India's Financial Sector: An Era of Reforms

Let us begin with the banking sector reform. The objective has been to make banks a profit-making unit along with desired financial strength and financial stability and ultimately to benefit those who were not so far the beneficiary of the banking facilities. To this end, capital adequacy norms were prescribed at par with the Basle norms that the banks were able to achieve. The CRR and SLR requirements were axed, so that the banks could have larger funds at their disposal for profitable lending. Interest rate structure was deregulated in order to do away with the artificial barrier and to allow the market forces [Page 195]to work. Non-performing Assets (NPAs) were brought to a manageable limit through greater provisioning and better loan recovery methods. Income recognition norms were made more transparent and financial supervision was made more workable. Competition among banks was encouraged through liberalising entry norms so as to help improve efficiency. Last but not least, customer service was taken care of.

With all these moves, the banks' efficiency and thereby profitability increased over one-and-a-half decades of reform period. There were, of course, variations among different groups of banks—public sector, private sector and the foreign banks operating in the country. However, the scheduled commercial banks as a whole improved their efficiency. The net interest earned/asset ratio and the operational expenses/net income ratio squeezed, respectively, from 3.30 to 2.35 per cent and from 55.73 to 48 per cent between FY 1991–92 and FY 2007–08. With increasing efficiency, profitability did increase. It moved up from 0.35 to 0.99 per cent during the same period. What is important is that the profitability ratio was quite in tandem with the international standards.

As far as financial stability is concerned, different ratios indicated improvement in this context over the period of reform. The banks' ability to cover NPAs through provisioning improved substantially. The provisioning/NPA ratio moved up from 16.20 to 52.59 per cent during FYs 1991–2008. The capital adequacy of the banks too improved as the capital/assets ratio surged up from 2.62 to 7.29 per cent. The fund volatility ratio, on the other hand, dropped from (–) 13.53 to (–) 31.37 per cent during the above period showing greater financial stability. These ratios too were comparable to international standards.

Finally, the efforts towards financial inclusion are only a recent one. Although steps were taken to reach the weaker sections of the society through no-frill accounts, yet, according to an RBI study, the progress has not been very satisfactory.

Again, as far as the Non-banking Financial Companies (NBFCs) are concerned, the focus of reform fell greatly on regulating them to ensure financial viability as well as to protect customers' interest. But still, [Page 196]the companies registered with the RBI are only a few meaning that a large number of NBFCs are yet to come under the RBI's regulatory umbrella. As regards capital adequacy, the situation improved over the years. At the end of March 2008, around 83 per cent of companies, especially the deposit-accepting ones had a CRAR of 20 per cent or above.

The NPAs' position improved significantly as the net NPA/asset ratio fell drastically from 7.4 per cent at the end of March 1998 to 0.3 per cent at the end of March 2008. However, these companies have not been able to attract large deposits in relation to the total deposits moving to the banking sector. Their deposits were barely 0.73 per cent of the deposits moving to the scheduled commercial banks at the end of March 2008. A sense of confidence needs to be generated among the depositors so as to bring the NBFCs at par with the banking companies.

Again, in view of various support measures, the efficiency of these companies improved. Although the financial expenses as well as operating expenses, both in relation to assets, remained moving, respectively, around 6 and 3 per cent between FY 1998–99 and FY 2007–08, the profitability ratio manifesting in net profit/asset ratio increased from 0.3 per cent in FY 1998–99 to 2.9 per cent in FY 2007–08. It could have been higher, had the NBFCs axed sizeably the operational and financial expenses.

Last but not least, the element of financial inclusion is still not very apparent. It should be a part of the NBFCs regulations in future.

The mutual fund business expanded since 1987 when a few organisations sponsored by banks and insurance corporations joined hands with the UTI to perform such business. Again, with the initiation of financial sector reforms, this business was further extended in 1993 to private sector companies, both domestic and foreign. Regulatory measures along with big doses of liberalisation were implemented on various fronts, such as maintenance of net worth, creation of new schemes, investment policy, profit distribution, so as to encourage the mutual fund companies to play an active role and, at the same time, to protect the interest of the small investors. All this had a positive impact on the size of resource mobilisation as the amount of gross [Page 197]resource mobilisation surged up from Rs. 930 billion in FY 2000–01 to Rs. 44,644 billion in FY 2007–08. The size of net assets under management too inflated from Rs. 906 billion to Rs. 5,052 billion during this period. The largest share, say, over four-fifths was accounted for by the private sector companies. The open-ended schemes and income/debt schemes proved more attractive. On the contrary, investment in money market instrument and in the government securities lagged far behind.

