In the assessment of risk in the global financial markets, the focus shifted from sovereign debt crisis to concerns regarding the slowdown in economic recovery. This change in assessment of risk of the global investors impacted Indian financial markets through two different channels, viz. appreciation of the Indian Rupee and rise in equity prices due to sharp increase in portfolio flows. The transmission of higher policy interest rates increasingly became effective, albeit with a lag. The deficit liquidity conditions impacted various segments of financial markets viz. CPs, CDs, CBLO, Treasury Bills, government securities and bank deposits. Activities in CPs market picked up in the post Base Rate scenario as corporates explored alternative sources of finance. Housing prices in major cities witnessed a rising trend.

V.1 The financial markets in advanced economies had started to price in uncertainties related to the sovereign debt crisis in the Euro area and its possible spillover impact on the banking sector, when renewed concerns regarding slowdown in recovery adversely affected the investor confidence. The financial markets in emerging market economies (EMEs), however, showed signs of further strengthening mainly on account of their strong growth potential vis-à-vis advanced economies. As a result, capital flows to EMEs strengthened, thereby exerting pressure on currencies to appreciate and asset prices to remain upbeat. The US dollar depreciated against most of the major currencies, most notably against the Japanese Yen. Currency markets remained volatile and received greater market attention based on expectations about country specific policy responses to deal with the costs of appreciating exchange rate.

V.2 The Indian financial markets remained largely stable, with range-bound turnover and decline in volatility. Call rates gradually firmed up, in step with changes in policy rates and deficit liquidity conditions. The LAF corridor was narrowed with a view to containing volatility. Both CPs and CDs markets witnessed higher issuances, as lenders (through CDs) and borrowers (through CPs) scouted for cheaper funds against the backdrop of sustained increase in policy rates. The yield in G-Sec market hardened in the initial part of the second quarter of 2010-11 reflecting hike in policy rates, tight liquidity conditions and high inflation. Thereafter, the yields softened as liquidity conditions improved and concerns over Euro area receded. The Indian Rupee appreciated against the US dollar and the Indian stock prices rose on the back of substantial portfolio inflows. The quarterly House Price Index of the Reserve Bank suggests that prices in the housing market, especially in Tier I cities continued to show signs of acceleration, even as prices in Tier II cities registered some moderation.

International Financial Markets

V.3 The concerns relating to sovereign debt crisis, which adversely affected the global financial market conditions since end 2009, considerably receded by the beginning of the third quarter of 2010. By end-July, however, concerns relating to the global growth outlook and its implications for asset prices assumed centre stage. Increasing evidence of slowdown in economic recovery in the US and other advanced economies led to lower inflation expectations and falling bond yields (Chart V.1a). The spread between corporate bond yield and G-sec yield widened, especially after September 2010 (Chart V.1d). Increasing concerns relating to slowdown in the US and other advanced economies led to depreciation of the US dollar against all major currencies, especially against the Japanese Yen (Chart V.1h).

V.4 Asset prices in EMEs registered significant gains as portfolio flows to these economies revived on the possibility of better returns in these countries. Their currencies also witnessed appreciation pressures (Table V.1).

V.5 The developments in the global financial markets spilled over to the Indian markets, particularly the equity and foreign exchange market. With deterioration in the outlook for growth in the advanced economies, there was a substantial increase in capital inflows led by FIIs. This contributed to significant increase in stock prices, besides leading to appreciation of exchange rate of the rupee against the US dollar. Improved global credit market conditions, and the widening interest rate differential facilitated higher access to ECBs by corporates. Financial markets in India, besides reflecting the global trend, were largely conditioned by the domestic growth-inflation outlook, monetary policy stance and the fiscal position.

Domestic Financial Markets

V.6 Strong domestic macroeconomicfundamentals and expectation of sustainedhigh growth provided the necessary comfortto the markets. The transaction volumes inthe markets remained range bound althoughthe spreads/volatility generally declined( Table V.2 and Chart V.2).

Money Market

V.7 The money market remained orderly during the second quarter of 2010-11. The call rate firmed up, starting from end-May 2010 due to the tightening of liquidity conditions on account of 3G/BWA auctions and advance tax payments. The call rate hovered around the upper bound of the LAF corridor till July 2010 as deficit liquidity conditions persisted due to the high Central Government cash balances. The call rate declined towards the end of August and early September with the easing of liquidity conditions. As the transmission of higher policy interest rates increasingly became effective and the liquidity conditions tightened, the call rate again firmed up from the middle of September 2010, and breached the upper bound of the informal LAF corridor. With a view to containing volatility in the call rate, the LAF corridor was reduced from 150 bps to 100 bps in two stages since July 2010(Chart V.3). The call rate has hovered around the upper bound of the informal corridor during October 2010.

