ROLE OF ECONOMIC REFORMS IN THE GROWTH OF INDIAN MONEY MARKET SINCE 2000

SUBMITTED IN PARTIAL REQUIRMENT FOR THE FULFILMENT OF THE AWARD OF POST GRADUATE DIPLOMA IN BUSINESS FINANCE (PGDBF)

SUBMITTED BY ADNAN KHUSRO WASTI EE-1595 09-DBF-13 SUBMITTED TO PROF. ABDUL QUAYYUM KHAN DEPTT. OF COMMERCE AMU,ALIGARH

Certificate

This is to certify that Mr. Adnan Khusro Wasti , bearing Roll no. 09-DBF-13 and Enrollment No.EE-1595 has completed his dissertation entitled Role of Economic Reforms In Indian Money Market Since 2000 under my supervision and guidance in partial fulfillment of the requirements for the award of the degree of P.G. Diploma In Business Finance (PGDBF). The work is suitable for the award of the degree of P.G. Diploma in Business Finance of the Department of Commerce, AMU, Aligarh.

Prof. Abdul Quayyum Khan (Supervisor)

Dedicated To My Parents & My Family

Contents

Acknowledgement

Introduction Chapter-1 Economic Reforms in Indian Money Market Since 2000

Chapter-2 Regulations of Money Market in India Chapter-3 Money Market and its Instruments

Chapter-4 Future Prospects and Strategies for Indian Money Market

Chapter-5 Conclusions and Suggestions

Bibliography

ACKNOWLEDGEMENT I have first to bow myself in front of the Almighty ALLAH for his constant shower of blessings which made this task accomplish bearing all phases of ups and downs. It is my proud privilege to acknowledge my deep gratitude to my supervisor Prof. Dr Abdul Qayyum Khan Professor, Department of Commerce, A.M.U., Aligarh, for this

dissertation. I am deeply indebted to him for his most valuable supervision , keen interest, kind cooperation and devotion of his precious time at all stages of the work. I am also indebted to Prof. Badar Alam Iqbal, Chairman ,Department of Commerce, A.M.U. and Prof. Sibghatullah Farooqi , Dean, Department of Commerce A.M.U. for their constant guidance, assistance and encouragement at all levels of the work. I would like to thanks Mr. Anis Ahmad and my friends Faizan & Zuhaib for their contribution and support. At last but not the least, all my thanks and words of praise fall short to convey my sincerest indebtedness to my parents and family members for their support and continuous encouragement.

ADNAN KHUSRO WASTI Roll. No. 09-DBF-13 Enrolment No. EE-1595

CHAPTER-1 Money Market and its Instruments

INTRODUCTION

Meaning of Money Market: Money market refers to the market where money and highly liquid marketable securities are bought and sold having a maturity period of one or less than one year. It is not a place like the stock market but an activity conducted by telephone. The money market constitutes a very important segment of the countrys financial system. The highly liquid marketable securities are also called as money market instruments like treasury bills, government securities, commercial paper, certificates of deposit, call money, repurchase agreements etc. The major player in the money market are central Bank of a country, like in indian money market the Reserve bank of India plays an important role in regulating its affairs and acts as an apex body beside RBI there are other institutions also like Discount and Finance House of India (DFHI), banks, financial institutions, mutual funds, government, big corporate houses. The basic aim of dealing in money market instruments is to fill the gap of short-term liquidity problems or to deploy the short-term surplus to gain income on that. Definition of Money Market: According to the McGraw Hill Dictionary of Modern Economics, money market is the term designed to include the financial institutions which handle the purchase, sale, and transfers of short term credit instruments. The money market includes the entire machinery for the channelizing of short-term funds. Concerned primarily with small business needs for working capital, individuals borrowings, and government short term obligations, it differs from the long term or capital market which devotes its attention to dealings in bonds, corporate stock and mortgage credit. According to the Reserve Bank of India, money market is the centre for dealing, mainly of short term character, in money assets; it meets the short term requirements of borrowings and provides liquidity or cash to the lenders. It is the place where short term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers agents comprising institutions and individuals and also the government itself.

According to the Geoffrey, money market is the collective name given to the various firms and institutions that deal in the various grades of the near money. Objectives of Money Market: A well developed money market serves the following objectives: Provides an equilibrium mechanism for ironing out short-term surplus and deficits. Provides a focal point for central bank intervention for the influencing liquidity in the economy. Provides access to the users of short-term money to meet their requirements at a reasonable price. General Characteristics of Money Market: The general characteristics of money market are outlined below: Short-term funds are borrowed and lent. No fixed place for conduct of operations, the transactions being conducted even over the phone and therefore, there is an essential need for the presence of well developed communications system. Dealings may be conducted with or without the help of the brokers. The short-term financial assets that are dealt in are close substitutes for money, financial assets being converted into money with ease, speed, without loss and with minimum transaction cost. Funds are traded for a maximum period of one year. Presence of a large number of submarkets such as inter-bank call money, bill rediscounting, and treasury bills, etc. Indian money market:

Till 1935, when the RBI was set up the Indian money market remained highly disintegrated, unorganized, narrow, shallow and therefore, very backward. The planned economic development that commenced in the year 1951 market an important beginning in the annals of the Indian money market. The nationalization of banks in 1969, setting up of various committees such as the Sukhmoy Chakraborty Committee (1982), the Vaghul working group (1986), the setting up of discount and finance house of India ltd. (1988), the securities trading corporation of India (1994) and the commencement of liberalization and globalization process in 1991 gave a further fillip for the integrated and efficient development of India money market. The Indian money market is not an integrated unit. It is broadly divided into two parts the organised and unorganised sector. There is compartmentalisation between the two sectors and as such the rate of interest different in organised sector as compared to that of unorganised. The unorganised sector comprises of primarily indigenous bankers and money lenders. Money lenders and indigenous bankers differs from one another in many aspects, their organisation and operations are not same and have very little business relations with each other that is totally different from modern banking system. On the other hand the organised sector of Indian money market is fairly integrated in one. Both the nationalised and commercial banks constitute the core of this sector. The Reserve bank of India(RBI), foreign banks, co-operative banks, Discount and Finance house of india(DFHI), other discounting and finance institutions like IDBI, ICICI, IFCI etc. investment finance companies like LIC, GIC, UTI and mutual funds market operates in this sector. The RBI is the apex institution in Indian money market and hence it leads and controls the money market and keeps a keen insight on its functioning,it has great responsibility in smooth functioning of financial system of the country especially in terms of money market. Since the Reserve Bank of India is the most important constituent of the money market and the market comes within the direct preview of the Reserve Bank of India regulations. Therefore the aims of the Reserve Banks operations in the money market are as follows: To ensure that liquidity and short term interest rates are maintained at consistent levels with the monetary policy objectives of maintaining price stability.

To ensure an adequate flow of credit to the productive sector of the economy and, To bring about order in the foreign exchange market . The Reserve Bank of India influence liquidity and interest rates through a number

of operating instruments - cash reserve requirement (CRR) of banks, conduct of open market operations (OMOs), repos, change in bank rates and at times, foreign exchange swap operations. Composition of indian money market: The Indian money market has been catagorised into unorganised and organised sectors . The unorganised sector consists of indigenous bankers who pursue the banking business on traditional lines and non banking financial corporations (NBFCs). The organised sector comprises of RBI, the SBI and its associate banks, 20 nationalised banks and other commercial banks (both Indian & foreign) The organised money market in india has a number of sub-markets the treasury bill market, the commercial bill market & the inter-bank call money market. Un-organised sector of indian money market: The banking facilities of un-organised sector is mainly confined and specific to small towns and villages where modern banking facilities are still inadequate. Farmers, artisans and other small scale producers and traders who do not have access to modern banks borrows money from this sector. In India, there are several types of unregulated non-banking financial intermederies among these the most prominent are money lenders, indigenous bankers, chit funds and nidhis. These non-banking financial intermederies mostly give loans and advances to farmers, artisans, wholesale traders and other self-employed people and charge high rate of interest varying from 36% to 48%. The chit funds are saving institutions and has regular members who made periodical subscriptions to the funds. The nidhis are somewhat like mutual funds as their dealings

are restricted only to the members, it operates in unregulated credit market and the principal source of deposits is deposits from members. Indigenous bankers are individual or private firms which deposit and advances loans and thus operates as banksbeside facing stiff competition from commercial and co-operative banks the indigenous bankers manages to survive because the loans provided by organised sector does not meet the needs of manufacturers and small traders adequately. Secondly, a part of loans provided by indigenous bankers is in the form of clear advances which is of great value to small borrowers. Finally, indigenous bankers offers personalized, informal and prompt servicest to borrowers. Money lenders on the other hand do not receive deposits and the amount they lend are mostly their own, they rarely borrows from banks. They generally gave advances to poor and weaker section of society who do not have enough bargaining power, they charges high rate of interests and also indulged in malpractices. The financial activities performed in un-organised sector is unsupervised and unregulated due to which the borrowers have been exploited by the lenders. Organised sector of Indian money market: Organised sector comprises of RBI, SBI and its subsidiaries, commercial banks and submarket. As the RBI is the apex institution in money market it regulates its functioning in terms of overall volume of money and credit, it also promotes development of financial infrastructure of market and also supervise, regulates and guides the functioning of commercial banks and acts as bankers bank. Commercial banks are the backbone of the countrys financial system and plays a vital role in nations economic growth and development.they creates credit andare the most important depositors and disburser of public finance by performing two major roles of mobilizing and lending the financial resources. The sub-market comprises of call money market, treasury bill market, repo market, commercial bill market, certificates of deposits market, commercial papers market acceptance market and money market mutual funds. Instruments of money market:

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Investment in money market is done through money market Instruments. Money market instrument meets short term requirements of the borrowers and provides liquidity to the lenders. Common Money Market Instruments are as follows: Treasury Bills (T-Bills): Treasury Bills, one of the safest money market instruments, are short term borrowing instruments of the Central Government of the Country issued through the Central Bank (RBI in India). They are zero risk instruments, and hence the returns are not so attractive. It is available both in primary market as well as secondary market. It is a promise to pay a said sum after a specified period. T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three-month, six-month and one-year maturity periods. The Central Government issues T- Bills at a price less than their face value (par value). They are issued with a promise to pay full face value on maturity. So, when the T-Bills mature, the government pays the holder its face value. The difference between the purchase price and the maturity value is the interest income earned by the purchaser of the instrument. T-Bills are issued through a bidding process at auctions. The bid can be prepared either competitively or non-competitively. In the second type of bidding, return required is not specified and the one determined at the auction is received on maturity. Whereas, in case of competitive bidding, the return required on maturity is specified in the bid. In case the return specified is too high then the T-Bill might not be issued to the bidder. At present, the government of India issues three types of treasury bills through auctions, namely, 91-day, 182-day and 364-day. There are no treasury bills issued by State Governments. Treasury bills are available for a minimum amount of Rs.25K and in its multiples. While 91-day T-bills are auctioned every week on Wednesdays, 182-day and 364- day T-bills are auctioned every alternate week on Wednesdays. The Reserve Bank of India issues a quarterly calendar of T-bill auctions which is available at the Banks website. It also announces the exact dates of auction, the amount to be auctioned and payment dates by issuing press releases prior to every auction. Payment by allottees at the auction is required to be made by debit to their custodians current account. T-bills auctions are held on the Negotiated Dealing System (NDS) and the members electronically submit their bids on the system. NDS is an

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electronic platform for facilitating dealing in Government Securities and Money Market Instruments. RBI issues these instruments to absorb liquidity from the market by contracting the money supply. In banking terms, this is called Reverse Repurchase (Reverse Repo). On the other hand, when RBI purchases back these instruments at a specified date mentioned at the time of transaction, liquidity is infused in the market. This is called Repo (Repurchase) transaction. Repurchase Agreements: Repurchase transactions, called Repo or Reverse Repo are transactions or short term loans in which two parties agree to sell and repurchase the same security. They are usually used for overnight borrowing. Repo/Reverse Repo transactions can be done only between the parties approved by RBI and in RBI approved securities viz. central government and State Govt Securities, T-Biliis, government bonds, Corporate bonds etc. Under repurchase agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date at a predetermined price. Such a transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities. Thus, whether a given agreement is termed as a Repo or Reverse Repo depends on which party initiated the transaction. The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counterparty. Effectively the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions. Commercial Papers: Commercial paper is a low-cost alternative to bank loans. It is a short term unsecured promissory note issued by corporate and financial institutions at a discounted value on face value. They are usually issued with fixed maturity between one to 270 days and for financing of accounts receivables, inventories and meeting short term liabilities. Say, for

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example, a company has receivables of Rs 1 lacs with credit period 6 months. It will not be able to liquidate its receivables before 6 months. The company is in need of funds. It can issue commercial papers in form of unsecured promissory notes at discount of 10% on face value of Rs 1 lacs to be matured after 6 months. The company has strong credit rating and finds buyers easily. The company is able to liquidate its receivables immediately and the buyer is able to earn interest of Rs 10K over a period of 6 months. They yield higher returns as compared to T-Bills as they are less secure in comparison to these bills; however chances of default are almost negligible but are not zero risk instruments. Commercial paper being an instrument not backed by any collateral, only firms with high quality credit ratings will find buyers easily without offering any substantial discounts. They are issued by corporates to impart flexibility in raising working capital resources at market determined rates. Commercial Papers are actively traded in the secondary market since they are issued in the form of promissory notes and are freely transferable in deemat form. Certificate of Deposit: It is a short term borrowing more like a bank term deposit account. It is a promissory note issued by a bank in form of a certificate entitling the bearer to receive interest. The certificate bears the maturity date, the fixed rate of interest and the value. It can be issued in any denomination. They are stamped and transferred by endorsement. Its term generally ranges from three months to five years and restricts the holders to withdraw funds on demand. However, on payment of certain penalty the money can be withdrawn on demand also. The returns on certificate of deposits are higher than T-Bills because it assumes higher level of risk. While buying Certificate of Deposit, return method should be seen. Returns can be based on Annual Percentage Yield (APY) or Annual Percentage Rate (APR). In APY, interest earned is based on compounded interest calculation. However, in APR method, simple interest calculation is done to generate the return. Accordingly, if the interest is paid annually, equal return is generated by both APY and APR methods. However, if interest is paid more than once in a year, it is beneficial to opt APY over APR. Bankers Acceptance:

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It is a short term credit investment created by a non financial firm and guaranteed by a bank to make payment. It is simply a bill of exchange drawn by a person and accepted by a bank. It is a buyers promise to pay to the seller a certain specified amount at certain date. The same is guaranteed by the banker of the buyer in exchange for a claim on the goods as collateral. The person drawing the bill must have a good credit rating otherwise the Bankers Acceptance will not be tradable. The most common term for these instruments is 90 days. However, they can very from 30 days to180 days. For corporations, it acts as a negotiable time draft for financing imports, exports and other transactions in goods and is highly useful when the credit worthiness of the foreign trade party is unknown. The seller need not hold it until maturity and can sell off the same in secondary market at discount from the face value to liquidate its receivables.

Reference: Indian Financial System (2004) By Bharati V. Pathak. Financial Service and Market (2005) -By Dr.S.Guruswamy. Money and Banking (Chartered And Financial Analyst Of India) Edition April 2009. Financial Institution and Market (2007)- Bhole, L.M. Money and Banking (2005)- Mithani D. M.

