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ROLE OF RESERVE BANK OF INDIA IN
INDIAN ECONOMY
A Minor Project
Submitted in partial fulfillment of the requirements for BBA (Banking &Insurance) Semester III Programme of G.G.S. Indraprastha University, Delhi
Submitted By
Rahul mehra
BBA (B&I) III SEM
0091221808
Delhi College of Advanced Studies
(B-7 Shanker Garden Najafgarh Road New Delhi)
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Literature Review
India's Growth Experience: An Overview
We are now passing through a period of remarkable change and very interestingtimes. For half a century before independence in 1947, there was hardly any
discernible economic growth in the whole Indian sub-continent. We have come
a long way from the growth of 3-3.5 per cent growth in 1950s, to around 5.5 per
cent in 1980s, 5.8 per cent in 1990s, and most recently to a sustainable growth
path of around 8.5 per cent plus ( Table 1 ). But, what is even more striking is the
fact that if we take into account the decline in the rate of population growth
from 2.2 per cent for 40 years during 1960-90 to 1.8 per cent in the 1990s and
further down to 1.6 per cent currently, the growth in per capita GDP has seen a
tremendous push from around 1.6 per cent a year in the 1950s to around 7 per
cent per year now.
Table 1: Growth and Inflation in India - A Historical Record
(Per cent)
Period (Averages) GDP Growth RateWPI Inflation RateGDP Growth Per Capita
1 2 3
1951-52 to 1959-60 3.6 1.2 1.6
1960-61 to 1969-70 4.0 6.4 1.7
1970-71 to 1979-80 2.9 9.0 0.6
1980-81 to 1990-91 5.6 8.2 3.3
1992-93 to 1999-006.3 7.2 4.2
2000-01 to 2006-076.9 5.1 5.3
2003-04 to 2006-078.6 4.9 7.1
Source: Reddy (2007).
With such a high rate of economic growth that we have now experienced inrecent years, progress in the country is now very palpable. The growth is
manifesting itself in many ways all across the country. Innovation and
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entrepreneurship are in the air. Exciting changes are taking place in all spheres.
Even in agriculture, which otherwise has exhibited low growth over the past
decade, a great deal of innovation is taking place.
Low and stable inflation is essential: high and uneven inflation enhances risk
and is hence inimical to innovation and risk taking. Investment cannot take
place without the availability of risk capital, buttressed by the availability of an
adequate flow of credit to nurture the investment climate. Furthermore, the cost
of money available must reflect appropriately the risk and opportunity cost of
lending. Under pricing of risk can lead to excessive risk taking, and overpricing
would lead to the converse. For people to take risk, to innovate and grow, to
have confidence in the future, the environment of low and stable inflation has to
be supported by the maintenance of overall financial stability. Finally, it is the
existence of sound financial institutions that is necessary for the appropriate
supply of financial resources to take place. It is the job of the central bank and
other regulatory institutions to ensure the existence of such an overall financial
environment.The whole process of economic reforms, capital market forms,
financial market reforms, banking reforms, and monetary policy reforms have
all combined to provide such an environment.
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Objectives of the Study
The objective of the research is
To find the different roles and policies that RBI makes to control the money
market instruments
To know whether RBI is able to control it properly or not?
To determine whether RBI has been successful to achieve its objectives with
which it was constituted
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Research Methodology
Research design is the plan/blueprint that specifies the sources and types of
information relevant to the research problem. It is the strategy specifying the
approach for gathering and analyzing data. It considers the cost and time
constraints.
In my study, I started with the exploratory research design and later went on to
secondary data based research design.
Research Methodology
The study would contain both exploratory research and secondary data study.
The following steps will be a part of most formal research, both basic and
applied:
Exploratory - Secondary Data Study
Provides understanding/insights.
Quick and economical method.
Review of earlier stated hypothesis in secondary data base.
Secondary data base can be internal/external
Internal data sources are found within the company.
External data sources are books, newspapers, journals, periodicals, government
published data sources, Internet etc. In my study I have used the secondary data
as it is quick accessible, it has lots of varieties and of its low-cost.
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Limitation
The problems of this method are deluge of information / search results, lack of
authentication and lack of updating. Study of secondary data research has no
formal design but is not done aimlessly. It can be expedited and effectively used
if done in an organized manner.
The secondary data is collected from various sources:
Newspapers Internet
Magazines
Journals
Websites
RBI published data which has enabled to understand the problem definition
of the research and find the answers to the question raised as well.
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Data Analysis
The April 17-2008, 50bp CRR hike announcement came as a surprise to many
market participants. While there were many who were expecting RBI to respond
with such an action, its timing was definitely not anticipated, especially with the
Credit Policy announcement just around the corner.
In general, the market has interpreted this as an emergency measure to addressthe aggravating inflationary scenario. The surge in inflation rate in the recent
months has put renewed focus on monetary policy administration. The headline
inflation rate has picked up dramatically in the recent months to little below 7.5
per cent and has come as a surprise also for the RBI. Not so far back, RBI was
expecting inflation to be anchored at 4.5 per cent and about six months back the
actual inflation was hovering around 3.5 per cent. The haste with which the
CRR action was initiated leads to some obvious questions. Will the RBI follow
up with rate hikes tomorrow? Are we headed for another round of more intense
tightening? And the more fundamental question of whether the Monetary
Policy measures have become ineffective in attaining price stability.
Looking at the recent history one notes that the ongoing monetary tightening
cycle started in October 2004; with initial focus on rate measures (till mid 2006)and later shifting to quantitative measures like increase in CRR rate and
tightening of adequacy rates for banks.
Over the entire tightening phase the reverse repo (i.e. the absorption rate) and
the repo rate (i.e. the liquidity injection rate) have been increased by 150 bps
and 175 bps respectively to 6 per cent and 7.75 per cent respectively. In
comparison, the CRR has increased by 350bps. Including the latest move the
CRR has been increased by 200 bps over Mach 2007 while the policy rates have
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remained unchanged. It is evident that concerns on inflation has been there for a
while and has figured in several forms in RBI's past statements. These included
concerns on overheating, concerns on financial stability and quality of credit
accumulation.
But despite the concerted efforts, inflationary threats have failed to recede. On
the contrary, things have got aggravated and now the RBI is getting increasingly
concerned about worsening inflationary expectation.
While it was hoped that the measured monetary steps towards slowing down
demand and supply creation emanating from huge capital formation will help bring down inflation, the obtaining situation so far indicate that the objective of
price stability has remained elusive. RBI's manufacturing sector survey tends to
suggest that despite the mild slowdown that we have seen in the recent quarters,
the capacity prevailing and expected utilization level for the manufacturing
sector have remained high around, which indicates continued supply
constraints. Possibly, the capacity creation in general has yet to materialize or the demand pressures have continued to overweigh.
A significant reason for the ineffectiveness of both fiscal and monetary
measures has been the fact that the demand and supply pressures we have is not
just local but also global. This is evident from similarity of inflationary
concerns faced by most emerging market economies. Even in advanced
economies, despite the slowdown threat, inflation continues to remain abovecomfort levels.
It's a common believe today that the current inflation is supply shock driven and
hence, monetary measures may not be effective. Hence, RBI should refrain
from tightening. Some have argued that a more aggressive strategy towards
easing supply bottlenecks will possibly address the problem better. There are
also views around banning futures trading in commodities market to prevent
speculative demand.
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In my view, the scenario may be somewhere in between. Supply constraints
have build up only because of continued demand pressure. Price escalations
have happened over a period of several years and hence, cannot be termed as a
shock. A large part of agro product price rise can be attributed to increasing
trend towards conversion of agro commodities into bio-fuel, which has been
catalyzed by high fuel prices.
