Forex Banking Faculty

AMITY University

Assignment

FOREX BANKING
Course code: MGBFN-20402

Semester: 4 Date: 21/04/2011

Submitted By: Submitted To:

Name: Waseem Raja Name: Prof. Arun Goel
Roll: 106. Lecturer
Reg.No: A3010909106 FB Faculty, Amity University
Q. No.1. What is Call Money Market? Discuss its nature & Working in India.

Ans:- Market in which brokers and dealers borrow money to satisfy their credit needs, either to finance their own
inventory of securities or to cover their customers' margin accounts.

CALL MONEY MARKET OPERATIONS IN INDIA 

The money market is a market for short-term financial assets that are close substitutes of money. 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/notice
money market forms an important segment of the Indian money market. Under call money market, funds are
transacted on overnight basis and under notice money market, funds are transacted for the period between 2 days
and 14 days. 
Banks borrow in this money market for the following propose. 
• To fill the gaps or temporary mismatches in funds 
• To meet the CRR & 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 

Participants 
Participants in call/notice money market currently include banks, Primary Dealers (PDs), development finance
institutions, insurance companies and select mutual funds. 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 May 5, 2001. In case any eligible institution has genuine difficulty in deploying its excess liquidity, RBI
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. 
Effective from Aug 06, 2005 non-bank participants except Primary Dealers are to discontinue participate, to make the
call money market pure inter-bank market. 
Prudential norms of RBI 
Lending of scheduled commercial banks, on a fortnightly average basis, should not exceed 25 per cent of their
capital fund. However, banks are allowed to lend a maximum of 50% on any day, during a fortnight. 
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. However, banks are allowed to borrow a maximum of 125 per cent of their
capital fund on any day, during a fortnight. 
Interest Rate 
Eligible participants are free to decide on interest rates in call/notice money market.

The call money market is an integral part of the Indian Money Market, where the day-to-day surplus funds (mostly
of banks) are traded. The loans are of short-term duration varying from 1 to 14 days. The money that is lent for one
day in this market is known as "Call Money", and if it exceeds one day (but less than 15 days) it is referred to as
"Notice Money". Term 
Money refers to Money lent for 15 days or more in the Inter Bank Market. 

Banks borrow in this money market for the following purpose: 

• To fill the gaps or temporary mismatches in funds 

• To meet the CRR & 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 

Call Money Market Participants :

1.Those who can both borrow as well as lend in the market - RBI (through LAF) Banks, PDs 

2.Those who can only lend Financial institutions-LIC, UTI, GIC, IDBI, NABARD, ICICI and mutual funds etc.

Reserve Bank of India has framed a time schedule to phase out the second category out of Call Money Market
and make Call Money market as exclusive market for Bank/s & PD/s.

The most active segment of the money market has been the call money market, where the day to day imbalances in
the funds position of scheduled commercial banks are eased out. The call notice money market has graduated into a
broad and vibrant institution.

Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent
for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose.
Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening
holidays) is "Call Money". 
When money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money". No collateral security is
required to cover these transactions.
The entry into this field is restricted by RBI. Commercial Banks, Co-operative Banks and Primary Dealers are allowed
to borrow and lend in this market. Specified All-India Financial Institutions, Mutual Funds, and certain specified
entities are allowed to access to Call/Notice money market only as lenders. Reserve Bank of India has recently taken
steps to make the 
call/notice money market completely inter-bank market. Hence the non-bank entities will not be allowed access to
this market beyond December 31, 2000.

From May 1, 1989, the interest rates in the call and the notice money market are market determined. Interest rates in
this market are highly sensitive to the demand - supply factors. Within one fortnight, rates are known to have moved
from a low of 1 - 2 per cent to dizzy heights of over 140 per cent per annum. Large intra-day variations are also not
uncommon. Hence there is a high degree of interest rate risk for participants. In view of the short tenure of such
transactions, both the borrowers and the lenders are required to have current accounts with the Reserve Bank of
India. This will facilitate quick and timely debit and credit operations. The call market enables the banks and
institutions to even out their day to day deficits and surpluses of 
money. Banks especially access the call market to borrow/lend money for adjusting their cash reserve requirements
(CRR). 
The lenders having steady inflow of funds (e.g. LIC, UTI) look at the call market as an outlet for deploying funds on
short term basis. The overnight call money or the inter-bank money market rate is presumably the most closely
watched variable in day-to-day conduct of monetary operations and often serves as an operating target for policy
purposes. The choice of operating tactics from quantity to rate based targeting, following the IS/LM based analysis of
Poole (1970), has been largely accepted in favour of interest rate targeting, because of the diminished link between
monetary aggregates and economic objectives of monetary policy as a result of the fast pace of financial innovations.
Most central banks, therefore, presently use indirect instruments in an attempt to maintain the short term interest rate
at a desirable level with the use of appropriate liquidity management practices. The most common of these
instruments of liquidity management is the central banks’ repo facility which enables modulation of the marginal
liquidity on a day to day basis so as to ensure stable conditions in the money market and, particularly, to maintain the
short term money market rate as close as possible to the official/policy rate. Changes in the short-term policy rate
made by central banks provide signals to markets, and various segments of the financial system, therefore, respond
by adjusting interest rates/returns depending on their sensitivity and the efficacy of the transmission 
mechanism. Economic implications for investment and spending decisions of producers and households follow as
usual, thereby affecting the working of the real sector viz., changing aggregate demand and supply, and eventually
inflation and growth in the economy. It is, therefore, clear that the interest rate stance of a central bank and its
implications for economic 
activity and inflation play an important role in the conduct of monetary policy.The objective of the paper is, therefore,
to assess the volatility pattern of the call money rate in India during the last three years and to estimate its sensitivity
vis-à-vis the Reserve Bank of India’s liquidity adjustment facility (LAF) auction decisions for the purpose of eliciting
underlying market characteristics. Attempt is made to provide evidence, albeit indirectly, on how regulatory changes
related to other instruments in the money market may have affected the functioning of the interbank call money
market. Finally, some evidence is also offered on the link between money market volatility and interest
sensitive financial markets, particularly the government securities market.The remainder of the paper is structured as
follows. Section I provides an overview of liquidity management in India while cross-country experience is set out in
Section II. Data used in the analysis are explained in Section III. Methodology used and the empirical analysis are
presented in Section IV and concluding observations are given in Section