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CHAPTER-2 Economic reforms in Indian Money market (With special reference from 2000)

Need for Reforms The Indian financial system of the pre-reform period essentially catered to the needs of planned development in a mixed-economy framework where the government sector had a predominant role in economic activity. As part of planned development, the macro-economic policy in India moved from fiscal neutrality to fiscal activism. Such activism meant large developmental expenditures, much of it to finance long-gestation projects fine rates, and understandably at below the market rates for private sector. In order to facilitate the large borrowing requirements of the Government, interest rates on Government securities were artificially pegged at low levels, which were unrelated to market conditions. The government securities market, as a result, lost its depth as the concessional rates of interest and maturity period of securities essentially reflected the needs of the issuer (Government) rather than the perception of the market. The provision of fiscal accommodation through ad hoc treasury bills (issued on tap at 4.6 per cent) led to high levels of monetization of fiscal deficit during the major part of the eighties. In order to check the monetary effects of such large-scale monetization, the cash reserve ratio (CRR) was increased frequently to control liquidity. The environment in the financial sector in these years was thus characterized by segmented and underdeveloped financial markets coupled with paucity of instruments. The existence of a complex structure of interest rates arising from economic and social concerns of providing concessional credit to certain sectors resulted in cross subsidization which implied that higher rates were charged from non-concessional borrowers. The regulation of lending rates, led to regulation of deposit rates to keep cost of funds to banks at reasonable levels, so that the spread between cost of funds and return on funds is maintained. The system of administered interest rates was characterized by

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detailed prescription on the lending and the deposit side leading to multiplicity and complexity of interest rates. By the end of the eighties, the financial system was considerably stretched. The directed and concessional availability of bank credit with respect to certain sectors resulted not only in distorting the interest rate mechanism, but also adversely affected the viability and profitability of banks. The lack of recognition of the importance of transparency, accountability and prudential norms in the operations of the banking system led also to a rising burden of non-performing assets. In sum, there was a de facto joint family balance sheet of Government, RBI and commercial banks, with transactions between the three segments being governed by plan priorities rather than sound principles of financing inter-institutional transactions. There was a widespread feeling that this joint family approach, which sought to enhance efficiency through coordinated approach, actually led to loss of transparency, of accountability and of incentive to measure or seek efficiency. The policies pursued did have many benefits, although the issue of the higher costs incurred to realize the laudable objectives remains. Thus, the post-nationalization phase witnessed significant branch expansion to mobilize savings and there was a visible increase in the flow of bank credit to important sectors like agriculture, small-scale industries, and exports. However, these achievements have to be viewed against the macro-economic imbalances as well as gross inefficiencies at the micro level in the financial sector compounded by non- transparent accounting of intra-public financial transactions.

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Institutional Aspects of Reforms Institutions At present, the institutional structure of the financial system is characterized by banks, either owned by the Government public or private (domestic or foreign) and regulated by the RBI; development financial institutions and refinancing institutions, set up either by a separate statute or under Companies Act, either owned by Government, RBI, private or other development financial institutions and regulated by the RBI and non-bank financial companies (NBFCs), owned privately and regulated by the RBI. Since the onset of reforms, there has been a change in the ownership pattern of banks. The legislative framework governing public sector banks (PSBs) was amended in 1994 to enable them to raise capital funds from the market by way of public issue of shares. Many public sector banks have accessed the markets since then to meet the increasing capital requirements, and until 2001-02, Government made capital injections out of the Budget to public sector banks, totaling about 2 per cent of GDP. The Government has initiated legislative process to reduce the minimum Government ownership in nationalized banks from 51 to 33 per cent, without altering their public sector character. The underlying rationale of the proposal appears to be that the salutary features of public sector banking is not in the transformation process. Reforms have altered the organizational forms, ownership pattern and domain of operations of financial institutions (FIs) on both the asset and liability fronts. Drying up of low cost funds has led to an intensification of the competition for resources for both banks and FIs. At the same time, with banks entering the domain of term lending and FIs making a foray into disbursing short-term loans, advisory services and the like. Currently, while Industrial Credit and Investment Corporation of India Ltd. (ICICI) is in the process of finalizing its merger with ICICI Bank, Industrial Development Bank of India (IDBI) is also expected to be corporatized soon. At present, the RBI holds shares in a number of institutions. The further reform agenda is to divest the RBI of all its ownership functions. In the light of legal amendments in 1997, the regulatory focus of the NBFCs was redefined, both in terms of thrust as well as the focus. While NBFCs accepting public deposits have been subject to the entire gamut of regulations, those not accepting public

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deposits have been sought to be regulated in a limited manner. In order to consolidate the law relating to the NBFCs, regulation is being framed to cover detailed norms with regard to entry point and the regulatory and supervisory issues. Competition Steps have also been initiated to infuse competition into the financial system. The RBI issued guidelines in 1993 is respect of establishment of new banks in the private sector. Likewise, foreign banks have been given more liberal entry. Recently, the norms for entry of new private banks were rationalized . Two new private sector banks have been given in-principle approval under these revised guidelines. The Union Budget 2002-03 has also provided a fillip to the foreign banking segment, permitted these banks, depending on their size, strategies and objectives, to choose to operate either as branches of their overseas parent or corporatize as domestic companies. This is expected to impart greater flexibility in their operations and provide them with a level-playing field vis--vis their domestic counterparts. As a group, however, the performance of PSBs in terms of profitability, spreads, non-performing assets and standard assets position seems to have been lower than that of the new private sector and foreign banks. There have been significant divergences in performance among the public sector banks - some have performed on par with private and foreign banks, whereas the performance of others has been relatively unsatisfactory. Hence, although PSBs have been subject to Government intervention, these do not appear to provide a complete explanation of bank performance. Bank specific factors such as rapid expansion, higher operating costs and differential industry focus seem to have been important considerations as well. Public sector banks operating in the same environment with the same constraints have shown varied performance; ultimately this reflects the performance of management. Regulation and Supervision A second major element of financial sector reforms in India has been a set of prudential measures aimed at imparting strength to the banking system as well as

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ensuring safety and soundness through greater transparency, accountability and public credibility. Capital adequacy norms for banks are in line with the Basel Committee standards and from the end of March 2000, the prescribed ratio has been raised to 9 percent. While the objective has been to meet the international standards, in certain cases, fine-tuning has occurred keeping in view the unique country-specific circumstances. For instance, risk weights have been prescribed for investment in Central Government securities on considerations of interest rate risk. Also, while there is a degree of gradualism, there is intensification beyond the 'best practices' in several instances in recent period, an example being exposure norms stipulated for the banking sector in respect of investment in equity. Investments are valued and classified into appropriate categories, as per international best practices. To take into account the vagaries of interest rate risks, a prescription for meeting a targeted Investment Fluctuation Reserve out of the realized profits from sale of investments within a stipulated time frame has also been prescribed recently. The supervisory strategy of the Board for Financial Supervision (BFS) constituted as part of reform consists of a four-pronged approach, including restructuring system of inspection, setting up of off-site surveillance, enhancing the role of external auditors, and strengthening corporate governance, internal controls and audit procedures. The BFS, in effect, integrates within the Reserve Bank the supervision of banks, NBFCs and financial institutions. Prudential regulations have had a significant impact on the banking system in terms of ensuring system stability even in the face of both external and internal uncertainties, almost throughout during the second half of the nineties. As at end-March 2001, 95 out of 100 scheduled commercial banks had capital adequacy ration of 9 per cent or more. There was a distinct improvement in the profitability of public sector banks measured in terms of operating profits as well as in terms of net profits to total assets. Reflecting the efficiency of the intermediation process, there has been a decline in the spread between the borrowing and lending rates as reflected by the decline in the ratio of net interest income to total assets. The most significant improvement has been in terms of reduction in NPAs.

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Policy Environment Changing Monetary Policy Framework Since the onset of the reforms process, monetary management in terms of framework and instruments has undergone significant changes, reflecting broadly the transition of the economy from a regulated to liberalized and deregulated regime. While the twin objectives of monetary policy of maintaining price stability and ensuring availability of adequate credit to productive sectors of the economy to support growth have remained unchanged; the relative emphasis on either of these objectives has varied over the year depending on the circumstances. Reflecting the development of financial markets and the opening up of the economy, the use of broad money as an intermediate target has been de-emphasized, but the growth in broad money continues to be used as an important indicator of monetary policy. The composition of reserve money has also changed with net foreign exchange assets currently accounting for nearly one-half. A multiple indicator approach was adopted in 1998-99 and further renewed in 2002-2003, wherein interest rates or rates of return in different markets (money, capital and government securities markets) along with such data as on currency, credit extended by banks and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange available on high frequency basis were juxtaposed with output data for drawing policy perspectives. Such a shift was gradual and a logical outcome of measures taken over the reform period since early nineties. The thrust of monetary policy in recent years has been to develop an array of instruments to transmit liquidity and interest rate signals in the short-term in a more flexible and bidirectional manner. A Liquidity Adjustment Facility (LAF) has been introduced since June 2000 to precisely modulate short-term liquidity and signal short-term interest rates. The LAF, in essence, operates through repo and reverse repo auctions thereby setting a corridor for the short-term interest rate consistent with policy objectives. There is now greater reliance on indirect instruments of monetary policy. The RBI is able to modulate the large market borrowing programme by combining strategic debt management with active open market operations. Bank Rate has emerged as a reasonable signally rate while the LAF rate has emerged as both a tool for liquidity management and signaling of 20

interest rates in the overnight market. The RBI has also been able to use open market operations effectively to manage the impact of capital flows in view of the stock of marketable Government securities at its disposal and development of financial markets brought about as part of reform. The responsibility of the RBI in undertaking reform in the financial markets has been driven mainly by the need to improve the effectiveness of the transmission channel of monetary policy. The developments of financial markets have therefore, encompassed regulatory and legal changes, building up of institutional infrastructure, constant finetuning in market microstructure and massive upgradation of technological infrastructure. Since the onset of reforms, a major focus of architectural policy efforts has been on the principal components of the organized financial market spectrum: the money market, which is central to monetary policy, the credit market, which is essential for flow of resources to the productive sectors of the economy, the capital market, or the market for long-term capital funds, the Government securities market which is significant from the point of view of developing a risk-free credible yield curve and the foreign exchange market, which is integral to external sector management. Along with the steps taken to improve the functioning of these markets, there has been a concomitant strengthening of the regulatory framework. The medium-term objective at present is to make the call and term money market purely inter-bank market for banks, while non-bank participants, who are not subject to reserve requirements, can have free access to other money market instruments and operate through repos in a variety of instruments. The Clearing Corporation of India Ltd is expected to facilitate the development of a repo market in a risk free environment for settlement. A phased programme for moving out of the call money market has already been announced and the final phase-out will coincide with the implementation of the Real Time Gross Settlement (RTGS) system. Further reform is being contemplated in terms of reduction of CRR to the statutory minimum of 3 per cent, removal of established lines of refinance, limits on call money borrowing lending and borrowing by banks and PDs and a move over to a full-fledged LAF. With the switchover to borrowings by Government at market related interest rates through auction system in 1992 and then again revised in 2004 it was possible to progress towards greater market orientation in Government

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securities. Further reforms in the Government Securities market have resulted in the rationalization of T-Bills market, increase in instruments and participants, elongated the maturity profile, created greater fungibles in the secondary market, instituted a system of delivery versus payment, strengthened the institutional framework through Primary Dealers and more recently Clearing Corporation, and enhanced the transparency in the market operations. Clarity in the regulatory framework has also been established with the amendment to the Securities Contracts Regulation Act. A Negotiated Dealing System for trading in Government Securities is in operation. Further developments in the Government Securities market hinges on legislative changes consistent with modern technology and market practices; introduction of a RTGS system, integrating the payments and settlement systems for Government securities and standardization of practices with regard to manner of quotes, conclusion of deals and code of best practices for repo transactions. The movement to a market-based exchange rate regime took place in 1993. Reforms in the foreign exchange market have focused on market development with prudential safeguards without destabilizing the market. Thus, authorized dealers have been given the freedom to initiate trading position in the overseas markets; borrow or invest funds in the overseas markets (up to 15 percent of tier I capital, unless otherwise approved); determine the interest rates (subject to a ceiling) and maturity period of Foreign Currency Non-Resident (FCNR) deposits (not exceeding three years); and use derivative products for assetliability management. These activities are subject to net overnight position limit and gap limits, to be fixed by them. Other measures such as permitting forward cover for some participants, and the development of the rupee-forex swap markets also have provided additional instruments to hedge risks and help reduce exchange rate volatility. Alongside the introduction of new instruments (cross-currency options, interest rates and currency swaps, caps/collars and forward rate agreements), efforts were made to develop the forward market and ensure orderly conditions. Foreign institutional investors were allowed entry into forward markets and exporters have been permitted to retain a progressively increasing proportion of their earnings in foreign currency accounts. The RBI conducts purchase and sale operations in the forex market to even out excess volatility.

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In respect of the financial markets, linkage between the money, Government Securities and forex markets has been established and is growing. The price discovery in the primary market is more credible than before and secondary markets have acquired greater depth and liquidity. The number of instruments and participants in the markets has increased in all markets, the most impressive being the Government Securities market. The institutional and technological infrastructures that have been created by the RBI to enable transparency in operations and secured settlement systems. The presence of foreign institutional investors has strengthened the integration between the domestic and international capital markets. Credit Delivery The reforms have accorded greater flexibility to banks to determine both the volume and terms of lending. The RBI has moved away from micro regulation of credit to macro management. External constraints to the banking system in terms of the statutory preemptions have been lowered. All this has meant greater lendable resources at the disposal of banks. The movement towards competitive and deregulated interest rate regime on the lending side has been completed with linking of all lending rates to PLR of the concerned bank and the PLR itself has been transformed into a benchmark rate. As a result of reforms, borrowers are able to the get credit at lower interest rates. The lending rate between 1991-92 and 2001-02 has declined from about 19.0 per cent to current levels of 10.5-11.0 per cent and further in 2004-2005 to a level of 10.3 percent. The actual lending rates for top rated borrowers could even be lower since banks are permitted to lend at below Prime Lending Rate (PLR). Further, since banks invest in Commercial Paper (CP), which is more directly related to money market rates, many top rated borrowers are able to tap bank funds at rates below the prime lending rates. These developments have been possible to banks because the overall flexibility now available in the interest rate structure has enabled them to reduce their deposit rates and still improve their spreads. In terms of priority sector credit also, the element of subsidization has been removed although some sort of directed lending to Agriculture, Small Scale Industry (SSI) and export sector have been retained. The definition of priority sector has been gradually increased to help banks make loans on commercially viable terms. However, the actual

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experience has been that the credit pick up is not up to the mark and has been generally less than projected by the RBI in its monetary policies, in a number of years. Also, while in general the rates of interest have come down, they are available more to highly rated borrowers than to the small and medium enterprises. There is considerable concern about the inadequate flow of resources to rural areas, and in particular agriculture, while interest rates have not been reduced to the extent they were, for the corporate sector. Fiscal Policy and Financial Sector There are several channels that link the fiscal and financial sectors and in the Indian context five of them appear significant. These relate to (a) governments borrowing programme; (b) guarantees extended by governments; (c) mechanisms such as direct debits; and (d) governments investments in financial sector. The market borrowing programme of the central government continued to be relatively large, both in gross and net terms. Since a large part of the borrowing programme has to be completed in the first half of the fiscal year, in view of seasonality for demand for credit on private account, the monthly average borrowing by centre is around three quarters of a percent of GDP in recent years. Further, there has been an upward revision in the borrowing programme of central government during the course of every year, usually, around three quarters of a percent of GDP. It has been possible for RBI as debt manager to complete the borrowing programme while pursuing its interest rate objectives without jeopardizing external balance, by recourse to several initiatives in terms of institution, instruments, incentives and tactics. At the same time, it has been able for RBI to reduce statutory preemptions in regard to banks to the prescribed minimum of 25% of their net liabilities. The banking system, in which PSBs account for about three quarters of activity, holds majority of the outstanding stock of government securities, and currently their holdings in excess of statutory prescriptions are far in excess of the annual borrowing programme of the Central and State Governments. In any case, a large part of outstanding government securities are held by Government owned financial institutions, especially in banking and insurance sectors. RBI has so far been able to successfully reconcile the interests of Government as its debt manager and of banks as regulator and supervisor. In this regard, recognizing the importance of containing interest rate risks and widening the participant profile, RBI has prescribed an Investment Fluctuation Reserve for banks and is pursuing