On the whole, the performance of the mutual funds got great impetus from the reform measures. Yet the investment by mutual funds in the secondary market did not influence vividly the stock market index. Again, as far as financial stability is concerned, this aspect needs greater attention of the policy makers.

First of all, in the primary market for securities, SEBI came to regulate the entire functioning with a view to making its structure and functioning greatly flexible and market oriented and protecting the interest of the investors. The development of infrastructure, such as merchant banking, venture capital funds and credit-rating agencies, and basing the pricing process on the market forces, known as book-building process, were the focus of reform. All this bore fruit. The amount of the resources mobilised in the domestic segment surged up from a meagre of Rs. 142 billion in FY 1991–92 and below Rs. 500 billion during the early 2000s to Rs. 2,963 billion during FY 2007–08. Private placement outweighed the public offerings. The share of the private sector companies was large in case of public offerings, but in private placement, the public sector companies fared well. The discussion reveals that a very large part of the funds raised was accounted by the services sector and especially by those services that were financial in nature. In the manufacturing sector, chemicals and machinery-related companies were significant.

Again, the securities were allotted mainly to big investors who could influence the market in their own way. However, the move of the Ministry of Finance towards dispersion of ownership in favour [Page 198]of individual shareholders may prove conducive to price stability and financial inclusion. Of late, the SEBI Advisory Committee has suggested to carry out the entire process of IPO through Internet and to lower the time lag between the issue and the listing of securities (Financial Express 10 March 2008). All this may boost further the primary market activities.

In the secondary capital market too, SEBI is the regulator. The NSE and a few other stock exchanges were set up as well as the FIIs and also the domestic and foreign mutual fund companies were permitted to operate in the market so as to foster competition in this area. The procedure of listing, trading, clearing and settlement was made transparent and convenient with the introduction, among others, of electronic devices. The market for derivatives was launched to compete with the cash segment of the market. The transaction cost was also axed, so as to make the market still more attractive. Last but not least, FDI was allowed in the BSE and the NSE that is expected to improve the functioning even further.

All these measures led to an upward move in the turnover, market capitalisation and the share price index. The turnover at BSE and NSE taken together swelled from Rs. 8,205 billion in FY 2001–02 to Rs. 51,299 billion during FY 2007–08. The total capitalisation during this period sped up from Rs. 12,491 billion to Rs. 99,961 billion. The annual average of BSE Sensex rose from 3,372 to 16,569 (FY 1978–79 = 100) and NSE Nifty recorded an increase from 1,077 to 4,897 (3.11.1995 = 100) during the same period. The derivatives segment is quite a new one but it showed faster growth in the turnover during the same period from Rs. 1,039 billion to Rs. 133,123 billion. Besides the trade in equity shares, the debt securities were also traded. Their turnover increased manifold from Rs. 9,472 billion in FY 2001–02 to Rs. 57,031 billion during FY 2007–08. However, a lion's share was accounted for by the government securities. The trade in corporate debt remained confined to a lower limit.

The rate of returns too improved over the years but volatility in the returns remained a major cause of concern, especially when we compare it with that among major international stock markets. [Page 199]In other words, financial stability is yet to be achieved. Last but not least, the market has moved towards greater efficiency but yet it has to go a long way to achieve the desired efficiency.

Apart from the primary and secondary market, the ray of reform fell also on the market for government securities—treasury bills and dated securities—so as to meet effectively the desired fiscal and monetary objectives. The reform measures were manifest especially in the diversified structure of this market, introduction of auctions, enhancement of marketability and liquidity, strengthening of the basic infrastructure and easing of the settlement procedure.

The central government securities, to which the present study is confined, played an important role in bridging the fiscal deficit. While they covered only around one-half of the central government's fiscal deficit during FY 1997–98, the percentage was almost 100 during FY 2006–07, although it was lower at 75 during FY 2007–08.

