Money Markets
Foreign Exchange Market

5.1 During 2000-01, financial markets in India were characterised by orderly and liquid conditions except for a brief period of uncertainty from mid-May to August 2000. A growing integration between money, gilt and foreign exchange market segments was visible in the convergence of financial prices, within and among various segments, and co-movement in turnovers. The call money market was broadly stable except for some pressures in June and August 2000 emanating from the foreign exchange market on account of unfavourable international developments. Apart from this brief period, the foreign exchange market experienced generally comfortable supply conditions. The Government securities market experienced a perceptible downward shift in yields in the primary as well as secondary segments during the second half of the year. The credit market tracked the movements in the other segments with a lag. The capital market exhibited isolated behaviour from the other segments of domestic financial markets with a clear indication of cross-border integration, particularly reflecting the large decline in international technology stock driven exchanges. Liquidity operations of the Reserve Bank were conducted keeping in view the market conditions (Table 5.1).

5.2 In view of the easy liquidity conditions at the beginning of 2000-01, the financial markets witnessed a softening of interest rates across segments up to mid-May 2000. The daily call money borrowing rates, on an average basis, moved generally within the corridor of the fixed rate repo of 5 per cent and slightly above the Bank Rate of 7 per cent. The 3-month and 6-month forward premia declined by 124 basis points and 64 basis points, respectively, in April 2000. The markets for Government securities witnessed price rallies with the yield-to-maturity (YTM) of 10-year residual maturity paper declining by 48 basis points as at end-April 2000 from its level a month ago. In the credit market, prime lending rates (PLRs) of public sector banks (PSBs) eased by 75-100 basis points in April 2000. The stock prices declined in the capital market in April 2000 with the BSE Sensex moving down by 6.87 per cent as compared with the previous month.

5.3 Excess demand conditions surfaced sporadically in the foreign exchange market during May-August, 2000. Monetary, regulatory and other measures were combined with repo auctions to break circuits of arbitrage running from money to foreign exchange segments. The tightening of market conditions affected the credit market as well and was reflected in the hardening of the PLRs of the PSBs, particularly in August 2000. The stock prices also went down in August 2000 with the BSE Sensex declining by 3.87 per cent as compared with April 2000.

5.4 As the foreign exchange market stabilised from November 2000 onwards, monetary measures were phased out during the last quarter of 2000-01 to return to the April 2000 position. Comfortable liquidity fuelled price rallies in the secondary market for Government paper and the PSBs also reduced PLRs during this period. The BSE Sensex also gained by 7.73 per cent in November 2000 as compared with the previous month.

5.5 Liquidity conditions eased in April 2001 in line with seasonal trends coupled with slackening in credit demand, after exhibiting the usual financial year-end hardening during March 2001. This was reflected in the large-scale participation in repo auctions and existence of unavailed refinance limits for banks and PDs. However, once the government commenced its market borrowing programme for 2001-02 there was a withdrawal from repo auctions under LAF with the outstanding amount of repos declining from a high of Rs.19,170 crore as on April 12, 2001 to Rs.110 crore as on April 27, 2001. The liquidity conditions continued to remain comfortable throughout the month with the call rates remaining within the informal corridor. Against this background the Reserve Bank rejected large repo bids on some occasions and reduced the repo and reverse repo cut-off rates by 25 basis points each to 6.75 per cent as on April 27, 2001 and 8.75 per cent as on April 30, 2001, respectively. Government completed around a quarter of its budgeted gross market borrowing programme for 2001-02 during April 2001 itself. As the ways and means advances of the Central Government crossed the limit of Rs.10,000 crore for the first half of the fiscal year, it privately placed three securities of Rs.4,000 crore each with the Reserve Bank on April 20, 2001. The Reserve Bank sold one of the securities (11.60% Government Security 2020) on the tap sale basis on April 21, 2001. The participants absorbed the entire issue. In the secondary gilt segment, the yields came down more prominently at the extreme ends of the maturity spectrum with the yields for the 10-year maturity paper not witnessing any significant change. The foreign exchange market was broadly stable during April 2001 with the increased supply of foreign exchange on account of foreign institutional investment inflows.