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retailing of government securities. While technological, institutional and procedural bottlenecks for retailing are being overcome by RBI, some of the constraints such as tax treatment and relatively high administered interest rates do persist banking and insurance sectors. RBI has so far been able to successfully reconcile the interests of Government as its debt manager and of banks as regulator and supervisor. In this regard, recognizing the importance of containing interest rate risks and widening the participant profile, RBI has prescribed an Investment Fluctuation Reserve for banks and is pursuing retailing of government securities. While technological, institutional and procedural bottlenecks for retailing are being overcome by RBI, some of the constraints such as tax treatment and relatively high administered interest rates do persist. The conduct of borrowing programme of State Governments is, however, posing several problems. While the market borrowing programme of states in aggregate is well below a quarter of centers market borrowings, in a liberalized environment, banks cannot be compelled to subscribe to the programme. It was necessary to provide investors a premium for states paper over the centres paper of a comparable maturity. Of late, the premium is widening and differing as between states, while in the case of some states, there have been some difficulties in ensuring subscriptions. In recent years, the increases in states budgeted borrowing programme have been large with the attendant problems of garnering subscriptions. It has, however, been possible for RBI to conduct the programme without serious disruption in the markets, since some states have also begun to take initiatives to improve their fiscal profile and discharge their liabilities, especially to banks, in a timely fashion. It is necessary to recognise that size of government borrowings is only one element in public debt management, since there are other liabilities also, especially ballooning of pension liabilities. In this regard, extra budgetary transactions are also emerging, which impinge on the balance sheets of banks and other financial institutions which take an exposure on them. For example, oil bonds to settle governments dues to public sector oil companies and power bonds to settle dues from State Electricity Boards to national level power utilities fall in this category. Banks exposure to food credit, which is in the nature of funding of buffer stock operations is also relatively large at over 2.0% of GDP. RBI had been advocating that a law be passed imposing a ceiling on government borrowings as

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enabled by the Constitution, but more recently, a Bill is under contemplation for fiscal responsibility at the centre and several states. Financial intermediaries, especially banks, take exposures with a great degree of comfort when there is a sovereign guarantee. Such guarantees are often formally extended and notified as such to the legislative bodies and financial markets. RBI has encouraged governments to pass a legislation prescribing a ceiling on such guarantees and also charge a fee without exception to ensure credibility to guarantees and comfort to subscribers. Several State Governments have passed such legislations, though some are less stringent than others. In view of the magnitudes of such guarantees by many States, banks have been advised to exercise due diligence in subscribing to them. Apart from explicit guarantees, recourse is occasionally made by governments to letters of comfort which have a similar effect, and RBI has been dissuading such relatively non-transparent practices. There are, in addition, what may be termed as implicit-guarantees which have maximum linkage between fiscal and financial sectors. A predominant point of financial intermediation through banks, mutual funds, and insurance, in spite of significant reform is undertaken by publicly owned or government backed financial institutions. Hence, public tend to repose confidence with a corresponding implicit direct obligation on the part of government to protect the interests of depositors or investors. Such a reasonable expectation is not only justified on the considerations of reputational risk and the concept of holding out or backing, but also by the obligations discharged in the past by the Government of India, in several cases; some of them at the instance of regulator concerned. In some cases, banks and financial institutions seek and obtain instructions for direct debit of dues to them from government accounts to ensure the timely recovery of dues to them and thus bring about comfort through credit enhancement. Since large scale recourse to such mechanisms, especially when State Governments are under fiscal strain has the potential of eroding both the integrity of budget process and the de facto comfort to financial intermediaries, RBI has been vigorously advocating avoidance of recourse to such direct debit mechanisms. The governments have, in its asset portfolio, equity holding and some debts of financial intermediaries that they own, and financial returns on these do impact the fiscal situation. More important, whenever pockets of vulnerability arise in financial sector, the headroom

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available in the fiscal situation to provide succour to financial entities needs to be assessed. Fortunately, on present reckoning, the magnitudes of the few pockets of vulnerability appear to be manageable without undue fiscal strain. In assessing fiscal financial linkage, the scope for money financing of budgets vis--vis bond financing also needs to be considered. Since there are elements of open capital account, the maneuverability for RBI in the short-term to monetize governments deficit is severely circumscribed by the direction and magnitudes of such flows. Keeping these considerations in view, RBI and Government have agreed upon freedom to RBI to determine the extent of monetization of government budget consistent with macroeconomic stability. Financial Sector Reform and Changes in Law Any reform has both public and private dimensions, and ideally all participants should recognize the emerging new realities, assess costs and benefits and make attempts to cope. Reform outcomes should thus, be related not only to public action but also several other factors. In public action itself, there can be legal, policy and procedural aspects including subordinate legislations and institutional changes. There are possibilities of significant policy and procedural changes within a given legal framework and these need to be explored since changes in law are often difficult to get through in any democratic process. RBI has been articulating the need for appropriate changes in Law, assisting the Government in the process and has also been brining about changes in the financial sector without necessarily waiting for changes in law. Thus, several legislative measures affecting ownership of banks, IDBI, debt recovery, regulation of non banking financial companies, foreign exchange transactions and money market have been completed. Those on the anvil include measures relating to fiscal and budget management, public debt, deposit insurance, securitization and foreclosure, and prevention of money laundering. The agenda for further legal reform, as identified by several Advisory Groups relate to RBI, Banking Regulations, Companies, Chartered Accountant, Income-tax, Bankruptcy, Negotiable Instruments, Contracts, Unit Trust of India, etc.

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The legislative process is complex in a democratic set up and it will be inadvisable to rush into legislation through a big bang approach. Furthermore, many elements of economic reform and underlying legislative framework need to be harmonized. At the same time, it may not be necessary to wait for legislative framework to change to bring about some of the reforms or initiate processes to demonstrate usefulness of reformorientation. In fact, there are several examples of managing reform within constraints of law which need to be recalled. For example, there are some enabling but not mandated provisions which may or may not be used. Thus, RBI had shed its direct developmental role in the sense of money financing, by ceasing to operate on relevant provision and by and large, confining money creation for Government of India only. Supplemental agreement to terminate automatic monetization (WMA) of governments deficit has been used, by way of a signed agreement between RBI and Government of India, though a legislative compulsion in still under consideration as part of Fiscal Responsibility and Management Bill. In several cases, contracts with stipulated conditions have been framed in the absence of specific law governing such transactions. Examples relate to regulation of Clearing Houses; operating current payment systems and functioning of electronic trading even before instructions under I.T. Act came into force. Similarly, it has been possible to invoke prudential regulations over RBI regulated financial institutions to effectuate best practices in financial markets, though the legal compulsion as a regulation on all market participants may not be possible; the example of successes achieved are dematerialisation of Commercial Paper and Demateralisation of Debt instruments, brought about in the requirements on Banks and financial institutions. There could also be use of incentives to conform though legal or formal regulation may be difficult. Examples relate to valuation and accounting norms being performed by a self regulatory organization and adopted by banks and proposals relating to information sharing with Credit Information Bureau pending legislative initiatives. A deliberate decision may be taken not to use regulatory powers, thus enabling development of markets. For example, current account convertibility in external sector was implemented even before a new law was introduced by recourse to large scale relaxations. Similarly, Credit Guarantee was virtually given up though a new law is yet to be enacted giving up the credit-guarantee

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function of Deposit Insurance Guarantee Corporation. In all these cases, however, a positive approach to law to enable reform was possible because of clarity about what was to be done and finding of legal ways of doing even if it were second best. Managing Uncertainties During Reform Reforms in the financial sector had to be implemented keeping in view not only the desirable directions and appropriate measures carefully sequenced, but also the emerging uncertainties, both in domestic and global arena. By all accounts, India has managed the uncertainties reasonably well. Recognizing that such uncertainties have a tendency to impact the exchange rate, it is instructive to briefly review the processes of management and drawn some tentative lessons. The Gulf crisis, which triggered the reform process was managed without any reschedulement of any contractual obligation, but with a recourse to stabilization measures and initiation of structural reforms. The current account convertibility in 1994 led to liberalization of gold imports and large capital inflows upto 1996. In 1997, the timely efforts to depreciate the currency warded off a possible crisis due to persistence of a relatively over valued rupee in the forex markets. This also enabled the implementation of a package of monetary and other prompt actions in resisting contagion effects of Asian crisis in late 1997 and early 1998. The imposition of sanctions by U.S. government and others consequent upon nuclear tests required replacement of normal debt flows with a type of extra ordinary financing. There was also an occasion, as in May-August 2000 where inexplicable changes in expectations put pressure on the currency warranting yet another package to counter the market sentiment. In contrast the events of September 11, 2001 needed measures to reassure the markets with timely liquidity and stability in monetary measures. The reasonable success in managing these uncertainties while adding to forex reserves with marginal addition to total external debt but maintaining both reasonable overall macroeconomic stability and pace of reform in financial sector has some tentative lessons to offer. First, stable and appropriate policies governing overall management of the external sector are important. As part of the reform process, a policy framework was developed to gradually liberalise the external sector, move towards total convertibility on current account, encourage non debt credit inflows while containing all external debt

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especially short term debt in capital account and make the exchange rate largely market determined. The policy reform in the external sector, accompanied by other changes was guided by the Report of High Level Committee on Balance of Payments, April 1993 (Chairman Dr.C.Rangarajan). Second, the impression that a closed economy is less vulnerable to crisis is not borne out by facts. India was a closed economy on the eve of the Gulf Crisis but the impact was severe. Though it is now a relatively more open economy, it could without serious disruptions withstand several uncertainties. Third, as evident from experience, if the fundamentals are weak, the economy is more vulnerable in the face of uncertainties. Fourth, in all instances of serious uncertainties, the existence and manifestation of harmonious relations between the Government and the central bank become critical and appropriate coordination is extremely useful. Fifth, while it is difficult to anticipate or assess the uncertainties, there may be advantages in taking the risk of early action than late action. Sixth, while in a rapidly changing world of uncertainties, commitment to ideology can prove to be a drag on policy, especially in emerging countries, which are attempting structural transformation, it has been demonstrated by events the world over as well as by the Indian experience, that when the going is good, government is perceived to be a problem but when the going gets tough, effective public policy may be the only solution. As such, the state has a pivotal role in stabilizing the economy when there is a spell of stormy weather. Seventh, there may be need for several short-term actions to meet challenges but this should not distort the medium term vision to proceed with economic reform to improve standards of living. In other words, it is necessary for the policy makers to be conscious and more importantly, essential for the policy maker to convince market participants that some measures to meet the crisis are short term, while some others may get embedded into the public policy in the medium-term. Related to this approach and to reinforce this, there is advantage in designing measures that are easily reversible, preferably with an explicit indication that the measures are reversible even as they are being announced, though a specific time frame may not be prescribed Eighth, as regards the techniques and instruments of managing uncertainties, they have to evolve keeping in view the reform

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process itself, especially developments in financial markets, monetary policy, the nature, composition and evolution of market participants and above all public opinion. Ninth, it is necessary to have an appropriate mix of surprise elements and anticipated elements in policy actions for meeting any uncertainties. As an example, when the markets are in need of comfort or assurances, when the convergence in the objectives of policy makers and the markets are matched, and such convergence is observable in regard to instruments, there is merit in taking the market into confidence and proceeding accordingly. Where there is a perception that the market expectations and their possible actions in the direction are not considered to be desirable by the policy makers, it is always advantageous to bring an element of surprise preferably with firmness and credibility so that all possible anticipatory actions as well as resistances are avoided. There may be occasions when the wavelengths of markets or segments thereof and policy maker differ significantly and in such circumstances, the conduct of policy would presumably be more complex and difficult. Finally, the issue of transparency is extremely important. There are many occasions where transparency is desirable but there are also occasions where instant transparency is not entirely essential and could even be counter-productive. An acceptable approach seem to be one that practices transparency as a rule but the timing of transparency could vary depending on the circumstances. RBI and Government During the early 1960s, Governor Iengar identified four areas of potential conflict between the Bank and the central government. These were interest rate policy, deficit financing, cooperative credit policies and management of sub-standard banks. It may be of interest to note that these four areas are still some of RBIs concerns. During the post-reform period, the relationship between the central bank and the Government took a new turn through a welcome development in the supplemental agreement between the Government and the RBI in September 1994 on the abolition of the ad hoc treasury bills to be made effective from April 1997. The measure eliminated the automatic monetisation of Government deficits and resulted in considerable moderation of the monetised deficit in the latter half of the Nineties.

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At the same time, with gradual opening up of the economy and development of domestic financial markets, the operational framework of the RBI also changed considerably with clearer articulation of policy goals and more and more public dissemination of vast amount of data relating to its operations. In fact, during the recent period, the RBI enjoys considerable instrument independence for attaining monetary policy objectives. Significant achievements in financial reforms including strengthening of the banking supervision capabilities of the RBI have enhanced its credibility and instrument independence. It has been pointed out by some experts that the RBI, though not formally independent, has enjoyed a high degree of operational autonomy during the post-reform period. In terms of redefining the functions of the RBI, enabling a movement towards meaningful autonomy, Governor Jalans statement on Monetary and Credit Policy on April 19, 2001 is a landmark event. First, it was decided to divest RBI of all the ownership functions in commercial banking, development finance and securities trading entities. Secondly, a beginning was made in recommending divestiture of RBIs supervisory functions in regard to cooperative banks, which would presumably be extended to non-banking financial companies and later to all commercial banks. Thirdly, the RBI signalled initiation of steps for separation of Government debt management function from monetary policy. These measures would enable the RBI to primarily focus on its role as monetary authority and enhance the possibility of a move towards greater autonomy. The emerging issues relating to autonomy of RBI can be addressed at different levels. First, at the level of legislative framework, several suggestions have been made to ensure appropriate autonomy and many of them are under consideration. In particular, proposed Fiscal Responsibility and Budget Management Bill and other amendments to Reserve Bank of India Act would cover significant ground. Several other suggestions relating to legal framework, as recommended by the Advisory Groups are yet to be taken up. Second, at the policy level, there are three important constraints on the operational autonomy even within the existing legal framework. One, the continued fiscal

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dominance, including large temporary mismatches between receipts and expenditures of Government warranting large involuntary financing of credit needs of Government by the RBI. Two, the predominance of publicly owned financial intermediaries and nonfinancial public enterprises, which has created a blurring of the demarcation between funding of and by Government vis--vis public sector as a whole. Three, the relatively underdeveloped state of financial markets partly due to legal and institutional constraints, which blunts the effectiveness of instruments of monetary policy. These issues need to be resolved to enhance genuine autonomy. Third, at the operational and procedural level, there is a problem of old habits die hard. In a deregulated environment, there is considerable scope to reduce micromanagement issues in the relations between the Government and the RBI. At the level of degree of transparency, there is a temptation to continue, what has been termed as the joint-family approach; which ignores basic tenets of accounting principles in regard to transactions between RBI and Government. In spite of difficulties in prioritizing the elements relevant for reform, an attempt is made to mention some elements which present themselves as critical in the light of experience gained so far. First, as elaborated in Governor Jalans recent statements on Monetary and Credit Policy, several legislative measures are needed to enable further progress. These relate in particular, to ownership, regulatory focus, development of financial markets, and bankruptcy procedures. Some of the serious shortcomings in the anticipated benefits of reform such as in credit delivery do need changes in legal and incentive systems. In particular, there is need to focus on reduction of transaction costs in economic activity, and enhancing economic incentives. Severe penalties in law, including criminal proceedings, may not be substitutes for increasing enforceability (i.e., probability of being caught, prosecuted, and punished adequately and in a timely fashion). In regard to institutions, there is need to clearly differentiate functions of owner, regulator, financial intermediary and market participant, to replace the joint-family approach that is a legacy of the pre-reform framework. Second, fiscal empowerment appears to be essential for obvious reasons. While the existing level of fiscal deficit may be manageable, the headroom available for meeting unforeseen circumstances appears rather limited. The problem is somewhat acute in regard to finances of states, which have serious structural problems and their resolution is

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possible only through accelerated fiscal support from Central Government consistent with the fiscal soundness of Central Government. Some of the legal reforms may also be necessary for this purpose and the link for further progress in the financial sector is obvious. In particular, the nature of fiscal dominance does constrain the effectiveness of monetary policy to meet unforeseen contingencies as well as maintain price stability and contain inflationary expectations. Third, the reforms in the real sector are needed to bring about structural changes in the economy. The liberalization of financial sector and of external sector can provide impetus for further growth and in turn help more rapid progress only when accompanied by reforms in the real sector, particularly in domestic trade. Fourth, there are what may be termed as overhang problems in the financial sector, such as non-performing assets of banks and financial institutions. There are similar overhang problems in other areas as well, and it is necessary to make a distinction between what may be termed as flow issues and overhang issues. There is merit in insulating the overhang problem from flow issues and demonstrably solve the flow problem upfront. For example, in regard to food stocks there is addition to buffer stocks virtually on a continuous basis and a policy needs to be evolved to tackle this flow. Any attempt to sort out the overhang accumulated excess stocks on an ad hoc basis would obviously have limited success. Any solution to the overhang problem of large magnitude is bound to be operational over the medium-term and may involve admission of the magnitude of possible losses to be incurred. Yet another example relates to the power sector, where addition to capacities to generate without ensuring cost recovery adds to the problem of accumulated losses. Prima facie, the major areas with considerable overhang problems apart from the financial sector are public enterprises, pension and provident fund liabilities and the cooperative sector. The criticality of the issue is in terms of their cumulative impact on financial sector as a whole. Fifth, it will be useful to distinguish between what a financial sector can contribute and what fiscal action can contribute to matters relating to poverty alleviation. In the interest of efficiency and stability of financial sector, intermediation may have to be progressively multi institutional rather than wholly bank-centred. Social obligations may have to be distributed equitably among banks and other intermediaries but that would be difficult to achieve in the context of emerging capital markets and relatively open