As far as the infusion of liquidity is concerned, the government securities played a significant role. They were transacted in the secondary market both outright and under repo arrangement. There was a big growth in the quantum of these transactions in past years. In FY 2007–08, those being outright amounted to Rs. 16,618 billion and those under repo arrangement were as large as Rs. 38,917 billion. The share of treasury bills was low compared to the dated securities. The only problem is that instability in the liquidity infusion still persists. However, it is quite evident from the study that liquidity has an impact on the yield and the yield has a definite role in anchoring rate of interest in the capital market. Last but not least, there has been diversification in the ownership pattern of the government securities with the result that the financial stability has been generated and market has grown more efficient. Greater integration within the government securities market is another plus point conferring greater efficiency on the market.

When one talks about reforms in the Indian financial market, the money market segment is no less significant. The Indian money market has [Page 200]different segments and variety of instruments. The objective of reform has been to encourage the turnover through infusing greater doses of transparency, to bolster a balanced development in different segments of this market and to foster stability through checking volatility in the interest rates primarily through repo and reverse repo measures. The CNMM was made a purely inter-bank market. Those participants who were barred from entering the inter-bank market can now use a newly created instrument, known as CBLO. The ceiling rate in case of CBLO is based on MIBOR and this instrument enjoys the provisions of marking to market and desirable haircuts. As a result, the turnover increased in this case. The average daily turnover (double leg) moved up from Rs. 5.15 billion in FY 2003–04 to Rs. 556.26 during 2007–08. Again, it is because of checking fluctuations in the call money rates that the turnover in the repo market outside the LAF too increased. The increase in terms of average of daily transactions (all legs) was recorded from Rs.104.35 billion in FY 2003–04 to Rs. 547.36 billion in FY 2007–08.

Besides, the Vaghul Committee twins—CPs and CDs were made more attractive through making changes in their structure, cutting the transaction cost and providing incentives. The turnover in their case did show an upward trend. The outstanding amount of CPs rose from Rs. 58.47 billion at the end of March 2001 to Rs. 325.92 billion by March 2008, except for a marginal drop during FY 2005–06. Similarly, in case of CDs, the outstanding amount rose from a bare figure of Rs. 7.71 billion at the end of March 2001 to Rs. 1,477.92 billion by March 2008.

The objective behind reforming money market was largely achieved. Besides increase in turnover in the money market as a whole, the share of call money market in the total turnover of the money market reduced and the reduction was in favour of CBLO. It shows a definite move towards creating the CNMM a purely inter-bank market and also the success of the CBLO. The call money rates could be stabilised to some extent insofar as, in the majority of the months under study, they moved within the tunnel provided by the repo and reverse repo rates. Last but not least, the correlation in the interest rates/discount rates between different segments of the money market turned greatly positive meaning that the different segments got highly integrated. Greater integration is the most valuable fruit of the reform measures.

Finally, the study is not limited to the capital and money market. It discusses also the reforms in Indian foreign exchange market. The move towards reform was manifest in the adoption of managed floating exchange rate system, restructuring of the very infrastructure of the market, introduction of a variety of activities, such as swaps and options and also a gradual move towards capital account convertibility. Besides, the intervention by the monetary authorities, say, RBI helped correct imbalances in supply and demand forces and infused stability in the foreign exchange market.

The turnover in the market increased from Rs. 1,387 billion in FY 2000–01 to Rs. 12,316 billion during FY 2007–08, although the size of the turnover was much lower in the merchant segment than in the inter-bank market. Again, instability in the monthly turnover was very much apparent that needs to be controlled. Nevertheless, the market attained greater efficiency in view of reduced bid-ask spread, greater alignment between forward premia and interest rate differentials and lower degree of the RBI's intervention giving way to the free play of market forces.

A number of Indian firms have issued FCCBs and also shares under the ADE/GDR arrangement to get foreign exchange and to reap the primary and secondary market gains abroad. The Indian government initiated the policy in 1992 and liberalised it from time to time with the result that annual figure of such issues increased over the years and it was as large as Rs. 366 billion during FY 2007–08. The shares of [Page 202]a number of firms were listed on major international stock exchanges. In past years, the volume of turnover of the ADRs/GDRs of Indian companies at the international stock exchanges swelled fast. While in many cases, ADRs/GDRs were traded at premium, trading at discount was not very uncommon. Nevertheless, one aspect is very significant to note. It is a very close integration between the Indian secondary market and the international secondary market in view of a highly positive correlation between the movement of price index of ADRs/GDRs and that of those shares in the domestic market.