Since there is a significant contribution from the demand side, it will be
incorrect to hypothesize irrelevance of monetary measures. In fact most other
emerging central banks have deployed monetary tightening measures to control
inflation. The common course of action is to moderate demand and credit flows.
These are coupled with measures to ease supply bottleneck.
Whether, this will translate into any immediate moderation in inflationary
pressures is questionable. Even while there has been containment of credit
growth in India, slowing of demand pressures has been moderate. Supply side
mismatch is unlikely to ease in the near term given the structural nature some of the factors have attained.
So while the options available to attain price stability is limited and the RBI is
likely to hold on to a tight monetary stance. But the possibility of policy rate
(repo and reverse repo rate) hikes is low given that it impacts most sectors
uniformly, which RBI is getting increasingly sensitive about.
The recent CRR rate hike move suggests that RBI will continue to rely more of
quantitative measures with a focus on managing liquidity, also through other
instruments such as LAF and open market operation.
While past measures have successfully slowed credit growth, money supply
growth has continued to remain above target. Hence, there will likely be
renewed focus on slowing money supply.
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Use of exchange rate appreciation as a policy tool to contain inflation may not
be a plausible option at the moment as the balance of risk does not seem to
support any significant rupee appreciation. Raising rates to enable such a
scenario is froth with the risk of further aggravating the liquidity management
problems.
I believe that while it might be inappropriate to conjecture that monetary
measures are ineffective, it will not be incorrect to say that in the current
scenario, the transmission of monetary signals towards impacting inflation has
weakened due to underlying factors attaining global dimensions.
The current situation requires coordinated and concerted efforts by major global
central banks and governments, specially in the emerging markets to attain price
stability, much akin to the efforts made by the Fed, the ECB and Bank of
England to attain financial stability through liquidity infusion measures.
Attainment of growth and price stability through isolated measures by RBI may
not be the most effective way.
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Conclusion
A central bank can operate a truly independent monetary policy when the
exchange rate is floating. If the exchange rate is pegged or managed in any way,
the central bank will have to purchase or sell foreign exchange . These
transactions in foreign exchange will have an effect on the monetary base
analogous to open market purchases and sales of government debt; if the central
bank buys foreign exchange, the monetary base expands, and vice versa.
Accordingly, the management of the exchange rate will influence domestic
monetary conditions. In order to maintain its monetary policy target, the central
bank will have to sterilize or offset its foreign exchange operations. For
example, if a central bank buys foreign exchange (to counteract appreciation of
the exchange rate), base money will increase. Therefore, to sterilize that
increase, the central bank must also sell government debt to contract the
monetary base by an equal amount. It follows that turbulent activity in foreign
exchange markets can cause a central bank to lose control of domestic monetary
policy when it is also managing the exchange rate.
Many economists began to believe that making a nation's central bank
independent of the rest of executive government is the best way to ensure an
optimal monetary policy, and those central banks which did not have
independence began to gain it. This is to avoid overt manipulation of the tools
of monetary policies to effect political goals, such as re-electing the current
government. Independence typically means that the members of the committee
which conducts monetary policy have long, fixed terms. Obviously, this is a
somewhat limited independence. Independence has not stunted a thriving crop
of conspiracy theories about the true motives of a given activities
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Bibliography
www.rbi.org.in www.bidocs.rbi.org.in
www.cpolicy.rbi.org.in
Reserve Bank of India Bulletin (March, 2008)
Reserve Bank of India, Functions and Workings (Published by RBI)
https://cdbmsi.reservebank.org.in
Economic Survey, At a Glance -2007-08
www.cir.rbi.org.in
www.wss.rbi.org.in
The Economics Times
http://www.rbi.org.in/http://www.bidocs.rbi.org.in/http://www.cir.rbi.org.in/http://www.wss.rbi.org.in/http://www.rbi.org.in/http://www.bidocs.rbi.org.in/http://www.cir.rbi.org.in/http://www.wss.rbi.org.in/ -
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Introduction
Reserve Bank of India
The Reserve Bank of India was established on April 1, 1935 in accordance with
the provisions of the Reserve Bank of India Act, 1934. The Central Office of the
Reserve Bank was initially established in Calcutta but was permanently movedto Mumbai in 1937. The Central Office is where the Governor sits and where
policies are formulated.
Though originally privately owned, since nationalisation in 1949, the Reserve
Bank is fully owned by the Government of India.
Preamble
The Preamble of the Reserve Bank of India describes the basic functions of the
Reserve Bank as: "...to regulate the issue of Bank Notes and keeping of reserves
with a view to securing monetary stability in India and generally to operate the
currency and credit system of the country to its advantage."
Central Board
The Reserve Bank's affairs are governed by a central board of directors. The
board is appointed by the Government of India in keeping with the Reserve
Bank of India Act.
Appointed/nominated for a period of four years
Constitution:
Official Directors
Full-time: Governor and not more than four Deputy Governors
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Non-Official Directors
Nominated by Government: ten Directors from various fields and one
Government Official
Others: four Directors - one each from four local boards
Functions: General superintendence and direction of the Bank's affairs
Local Boards
One each for the four regions of the country in Mumbai, Calcutta, Chennai and
New Delhi
Functions: To advise the Central Board on local matters and to represent
territorial and economic interests of local cooperative and indigenous banks; to
perform such other functions as delegated by Central Board from time to time.
Financial Supervision
The Reserve Bank of India performs this function under the guidance of the Board
for Financial Supervision (BFS). The Board was constituted in November 1994 as
a committee of the Central Board of Directors of the Reserve Bank of India.
Objective
Primary objective of BFS is to undertake consolidated supervision of the financial
sector comprising commercial banks, financial institutions and non-banking
finance companies.
Constitution
The Board is constituted by co-opting four Directors from the Central Board as
members for a term of two years and is chaired by the Governor. The Deputy
Governors of the Reserve Bank are ex-officio members. One Deputy Governor,usually, the Deputy Governor in charge of banking regulation and supervision, is
nominated as the Vice-Chairman of the Board.
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BFS meetings
The Board is required to meet normally once every month. It considers inspection
reports and other supervisory issues placed before it by the supervisory
departments.
BFS through the Audit Sub-Committee also aims at upgrading the quality of the
statutory audit and internal audit functions in banks and financial institutions. The
audit sub-committee includes Deputy Governor as the chairman and two Directors
of the Central Board as members.
The BFS oversees the functioning of Department of Banking Supervision (DBS),
Department of Non-Banking Supervision (DNBS) and Financial Institutions
Division (FID) and gives directions on the regulatory and supervisory issues.
Functions
I. Some of the initiatives taken by BFS include:
II. Restructuring of the system of bank inspections
III. Introduction of off-site surveillance,
IV. Strengthening of the role of statutory auditors and
V. Strengthening of the internal defences of supervised institutions.
The Audit Sub-committee of BFS has reviewed the current system of concurrent
audit, norms of empanelment and appointment of statutory auditors, the quality and
coverage of statutory audit reports, and the important issue of greater transparency
and disclosure in the published accounts of supervised institutions.
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Current Focus
Supervision of financial institutions
Consolidated accounting
Legal issues in bank frauds
Divergence in assessments of non-performing assets and
Supervisory rating model for banks.
Legal Framework
Umbrella Acts
Reserve Bank of India Act, 1934: governs the Reserve Bank functions
Banking Regulation Act, 1949: governs the financial sector Acts governing
specific functions.