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economy. In such a situation, banks which are special and backbone of payment systems, may face problems if they are subject to disproportionate burdens. Hence, mechanisms have to be found to reconcile these dilemmas. Furthermore, monetary policy is increasingly focused on efficient discharge of its objective including price stability, and this no doubt would help poverty alleviation, albeit indirectly, while the more direct attack on poverty alleviation would rightfully be the preserve of fiscal policy. Monetary and financial sector policies in India should perhaps be focusing increasingly on what Dreze and Sen call growth mediated security while support-led security, mainly consisting of direct anti-poverty interventions are addressed mainly by fiscal and other governmental activities. References : Indian Economy (2006)- Ruddar Datt & K.P.M. Sundaram . Financial Institutions & Market (2002) -Meir Kohn. Indian Financial System and Commercial Banking (2001)-Varshney Monetary And Financial Sector Reforms in India, A Central Bankers Perspective- Reddy Y.V. (2000) Fiscal and Monetary Policy Interface: Recent Developments in India, RBI BulletinReddy, Y.V. (2000) Developments in Monetary Policy and Financial Markets In India, RBI Bulletin-Reddy, Y.V. (2001)

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CHAPTER-3 Regulation of Money Market in India

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. 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 noncash exchange through barter preceded the introduction of money. Barter, however, coexists 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

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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 the holder 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 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 by customers 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

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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 the ultimate beneficiary and the destination could be pre-determined. In all these 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 the financial 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. 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

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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 is the Central Bank of the country (i.e. Reserve Bank of India) which has the settlement accounts of the banks and sustains the payments process. Payments System In the Payments System, the Central Bank has a special role to play as the settling bank maintaining settlement accounts for banks. These are used by banks to discharge their obligations amongst themselves. While the settlement account can be maintained with any bank, there is always a risk of default by the settling bank. A failure of a settling bank can have disastrous consequences leading to a possible systemic collapse. Settlement accounts maintained with the Central Bank, on the other hand, provide the basic stability to the settlement process as the Central Banks cannot fail. The involvement of the Central Bank in the settlement process is therefore crucial. This monograph is organized in the following way. After giving a brief account of the evolution of payments system in India in Chapter II, the various paper based instruments in vogue in India are discussed in Chapter III. The complexities of the existing paper based payments and settlement systems, Remittance Facilities and Currency Chests and the Uniform Regulations and Rules of Clearing for paper based instruments form the subject matter of 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

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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 payments system. Evolution of RBI Government business in India was initially handled by the Presidency Banks of Bengal, Madras and Bombay from 1862 to 1921 and thereafter by the Imperial Bank of India, which came into existence as a result of amalgamation of the Presidency Banks. Since April 1, 1935, the Reserve Bank has been the banker to the Central and State Governments. According to Article 283(1) and (2) of the Indian Constitution, it is open to the Central Government and to any State Government to make rules for the receipt, custody and disbursement of all the amounts accruing to or held in its consolidated or contingency funds or in its public account. Sections 20 and 21 of the Reserve Bank of India Act, 1934 provide that the Central Government shall entrust the Bank with all its money, remittance, exchange and banking transactions in India and the management of its public debt, and shall also deposit all its cash balances with the Bank free of interest. The Bank may, by agreement with any State Government, take over similar functions on behalf of that Government under Section 21A of the RBI Act. Accordingly, the RBI is the common banker to the Central Government and all the State Governments in the Indian Federation with the exception of Jammu & Kashmir and Sikkim. The Reserve Bank, as banker to various Governments, has well defined obligations and provides several services. First, the Central Government Treasury Rules, the Central Government Account (Receipts and Payments) Rules, in respect of the transactions of the Central departments, and the corresponding provisions in the State Financial codes are

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deemed to be legally binding on the Bank. Second, the Bank carries on the General Banking business of the Centre and the States in terms of the working agreement between the Government and the Reserve Bank. The liability of the Bank to the Governments in the conduct of the Government business is that of a banker to an ordinary customer. Third, the Bank also undertakes to float loans and manage the loans on behalf of the Governments on agreed terms. Fourth, where there is no full-fledged office of RBI, it appoints commercial banks as agents of RBI and they are made responsible for transacting the entire Government business. Fifth, the Bank does not charge to Governments, the cost of carrying on Government business through its offices or the agency banks. Sixth, a facility for grant of ways and means advances is provided by Reserve Bank to the Governments, to meet the temporary mismatches in their income streams. Seventh, the RBI arranges for investments of surplus cash balances of the Governments as a portfolio manager. Eighth, the RBI also acts as Adviser to Government, whenever called upon to do so, on monetary and banking related matters besides dispensing merchant banking services. Role as a Banker to the Government The title of the address refers to being banker to governments simply because RBI is a banker not only to the Central Government, but also State Governments. RBI by virtue of its charter performs several functions, the most important being to secure stability in the internal and external value of the currency mainly through conduct of monetary policy, while at the same time, ensuring adequate availability of credit to meet the genuine needs of a growing economy. Currency management is yet another function of the RBI which impacts the transactions of a large number of people. managing public debt is also assigned to RBI, but this is sought to be separated from RBI in due course. Its regulation of money and forex markets flows from its primary responsibility while its role in debt markets is closely linked to it being manager of public debt. RBI is also a regulator and supervisor of banks, development financial institutions, and non-banking financial companies, but the process of supervision is overseen by an independent Board for Financial Supervision, within RBI. Incidentally, RBI is also a banker to banks. Payment System is also under the aegis of RBI, and the technological infrastructure for the financial sector, especially in the money and Government Securities market is provided

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by RBI to sub serve its overall responsibilities. To the governments it renders advice on financial matters, whenever called upon to do so. Being banker to governments is also an important function, but is seldom in high profile, perhaps due to the reason that it does not directly or visibly impinge on prices or output. However, as will be explained today, though it is not a big-ticket item on RBIs balancesheet, its role as a banker to governments is very significant and it has been evolving in the recent years reflecting the process of economic reform. The Bank provides banking services to both Central and State Governments such as acceptance of moneys on Government account, payment / withdrawal of funds and collection and transfer of funds by various means throughout India. The Governments' principal accounts are maintained at Central Accounts Section of the Bank at Nagpur. Government accounts are handled by RBI at 15 Offices, besides two State Government Cells at Bhopal and Chandigarh. Further, all public sector banks and two private sectors banks handle Governments accounts through their 20,800 branches. Currently, the Agency banks handle Governments transactions of around Rs.12 lakh crore in a full Financial year. Over and above these, sizeable transactions are handled at Reserve Bank Offices. Some transactions, though minimal, are handled in Governments own treasuries and sub treasuries, numbering 453, equipped with Currency Chests. This data gives the Magnitude and spread of transactions relating to Governments. The first part of todays presentation will cover very briefly cross-country practices. The second part provides the legal and institutional framework in India for conduct of Governments business in banking. The third section describes the range of Banking services provided by RBI to Governments. The fourth part describes some of the reforms already undertaken in this area. The fifth section describes major issues while the concluding section indicates a possible agenda for immediate actions.

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Cross-Country Practices By custom and tradition or by express provision in the laws by which they have been established, Central Banks are bankers to their respective Governments. In the view of Sir Montague Norman of the Bank of England and Benjamin Strong of the Federal Reserve System, the Central Bank should undertake all the banking business on behalf of their own Governments. However, the actual practices do vary among countries. In the UK, Bank of England is the main banker to Government and maintains the Principal Central Government Account. Individual Government departments are not obliged to use Bank of England as their banker. Typically Government Department with significant requirements for banking service put some or all of their banking business out to tender. In the case of South Africa, the South African Reserve Bank acts as banker to The Central Government. Provincial Governments are, however, the clients of private banking sector. In Japan, Bank of Japan carries out the transactions with the National Government but not with local Governments. As regards USA, the Federal Reserve acts as the banker to US Government. The Reserve Banks serve as depositories of the United States and perform several payment-related services. Legal and Institutional Framework Government business in India was initially handled by the Presidency Banks of Bengal, Madras and Bombay from 1862 to 1921 and thereafter by the Imperial Bank of India, which came into existence as a result of amalgamation of the Presidency Banks. Since April 1, 1935, the Reserve Bank has been the banker to the Central and State Governments. According to Article 283(1) and (2) of the Indian Constitution, it is open to the Central Government and to any State Government to make rules for the receipt, custody and disbursement of all the amounts accruing to or held in its consolidated or contingency funds or in its public account. Sections 20 and 21 of the Reserve Bank of India Act, 1934 provide that the Central Government shall entrust the Bank with all its money, remittance, exchange and banking transactions in India and the management of its public debt, and shall also deposit all its cash balances with the Bank free of interest. The Bank may, by agreement with any State Government, take over similar functions on behalf of that Government under Section 21A of the RBI Act. Accordingly, the RBI is the common banker to the Central Government and all the State Governments in the

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Indian Federation with the exception of Jammu & Kashmir and Sikkim. The Reserve Bank, as banker to various Governments, has well defined obligations and provides several services. First, the Central Government Treasury Rules, the Central Government Account (Receipts and Payments) Rules, in respect of the transactions of the Central departments, and the corresponding provisions in the State Financial codes are deemed to be legally binding on the Bank. Second, the Bank carries on the General Banking business of the Centre and the States in terms of the working agreement between the Government and the Reserve Bank. The liability of the Bank to the Governments in the conduct of the Government business is that of a banker to an ordinary customer. Third, the Bank also undertakes to float loans and manage the loans on behalf of the Governments on agreed terms. Fourth, where there is no full-fledged office of RBI, it appoints commercial banks as agents of RBI and they are made responsible for transacting the entire Government business. Fifth, the Bank does not charge to Governments, the cost of carrying on Government business through its offices or the agency banks. Sixth, a facility for grant of ways and means advances is provided by Reserve Bank to the Governments, to meet the temporary mismatches in their income streams. Seventh, the RBI arranges for investments of surplus cash balances of the Governments as a portfolio manager. Eighth, the RBI also acts as Adviser to Government, whenever called upon to do so, on monetary and banking related matters besides dispensing merchant banking services. Range of Banking Services Banker to Central Government the work relating to Government business is attended by the Public Accounts Department of the RBI. The discharge of the Bank's functions as banker to Government involves the receipt and payment of money on behalf of the various Governments departments. For this purpose, under Section 45 of the RBI Act 1934, initially the RBI appointed State Bank of India as its sole agent at all places where the Bank had no office or branch of its Banking Department. In turn, SBI entered into agency agreements with all its associate banks and delegated the agency functions to some of the branches of the associate banks at certain centers. Considering the increasing volume of Government business and nationalization of some commercial banks, the Government and the RBI associated

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nationalized banks, which had a vast network of branches, to conduct Government business. In 1970, the Government empowered the RBI to appoint them as agents at any centre. By 1976, the SBI, Associate Banks and nationalized banks were acting as agents of the RBI for this business. In order to facilitate the handling of Government receipts and payments, currency chests were established with a number of branches of nationalized banks in addition to SBI and Associate Banks. Prior to 1976, the responsibility for arranging payments and compiling accounts of receipts and disbursals and auditing of transactions of all Central Government Ministries devolved on a single authority, viz., Comptroller and Auditor General of India. The Government introduced from April 1976, a scheme in stages for decentralization and departmentalization of accounts of individual Ministries at the Centre, thereby transferring the responsibility for maintenance of accounts at all stages to the Ministries / Departments themselves. Under this scheme each ministry/ department has been allotted. A specific public sector bank for handling its transactions based on the principle of 'one bank - one ministry/department'. Hence, the Reserve Bank does not handle governments day-to-day transactions as before, except where the Bank itself has been nominated as banker to a particular ministry/department. Banker to State Governments the financial transactions of the State Governments are carried out at a number of offices, including those of the RBI SBI, nationalized banks, Treasuries, etc. The Government transactions conducted at all such places are allowed without any reference to the actual position of the cash balance of the State Government, the accounts of which are maintained at the Central Accounts Section of the RBI at Nagpur agency banks has set up a link office at Nagpur to liaise with CAS for funds settlement. Thus, the Bank's offices and agency banks' branches function like tributaries, Which flow in the direction and merge into the Central Accounts Section. CAS, Nagpur, thus plays a pivotal role in consolidating the transactions and working out the overall daily position of each government. The actual day-to-day transactions are handled by the Bank's offices and agency bank branches. They render accounts to respective Government accounting authorities while effecting monetary settlement with RBI. Since frequent adjustments between the various Governments are unavoidable, settlement of these transactions through Central Accounts Section is convenient, accurate and

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expeditious. Reserve Bank through its Remittance Facilities Scheme operates a funds transfer system. It carries out the adjustments as between the various Governments providing in effect, facilities for the transfer of funds on a very large scale within the Government Sector. In order to facilitate the actual conduct of Government transactions, the Reserve Bank has built up over the years, a network of currency chests, repositories and small coins depots, all of which are intended to service all the Governments in the country. As banker to the Government, Reserve Bank works out the overall funds position and sends daily advices showing the balances in its books, ways and means granted and investments made. The daily advices are followed up with monthly statements, and are Useful from the point of view of enabling the Government to prepare their ways and means budgets. The arrangement between the Government of India and the Reserve Bank on the one hand and the public sector banks and the Reserve Bank on the other, are based largely on trust as well as being merely contractual. Treasury System all payments on account of Central and State Governments are made either by cheques or by bills. The Government of India, Reserve Bank and the banks, which serve the treasuries and subtreasuries normally, prefer cheques to bills. Certain States like Maharashtra, Gujarat, Karnataka, West Bengal etc. have adopted the system of payments by cheques at their Treasuries. However, a large number of States are yet to introduce the cheque System. In view of the advantages of cheques as compared with bills, Official policy continues to be in favour of changing over to cheque system. Since 1976, Treasuries and non- departmental Pay and Accounts Offices have ceased to be responsible for handling transactions on behalf of the Central (Civil) Departments as integrated financial advisers and principal accounts officers of these departments have taken over the responsibility for receiving and paying money, Compiling and maintaining the accounts, in respect of all the transactions relating to these departments. The pay and accounts officer or a drawing and disbursing officer of each Ministry or Department are linked to a designated public sector bank or RBI and are not allowed to draw on a treasury. Other Services In addition to being a pure banker to Government, RBI provides a full range of related services to Government.