As far as the FIIs' investment in the Indian secondary market is concerned, the amount of the net investment was quite substantial. In this case too, the policy was initiated in 1992 and was liberalised from time to time. The amount of FIIs' net investment in the Indian secondary market varied widely over different months and also over different years. The apparent reason was that the FIIs being a fair weather friend were greatly influenced by the international economic scenario as well as the economic scenario in India. However, their net investment was over US$16 billion during FY 2007–08.

These investors showed preference for equity in view of reaping gains from price fluctuations, although they invested in debt instruments too. The reasons for their investment in the Indian market as per the present study were mainly the interest rate differential and the liberalisation of the governmental policy on this count. It is true that the net investment of the FIIs accounted for a very small share in the total domestic investment; yet, their influence on the stock market activities was profound.

The reversal is the aftermath of the factors prevailing both in the international economy and in the domestic economy. There is a view based on the ‘decoupling’ concept that the economic scenario prevailing in a country does not necessarily influence the economic variables in other countries. Akin and Kose (2007) found in their study that the emerging market economies had stood decoupled from performance of the developed countries for past couple of decades. But the recent crisis in the Indian financial market following the financial crisis in the US has put the decoupling concept in a wrong box.

The financial crisis in the US was primarily the sub-prime crisis that was quite enormous. A continued escalation in the real estate prices for a decade or so and then a sudden and drastic drop in those prices during 2007 made the collateral of the home loans sub-prime. There were large defaults that in turn led to huge bank losses and put abnormal pressure on the functioning of the banks. The losses on this account were estimated to be over US$400 billion, over [Page 204]one-half of which was to be borne by banks and other highly leveraged financial institutions. For each dollar of loss, these institutions had to shrink their balance sheet by US$10 to US$25 with the result that their lending was greatly affected. As per an estimate, there should be a squeeze over US$2 trillion in their lending activities (http://www.livemint.com). All this had a spillover effect in form of dwindling currency, an economic recession and subdued activities in the financial market of the US.

The factor at the domestic front was the galloping inflation. The rate of inflation in the country, which was barely 4.26 per cent during the week ended on 5 January 2008, rose to 7.75 per cent by the last week of March 2008 and to 11.89 per cent by 28 June 2008. It crossed subsequently the 12-per cent mark and continued to maintain almost the same level during the second quarter of FY 2008–09. The reason behind the fast-growing rate of inflation lies outside the scope of our discussion. However, one must accept that it did put a definite impact on the activities in the Indian financial sector more directly in terms of falling real income from investment. ‘Fisher effect’ clearly explains that higher the rate of inflation, lower is the real interest rate with a given nominal interest rate. It is true that the growth in the rate of inflation began to recede during the closing months of 2008, yet the damage created by it was enormous.

These two factors along with many others, first of all, accelerated the disinvestment by the FIIs and thereby put a curb on the secondary and primary capital market activities. The spillover effect permeated over other areas of the financial market and also over the entire economy.

It is true that rising inflation axed considerably the real return of the FIIs from the Indian secondary market that was, in the sequel, responsible for their disinterestedness in investing at the Indian stock exchanges. But the most significant factor responsible for withdrawal of their investment was the US sub-prime crisis. The FIIs pulled back their investment from the Indian market perhaps for the purpose of making up of the losses in the US market. They also pulled back their investment in those securities where price oscillations were greater. [Page 205]It is a psychological phenomenon that whenever there is a crisis, the investors try to avoid risk taking and make investment only in less risky channels. The pull-back was quite large and resultantly, their net disinvestment in India was as large as US$8.991 billion and US$1.643 billion, respectively, in February and March 2008 (RBI 2009).