5.6 During May 2001, the call money rates moved above the repo-reverse repo corridor reflecting rationalisation of standing facilities available to the commercial banks and primary dealers at the Bank Rate, and call money lendings by non-bank financial institutions. The Reserve Bank injected liquidity through the reverse repos which nudged the call money rates back to the corridor by May 19, 2001. As the liquidity conditions became comfortable, the Reserve Bank absorbed excess liquidity through repos and the repo cut-off rate was further reduced by 25 basis points to 6.5 per cent on May 28, 2001. The Central Government resumed its market borrowing through a price-based re-issue of Rs.4,000 crore on May 17, 2001 and a twin yield-based auction of Rs.3,000 crore and Rs.2,000 crore, respectively, which were all oversubscribed. There was a private placement of Rs.5,000 crore of Government security with the Reserve Bank on May 30, 2001 which was only partially off-loaded to the market during the first week of June 2001. With the cut in Federal Reserve Bank's Fund rate of 50 basis points to 4.0 per cent on May 15, 2001, preceded by the announcement of the CRR cut of 50 basis points to 7.5 per cent with effect from fortnight beginning May 19, 2001, the yields of Treasury Bills and Government securities came down. The foreign exchange market was generally stable during May 2001 with orderly movements in the exchange rate. The PLR of PSBs was reduced by 25 basis points in May 2001.

5.7 Liquidity in the financial markets was comfortable during June 2001 and call rates remained generally within 7.0-7.5 per cent, i.e., well within the repo-reverse repo corridor, on account of unusually low quarter-end advance tax outflow from the banking system to the Government, resource augmentation due to CRR cut along with an appreciable mobilisation of time deposits since April 20, 2001, a moderate off-take in non-food credit and a tapering off of the tempo of gilt auctions. The reverse repo cutoff rate declined by 25 basis points to 8.5 per cent on June 7, 2001 reflecting the comfortable liquidity position. A firming up of the weighted average call money borrowing rate to 8.0 per cent on June 8, 2001 on account of outright absorption of liquidity through the open market operations was stabilised through the reverse repo operations. The privately placed Government paper of Rs.4,000 crore on June 20, 2001 could be entirely off-loaded to the market through the open market sales. The implicit yields at the cut-off prices in the month-end twin issuances of 9.39 per cent Government security, 2011 for Rs.4,000 crore and 10.45 per cent Government security, 2018 for Rs.2,000 crore turned out to be below the corresponding secondary market yields of gilts reflecting prevalence of ample liquidity in the system. The excess liquidity was absorbed through repos during the course of the month. As the non-food credit off-take was low and the direct market off-take of funds by the Government took place only at the month-end, there was a rally in the prices of secondary market of gilts where the 10-year paper touched a low of 9.48 per cent by end-June 2001. The foreign exchange market was generally stable with the increased supply of foreign exchange on account of foreign institutional investment inflows.

5.8 The liquidity situation remained comfortable during July 2001 as deposit growth continued to be buoyant with low non-food credit off-take. The call money rates (weighted average) generally ruled in the range of 6.7-8.9 per cent averaging at 7.2 per cent. The liquidity was ample in the first week of July 2001. There was some tightness when liquidity was absorbed through the open market sales on July 12, 2001. Nevertheless, the weighted average call money rate remained within the corridor throughout the month except on the reporting Friday after the gilt auction on July 25, 2001. The Government continued its market borrowing programme through price-based auctions and completed 59.5 per cent of the gross budgeted amount of borrowings for 2001-02 by July 31, 2001. The rally in prices of gilts in the secondary market persisted till the open market sales of a short-term paper through an auction on July 12, 2001 arrested it. Thereafter, the yields hardened at the long-end and softened somewhat at the short- and medium-ends, thereby making the yield curve steeper as at end-July 2001 in relation to a month ago. The foreign exchange market continued to exhibit orderly conditions during July 2001 with the exchange rate moving in a narrow range of Rs. 47.07-47.18 per US dollar. The average forward premia eased during the month across all maturities. The comfortable liquidity conditions continued in August 2001 so far (up to August 10) and the call money rates remained around the Bank Rate. The PLR of PSBs and deposit rates were reduced by about 25 basis points each.

5.9 The stock prices tended to move generally downward between April-July 2001. The Sensex declined by 5.40 per cent between April 2001 and July 2001. The slowdown in the industrial sector and profit warnings issued by various software companies for the coming quarters had a negative impact on the market sentiment. In May 2001, the SEBI announced significant changes in the capital market in keeping with the international practices. The ban on deferral products in the cash segment by SEBI and the ban by UTI on sales and repurchases of US-64 units affected the market sentiment adversely in July 2001. The subdued market sentiment continued in August 2001. The Sensex declined by 6.6 per cent between April 21 and August 14, 2001 in sharp contrast to gains of 10.2 per cent by the Nasdaq and 6.5 per cent by the Dow Jones.

