61] [7.04]

    edge of the regions and clientele they

    August 22 1,500.00 68 2,235.00 53 1,500.00 0.00 96.41 7.47 27,141.00 serve. The banking system can be strong, (1) (1,500.00) (1) (1,500.00) [96.45] [7.38]

    healthy, and dynamic only if such a model 2008
    is persevered with. August 6 1,500.00 90 4,666.50 38 1,500.00 0.00 95.57 9.30 20,683.00
    (1) (1,000.00) (1) (1,000.00) [95.59] [9.25]
    2 Money, Gilt-Edged and Forex Markets August 20 1,500.00 85 3,915.65 31 1,500.00 0.00 95.56 (1) (1,000.00) (1) (1,000.00) [97.57] Figures in the square brackets represent weighted average price and the respective yield. 9.32 [9.30] 22,683.00
    In August, there was a shift in the market Figures in brackets represent numbers and amounts of non-competitive bids which are not included in the total.
    sentiments from heightened uncertainty Table 6: Auctions of 364-Day Treasury Bills (Amount in rupees crore)
    to subdued caution as the international Date of Notified Bids Tendered Bids Accepted Subscription Cut-off Auction Amount Devolved Price Cut-off Yield Amount Outstanding
    crude oil prices remained volatile but with a downward bias and domestic inflation No Face Value No Face Value on PDs (Rupees) (Amount) (Amount) (Amount) 2007 Rate (%) on the Date of Issue
    also began to show signs of peaking. The August 1 2,000.00 84 4,675.00 43 2,000.00 0.00 93.26 7.25 55,627
    yields on gilt-edged securities began to (0) (0.00) (0) (0.00) [93.31] [7.19]
    ease and the secondary market turnover increased as the expectations of possible August 14 2,000.00 104 4,685.00 33 2,000.00 0.00 93.05 (0) (0.00) (0) (0.00) [93.10] August 29 2,000.00 113 5,415.00 37 2,000.00 0.00 93.02 7.49 [7.43]7.52 55,619 55,643
    RBI’s monetary tightening waned. However, (2) (93.06) (2) (93.06) [93.06] [7.48]

    due to the cumulative effect of the succes-2008 July 30 2,000.00 153 9,661.00 25 2,000.00 0.00 91.30 9.56 55,923

    sive cash reserve ratio (CRR) hikes in the

    (1) (36.55) (1) (36.55) [91.31] [9.54]

    recent past, there was pressure on the

    August 13 2,500.00 138 8,411.50 53 2,500.00 0.00 91.52 9.29 56,423 short-term rates which had realigned (0) (0.00) (0) (0.00) [91.57] [9.23]

    themselves to the high new repo rate set at August 27 2,000.00 139 10,229.00 23 2,000.00 0.00 91.61 9.18 56,416

    (1) (26.65) (1) (26.65) [91.64] [9.15]

    9 per cent in the first quarter review of

    Figures in the square brackets represent weighted average price and the respective yield. the credit policy announced on July 29. Figures in brackets represent numbers and amounts of non-competitive bids which are not included in the total.

    september 27, 2008

    MONEY MARKET REVIEW

    affected market sentiments adversely as they began expecting some policy actions, which was compounded by the higher weekly inflation data release. Also, the prime minister’s Economic Advisory Council report asserted that inflation would remain high and that the pace of economic growth would slow down. Some rebound in the international crude oil prices following the OPEC’s cut in output supported these worries. The acceptance of the recommendations of the Sixth Pay Commission did not help the sentiments as market participants remained apprehensive of its implications on the fiscal deficit and consequently on its fallout on the interest rates. In the last week of the month, the market sentiments turned positive given the redemption inflows, the headline inflation rate declined after five consecutive weeks and there was a fall in international crude oil prices. The yields on medium- and long-term securities edged lower while the short-term yields remained sticky resulting in a flat yield curve. Following the gilt-edged yields, the interest rates offered on corporate bonds also showed that shorter maturities were offered higher yields as compared with those on long-term ones.

    In the forex market, the rupee depreciated against the dollar partly in response to the RBI’s decision to terminate the temporary financing arrangement under special open market operations (SMO) for the oil companies in view of the extraordinary situation, but more significantly due to the strengthening of the US dollar amidst sustained demand for dollars against dwindling supplies as foreign investors turned risk-averse against the backdrop of weak domestic stock markets. On August 29, the currency futures were introduced on the NSE on rupee-dollar exchange rate.

