The Indian Money Market
What is a Money Market?
A money market is a one that deals in short-term loans or financial assets. It refers to the market for short-term requirement and deployment of funds where participants lend and borrow. It is a market wherein financial institutions (FIs) work together for the purpose of dealing in financial or monetary assets, generally referred to as near substitutes of money, which may be of short-term or long-term maturity. ‘Short-term’ implies, generally a period up to one year and the term ‘near substitutes of money’ refers to financial assets which can be quickly converted into money with minimum transaction cost. One of the most appropriate and meaningful definitions of money market is that of Geoffrey Crowther. To him, ‘The money market is the collective name given to the various firms and institutions that deal in the various grades of money.’1 The money market does not mean that there is a specific place where transactions for short-term funds take place. But it refers to all individuals, institutions and intermediaries dealing with short-term funds. The actual transactions between lenders and borrowers and middlemen may take place through agents, telephone, telegraph, faxes, mails and couriers. A money market transaction does not envisage personal contact or presence of contracting parties for negotiations. For instance, the Bombay money market is the primary centre for short-term loanable funds of not only for Bombay or Maharashtra, but the whole of India.
Characteristics of Money Market Instruments
‘The money market encompasses a wide range of instruments with maturities ranging from one day to a year, issued by the government and by banks and corporations of varying credit rating, and traded in markets of varying liquidity. The money market is also intimately linked with the foreign exchange market through the process of covered interest arbitrage in which the forward premium acts as a bridge between domestic and foreign interest rates.’2 The most important feature of a money market instrument is that it is liquid and can be turned over quickly at low cost and provides an avenue for equilibrating the short-term surplus funds of lenders and the requirements of borrowers. The call money market forms an important segment of the Indian money market. Under call money market, funds are transacted on an overnight basis and under notice money market, funds are transacted for the period between 2 and 14 days.3
The following are the objectives of a money market:
- It provides space for parking and using gainfully surplus funds.
- It offers a forum for overcoming deficiencies of short-term instruments.
- It enables the Reserve Bank, through its function of market intervention, to impact and regulate liquidity to the economy.
- It offers a chance to the users of short-term funds to access their needs from suppliers easily, adequately and cost-effectively.
Money Markets Versus Capital Markets
Though both money markets and capital markets are part and parcel of a country’s financial system, there are several differences between the two as are explained below:
- Duration of funds provided: Money markets deal with short-term loanable funds for a period of one year or less, while capital markets deal with long-term funds exceeding one year.
- Purpose of funds supplied: Money markets provide funds for current business activities and working capital requirements of industries as well to cater to the needs of the government for a short duration. The capital market, on the other hand, offers funds for long periods such as for fixed capital requirements of private sector trade and commerce and to the long-term needs of the government.
- The instruments used: Money markets deal in instruments such as bills of exchange, treasury bills (TBs), certificates of deposit (CDs) and commercial papers (CPs), while capital markets trade in instruments such as shares, debentures, government bonds, and so on.
- The value of instruments used: In the money market, participants deal in high value instruments. For instance, a TB is valued for a minimum of INR 1,00,000; and a CP for a minimum of INR 2.5 million. In the capital market each instrument is valued for a small amount. For instance, each share of a company costs INR 10 and each debenture is INR 100.
- Constituents of the market: The Reserve Bank, commercial banks and discount houses, acceptance houses and non-banking finance companies (NBFCs) constitute the money market, whereas the capital market comprises development banks and insurance companies. They are the dominant players in the capital market.
- Existence of secondary markets: Generally there are no secondary markets for instruments of money market. On the other hand, capital market instruments have a secondary market. For instance, a shareholder can sell his/her shares to another person through brokers and get the deal registered in a stock exchange.
- Medium of transactions: In money market, transactions are mostly carried out over phones and other means of modem communication and a formal place for such an activity is unnecessary. In the capital market, transactions are conducted through authorized dealers.
There are different financial instruments in a money market with different time spans and maturity periods. We will study them in depth in the following pages:
Money Market Instruments
Since the money market is a market for short-term money and financial assets that are near substitutes for money, which can be quickly converted into money with minimum transaction cost, money market instruments should have some specific characteristics.