5.10 Recent empirical analyses of financial market behaviour in India have yielded evidence of growing integration between money, debt and foreign exchange markets with relatively weak convergence of capital markets. The experience of 2000-01 suggests that market integration has tended to strengthen during episodes of volatility, pointing to a swifter transmission of market pressures from one segment to another than in earlier years. An indication of this integration during periods of market pressures is the existence of excess returns contemporaneously in various segments. This imposes additional constraints on the management of market conditions requiring simultaneous action across the spectrum (Box V.1).

The progress of financial sector reforms in India has been marked by a growing integration within the financial market spectrum. Evidence of market inter-linkages is reflected in the close co-movement of turnovers and rates of return. The structure of financial returns across markets continues to be differentiated by maturity, liquidity and risk, indicative of seams in the integration. In periods of orderly market conditions, the strengthening linkages between market segments suggests enhancement in the operational efficiency of markets as well as the conduct of monetary policy, the latter through the improvement in the transmission channels that integrated markets provide. On the other hand, the emerging market integration has entailed a swifter diffusion of turbulence originating in one market segment across the spectrum. Episodes of volatility have tended to unleash almost contemporaneous perturbations in several market segments, particularly the money, debt and foreign exchange markets. This has severely constrained monetary policy. On several occasions in the late 1990s and again during May-August, 2000 monetary operations have had to be undertaken simultaneously in various market segments in order to localize contagion in the presence of the asymmetric integration of markets. This has necessitated a flexible approach, allowing for temporary departures from the announced stance to contend with disorderly conditions across the market spectrum. The monetary policy reaction has been in terms of a combination of instruments, including regulatory action, to ensure the rapid restoration of stability. In general, markets have responded positively to the policy signals, returning to normalcy fairly quickly and this, in turn, has enabled a smooth vacation of market interventions to revert to the monetary stance. Under these conditions, the evolving channels of financial market integration in India warrant close and continuous scrutiny so as to distinguish between market reactions to fundamentals and transitory forces and thereby shape the policy response to the growing frequency of episodes of heightened but asymmetric inter-linkages.

In the economics and finance literature, a necessary condition for financial market integration is the convergence of risk-adjusted returns across the market continuum. The existence of a reference rate around which this convergence occurs is regarded as a sufficient condition of integration. As noted in the literature co-movement need not, however, indicate integration. Studies have found that market co-movements can also be the result of market contagion. In a world of asymmetric information about market prices, price changes in one market segment may depend on price changes in other segments through 'structural contagion coefficients'. As a consequence, markets do not absorb all information simultaneously and price movements exhibit lead/lag correlation structures. Empirical studies conducted in the Indian context have provided reasonably robust evidence of integration between the money market segments i.e., call money, commercial paper (CPs) and certificates of deposit (CDs), the gilt market represented by the Treasury Bill segments and the forward foreign exchange market segment. The equity market is found to have remained segregated from this integration. The 91-day Treasury Bill rate was observed to have the potential of emerging as a reference rate. Cross-border integration of the forex market is weak: while there is some evidence that covered interest parity may hold in India, the occurrence of uncovered interest parity is unambiguously rejected. This points to forward market inefficiency as the forward exchange rate does not provide unbiased predictions of the future spot exchange rate. Moreover, modeling market efficiency in the forward market segment indicates the persistence of excess returns, i.e., deviations from uncovered interest parity.

Preliminary evidence of financial market integration is provided by the strength of association in the movements of rates of returns, i.e., the cross correlation structure. The balance of opinion in the literature, however, does not favour the use of correlations for empirical verification of market integration. This is because financial rates of return predominantly exhibit 'random walk' properties, i.e., that today's prices cannot be used to predict future prices or that they are non-stationary with no tendency to revert to an underlying trend value. Variance is infinite under these conditions and this yields inconsistent estimates of the parameter. In India, most financial rate movements are found to be non-stationary. Accordingly, the series were differenced to make them stationary and correlation coefficients were computed on the differenced data. A comparison with the results of earlier studies (conducted on non-stationary data) shows a significant improvement in the correlation coefficient for call money rates and 91-day Treasury Bill rates from 0.62 in the period 1993-98 to 0.73 in 2000-01, the latter period containing the most recent episode of market volatility spread across segments. The correlation between 91-day Treasury Bill rate and the three-month forward premia improved from 0.49 to 0.87 and the correlation between call money rates and the forward premia remained high at 0.70.