    2.1 Call Money Market

    The weighted average of overnight call rates ruled above the informal corridor set by the new repo rate of 9 per cent and reverse repo rate of 6 per cent, except for a few days during the month, despite the RBI’s measures to support the liquidity through the LAF window (Table 1, p 30). Given the firmness in call rates, the standard deviation, a measure of volatility fell from 0.98 in July to 0.90 in August (Table 2, p 31).

    The call money rate slipped to 6.2 per cent on August 1 from 8.22 per cent on July 31, the first reporting Friday of the month, as banks had already covered their positions. As the repo rate was hiked to 9 per cent in the first quarter review of the credit policy announced on July 29, the overnight rate realigned itself with it and rose to 9.35 per cent on August 2. With higher absorptions under treasury bills as well as second dated securities auction, there was immense pressure on the call money market, which pushed the rate to a peak of 9.71 per cent on August 21 even as the repo injections remained substantial. Due to inflows on account of redemptions and coupon payments, the liquidity situation improved and overnight call rate slipped to 8.12 per cent on August 28 and further to 5.98 per cent on August 29, the third and last reporting Friday of the month. But, the rate again rose to 9.38 per cent on August 30 as the cash reverse ratio was hiked to 9 per cent with effect from the ensuing fortnight. (Graph A, p 30).

    The spread between call and CBLO rates and even between call and repo narrowed in August as compared with that in July, reflecting the pressure on liquidity (Table 3, p 31).

    2.2 Forex Market

    The rupee-dollar exchange rate depreciated by 142 paise due to a combination of factors that adversely affected the demand-supply balance. The demand for dollars remained firm given the termination of the SMO for the oil companies which began to tap the open market for their dollar requirements; in addition, weaknesses in domestic stock markets resulted in investment outflows. Also, the RBI allowed the rupee to respond to the underlying demand-supply scenario and intervened sporadically only when it feared that the movements were rather rapid. But, the most significant impact on the rupee rate came from the strengthening of the dollar against the major currencies; this pushed the rupee lower. The apparent strengthening of the dollar happened with the US economy weakening rather progressively as it was reeling under a financial sector crisis, which has been reversed due to increased prospects of greater weaknesses in other developed countries, which helped the dollar strengthen.

    Following the stronger than expected monetary measures of a hike in the repo rate as well as an increase in the CRR in the first quarter policy review along with easing of international crude oil prices, the rupee-dollar exchange rate appreciated from

    Table 7: Operations of RBI’s Liquidity Adjustment Facility ** (Amount in rupees crore)

    For the Week Range of Repo (Injection) * Reverse Repo (Absorption) * Net Injection Net
    (July-August 2008) Repo / RR Period Bids Received Bids Accepted Bids Received Bids Accepted (+)/ Outstanding
    Days Number Amount Number Amount Number Amount Number Amount Daily Absorption (-) Amount
    Averages of of Liquidity at the
    Bids Accepted Week End@
    1 2 3 4 5 6 7 8 9 10 11 12 13
    30 June -04 July 08 1-3 25 24,780 25 24,780 30 25,915 30 25,915 6,478.75 -1,135 11,700
    07 July -11 July 08 1-3 157 1,87,605 157 1,87,605 0 0 0 0 0 1,87,605 -45,295
    14 July -18 July 08 1-3 125 1,67,920 125 1,67,920 1 5 1 5 1 3,95,945 -34,325
    21 July -25 July 08 1-3 200 2,28,030 200 2,28,030 0 0 0 0 0 2,28,030 -43,260
    28 July - 01 Aug 08 1-3 60 75,100 60 75,100 19 4,875 19 4,875 975 70,225 -8,200
    04 Aug -08 Aug 08 1-3 112 1,12,815 112 1,12,815 0 0 0 0 0 1,12,815 -32,720
    11 Aug -14 Aug 08 1-4 119 1,19,440 119 1,19,440 5 1,300 5 1,300 325 1,18,140 -30,335
    18 Aug -22 Aug 08 1-4 105 1,35,780 105 1,35,780 0 0 0 0 0 1,35,780 -32,675
    25 Aug -29 Aug 08 1-3 42 38,415 42 38,415 10 2,100 10 2,100 420 36,315 -7,600
    01 Sept -05 Sept 08 1-3 59 59,425 59 59,425 1 1,000 1 1,000 250 58,425 -18,550
    * Reverse Repo Rate is 6.00 % and the Repo rate with effect from 29th July has been increased to 9.00% from 8.50%. @ Net of Repo and Reverse Repo Outstandings.
    ** includes second LAF conducted on every reporting Friday with effect from August 01, 2008.
    Economic & Political Weekly september 27, 2008 33
    EPW