Public Debt Act, 1944/Government Securities Act (Proposed): Governs
government debt market. Securities Contract (Regulation) Act, 1956: Regulates government securities
market
Indian Coinage Act, 1906:Governs currency and coins
Foreign Exchange Regulation Act, 1973/Foreign Exchange Management
Act,
1999: Governs trade and foreign exchange market Acts governing Banking Operations
Companies Act, 1956:Governs banks as companies
Banking Companies (Acquisition and Transfer of Undertakings) Act,
1970/1980: Relates to nationalisation of banks
Bankers' Books Evidence Act
Banking Secrecy Act Negotiable Instruments Act, 1881
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Acts governing Individual Institutions
State Bank of India Act, 1954
The Industrial Development Bank (Transfer of Undertaking and Repeal)Act, 2003
The Industrial Finance Corporation (Transfer of Undertaking and Repeal)
Act, 1993
National Bank for Agriculture and Rural Development Act
National Housing Bank Act
Deposit Insurance and Credit Guarantee Corporation Act
Main Functions
Monetary Authority: formulate implement and monitors the monetary policy.
Objective: maintaining price stability and ensuring adequate flow of credit to
productive sectors.
Regulator and supervisor of the financial system:
Prescribes broad parameters of banking operations within which the
country's banking and financial system functions.
Objective: maintain public confidence in the system, protect depositors'
interest and provide cost-effective banking services to the public.
Manager of Foreign Exchange
Manages the Foreign Exchange Management Act, 1999.
Objective: to facilitate external trade and payment and promote orderly
development and maintenance of foreign exchange market in India.
Issuer of currency:
Issues and exchanges or destroys currency and coins not fit for circulation.
Objective: to give the public adequate quantity of supplies of currency notes
and coins and in good quality.
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Developmental role
Performs a wide range of promotional functions to support national
objectives.
Related Functions
Banker to the Government: performs merchant banking function for the
central and the state governments; also acts as their banker.
Banker to banks: maintains banking accounts of all scheduled banks.
Brief history of RBI
The Reserve Bank of India is the central bank of the country. Central banks are a
relatively recent innovation and most central banks, as we know them today, were
established around the early twentieth century.
The Reserve Bank of India was set up on the basis of the recommendations of the
Hilton Young Commission. The Reserve Bank of India Act, 1934 (II of 1934)
provides the statutory basis of the functioning of the Bank, which commenced
operations on April 1, 1935.
The Reserve Bank of India was set up as a Share Holders' Bank. The Share Issue of
the Bank offered in March, 1935 was the largest share issue in India at the time.
The matter was further compounded by the conditions and restrictions imposed
under the Act. These conditions related to qualifications of the shareholders, the
geographical distribution and allotment of shares (to avoid concentration of shares
and to ensure that those holding the shares were fit and proper. To simplify
matters, Share Certificate Forms of the different registers were printed in differentcolours. Despite the intricate and gigantic nature of the task, it was carried out with
great 'accuracy and dispatch'.
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A message sent by the Viceroy to the Governor, Osborne Smith when the Reserve
Bank of India commenced its operations on 1st April, 1935
Message
Osborne smith governor reserve bank Calcutta. Following has been received from
secretary for you. Begins, as reserve bank commences operations today i take
opportunity to convey you and your colleagues on the board my most good wishes
and to express my confidence that this great undertaking will contribute largely to
the economic well being of India and of its people. Private secretary viceroy
Reserve Bank Begins Business
Bombay Office
Functions Taken Over From Imperial Bank
In Bank Street Bombay under an ironwork verandah, recalling more than one
Shaftesbury Avenue Theatre, is a new very large brassplate. Across the plate arewritten the words "Reserve Bank of India". To right and left of the plate are open
doors, for the Bank is now open to the public and business is in full swing to the
tune of much hammering. The overpowering smell of fresh paint and the rushing to
and fro of new peons in new drab brown suits.
The building is a famous one having housed for many years the Bombay Head
Office of the Imperial Bank of India. It will become more famous now as the headoffice in the west of India for the Reserve Bank. It is old fashioned as banking
buildings go, but has three roomy floors and ample space.
Managing this new concern is Mr. W.T. Mc Callum from the Imperial Bank of
India. He has a staff of 180. The Bank will have no branches but will work in
mofusil through the branches of the Imperial Bank. The Reserve Bank Head Office
is situated in Calcutta.
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Bankers' Clearing House
The Reserve Bank opened by taking over the Public Debt Office, the Public
Accounts Office and the Currency Department. It will not resume its full
responsibilities until July 1 when the accounts of the Scheduled Banks will be
taken over under Section 42 of the Act. Within a few weeks it will take the
Bankers' Clearing House. To counter balance the removal of these important
functions from the Imperial Bank of India that Bank will extend more along the
lines of the regular commercial banking firm. It is now free to deal in exchange
business whereas hitherto it hqad to work through other banks. A start has not,
however, actually been made.
It is also understood that the Imperial Bank will open a new department, which will
enable it to undertake the work of trustees and executors.
The Reserve Bank of India was nationalised with effect from 1st January, 1949 on
the basis of the Reserve Bank of India (Transfer to Public Ownership) Act, 1948.
All shares in the capital of the Bank were deemed transferred to the Central
Government on payment of a suitable compensation. The image is a newspaper
clipping giving the views of Governor CD Deshmukh, prior to nationalisation.
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The Bank was constituted to
Regulate the issue of banknotes
Maintain reserves with a view to securing monetary stability and
To operate the credit and currency system of the country to its advantage.
The Bank began its operations by taking over from the Government the functions
so far being performed by the Controller of Currency and from the Imperial Bank
of India, the management of Government accounts and public debt. The existing
currency offices at Calcutta, Bombay, Madras, Rangoon, Karachi, Lahore andCawnpore (Kanpur) became branches of the Issue Department. Offices of the
Banking Department were established in Calcutta, Bombay, Madras, Delhi and
Rangoon.
Burma (Myanmar) seceded from the Indian Union in 1937 but the Reserve Bank
continued to act as the Central Bank for Burma till Japanese Occupation of Burma
and later upto April, 1947. After the partition of India, the Reserve Bank served as
the central bank of Pakistan upto June 1948 when the State Bank of Pakistan
commenced operations. The Bank, which was originally set up as a shareholder's
bank, was nationalised in 1949.
An interesting feature of the Reserve Bank of India was that at its very inception,
the Bank was seen as playing a special role in the context of development,
especially Agriculture. When India commenced its plan endeavours, the
development role of the Bank came into focus, especially in the sixties when the
Reserve Bank, in many ways, pioneered the concept and practise of using finance
to catalyse development. The Bank was also instrumental in institutional
development and helped set up insitutions like the Deposit Insurance and Credit
Guarantee Corporation of India, the Unit Trust of India, the Industrial
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Development Bank of India, the National Bank of Agriculture and Rural
Development, the Discount and Finance House of India etc. to build the financial
infrastructure of the country.
With liberalisation, the Bank's focus has shifted back to core central banking
functions like Monetary Policy, Bank Supervision and Regulation, and Overseeing
the Payments System and onto developing the financial markets.
Economic Development
The economic development of a nation is reflected by the progress of the various
economic units, broadly classified into corporate sector, government and
household sector. While performing their activities these units will be placed in a
surplus/deficit/balanced budgetary situations.
There are areas or people with surplus funds and there are those with a deficit. A
financial system or financial sector functions as an intermediary and facilitates the
flow of funds from the areas of surplus to the areas of deficit. A Financial System
is a composition of various institutions, markets, regulations and laws, practices,
money manager, analysts, transactions and claims and liabilities.
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Financial System
The word "system", in the term "financial system", implies a set of complex and
closely connected or interlined institutions, agents, practices, markets, transactions,
claims, and liabilities in the economy. The financial system is concerned about
money, credit and finance-the three terms are intimately related yet are somewhat
different from each other. Indian financial system consists of financial market and
financial intermediation. These are briefly discussed below;
Financial Markets
A Financial Market can be defined as the market in which financial assets are
created or transferred. As against a real transaction that involves exchange of
money for real goods or services, a financial transaction involves creation or
transfer of a financial asset. Financial Assets or Financial Instruments represents a
claim to the payment of a sum of money sometime in the future and /or periodic
payment in the form of interest or dividend.