The following sections discuss some of the important money market instruments and their characteristics:
The Call/Notice Money Market
The call money market is that part of the national money market where the day-to-day surplus funds, mostly of banks, are traded in India; call money loans are given to the bill market for the purpose of dealing in the bullion markets and stock exchanges between banks and high worth individuals for trade purposes with a view to saving interest on cash credits and overdrafts.
Since Call/Notice money is the money borrowed or lent on demand for a very short period, usually for a day, it is known as call (overnight) money. Intervening holidays and/or Sunday are not counted for this purpose. Thus, money, borrowed on a day and repaid on the next working day is called call money. When money is borrowed or lent for more than a day and up to 14 days, it is known as notice money. It is not necessary to provide collateral security to cover these transactions. Regular players in the call money/notice money market are (i) scheduled and non-scheduled commercial banks; (ii) foreign banks; (iii) state, district and urban cooperative banks; (iv) Discount and Finance House of India (DFHI) and Securities and Trading Corporation of India (STCI).These participants, DFHI and STCI participate in the call/notice money market both as borrowers and lenders. Call money markets are located in big metropolitan and commercial centres such as Mumbai, Calcutta, Chennai and Ahmedabad, which are also, incidentally major centres of stock exchanges.
Different Kinds of Call Money Instruments
A money market is not a single homogenous market. It 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 governments, banks and financial institutions.’4 It consists of submarkets, each specializing in a specific type of financing such as.
- Call money market, wherein money is lent for a day.
- Notice money, lent for more than 1 day and up to 14 days.
- Term money, lent for 15 days or more.
- Held till maturity, wherein securities are held till maturity.
- Held for trading, wherein securities acquired by the banks with the view to trading by trying to gain from the short-term price/interest rate movements.
- • Available for sale, wherein the securities which fall between held till maturity and held for trading.
- Yield to maturity, which refers to expected rate of return on an existing security purchased from the market.
- Coupon rate specified, which refers to the interest rate on a fixed maturity security fixed at the time of issue.
- Treasury operations, an investor bank can purchase the government securities in the primary market and trade them in the secondary market.
- Gilt edged security, a government security that is a claim on the government and is a secure financial instrument which guarantees certainty of both capital and interest. These securities are free of default risk or credit risk, which leads to low market risk and high liquidity.
Banks, primary dealers (PDs), development finance institutions, insurance companies and select mutual funds are currently the participants in call/notice money market. Of these, banks and PDs can operate both as borrowers and lenders in the market. But, non-bank institutions such as all-India FIs, select insurance companies or mutual funds, which have been given specific permission to operate in call/notice money market, can, however, operate as lenders only. No new non-bank institutions are permitted to operate (i.e. lend) in the call/notice money market with effect from 5 May 2001. In case any eligible institution has genuine difficulty in deploying its excess liquidity, the central bank may consider providing temporary permission to lend a higher amount in call/notice money market for a specific period on a case-by-case basis.
Prudential Norms of RBI
According to the Prudential Norms set by RBI, lending of scheduled commercial banks, on a fortnightly average basis, should not exceed 25 per cent of their capital fund, while they can lend a maximum of 50 per cent on any day, during a fortnight.
The Prudential Norms also stipulate that borrowings by scheduled commercial banks should not exceed 100 per cent of their capital fund or 2 per cent of aggregate deposits, whichever is higher, while they can borrow a maximum of 125 per cent of their capital fund on any day, during a fortnight.
Eligible participants are free to decide on interest rates in call/notice money market.
Interbank Call Markets
Developed in England in the 1960s, the interbank call market refers to the exclusive financial marketing in which transactions in short-term funds take place between banks. These are unsecured loans and clearing banks do not participate in this market.
Interbank market for deposits of maturity beyond 14 days is referred to also as the term money market. The entry restrictions for interbank market are the same as those for call/notice money market except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days.
Banks borrow in this money market for the following purposes:
- To fill the gaps or temporary mismatches in funds
- To meet the CRR and SLR mandatory requirements as stipulated by the central bank
- • To meet sudden demand for funds arising out of large outflows
Thus call money usually serves the role of equilibrating the short-term liquidity position of banks. Effective from 6 August 2005, non-bank participants except the PDs are to discontinue their participation, to make the call money market pure interbank market.