    MONEY MARKET REVIEW

    Rs 42.37 on August 1 to Rs 41.89 on August 7. Rs 43.58 on August 25. The arbitrage The rupee edged up marginally due
    But following the termination of the SMO, opportunities between onshore and off to heavy intervention by the RBI to
    the oil companies tapped the spot market shore markets supported the depreciating close the month at Rs 43.79 on August 29
    for their dollar requirements, which pushed trend. The already strained situation dete (Graph B, p 31).
    the exchange rate lower to Rs 42.67 on riorated further with the month-end With the increased arbitrage between
    August 13. With the weakness in domestic demand for dollars from oil companies onshore and offshore markets as well
    stock markets and a strengthening dollar, and the rupee fell sharply to Rs 44.07 on as decline in international crude oil
    the rupee continued to depreciate to August 26 despite the RBI’s intervention. prices, the forward premia declined
    Appendix Table: Secondary Market Operations in Government Papers: NDS and NDS-OM Deals (Amount in rupees crore)
    Descriptions Week Ending August 2008: Yield to Maturity on Actual Trading Total for the Month
    29 22 14 8 1 of August 2008
    AMT YTM CY AMT YTM CY AMT YTM CY AMT YTM CY AMT YTM CY AMT YTM CY
    1 Treasury Bills A 91-Day Bills 2450.83 9.03 1304.32 9.10 1676.13 9.02 1315.50 9.14 969.88 9.17 7716.66 9.08
    B 182-Day Bills 43.93 9.06 502.07 9.26 34.87 9.10 159.53 9.21 227.55 9.14 967.95 9.21
    C 364-Day Bills 45.00 8.99 370.55 9.17 694.31 9.16 917.12 9.28 1395.89 9.15 3422.87 9.19
    2 GOI Dated Securities
    A Regular (%: Year)
    5.48 , 2009 969.25 9.18 5.64 955.00 9.26 5.64 772.00 9.06 5.64 1727.05 9.20 5.65 245.00 9.38 5.66 4668.30 9.19 5.64
    6.65 , 2009 373.21 9.10 6.75 8.83 9.44 6.76 150.00 9.29 6.76 165.00 9.19 6.76 100.00 9.49 6.77 797.04 9.21 6.75
    6.96 , 2009 OMC SB - - - - - - - - - 5.00 9.76 7.08 25.00 9.98 7.10 30.00 9.94 7.09
    6.96 , 2009 - - - - - - 30.00 9.78 7.08 - - - - - - 30.00 9.78 7.08
    7.33 , 2009 OIL MKT BONDS 25.00 9.71 7.42 - - - - - - 3.50 9.45 7.42 - - - 28.50 9.68 7.42
    7.33 , 2009 OMC SB 25.00 9.90 7.43 - - - - - - - - - - - - 25.00 9.90 7.43
    11.99 , 2009 - - - 0.05 9.07 11.79 116.27 9.15 11.79 1.25 9.18 11.79 0.25 9.29 11.79 117.82 9.15 11.79
    5.87 , 2010 798.50 9.18 6.12 394.50 9.24 6.13 475.30 9.06 6.12 645.50 9.18 6.13 1620.00 9.34 6.15 3933.80 9.24 6.13
    7.55 , 2010 0.66 9.20 7.75 - - - 50.00 9.15 7.75 10.00 9.22 7.76 - - - 60.66 9.16 7.75
    11.30 , 2010 130.10 9.20 10.91 358.02 9.26 10.92 370.91 9.17 10.89 310.07 9.28 10.91 325.65 9.55 10.96 1494.75 9.30 10.92
    12.25 , 2010 0.41 9.88 11.92 122.00 9.24 11.67 182.00 9.33 11.68 50.00 9.23 11.66 45.00 9.46 11.69 399.41 9.30 11.68
    6.57 , 2011 25.00 9.16 6.96 - - - 135.00 9.03 6.95 185.00 9.19 6.98 660.00 9.33 7.00 1005.00 9.26 6.99
    9.39 , 2011 - - - 10.15 9.22 9.35 - - - 25.00 9.23 9.35 348.31 9.34 9.38 383.46 9.33 9.38
    12.00 , 2011 - - - - - - - - - - - - 30.00 9.22 11.15 30.00 9.22 11.15
    12.32 , 2011 - - - - - - - - - 45.00 9.31 11.57 80.00 9.36 11.57 125.00 9.34 11.57
    7.27 , 2013 205.00 9.05 7.82 1405.00 9.19 7.87 1505.00 9.16 7.86 335.00 9.24 7.89 185.00 9.28 7.90 3635.00 9.18 7.87
    9.00 , 2013 0.70 9.11 9.04 0.60 9.34 9.12 20.00 9.02 9.01 - - - 21.30 9.04 9.01
    12.40 , 2013 4.01 9.00 10.94 1.40 9.15 10.99 0.54 9.07 10.96 1.25 9.28 11.04 9.34 9.44 11.10 16.54 9.28 11.04
    7.37 , 2014 5.63 8.85 7.88 0.50 9.16 7.99 - - - 184.60 9.20 8.01 15.48 9.23 8.02 206.21 9.19 8.01