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These include exchange, remittance transactions, and management of public debt and issue of new loans, handling the forex transactions of the Government of India, investment of surplus funds of Governments, providing safe custody facility, providing of ways and means advances, management of special funds Like Consolidated Sinking Fund, Guarantee Redemption Fund, Calamity Relief Funds, National Defence Scheme, etc., issue and management of tap bonds like Relief Bonds, Administration of the Scheme for disbursal of pensions of Central and State Governments employees through public sector banks and as Advisor to Government on all matters involving monetary and economic perspective. The fee recovered by the Bank for some of the above services, which are rendered as an adjunct to its role as Banker to Government, are nominal and do not even cover the costs, while for most other services no charge is levied. Recent Reforms Undertaken Focal Point and Beyond. The experience of the working of the "Departmentalized Scheme" has shown a few shortcomings. With the large number of bank branches handling the work, delays often occurred in the transmission of the relevant documents (paid cheques, challans scrolls etc) to Pay and Accounts Officers (PAOs) for accounting. Besides, there were certain difficulties in reconciliation of figures between government departments and Banks. In order to obviate these difficulties as well as making reconciliation easier, a Working Group was set up in 1986 to review the working of the scheme, and on the basis of its recommendation existing procedures were revised. This marked the beginning of focal point approach for reporting and settlement of government transactions and set the pace for further refinement of the accounting system. The focal point approach envisages "one focal point branch - one (Pay and Accounts Office) PAO". This concept was incorporated into the system to bring about an interactive method of resolving the daytoday problems while achieving expeditious reconciliation. This system ensures updating of accounts at PAO level and speedy settlement of funds at Central Accounts Section at Nagpur. It has, sought to bridge the gap between RBI accounts and Government accounts. Based on its success, it has been subsequently adopted in phases, in Central Board of Direct Taxes (CBDT) and extended to Departmentalized Ministries Accounts

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(DMA) (both civil and non- civil ministries). There has been a close alignment between accounting jurisdiction of the government and the dealing branches of the bank. However, in the envisaged computerized environment, with electronic connectivity, the settlement of funds on real time basis, directly between the dealing branches and CAS at Nagpur for credit of Government Account without the intervention If Focal Point and Link Cell may be a distinct possibility in the near future. Standing Committee on Computerization Given the large magnitude of the transactions in Government account, the manual system results in delays in handling transactions. Complete electronic data processing in the preparation and settlement of the accounts of Government business by the agency banks as also for compilation of accounts at Treasury/Pay and Accounts Office/Accountant General will eliminate the time lag in the flow of information and improve standards of accuracy. During the last few years, RBI offices and agency banks have initiated steps for computerization of Government transactions at their dealing Branches. The Committee on Technology Up gradation in Banking Sector laid down the Road map for computerization of bank branches handling Government business, to be achieved in phases. The first phase envisaged computerization of all Focal Point branches of agencies by March 31, 2000 and State government Link Cells / dealing branches in the second phase thereafter. The Committee desired that efforts should be made to interconnect the computerized branches dealing in Government Accounts with Link Offices/ branches, and the Public Accounts Departments of the Bank and also Central Accounts Section, Nagpur where it is ultimately accounted for in the books of accounts. On Government side, the Committee suggested that all PAOs/Circle Offices of Government should be computerized by March 31, 2001 and the Drawing Offices / Treasury Offices well before March 31, 2002 in alignment with computerization of Focal Point and Dealing branches. A Standing Committee comprising members from RBI, Government and agency banks is monitoring the computerization of government transactions. There have been some delays in adhering to the time schedule mentioned. RBI has been urging the agency banks to capture 80 per cent of Government business by June 2002. Payment Systems Reforms Payment and Settlement Systems constitute the backbone of any economy and the

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existence of competent payment and settlement systems have a positive impact on the efficient functioning of the various sectors of the economy. Central Banks in the world are according great importance to well established payment and settlement systems. The Reserve Bank, too, has taken up as its mission, the establishment of a robust, safe, and secure and efficient payment and settlement system for the country as part of its initiatives aimed at financial sector reforms in this area. Constituted in 1999, the National Payments Council is the Apex level body, which provides general policy directions and guidelines for reforms in the Payment and Settlement Systems of the country. Initiatives aimed at improvements in the payments and settlement systems are centered on the three-pronged strategies of consolidation, development and integration of the various components of the payment and settlement systems. Consolidation takes its base from existing activities such as computerized clearing, etc. Development envisages opening of new clearing houses, introduction of systems such as the Centralized Funds management System and Real Time Gross Settlement (RTGS) and Integration of all these initiatives both within the Reserve Bank and for the banking Sector as a whole would result in the culmination of the reform process. Non-paper based payment systems, such as Electronic Funds Transfers (EFT) and Electronic Clearing Services (debit and Credit Clearing), have been accepted widely for use within the country. The proposed introduction of the Real Time Gross Settlement (RTGS) System would ensure settlement of funds in real time and in an electronic manner. All these would have positive impact for the government sector too, which could exploit the benefits of ECS and EFT for even their conventional payments - such as tax collections, various payments, tax refunds, drawback payments, etc. Since movement of funds is scheduled to take place using electronic means, the need for providing for a more elaborate and clear legal infrastructure has also been recognized. Accordingly, work has commenced on draft legislation to regulate the payment systems, which may not only be restricted to banks and financial institutions, but could also go beyond that. The proposed legislation will also have powers to regulate EFT, except that the proposed EFT regulation will deal only with credit transfer.

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The debit transfer transactions will continue to be governed by the Negotiable Instruments Act, 1881. Further, in order to deal with electronic instruments like echeques, which are in the nature of debit transfer, amendments to the Negotiable Instruments Act 1881 and IT Act 2000 have been suggested for consideration of Government. Since July 1, 2001, a state-of-the-art technological Architecture for management of Government Accounts at Central Accounts Section, Nagpur was set up. The system provides online data processing capability in front office mode and on line connectivity to all the RBI offices, agency banks and State Governments. The system is designed to provide information on a real-time on-line basis to Central and State Governments for ascertaining their cash balance position and other transactions. As a further improvement, a Virtual Private Network (VPN) is being established between CGA and Principal Accounts Officers of various ministries. The network is also proposed to be extended to the Pay & Accounts Office level. The network would act as a hub for electronic interchange of information between CAS Nagpur and various civil and noncivil ministries. While Inter Government Transactions would be handled on an Online basis, the Agency Bank transactions will be available as and when reported to CAS. The above arrangements when fully put in place will enable the various Principal Accounts Offices to send Inter-Government Transactions, along with details of the relative sanction orders to CAS electronically, get confirmation advices (clearance memos) instantly and eliminate most of the reconciliation problems not only at the level of Central Government but also facilitate proper accounting in the States. In fact State Governments have been complaining regarding delays in receipt of action orders as a result of which they are unable to know the purpose of the funds being given from Central Government at the time of such amount being credited by RBI to their accounts. RBI has also taken initiative in redesigning the format of the IGA (Inter Government Adjustment) advice and Clearance Memo to ensure that the advice being sent to CAS is comprehensive and meets requirements of the State Governments as well. I would request the Office of CGA to examine the suggestions made by us in this regard and implement the revised IGA format at the earliest. Another benefit of the connectivity would be strong MIS support. From the Bank's view point, on-line access will eliminate

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the need for periodical statements being sent to the accounting authorities as the authorities will be able to choose the period (a week, fortnight, month or more) for which they want the data and then can use it for any number of MIS purposes. Maintenance of parallel records can also be eliminated. The RBI is also examining the feasibility of using the Internet to connect all State Governments, Central Government Departments and various agency banks to implement total workflow automation in respect Government transaction. Under the current procedure, the fund settlement at CAS Nagpur takes place after the rendering of accounts by the focal point branches to the local PAO. The focal point branches receive the scrolls and the documents from the dealing branches by post (normally by Registered post). This means that settlement of funds is inevitably delayed for the period of postal transit plus the time for consolidation at focal point branch creating a lag in final accounting in government account with CAS Nagpur. During this lag, the funds remain in pipeline as a float at the cost of government departments. Often, the banks also suffer opportunity loss due to delay in monetary settlement. With the computerization of transactions both at the bank branches and government departments, it would be possible to re-engineer the process. Forwarding of paper scroll/receipted challans and paid cheques to government offices could take place at a later stage than the electronic transmission of transactions. This means that the focal point branch would transmit the transactions to CAS Nagpur without waiting for the scrolls received from the Branches to be consolidated and verified. The Committee on Technology Upgradation in Banking Sector examined this aspect and felt that this would help in quicker finalization of government account and fund settlement at CAS Nagpur. The issue remains open. Interaction with States A forum has been provided by the Reserve Bank bringing all the Finance secretaries of State Governments and the Union for exchange of ideas and sorting out the problems. These conferences are held in Reserve Bank for the last few years and the deliberations have proved useful in identifying the common problems and developing best practices in regard to Government finances. Between November 1997 and November 2001, nine such conferences have been held. A number of important initiatives relating to ways and means advances, approach to market borrowing programme, investment of surpluses,

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ceilings on State guarantees, apart from changes in the content and format for reporting have emanated and taken shape as a result of interactions in these meetings. Major Issues Minimum Balances Requirements in Government The RBI is authorized to provide Ways and Means Advances to Central and State Governments in terms of Section 17(5) of the RBI Act. Until 1994-95, the needs of Government were accommodated through automatic monetization by issuing ad hoc Treasury Bills at 4.6 per cent. Considering the ill effects of automatic monetization of Government deficit, the Reserve Bank and the Government agreed mutually in September 1994 to restrict the issue of ad hocks for the year-end and also within the year and for scrapping the issue of ad hoc treasury bills from 1 April 1997. Accordingly the issue of ad hoc treasury bills was discontinued with effect from 1 April 1997. Simultaneously, a scheme of granting Ways and Means Advances by the Reserve Bank to 10Government of India has been introduced to accommodate temporary mismatches in Government receipts and payments, interest on which was initially confessional, is presently at Bank Rate. Currently, Central Government is required to maintain a minimum balance of Rs.10 crore on a daily basis and Rs.100 crore on Fridays. The limit For Ways & Means Advances for 2001-2002 to Central Government has been fixed at Rs. 10,000 crore for the first half year and at Rs. 6,000 crore for the second half year. When the Government utilizes 75 per cent of the WMA limit, the Reserve Bank considers fresh floatation of market loan depending on market conditions. State Governments were expected to match the outflows with inflows very carefully so as to avoid recourse to ways and means advances from RBI. If a State Government allowed its account to emerge in overdraft, this would have been regarded with extreme disfavor and also as reflecting on the competence and ability of the State Government to manage its own finances. Over the years, the State Governments resorted increasingly to WMA and overdraft. The WMA limits were fixed as a multiple of minimum balance of States. However, while the multiples increased, the minimum balances required to be maintained by the State Governments were not revised between 1976 and 1999. Since 1999, the WMA Scheme is being worked out on the basis of the Recommendations of the B.P.R.Vittal Committee (1998).

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The Committee recommended that the minimum balance should be revised and linked to the same base as normal WMA which itself is worked out taking into account the sum of revenue receipts and capital expenditure. The first revision after the implementation of the Vittal Committee formula was effected from April 1, 1999, followed by the next revision from February 1, 2001. The latest revision took effect from April 1, 2002. However, the minimum balances have not been revised since April 1, 1999. A review of the WMA scheme will be made in April 2003. Automatic Debit Mechanism The Technical Committee of State Finance Secretaries on the State Government Guarantees has observed that such a mechanism runs the risk of resulting in insufficient funds for financing minimum obligatory payments and other grounds as well. Using an automatic recovery mechanism for inviting subscription to bonds issued by autonomous bodies with State Government Guarantees not only erodes the credibility of the State Government, but also would prompt other States to request for such assurance to offer additional comfort for investors. The matter is under the consideration of the Reserve Bank and the Central Government. Expansion in Agency Banks At present, the RBI, SBI and nationalized banks conduct business relating to Governments. More recently, private banks promoted by the all India Financial Institutions (AFI), which meet the defined criteria, are also being considered for induction for conduct of Government business. The objective is to help the State Governments to get better, quick service with safety of funds. The question is to strike a balance between the two and this may have to be decided by the States with the help of RBI. Thus, there can be competition for Government business in the future. The Reserve Bank, being a Central Bank, for achieving the functional focus, may have to consider in due course, shedding of the retail banking business in relation to Governments in favour of the agency banks with a view to ensuring that in the long run, the Bank will maintain only the Principal Accounts of the Governments, leaving the dayto- day banking business to the commercial banks functioning as its agents. Treasury The treasury system has evolved very gradually over a number of years and has worked with reasonable satisfaction. Nevertheless, there is scope for improvement with a view to

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providing more facilities to the general public in a number of ways. First, the nonbanking treasuries / sub-treasuries, which handle the cash business itself, could be gradually converted into banking treasuries by transferring their cash business to banks. Second, States may weigh the option of introducing separation of audit and accounts and departmentalization of accounts on the lines of Centre gradually. Third, as cheques for various reasons are preferable to bills, it is desirable to encourage wider use of cheques. The treasury is the primary accounting unit and its cash accounts are prepared and rendered to Accountant General. Fourth, in order to cut short delays, many treasuries, sub-treasuries and pay and accounts offices have made arrangements for disbursing small amounts in cash without the intervention of the bank, even when they are served by the public sector banks as agents. It may be advantageous to raise the monetary limit for payments across the counters, without requiring the payees to visit the banks. Rationalizing Agency Charges The agreements entered into by Bank with the State Governments provide that the Bank shall not be entitled to any remuneration for the conduct of ordinary banking business of the Government other than such advantage that may accrue to it from holding of cash balances free of obligation to pay interest thereof. The minimum balances by no means compensate the Bank for the cost of conducting Government business. On the contrary, the Bank has been remunerating the Agency banks for conducting the Government business on its behalf at a rate related to the costs incurred by them for conducting Government business. The rate is revised from time to time quinquennially after ascertaining the actual cost of conducting the government business and the present rate is 11.80 paise per Rs.100 of Government turnover. Agency banks requested for a revision of the methodology of determining the rates and an Expert Committee was constituted to study their request. Recently in its report, the Expert Group on revising the methodology for determining the cost of conducting Government business has observed that in most of the countries, the cost is borne by the respective Governments and not the Central Bank. The cost of conducting government business has been rising in the recent years. A possible way of rationalizing the agency charges from the present cost plus system could be to move over to a system of bidding for Government business by agency.

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Banks Reducing Lags in Credit At present, banks have been allowed a transit time of 5 days in respect of local receipts and 9 days in respect of outstation receipts for settlement of funds. In order to ensure expeditious credit to Government account by the dealing branches, a deterrent measure has been put in place. Accordingly, any delay in crediting the receipts to Government account beyond the stipulated period (of 15 days in case of delayed remittances over Rs.1 lakh and one month in other cases) attracts penal interest. As compared to public sector banks, the newly inducted private banks are allowed merely 5 days for settlement. This is based on the distinction in regard to the degree of computerization of public sector banks vis--vis private banks. With the up gradation of payment systems in the country and electronic connectivity, the cut off limits needs to be made more stringent with the ultimate goal of achieving real time settlement in Government Account, with CAS, Nagpur. Possible Improvements by Government Submission of Scrolls in Electronic Form At present, the scrolls are submitted in paper form separately for receipts and payments. With the computerization of bank branches and government departments, the scrolls in magnetic media (floppy form) should be acceptable to Government Departments. A switch over to submission of scrolls on magnetic media, will necessitate Delinking of paid instruments and the payment scrolls. The Reserve Bank has introduced 'Electronic Clearing Service' (ECS) for bulk receipts / payments which involve multiple credits with a single debit or vice-versa. ECS is customer friendly and remains untapped by Government. Government should use ECS for bulk and repetitive transactions like salary, pension, income tax refund orders etc. As recommended by the Committee on Technology Upgradation in the Banking Sector, the Government may examine the feasibility of introducing a variant of an electronic funds transfer system to facilitate collection of taxes, beginning with direct taxes. Elimination of Paper-based Reporting System Under the present system, it is a government requirement that all deposits in the government account should be accompanied by appropriate channels. The channels are in multiple copies, different shapes and sizes. This requirement of the government has constrained the process of

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electronic banking in government business. Over the years, despite the deliberations in various fora, it has not been possible to reduce the number of copies of channels. With the swift progress in banking, and the electronic connectivity as envisaged, it would become possible for the assesses to deposit the government dues in any designated bank by using a simple pay-in slip as in the case of bank deposit, and at a later stage, electronically by quoting the PAN. The elimination of the channels would pave the way for electronic settlement. Discontinuance of Advice System for Income Tax Refund Orders At present, Income-tax refund orders advices for value upto Rs.999 are sent directly to assess while advices for Rs.1, 000 and above are forwarded to payee banks. The advices are not received promptly resulting in the return of refund orders causing inconvenience to assess. Significantly, even after switchover to MICR form with all its in-built security features on par with a cheque, the advice system has been continued regardless of the difficulties caused to the assesses. At the Government level, issues related to ECS and forwarding of advices in electronic formats viz., magnetic media, etc., are being considered. Customer Service Government of India has constituted a standing committee at Apex level to monitor the working of the schemes pertaining to Departmentalized Ministries. Similar monitoring committees at local level are also functioning for Central Board of Excise and Customs (CBEC) and CBDT. Reserve Bank has been proactive in extending prompt and courteous customer service. The bank has an institutionalized set up for redressal of complaints from customers on regular basis. The Bank has also taken Citizen Charter initiatives and displayed the Charter for frontline Departments with public interface. Specific to this, customer satisfaction surveys are organized at frequent intervals and appropriate responses are formulated for improving service and avoiding recurrence of complaints, to the extent feasible. In order to assess the level of customer satisfaction rendered by the Reserve Bank and its agencies in acting as banker to Governments in the light of all round technological developments taking place at RBI/agency banks/Government Departments and to suggest improvements in the day-to-day operations of the Government business, Reserve Bank had constituted five sub- Groups in October 2001, one each at Bangalore, Chennai, Hyderabad, Mumbai and Nagpur offices comprising officials from Reserve Bank,