V.THERE seems to be a role reversal of sorts in the inter-bank call money market. Excepting a few big fish, most 
nationalised banks, traditionally lenders in the overnight lending and borrowing market, have turned borrowers. With
a large portion of their funds locked in government securities, many public-sector banks are now facing dearth of
liquidity in patches, say bankers. 
" We have even borrowed up to Rs 600-700 crore on a particular day'', said an official in a public-sector banker. 
The increased demand for funds seems to be due to a combination of factors - - a pick-up in credit disbursal
witnessed over the past month, being the prominent among them. Other requirements are more routine needs such
as fulfilment of statutory norms, the cash reserve requirement, deposit redemption and asset-liability management of
these banks. 
" With demand for large funds coming from the oil sector over the past 6-8 weeks, we have been resorting to
borrowing in the call money market as a stop-gap arrangement for funding needs,'' confided the treasury head of a
public-sector bank. The rates in the call money market had been low and `attractive' in the 5.50-5.60 per cent range,
much lower than the average cost of funds at 6.75 per cent, he added. 
Public-sector banks are locked into their holdings in government securities at the moment. Said the treasury head of
a nationalised bank: "We had bought these govt. sectors at higher prices and therefore it does not make sense to sell
them now and book losses when the market is dull.'' 
With prices dropping in the govt. sectors market over the past fortnight as much as Rs 5-10, public sector banks are
sitting on depreciation in the value of their holding. On an average 40-45 per cent of most nationalised banks'
balance sheets were invested in `zero-risk' government securities, said a debt market analyst. However, the liquidity
in the system has not vanished 
over-night. Bankers are keeping their fingers crossed with the hope that g-sec prices will rise once again on quelling
of tensions in West Asia. 
If and when g-sec prices rise again, the banks can sell their stocks, realise funds plus book profits. Meanwhile, there
have also been some unusual lenders in the call money market which include private-sector banks, who are by
nature borrowers. "Having sold our positions in g-secs over the past fortnight, we are now sitting on pots of cash,
which have to be lent out,'' said the trading head of a private sector. 
Call money rates ruled at around 7.75-8% last week. Demand remained modest despite a scheduled auction of Rs
5,000 crore and was adequately matched by available supplies. Consequently, call rates were steady. 
Also, as liquidity was aided by RBI’s reported intervention in the forex market (buying dollars), inter-bank rates
remained supported at around the current levels. The average repo numbers at the liquidity adjustment facility
window stood at Rs 12,149 crore against Rs 13,332 crore 
previously, while the average reverse repo figure was up at Rs 210 crore against Rs 171 crore of the previous
week. The cumulative collateralised borrowing and lending obligation volumes for the week fell to Rs 72,994 crore
from Rs 97,246 crore. 
The overnight weighted average yield was lower at 7.2366% against 7.2439% in the previous week. Inter-bank rates
would re-align in case RBI tightens rates in the policy review.
Rates on the call money market ended in a range of 7.7-7.9%, down from the previous closing levels of 7.8-8%. RBI
mopped up bids worth only Rs 210 crore through the reverse repo operations at the second session of liquidity
adjustment. 
On the other hand, the central bank infused funds worth Rs 12,115 crore through the repo operations under both
sessions. The bond market did witness some improvement in volumes on Tuesday, while prices rose by almost 20
paise. Traders expected the inflation to soften in the weeks ahead, and interest rates to rise at a slower pace, after
the government 
cut import duty on some items. The yield on the benchmark 8.07% 2017 bond ended at 7.87%, lower than the
previous close of 7.9%.Traders widely expect a 25 basis point increase in interest rates when RBI announces its
quarterly policy review on January 
31. The government reduced import duties on a variety of items late on Monday after annual inflation hit a two-year
high of 6.12%,breaking above the central bank’s estimate of 5-5.5% at March-end. 

Q No. 2. Explain various theories that discuss relationship between financial

system and economic development .