V.8 Rates in the collateralised segments continued to move in tandem with the call rate, albeit below it, during the second quarter of 2010-11. Transaction volumes in the collateralised borrowing and lending obligation (CBLO) and market repo segments remained high during this period reflecting active market conditions (TableV.3). As in the previous quarter, banks continued to remain the major borrowers in the collateralised segment whereas mutual funds (MFs) remained the major lenders of funds in that segment. The share of MFs in the total lending in the collateralised segment declined during June-August 2010 from the level in April-May 2010. The collateralised segment of the money market continued to remain the predominant segment, accounting for more than 80 per cent of the total volume during the second quarter of 2010-11.

V.9 The average fortnightly issuance of certificates of deposit (CDs) remained higher during the second quarter as compared with the previous quarter. The higher issuance of CDs is reflective of banks’ efforts to raise bulk deposits at lower cost as deposit interest rates started moving northward. In line with the movement of rates in other money market segments, the weighted average discount rate (WADR) of CDs increased. The average fortnightly issuance of Commercial Paper (CPs) also remained higher during the second quarter as compared with the previous quarter. ‘Leasing and Finance’ and manufacturing corporates were major issuers of CPs (Table V.4). The higher issuance of CPs suggests efforts by the commercial sector to raise resources from alternative sources of finance in the face of tight liquidity conditions. The WADR in CPs also increased during the quarter.

Government Securities Market

V.10 Reflecting the policy of front loading of market borrowings during the first half of the year, the Government of India has completed 63 per cent of its borrowing programme for 2010-11, ensuring that there is no crowding-out in the latter half of the year when the private credit demand is normally robust. While the average maturity of debt issuances increased during 2010-11 (up to September 2010), the weighted average yield also firmed up as compared to the corresponding period of the previous year (Table V.5). In case of borrowings by the states, 18 states have raised `49,362 crore on a gross basis during the first half of the year, which constituted about 32 per cent of the gross allocation for 27 States under the scheme of borrowings for 2010-11 as compared with 53.5 per cent during the corresponding period of 2009-10.

V.11 The prevalence of tight liquidity conditions on account of outflow following the 3G/BWA auctions and the rise in policy rates have resulted in an upward movement in the primary market yields for short and medium term securities, while some softening was observed at the longer end during the second quarter in anticipation of reduction in governments’ market borrowings.

V.12 Taking into account the need for fiscal consolidation and other additional revenues generated so far for financing the fiscal deficit, the net market borrowings of the Government of India have been scaled down by `10,000 crore as per the indicative borrowing calendar issued for the second half of 2010-11. Based on the demand pattern of the market participants as also the scope for issuance of securities in different maturities, the maturity profile of dated securities is set to be elongated in the calendar. As regards the States borrowings, about one third of the gross allocations for the States have been raised till the end of the second quarter. Taking into account the comfortable cash balances of the State Governments and the borrowing programme adopted by the States so far, it appears that there may be a moderation in their borrowings during the current financial year. It is expected that the calibrated strategies adopted in the borrowing programme of the Government of India and the State Governments would ensure its completion in a non-disruptive manner.

V.13 The yield on 91-day Treasury Bills firmed up by 81 basis points between June and September 2010, whereas the yield on both 182-day and 364-day Treasury Bills increased by 110 bps during the same period (Table V.6). Keeping in view the comfortable cash balance of the Government of India, the Reserve Bank, in consultation with the GoI, scaled down the notified amount of Treasury Bills during the second quarter. In addition, an amount of `9,614 crore was bought back by the Government as part of the cash management operations during the quarter.

V.14 During Q2 of 2010-11, the G-Sec yields generally hardened till the third week of August 2010 amidst intermittent easing. The hardening of yields was mainly on account of hike in policy rates, tight liquidity conditions and high inflation. Thereafter, the yields declined as liquidity conditions improved and concerns over Euro area receded. Although liquidity conditions tightened towards the middle of September against the backdrop of quarter-end advance tax outflows, the increase in the investment limits of FIIs in the government securities and corporate bonds and lower than budgeted borrowing programme for the second half of the current fiscal year provided fillip to the market (Chart V.4). During the month of October 2010, the yields have risen on account of inflationary concerns and tight liquidity conditions.

Credit Market

V.15 The spreads on corporate bonds over the government bond yield declined further in Q2 of 2010-11 over the levels in Q1 of 2010-11, partly reflecting further reduction in risk perception for corporates due to improved growth outlook as well as lower inflationary expectations (Chart V.2c).