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preventatives from Finance Department of the State Governments. The sub-Groups had deliberated on the day-to-day operational procedures in vogue in Reserve Bank and evaluated their efficiency in relation to the users and accounting authorities. The Groups came up with very valuable suggestions in January 2002. This includes laying down a roadmap for enhancing the level of computerization, both at agency banks and Government Departments, provision of tele-banking facility at all Link Offices, simplification of challan forms, making the challans easily available through internet, transmission of scrolls / DMS through electronic media in addition to regular Mode, phasing out of non-MICR instruments, acceptance of only local cheques for Government payments instead of outstation instruments, cheque system to replace bill 14 System at Government Departments, use of ECS for effecting Government payments, introduction of note sorting machines at Government Departments, easing pensioners' problems, acceptance of cash by RBI beyond working hours, curtailing the cut-off period for levy of penal interest on delayed remittance of Government collections / funds to RBI by agency banks progressively, extension of time available at CAS for settlement of funds by link cells of agency banks at Nagpur. The RBI is earnest in its intent to implement all these recommendations in consultation with the Governments/agency banks. The RBI is also formalizing the review mechanism by setting up Standing Advisory Committees under the Regional Directors of RBI offices at all centers, so as to ensure optimum customer satisfaction at all times. The day-to-day procedures are being recast in the light of the suggestions, which have emerged. The Endeavour of the RBI is to create conditions for the common person to pay Government dues at his/her bank branch of choice, while ensuring instantaneous credit to the Government account with Reserve Bank. This can be achieved with a high degree of computerization with appropriate connectivity / net-working, encompassing agency banks, Government Departments and Central Bank for expeditious, cost effective and seamless financial flows, in a paperless environment. In view of the enormous work of Government and complexities and inter linkages between the Central and State Governments and the banking system, it maybe possible to explore the setting up of an Advisory Board, which could meet quarterly, for evolving

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Best practices in the overall interest of discharging the Reserve Bank's duties as Banker to Governments. This arrangement will be analogous to the Cash and Debt Management Group in which Government of India and the RBI are involved. I commend the acceptance of this proposal as a fitting tribute to this Silver Jubilee Celebrations. The Role of RBIs Monetary Policy Coming to the role of monetary policy: what we have achieved over the last decade? And how is it relevant for fostering innovation, entrepreneurship and growth? A great deal of market development has taken place in the financial sector. We now have market related flexible interest rates, more open forex markets, and flexible market related exchange rates, although the Reserve Bank continues to intervene in the forex market. We also have a active capital market for equities, though the corporate bond market has some way to go. We also have more competition in banking. So there has been pro-active monetary and financial sector policy during last decade or so, which has promoted economic growth, maintained low inflation along with financial stability. 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 recognize that the best

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contribution that monetary policy can make is indeed to ensure that inflation and inflation expectations are well anchored. There is evidence that pro-cyclical behavior 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. 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 overextension. 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 5year 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 economic history, 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 to occur 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 crucial stage 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. Economic Reforms and Evolving Role of RBI Founding of Accounts Organization and I recognize it as a reflection of the close cooperation and understanding that have evolved between Reserve Bank of India (RBI) as a banker to Government of India and its Accounts organization. The title of the address refers to being banker to governments simply because RBI is a banker not only to the Central Government, but also State Governments. RBI by virtue of its charter performs several functions, the most important being to secure stability in the internal and external value of the currency mainly through conduct of monetary policy, while at the same time, ensuring adequate availability of credit to meet the genuine needs of a growing economy.

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Currency Management is yet another function of the RBI which Impacts the transactions of a large number of people. Managing public debt is also assigned to RBI, but this is sought to be separated from RBI in due course. Its regulation of money and forex markets flows from its primary responsibility while its role in debt markets is closely linked to it being manager of public debt. RBI is also a regulator and supervisor of banks, development financial institutions, and non-banking financial companies, but the process of supervision is overseen by an independent Board for Financial Supervision, within RBI. Incidentally, RBI is also a banker to banks. Payment System is also under the aegis of RBI, and the technological infrastructure for the financial sector, especially in the money and Government Securities market is provided by RBI to sub serve its overall responsibilities. To the governments it renders advice on financial matters, whenever called upon to do so. Being banker to governments is also an important function, but is seldom in high profile, perhaps due to the reason that it does not directly or visibly impinge on prices or output. However, as will be explained today, though it is not a big-ticket item on RBIs balancesheet, its role as a banker to governments is very significant and it has been evolving in the recent years reflecting the process of economic reform. The Bank provides banking services to both Central and State Governments such as acceptance of moneys on Government account, payment / withdrawal of funds and collection and transfer of funds by various means throughout India. The Governments' principal accounts are maintained at Central Accounts Section of the Bank at Nagpur. Government accounts are handled by RBI at 15 Offices, besides two State Government Cells at Bhopal and Chandigarh. Further, all public sector banks and two private sectors banks handle Governments accounts through their 20,800 branches. Currently, the Agency banks handle Governments transactions of around Rs.12 lakh crore in a full Financial year. Over and above these, sizeable transactions are handled at Reserve Bank Offices. Some transactions, though minimal, are handled in Governments own treasuries and sub treasuries, numbering 453, equipped with Currency Chests. This data gives the Magnitude and spread of transactions relating to Governments. The first part of todays presentation will cover very briefly cross-country practices. The second part provides the legal and institutional framework in India for conduct of

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Governments business in banking. The third section describes the range of Banking services provided by RBI to Governments. The fourth part describes some of the reforms already undertaken in this area. The fifth section describes major issues while the concluding section indicates a possible agenda for immediate actions. References : Balachandaran, G., The Reserve Bank Of India. Mishra & Puri (Indian Economy). Mithani, D.M., (Money And Banking). Dewett, K.K., (Indian Economy).

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CHAPTER-4 Future Challenges and Opportunities To Money Market

The Indian economy is doing very well with almost every indicator looking up. The finding has reconfirmed its FY11 GDP expectations at 8.75 percent which in turn is the background for improved deficit at 5.5 percent of GDP. The RBI is bracing itself with credit growth estimates of 20 percent and has already commenced withdrawal of monetary policy measures without really causing too much of an upset. The Union Budget not only recognised the need to lower deficits but also quantified the milestones. S&P recently upgraded India outlook from 'negative' to 'stable'. Despite giving in to the temptation for a little back slapping, it seems as though India's financial sector did emerge stronger from the crisis. Our balance of payments also survived the global trade drop, demonstrated the ability to absorb fairly disproportionate capital flows and ended 2009 with exchange reserves of $283 bln. All said my faith in in policy rates seems to have been absorbed. On the other hand delivery volumes the long term India story remains as strong as ever. Looking at tax collections, I expect corporate growth rates to easily average a good 20 to 22 percent this year and even better itself to 25 percent next year. On the global front, the latest (draft) IMF World Economic Outlook expects the world economy to grow 4.1 percent this year, 0.2 percent over its previous forecast on the back of faster than expected growth in emerging economies. Whilst the U.S. economic growth is 0.3 percent higher at 3 percent, Euro zone is expected to recover at a slower pace at 0.8 percent mainly due to laggards like Greece and Italy. On the other hand global rates are expected at a similar 4.3 percent as well. China is expected to record a lower 9 percent growth in 2011 against 10 percent in the current financial year and power the global economy. Significantly, this IMF report states that, the money markets have stabilised, the stock and bond markets have recovered and the credit crisis seems to have come to an end. 63

However, at this stage I recall what Navjot Sidhu said when commenting in one of the recent matches "when we find everything coming our way; we need to check if we are driving in the opposite direction!" The obvious question in everyone's mind being -- how long will this party go on What looked like a secular bull run has now slowed down into an upward crawl although, despite the constant pulls and pushes, the market continues to hold and better its levels Even the RBI's 25 bps increases have been consistently coming down which points to the increasing levels of investor anxiety. At a PE multiple of about 22 on a historical basis and 16 multiple on a year forward they are not cheap by any standard even if we were to make allowance for the various arguments which seek to justify a higher markets. PE for Indian These levels are 122 percent higher than the intra day low of 8,047 on 6th March 2009, only about a year ago. This is further bettered by the small and mid caps. Its really like going out with a leg each in two boats -- the global economy and the domestic economy. On the domestic front, the biggest risk is posed by inflation which seems to be forging ahead towards double digits. The food inflation which may look tamer due to the base effect is gradually turning structural. The wholesale price inflation already at 9.9 percent is greatly vulnerable to that wild card: oil prices which are at $86 Pd on the back of rising demand resulting from global economic recovery expectations. Recently the OPEC has declared a price range of $80 to 100 Pd over the next one to two years. One therefore cannot expect this one factor to be of much help. Even though I do not believe that the monsoons are our antidote for inflation, they continue to pose the one single most important risk to the stability of our economic wellbeing; especially considering the importance of agriculture output in reaching the projected FY11 GDP growth rate. Sceptics continue to overestimate the impact of stimulus on growth and caution against the adverse impact its withdrawal may have on the state of our economy during the latter half of FY11. There are others who worry about the effect of an appreciating Indian rupee on IT and other exporting industries.Shifting attention to the global front, the surplus liquidity sloshing around has contributed to this spectacular recovery in emerging stock markets and that includes India which took in about $4 bln and kept it ahead of fundamentals.Many economists fear a "double dip recession" in developed economies;

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which if were to play out will also bring down the emerging markets. This is because a lot of the growth is seen to be driven by public spending whilst private consumer spending is yet to pick up.Although India is largely a domestic economy it will nevertheless get impacted due to lack of availability of capital in the event of a setback to developed economies. The India markets will also see severe dips if FII money is withdrawn as in March 2009. This scenario is justified by those who see the Greek tragedy repeating itself in Spain, Portugal and even the UK. More subprime writeoffs in the U.S. and an escalation in the renminbi valuation spat. About a 2-3 percent appreciation in the Chinese currency could lead to bankruptcies of exporters who operate on similar margins which will undoubtedly slow down what could easily be one of the single most important contributors of global economic growth Looking back a year, the picture today is not too different although I would like to believe that the threats if any are really more on the global front than domestic. The Indian markets can at the most be considered well priced but certainly not cheap. Going forward investors will be well advised to approach the next half year with muted expectations and given there are no crises like happenings on the global front the markets can be expected to remain volatile yielding at best about 10 percent gains. On the other hand if the sceptics were to have their way, the market could see a correction giving the retail investors an opportunity to enter the market and make up for what they missed in March 2009. However, irrespective of all what is said above, retail investors are best advised to stay invested and continue to take the SIP route into mutual funds To put it in succinct and current terms, moneys destiny is to become digital. Conference participants came to this general conclusion by looking at both moneys long historical record and its likely relationship to future socio-economic changes. Historically, money has been on the path towards greaterabstraction, or pure symbolic representation disassociated from a precise physical materialization, for millennia. Less evident for many was the question of the rate at which the last vestiges of physical money will disappear and, for some, if it is destined to vanish at all. Views also differed regarding the economic and social importance of traversing this last mile and what it would take to achieve it. At one end of the spectrum, Singapores Board of Commissioners of Currency is moving forward with a comprehensive effort that is meant to replace, by 2008, the

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physical money it issues with a functionally equivalent and much more efficient digital system. At the other end of the spectrum, many central banks and governments have taken predominantly conservative stances, which accounts in part for the very limited success of recent efforts to diffuse digital money more widely. Reflecting on these divergent approaches a case can be made for reconsidering both the significance, in economic and social terms, of much fuller digitisation of money and how to make it happen. On the economic front it was argued that there are high costs, public and private, because of the slow pace at which new payment systems, capable of generalising digital money throughout the economy, are being introduced. These costs are not only the familiar direct ones caused by the large expenses involved in handling, clearing and policing physical cash, but also the less obvious losses associated with the difficulties of making the transition towards a new economy of intangibles. From this opportunity cost vantage point, instantaneous digital payment systems that extend throughout the economy were seen as a crucial and still underdeveloped part of the infrastructure necessary for the flourishing of tomorrows global knowledge-intensive economy where electronic commerce, in all its forms, is likely to be one of the key determinants of overall economic performance. In social terms concern was expressed regarding the ways in which payment system costs are distributed and how accessibility issues will be addressed. Today the costs of cash (and near cash instruments like cheques and credit cards) are largely hidden for consumers. For instance there is little discussion of the equity dimension of the cross-subsidy, imposed when credit card companies prohibit merchants from offering discounts for cash payment, between people who pay cash (particularly the unbanked without other options) to those who pay with credit cards. Similarly many clearing and settlement systems give rise to expensive service charges and lucrative floats that have serious social consequences in areas such as remittances by foreign workers, providing financial services to the excluded encouraging the start-up of micro-enterprises. Equally serious is the possibility that a major social

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fault line could develop in the future when access to digital money becomes the principal way to benefit from lower transaction costs and burgeoning cyber-markets. Adding these social concerns to the economic ones makes a strong case for proactive policies that aim to accelerate the diffusion of digital money to the point where it marginalizes physical cash. This conclusion has not emerged from most other recent discussions of the future of money because, for the most part, the focus has understandably been on the new and exciting technologies that might replace the physical with the digital and concerns about the implications of these technologies for central banks. These discussions have provided reassuring conclusions regarding the implications of new technologies for the effective pursuit of macroeconomic policy. However, such a technology-centric approach tends to obscure both key forces likely to influence the future of money and important policy issues and tools. Indeed, as became apparent at this conference, policy makers have good reasons not only to increase the pace at which tomorrows digital money diffuses throughout the economy but also to shift the policy focus away frommonetary technology (physical) towards monetary agreements and standards (virtual) that underpin clearing and settlement systems that could be used by all participants to money based transactions. Two precedents offer important insights into why it makes sense to redirect policy efforts towards the virtual side of money. First, the internet, as a network of networks, shows how uniform standards (TCP/IP and HTML, both originally sourced from the public sector) can be neutral with respect to the particular technologies (physical and digital) that use the system. This is crucial because it creates a wide-open market on the connection side where competition, technical advances and a very wide diversity of uses can flourish. Second, the national inter-bank clearing systems and international currency markets provide some examples of how, in the past, policy makers have helped to introduce the rules, as well as nurture the institutions, that run complex settlement systems with relatively high degrees of confidence and efficiency. Taking these kinds of policy initiatives could go a long way towards transforming technological potential into practical and efficient economic reality. Finally, recent terrorist events give additional salience and urgency to the accelerated introduction of much more widespread clearing and settlement systems based on broadly

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agreed rules for ensuring transparency of financial transactions. Establishing internet type open standards for ubiquitous payment systems, with internationally agreed principles for respecting privacy and the responsibilities of citizenship embedded in the basic software code, offers a major opportunity to marginalise illegal transactions of all kinds. First by significantly reducing the place of cash and second by bringing all economic agents on to a level playing field when it comes to the transparency of their financial activities. Many pieces of such systems are either in place or being developed. Now, with global interdependence so clear to everyone, there is an opportunity to add a sense of urgency to setting an ambitious and innovative policy agenda for the future of money. Over the last few years the future of money has received considerable attention. Many important questions have been posed and many answers provided. This conference built on previous efforts to clarify a number of crucial issues and added a dimension that has been largely ignored up to now to what extent do major advances in economic and social conditions, two to three decades from now, depend on as well as give rise to the use of digital money in most (if not all) market transactions? Consideration of this latter question follows directly from the mission and preceding conferences of the OECD International Futures Programme, in particular the findings of the recent 21st Century Transitions conference series on the prospect that there may be technological, economic, social and governance changes on par with the radical transformations that characterised the transition from agricultural to industrial society. For the sake of brevity this Key Points synthesis of the Forum for the Future conference on the Future of Money offers a four point overview of the main findings that emerged from the background documentation and lively discussion: 1) Defining the Issues; 2) Implications of Long-run Historical Trends; 3) The Imperatives of Economic and Social Change; and 4) Time for Policy Breakthroughs? 1) Defining the Issues Fairly often discussions of the future of money get sidetracked by confusion over the definition of money, its many functions, various forms and the multitude of mechanisms for effecting transactions. Without offering a systematic review of the numerous strands of thought and differences in vocabulary, it is worth covering three basic points that together provide a solid analytical foundation for thinking about the future of money.