5.11 The call money market remained orderly during 2000-01 with short-lived episodes of volatility in June and August 2000. Call rates were range-bound within the informal corridor created by the Reserve Bank's liquidity operations. The daily call money borrowing rates, on an average basis, moved between a peak of 10.35 per cent and a low of 7.55 per cent. The Liquidity Adjustment Facility (LAF) introduced from June 5, 2000 onwards modulated short-term liquidity under varied financial market conditions and thereby imparted stability to market conditions during the year. The average of daily weighted average call money borrowing rate was higher at 9.15 per cent during 2000-01 than 8.87 per cent during 1999-2000 (Table 5.2).

5.12 Market liquidity was ample up to mid-May 2000, and the call money rates (weighted average borrowing rate) generally ruled steady in the range of 7.0-8.0 per cent. Market conditions tightened in June 2000 as foreign currency sales by the Reserve Bank in the face of uncertainty in the foreign exchange market sucked out domestic liquidity. This coincided with the seasonal tightening on account of advance tax outflows. The Reserve Bank injected liquidity through a series of reverse repo auctions under the LAF progressively increasing the reverse repo cut-off rate from 9.05 per cent on June 5, 2000 to 10.85 per cent on June 14, 2000 (Appendix Table V.1). However, the weighted average call money borrowing rate spurted to touch a high of 20.34 per cent on June 17, 2000. The reverse repo cut-off rate was further raised to 14.0 per cent on June 20, 2000 in order to prevent spillovers between the call money and foreign exchange market segments. As the call money rates moved down from June 21, 2000 onwards and pressures eased, the reverse repo cut-off rate was reduced to 12.25 per cent by June 28, 2000. The call money rates tracked the reverse repo rate movements, declining to 7.14 per cent by the end of June 2000. Thus, liquidity management ensured that a further run away spike, after a temporary spurt in the call money rates in response to the transient impact of market volatility, was contained (Chart V.1).

5.13 Market conditions eased during the first half of July 2000 with the coupon payments and redemption of zero coupon bonds. The reverse repo cut-off rate declined to 9 per cent and the call rates also moved down to around 7.0 per cent. A temporary renewal of pressures in the foreign exchange market was countered by monetary tightening on July 21, 2000. Call rates edged up, ruling in the range of 8.4 per cent to 9.7 per cent between July 22-24, 2000. In August 2000, following persistent pressures from the foreign exchange market, a significant amount of liquidity was absorbed by the Reserve Bank through daily, three-day and seven-day repos. Progressively higher cut-off rate, from 8.0 per cent as on August 2, 2000 to a peak of 15.0 per cent as on August 18, 2000, were set in repo auctions and call rates moved in tandem, hovering around 14.0 per cent level during a greater part of the month.

5.14 Foreign exchange market conditions stabilised in September 2000. Accordingly, repo cut-off rate was progressively reduced to 10.0 per cent on September 11, 2000 and further to 8.0 per cent on October 25, 2000. The call rates also decreased from an average of 10.32 per cent during September 2000 to 9.07 per cent during October 2000 (Table 5.3). In the second week of November 2000, liquidity conditions tightened. Reverse repos were employed to inject liquidity and assuage market pressure at a cut-off rate of 10.0 per cent. Thereafter, liquidity improved substantially on account of India Millennium Deposits (IMD) inflows. Outright open market sales along with repo auctions under LAF effectively absorbed excess liquidity. The repo cut-off rate at 8.0 per cent served as a floor for the call money rates.

5.15 Seasonal tightening of the call money rates during the last week of December 2000 owing to advance tax payments and a price rally in the Government securities market was eased through reverse repo operations during December 22, 2000-February 2, 2001. Monetary easing in the form of Bank Rate and CRR cuts between mid-February and early March 2001 enabled a further decline in call rates to an average of 8.5 per cent in February 2001 and 7.8 per cent during March 2001. The usual year-end tightening at the end of March 2001 on account of balance sheet considerations was accommodated through the reverse repo auctions including a special LAF auction on March 31, 2001 in order to adjust market mismatches of funds.