Ans. The economic development in India followed a socialist-inspired policies for most of its independent
history, including state-ownership of many sectors; extensive regulation and  red tape known as "Licence
Raj"; and isolation from the world economy. Since the mid-1980s, India has slowly opened up its markets
through Economic Liberalisation. After more fundamental reforms since 1991 and their renewal in the
2000s, India has progressed towards a free market economy.

In the late 2000s, India's growth has reached 7.5%, which will double the average income in a
decade. Analysts say that if India pushed more fundamental market reforms, it could sustain the rate and
even reach the government's 2011 target of 10%. States have large responsibilities over their economies.

The economic growth has been driven by the expansion of services that have been growing consistently
faster than other sectors. It is argued that the pattern of Indian development has been a specific one and
that the country may be able to skip the intermediate industrialization-led phase in the transformation of its
economic structure. Serious concerns have been raised about the jobless nature of the economic growth. 

The progress of economic reforms in India is followed closely. The World Bank suggests that the most
important priorities are public sector reform, infrastructure, agricultural and rural development, removal of
labor regulations, reforms in lagging states, and HIV/AIDS. For 2010, India ranked 133 rd in Ease of Doing
Business Index, which is setback as compared with China 89th and Brazil 129th.

India is 15th  in services sector. Service Industry employs 23% of the work force and is growing quickly, with
a growth rate of 7.5% in 1991–2000. It has the largest share in the GDP, accounting for 57% in 2010.
Business services (information technology, enabled services, business process outsourcing) are among the
fastest growing sectors contributing to one third of the total output of services in 2000. The growth in the IT
sector is to increase specialisation and availability of a large pool of low cost, highly skilled, educated and
English-speaking workers on the supply side and on the demand side, has increased demand from foreign
consumers interested in India's service exports or those looking to outsource their operations. India’s IT
industry, despite contributing significantly to its balance of payments, accounts for only about 1% of the
total GDP or 1/50th of the total services.

The ITES-BPO sector has become a big employment generator especially amongst young college
graduates.
Since liberalisation, the government has approved significant banking reforms. While some of these relate
to nationalised banks and other reforms have opened up the banking and insurance sectors to private and
foreign players.

Currently, in 2007, banking in India is generally mature in terms of supply, product range and reach-even,
though reach in rural India still remains a challenge for the private sector and foreign banks. The RBI is an
autonomous body, with minimal pressure from the government.
Currently, India has 88 scheduled commercial banks (SCBs) — 28 public sector banks (that is with
the GOI holding a stake), 29 private banks (these do not have government stake; they may be publicly
listed and traded on stock exchanges) and 31 foreign banks.

Q No. 3:- How have the trends in the banking changes in India during the period of Liberalisation?

Ans:- The three major changes in the banking sector after liberalization are:

 Step to increase the cash outflow through reduction in the statutory liquidity and cash reserve ratio.
 Nationalized banks including SBI were allowed to sell stakes to private sector and private investors were
allowed to enter the banking domain. Foreign banks were given greater access to the domestic market,
both as subsidiaries and branches, provided the foreign banks maintained a minimum assigned capital and
would be governed by the same rules and regulations governing domestic banks.
 Banks were given greater freedom to leverage the capital markets and determine their asset portfolios. The
banks were allowed to provide advances against equity provided as collateral and provide bank guarantees
to the broking community.
 In the first week of August 2005, Reserve Bank of India (RBI), country’s central bank, issued a list
of 391 under-banked districts in India with population per branch more than the national average of
16,000. The list was part of a policy directive issued by the central bank to all commercial banks
asking them to work out their branch expansion strategies “keeping in mind the developmental
needs of unbanked regions.” The directive called for greater emphasis to be given to under-banked
regions while seeking licenses for bank branches.
 The policy directive (including the list of under-banked districts) was posted at the RBI’s website.
However, the document was removed from its website the very next day. No explanations were
given by the central bank on why the document was removed from the website. Apparently, the
document was removed at the behest of Finance Ministry’s pressure as it expected to fuel a strong
public reaction that may imperil the ongoing move towards greater banking sector liberalization.
This speaks volumes about the present-day discourse on transparency and accountability in
economic policy-making.
 If 391 districts out of a total 602 districts in India are under-banked, it raises several policy issues
which cannot be suppressed by keeping public in dark about the ground realities of the banking
sector. On the contrary, such an anomaly could only be addressed through wider public
consultation and debate.
 According to the RBI’s list, states such as Uttar Pradesh, Madhya Pradesh and Bihar have the
maximum number of under-banked districts in the country (see Table 1) while states and union
territories such as Goa and Chandigarh do not have any under-banked districts. Interestingly,
some of the under-banked districts also include prominent industrial cities such as Surat in Gujarat.
  