A TB is a promissory note issued by the government under discount for a period stated in the document. TBs are short-term (up to one year) borrowing instruments of the Central government. It is an IOU of the government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days, i.e., less than one year). They are issued at a discount to the face value, and on maturity, the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction. A TB is purely a finance bill and does not arise out of any transaction. A TB being a claim against the government, it does not call for any ‘endorsement’ or ‘acceptance’ or ‘grading’.
The RBI, being the manager of government finances, issues TBs to meet temporary shortfall in government finances.
In India, there are two kinds of TBs—ordinary or regular and ad hocs. The ordinary TBs that are marketable and have a secondary market are issued to the public and FIs. ‘Ad hocs’ are issued only in favour of the RBI which is authorized to issue currency notes against them. These TBs apart from helping the union government raise its finances and provide an investment medium for State governments, quasi government departments and foreign central banks to invest their temporary surpluses.
TBs are of three different tenures—91, 182 and 364 days.
Certificates of Deposit
Certificates of Deposit are bank deposit accounts. They are also known as negotiable certificates of deposits (NCDs). Negotiable money market instruments are issued in dematerialized form or as a usance promissory note, for funds deposited at a bank or other eligible FIs for a specified period of time at a specified rate of interest. They are marketable receipts and are negotiable, and are traded in secondary markets. Liquidity and marketability are said to be the hallmarks of CDs. Guidelines for issue of CDs are presently governed by CD-specific directives issued by the RBI. CDs can be issued by (i) scheduled commercial banks excluding regional rural banks (RRBs) and local area banks (LABs); and (ii) selected all-India FIs that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by the RBI. Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments, viz., term money, term deposits, CPs and inter-corporate deposits, should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet.
‘A Commercial Paper (CP) is relatively a new instrument in the money market, made popular after 1980s. CPs are short-term usance promissory notes with fixed maturity issued mostly by the leading nationally reputed, credit worthy and highly rated large corporations’.5 CPs are also known as Corporate Paper, Industrial Paper or Finance Paper depending upon whose liability the paper is.
A CP is a note in evidence of the debt obligation of the issuer, is transformed into an instrument. CP is an unsecured promissory note privately placed with investors at a discount rate at a face value determined by market forces. CP is freely negotiable by endorsement and delivery. A company shall be eligible to issue CP subject to the fact that (i) the tangible net worth of the company, as per the latest audited balance sheet is not less than INR 40 million; (ii) the working capital (fund-based) limit of the company from the banking system is not less than INR 40 million; and (iii) the borrowal account of the company is classified as a Standard Asset by the financing bank(s). The minimum maturity period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies.6
Repo refers to an instrument employed in money market which facilitates collateralized short-term borrowing and lending through sale/purchase operations in debt instruments. Under a repo transaction, a holder of securities sells them to an investor with a mutual agreement to buy them back at a date and at a rate determined at the time of transaction. Repo is also called a ready forward transaction since it implies a means of raising short-term security and repurchasing the same on a forward basis. Under reverse repo transaction, securities are bought with a simultaneous commitment to resell at a predetermined rate and date.
Earlier, repos were allowed by the RBI in the central government TBs and dated securities by converting some of the TBs. The RBI allowed repo transactions in all government securities and TBs of all maturities with a view to making the repo market a balancing force between the money market and securities market. Recently, the RBI has permitted state government securities and bonds of PSEs and private corporate securities to be eligible for repos so as to widen the repo market.
The usefulness of repos has been explained by the RBI thus: ‘Repos help to manage liquidity conditions at the short-end of the market spectrum. Repos have been used to provide banks an avenue to park funds generated by capital inflows to provide a floor to the call money market. During time of foreign exchange volatility, repos have been used to prevent speculative activity as the funds tend to flow from the money market to the foreign exchange markets.’
Term Money Markets
This kind of monetary instrument and the market for it are still in a state of development in India. This market is also known as inter-bank market for deposits with a maturity of 14 days. RBI has allowed only select FIs such as the Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Finance Corporation of India (IFCI), Industrial Investment Bank of India (IIBI), Small Industries Development Bank of India (SIDBI), EXIM Bank, National Bank for Agriculture and Rural Development (NABARD) and National Housing Bank (NHB) to borrow from the money market for 3–6 months maturity within specified limits for each institution.
Commercial Bill Markets
The Commercial Bill Market is the submarket in which the trade bills or commercial bills are traded, with a view to facilitating credit sales, basically in the domestic market. Commercial bills can be discounted with banks, which in turn can get them rediscounted in money market, when they are in need of funds. In India, the commercial bill market is underdeveloped primarily because of (i) the popularity of cash credit system in bank lending and (ii) the diffidence of large buyers to bind themselves to payment discipline relating to commercial bills.