Money Market- The money market is a wholesale debt market for low-risk,
highly-liquid, short-term instrument. Funds are available in this market for periods
ranging from a single day up to a year. This market is dominated mostly by
government, banks and financial institutions.
Capital Market - The capital market is designed to finance the long-term
investments. The transactions taking place in this market will be for periods over a
year.
Forex Market - The Forex market deals with the multicurrency requirements,
which are met by the exchange of currencies. Depending on the exchange rate thatis applicable, the transfer of funds takes place in this market. This is one of the
most developed and integrated market across the globe.
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Credit Market- Credit market is a place where banks, FIs and NBFCs purvey
short, medium and long-term loans to corporate and individuals.
Constituents of a Financial System
Financial Intermediation
Having designed the instrument, the issuer should then ensure that these financial
assets reach the ultimate investor in order to garner the requisite amount. When
the borrower of funds approaches the financial market to raise funds, mere issue of
securities will not suffice. Adequate information of the issue, issuer and the
security should be passed on to take place. There should be a proper channel
within the financial system to ensure such transfer. To serve this purpose, Financial
intermediaries came into existence. Financial intermediation in the organized
sector is conducted by a wide range of institutions functioning under the overall
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surveillance of the Reserve Bank of India. In the initial stages, the role of the
intermediary was mostly related to ensure transfer of funds from the lender to the
borrower. This service was offered by banks, FIs, brokers, and dealers. However,
as the financial system widened along with the developments taking place in the
financial markets, the scope of its operations also widened. Some of the important
intermediaries operating ink the financial markets include; investment bankers,
underwriters, stock exchanges, registrars, depositories, custodians, portfolio
managers, mutual funds, financial advertisers financial consultants, primary
dealers, satellite dealers, self regulatory organizations, etc. Though the markets are
different, there may be a few intermediaries offering their services in move thanone market e.g. underwriter. However, the services offered by them vary from one
market to another.
Intermediary Market Role
Stock Exchange Capital MarketSecondary Market tosecurities
Investment BankersCapital Market, CreditMarket
Corporate advisoryservices, Issue of securities
UnderwritersCapital Market, MoneyMarket
Subscribe to unsubscribed portion of securities
Registrars, Depositories,Custodians Capital Market
Issue securities to the
investors on behalf of thecompany and handle sharetransfer activity
Primary Dealers SatelliteDealers
Money MarketMarket making ingovernment securities
Forex Dealers Forex MarketEnsure exchange ink currencies
India's Growth Experience: An Overview
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We are now passing through a period of remarkable change and very interesting
times. For half a century before independence in 1947, there was hardly any
discernible economic growth in the whole Indian sub-continent. We have come a
long way from the growth of 3-3.5 per cent growth in 1950s, to around 5.5 per cent
in 1980s, 5.8 per cent in 1990s, and most recently to a sustainable growth path of around 8.5
per cent plus ( Table 1 ). But, what is even more striking is the fact that if we take into account the
decline in the rate of population growth from 2.2 per cent for 40 years during 1960-90 to 1.8 per
cent in the 1990s and further down to 1.6 per cent currently, the growth in per capita GDP has
seen a tremendous push from around 1.6 per cent a year in the 1950s to around 7 per cent per
year now.
Table 1: Growth and Inflation in India - A Historical Record
(Per cent)
Period (Averages) GDP Growth Rate WPI Inflation Rate GDP Growth Per Capita
1 2 3
1951-52 to 1959-60 3.6 1.2 1.6
1960-61 to 1969-70 4.0 6.4 1.7
1970-71 to 1979-80 2.9 9.0 0.6
1980-81 to 1990-91 5.6 8.2 3.3
1992-93 to 1999-00 6.3 7.2 4.2
2000-01 to 2006-07 6.9 5.1 5.3
2003-04 to 2006-07 8.6 4.9 7.1
Source: Reddy (2007).
With such a high rate of economic growth that we have now experienced in
recent years, progress in the country is now very palpable. The growth is
manifesting itself in many ways all across the country. Innovation and
entrepreneurship are in the air. Exciting changes are taking place in all spheres.
Even in agriculture, which otherwise has exhibited low growth over the past
decade, a great deal of innovation is taking place.
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Low and stable inflation is essential: high and uneven inflation enhances risk
and is hence inimical to innovation and risk taking. Investment cannot take place without the availability of risk capital, buttressed by the availability of an
adequate flow of credit to nurture the investment climate. Furthermore, the cost
of money available must reflect appropriately the risk and opportunity cost of
lending. Under pricing of risk can lead to excessive risk taking, and overpricing
would lead to the converse. For people to take risk, to innovate and grow, to
have confidence in the future, the environment of low and stable inflation has to be supported by the maintenance of overall financial stability. Finally, it is the
existence of sound financial institutions that is necessary for the appropriate
supply of financial resources to take place. It is the job of the central bank and
other regulatory institutions to ensure the existence of such an overall financial
environment.
The whole process of economic reforms, capital market forms, financial market
reforms, banking reforms, and monetary policy reforms have all combined to
provide such an environment. We need to ensure that this kind of growth
environment low and stable inflation and financial stability is indeed
maintained and sustained in the medium to long-term, so that in India,
entrepreneurship can flower and flourish further.
Conditions for Innovation and Growth
The foremost economic thinker who talked about innovation was Joseph
Schumpeter. He defined it to encompass any of a number of different features.
The introduction of a new method of production would naturally embody some
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Indian examples can be many. As regards supply chain innovation, the best
example comes from the rural sector particularly the agriculture sector, but
which is still in its infancy in India.
All these innovations take place when there is some need. The old saying that
"necessity is the mother of all invention" is clearly true. What has spurred the
acceleration of invention in India is the overall economic reform process. For
example, delicensing of industry in 1991 ushered in a new era of competition;
which was then reinforced by continuing trade liberalization and tariff reformthroughout the decade. Furthermore the freeing of foreign direct investment
(FDI) not only provided new competition, but also brought new techniques and
technology into the country. Thus, Indian industry was forced to innovate in all
the different ways mentioned to cope with the new competition.
All the innovations in the real sector needed corresponding innovations in the
financial sector as well. Innovations in products and services in the real sector
therefore, move ideally in parallel with innovations in the financial sector.
Furthermore, strong public policies and good governance structures nurture
these two developments and direct them in a non-disruptive and constructive
manner so that the positive growth process can be sustained. Financial
innovation involves development of new financial services and products. And
these new products and services need to be more easily accessible. So, financial
firms have to innovate to broaden access to their services. Greater financial
inclusion is a must. The spread of micro finance is one method by which
financial inclusion is being sought to be achieved.
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Innovation involves risk. If risk is to be financed effectively, it is essential for
financial institutions to improve their risk management systems in their entirety.
First is the need to develop appropriate risk assessment systems. Here the
proposed introduction of credit information bureaus should help greatly in the
future. Second is the development of risk mitigation systems. Third, appropriate
risk allocation mechanisms have to be developed, so that risk is adequately
distributed from the point of view of the financial institutions. As financial
systems become more market oriented and as price discovery of interest rates
becomes more efficient, financial institutions find better and better ways of
managing and allocating risk. Effective development of financial systems tofinance innovation takes a good deal of time.
Innovations can either be supply induced or demand led. Supply led innovations
arise from new research and development activities that give rise to new
technologies, new products, and new processes. Demand led innovation
essentially arises from the pressures of new competition. And, of course, R & D
itself can be demand induced.
For innovation to take place on a continuous and efficient basis in response to
the pressures felt there is a need for an effective national innovation system.
Apart from the structuring of in house mechanisms within firms, there is need
for the existence of mutually supporting networks of organizations that nurture
the culture of research development and innovation. R & D institutions have to
be supported by standard setting organizations, technical consultancies and the
like so that firms have adequate technical support systems. Clusters and
incubators are also needed for creating such supportive environments for small
and medium firms.