The SEBI eased the registration norms for FIIs. The result was positive. There were 68 new registrations during one-and-a-half months of 2008 compared to 226 during the whole of 2007. The Indian government too liberalised the policy and broadened the definition of the FIIs. It brought into the ambit of FIIs also the sovereign wealth funds, NRIs-owned asset management companies, unregulated university funds, endowments and charitable fund, bilateral and multilateral organisations and overseas central banks. The ceiling on FIIs' cumulative investment in government securities was raised from US$3.2 billion to US$5.0 billion. In corporate securities, it was raised from US$1.5 billion to US$3.0 billion. This was on first-come-first-serve basis with an individual entity limit of US$200 million (Financial Express 18 June 2008). But FIIs' investment position failed to improve. FIIs recorded a net disinvestment of over US$12.409 billion during the first 9 months of FY 2008–09 compared to a net investment worth US$24.472 billion during the first 9 months of FY 2007–08 (RBI 2009) (see Table PS 1).

A further anatomy of figures makes it clear that disinvestment was vivid in case of equity rather than debt securities perhaps in view of [Page 206]the fact that investment in equity carried greater risk. During the first 9 months of FY 2008–09, debt securities presented a net investment for Rs. 82.010 billion vis-à-vis equity that showed a net disinvestment for Rs. 415.55 billion (SEBI 2009).

The FIIs' disinvestment influenced many areas of the Indian financial sector. Its direct and more proximate repercussions fell on the secondary market transactions. Since FIIs dominate the Indian secondary market, their pulling back of investment was manifest in the crash of stock price index at the Indian stock exchanges. In January 2008 alone, the fall was recorded at 16 per cent which was higher than 12.44 per cent for the emerging market as a whole, although lower than 16.12 per cent in Russia, 21.40 per cent in China and 22.70 per cent in Turkey (Financial Express 12 February 2008). In February and March 2008, there was a further drop in the share price index. A comparative analysis shows that the BSE Sensex which was 20,301 on 1 January 2008 plunged to 14,833 on 18 March 2008. The respective figures for NSE Nifty were 6,144 and 4,533.

The galloping rate of inflation put fuel to the fire. It caused the real rate of return to shrink. Furthermore, the profitability of the companies relying largely on debt shrank fast. The price of their shares fell fast pulling down in the sequel the stock market index. The explanation is that the RBI increased the interest rate in order to check the inflationary pressure. Higher interest rate helped enlarge the interest payment. The pre-tax profit fell despite large operating profits. As per a study conducted by Mint, there was a dramatic slowdown in the growth of net profit of the Indian companies that constituted the country's stock market indices—BSE Sensex and NSE Nifty. The situation was even worse if the oil firms were excluded from the sample (Mint 30 June 2008). Another study of the Economic Times (2 July 2008) reveals that 347 listed companies paid 26 per cent lower dividend during the first half of 2008 compared to the corresponding period of 2007. The profitability being the first victim, the BSE Sensex and NSE Nifty sagged further despite minor revival in a few months. The average figures of BSE Sensex and NSE Nifty during the first nine months of FY 2008–09 are presented in Table PS 2.

[Page 207]It is evident from the figures that the BSE Sensex fell by over 42 per cent during the above period. The NSE Nifty was not in a much better form as it too fell by over 41 per cent during the same period. A study of Mint (1 January 2009) presents the extent of fall in 14 stock market indices covering different countries during the whole of 2008 and finds that the fall in BSE Sensex and NSE Nifty was the largest only to Shanghai SE Composite Index that slipped by 65.39 per cent. The BSE Sensex fell by 52.45 per cent followed by NSE Nifty which plunged by 51.79 per cent compared to a fall between 49 and 33 per cent in 11 other indices.

With all these symptoms, it was natural for the market capitalisation to shrink. The market capitalisation at the BSE squeezed from Rs. 57,943 billion to Rs. 31,448 billion between April and December 2008. At the NSE, there was recorded a drop in market capitalisation from Rs. 54,428 billion to Rs. 29,168 billion during the same period. In relation to the gross domestic product, the market capitalisation at the BSE fell from 152.1 per cent at the end of 2007–08 to 59 per cent during December 2008. At the NSE, it was a fall from 138.8 to 55.5 per cent during the same period (http://www.rbi.org).

