2.86 There was a sharp expansion in the emerging segments of the financial markets. The repo market (outside the Reserve Bank) has been expanding with the gradual conversion of the call money market into a pure inter-bank market. The futures markets, in the form of forward rate agreements (FRAs) and interest rate swaps (IRSs), continued to witness a jump in the notional amount.

2.87 The collateralised borrowing and lending obligation (CBLO) operationalised through the Clearing Corporation of India Limited (CCIL) in January 2003, emerged as a new money market instrument. So as to aid its development as a money market instrument, the CBLO has been exempted from CRR subject to banks maintaining a statutory minimum CRR of 3 per cent. As at end-December 2003, out of total 59 members, 46 members were activated under the CCIL’s system for CBLO. The CBLO market recorded major gains in the second quarter of the current financial year. The daily average turnover in CBLO increased from Rs.47 crore in April 2003 to Rs.363 crore in December 2003. With regard to the changing profile of participants under the CBLO, it has been found that on the lending side more mutual funds have started participating in the market apart from an insurance company. On the borrowing side, the participants are largely co-operative banks.

2.88 The gross market borrowings of the Central Government during 2003-04 was budgeted at

Rs.1,66,230 crore, up by 10.0 per cent over the preceding year’s actual borrowings. A highlight of the current year so far has been the continued endeavour for restructuring of domestic debt through debt-swap by the State Governments and buy-back of high coupon loans by the Central Government frombanks. Adjusting for the inflows of States’ repayments of high-cost loans to the Centre under the debt swap scheme, the gross and net market borrowings of the Central Government are expected to be lower by 21 per cent and 33 per cent, respectively, than the budgeted amounts. The Central Government conducted its first buyback in July 19, 2003 when 19 high cost, illiquid securities amounting to Rs.14,434 crore (face value) were bought back and in their place four liquid securities of equal face value were issued. During the current fiscal year so far (up to December 31, 2003), the gross and net market borrowings of the Central Government amounted to Rs.1,15,036 crore and Rs.77,319 crore, respectively (excluding buyback of Rs.14,434 crore). This constituted 69.2 per cent of the budgeted gross market borrowings. Of the gross amount raised so far, about 83 per cent was raised through dated securities and the balance through 364-day Treasury Bills.

2.89 The issuance of floating rate bonds with some modifications was continued in 2003-04 as well, with a view to providing the investor an effective instrument for hedging interest rate risk in the context of the elongation of the maturity profile of Government debt.There were three issues of floating rate bonds up to December 15, 2003, with maturities ranging from 8 years to 11 years which raised a total of Rs.16,000 crore, with the variable bank rate linked to 364-day Treasury Bills. The Reserve

Bank’s recent Working Group on Rupee Interest Rate Derivatives (Chairman: G. Padmanabhan) recommended several measures to develop the interest rate derivatives market. Besides, the Group has suggested changes in risk reporting to reflect the interest rate risk of bank’s trading activities in interest rate products, both cash market and derivatives market.

2.90 Ample liquidity during 2003-04 so far enabled a sharp lowering of the weighted average yields of the dated securities issued despite the increase in the weighted average maturity, a lower order of primary placements on the Reserve Bank and no devolvements on primary dealers and the Reserve Bank (Table 2.39). During the current year so far (up to January 7, 2004), primary yields of 91-day Treasury Bills and 364-day Treasury Bills declined by 165 basis points and 152 basis points, to 4.24 per cent and 4.37 per cent, respectively.

2.91 The auction calendar for the second half of the year set a borrowing target of Rs.25,000 crore for the period October 2003 to March 2004 after adjusting amounts received from the State Governments towards prepayment of small savings loans and keeping in view trends in other receipts.