The Reserve Bank introduced a bill market scheme as early as 1970, which has been modified from time to time.
Money Market Mutual Funds
Scheduled commercial banks and public FIs were allowed in April 1992 to set up Money Market Mutual Funds (MMMFs) with the view to providing an additional short-term avenue to individual investors. Investors could enjoy the facility provided by the scheme subject to certain terms and conditions. Since these were restrictive, they were relaxed later on in a number of amending provisions between November 1995 and July 1996 with a view to imparting more flexibility, liquidity and depth to the market. MMMFs were allowed to invest in rated corporate bonds and debentures with a residual maturity of 1 year. The minimum lock-in period for units of MMMFs which was earlier 30 days was relaxed to 15 days in May 1998. In 1999–2000, MMMFs were also allowed to offer ‘cheque writing facility’ in a tie-up with banks to lend more liquidity to unit holders. Funds received by the MMMFs could earlier be invested only in call/notice money, TBs, CDs, CPs commercial bills arising out of a genuine trade/commercial transactions and government securities having an unexpected maturity of 1 year. MMMFs, which were regulated under the guidelines issued by the Reserve Bank, have been brought under the purview of the SEBI regulations since 7 March, 2000. Banks are now allowed to set up MMMFs only as a separate entity in the form of a trust. Presently, there are only three MMMFs in operation.
Figure 35.1 explains the structure of the Indian money market including the submarket, participating institutions and money market instruments.
Figure 35.1 Indian Money Market Structure
The Indian Money Market: Structure
Like the Indian banking industry, the country’s money market too is characterized by dichotomy. For an easy grasp of the components of Indian money market, see Figure 35.2. There are two sectors, one well organized and the other unorganized, which hardly ever meet.
Figure 35.2 Structure of Indian Money Market
The organized sector consists of those money market institutions that owe their origin, establishment, management and organization to the institutional arrangements developed in Western countries. Thus, in the organized sector, the Reserve Bank, banks belonging to both public and private sectors, foreign banks, LIC, UTI, development banks and other FIs play a decisive role. Strictly speaking, the cooperative sector units have some features and objectives that they may lie between the organized and unorganized sector. However, the cooperative sector too, like the organized sector, is governed by the rules, regulations and guidelines that are applicable to institutions in the organized sector. Since cooperative societies and entities are also subject to strict control and supervision of public authorities, we may consider them as constituents of the organized sector. The Reserve Bank as the central bank and key monetary authority of the country is the kingpin of the monetary system and leader of the Indian money market. Commercial banks constitute the nucleus of the Indian money market. In the organized sector, the Reserve Bank enjoys a moral authority by virtue of the powers conferred on it by the government and is, therefore, able to bring necessary discipline among the constituents of the money market. The Reserve Bank enjoys autonomy in matters connected with its management of the Indian money market. As seen in the Figure 35.2, the unorganized sector exists away from the organized sector of the money market. Notwithstanding the great efforts made by the RBI and the Government of India, the indigenous sector remains outside the jurisdiction of the central bank. The village money lenders and their ilk refuse to abide by any guideline or regulations the central bank wish to make them follow. This makes the Indian money market fragmented, disorganized and underdeveloped.
The Indian Money Market: Characteristics
The following are the characteristics of the Indian money market:
- Existence of a large unorganized sector: The unorganized sector primarily consists of indigenous bankers, who charge usurious rates of interest and follow their own rules of banking and finance.
- Lack of integration between the organized and unorganized sectors: The lack of integration causes immobility of funds between them, which in turn leads to diversity in interest rates and fluctuations in security prices.
- Seasonal nature of demand for funds: To a very large extent, even today, the Indian economy is dependent on agriculture and its performance. The busy season in the Indian money market is from October to April. This is the time money is largely needed for financing of marketing of agricultural produce and industries that have a linkage effect with agriculture and its performance. In the interim between April and October, there is a perceptible decline in the demand for money. As a result, the money rates fluctuate from one period to another. The RBI tries to smoothen the mismatch in money supply situation by enhancing it during busy season and withdrawing it during the lean season.
