aman lamba final project file

8/8/2019 Aman Lamba Final Project File

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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
http://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Foreign_exchangehttp://en.wikipedia.org/wiki/Executive_(government)http://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Foreign_exchangehttp://en.wikipedia.org/wiki/Executive_(government)


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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.
http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=383#t1%23t1http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=383#t1%23t1


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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

aman lamba final project file

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