It was not simply an overall downtrend in the stock market index or the market capitalisation. A high degree of volatility was marked in the stock market indices. As Table PS 3 shows, the annualised volatility in BSE Sensex and S&P CNX Nifty during April to December 2008 was, respectively, 45.69 and 43.89 per cent. This figure was much higher than the annualised volatility in many other indices around the world.

Table PS 3 Annualised Volatility in Stock Market Indices during April to December 2008

The gloom prevailed also in case of the fund mobilisation through the euro issues. During January to June 2008, funds raised through overseas depository receipts and through the issue of FCCBs amounted, respectively, to US$211 million and US$424 million compared to US$4.847 billion and US$4.717 billion, respectively, during the whole of 2007 (Mint 4 July 2008). The situation was not very different during the first three quarters of FY 2008–09. As per the RBI figures, the funds mobilised through euro issues amounted to Rs. 46.85 billion during April to December 2008 compared to Rs. 249.72 billion during the corresponding period of the previous financial year (http://www.rbi.org).

[Page 211]The impact was seen also on the price of the ADRs/GDRs of the Indian firms at the overseas secondary markets. The Appendix PS A1 covers 86 cases and presents a comparative picture of their market price during first two quarters of 2008. In the first quarter, a comparative picture of four cases is not found as they were not traded on 1 April 2008. Out of 82 cases, there was appreciation in the market price of two cases. In the rest 80 cases, the market price plunged. The extent of the drop in prices varied widely. In 15 cases, the price fall was less than 20 per cent. In 34 cases, it was over 20 per cent but less than 40 per cent. In 29 cases, the price ebbed over 40 per cent but less than 60 per cent. There were only two cases where the drop was over 60 per cent. In the second quarter of 2008, there were 11 cases where the prices rose, although the rise was only meagre. In 25 cases, they fell below 20 per cent. In 37 cases, the fall was recorded 20 per cent or more but less than 40 per cent. There were four cases where the fall was steeper at 40 per cent or higher but less than 60 per cent. There was a lone case where the price decline was beyond 60 per cent.

The Instanex Skindia Index shows that the GDR/ADR price index at the international stock exchanges decreased from 3639.43 on 1 January 2008 to 1278.89 on 23 December 2008. It was a drop of 64.8 per cent.

On comparing the fall in the ADR/GDR prices with those of domestic share prices of the same firms, it is revealed that the plunge in the former was steeper. Mint (25 March 2008) has made a study of 14 such firms and has found that out of 14 Sensex firms, 13 experienced a steep fall in their ADR/GDR prices compared to their local share prices between 10 January and 19 March 2008 (Table PS 5).

The comparison shows, first, greater integration between the Indian financial market and the international financial markets and that the impact of sub-prime crisis in Indian secondary market was not as intense as it was in case of international financial markets.

Moreover, it is because of lowering price of ADRs and GDRs that the debt burden of the Indian firms was expected to rise abnormally. The explanation is that the Indian firms issue FCCBs that are converted into equity shares after some time at a predetermined rate. If the stock price is greater than the conversion price, the bonds are converted into equity shares and, in the sequel, the burden of interest payment and repayment is over. But, in many cases, when the conversion price was greater in the wake of falling stock prices, it was not [Page 212]in the interest of the firm to convert the FCCBs into equity shares. Servicing of bonds remained a major problem. In fact, the Indian firms with FCCBs valued at US$17.7 billion were facing this problem (Mint 13 March 2008). However, many firms managed to lower the conversion price under the provisions of the reset clause where the conversion price might be revised with a fall in the company's share price below a predetermined level. Pioneer Embroideries Ltd lowered the conversion price by 30 per cent in March 2008. In January 2008, it had already lowered the price by 10 per cent. As a result of the fall in the conversion price, the dilution in the equity turned higher and the firms needed the issue of more shares.

The downtrend was observed not only in the ADRs/GDRs prices abroad. The prices of bonds issued overseas by the Indian firms were also on the ebb in the final quarter of FY 2007–08. The yield turned greater than the coupon rate. In such cases, the Indian firms had to start buying back the debt securities. ICICI Bank Ltd bought back US$50 million worth of overseas bonds that were to mature in 2012 (Mint 13 March 2008). Other banks might follow the lead. In other words, issuing overseas bonds did not remain lucrative. In view of this problem, the Indian government permitted the funds raised through FCCBs to be used for the equity of other companies of the group, [Page 213]subject to the necessary FDI cap (Financial Express 16 February 2008). How far this provision is workable is not beyond doubt.