2.92 The market borrowings of State Governments have gone up substantially in the wake of the debt-swap scheme which allowed the States to retire their high-cost debt to the Government of India. The gross and net market borrowings allocated for States for fiscal 2003-04 (provisional) amount to Rs.40,802 crore and Rs.36,657 crore, respectively. This is

inclusive of the additional allocation of Rs.23,000 crore under the debt-swap scheme. During the current year so far (up to December 31, 2003), the State Governments have raised Rs.38,752 crore (Rs.36,357 crore through tap sales and Rs.2,395 crore through auction) under the market borrowing programme, of which Rs.23,000 crore was raised under the debt-swap scheme. In order to elongate the maturity profile of State loans, a 12-year bond was issued on August 25, 2003 through the tap sale of 6.20 per cent State Development Loan(SDL) 2015. The declining trend in interest rates on market borrowings of the State Governments continued during 2003-04. During 2003-04 (up to December 31, 2003), the interest rate on market borrowings ranged from 6.40 per cent to 5.78 per cent.

2.93 During the current year so far (up to December 2003), the average monthly volume of secondary market transactions through the Subsidiary General Ledger (SGL) in Government securities increased sharply to Rs.2,23,769 crore from Rs.1,61,806 crore during 2002-03. Exchange-traded Interest Rate Derivatives (IRDs) were enabled on the National Stock Exchange (NSE) from June 3, 2003 with the introduction of interest rate futures on notional Government bonds/Treasury Bills were introduced in the first phase. With a view to enabling PDs to manage their exposure to interest rate risks as well as to provide liquidity in the IRD segment, they were allowed to deal in IRDs for both hedging and trading. In the first phase, banks could transact in interest rate futures on notional bonds and Treasury Bills for the

limited purpose of hedging the risk in their underlying investment portfolio.

2.94 Looking at the trends in secondary markets, the year 2003-04 commenced with the usual flush of early April liquidity fuelling a rally in prices of government securities which was subsequently moderated with the concerns of rising inflation. The price rally was sustained in June 2003 amidst a positive response in primary auctions as also a rate cut of 50 basis points by the European Central Bank (ECB). The rally, however, reversed following a clarification from the Reserve Bank that a repo rate cut was not on the anvil. Thereafter, prices remained range bound in view of favourable liquidity conditions despite advance tax flows. Since mid-July 2003, expectations of a further fall in inflation improved the sentiments.

2.95 Due to the reduction of the repo rate by 50 basis points from 5.00 per cent to 4.50 per cent from August 25, 2003, there was a sharp decline in the yields and the 10-year yield touched a historic low of 5.23 per cent on August 26, 2003. During September 2003, the reduction in the interest rate cap on NRE deposits to 100 basis points above from the existing cap of 250 basis points above Libor affected market sentiments on expectations of slow forex inflows and a squeeze in Rupee liquidity. The announcement of a modest borrowing target in the calendar of issuance of Government securities for the second half of 2003-04 led to a rally in prices. Prices continued to go up on expectations of monetary easing in the run up to the Mid-Term Review. The 10-year yield reached a further low of 4.95 per cent on October 16, 2003. The yields, however, firmed up on the announcement of the 28-day LAF auction and OMO auction on October 18, 2003. During August 25-November 3, 2003, the 10-20 year spread widened from 55 basis points to 76 basis points. Although expectations of rate cuts in the Mid-Term Review did not materialise, the markets stabilised in view of the Reserve Bank’s benign inflation outlook and the reiteration of the soft interest rate stance of monetary policy. The yields moved in a range thereafter. The benchmark 10-year yield declined to 5.14 per cent on December 31, 2003 from 6.21 per cent as on March 31, 2003, a decline of 107 basis points. Reflecting the persistence of easy liquidity conditions, the yield curve has been trending steadily downwards in recent years (Chart II.14).

2.96 Surplus conditions prevailed in the foreign exchange market on account of sustained foreign exchange inflows from export proceeds, inward

remittances and investment by FIIs during fiscal 2003-04. Increased foreign exchange inflows coupled with absence of adequate dollar demand from corporates and importers helped the Indian Rupee to steadily appreciate by 4.2 per cent against the US dollar from Rs.47.51 per US dollar as at end-March 2003 to Rs.45.61 per US dollar as at end-December 2003. The Rupee moved in the range of Rs.45.26-47.46 per US dollar during April-December 2003. The exchange rate of the Rupee was at Rs.45.45 per US dollar as on January 16, 2003. Despite a appreciation of the Rupee against the US dollar, the 5-country (trade-weighted) REER and NEER depreciated by 2.0 per cent and 3.9 per cent, respectively, during the same period mainly on account of depreciation of US dollar against the major currencies.