While it is interesting to note that productivity appears to have picked up
worldwide over the last decade or so and new investments could have been the
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source of its acceleration, the implications of such positive shocks for sustained
growth need to be understood. The rapid replacement of new technology means
that the technological progress gets embedded in the accumulation of fresh
capital stock at a faster rate than would otherwise be the case. Second, recent
research shows that new technology is quite sensitive to movements in the cost
of capital. A combination of high price elasticity and the declining price of
high-tech equipment also contributes to an investment boom. Third, these
investments have considerable externalities or spill over effects. The application
of new technology has helped to reduce operating expenses and as a result of
higher productivity there has been considerable stability in labour costs.Globalisation in terms of outsourcing combined with the availability of new
skilled labour in China and India has also contributed to low inflation
worldwide. Combined with the impact of competition in exercising pricing
leverage, these developments have helped significantly in containing
inflationary pressures during the expansion phase of global GDP over the past
decade.
In this process, the law of supply creating its own demand also operates. First,
productivity increases result in a higher potential for growth and this in turn
generates further demand for goods and services. The real rate of return on new
investments increases and capital spending accelerates to take advantage of the
profit opportunities. Employment and income generated help to augment
consumer demand as well. The spurt in capital market valuations could be a
reflection of such higher profitability. The wealth effect of such a capital market
spurt could further accelerate both consumer and investment demand.
Higher the growth in productivity, higher is the overall growth at given levels of
investment and that also means that much higher growth can be sustained by
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higher investments without arousing inflationary pressures. The best thing thus
one can do is to encourage innovation, productivity and growth which can then
bring about better control over inflation. This is exactly what has happened in
the world in the last 10 years. Central banks around the world congratulate
themselves for having been very successful especially in the last 10 to 15 years
for having tamed inflation internationally. But, what lies behind that
achievement through monetary policy is also the gains that have come through
increases in productivity. The productivity boom in the US has contributed
immensely to non-inflationary growth in the US and also globally in the last
decade. What is important from the central bankers point of view is that thisinflation moderation has taken place in the presence of considerable monetary
accommodation over the same period. In the US, most of the 1995-2000
productivity growth acceleration can be attributed to investments in technology
and management know-how needed to exploit it. Thus, encouraging innovative
activity through investments in R & D activity is something that is central to the
concern of central banks. Innovation and productivity growth contribute to theattainment of low and stable inflation, and low and stable inflation, in turn,
provides an appropriate environment for innovation. Whereas innovation is
characteristically done within firms or in R&D organization, for such activity to
flourish, it is essential that there is both macroeconomic and financial stability.
In sum, we need a conducive macroeconomic environment for innovation and
growth, a supportive financial system and an innovation nurturing environmentthrough national innovation systems.
There are now some signs that inflation could be again increasing worldwide.
Commodity prices, particularly of food and oil, have been increasing in
particular. Similarly there are indications that global growth could be slowing
down at the same time, particularly in the United States. Is this happening
because innovation and productivity growth is slowing down in the US? Similar
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coupled with the introduction of newer products and players. Side-by side,
conscious steps have been undertaken towards building up of the institutional
architecture in terms of markets, technological and legal infrastructure.
Consequent upon the wide array of such measures, the cost of funds for the
corporate sector has become market-related. Coupled with greater access to
foreign investment alongside improvements through trade liberalization, there is
a significant growth in manufacturing exports as also the import intensity of
exports. The corporate sector has thus become increasingly exposed tointernational product and factor prices. Such market-driven pricing of products
and factors combined with gradual reduction in rates of interest in an overall
benign interest rate environment and moderate debt equity ratios have resulted
in lower interest outgo. This, in turn, has promoted better resource allocation
and efficient use of new technology, which has become reflected in their profit
and efficiency parameters.
What has been the result in terms of corporate performance? All the important
parameters: sales, gross profit, profit after tax, all have recorded robust growth
rates since 2002-03, implying that economic activity in the corporate sector hasimproved tremendously over this period . The dependence on banks for
financing has indeed gone down. There has been a very significant reduction of
interest expenses in total expenditure. To that extent, the corporate sector could
have become more insensitive to small movements in interest rates. The high
growth in profits of the corporate sector suggests that competition is inadequate
and that entry of new firms or even the threat of entry of new firms is low.
Growth in output is being driven more by expansion of existing firms rather
than through the creation of new firms. This pattern would suggest that new
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firms are not finding it easy to access funds from the banking system at
reasonable risk adjusted rates. It is essential that banks should be careful in their
risk assessment, and that the interest rates charged and volumes of funds lent
should reflect the risk assessed. In the presence of the kind of high growth rates
being observed in the economy, are banks being adequately supportive? What is
the evidence?
First, the pattern of funding from banks is predominantly to the urban and
metropolitan sectors which account for the overwhelming share of credit. Theshare of metropolitan areas, in fact, has risen further in the current decade, with
that of rural and urban areas declining (Table 2).
Table 2: Population group-wise outstanding credit of commercial banks
(Per cent to total)
PopulationGroup
March 2001 March 2005 March 2006March2007
Rural 10.1 9.2 8.4 7.9
Semi urban 11.5 11.3 10.0 9.7
Urban 16.8 16.4 16.4 16.2
Metropolitan 61.6 63.1 65.3 66.1
Memo:Amount (Rupees billion)
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All India 5564 11578 15175 19496
Source: Reserve Bank of India
Second, the pattern of funding by the banks remains skewed towards larger
firms. The problem for the banks, however, is that profit growth in the corporate
sector has been so high in recent years, that they do not need much bank
borrowing, and the share of debt service in corporate balance sheets has been
getting lower and lower. In fact, in view of the reduced need of large firms for
bank funding there is great competition among banks to fund the incumbents, to
fund the larger firms, leading to lending rates levied on them becoming much
lower than the declared benchmark prime lending rates (BPLR). This is in some
sense an encouraging sign, so that if the banks do not have enough income
generation from the larger firms, they may be willing to lend more to the newer
entrepreneurs. The existing preference for lending to larger firms is presumably
due to the old banking habit of greater comfort with incumbents to whom it is
safer and easier to lend. Finding new entrepreneurs, new ideas, new products,
and new services to finance need greater effort and more sophisticated risk management systems. Indian banks have also been handicapped by the absence
of credit information bureaus and any availability of centralized credit records
of small and medium entrepreneurs. This problem should now get rectified
since the Credit Information Companies Act has been passed by parliament.
Guidelines for these companies have also been issued by the Reserve Bank, so
we can expect such new companies to get established in the near future.
There is some corroborating evidence suggesting the difficulty of entry for new
business entrepreneurs. When we look at the World Bank surveys on doing
business across countries, India typically ranks quite low in the range of 120-
130. At the same time, we find that both the level of profits of the corporate
sector in India and growth of profits is among the highest in the world. How can
both be true: that doing business in India is more difficult than in other
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countries, while at the same time the Indian corporate sector has exhibited
higher profit growth than probably any other country in the world over the past
4-5 years? A possible explanation for this apparent contradiction seems to be
the high entry costs: once you get in, it is easy to grow, but getting in, in the
first place, is difficult. This suggests that the Indian financial system is, perhaps,
still not adequately geared to finance new ideas and new firms.