The impact of the sub-prime crisis along with the domestic inflation was visible also on the exchange rate. With the outflow of funds on FIIs' account, falling stock market index and tight position of the inflow of fresh investments on account of liquidity crunch in the overseas market, the rupee depreciated by around 2.5 per cent during the last quarter of FY 2007–08 after gaining 12.3 per cent during the first three quarters of the same financial year. On 17 March 2008, rupee touched a 6-month low of 40.735 a dollar. The depreciation continued to persist in the first three quarters of FY 2008–09. Table PS 6 shows the average exchange rate of rupee in relation to US dollar and euro.

It is evident from the figures that the rupee depreciated vis-à-vis US dollar from Rs. 40.65 in April 2008 to Rs. 49.69 during November 2008, although there was a slight appreciation during the following month to Rs. 48.45. Similarly, the trend in Rs./euro was not very different. Barring a few months when there was marginal appreciation, rupee fell from 62.78 to 68.22 vis-à-vis euro during the same period. It may be noted that the depreciation of rupee continued to remain despite huge selling of US dollar by RBI in the foreign exchange [Page 214]market ranging between US$1.477 billion and 20.626 billion a month during May–December 2008 (RBIB, March 2009).

There were basically four reasons. First, it was the bounce in US dollars as Fed rate cut seemed to be coming to an end. Second, it was the FIIs' net disinvestment that was really huge. Third, it was the soaring oil prices, at least for only a few months that led to greater demand for dollars to meet the oil import bill. Fourth, it was the psyche of the general importers who advanced their imports in face of depreciating rupee in order to minimise their exchange rate exposure. These factors led to a rise in demand for dollars, euro and other foreign currencies and, in the sequel, to depreciation of rupee.

As far as the nominal and real effective exchange rates are concerned, the six-currency trade weighted NEER and REER of the rupee depreciated, respectively, by 8.5 and 3.7 per cent between March 2008 and September 2008. By December 2008, these rates slid further. To be precise, during December 2008, NEER, based on six-currency weight, was 62.66 compared to an average of 74.17 in FY 2007–08 (1993–94 = 100). The respective figures for REER were 99.89 and 114.09 (RBI 2009).

Despite the downtrend, the government set up the market for currency futures following the recommendations of the Raghuram Rajan Committee and the Expert Group at the RBI. The three Indian exchanges, namely, BSE, NSE and MCX applied for dealing in currency futures. RBI and SEBI released the guidelines in this respect on 6 August 2008. Finally, NSE started operating on 29 August 2008. MCX and BSE followed the suit.

The guidelines allowed only US dollar–rupee contracts with a size of US$1,000 for a maturity not exceeding 12 months. The trading is done on Monday through Friday excluding public holidays between 9.00 a.m. and 5.00 p.m. and settlement is done on the last working day of the month, and not earlier. Thus, the standardised size is smaller than those at the international exchanges. The contracts are quoted and settled in rupee.

The membership of the currency futures market would be separate from the membership of derivatives/cash segment. Again, only [Page 215]a resident Indian, including banks, can participate in the deal. This means that the FIIs/NRIs are not entitled to participate in the deal. A bank being a member must have reserves worth Rs. 5 billion, 10 per cent CRAR, an NPA of 3 per cent at the maximum and a profit record for at least 3 years. The trading limit for an individual client is US$5 million or 6 per cent of the total open interest, whichever is higher. For a trading member—bank or broker, it is US$25 million or 15 per cent of the total open interest, whichever is higher.

The hedger or the client is first registered with the trading member who buys or sells the currency futures contract on behalf of the client. The marking to market is based on the daily settlement price which is arrived at after taking the weighted average of last half an hour's transactions. The loss or gain arising out of this process is settled on t + 1 basis. At the end of the day, net positions are reset with respect to the current day's daily settlement price and are carried forward to next day. Finally, on the settlement day, the settlement is done in cash payable in rupee.