2.97 Reflecting excess liquidity conditions in the spot exchange market, as banks, exporters and corporates resorted to heavy forward dollar sales, the average one-month, three-month and six-month forward premia declined sharply to (-)0.46 per cent, (-)0.30 per cent and 0.04 per cent, respectively, in December 2003. Activity in both the merchant and inter-bank segments of the foreign exchange market increased strongly. While the merchant turnover increased from US $ 25 billion in April to US $ 41.5 billion in November 2003, the inter-bank turnover increased from US $ 89.4 billion to US $ 129.1 billion during the same period. The inter-bank to merchant turnover ratio, however, remained broadly stable at around 3 during the period.

2.98 During the current financial year (up to November 2003), the primary market remained sluggish despite a pick-up in the industrial activity, a strong economic outlook and a vibrant stock market. There are, however, some early signs of a pick-up as some corporates have announced plans of floating public issues. Moreover, sanctions and disbursements by All-India Financial Institutions (AIFIs) have increased after a gap of more than two years. In the public issues market, out of nine issues floated during April-November 2003, there were six equity issues amounting to 49 per cent of the total resources mobilised through public issues. Resource mobilisation from the private placement market increased during April-September 2003, the period for which data are available (Table 2.40). Public sector companies continued to raise substantial resources from the private placement market. Resource mobilisation during April-November 2003 from the Euro issues market in the form of American Depository Receipts (ADRs), Global Depository Receipts (GDRs) and Foreign Currency Convertible Bonds (FCCBs) also registered a rise.

2.99 Net resource mobilisation by mutual funds (excluding UTI-I) increased significantly during April-November 2003 (Table 2.41). The substantial improvement was on account of a turnaround in UTI and considerably higher inflows into private sector mutual funds. Due to the buoyancy witnessed in the equity and debt market, mutual funds have attracted huge inflows.

2.100 The stock markets, which had remained subdued since February 2000, recorded a sustained rally in the current financial year, especially since end-May 2003. The BSE Sensex crossed the 4000 mark in mid-August 2003, the 5000 mark in November 2003 and the historical high of 6100 in early January 2004. The BSE Sensex climbed by over 100 per cent over mid-May 2003. Various factors like good monsoons, encouraging quarterly results by major corporates, strong institutional support, especially by FIIs, positive trends in international markets, sector-specific factors and strong macroeconomic fundamentals along with the appreciation in the Rupee contributed to the buoyant market sentiments which supported the rally. The BSE Sensex had crossed the 6000 mark only once before -during February 2000 in intra-day trading. The rally in the year 2000 was, however, driven mainly by technology scrips. In contrast, the recent rally is far more broad-based covering almost all sectors.

2.101 The present rise in indices is accompanied by a rise in turnover. This is reflected in the fact that while the BSE Sensex and the S&P CNX Nifty registered gains of 27.7 per cent and 25.1 per cent, respectively, during April-December 2003 over the corresponding period last year, the turnover witnessed even larger growth (Table 2.42). Though the volatility, as measured by coefficient of variation has risen, it is not a cause for concern as the speculative interest seems to have declined during the current rally as is evident from a rise in deliveries as a percentage of turnover. Although market capitalisation and the price-earning (P/E) ratio rose as a result of the increase in prices, the present P/E ratio on Indian markets still remains attractive as compared with certain other emerging markets.

2.102 The present rally is not restricted to the blue-chip indices but is broad-based, with mid-cap and small-cap scrips also registering substantial gains. During April-December 2003, the broad-based BSE 500 index registered a gain of 120.9 per cent and the S&P CNX Mid-Cap Index registered a gain of 168.4 per cent while the blue-chip BSE Sensex posted a gain of only 91.5 per cent. Almost all the sectors including fast moving consumer goods (FMCG), technology, capital goods, banking and public sector undertaking (PSU) participated in the rally (Chart II.15).