5.16 During the first quarter of 2001-02, the call money rates remained easy and well within the repo-reverse repo corridor except for a brief period during May 9-21, 2001, reflecting adjustment of the market with revised guidelines under the second stage of LAF. The call money market eased in April 2001 after the usual hardening in end-March 2001 with the weighted average call money borrowing rates hovering slightly above the repo rate of 7.0 per cent for most part of the month. The excess liquidity was absorbed by a series of repo auctions and the repo outstanding amount averaged Rs.11,544 crore during April 3-29, 2001. However, as the market borrowing programme of the Government built up tempo during the latter half of the month the outstanding amount of repos declined from Rs.19,170 crore on April 12 to Rs.110 crore on April 27, 2001. Reflecting the prevalence of comfortable liquidity conditions the repo and reverse repo rates declined by 25 basis points each to 6.75 per cent and 8.75 per cent, respectively. However, in response to the rationalisation of standing facilities available to the commercial banks and PDs under the second stage of LAF, the weighted average call money borrowing rate moved up to 9.13 per cent on May 9, 2001 and remained generally above the ceiling of the corridor till May 18, 2001. A series of liquidity injections in the form of reverse repos (averaging an outstanding amount of around Rs.3,340 crore during May 8-23, 2001) as well as a cut in the CRR by 50 basis points to 7.5 per cent of net demand and time liabilities effective May 19, 2001 could nudge the call rates back to the corridor by May 21, 2001. With appreciable mobilisation in time deposits during May-June 2001, a decline in non-food credit up to fortnight ended June 1, 2001 followed by a low increase thereafter and a low advance tax outflow to Government in June 2001, the liquidity conditions remained easy. Mirroring this, the call money rates remained well within the corridor hovering between 7-7.5 per cent for the rest of the first quarter of 2001-02. The excess liquidity was absorbed through a series of repo auctions.

5.17 During July 2001, liquidity conditions were comfortable and call money rates (weighted average) generally ruled in the range of 6.70-8.88 per cent averaging 7.19 per cent. This comfortable liquidity was underscored by the substantial over-subscription to the issue of Government dated securities during the month. However, following the sale of dated securities, there was some firmness in the call money rates during the concluding part of second and fourth weeks of the month. Reverse repos were employed to inject liquidity in the market. The liquidity conditions remained comfortable during August 2001 (up to August 10) with daily call rates hovering mostly below the Bank Rate.

5.18 There has been a steady rise in outstanding transactions in this segment of the market, though the volumes continue to be small. During March 2001, the daily volume of transactions (outstanding) ranged between Rs.1,242-2,687 crore as compared with that of Rs.941-1,489 crore in March 2000. During April-July 2001 the daily volume of transactions (outstanding) ranged between Rs.2-2,556 crore as compared with that of Rs.258-1,977 crore during the corresponding period of the previous year.

5.19 Developments in the CD market closely reflected the alternating phases of money market behaviour. The outstanding amount of CDs issued by scheduled commercial banks (SCBs) declined from Rs.1,273 crore as on April 21, 2000 to Rs.872 crore as on May 5, 2000 on account of improvement in liquidity (Appendix Table V.2). Thereafter, following tight liquidity condition as also reduction in maturity period of CDs to 15 days effective May 3, 2000, issuances started rising and outstandings touched a peak level of Rs.1,695 crore as on October 20, 2000. However, with a return of comfortable liquidity conditions, the outstanding amount of CDs declined to Rs.771 crore as on March 23, 2001. The typical discount rates (for 3 months maturity) on CDs, which declined from 11.00 per cent as on April 7, 2000 to 8.50 per cent as on June 16, 2000, ranged between 10.0 - 10.50 per cent during August-November 2000, reflecting market conditions. In the following months, discount rates started declining and ranged between 8.00 - 10.0 per cent during the period December 2000 to March 23, 2001.

5.20 During 2001-02 the outstanding amount of CDs issued by scheduled commercial banks decreased from Rs.1,042 crore as on April 6 to Rs.905 crore on April 20, 2001, reflecting easy conditions. However, it rose to Rs.935 crore on May 18, 2001 on account of the tight liquidity conditions prevailing during the second and third weeks of the month. It moved down to Rs.921 crore as on June 29, 2001. The typical discount rate (for three-month maturity) on CDs, which increased from 9.75 per cent as on April 6, 2001 to 10.00 per cent as on April 20, 2001, declined to 8.00 per cent as on May 18, 2001 and remained at that level as on June 29, 2001. The typical discount rate ranged between 8.00-10.00 per cent during April-June 29, 2001, reflecting the market conditions.

5.21 The weighted average discount rates on commercial paper (CP) which were ruling in a narrow range of 9.55 - 9.95 per cent during April 30- June 15, 2000, firmed up to 12.03 per cent in the fortnight ended September 15, 2000 in consonance with other financial prices. As a result, the outstanding amount of CP which increased from Rs.5,634 crore as on April 15, 2000 to Rs.7,627 crore as on June 30, 2000, declined subsequently to Rs.5,577 crore as on September 15, 2000 (Appendix Table V.3). With easing of liquidity conditions, discount rates declined from 11.44 per cent in the fortnight ended October 15, 2000 to 9.87 per cent in the fortnight ended March 31, 2001. During the second half of the year, the CP market recorded heightened activity. By end-December 2000, the outstanding amount of CP reached the peak level of Rs.8,343 crore before declining to Rs.6,991 crore as on March 15, 2001 and further to Rs.5,847 crore as on March 31, 2001. During 2000-01, manufacturing and related companies issued 86.2 per cent of the total CPs issued while 12.7 per cent of the total were issued by leasing and finance companies and the balance 1.1 per cent by financial institutions.