Further, one of the distinguishing features of the high credit growth in recent
years has been the continuing low share of credit going to small and mediumenterprises (SMEs), although there has been some change in the trend this past
year. Again, it is puzzling how the credit growth to SMEs among all the
segments has actually been the lowest. What has really happened is that banks
have essentially moved from lending to the corporate sector to individuals and
retail, still leaving out the middle, namely SMEs. And again, banks appear to
have moved to individuals and retail because of the high quality of collateralavailable for such loans. For the financial system to nurture innovation and
growth, its risk assessment practices need to improve while transaction costs are
reduce. Greater availability of credit histories and credit information should
help in this regard. All these will lead to better capacity in the financial system
to take informed credit decisions. As we go ahead with further development of
the financial system, it should enable slicing of risk in such a way that investors
with different risk appetites from higher to lower, are able to find appropriate
vehicles for investment. The issue is basically one of informed risk management
in terms of segregating more risky from less risky credits and finding
appropriate ways of financing them. As we go along with reforms, we need to
work harder to develop such institutions and systems.
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In India, monetary policy has the twin objectives of price stability and growth.
While the Reserve Bank does not target an explicit inflation rate as some
countries do, the objective currently is to contain the inflation rate within an
upper bound of 5 percent and attempt to reduce it further in the medium term.
The relative emphasis of monetary policy stance varies with the prevailing
macroeconomic and monetary conditions: for example, inflation was an issue
during much of 2007, and continues to be of concern now. The upshot of these
concerns has been reflected in a gradual tightening of policy rates and additional
measures such as increase in cash reserve ratio since the latter part of 2004.
The best contribution that monetary policy can make for fostering innovation
and growth is to provide an environment of low inflation, low inflation
expectations, along with confidence in the maintenance of financial stability.
Entrepreneurs take considerable risk as it is: on top of that if we add macro-
economic risks in terms of higher inflation, high inflation volatility and higher
interest rates, then the risk perception can be such that entrepreneurship,
innovation and investment gets effectively constrained. That will inevitably
result in lower investment rates and hence lower economic growth. Therefore,
to keep the momentum of high growth, it is extremely important to recognise
that the best contribution that monetary policy can make is indeed to ensure thatinflation and inflation expectations are well anchored.
There is evidence that pro-cyclical behaviour of financial markets and pro-
cyclical macroeconomic policies have not encouraged growth; they have in fact
increased growth and consumption volatility in developing countries that have
integrated to a larger extent in international financial markets. The menu of
macroeconomic policies for financial and real economic stability has thus
expanded in recent years to multiple objectives and significant trade-offs.
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Preventive or prudential macroeconomic and financial policies, which aim to
avoid the excess accumulation of public and private sector debts during periods
of upward cycle, have become a part of the standard policy prescription.
Policy choices presently involve a mix of counter-cyclical fiscal and monetary
policies, which also include the practice of an appropriate exchange-rate regime,
buttressed by active capital account management that reduces the risks that can
arise from turbulence in international financial markets. Such measures would
also include adequate prudential regulation of the financial sector, and particularly of the banking system. Thus, for instance, the increase in risk
weights on lending to certain sectors such as real estate has been aimed at
curbing excessive credit growth to sectors that seem in danger of over-
extension.
While India has been maintaining one of the highest growth rates among
countries for quite some time now, the growth dynamics has dramatically
shifted in the last three to four years and the economy is poised to break from an
intermediate growth rate of around 6 percent to a high growth rate regime of
well above 8 percent. Despite high levels of internal resource generation and
access to external borrowings, credit demand across sectors also had picked up
quite substantially pushing the rate of investment to new heights. The increasing
consumer and business confidence have been attracting foreign investment
flows resulting in easy liquidity conditions in the financial system. The central
bank had to address these complex set of pressures of increased liquidity,
substantial expansion in credit particularly to certain sensitive sectors such as
real estate and retail and the growing capital inflows and consequent need for
sterilization.
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A cross-country comparison of major EMEs that have adopted inflation
targeting (IT) indicates that growth in India has been amongst the highest while
inflation remains relatively low (Mohan, 2007). Thus, the recent record of
macroeconomic management in India is exemplary, even amongst the EMEs
that target inflation. The challenge for monetary policy now is to reduce
inflation further in the medium term towards international levels, while
maintaining the momentum of high growth and preserving financial stability.
Real GDP growth has averaged 8.7 per cent per annum during the 5-year period
ending 2007-08. The present domestic investment rate of around 36-37 per cent
is expected to help sustain the current growth momentum. In Indian economichistory, there has never been this order of growth for five consecutive years; this
has been achieved while keeping inflation low and stable and anchoring
inflationary expectations. Apart from increase in productivity, benefits through
trade liberalization, fiscal consolidation and more effective monetary policy
have also helped in sustaining relatively a low inflation rate since the mid-
1990s. Spikes and seasonal falls in headline inflation rates will continue tooccur due to relative price adjustments and supply shocks emanating from
agricultural and other commodity prices. Such shocks have evidently amplified
over the past 2-3 years on account of large increases in a range of global
commodity prices such as oil, food and metals. In view of the success in
reducing inflation from the long-run average of 7-8 per cent to 4-5 per cent
now, the society's tolerance rate of inflation has also come down. In this crucialstage of transition, it is important to recognize that price and financial stability
are very crucial to sustain the growth at current levels without any disruptive
forces coming into play.
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MONEY MARKET DEVELOPMENTS
MID-1980s ONWARDS
The Vaghul Working Group (1987) recommended several measures for
widening and deepening the money market. Some of the major
recommendations, inter alia, included (i) activating existing instruments and
introducing new instruments to suit the changing requirements of borrowers and
lenders; (ii) freeing interest rates on money market instruments; and (iii)
creating an active secondary market through establishing, wherever necessary, a
new set of institutions to impart sufficient liquidity to the system. The
Committee on the Financial System, 1991 further recommended phased
rationalisation of the CRR for the development of the money market. Second
generation reforms in the money market commenced when the Committee on
Banking Sector Reforms, 1998 recommended measures to facilitate the
emergence of a proper interest rate structure reflecting the differences in
liquidity, maturity and risk.
In pursuance of the recommendations of the two committees, a comprehensive
set of measures was undertaken by the Reserve Bank to develop the money
market. These included (i) withdrawal of interest rate ceilings in the money
market; (ii) introduction of auctions in Treasury Bills; (iii) abolition of ad hocTreasury Bills; (iv) gradual move away from the cash credit system to a loan-
based system; (v) relaxation in the issuance restrictions and subscription norms
in the case of many money market instruments; (vi) introduction of new
financial instruments; (vii) widening of participation in the money market; and
(viii) development of a secondary market. All these policy measures have
helped in developing the money market significantly over the years as reflectedin the volumes and turnover in various market segments.
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Prior to the mid-1980s, as discussed earlier, the market participants heavily
depended on the call money market for meeting their funding requirements.
However, inherent volatility in the market impeded efficient price discovery,
thereby hampering the conduct of monetary policy. Against this backdrop, the
Chakravarty Committee (1985) recommended activation of the Treasury Bills
market (with the discount rate being market related) to reduce dependence on
the call money market and abolish ceilings on the call rate along with permitting
more institutional participation to widen the market base. The Vaghul
Committee, in view of the continued existence of an unaligned overall interest
rate structure, recommended abolition of the ceiling interest rate on the callmoney market. However, it held the view that the call money market should
continue to remain a strictly inter-bank market (barring LIC and the erstwhile
UTI which could continue as lenders only) and recommended the setting up of a
Finance House of India to impart liquidity to short-term money market
instruments.
The reforms commenced with the setting up of an institution, viz., the Discount
and Finance House of India (DFHI) in 1988 as a money market institution to
impart liquidity to money market instruments. Interest rate in the call money
market was deregulated with the withdrawal of the ceiling rate with respect to
DFHI from October 1988 and with respect to the call money market in May
1989. Although the Vaghul Committee had recommended that call/notice
money should be restricted to banks only, the Reserve Bank favoured the
widening of the call/notice money market. In the absence of adequate avenues
for deployment of short-term surpluses by non-bank institutions, a large number
of non-bank participants such as FIs, mutual funds, insurance companies and
corporates were allowed to lend in the call/notice money market, although their
operations were required to be routed through the PDs from March 1995. In this
context, PDs and banks were permitted to both lend and borrow in the market.