2.103 Strong FII inflows into the equity markets in the current financial year have been viewed as one of the major driving forces of the present rally. FII investment in debt instruments increased too. Mutual funds turned buyers in equities but invested a large amount in debt instruments (Table 2.43).

2.104 Along with the rally in the cash segment of the markets, the derivatives segment has also been recording large turnover. In fact, the turnover in the

derivatives market exceeded that of the cash markets (Table 2.44). The scrip-wise futures have been attracting a large turnover. However, the volumes in interest rate futures introduced on the NSE in June 2003 are yet to pick up.

2.105 During 2002-03, scheduled commercial banks witnessed an increase in profitability with their net profits touching 1.0 per cent of total assets as at end-March 2003. This was driven by: (i) substantial trading income, reflecting the continuing softening of interest rates; (ii) an increase in the credit portfolio, with the revival of industrial demand; and (iii) containment of operating expenses, par tly offset by higher provisioning. Spreads also widened during the year, reflecting the fact that the decline in deposit rates outstripped the decline in lending rates.

2.106 During the first half of 2003-04, based on regulatory returns, net profits, at 0.64 per cent of total assets, were higher than 0.49 per cent recorded in the comparable half of the previous year, driven by a containment of expenses partly offset by higher provisioning.Some banks have already made ad hoc provisions in view of the impending 90-day delinquency norm, effective end-March 2004.The enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 has provided the scope for sustained recovery of dues: as at the end of September 2003, banks had issued notices in 42,047 cases worth Rs.14,141 crore and recovered Rs.769 crore from 13,583 cases.

2.107 The increase in bank profitability was accompanied by an improvement in indicators of balance sheet health (Table 2.45). Asset quality continued to improve.The ratio of gross NPAs to gross advances declined during 2002-03. Besides, capital adequacy continued to be satisfactory with as many as 91 of the 93 SCBs achieving the stipulated 9.0 per cent capital to risk-weighted assets ratio (CRAR). The Investment Fluctuation Reserve, a cushion against any adverse movements in interest rates in the future, worked out to 1.7 per cent of eligible investments as at end-June 2003.

2.108 The profitability of co-operative banks continued to be less than satisfactory, partly reflecting a narrowing of spreads. Reflective of the difficulties faced by the sector, urban co-operative bank deposits and credit off-take decelerated during 2002-03 (Table 2.46). Scheduled urban co-operative banks continued to record a net loss for the third year in succession, reflecting a narrowing of spreads, on the one hand, and a reduction in the size of the credit portfolio, on the other. The asset quality of urban co-operative banks remained, more or less, the same. The performance of rural co-operatives continued to be under some strain with the asset quality of the lower tier being relatively worse than that of the upper tier. State co-operative banks, however, continued to post profits in 2002-03.

2.109 The performance of All-India financial institutions (FIs), as a group, witnessed further deterioration over the previous year on account of declines in the spread as well as non-interest income and rise in other expenses. All FIs, excluding IIBI and IFCI, however, registered positive operating and net profit. The CRAR of all institutions, excepting IFCI and IIBI. remained well above the benchmark minimum of 9 per cent. There is, neverthless, a pick up in project finance from FIs this year.

2.110 The FIs’ support to the commercial sector has been gradually shrinking reflecting the emergence of alternative sources of project finance for the Indian corporates as well as paucity of new business in view of the economic slowdown. This is reflected not only in the gross financial assistance in the form of sanctions and disbursements but also in terms of net flow of resources, which has been consistently negative since 2001-02 (Table 2.47).