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First, for most participants at this conference money serves three classic functions - as unit of account, means of payment and store of value. In the future there is little prospect of change in these basic attributes of money. Second, there are a range of forms of money, not all of which must serve all three of moneys primary functions. In the future there is a good chance that current forms of money will be joined by new ones, although it is difficult to ascertain the likelihood of widespread acceptance. And third, there can be little doubt that there will be a proliferation of monetary mediums or transaction methods, both physical and digital, over the next few decades. These points of departure are helpful for clarifying the issues at stake in a discussion of the future of money. However, two additional concepts make it much easier to assess the many possible trajectories that monetary forms and means of payment might take over the coming decades. One is the idea of a monetary space which refers to a domain, understood both in the physical sense of a particular territory and in the virtual sense of a specific market, within which a particular money serves one, two or all three functions. For instance the territory of Japan defines a territorial monetary space that uses Yen, while oil markets define a virtual monetary space that uses American dollars. The second useful concept is that of a monetary hierarchy that exists within a monetary space. This notion helps to distinguish different forms of money and the relationships that exist amongst them. Dominating the hierarchy is the form of money that inspires the greatest confidence and can perform fully all of moneys primary functions. Here it is worth recalling that money is a form of credit, with state debt in the form of issued currency usually having the highest degree of credibility in terms of the expectation of future redeemability. Legitimate and stable political authority has two strong advantages when it comes to ensuring that its money constitutes the common denominator of the monetary hierarchy. First the state can specify that the payment of tax liabilities must be in a specific currency. Second, in so far as a government maintains its fiscal balances within acceptable limits, respects the prevailing rules of political legitimacy and seems well positioned to maintain its territorial sovereignty, there is usually widespread confidence that the currency will be a generally accepted unit of account and means of payment in

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the future (often this acceptance is a legal requirement within a territorial monetary space). Other forms of money occupy a less dominant or less central position in the hierarchy either because of less credibility or an inability to perform one or two of moneys general functions. For the most part, the position of a particular form of money in the monetary hierarchy is determined by two attributes: its liquidity, which means the ease with which it is redeemable into the dominant currency, and its effectiveness in performing moneys different functions. To take one example, the tokens stored on the smart-cards used by some phone companies do not function at all as a generalised unit of account (no prices are posted in these units) and are limited as both a store of value (to the extent that they expire) and even as means of payment (no one else accepts them). Furthermore, these tokens are not at all liquid in so far as there is no redeemability back into the original currency. Frequent flyer miles and loyalty dollars are another example of a form of money with relatively narrow functionality. However, despite such limitations these private tokens are a genuine form of money, while a credit card or other transaction mechanisms, like a debit card, simply facilitate exchange using, in most cases, the dominant form of money. Looked at in terms of monetary spaces and hierarchies it becomes clear that most current discussions of electronic money are not about new forms of money at all but rather about new ways of executing transactions with existing forms. Genuinely new forms of money emerge when a person or institution offers to create a token which has no prior record and which they promise to redeem at a particular value in the future. In most circumstances this new token starts at a very weak position in the monetary hierarchy. By way of contrast, new tools or technological means for engaging and recording transactions often try to overcome the steep hurdles to widespread acceptance by using the most familiar and dominant form of money. So when credit cards were introduced there was no effort to compound the problems of gaining users confidence by attempting to introduce a new form of private money at the same time. Credit cards simply offer an easier way to use the currency that dominates the monetary hierarchy. Diagram 1 below uses these concepts to provide a graphical context for mapping possible directions for the future of money. The bottom left quadrant of the diagram applies to

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situations where most transactions use: the dominant currency of the monetary hierarchy, occur within a particular territory and are conducted using a physical medium. Historically most societies have operated in this quadrant and even today this is still the sphere of the majority of transactions involving individuals, retail merchants and small businesses. However, over time the weight of transactions measured in terms of value has moved more towards the bottom right quadrant. In specific markets like oil, foreign currency and financial markets more generally, transactions have become less territorially circumscribed and more virtual, although for the most part the strongest currencies of the monetary hierarchy have continued to dominate. Secondary forms of money (private) Dominant form of money (state) For the future, the question is to what extent transactions will shift towards other quadrants, particularly the upper right where conditions contrast the most with those that pertain today. Two distinct and mutually reinforcing answers, dealt with in turn in the following sections, were provided by the conference: one based on the long-run trends of monetary development and the other rooted in an assessment of the implications for money of future economic and social changes. 2) Implications of Long-run Historical Trends The likely path money might take in the future can be partly assessed by looking at three non-linear but nevertheless persistent trends that have marked moneys long history. First is the gradual dematerialization or abstraction of money from a tangible object to an almost entirely intangible sign or digital record. Initial steps along this path can be found in some of the earliest written records. For instance, Plutarch describes how monetary reform in the 6th century BC, aimed at easing the debt load of poor peasants to their landlords, involved reducing the weight of the Drachma by 30%. Another prominent step along this same path came with the Italian Renaissance and the introduction of bills of exchange that dematerialized money into entries in the accounts of creditors and debtors. The second long-run historical trend relates to the efficiency with which the relationships between creditors and debtors are managed, particularly within the financial sector which

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plays a pivotal role in sustaining confidence in a specific monetary hierarchy and space. The key development here has been the steady improvement in the agreements and standards that ensure mutually acceptable and routine resolution of daily inter-bank obligations. This trend displays two dimensions, one towards greater centralisation of the management of system-wide clearing, and the other, a growing capacity to support complex, decentralised forms of money and payment mechanisms. The first is most clearly seen in todays networked national payment systems where central banks and a specialised public regulator are usually the backstop and supervisor. The second dimension, made possible by the high integrity of the core financial sectors payment systems, is manifested in many OECD countries by the proliferation of new financial instruments (like mortgage bonds and hedge funds) and payment technologies (like smart cards and thenew person-to-person Internet based payment intermediaries e.g. Pay pal to another. The third trend that marks moneys historical record also points towards the importance of regulatory conditions. Here the story is one of the enhancements made to governance capacity, not only in the relatively narrow field of inter-bank clearing and the integrity of the financial sector, but broadly in terms of how money and the financial sector interact with the rest of the economy and society. Todays monetary spaces and hierarchies rest on governance systems that have the capacity to handle challenges that combine broad economic and monetary dimensions such as controlling inflation, dealing with bank failures, and resolving the conflicts of interests that divide different constituencies (e.g. importers vs. exporters, debtors vs. creditors). For instance, in most OECD countries, the credibility of the rules and institutions that underpin a specific monetary space and hierarchy is realised through the regular publication of dependable economic statistics (e.g. the consumer price index), the establishment of clear lines of accountability and transparency (e.g. in state budgets, stock markets and central banks), and open processes for resolving disputes amongst competing interests (e.g. legislative debate and judicial remedies). In this system the state is the lender of last resort, legal enforcer of the national currency as means of payment, supervisor of the integrity of the financial sector and guardian of macro-economic stability. Based on its legitimate political authority the state can make decisions that have a major impact on who are the winners and losers in

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society, including choices in the monetary sphere that at times favour creditors over debtors, bank share-holders over taxpayers, exporters over importers, and even owners over creators of intellectual property (by, for instance, failing to introduce a level playing field for micropayments). For the future, however, governance capacities may need to be significantly enhanced. The biggest challenges seem likely to arise from the need to negotiate new rules and reform or launch institutions capable of setting the standards and supervising the operation of a universally accessible digital currency. Many issues will need to be resolved, from the best method for establishing universal systems for verifying peoples identities and providing effortless access to a digital money accounts to ensuring high levels of interoperability on both the software and hardware sides of the monetary network. These challenges will require concerted efforts on the part of public authorities, the sphere of territorially defined monetary spaces with state dominated hierarchies. At the global level few of the requisite decision making and implementation mechanisms are in place. The extent to which this could pose a problem will depend, as discussed in the next section, on the nature of the changes and public policy goals likely to prevail. 3) The Imperatives of Economic and Social Change If moneys long-run trends signal that major shifts in monetary spaces and hierarchies are possible, it is the strong connection to socio-economic change that offers a way of assessing the probability and desirability of such movement over the next few decades. Many conference participants noted that there is a clear inter-dependency between specific socio-economic conditions and the success of specific forms of money as well as payment mechanisms. For instance, inter-city trading during the Italian Renaissance helped to both inspire and diffuse the use of bills of exchange. Taking more current examples, there is a mutually reinforcing relationship between credit cards as a payment mechanism and the conspicuous consumption patterns characteristic of certain social groups. While the use of American dollars in parts of the world where the state lacks sufficient fiscal credibility (Argentina) or the legal economy is weak (Russia) also demonstrates that there is close connection between specific socio-economic and monetary systems.

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In the future, four potential sets of developments seem likely to exhibit a strong interdependency with the emergence of new payment systems and possibly forms of money: the transition to a global knowledgeintensive economy; the demands for equitable access in more diversified societies; technological advances that open up new possibilities for payment and settlement mechanisms; and the pursuit of societal interests in the context of the public good dimensions of money Transition to a global knowledge-intensive economy: Despite the recent popularisation of the Internet and the long-standing recognition that many OECD countries have become post-industrial, a number of conference participants argued that there is considerable scope for further profound changes in economic functioning. In particular, it was contended that the evolution towards an economy where intangibles such as knowledge are the primary source of value-added will both enable and demand fundamental changes to transaction systems. The importance of changes in the monetary sphere for the development of the global knowledge-intensive economy stems from the difficulties, already encountered by so many of the failed Internet start-ups, of creating markets for intangibles like ideas and entertainment. Perhaps the clearest early sign, without going into detail, that the appropriate payment systems have yet to be worked out, is in the field of music. Here the creators and owners of music, now traded using digital files, have been unable to find efficient ways of getting paid. The economy-wide consequences of this genuine market failure, often referred to as the lack of a viable business model, may be much more severe as an ever greater share of total wealth creation falls into the realm of intangible knowledge. Equitable access in a more diversified society: Recent analyses of the digital divide have already drawn attention to the potential for polarisation and exclusion as more everyday activities migrate to the Internet. A future where digital money is predominant for all types of transactions could either exacerbate accessibility problems or, under certain policy regimes, be an effective way of opening up the digisphere to tomorrows highly differentiated societies. The former possibility arises most obviously if digital money only works in conjunction with relatively expensive technology or identity requirements that are not universally accessible. Alternatively, network money could be specified and implemented in ways

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that make it both less expensive to use than physical cash and a means of achieving greater social inclusion. Granting all people the right to a verifiable Internet identity and a basic money account, in the context of a much more universally accessible network, would put in place a strongly inclusive foundation for a monetary space that uses predominantly digital money. The pursuit of this more accessible path not only illustrates the close connection between changes in the socio-economic and monetary spheres but also the determinant role of public and private innovation in setting the direction and pace of change. Technological possibilities: Digital money will only match the attributes of physical cash if there are major advances in the ease, cost and certainty with which digital transactions are handled. In particular there will need to be considerable progress in the following areas: verification, confidentiality, ease-of-use, interoperability and reliability throughout the entire transaction chain. Many of these advances willrequire improvements in regulatory frameworks and related instruments. For instance, privacy laws can play a major role in ensuring that the required confidentiality levels for different types of transactions are met. The implementation of mandatory cryptographic, insurance, supervisory and other safety standards like those applied to so many other products, such as cars and food, could go a long way towards creating the necessary confidence in digital money. There is also a more scientific dimension, where technical progress in fields ranging from biometrics and ubiquitous computing to network protocols and intuitive interfaces, can be expected to spur the invention of new payment systems and forms of money as well as improving the chances that such innovations will be successful in gaining acceptance. Pursuing the public interest: Another crucial force likely to drive the diffusion of digital money over the long-run is the pursuit of the general public interest in: lower transaction costs, less crime, easier collection of taxes and greater competition in both new and existing markets. The introduction of monetary systems where digital money predominates could achieve these goals. The most evident link between lower transaction costs and digital money arises from the potential to eliminate the significant costs associated with printing, handling and back-office accounting of physical cash and near cash-like cheques. Further considerable savings might be possible if the clearing and

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settlement systems could be improved to reduce the costs of delay, intermediation and enforcement. There is also a clear connection between the underground economy in all its forms and physical cash. The marginalisation of physical cash, perhaps even to the point where it is marginalised, could serve to make many types of illegal transaction (including the financing of terrorism) much more difficult. Tax collection and verification methods that hinder criminal activity could also be automated in a variety of ways if the vast majority of monetary exchanges take place digitally through interoperable, secure and authenticated network based clearing and settlement systems. Finally, given the appropriate standards and regulations, the shift to the predominant use of digital money could facilitate both the entry of new competitors into the financial sector and encourage the emergence of new revenue models for many intangibles, including intellectual property. How far, at what pace, and with what kind of complications will depend largely on the vigour and effectiveness of the public policies that are fundamental for shaping monetary systems. 4) Time for Policy Breakthroughs? The answer to this question depends, in part, on expectations regarding what might be accomplished by accelerating the transition to more fully digital monetary systems and, in part, on the plausibility that new policy approaches are both available and likely to be effective. The results of this conference suggest that there would probably be a fairly high pay-off from a more rapid transition, particularly in terms of encouraging the emergence of an Internet enabled global knowledge-intensive economy. Moving fairly quickly to introduce the appropriate policies can be justified on both short- and long-run grounds. Looking to the shorter term, policies for accelerating the diffusion of digital money have taken on added urgency for two reasons. First, actions to re-establish confidence and encourage investment are now more important in light of the present global economic slowdown and the new economy backlash in particular. A second and equally important current reason for an activist stance is that governments need to find ways to support the creation of worldwide markets in ways that facilitate inclusion and participation. Looking to the longer-run, by pushing for policy breakthroughs in these domain governments can make a major and timely contribution to bringing the monetary system into closer alignment with changing socio-economic conditions. By so doing there

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is a good chance of both reducing the costs and expanding the benefits of the fundamental economic and social transformations underway. Government policies with respect to the future of money seem most likely to succeed by: first, making the rapid extension of the use of electronic money throughout the economy a clear policy goal; and second, as the primary method for implementing this goal, work to accelerate the development and diffusion of economy-wide instantaneous clearing and settlement methods, similar to the ones that have been taking over in the sphere of interbank transactions. Government efforts in this direction will need to: use technology neutral approaches that rigorously maintain inter-operability (like that of the Internet where one standard for communication TCP/IP allows a flourishing of a vast range of different types of connections and uses), meet key social criteria with respect to privacy and universal access (judicial protection for individuals, mandatory technical safeguards), and fulfill basic economic criteria regarding transparency and trust (monitoring of monetary aggregates, tax collection, illegal activity, authentication). This means that there will be a crucial role for the processes and institutions that develop and approve standards within and across monetary spaces. At least two major concerns have been voiced about the risks of rapid movement towards more fully digital monetary systems: one is in terms of the potential to undermine both macroeconomic goals and tools; and the other is related to the magnitude of the governance challenge (how to make and implement the necessary decisions), particularly at the global level. Considering macroeconomic policy first, an initial analytical distinction needs to be made between monetary spaces that are isolated and those that are permeable. In the case of a relatively autonomous monetary space that has a stable, state dominated monetary hierarchy, there seems little reason to worry. Even if physical currency becomes marginal or disappears altogether, most experts agree that a state supported central bank would be able to control short term interest rates by buying and selling financial obligations, at a loss if necessary. With respect to the implications of a predominantly digital monetary system for assessing monetary aggregates and the velocity with which money circulates in the economy, there is a case to be made that the clearing and settlement systems that underpin a virtual monetary space could offer authorities greater transparency. Current