    10.50 , 2014 - - - - - - 0.67 9.18 9.89 13.28 9.23 9.92 - - - 13.95 9.23 9.92
    11.83 , 2014 0.70 9.02 10.46 39.50 9.30 10.59 - - - 2.33 9.32 10.59 2.33 9.80 10.82 44.85 9.32 10.60
    7.38 , 2015 176.74 9.00 8.05 60.50 9.13 8.11 100.00 9.21 8.14 242.64 9.18 8.13 60.10 9.30 8.18 639.98 9.14 8.11
    10.47 , 2015 5.00 9.18 9.86 - - - 10.00 9.06 9.80 - - - 0.01 9.59 10.05 15.01 9.10 9.82
    10.79 , 2015 24.80 9.16 9.99 30.94 9.67 10.23 - - - 10.00 10.51 10.65 - - - 65.74 9.60 10.20
    11.50 , 2015 - - - 3.55 9.21 10.33 - - - 8.08 9.21 10.33 - - - 11.63 9.21 10.33
    7.59 , 2016 20.76 8.91 8.18 10.00 9.10 8.27 135.00 9.13 8.29 355.10 9.12 8.28 - 520.86 9.12 8.28
    12.30 , 2016 7.20 8.95 10.37 206.20 9.30 10.56 1.20 9.03 10.41 6.40 9.37 10.59 6.40 9.60 10.72 227.40 9.30 10.56
    7.49 , 2017 61.72 9.07 8.26 0.46 9.10 8.28 - - - 20.22 9.33 8.40 5.54 9.38 8.42 87.94 9.15 8.30
    7.99 , 2017 545.30 9.07 8.55 141.78 9.16 8.59 79.11 8.97 8.50 120.76 9.19 8.61 139.34 9.26 8.65 1026.29 9.12 8.57
    8.07 , 2017 30.40 8.93 8.50 0.07 9.25 8.66 - - - 20.07 9.27 8.67 - - - 50.53 9.07 8.57
    5.69 , 2018 6.75 8.98 7.25 5.00 9.89 7.74 0.50 9.01 7.27 1.50 9.30 7.43 182.00 9.06 7.30 195.75 9.08 7.31
    8.24 , 2018 20111.00 8.88 8.59 13068.50 9.13 8.74 20916.64 8.98 8.65 18035.36 9.08 8.71 17498.08 9.28 8.82 89629.57 9.06 8.69
    12.60 , 2018 ON TAP - - - 95.00 9.29 10.37 - - - - - - - - - 95.00 9.29 10.37
    7.94 , 2021 - - - - - - 30.00 9.29 8.82 50.09 9.44 8.93 - - - 80.09 9.39 8.89
    8.35 , 2022 4.10 9.18 8.92 14.70 9.42 9.09 8.10 9.41 9.09 6.00 9.57 9.20 18.50 9.32 9.03 51.40 9.38 9.07
    8.01 , 2023 OMC SB - - - - - - 0.17 9.60 9.17 0.35 9.60 9.17 10.00 9.61 9.18 10.52 9.61 9.18
    8.30 , 2023 FERT SB 2.79 9.58 9.24 21.59 9.62 9.27 7.82 9.56 9.23 25.47 9.75 9.37 6.98 9.62 9.27 64.65 9.67 9.31
    8.03 , 2024 FCI SB 0.10 9.59 9.21 4.10 9.60 9.21 16.38 9.60 9.21 0.07 9.76 9.34 0.62 9.65 9.25 21.27 9.60 9.21
    8.20 , 2024 OMC SB 0.70 9.62 9.25 5.42 9.60 9.23 1.30 9.50 9.16 12.57 9.56 9.20 2.37 9.62 9.25 22.36 9.57 9.21
    7.95 , 2025 OMC SB 1.00 8.66 8.47 0.35 9.62 9.21 45.00 9.50 9.11 - - - 12.87 9.49 9.10 59.22 9.48 9.10
    8.40 , 2025 OMC SB - - - - - - - - - 19.45 9.61 9.33 10.10 9.60 9.33 29.55 9.61 9.33
    7.95 , 2026 FERT SB - - - - - - 30.00 9.59 9.22 - - - 0.64 9.76 9.36 30.64 9.59 9.22
    8.24 , 2027 10733.66 9.72 9.43 1042.61 9.85 9.53 10.25 9.45 9.21 14.69 9.52 9.26 10.53 9.64 9.36 11811.73 9.73 9.44
    7.95 , 2032 1145.20 9.73 9.51 1293.72 9.86 9.63 4188.78 9.64 9.43 866.20 9.82 9.59 31.76 9.74 9.53 7525.66 9.71 9.50
    8.28 , 2032 - - - - - - 130.00 9.54 9.38 251.20 9.61 9.44 258.80 9.75 9.57 640.00 9.65 9.48
    8.33 , 2036 341.50 9.72 9.61 300.00 9.68 9.57 310.72 9.46 9.36 331.50 9.56 9.46 304.50 9.79 9.68 1588.22 9.64 9.54
    Sub-total 35802.56 9.19 8.72 19617.82 9.25 8.67 29831.90 9.10 8.65 24111.14 9.14 8.46 22280.89 9.31 8.59 131644.30 9.19 8.63
    B RBI’s OMO: Sales 3411.00 - - 21.00 - - 12.00 - - 1.00 - - 119.00 - - 3564.00
    Purchase 3635.00 - - 625.00 - - 10.00 - - - - - 277.00 - - 4547.00
    Sub-total 7046.00 - - 646.00 - - 22.00 - - 1.00 - - 396.00 - - 8111.00
    (A+B) 42848.56 9.19 8.72 20263.82 9.25 8.67 29853.90 9.10 8.65 24112.14 9.14 8.46 22676.89 9.31 8.59 139755.30 9.19 8.63
    3 Market Repo 62926.19 49666.37 49007.64 61255.51 68817.11 291672.82
    4 State Govt Securities 54.32 9.28 9.46 84.40 9.46 9.52 97.53 9.39 9.60 418.25 9.71 9.76 35.95 9.70 9.46 690.45 9.60 9.67
    Grand total (1 to 4) 108368.83 72191.53 81364.38 88178.05 94123.27 444226.05