2.111 Non-banking financial companies continued to stagnate, as a sector, with their public deposits working out to about 1.0 per cent of broad liquidity

bank financial companies (RNBCs)), there was a decline in the share of public deposits in total assets, partly substituted by a larger recourse to bank loans during 2002-03 (Table 2.48). The major portion of the assets of NBFCs (excluding RNBCs) continued to be in the form of their specialised areas of hire purchase and lending while the equipment leasing business continued to contract partly reflecting, inter alia, changes in taxation.

2.112 The NBFCs, as a sector, recorded losses for the second year in succession during 2001-02, as the decline in expenditure could not keep pace with the drop in both fund-based and fee-based income. The decline in fund income was particularly steep in recent years. Total expenditure fell less sharply as operating expenditure and tax provisions have tended to be sticky. Operating costs of NBFCs, however, continue to be higher than those of banks and financial institutions. The gross and net non-performing assets of reporting NBFCs has experienced a steady decline in recent years.

2.113 Global output expanded strongly in the third quarter of 2003, following recovery in the United States and strong growth prospects in Asia. Global GDP growth is projected to grow by 4.1 per cent in 2004, up from 3.2 per cent in 2003 (IMF, September, 2003). Recent months have seen the emerging signs of a recovery in economic activity, particularly in the US, Japan and emerging Asia. In the US, the pace of growth has picked up, assisted by expansionary macroeconomic policies and supportive financial conditions. Equity and bond markets have responded with optimism to the prospects of recovery with investor interest returning to technology stocks more rapidly than to other sectors. In Japan, economic activity exhibited stronger signs in the third quarter of this fiscal which indicated that a cyclical upswing is underway, led by industrial activity and exports. In the UK and Australia, signs of recovery are clearly evident with rising household spending reflected in retail price

inflation, prompting the monetary authorities to raise key policy interest rates. China continues to grow at a remarkably strong pace while activity in other parts of Asia is bouncing back from the effects of SARS.

2.114 There is, never theless, considerable uncertainty regarding the durability of the pick-up. In the US, labour markets remain sluggish and significant excess capacity persists. Moreover, the substantial support provided to consumption by tax cuts is unlikely to be sustained. Despite the prospects of stronger growth, Japan continues to experience deflation. The ongoing concerns relating to structural weaknesses in the financial system remain. In contrast to the rest of the world, the euro area remains conspicuously weak although there are tentative signs of a modest recovery in recent months. Household demand remains sluggish and the unemployment rate for the area as a whole has risen.

2.115 In the euro area, whereas monetary policy can be adjudged to have been successful in an inflation targeting framework, the economic slowdown has been deep and prolonged, with GDP declining in the second quarter of 2003. The large economies – Germany, France, the Netherlands and Italy – are in recession with high levels of unemployment.Despite some recent improvement in expectations, household and business confidence remains depressed. The poor performance of Germany, in particular, threatens to hold back the region’s recovery. Corporate balance sheets are still adjusting to the bursting of the asset price bubble of the late 1990s holding down investment spending.

Exports have been adversely affected by weak external demand as well as the substantial appreciation of the euro vis a vis the US dollar over the past two years. Monetary policy has been accommodative but distinct inflation and unemployment rates in different countries blur the effectiveness of the common monetary policy. Although Germany and France are expected to post fiscal deficits above 4 per cent of GDP in 2003, the scope for countercyclical fiscal policy is limited by the Stability and Growth Pact.

2.116 In Japan, macroeconomic performance during 2003 has exceeded expectations alongside an improved external environment and an upturn in equity markets. The outlook remains overcast with deflationary pressures and persistent weakness in the financial sector. The possibility of declines in equity or bond prices, a sustained appreciation of the Japanese Yen and rising public debt remain dangers to a durable recovery. Quantitative easing of monetary policy has kept short-term interest rates at zero, but has not been aggressive enough to end deflation.

2.117 Overall, global macroeconomic imbalances and the associated misalignment of the G-3 currencies remain the most serious threat to a broad-based and robust recovery. This has implications for the pattern of capital flows. A current issue of concern is the practice of greater flexibility in the exchange rate regimes of these countries, and the resulting effects on the real economy. Studies have shown that greater volatility in developing countries’ real exchange rates has been associated with greater

misalignment in G-3 countries with disruptive effects on both trade and finance channels (see Chapter VII). This emerges as a major source of uncertainty for the conduct of monetary policy.