- Absence of bill market: The bill market in India is in a nascent stage. The core of the Indian money market consists primarily in the transactions in the interbank call money market. Government and semi-government securities do not command a large market. Only institutional investors deal in them. The market for bills of exchange and TBs is also quite small in India.
- Little contact with well-developed Western markets: The Indian money market is traditionally insulated from such markets in other countries. It does not attract as much foreign funds as some of markets of the developed and even developing countries.
- Small basket of financial products: We have a very limited money market instruments such as bills, TBs, etc., compared to the high demand for short-term funds. This limits the growth and versatility of the Indian money market.
- Limited number of participants: The number of participants in the Indian money market is limited by virtue of the fact that the entry norms are very strict. There are a large number of borrowers, but few lenders making the market small and non-directional.
- Small size of secondary market: In terms of money market instruments, we have much less than in advanced countries. India being a developing country with limited incomes and poor banking habits, people here prefer cash credit and businessmen overdraft facilities to bill financing. Financial transactions in the money market are mostly restricted to rediscounting of commercial and TBs. Low yield of TBs and the tendency to hold the bills till maturity are other reasons for the slow and lopsided development of organized money market in India.
However, the Reserve Bank has been attempting to improve the situation. Institutions in the unorganized sector are gradually being subjected to the control and regulation of the central bank. Some of them are already availing rediscounting facilities from the central bank. In recent times, efforts have been made to broaden the call money market by permitting LIC, GIC, IDBI, UTI and specified mutual funds to be lenders. More participants such Discount and Finance House of India (DFHI) and Securities Trading Corporation of India Ltd (STCI) are being roped into the money market. New financial products such as CDs and CPs are being introduced. Along with these measures, the ceiling on interest rate has been abolished, thereby offering for the instruments market rate of interest to make them attractive for transactions in the money market. Other positive measures include attempts at promoting a bill culture, facilitating entry of market mutual funds, adoption of suitable monetary policy, setting up of credit rating agencies which help raising of funds by providing credit ratings to instruments, and establishment of the DFHI and STCI. All these measures have been useful to push up reforms in the money market so as to make it free from the deficiencies that have been the road blocks to its orderly development in the past.
Functions of a Money Market
‘A well-developed money market is the basis for an effective monetary policy. It is in the money market that the central bank comes into contact with the financial sectors of the economy as a whole and it is through varying the liquidity in the market and thereby influencing the cost and availability of credit that the Bank achieves its economic objectives.’
This clear elucidation of the role and significance of the money market in the formulation and implementation of monetary policy by the Reserve Bank stresses the place money market occupies in the overall scheme of things in the management of macro economy.
The following are the important functions performed by money market in an economy:
- Money market helps in mobilizing savings, capital formation and supply of funds to trade and industry by offering different types of suitable and attractive schemes to match the needs of various sections of society.
- A proper, balanced and efficient working of money market helps in balancing excessive or limited supply of funds match seasonal variations in demand.
- A well-functioning money market helps to minimize seasonal fluctuations in interest rates.
- A money market enables borrowers to get funds at cheaper interest rates by facilitating increased supply of funds and making them available to legitimate borrowers.
- An orderly and efficient functioning money market helps different regions through quick transfer of funds from one place to another.
- A money market augments the liquidity available to the entire economy.
- A money market, by offering a platform for profitable investment opportunities for short-term surplus funds, helps to increase the profit of individuals and FIs.
A well-developed and organized money market performs very useful functions and helps the central bank carry out its responsibilities to increase or reduce liquidity in the economy. It helps to equilibrate demand for and supply of surplus funds. A good and efficient market is of utmost importance to the overall development of the economy. However, for the Indian money market to be efficient and to fulfil its objectives, there is a need to vest more and undisputed authority with the Reserve Bank. To achieve this ideal, there is a dire need to bring the unorganized money market in the mainstream. This will enable the money market to be fully integrated and large enough to play its role in the Indian economy decisively and usefully.
35.1. What is a money market? What are its objectives? Discuss the differences between money market and capital market.
35.2. Discuss in brief various kinds of money market instruments. Which amongst these market instruments suits Indian conditions better?
35.3. Explain the structure of the Indian money market. Discuss the possibility of integrating the indigenous bankers with the organized money market.
35.4. What are the functions and usefulness of a well-developed money market? In this context, explain the characteristics of Indian money market.
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