 Table 1: Number of Under-banked Districts in India
  
 Andhra Pradesh           13            Karnataka                  7               Orissa                   22
 Arunachal Pradesh       11            Kerala                        1               Pondicherry             1
 Assam                         22            Madhya Pradesh      43               Punjab                     1
 Bihar                           37            Maharashtra             26               Rajasthan              25
 Chhattisgarh                15            Manipur                     8               Sikkim                     1
 Gujarat                        12            Meghalaya                  3               Tamil Nadu           14
 Jammu & Kashmir         4            Mizoram                     2               Uttar Pradesh        63
 Jharkhand                    18            Nagaland                  11               West Bengal          16
  
 No one can deny the fact that rapid increase in bank branches took place in the post-1969 period
when India nationalized its banking sector. There were several objectives behind the bank
nationalization strategy including the transformation of class banking into mass banking and to
reach out to neglected sectors such as agriculture and small scale industries. At the time of
nationalization, there were only 89 scheduled commercial banks with 8262 branches throughout
the country. But in March 2004, the number of scheduled commercial banks increased to 290 and
the branch network increased to 69071. With such a rapid increase in bank branches, the
population covered per branch, which was 64000 in 1969, also decreased to 16000 in 2004.
 Even the proponents of banking sector liberalization admit that such a rapid expansion of bank
branches, with more than half of the branches opened in rural areas, after nationalization was
unparalleled in the recent economic history of any other developing country. No doubt, the banking
system under the nationalization regime was not perfect as it failed to meet the banking needs of
remote rural areas and small borrowers but at least a serious effort was made to spread banking
services both geographically and functionally. No one can deny that there was corruption, lack of
transparency and bureaucratic control which affected the functional efficiency of the banking
system. But despite all these operational and other problems, the positive thing about that regime
was that the entire banking system was subservient to theneeds of the real economy; which is
certainly not the case in the post-liberalization period.
 In the post-liberalization period, one finds that the rural bank branches are being closed down (from
32939 in March 1997 to 32227 in 2004) in order to meet the profitability criteria, while there has
been a rapid growth in the bank branches in the urban, metropolitan areas (from 8390 in March
1997 to 9750 in 2004). However, there are several regional disparities. For instance, Uttar
Pradesh, Bihar and the entire North-eastern region witnessed a decline in the number of branches
in the post-liberalization period. Whereas states such as Delhi, Haryana, Punjab
and Maharashtra have witnessed a steep hike in the bank branches. Delhi, for instance, witnessed
a jump of more than 30 per cent in bank branches, from 1256 branches in 1997 to 1639 in 2004.
 More importantly, the banking sector under the post-liberalization period is witnessing a secular
decline in rural credit. The rural credit went down from 15.7 per cent in 1992 to 11.8 per cent in
2002 (see Table 2).
 Table 2: Decline in Rural Credit
  
                                 Year                     Percentage of Rural Credit to Total Credit
                                    
                                 1992                                                     15.7
                                 1993                                                     14.8
                                 1994                                                     14.7
                                 1995                                                     12.8
                                 1996                                                     12.3
                                 1997                                                     12.3
                                  1998                                                     12.3
                                 1999                                                     11.9
                                 2000                                                     11.5
                                 2001                                                     11.0
                                 2002                                                     11.8
 According to a recent study by the Associated Chambers of Commerce and Industry of India
(Assocham), an influential business lobby group, the regular fall in rural credit in the last decade
led to an adverse development in the agricultural sector, and also increased the apathy of
institutionalized finance for the farming community.
 While putting the onus on the banking sector liberalization program on the poor performance of
agricultural sector, the Assocham study pointed out that while the banking sector garnered
deposits exceeding Rs. 1000000 million from the farming community in the last decade, the credit
extended to them did not even touch Rs. 500000 million. The study also noted that out of 27 state-
owned banks and as many banks in the private sector, only five public sector banking institutions
and two from the private sector met the required 18 per cent agricultural credit extension target to
the farming community between 1992 and 2002. Further the study found that credit allocation
towards metropolitan region increased from 44.84 per cent in 1990-91 to 61 per cent by the end of
2003-04, thereby revealing a clear urban bias in the credit allocation.
 Given the fact that the bias towards urban areas is expected to grow as Indian credit markets are
driven by consumer loans and just 20 cities contribute over three-fourths of new assets creation,
this anomaly needs to be addressed by policy makers.
 In this context, it is also important to highlight that much-touted microcredit programs launched
by self-helf groups and NGOs are no substitute for the bank lending provided by commercial and
regional rural banks in India. At best, microcredit programs can complement, not substitute, the
growing credit needs of farmers, rural entrepreneurs, small enterprises and informal sectors of
economy.
 In the post-liberalization period, one also finds that the lending to small and medium enterprises
(SMEs) has declined from 15 per cent in 1991 to 11 per cent in 2003. SMEs are the engines
of India’s economic growth, together they contribute 40 per cent of India’s total production, 34 per
cent of exports and are the second largest employer after agriculture. The growing neglect of bank
lending to SMEs can have adverse implications on economic growth and employment.
 At the consumer level too, small borrowers and depositors are facing the burnt of liberalization
policies. Banks are charging higher fees from customers and it is becoming more expensive to
maintain a bank account.
 In the light of these developments, it remains to be seen whether commercial banks would follow
the RBI’s directive of providing banking services to unbanked regions or pursue their narrow
commercial interests. As the recent experience shows, it is highly unlikely that the commercial
interests of banks would match with the developmental needs of unbanked regions of the country.
Rather than expecting banks to voluntarily open branches in rural and remote regions, the RBI
should issue strict guidelines to ensure that banking services are made accessible to unbanked
regions and people at large.