5.22 The liquidity premium on CPs, measured by the differential between the 91-day Treasury Bill rate and the weighted average effective rate of discount on CPs (60-90 days), remained stable at an average of 1.5 percentage points in 2000-01(Chart V.2). The average differential between the average discount rate on CPs (60-90 days) and 91-day Treasury Bill rate worked out to 1.7 percentage points during 1999-2000.

5.23 Reflecting the trends in other segments of money market, the weighted average discount rate on CP ruled in a narrow range of 9.4-9.98 and the outstanding amount of CP issued by corporates rose steadily from Rs.6,295 crore as on April 15, 2001 to Rs.8,566 crore as on June 30, 2001 on account of improvement in liquidity. The share of manufacturing and other companies in the amount of CP issued increased from 78.31 per cent as on April 15, 2001 to 90.96 per cent on May 15, 2001 but decreased to 81.54 per cent on June 30, 2001 with concomitant variations in the share of finance/leasing companies/FIs. Guidelines of CP issuance in terms of dematerialised form came into effect from July 1, 2001. The outstanding amount of CPs declined to Rs.7,275 crore as on July 31, 2001.

5.24 The outstanding amount of commercial bills rediscounted by commercial banks and various financial institutions stood at Rs.1,033 crore at end-December 2000, higher than that of Rs.785 crore during the corresponding period of the previous year. The stock of rediscounted commercial bills rose further to Rs.1,063 crore at end-January 2001. The activity in the bill market slowed down with the outstanding amount of bills rediscounted by banks and FIs declining to Rs.668 crore as at end-February 2001 but rose to Rs.1,013 crore as at end-March 2001. The outstanding amount of bills rediscounted by banks with financial institutions as at the end of April 2001 declined sharply to Rs.691 crore before recovering a little to Rs.700 crore as at end-June 2001.

5.25 During the year, the weekly turnover in the inter-bank repo market ranged between Rs.196 crore and Rs.4,216 crore except during the last weeks of June and November 2000 when the turnover spurted to Rs.5,799 crore and Rs.6,907 crore, respectively. Reflecting the trends in other segments of the money market, repo rates which ranged between 5.0-10.0 per cent up to mid-June 2000, started rising and ranged between 6.5-22.0 per cent in the latter half of June 2000. Subsequently, rates started rising and ranged between 7.50 - 16.50 per cent up to September 8, 2000. During October 2000 - April 2001, the inter-bank repo rate moved between 8.00 - 12.30 per cent.

5.26 During the period April-July 2001, the weekly turnover in the inter-bank repo market ranged between Rs.3,035 crore and Rs.8,176 crore. Reflecting the trends in other segments of the money market, repo rates ranged between 6.40 - 10.25 per cent up to July 2001, except during the first week of April 2001, when repo rate had increased to 14.0 per cent. The volume of turnover in the inter-bank repo market is expected to go up in future following the gradual phasing out of non-bank entities from the call/ notice money market coupled with the setting up of the Clearing Corporation.

5.27 There were increases in volumes of FRAs/ IRS during 2000-01. FRAs/IRS transactions, both in terms of number of contracts and outstanding notional principal amount, rose from 216 contracts amounting to Rs.4,249 crore as on March 24, 2000 to 399 contracts for Rs.6,617 crore as on August 11, 2000 and further to 1,521 contracts amounting to Rs.21,504 crore as on March 23, 2001. The participation in the market continued to be restricted mainly to a few foreign and private sector banks, PDs and all-India financial institutions.

5.28 During 2001-02 up to July, the number of contracts in FRAs/IRS transactions rose from 1,615 contracts as on April 6, 2001 to 2,383 contracts as on July 27, 2001 and the outstanding notional principal amount increased from Rs.22,865 crore to Rs.38,101 crore. Though there was a significant increase in the number and amount of contracts, participation in the market continued to be restricted mainly to foreign and private sector banks, PDs and all-India financial institutions.