In the entire process, the clearing member has a crucial role to play. At the NSE, its wholly owned subsidiary, National Securities Clearing Corporation Ltd (NSCCL) carries out the entire clearing and settlement process. It acts as counter party to all transactions and guarantees the final settlement. It carries out also novation which means that it helps replacement of one obligation with another with the mutual consent of both the parties. The clearing banks help NSCCL in carrying out clearing and settlement.

The NSCCL monitors the members' operation online and asks for immediate halt of any transaction if the open position or the margin money requirements are violated. Here, it may be mentioned that the margin requirements are enforced by the NSCCL. It calculates the initial margin money requirements on the client's level using Standard Portfolio Analysis of Risk methodology and informs the trading members daily about the clients' margin liability. The trading members submit the compliance report. The extreme loss margin in case of the trading members is 1 per cent of the value of their gross open position.

Now the question is whether the currency futures are better than the forwards transacted in India. First of all, while in case of OTC forward contracts, the banks quote different bid-ask rates for different [Page 216]customers, future rates are shown on the screen of the exchange. Thus, the price discovery is more transparent in case of futures.

Second, participants, such as exporters and importers, can go for a forward contract only for their underlying transactions. Their purpose cannot be speculation. But in case of currency futures, no underlying securities are required.

As far as trading size is concerned, the value differed widely from one stock exchange to the other. At the NSE, the amount moved up from Rs. 2.620 billion in September 2008 to Rs. 10.876 billion in December 2008. At MCX too, it moved up from Rs. 3.248 billion in October 2008 to Rs. 10.922 billion in December 2008. On the contrary, at the BSE, it plummeted from Rs. 383 million to Rs. 13 million during October to December 2008 (SEBI Bulletin January 2009).

It is true that during the first quarter of FY 2008–09, the daily average call rate continued to remain normally within the tunnel created by reverse repo and repo rates. But during the following quarter, the call rate mostly hovered around the repo rate reflecting perhaps the impact of the increase in the CRR in three stages to 9 per cent and in repo rate to 9 per cent. The average call rate was 9.10 per cent during August 2008 and 10.52 per cent in September 2008. As regards treasury bills, the primary market yields tended to harden as a sequel to high money market interest rates. In the third quarter, the pressure on the Indian money market continued on account of RBI's intervention in the foreign exchange market, but a cut in CRR checked the call money rate from unwarranted appreciation.

During mid-September, the failure of Lehman Brothers led to a panic in the world financial market. However, the Indian money market activities were not so badly affected. During the third quarter, there was some minor improvement in the money market scenario.

Table PS 7 shows the trends in different segments of the Indian money market during April to December 2008 compared to those during FY 2007–08. Let us first talk about the average daily volume of transactions (one leg) in the call money market; it showed a marginal increase during April to December 2008 over that during FY 2007–08. The transactions in CBLO and term money market were almost [Page 217]constant during the above period. Repo outside LAF declined but only marginally. The outstanding amount of CP and CD rose during the first nine months of FY 2008–09.

Table PS 7: Transactions in Indian Money Market

However, a few push-ups in CRR entailed upon the profitability of many banks. The net profit of some of the banks, namely, Canara Bank, Allahabad Bank, Indian Overseas Bank, fell by a good margin.

Again, in order to make the NBFC financially stronger to sustain the upheavals in the economy and to bring in greater transparency in their working, RBI issued guidelines on 2 June 2008. The guidelines prescribed, first, to raise CRAR from 10 to 12 per cent immediately and further to 15 per cent from April 2009. Second, they made it mandatory to disclose some additional information in their balance sheet, especially related to CRAR, derivative deals and maturity pattern of assets and liabilities. Moreover, the NBFCs are now to submit half-yearly reports relating to various aspects of liquidity, such as structural liquidity, short-term dynamic liquidity and the interest rate sensitivity. RBI tightened further the deposit-accepting policy of the NBFCs. An NBFC with a minimum investment grade credit-rating and a capital adequacy ratio of 12 per cent can accept deposit only up to 1.5 times of their NOF. Earlier it was four times. In other cases, this multiple is 1. Any excess level of deposit has to be brought down by March 2009. But these measures have hardly improved their financial strength.

[Page 218]To conclude, India's financial sector continued to remain under strains during the first three quarters of FY 2008–09.