Q. No. 4:- Explain administered and Market Determined Interest Rates both using the Indian and
International Markets?

Ans:- Benchmarking of Administered Interest Rates:The current schemes of small savings in India serve a
dual purpose: (i) of providing an instrument for the small savers from rural and semi urban areas and (ii)
towards borrowing requirements of the Government. As such, these savings are mobilised with incentives
like higher interest rate than other competing instruments and in some cases with tax concessions. Further,
the interest rates on such small saving schemes are administered by the Government considering various
factors and are not generally revised quite often. As tax incentives are available to these schemes, income-
tax payers from urban areas also have substantial investments in these schemes thus, in some way
creating a distortion among small saving schemes.The Gupta Committee felt the need for revision of
interest rates of these saving schemes because the other commercial interest rates have been freed from
administrative control and are market determined. Therefore, the Committee felt that the small savings
rates should be in alignment with commercial rates and without affecting adversely the small savings
collections.

Current Status

At present, there are ten small saving instruments with varied maturities ranging from less than one year to
15 years carrying different interest rates. On some instruments, interest is calculated on a quarterly basis,
on some on annual basis and some on compounding basis. Further, one instrument is a bearer instrument,
which is out of alignment in salient features with other instruments. Further, certain schemes enjoy the
facility of withdrawal after a prescribed lock in period and certain schemes have to be held to maturity. The
small saving schemes [including Public Provident Fund (PPF)] account for nearly 26.0 per cent of the total
liabilities of the central government. According to Budget Estimate of 2000-01, the average interest cost of
these schemes was around 12.22 per cent vis-à-vis 9.99 per cent on the total borrowings. The fiscal
concessions given to these schemes also differ. Under the Income Tax Act, investment in small saving
instruments enjoys two types of tax concessions (i) exemption of interest income from direct tax under
Section 80-L and Section 10 of IT Act. While Union Budget reviews the limits on interest income on
instruments under Section 80-L, in the case of instruments under Section 10, the entire interest income on
these instruments is exempt from income tax; and (ii) Tax rebate at a rate of 20.0 per cent an investment
under Section 88 with a limit reviewed regularly in the Budget.

Issues

If the fiscal concessions available to small saving schemes are factored into the rates of return offered on
them, the effective rates of return on these instruments naturally become higher than the nominal rates of
return. Further, with in-built tax concessions the effective cost of borrowings to the Government becomes
higher. The higher the tax rebate, the higher the cost of funds. Further, the fiscal concessions create
distortion in the effective yields across instruments and the interest to maturity structure of small saving
instruments gets vitiated. It was also noticed that instruments with a similar maturity have different tax
concessions, thereby differing in effective rates.

With financial sector reforms, interest rates on several financial instruments are market determined. Banks
which play an important role in the credit markets have been given freedom for fixing the interest rates on
deposits (excepting saving deposit rate) and on loans and advances. The yield on government securities is
also market determined through auction system. Unlike the above, interest rates on small savings are still
administered and are not in alignment with interest rates on competing instruments. Further, the monetary
policy stance of the RBI does not seep to these saving instruments. If interest rate channel for monetary
policy transmission is to evolve, all the interest rates in the economy should respond to monetary policy
changes.

Issues in Benchmarking

As interest is a future income it is argued that the interest income should at least preserve the value of the
principal in future and also generate additional income to the saver. In this context, fixing interest rate
factoring inflation expectations becomes valid. This ensures a positive real rate of return to the investors.
Since various risks are involved in a competitive market, the interest rates should have a margin over a risk
free asset. This brings in the importance of linking the interest rate of small saving instrument to return on
risk free instrument besides inflation expectation. The question then arises what could be the benchmark
for these schemes and whether the benchmark rate should be a leading rate or following rate. The leading
rate is likely to influence other rates and benchmarking to such a rate has in built expectations; whereas, in
linking to a following rate, the prevailing rate is used. Ideally, the benchmark should evolve from the market
and other interest rates should be linked to such benchmark rate. There are various issues that come up
while finding out a benchmark which serves as a reference rate.

A good reference rate should be a stable rate; stability here is defined as less volatility. Other rates when
linked to such stable rate also do not fluctuate widely. The crucial issue here is whether interest rates have
to be linked to ex post indicators or lead indicators. Some argue that, linking to ex post indicators is not
desirable as they will not be able to influence the investor’s preferences. As such, lead indicators become
ideal choice in this context.

The present Committee while recognising the need for revision in interest rates have also discussed choice
of reference rate to which the interest rate on small savings can be linked. There are various options
available as benchmark rates. The Committee reviewed these options individually.

Inflation as a Benchmark

The simplest way of benchmarking is linking to the current inflation rate. Many measures are available for
measurement of inflation like Wholesale Price Index (WPI) (on a point-to-point basis and on average basis),
Consumer Price Index (CPI) or national income deflator. The availability of these indices also differs from
weekly to quarterly. The basic premise for linking with inflation is to ensure a positive real rate of interest to
the investors.