5.29 Comfortable supply conditions characterising the foreign exchange market in the early part of 2000-01 were dissipated by the hardening of international oil prices, successive interest rate increases in industrial countries and the withdrawal of portfolio flows during the period mid-May to mid-August 2000. Inflows under the IMDs during October-November 2000 eased market tightness and brought stability to various segments of the foreign exchange market.

5.30 During April 2000, excess supply conditions were reflected in net market purchases of US $ 368 million by the Reserve Bank. With pressures mounting in May 2000 due to the adverse international environment, the exchange rate moved from Rs.43.66 per US dollar at end-April 2000 to Rs.44.28 per US dollar as on May 25, 2000. Excess demand conditions were reflected in the spot market gap in the merchant segment increasing from US $ 202 million in April 2000 to US $ 855 million in May 2000 (Table 5.4). In the inter-bank segment, banks took positions in response to merchant activity (Table 5.5). Monetary measures in the form of interest rate surcharge of 50 per cent of the lending rate on import finance, penal interest at 25 per cent per annum (minimum) in respect of overdue export bills and net foreign exchange sales of US $ 1,948 million during May-June 2000 were undertaken by the Reserve Bank to meet genuine demand-supply mismatches and to prevent building up of speculative positions (Table 5.6). In response to these measures, the rupee regained stability, trading within a narrow range of Rs.44.57-Rs.44.79 per US dollar during June 2000.

5.31 The exchange rate, which was trading in the range of Rs.44.67-Rs.44.73 per US dollar during the first half of July 2000, moved to Rs.45.02 per US dollar on July 21, 2000 as the market gap in the spot merchant segment more than doubled from US $ 233 million in June 2000 to US $ 586 million in July 2000 and compensating activity built up in the inter-bank segment. Market pressures were met with orthodox monetary tightening in the form of increases in the Bank Rate and the CRR and reduction in the limits available to banks for all refinance facilities. The rupee remained range-bound around Rs.45.00 per US dollar in the last week of July 2000.

5.32 Demand pressures resurfaced during the first few days of August 2000 with the exchange rate moving from Rs.45.00 per US dollar at end-July 2000 to Rs.45.83 per US dollar on August 11, 2000. Balances in Exchange Earners Foreign Currency (EEFC) accounts were scaled down and restrictions were imposed on future accretions and credit facilities available against EEFC accounts. Market supply improved as a result, and the rupee traded in a narrow band of Rs.45.67-Rs. 45.91 per US dollar during the last fortnight of August 2000. The monetary and other measures were further supported by the Reserve Bank through net sales of US $ 1,656 million during July-October 2000 on top of net sales of US $ 1,948 million during May-June 2000 or a total of US $ 3,604 million during May-October 2000 to meet temporary demand-supply mismatches.

5.33 In the remaining period of the year, orderly conditions returned to all segments of the market. Buoyant supply conditions were reflected in net market purchases of US $ 5,593 million by the Reserve Bank between November 2000-March 2001 which more than offset the net sales of US $ 3,604 million during the earlier part of the year (May-October 2000). For the year as a whole, the Reserve Bank's net market operations, therefore, resulted in net market purchases of US $ 2,356 million (Chart V.3 and Table 5.6). The interest rate surcharge on import finance and the penal interest rate on overdue export bills were withdrawn with effect from January 6, 2001.

5.34 The average monthly turnover in the merchant segment of the foreign exchange market increased from US $ 20 billion during 1999-2000 to US $ 23 billion during 2000-01. The average monthly turnover in the inter-bank foreign exchange market increased to US $ 93 billion during 2000-2001, reversing its declining trend of the previous two years. The average monthly total turnover (inter-bank plus merchant) increased from US $ 95 billion in 1999-2000 to US $ 116 billion in 2000-01. The ratio of inter-bank to merchant turnover hovered around 4 reflecting orderly market activity. Between May and August 2000, however, the ratio exceeded 4 indicating hectic inter-bank activity (Chart V.4).

5.35 The recent experience with exchange rate regimes in the world over indicates that central banks are getting more actively involved in the dynamics of market processes with a view to signaling their stance on exchange market developments. Monetary authorities' reactions to exchange market pressures are typically swift with a preference for withdrawal from market activity as soon as orderly conditions prevail. In general, they tend to adopt a combination strategy within which monetary policy and regulatory measures are employed to support direct and indirect interventions.

5.36 To investigate the practice of foreign exchange intervention, a recent survey based on response of 22 institutions out of 43 institutions that participated in the Bank for International Settlements (BIS) and the European Central Bank, presents interesting results on issues like instruments, timing, amounts, motivation, secrecy and perception of efficacy of foreign exchange interventions (Box V.2).