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The Reserve Bank exempted inter-bank liabilities from the maintenance of
CRR/ SLR (except for the statutory minimum) effective April 1997 with a view
to imparting stability to the call money market.
The Narsimham Committee (1998), however, noted that the money market
continued to remain lopsided, thin and extremely volatile. While the non-bank
participation was a source of comfort, it had not led to the development of a
stable market with depth and liquidity. The non-bank participants, unlike banks,
were not subjected to reserve requirements and the call/notice money marketwas characterised by predominant lenders and chronic borrowers causing heavy
gyrations in the market. There was also over-reliance of banks in the call/notice
money segment, thereby impeding the development of other segments of the
money market. The Reserve Bank also did not have any effective presence in
the market and operated with pre-determined lines of refinance. As interest rates
in other money market segments move in tandem with the inter-bank callmoney rate, the volatility in the call segment inhibited proper risk management
and pricing of instruments. Thus, freeing of interest rates did not result in a
well-defined yield curve. Furthermore, banks role in the money market was
further impaired by the health of their own balance sheets, lack of integrated
treasury management and sound asset-liability management.
The Narasimham Committee (1998) made several recommendations to further
develop the money market. First, it reiterated the need to make the call/notice
money market a strictly inter-bank market, with PDs being the sole exception,
as they perform the key function of equilibrating the call money market and are
formally treated as banks for the purpose of inter-bank transactions. Second, it
recommended prudential limits beyond which banks should not be allowed to
rely on the call money market. The access to the call money market should only
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be for meeting unforeseen fund mismatches rather than for regular financing
needs. Third, the Reserve Banks operations in the money market need to be
market-based through LAF repos and reverse repo auctions, which would
determine the corridor for the market. Fourth, non-bank participants could be
provided free access to rediscounting of bills, CP, CDs, Treasury Bills and
money market mutual funds.
Following the recommendations of the Reserve Banks Internal Working Group
(1997) and the Narasimham Committee (1998), steps were taken to reform thecall money market by transforming it into a pure inter-bank market in a phased
manner. The corporates, which were allowed to route their transactions through
PDs, were phased out by end-June 2001. The non-banks exit was implemented
in four stages beginning May 2001 whereby limits on lending by non-banks
were progressively reduced along with the operationalisation of negotiated
dealing system (NDS) and CCIL until their complete withdrawal in August2005. In order to create avenues for deployment of funds by non-banks
following their phased exit from the call money market, several new
instruments were created such as market repos and CBLO. Maturities of other
existing instruments such as CPs and CDs were also gradually shortened in
order to align the maturity structure to facilitate the emergence of a rupee yield
curve. The Reserve Bank has been modulating liquidity conditions through
OMOs (including LAF), MSS and refinance operations which, along with
stipulations of minimum average daily reserve maintenance requirements, have
imparted stability to the call money market.
Despite these reforms, however, the behaviour of banks in the market has not
been uniform. There are still some banks, such as foreign and new private sector
banks, which are chronic borrowers and public sector banks, which are thelenders. Notwithstanding excessive dependence of some banks on the call
money market, the short-term money markets are characterised by high degree
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of stability. The Reserve Bank has instituted a series of prudential measures and
placed limits on borrowings and lendings of banks and PDs in the call/notice
market to minimize the default risk and bring about a balanced development of
various market segments. In order to improve transparency and strengthen
efficiency in the money market, it was made mandatory for all NDS members to
report all their call/notice money market transactions through NDS within 15
minutes of conclusion of the transaction. The Reserve Bank and the market
participants have access to this information on a faster frequency and in a more
classified manner, which has improved the transparency and the price discovery
process. Furthermore, a screen-based negotiated quote-driven system for alldealings in the call/notice and the term money markets (NDS-CALL),
developed by CCIL, was operationalised on September 18, 2006 to bring about
increased transparency and better price discovery in these segments.
Various reform measures over the years have imparted stability to the callmoney market. It has witnessed orderly conditions (barring a few episodes of
volatility) and provided the necessary platform for the Reserve Bank to conduct
its monetary policy. The behaviour of call rates has, historically, been
influenced by liquidity conditions in the market. Call rates touched a peak of
about 35 per cent in May 1992, reflecting tight liquidity on account of high
levels of statutory pre-emptions and withdrawal of all refinance facilities,
barring export credit refinance. After some softness, call rates again came under
pressure to touch 35 per cent in November 1995, partly reflecting turbulence in
the foreign exchange market. The Reserve Bank supplied liquidity through
repos and enhanced refinance facilities while reducing the CRR to stabilise the
market. After softening to a single digit level, the rate hardened again to touch
29 per cent in January 1998, reflecting mopping up of liquidity by the Reserve
Bank to ease foreign exchange market pressure. Barring these episodes of
volatility, call rates remained generally stable in the 1990s. After the adoption
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of the LAF in June 2000, the call rate eased significantly to a low of 4.5 per cent
in September 2004, reflecting improved liquidity in the system following
increased capital inflows. However, it came under some pressure in December
2005 on account of IMD redemptions and increased to about 7 per cent in
February 2007, partly due to monetary tightening. With the institution of LAF
and consequent improvement in liquidity management by the Reserve Bank, the
volatility in call rates has come down significantly compared to the earlier
periods. The mean rate has almost halved from around 11 per cent during April
1993-March 1996 to about 6 per cent during April 2000-March 2007.
Volatility, measured by coefficient of variation (CV) of call rates, also halved
from 0.6 to 0.3 over the same period. Thus, while statutory pre-emptions like
CRR and SLR, and reserve maintenance period were the main factors that
influenced call rates in the pre-reform period, it is the developments in other
market segments, mainly the foreign exchange and the government securitiesmarket along with the Reserve Banks liquidity management operations that
have been the main driver of call rates in the post-reform period. This signifies
increased market integration and improved liquidity management by the
Reserve Bank. With the transformation of the call money market into a pure
inter-bank market, the turnover in the call/notice money market has declined
significantly. The activity has migrated to other overnight collateralized market
segments such as market repo and CBLO. The daily average turnover in the call
money market, which was Rs.35,144 crore in 2001-02, declined to Rs.14,170
crore in 2004-05 before increasing again to Rs.21,725 crore during 2006-07.
The recent rise in call money market turnover reflects the general tendency of
heightened market activity following the imbalance between growth in bank
credit and bank deposits in recent years against the backdrop of sustained pick-
up in non-food credit.
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Since forward trading in securities was generally prohibited in India, repos were
permitted under regulated conditions in terms of participants and instruments.
Reforms in this market have encompassed both institutions and instruments.
Both banks and non-banks were allowed in the market. All government
securities and PSU bonds were eligible for repos till April 1988. Between April
1988 and mid-June 1992, only inter-bank repos were allowed in all government
securities. Double ready forward transactions were part of the repos market
throughout this period. Subsequent to the irregularities in securities transactions
that surfaced in April 1992, repos were banned in all securities, except Treasury
Bills, while double ready forward transactions were prohibited altogether.Repos were permitted only among banks and PDs. In order to reactivate the
repos market, the Reserve Bank gradually extended repos facility to all Central
Government dated securities, Treasury Bills and State Government securities. It
is mandatory to actually hold the securities in the portfolio before undertaking
repo operations. In order to activate the repo market and promote transparency,
the Reserve Bank introduced regulatory safeguards such as delivery versus payments (DvP) system during 1995-96. The Reserve Bank allowed all non-
bank entities maintaining subsidiary general ledger (SGL) account to
participate in this money market segment. Furthermore, non-bank financial
companies, mutual funds, housing finance companies and insurance companies
not holding SGL accounts were also allowed by the Reserve Bank to undertake
repo transactions from March 2003, through their gilt accounts maintainedwith custodians. With the increasing use of repos in the wake of phased exit of
non-banks from the call money market, the Reserve Bank issued comprehensive
uniform accounting guidelines as well as documentation policy in March 2003.