As argued by several researchers that the measurement of real interest rate should use expected inflation
rather than current inflation. However, the problem in this context is about measuring inflation expectation.
The assessment of inflation expectations is difficult because of methodological problems besides the
choice of a suitable index for the measurement of inflation viz. Wholesale Price Index or Consumer Price
Index or GDP deflector. The inflation expectations can be assessed either through econometric techniques
or by surveys. One simple way which many researchers use is to treat the current inflation rate as the
expected inflation in the next period. Some feel that inflation expectations can be measured by distributed
lag model wherein the expected inflation is derived as weighted average inflation with higher weight
attached to the recent past inflation or the contemporaneous inflation and weights decline with the lags.
However, it may be recognised that a 5 year weighted index on annual basis may give a different inflation
expectation from the one measured through half yearly inflation rates. Therefore, in the lagged scheme, the
length of the lag becomes subjective. Depending upon the lagged structure, the benchmark rate could be
different. This shows that real interest rates which are derived as nominal interest rates minus the inflation
expectation may not be credible. Because of this, some members felt that the present inflation rate is
simpler and a better measure of future inflation expectations.

Inflation expectations may be suitable for small saving schemes with a maturity of more than one year but
do not serve for linking to the postal savings bank deposits because of the fact that inflation expectations
do not change much in short period. Further, if inflation is volatile, by linking to inflation, the volatility in
inflation gets translated into the saving instruments also. In such case, savers may not like to build this
volatility in their investment decisions. Thus, there are difficulties associated with linking inflation rates with
small saving instruments viz. estimation of credible measure of expected inflation, artificial fixation of real
interest rate and derivation of term structure of interest rates on small saving instruments.

Yields on Government Securities as Benchmark

As small savings are borrowings by the Government on long-term basis, it is logical that their yields also
should correspond to yields on government securities. Besides this, as small savings are not as liquid as
dated securities some compensation for the illiquid characteristic may have to be given to the small
savings. While considering the acceptance of yields on government securities as benchmark rates for fixing
interest rates on small saving schemes, a comparative risk assessment of both the instruments viz. small
saving instrument and government dated securities is needed. Though, they are perfectly comparable in
respect of counterparty risk, they are not comparable in regard to liquidity and price risk. Government dated
securities on account of active secondary market are inherently more liquid vis-à-vis small saving
instruments and also carry more price risk unless held till maturity. The major criticism in adopting yield on
government securities as benchmark is that the secondary market yield emanate from low levels of
secondary market transactions reflecting low levels of liquidity particularly at higher end. The positive
aspect in this regard is that the yield is market determined, though al beit a thin market. Since the small
savings schemes are of various maturities, the yields on similar type of maturities, in the government
securities can be used; for e.g. for fixing the interest rates on provident funds the yield on government
securities of 15 year maturity can be used.

Bank Deposit Rates as Benchmark

The Gupta Committee analysing this benchmarking with market determined interest rates suggested that
interest rates offered by banks and financial institutions may be considered for benchmarking the small
savings schemes. Since the interest rates on deposits except in the case of savings bank are deregulated
bankers are given freedom to fix the interest rates on deposits. As such, the interest rates on bank deposits
can be viewed as market determined. However, there is no conclusive evidence regarding the direction of
causality among these rates i.e. whether bank deposit rates determine the interest rates on postal deposits
or vice versa. However, since they are not traded in the sense of tradability of government securities some
felt that linking to government securities will not be advantageous.

Besides being a market determined interest rate, the market share of the instrument is also important for
ascertaining what could be the benchmark. For e.g. if the administered market segment is relatively larger
in volume with large number of savers than the non-administered segment, then administered rates can act
as benchmark for market interest rates. This is because in order to survive, the non-administered segment
has to offer interest rates higher than the prevailing in the administered segment. Further, it needs to be
seen whether a single benchmark is sufficient to act as a reference rate for all the small saving schemes
with different maturities or there could be different reference rates for different maturities. In this context, it
was suggested that small saving schemes could be bifurcated into two broad categories: the first category
consisting of post office saving bank, post office term deposits/ recurring deposits etc. and the second
consisting of National Savings Scheme, National Savings Certificate, PPF etc. For benchmarking the
interest rates in first category, it was suggested that the rates on such schemes could be aligned with
movements in deposit rates in the banking system because these schemes are akin to bank deposits.

Average Yield Curve as Benchmark

Since, the movements on yield curve are susceptible to various shocks, it is suggested that the average of
yield curves for a particular period can be considered for benchmark. For example, in the United States,
interest rates on small savings bond are based on 90.0 per cent of the six month average of five year
treasury securities. In some other cases, variable investment yield is used to benchmark the small saving
investment; the range varies between 85.0 per cent and 90.0 per cent. Considering all these factors for the
purposes of benchmarking of small savings (i) conversion of yield of government dated securities into par
yield (b) a six month averaging of par yield so derived and (ii) appropriate adjustment for price and liquidity
risks on the part yield derived as above may need to be undertaken.

One view is that the relevant interest rates on a zero coupon yield curve can be a benchmark for these
small saving schemes. For e.g. the interest rate on the zero coupon yield curve minus transaction costs of
the small savings could be the interest rate on the small savings scheme of that maturity.