Surveying the mechanics of monetary authorities' foreign exchange intervention reveal the following :

• Official intervention, both sterilised and unsterilised, was reasonably common in foreign exchange markets; the Reserve Bank of New Zealand was the only authority to report that it had not intervened in the last 10 years. The central banks indicated a preference for dealing with major domestic banks but they also transact with major foreign banks. About 50 per cent of central banks sometimes conducted business with other entities like other central banks (23.5 per cent) or investment banks (25 per cent).
  
• About 95.2 per cent of authorities reported that the official intervention activities always include spot market transactions and other 4.8 per cent sometimes include spot transactions. Around 52.9 per cent sometimes used the forward market, perhaps in conjunction with spot market to create a swap transaction; no authority reported always using the forward market.
  
• Direct dealing over telephone is the most popular method of intervention with 43.8 per cent of authorities using direct dealing over an electronic network. Live foreign exchange brokers are used sometimes or always by 63.2 per cent of the respondents.
  
• About 95 per cent of central banks reported that the size of intervention sometimes or always depended on market reaction to initial trades.
  
• Most interventions took place during the business day but almost half of central banks surveyed reported that they sometimes intervene prior to business hours and more than half intervenes after business hours ( e . g . , Reserve Bank of Australia).
  
• About 23.8 per cent of authorities reported sometimes intervening with indirect methods like changing banking regulations on foreign exchange exposure and moral suasion.
  
• 89.5 per cent of authorities sometimes or always intervened to resist short-run trends and 66.7 per cent of the authorities intervened to make the exchange rates return to "fundamental values". Some countries specified "other" reasons that might be interpreted as variations on the leaning-against-the-wind or misalignment hypothesis. Still other countries indicated macroeconomic goals such as limiting exchange rate pass-through to prices, defence of an exchange rate target or accumulating reserves as motivating factor behind intervention. The profitability consideration in intervention decisions was uniformly rejected by all respondents.
  
• As regards secrecy in intervention, about 76.5 per cent of authorities reported sometimes or always intervening secretly to maximise market impact, whereas 57.1 per cent of authorities reported sometimes or always intervening secretly to minimise market impact. No central bank cited portfolio adjustment as a reason for secret intervention.
  
• As regards effect of intervention on exchange rates as well as the time horizon of the effect, all the central banks felt that intervention had some effect on exchange rates. Most of the respondents believed in a relatively rapid response, over a few minutes (38.9 per cent) or a few hours (22.2 per cent). A substantial minority expressed that intervention's full effect is seen over a few days (27.8 per cent) or more (11.1 per cent).

5.37 The excess demand for merchant transactions in the forward segment increased from US $ 845 million in April 2000 to US $ 1,909 million in May 2000 and remained large, moving in a range of US $ 1,602-1,914 million during July-September 2000. In reflection, the six-month forward premia increased from 2.5 per cent in May 2000 to 4.9 per cent in September 2000. The one-month premia increased from 2.2 per cent in May 2000 to 6.1 per cent in August 2000. Volatility in the forward segment was reflected in an inversion of the forward premia curve (Chart V.5). Net forward sales by the Reserve Bank increased from US $ 670 million as at end-April 2000 to US $ 2,225 million as at end-August 2000. With the return of normalcy, forward premia generally remained stable from October 2000 onwards. The one-month premia declined from its peak of 6.1 per cent during August 2000 to 4.3 per cent during March 2001 while the six-month premia declined from 4.9 per cent during September 2000 to 4.6 per cent during March 2001. Net forward sales of the Reserve Bank declined, in tandem, from US $ 2,225 million as at end-August 2000 to US $ 1,259 million as at end-March 2001. The average six-month forward premia for the fiscal year 2000-01 at 3.9 per cent was lower than that of 4.7 per cent during the preceding year (Table 5.7).

5.38 During 2001-02 so far (up to August 10), the foreign exchange market exhibited orderly conditions with the rupee moving in a range of Rs. 46.56 - 47.18 per US dollar. The excess supply conditions resulted in net purchases by the Reserve Bank from the market amounting to US $ 487 million during the first quarter of 2001- 02. The spot exchange rate moved to an average of Rs.47.14 per US dollar in July 2001 from an average of Rs.46.62 per US dollar during March 2001. The 6-month forward premia which increased marginally to 5.0 per cent during June 2001 from 4.6 per cent during March 2001 fell to 4.7 per cent during July 2001. The orderly market conditions also enabled a reduction in outstanding forward liabilities of the Reserve Bank to US $ 800 million as at end-June 2001 from US $ 1,259 million as at end-March 2001.