V.16 As part of the calibrated exit, Reserve Bank increased its repo rate by 125 bps, reverse repo by 175 bps and CRR by 100 bps during February-September 2010. In response to these policy rate changes, 72 SCBs raised their deposit rates in the range of 25-125 bps during February- October 15, 2010 across various maturities (Table V.7). On the lending side, the benchmark prime lending rates (BPLR) of SCBs remained unchanged between July 2009 and July 2010. Thereafter, several SCBs increased their BPLR in the range of 25-75 bps during July-September, 2010.

V.17 In line with hike in policy rates, several banks increased their Base Rates by 10-50 basis points by October 2010. As many as 53 banks with a share of 94 per cent in total bank credit have fixed their Base Rates in the range of 7.50-8.50 per cent, indicating convergence in the Base Rates announced by banks.

Foreign Exchange Market

V.18 The Indian rupee exhibited twoway movement against major international currencies during Q2 of 2010-11. It appreciated against the US Dollar, while depreciated against the Pound Sterling, Euro and Japanese Yen. During the quarter, the rupee exhibited depreciating trend against the US dollar up to the third week of July 2010 and thereafter remained largely range bound during August 2010. The Rupee has generally appreciated since the first week of September 2010 on the back of pick-up in capital inflows and strengthening of growth outlook (Chart V.5a). The 1-month as well as 3-month forward premia increased during the quarter (Chart V.5b).

V.19 The turnover in both inter-bank and merchant segments of the forex market declined during July 2010 and recovered thereafter since August 2010 (Chart V.6).

Equity and Housing Markets

V.20 Stock prices continued the bullish trend during July-September on the back of strong FII investments in equities. India, along with other EMEs experienced strong portfolio inflows as interest rate differential between these countries and advanced economies turned more lucrative. Strong macroeconomic fundamentals in the Indian markets, buoyancy in the industrial and services sector as also possibility of further increase in rural demand on expected better performance of the agricultural sector were some of the pull factors responsible for the FII inflows. As at end-September 2010, the Sensex and the Nifty both registered gains of 14.5 per cent and 14.9 per cent, respectively, over end- March 2010 (Table V.8).

V.21 The activity in the primary segment of the domestic capital market continued to display signs of buoyancy during April- September 2010. The resources raised through public issues increased marginally during April-September 2010 as compared to the corresponding period last year (Table V.9). Mobilisation of resources through private placement (`92,787 crore) also increased by 20.5 per cent during April-June 2010. The resource mobilisation by mutual funds was lower during April-September 2010 as compared to previous year due to constrained liquidity conditions and withdrawal of money by banks and corporates from mutual funds for the 3G/ BWA auction.

V.22 The FIIs were net buyers and mutual funds turned net sellers during April-October 2010. Net FII investment in Indian equities, which was subdued during April-June 2010 increased significantly during July-October 2010, encouraged by strong growth prospects of the Indian economy and improved global liquidity conditions (Chart V.7a). The FII investments in stock markets resulted in buoyant market conditions as well as increase in turnover in both cash and derivative segments (Chart V.7b).

V.23 The quarterly House Price Index (HPI) for various centres based on data collected from the Department of Registration and Stamps (DRS) suggests that property prices are picking up in most tier I cities though some slowdown is witnessed in tier II cities (Chart V.8a). According to these data, prices in Mumbai in the last three quarters are showing moderate growth, while prices in Delhi are growing at a faster rate, which partly reflects activities relating to the Commonwealth Games. The number of transactions in Mumbai, which had registered a sharp rise in Q3 of 2009-10 seem to have reached a plateau. Housing prices in Bengaluru, which were almost flat for the past one and half years, are showing some signs of increase. This was also corroborated by the trends on NHB Residential Price Index (Chart V.8b).

V.24 The growing risk perceptions and uncertainty in the global markets impacted Indian financial markets through two different channels viz. pressure for appreciation of the Indian Rupee and rise in equity prices due to sharp rise in portfolio flows. Despite global market uncertainties, domestic markets functioned normally, with stable volumes and lower volatility. The transmission of higher policy rates were visible in higher issuances of CDs, CPs as also higher yields on TBs and G-Sec and even in deposit rates. Lending rates have also started to move up, with a lag. In the Base Rate environment, there have been signs of corporates increasing their dependence on the CPs market. Banks have also used the CDs route to mobilise bulk deposits. Given the outlook for possible significant large increase in portfolio flows to EMEs in the near term, their impact on exchange rate and asset prices will have to be closely monitored because of their implications for domestic inflation and external competitiveness.