For the second category as long term savings do not generate current income but takes the role of social
security, it is suggested that the yield on government securities or bond rate can be used as benchmark.
However, there are difficulties in adopting this, as market instruments carry market rates and long-term
savings cannot be compared to market instruments per se. Secondly, as long term saving schemes remain
illiquid till maturity, they cannot be compared with market securities, which are liquid in nature and generate
current incomes.

Bank Rate as a Benchmark

A good benchmark rate is one which leads the other interest rates in the economy. If such a rate is also a
policy variable then the benchmark not only has credibility but also reflect the policy changes. At present, a
transmission mechanism of the monetary policy stance is through the interest rates and in this context, RBI
is developing the necessary instruments towards this end. Bank Rate is activated, and reliance on indirect
instruments rather than direct instruments in the conduct of monetary policy has increased. The daily
liquidity management by the RBI is conducted through repos and OMOs and for the medium term Bank
Rate is used to affect the cost of funds in the system. The repo rates are market determined through
auction system and as such the quantity and rate reflect the liquidity conditions prevailing in the market. In
the case of Bank Rate as it affects the cost of funds, the general interest rates in the economy react to
changes in the Bank Rate. Further, Bank Rate gives a positive real interest rate because it is slightly higher
than the inflation rate. Changes in the Bank Rate are contemplated by RBI taking into account the
macroeconomic developments, developments in various financial markets and inflation. As such, though it
is policy variable in the hands of RBI, changes in the Bank Rate reflect changes in the macroeconomic
environment and in that sense it can also be treated as a market related interest rate. Besides the above,
Bank Rate changes effect the interest rates of the banking system including deposit rates. However, some
observers feel that as Bank Rate is an administered rate of the monetary authority and not a market
determined rate in the strict sense it may not be proper to link up the interest rate on long term savings to
Bank Rate. However, the savings deposits with the post office will not be necessarily affected by the
changes in the Bank Rate at present causing distortion in the interest rate structure of similar instruments.

The repo/reverse repo rate evolving through the Liquidity Adjustment Facility (LAF), which is an effective
mechanism for absorbing, and/or injecting liquidity on a day-to-day basis in a more flexible manner will
provide a corridor for the call money market. As the call money market in future will be purely an inter-bank
market a transmission mechanism of the monetary policy through interest rates will be established at a
future date. As such, it is suggested that the Bank Rate be treated as benchmark for linking the interest
rates on small savings schemes. The margins over the Bank Rate will have to be fixed according to the
maturity of the scheme. For schemes with maturity of less than one year, the average Bank Rate in the
previous year can be the interest rate. For maturity of one to five years, Bank Rate plus one percentage
point and for all instruments of maturity more than five years it could be Bank Rate plus 3.0 percentage
point. This will ensure a real rate of return to the investors between 1.0 – 4.0 per cent, which is in
accordance with the real rates of interests in the international markets. These rates can be reset every
year.

Critical Evaluation of Different Benchmarks

It is argued that in the context of benchmarking, stability in the benchmark rates should be an important
issue. Stable rate would be that one which would fluctuate within a narrow range and having a low
coefficient of variation. The stability could be tested based on a long-term time series, or through moving
average. For testing interest rates for stability as defined above, various interest rate series were tested
and compared through descriptive statistics. Among the market related rates, government securities of 10-
year maturity appear to be more stable both in terms of range and coefficient of variation. The result was
robust if one uses three or six months moving average for the monthly series. Compared to government
securities of 10-year maturity, other interest rates as well as different inflation rates appear to be volatile.
Incidentally, it may be noted that inflation measured in terms of both WPI and CPI moved in a wider range.
However, three month and six month moving averages marginally narrowed the respective ranges. It may
be interesting to note that between April 1998 and March 2001 the market determined rates like bank
deposit rate and lending rate are found to be stable whereas in the case of G.10 the variability was larger.
During this period, the variations in inflation rates though reduced are still higher than some of the nominal
interest rates. Thus, stability of the rates varied over time (sample bias) and are changing over their
respective order with respect to variability. Although, stability of rates is an important factor for
benchmarking, it may be kept in mind that the ultimate variation in the small saving rate would depend upon
the way it is benchmarked to the market related rate. For e.g. if an instrument is given an interest rate of 5.0
percentage point over half the rate of inflation during the given period, this would induce half the variation in
inflation on the rate of saving instrument during the specific period. Therefore, even though, some of the
nominal rates appear more stable than inflation rates, by devising appropriate rules, it is possible to have
an inflation rate based benchmark that would have the same variation as some of the nominal rates
currently enjoy. Thus, as far as choice of benchmark is concerned variation in rate is not important per se
but would depend upon the way it is smoothened.

For benchmarking however, framing up of any linear rule based on the market determined rate would leave
the correlation between that rate and the small saving rate uneffected. Further analysis revealed that
deposit rates, lending rates, average inflation rates (based on CPI) and the yield rates on securities of 10-
year maturity are well aligned. Although, no instrument among the market determined rates emerged
uniformly superior in terms of its strength of relation with small saving rates, deposit rate, lending rate and
yield on 10 year government dated securities appeared to be better than others. It is interesting to note that
after April 1998 the correlation of six months moving average of Bank Rate with most of the rates of small
saving appeared to be high giving possible direction that Bank Rate can also be viewed as a benchmark for
interest rate on small savings.