2.118 According to the International Trade Statistics (ITS) 2003 released by the WTO, world merchandise exports recorded a growth of 15 per cent in US dollar terms during the first half of the calendar year 2003.¹ This marks a strong acceleration over the growth of 4 per cent recorded in 2002. The growth in world merchandise exports in volume (or real) terms during 2003 is, however, projected to be about 3 per cent, the same as that achieved in the previous year. The main factor behind buoyant trade growth in US dollar terms is the depreciation of the US dollar against the major currencies in Europe and Asia in the first six months of

2003. Higher oil and non-fuel commodity prices have also contributed to the increase in the value of international trade (Table 2.49). This is in contrast with the period 1998 to 2000 when the appreciation of the US dollar over other major currencies more than compensated for the price changes. As a result, volume growth during those years exceeded the growth in merchandise trade in US dollar terms.

2.119 The latest data, released by the Directorate General of Commercial Intelligence and Statistics (DGCI&S), indicate that India’s exports during the first eight months of the current fiscal 2003-04 witnessed a lower order of increase as compared to the previous year (Table 2.50). Imports registered an increase mainly on account of higher non-oil imports. On the other hand, the growth rate of oil imports during this period

decelerated. The trade deficit during April-November 2003 doubled over the same period lastyear.

2.120 Commodity-wise data on India’s foreign trade, available for the first half of the fiscal year 2003-04, show that while the exports of ‘primary products’ declined, there was a substantial rise in the exports of ‘petroleum products’. ‘Manufactured goods’, which accounted for over three-fourth of India’s exports, witnessed a moderate increase during this period. Within the broad ‘manufacturing goods’ group, however, the exports of ‘leather and manufactures’, ‘textiles’, ‘handicrafts’ and ‘carpets’ recorded negative growth. On the other hand, exports of ‘chemical and related products’ and ‘engineering goods’ increased significantly during April-September 2003 (Table 2.51).

2.121 The decline in exports of ‘leather and manufactures’, ‘textiles’ and ‘handicrafts’ and ‘carpets’ is mainly due to a subdued demand for such products in advanced countries, especially in the USA. Although most of the ‘engineering goods’ had a moderate rise in exports during 2003-04 so far, the important item that led this group’s growth has been ‘iron and steel’, ‘manufactures of metals’ and ‘machinery and instruments’. This was mainly due to rising demand from countries in East Asia and China supplemented by higher domestic production.

2.122 The USA continued to remain the most important destination of India’s exports, followed by the UAE and the UK (Table 2.52). However, the market that is rapidly emerging as one of the prime

Table 2.53: India’s Principal Imports

destinations in recent years is China. Shar p increases in exports were also observed in respect of Iran, Italy, Germany and Netherlands. During April-September 2003, there were considerable declines in exports to Japan, Russia and East Asian countries, such as, South Korea, Malaysia, Singapore and Thailand.

2.123 Commodity-wise analysis of imports during the first half of 2003-04 showed that the growth was largely on account of the sharp increases in the imports of ‘gold and silver’, ‘edible oil’, ‘iron and steel’ and ‘capital goods’. The increase in the import value of ‘gold and silver’ was primarily due to the hardening of international prices during this period while the

sharp rise in ‘edible oil’ imports could be attributed to lower domestic production, consequent upon drought conditions last year. Within the ‘non-oil non-gold/silver’ imports, ‘iron and steel’ and ‘capital goods’ imports recorded an impressive rise in April-September 2003, mainly reflecting the industrial recovery (Table 2.53).

2.124 As regards sources of India’s impor ts, although the USA and Belgium continued to remain the two most important countries, China has become the third important source during the current year. Country-wise data showed sharp increases in imports from Switzerland, South Africa, and East Asian countries such as Hong Kong, South Korea and Malaysia during April-September 2003 (Table 2.54).