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efforts at data collection encounter substantial problems because physical cash remains very costly to trace and it is still in use for a very large number of day to day transactions. Shifting to much more sophisticated digital money systems that depend on universal accessibility to network clearing and settlement opens up the opportunity for real-time verification of almost all transactions by volume and kind, without necessarily abandoning confidentiality. Contrary to some expectations, digital money could appreciably facilitate the tracking of monetary aggregates and thereby improve the effectiveness of policy adjustments aimed at meeting macroeconomic objectives. In the case of a much less isolated monetary space there seems, at least in theory, to be a more serious threat to the effectiveness of certain macroeconomic management tools. Experience with the interpenetration of monetary spaces shows how the use of outside money can threaten to displace the local currency. This in turn can lead to situations where the effectiveness of the central banks tools for controlling monetary policy are weakened. Recent examples where an outside currency, in this case the American dollar, has been disruptive can be seen in Russia and even more so in Argentina with the adoption of a currency board. Projected to a global level the introduction of universally accessible and accepted networked money could increase the risk that strong outside currencies would replace weaker local currencies. Pushed to its logical conclusion this path might create a single worldwide monetary space and hierarchy. Without pronouncing on the desirability or not of this outcome, an issue long debated by advocates and opponents of a gold standard, it is clear that many formidable obstacles stand in the way. Two are worth highlighting here. First, the creation of a fully open global transaction system that is entirely agnostic regarding the particular currency being used runs counter to strong perceptions of national or regional interest. Second, the strength of the dominant money within a monetary space rests on the extent to which people have confidence that the policies of the issuer will serve the general interest in a politically legitimate way. Despite the views of some that the American dollar, in more or less competition with other currencies like the Euro and the Yen, could serve as a global digital money, the institutional foundations for a global monetary space and hierarchy remain a long way off. In the same way that the first monetary hierarchies did not spring to life simply because money is more efficient than barter neither will the global digital

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currency suddenly appear. The creation of a global monetary space and hierarchy, like national ones before, would require a legitimate and credible authority. Governance is the second challenge to policies aimed at accelerating the diffusion of digital money. Here again the problems posed at the national level look to be more manageable than those at the global level. In a national monetary space many of the necessary institutional, legal and regulatory starting points are already in place. For example, Singapores bold move to introduce digital money that is universally accessible, clears in real-time, and allows for peer-to-peer transactions amongst all economic agents, offers a useful set of guidelines for bringing together the key constituencies and setting out technical goals for accessibility, inter-operability, etc.. Authorities in larger, more heterogeneous jurisdictions may encounter a few more hurdles. Initial resistance can be expected from banks and other intermediaries that generate significant revenues from the delays and service charges that are associated with physical cash and near cash instruments, usually in the context of rather antiquated clearing and settlement systems. Digital systems can drastically reduce many of these transaction costs, including the time it takes for cheques to clear, the service charges added to foreign exchange activities, and the expenses incurred trying to stop criminals from both stealing and using cash. Faced with the advantages of digital money there is a good chance that the champions of change will at least get the ball rolling. The more stubborn obstacles may arise further down the road with the efforts to actually introduce the rules and standards that make economywide and universally accessible digital monetary systems workable. Serious conflicts are likely to emerge because these parameters determine the competitive conditions that apply at both the basic level of which institutions have the right to issue digital currency and, at the operational level, of which companies will supply the technology (hardware, operating systems, etc.). Resolving conflicts in this arena, in ways that sustain confidence in the monetary space and hierarchy, poses the most significant challenge to policy makers. Part of the problem stems from the paradoxical situation of central banks. On the one hand these are the institutions with the credibility and knowledge to champion change in the monetary sphere. On the other hand actions that might destabilize the monetary system or undermine confidence in the central bank risk undermining the banks central functions. This means that policy leadership will likely fall to the

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legislative and executive branches of government which are, in any case, better suited to the challenges of overcoming entrenched interests, opening up new fields for competition, and representing the broader societal interest in socio-economic transformation. Indeed, recalling moneys second and third long-run trends, namely the development of regulatory infrastructures, it is to be expected that supervising the integrity and functioning of the clearing and settlement system is a job for central banks and/or oversight institutions. While the challenge of setting out the goals and rules that link the monetary system to society as a whole falls naturally to less specialised parts of government. In short, the governance capacities at the national, or in the European case regional level are probably both appropriate to and capable of introducing universal digital money. Looking to the global level the challenge is severely compounded by the limited decision making and implementation capacities of todays international political institutions and processes. This global governance deficiency is manifested across a broad range of international issues, from the supervision of competition and the redesign of the financial architecture to environmental protection and social equity. Indeed, it is this inadequate governance capacity that leads to fears that the rapid introduction of digital money without the requisite codes and standards will simply serve to facilitate illegal activities like tax evasion, money laundering and violations of privacy rights. One approach that might overcome some of these fears and governance inadequacies involves the development of a common global framework for the introduction of national digital money networks. Building on this shared foundation in national monetary spaces might make it easier to knit together a global network that dispenses with the kind of central authority that has so far been a pre-requisite for an efficient and durable monetary space and hierarchy. In this case the global clearing system would operate in ways that are similar to other networks, from social to digital, that use common protocols to create the transparency and understanding that are essential for communication and exchange. Confidence in such a global network might be sustained, in part, by spreading risk over an immense number and diversity of transactions and participants. However, setting the rules and supervising decentralised global networks, particularly with the degree of certainty and transparency required for sustaining trust in a monetary system, will also call for policies that go beyond national interests. Current circumstances are already

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spurring innovative efforts of this kind, such as the International Corporation for Assigned Names and Numbers (ICANN), the organisation charged with supervising key aspects of the Internets technical infrastructure. Although this experiment is encountering great difficulty in finding ways to legitimately articulate a global view, the imperatives pushing this kind of institutional evolution seem unlikely to diminish. In the interim, while global governance capacities mature, the challenge for national policy makers is to accelerate the introduction of universally trusted and accessible peer to peer, instant clearing systems for all transactions throughout the entire economy. Information technology makes this goal feasible, but in the end only the appropriate rules and institutions can make it practical locally and globally. References : ECONOMIC SURVEYS (ISSUES OF 2007-2009) GENERAL STUDIES OF INDIAN ECONOMY (2003-2007) Reddy, Y.V., Autonomy of the Central Bank: Changing Contours In India, RBI Bulletin. Reserve Bank of India, Annual Report for the Years 1997-2001. Reserve Bank of India (1997) Report of the Committee on Banking Sector Reform

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CHAPTER-5

Conclusion

Money is unique in nature. The money market in developed and developing countries differ markedly from each other in many senses. Indian money market is not an exception for this. Though it is not a developed money market, it is a leading money market among the developing countries. It is a significant aspect of the Indian money market. It has a simultaneous existence of both the organized money market as well as unorganized money markets. The organized money market consists of RBI, all scheduled commercial banks and other recognized financial institutions. However, the unorganized part of the money market comprises domestic money lenders, indigenous bankers, trader, etc. The organized money market is in full control of the RBI. However, unorganized money market remains outside the RBI control. Thus both the organized and unorganized money market exists simultaneously. The demand for money in Indian money market is of a seasonal nature. India being an agriculture predominant economy, the demand for money is generated from the agricultural operations. During the busy season i.e. between October and April more agricultural activities takes place leading to a higher demand for money. In Indian money market, we have many levels of interest rates. They differ from bank to bank from period to period and even from borrower to borrower. Again in both organized and unorganized segment the interest rates differ. Thus there is an existence of many rates of interest in the Indian money market. In the Indian money market, the organized bill market is not prevalent. Though the RBI tried to introduce the Bill Market Scheme (1952) and then New Bill Market Scheme in 1970, still there is no properly organized bill market in India. This is a very important feature of the Indian money market. At the same time it is divided among several segments or sections which are loosely connected with each other. There is a lack of coordination among these different components of the money market. RBI has full control over the components in the organized segment but it cannot control the components in the unorganized segment. The call money market is a market for very short term money. Here money is demanded at the

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call rate. Basically the demand for call money comes from the commercial banks. Institutions such as the GIC, LIC, etc suffer huge fluctuations and thus it has remained highly volatile. It is in fact a defect of the Indian money market. In our money market the supply of various instruments such as the Treasury Bills, Commercial Bills, Certificate of Deposits, Commercial Papers, etc. is very limited. In order to meet the varied requirements of borrowers and lenders, It is necessary to develop numerous instruments. Defects or Drawbacks of Indian Money Market Though the Indian money market is considered as the advanced money market among developing countries, it still suffers from many drawbacks or defects. These defects limit the efficiency of our market. Some of the important drawbacks of Indian Money Market are The Indian money market is broadly divided into the Organized and Unorganized Sectors. The former comprises the legal financial institutions backed by the RBI. The unorganized statement of it includes various institutions such as indigenous bankers, village money lenders, traders, etc. There is lack of proper integration between these two segments. In the Indian money market, especially the banks, there exist too many rates of interests. These rates vary for lending, borrowing, government activities, etc. Many rates of interests create confusion among the investors. The Indian economy with its seasonal structure faces frequent shortage of financial recourse. Lower income, lower savings, and lack of banking habits among people are some of the reasons for it. In the Indian money market, various investment instruments such as Treasury Bills, Commercial Bills, Certificate of Deposits, Commercial Papers, etc. are used. But taking into account the size of the population and market these instruments are inadequate. In India, as many banks keep large funds for liquidity purpose, the use of the commercial bills is very limited. Similarly since a large number of transactions are preferred in the cash form the scope for commercial bills are limited. In India even through we have a big network of commercial banks, still the banking system suffers from major weaknesses such as the NPA, huge losses, and poor efficiency. The

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absence of the organized banking system is major problem for Indian money market. There are poor number of dealers in the short-term assets who can act as mediators between the government and the banking system. The less number of dealers leads to the slow contact between the end lender and end borrowers. These are some of the major drawbacks of the Indian money market; many of these are also the features of our money market. Indian Government appointed a committee under the chairmanship of Sukhamoy Chakravarty in 1984 to review the Indian monetary system. Later Narayanan Vaghul working group and Narasimham Committee was also set up. As per the recommendations of these study groups and with the financial sector reforms initiated in the early 1990s, the government has adopted following major reforms in the Indian money market. In recent period the government has adopted an interest rate policy of liberal nature. It lifted the ceiling rates of the call money market, short-term deposits, bills rediscounting, etc. Commercial banks are advised to see the interest rate change that takes place within the limit. There was a further deregulation of interest rates during the economic reforms. Currently interest rates are determined by the working of market forces except for a few regulations. In order to provide additional short-term investment revenue, the RBI encouraged and established the Money Market Mutual Funds (MMMFs) in April 1992. MMMFs are allowed to sell units to corporate and individuals. The upper limit of 50 crore investments has also been lifted. Financial institutions such as the IDBI and the UTI have set up such funds. The Discount and Finance House of India (DFHI) was set up in April 1988 to impart liquidity in the money market. It was set up jointly by the RBI, Public sector Banks and Financial Institutions. DFHI has played an important role in stabilizing the Indian money market. Through the LAF, the RBI remains in the money market on a continue basis through the repo transaction. LAF adjusts liquidity in the market through absorption and or injection of financial resources. In order to impart transparency and efficiency in the money market transaction the electronic dealing system has been started. It covers all deals in the money market. Similarly it is useful for the RBI to watchdog the money market. The Clearing Corporation of India limited (CCIL) was set up in April 2001. The CCIL clears all transactions in government securities, and repose reported on the Negotiated Dealing System. The government has consistently tried to introduce new short-term investment instruments. Examples: Treasury Bills of various duration, Commercial papers,

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Certificates of Deposits, MMMFs, etc. have been introduced in the Indian Money Market. These are major reforms undertaken in the money market in India. Apart from these, the stamp duty reforms, floating rate bonds, etc. are some other prominent reforms in the money market in India. Thus, at the end we can conclude that the Indian money market is developing at a good speed. The impact of ten years of gradualist economic reforms in India on the policy environment presents a mixed picture. Progress has been made in several areas of financial sector reforms, though some of the critical issues relating to government ownership of the banks remain to be addressed. However, the outcome in the fiscal area shows a worse situation at the end of ten years than at the start. Financial sector reforms, particularly the reform of banking, remain a distant goal. While foreign banks are now allowed freely to open branches in India, they have not yet moved in aggressively. Banking sector privatization will take time but large efficiency gains could be achieved if labor laws are reformed to restore the hire and fire policy. Layoffs in banks have been very difficult and voluntary retirement schemes extremely costly. Beside these, Some of the serious shortcomings in the anticipated benefits of reform such as in credit delivery do need changes in legal and incentive systems. Recommendations In spite of difficulties in prioritizing the elements relevant for reform, an attempt is made to mention some recommendations in the light of experience gained so far. First, as elaborated in Governor Jalans statements on Monetary and Credit Policy, several legislative measures are needed to enable further progress. These relate in particular, to ownership, regulatory focus, development of financial markets, and bankruptcy procedures. Some of the serious shortcomings in the anticipated benefits of reform such as in credit delivery do need changes in legal and incentive systems. In particular, there is need to focus on reduction of transaction costs in economic activity, and enhancing economic incentives. Severe penalties in law, including criminal proceedings, may not be substitutes for increasing enforceability (i.e., probability of being caught, prosecuted, and punished adequately and in a timely fashion). In regard to institutions, there is need to clearly differentiate functions of owner, regulator, financial

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intermediary and market participant, to replace the joint-family approach that is a legacy of the pre-reform framework. Second, fiscal empowerment appears to be essential for obvious reasons. While the existing level of fiscal deficit may be manageable, the headroom available for meeting unforeseen circumstances appears rather limited. The problem is somewhat acute in regard to finances of states, which have serious structural problems and their resolution is possible only through accelerated fiscal support from Central Government consistent with the fiscal soundness of Central Government. Some of the legal reforms may also be necessary for this purpose and the link for further progress in the financial sector is obvious. In particular, the nature of fiscal dominance does constrain the effectiveness of monetary policy to meet unforeseen contingencies as well as maintain price stability and contain inflationary expectations. Third, the reforms in the real sector are needed to bring about structural changes in the economy. The liberalization of financial sector and of external sector can provide impetus for further growth and in turn help more rapid progress only when accompanied by reforms in the real sector, particularly in domestic trade. Fourth, there are what may be termed as overhang problems in the financial sector, such as non-performing assets of banks and financial institutions. There are similar overhang problems in other areas as well, and it is necessary to make a distinction between what may be termed as flow issues and overhang issues. There is merit in insulating the overhang problem from flow issues and demonstrably solve the flow problem upfront. For example, in regard to food stocks there is addition to buffer stocks virtually on a continuous basis and a policy needs to be evolved to tackle this flow. Any attempt to sort out the overhang accumulated excess stocks on an ad hoc basis would obviously have limited success. Any solution to the overhang problem of large magnitude is bound to be operational over the medium-term and may involve admission of the magnitude of possible losses to be incurred. Yet another example relates to the power sector, where addition to capacities to generate without ensuring cost recovery adds to the problem of accumulated losses. Prima facie, the major areas with considerable overhang problems apart from the financial sector are

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Public enterprises, pension and provident fund liabilities and the cooperative sector. The criticality of the issue is in terms of their cumulative impact on financial sector as a whole. Fifth, it will be useful to distinguish between what a financial sector can contribute and what fiscal action can contribute to matters relating to poverty alleviation. In the interest of efficiency and stability of financial sector, intermediation may have to be progressively multi institutional rather than wholly bank-centered. Social obligations may have to be distributed equitably among banks and other intermediaries but that would be difficult to achieve in the context of emerging capital markets and relatively open economy. In such a situation, banks which are special and backbone of payment systems, may face problems if they are subject to disproportionate burdens. Hence, mechanisms have to be found to reconcile these dilemmas. Furthermore, monetary policy is increasingly focused on efficient discharge of its objective including price stability, and this no doubt would help poverty alleviation, albeit indirectly, while the more direct attack on poverty alleviation would rightfully be the preserve of fiscal policy. Monetary and financial sector policies in India should perhaps be focusing increasingly on what Dreze and Sen Call growth mediated security while support-led security, mainly consisting of direct anti-poverty interventions are addressed mainly by fiscal and other governmental activities. In particular, there is need to focus on reduction of transaction costs in economic activity, and enhancing economic incentives. Severe penalties in law, including criminal proceedings, may not be substitutes for increasing enforceability (i.e., probability of being caught, prosecuted, and punished adequately and in a timely fashion). In regard to institutions, there is need to clearly differentiate functions of owner, regulator, financial intermediary and market participant, to replace the joint-family approach that is a legacy of the pre-reform framework.

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