    (-) means no trading. YTM = Yield to maturity in percentage per annum. CY = Current yield in per cent per annum. SGL = (RBI’s) Subsidiary General Ledger. OMO = Open Market Operations. OMC SB= Oil Marketing Companies Special Bonds . NDS = Negotiated Dealing System. OM = Order Matching Segment. Securities with small-size transactions (Rs 10 crore or less) have been dropped from the above list but included in the respective totals. (1) Yields are weighted yields, weighted by the amounts of each transaction. (2) Current yield has not been worked out for treasury bills. (3) For Floating Rate Bonds (FRB’s) Current yields are based on the latest half-year yield determined in the auction.

    september 27, 2008

    MONEY MARKET REVIEW

    Graph C: Annualised Forward Premia in Percentage for the US Dollar in the Domestic

    6 month Weighted Averages of Call Rates (Right axis) 1 month

    across the board. The annualised six-3.2 Treasury Bills month forward premia eased from 6.51 In sync with the secondary market per cent on August 1 to 2.93 per cent on yields on gilt-edged securities, the yields August 27 but edged up to 3.33 per cent on treasury bills (TBs) declined over the on August 29 (Graph C). month despite the firmness in the short

    term money markets.

    During the month, the

    Inter-Bank Market and Weighted Averages of Call Rates for August 2008

    government increased

    8– –12

    the notified amount

    7–

    – 10 under the 91-day

    6–

    –8 treasury bills under

    5–

    regular borrowings

    4–

    –6

    to Rs 9,500 crore,

    3–

    4 which could be for

    2–

    building up of their

    –2

    1–

    cash positions. Thus,

    0– –0

    the aggregate mobili

    28/07 31/07 3/08 6/08 9/08 12/08 15/08 18/08 21/08 24/08 27/08

    sations under all 3 Primary Markets treasury bills were at Rs 23,500 crore in Yields offered in primary markets gener-August as compared with Rs 18,000 crore ally showed a sharp firmness. in July (Tables 4 to 6).