Moreover, the DvP III mode of settlement in government securities (which
involves settlement of securities and funds on a net basis) in April 2004
facilitated the introduction of rollover of repo transactions in government
securities and provided flexibility to market participants in managing their
collaterals.
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The transactions that are put through at various agency bank branches in the
State concerned are consolidated at the link cell in the respective State capitals
and settled with the Reserve Bank Office in the State. Currently, Reserve Bank
also handles directly, banking business of four State Governments viz.,
Karnataka, Maharashtra, Thailand and West Bengal. The consolidated position
including the State Government transactions put through at RBI Offices is
ultimately booked in the Principal Account of the respective State maintained at
CAS, Nagpur. Central Accounts the Central Accounts Section (CAS) at the RBI
maintains the principal accounts of both Central and State Governments. The
principal accounts in Nagpur are based on the daily position / aggregate receiptsand payments in respect of each Government, Ministry / department, received
from RBI offices and agency banks. Each of the accredited a
Role Of Central Bank for Regulating Banking System
Need of Central Bank
The Payments System provides the arteries or highways for conducting trade,
commerce and other forms of economic activities in any country. An efficient
payments system functions as a lubricant speeding up the liquidity flow in the
economy and creating a momentum for economic growth. The payments
process is a vital aspect of financial intermediation; it enables the creation and
transfer of liquidity among different economic agents. A smooth, well
functioning payments system not only ensures efficient utilization of scarce
resources but also eliminates systemic risks.
The payments system assumes importance in the context of domestic financial
sector reforms and global financial integration. The time value of money flows
has increased sharply in view of the competing demands on the financial sector.
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Efficient, low cost cross-border payments flow helps to promote international
trade in goods and services. Foreign investments (direct and portfolio) are
encouraged by the availability of an efficient payments system. For these
reasons, an efficient and technologically advanced payments and settlement
system performs a vital infrastructural function in the economy. Central banks
have, therefore, been taking measures to set up such an infrastructural set up.
Use of money for settlement of payment obligations has a very long history.
Use of non-cash exchange through barter preceded the introduction of money.Barter, however, co-exists with monetized economy in some underdeveloped
agricultural societies even now. But currency or cash is the most readily
accepted medium of exchange in all modern societies because it is the legal
tender and helps to bring about irrevocable settlement. There are, however,
certain disadvantages associated with the use of cash. Holding cash does not
fetch any return-the interest foregone because of cash holding is a cost to theholder of cash. Besides, the holder of cash bears some insurance costs in terms
of the premia that is paid to cover any loss/theft. Moreover, carrying of large
quantities of cash to make large-value payments is a security risk and also
involves transportation costs. The requirements of a modern economy in regard
to settlement of transactions are diverse and variegated and the needs of
manufacturing, trade, and commerce activities involve large value payments
over vast geographic distances. External trade with the rest of the world
involves payments in different currencies. Payments can no longer be
completed by simple cash transfer in such cases. Therefore, there arises the need
for additional forms of payments, which can be facilitated with improved
financial intermediation and expansion of financial instruments. Cheques and
other paper based instruments and to some extent electronic instruments have
become important modes of payment in recent times in most countries because
of growing financial intermediation. Individuals, business entities or
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governments issue cheques or other forms of order on their banks in discharge
of their payment obligations. The recipients of these orders would then get the
funds embodied in these payment instruments through their own banks. As the
number of banks grew over time, the volume of instruments exchanged among
them increased substantially.
Consequently, as also to have an orderly means of transfer of payment
instructions among banks at a location or centre, a common set of practices and
mechanisms of exchange had to be evolved. When instruments presented bycustomers of banks become payable at outside locations, special collection
arrangements are set in motion to collect the funds.
If the collecting bank has a branch at the relevant outside location, there would
be no problem, but, if the collecting bank does not have a branch at the outside
location, it will have to enter into correspondent banking relationship with
another bank at the said outside location for the purpose of collecting funds. The
payment instruments which are routed through financial intermediaries involve
book entries at various levels to transfer funds from one party to the other. The
range of intermediation varies to take care of different situations. This may, for
instance, consist of instructions to intermediaries to move goods coinciding with
the movement of funds as in the case of a Letter of Credit. Or, the instruction
could be for payment of specified sums of money to the bearer of a payment
instrument, as in the case of a bearer cheque.
In some cases, the payment instruments are negotiable in the sense that they can
be transferred from person to person in lieu of cash. In yet other cases, both theultimate beneficiary and the destination could be pre-determined. In all these
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cases, banks play a crucial part in conveying, transmitting and carrying out the
instructions embodied in the payment instruments. While doing so, these
intermediaries have to settle among themselves the monetary claims arising
from the execution of payment instructions.
Thus, whenever non-cash payment instruments are involved, they are
accompanied by a chain of related fund transfers as well as a stream of book
entries and messages. Banks in turn need an intermediate agency such as the
clearing house where these instruments can be exchanged and where thefinancial claims on one another can be settled through a settlement bank, which
is usually the Central Bank of the country.
Clearing Houses facilitate the exchange of instruments and processing of
payment instructions at a central point among the participating banks. Clearing
Houses-manual and paper based in many advanced countries have gradually
extended their range of activities to include automated (ACH) and electronic
means for settlement of payment transactions. Such an evolution is also seen in
emerging economies. Banks, as crucial intermediaries in the payments stream,
provide deposit accounts to non bank agents (i.e. individuals, firms/corporate
bodies) which are considered as liquid assets and facilitate payments
transactions. Banks provide credit facilities so that such payments can be
effected with lower working balances. Moreover, they act as conduit through
which domestic and international capital markets provide resources to the
commercial sector. The payments system has a multiplicity of layers where
several levels of intermediation occur in the transfer of funds from one person
and/or institution to another. The structure of the Payments System can be
visualized as a Pyramid, with linkages among different tiers of the payment
intermediaries.
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At the base of the Pyramid are the non banks (all non-depository corporations
including individuals and firms) whose assets are diverse, including bank notes
and deposits. The types of payments at the base of the Pyramid include both
cash and non-cash modes of payments. Banks are at the intermediate level.
The assets of the banks comprise, among others, their reserves with the Central
Bank, deposits with the correspondents and claims on the correspondents, and
investments in Government and other securities, loans and advances and cash in
their vaults. Typically, their liabilities would among others, be made up of
deposits from non banks and correspondents and loans from the Central Bank.
The Clearing House and the settlement bank are the financial intermediaries
who channel the funds flow between the banks. At the apex of the pyramid isthe Central Bank of the country (i.e. Reserve Bank of India) which has the
settlement accounts of the banks and sustains the payments process.
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Chapter IV. Given the increase in the volume of paper based instruments and
the time taken for clearing these instruments, it was inevitable to move towards
item-based computerized processing and settlement for improving systemic
efficiency as well as customer service. These and other related aspects are the
main themes of interest in Chapter V. In the early and mid 90s, a beginning was
made in introducing ACH (Automated Clearing House) services such as
Electronic Clearing Service (ECS) and Electronic Funds Transfer (EFT).
The developments in this regard, including the establishment of a Shared
Payment Network System (SPNS) of Automated Teller Machines (ATMs) are
highlighted in Chapter VI. For an efficient electronic payments system, a strong
and robust telecommunication network is necessary. The efforts made by the
Reserve Bank in particular as well as the banking industry in general in setting
up a telecommunication network to serve the needs of the industry form the
contents of Chapter VII. The final chapter provides a brief idea of the
challenges ahead in modernizing the Indian pay