It was observed that if interest rates are benchmarked to inflation, in whatever manner inflation is
measured, there need not be any tax rebate or concessions on interest income as the benchmark can be
set appropriately. However, it may be noted that benchmarking need not remove large distortions in the
effective interest rates arising due to differential fiscal concessions and therefore prescribing benchmark
becomes difficult.

Options

A possible option before arriving at a benchmark for the small savings interest rate is the removal of fiscal
concessions to these schemes. This makes the small savings cost effective as there is a level playing and
then benchmark can automatically evolve. Perhaps, there could be a marginal fall in the collections of small
savings once the tax incentives are withdrawn but the experience so far with Kisan Vikas Patra amply
demonstrates that only higher nominal returns matter but not the tax incentives attached.

As the monetary policy changes effect the savings and investment decisions in the economy, it is
necessary that the savings generated in the economy are captured in the monetary aggregates which are
closely monitored by the central bank for its policy formulation. At present, the broad money supply
aggregate (M3) does not take into account the post office savings schemes and therefore, monetary policy
actions do not directly reflect in these instruments. It may be mentioned here that these instruments on the
recommendation of Dr. Y.V. Reddy Committee on “Money supply compilation” are being included in the
liquidity aggregates.

One can also think about giving the investor a choice between fixed rate and floating rate. Choosing
floating rates will enhance the ability of the investors in exploiting the financial markets for returns on their
savings. If this happens a financial structure will evolve wherein investors trying to maximise their returns
on their savings will have a host of instruments and opt for such instruments to their advantage. In such a
case, there is a likelihood that government’s borrowing requirements may be through such funds rather
than the present small saving schemes. The liquidity funds which offer competitive rates for mobilising
these saving in turn will invest in the borrowings of the government through securities. In this scenario the
deposits with post offices will melt into bank deposits and other contractual savings will then be social
security funds. The long-term savings schemes like Provident Fund etc. which will give a positive real rate
of return can take care of social security needs of the investors.

Summary and Conclusions

The Committee has to critically examine the various features of different saving instruments and decide
whether interest rates of these schemes should be market related or benchmarked to a reference rate.
Before attempting such a thing, it will be better if the schemes be rationalised by removing the distortions in
the features of the schemes. The first step towards this end could be to differentiate between small saving
schemes which essentially cater to park savings for a short/medium term and schemes which are by nature
akin to social security funds. All the tax benefits to the former schemes may be withdrawn, whereas
schemes in second category may continue to have the tax benefits. After carefully examining different
reference rates in the light of their market relatedness, stability and other properties, all the schemes in the
second category may be linked to Bank Rate with a positive spread as Bank Rate is a policy signalling
variable and determines the general interest rates in the economy or to yield on government securities. The
benchmark can be reset at the beginning every financial year by taking the average bank rate or average
yield on government securities in the preceding year. For small saving schemes, for less than one year, a
suitable benchmark like an average repo rate or bank deposit rate can be considered.

Q No. 5:- Discuss discounting services and its importance in money market.
Ans5. In the global money market, commercial paper is an unsecured promissory note with
a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued
(sold) by large banks and corporations to get money to meet short term debt obligations (for
example, payroll), and is only backed by an issuing bank or corporation's promise to pay the
face amount on the maturity date specified on the note.

Commercial bill is a short term, negotiable, and self-liquidating instrument with low risk. It
enhances he liability to make payment in a fixed date when goods are bought on credit.
According to the Indian Negotiable Instruments Act, 1881, bill or exchange is a written
instrument containing an unconditional order, signed by the maker, directing to pay a certain
amount of money only to a particular person, or to the bearer of the instrument. Bills of
exchange are negotiable instruments drawn by the seller (drawer) on the buyer (drawee) or
the value of the goods delivered to him. Such bills are called trade bills. When trade bills are
accepted by commercial banks, they are called commercial bills. The bank discounts this bill
by keeping a certain margin and credits the proceeds. Banks, when in need of money, can
also get such bills rediscounted by financial institutions such as LIC, UTI, GIC, ICICI and
IRBI. The maturity period of the bills varies from 30 days, 60 days or 90 days, depending on
the credit extended in the industry. Commercial bill is an important tool finance credit sales.
It may be a demand bill. A demand bill is payable on demand, that is immediately at sight or
on presentation by the drawee. A commercial bill assists you to raise the finance you need
for investment purposes through negotiable bank bills.

IMPORTANCE OF COMMERCIAL BILL

Commercial bill is important for trade and industry and also for the development of money
market in the following ways:

 Bill financing is a prevalent method of meeting credit needs of trade and industry.
 Commercial bills are self-liquidating in character because they have a fixed
tenure.
 Commercial bills have high level of liquidity – next only to cash, call loans and
treasury bills. They can be easily discounted.
 Use of commercial bills as an instrument of credit imposes financial discipline on
the borrowers, as its payment must be made on the due date of the bill.
 Banks can meet their short-term liquidity requirements by rediscounting these
bills.