    3.1 Dated Securities 3.3 Corporate Bonds Market

    As per the scheduled calendar of issuances, Given the improved market sentiments, the government raised Rs 16,000 crore the mobilisations through the primary through two issuances by reissuing three corporate bond market increased to securities. In the first case, on August 8, Rs 3,400 crore in August, as compared the government reissued 8.24 per cent with Rs 2,900 crore in July as well as higher 2018 and 7.95 per cent 2032 for notified than that mobilised in August 2007 of amounts of Rs 6,000 crore and Rs 4,000 Rs 878 crore. Of the Rs 3,400 crore raised crore, respectively, through price-based in August 2008, the central undertakings auctions using uniform price method. The account for Rs 2,450 crore, that is, 72 per cut-off yield for the 10-year paper was set cent of the total amount raised. Among higher at 9.14 per cent as against the rul-them, after a gap of six years, Indian Oil ing secondary market yield of 9.09 per Corporation (IOC) tapped the bond market cent as well as that set in the previous to raise an aggregate amount of Rs 1,500 month at 9.13 per cent. The cut-off yield crore by offering 11 per cent for 10 years set on 24-year paper was set higher at 9.88 and 11.15 per cent for three years. per cent against 8.72 per cent set in June Following the yields offered in the gilt2008. In the second instance, on August 22, edged market, the corporate bond issuers the government reissued 8.24 per cent 2027 too offered higher yields at the short-end for a notified amount of Rs 6,000 crore of the curve while offering lower yields for through price-based auction method using longer tenures, thus, resulting in an invertuniform price method for which the cut-ed yield curve. For instance, the Rural off yield was set at 9.86 per cent as com-Electri fication Corporation (REC) offered pared with 9.25 per cent set in June 2008 10.95 per cent for three years while for

    Three state governments, Mizoram, 10 years it offered only Rs 10.85 per cent. Punjab and Uttar Pradesh, auctioned 10-year development loans for an aggre-4 Secondary Market gate amount of Rs 2,060 crore through a With the subdued inflationary expectayield-based auction using multiple price tions due to easing of international crude auction method. The cut-off yield was set oil prices, there was a jump in the secondary at 9.30 per cent for Punjab and Uttar market turnover for gilt-edged securities. Pradesh while for Mizoram, it was set at With the RBI setting the cut-off yield in

    9.44 per cent; in July, Punjab had to offer the first dated securities auction higher

    9.81 per cent for the same maturity. than market expectations, the market

    Economic & Political Weekly

    EPW
    september 27, 2008

    sentiments were buoyant. But with the higher than expected IIP and acceptance of the Sixth Pay Commission’s recommendations, the sentiments were cautious. In the last week, as the liquidity situation improved due to inflows, the sentiments were again buoyant.

    As the medium- and long-term yields responded to the inflationary expectations, they declined over the month, but as the short-term yields reflected the underlying liquidity situation, which remained tight, the short-term rates as a result remained firm. The spread between one-year and 10-year securities ranged between (-)10 bps and (-)31 bps while that between the

    Graph D: Yield Curves for Dated Securities – Weighted Averages for the First and Last Week of August 2008

    10

    Week ending August 1

    Yield (per cent per annum)9 9.5 Week ending August 29

    8.5 1 3 4 5 6 7 8 9 101112151617181920212529

    Years to Maturity

    same 10-year security and 21-year paper was between 36 bps and 84 bps, indicating the inversion of the yield curve (Graph D) (see also Appendix Table, p 34).

    4.1 RBI Reverse Repos, OMOs and MSS

    With the pressure on liquidity mounting due to the successive hike in the CRR rate, the average daily injections through repo under the LAF increased from Rs 8,622 crore in June to Rs 27,961 crore in July and then eased marginally to Rs 22,076 crore in August. In response to the need for finetuning bank reserves on the last day of the maintenance period, the RBI introduced the second LAF (SLAF) on the reporting Friday effective from August 1 (Table 7, p 33).

    Unlike secondary market turnover, the turnover in repo outside RBI fell from Rs 2,91,673 crore in July to Rs 1,88,713 crore.

    4.2 Commercial Bonds

    The aggregate trading in corporate bond as reported on the Securitised Exchange Board of India (SEBI) web site declined to Rs 4,250 crore in August from Rs 6,536 crore in July.

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