WHY MONEY MARKET NEEDED IN INDIA

SUBMITTED BY: ALTAF DHALANI RUCHIR KELKAR SHAMEESH JOSHI NITIN PATIL NISHANK SHETTY SUBMITTED TO: SHAILAJA MADAM C-12 C-27 C-34 C-17 EX-03

WHAT IS MONEY MARKET?

The money market is a subsection of the fixed income market. We generally think of the term fixed income as being synonymous to bonds. In reality, a bond is just one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money market investments are also called cash investments because of their short maturities.

Money market securities are essentially issued by governments, financial institutions and large corporations. These instruments are very liquid and considered extraordinarily safe. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities.

One of the main differences between the money market and the stock market is that most money market securities trade in very high denominations. This limits access for the individual investor. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this to the stock market where a broker receives commission to acts as an agent, while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems. The easiest way for us to gain access to the money market is with a money market mutual funds, or sometimes through a money market bank account. These accounts and funds pool together the assets of thousands of investors in order to buy the money market securities on their behalf. However, some money market instruments, like Treasury bills, may be purchased directly. Failing that, they can be acquired through other large financial institutions with direct access to these markets.

There are several different instruments in the money market, offering different returns and different risks. In the following sections, we'll take a look at the major money market instruments.

FEATURES OF MONEY MARKET

Dichotomic Structure: It is a significant aspect of the Indian money market. It has a simultaneous existence of both the organized money market as well as unorganised 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.

Seasonality: 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.

Multiplicity of Interest Rates: 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 rate differs. Thus there is an existence of many rates of interest in the Indian money market.

Lack of Organized Bill 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.

Absence of Integration: 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.

High Volatility in Call Money Market: The call money market is a market for very short term money. Here money is demanded at the 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.

Limited Instruments: 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.

FUNCTIONS OF MONEY MARKET

Money market is an important part of the economy. It plays very significant functions. As mentioned above it is basically a market for short term monetary transactions. Thus it has to provide facility for adjusting liquidity to the banks, business corporations, non-banking financial institutions (NBFs) and other financial institutions along with investors. The major functions of money market are given below:1. To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money for short term monetary transactions. 2. To promote economic growth. Money market can do this by making funds available to various units in the economy such as agriculture, small scale industries, etc. 3. To provide help to Trade and Industry. Money market provides adequate finance to trade and industry. Similarly it also provides facility of discounting bills of exchange for trade and industry. 4. To help in implementing Monetary Policy. It provides a mechanism for an effective implementation of the monetary policy. 5. To help in Capital Formation. Money market makes available investment avenues for short term period. It helps in generating savings and investments in the economy. 6. Money market provides non-inflationary sources of finance to government. It is possible by issuing treasury bills in order to raise short loans. However this does not leads to increases in the prices. Apart from those, money market is an arrangement which accommodates banks and financial institutions dealing in short term monetary activities such as the demand for and supply of money.

STRUCTURE OF MONEY MARKET

The entire money market in India can be divided into two parts. They are organized money market and the unorganized money market. The unorganized money market can also be known as an unauthorized money market. Both of these components comprise several constituents. The following chart will help you in understanding the organizational structure of the Indian money market.

MONEY MARKET INSTRUNMENTS INDIA

Certificate of deposit (CD) A is a time deposit with a bank. CDs are generally issued by commercial banks but they can be bought through brokerages. They bear a specific maturity date (from three months to five years), a specified interest rate, and can be issued in any denomination, much like bonds. Like all time deposits, the funds may not be withdrawn on demand like those in a checking account.

Commercial paper (CP) Is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivable and inventories. It is usually issued at a discount, reflecting current market interest rates. Maturities on commercial paper are usually no longer than nine months, with maturities of between one and two months being the average. For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and credit worthiness issue commercial paper.

A bankers' acceptance (BA) Is a short-term credit investment created by a non-financial firm and guaranteed by a bank to make payment. Acceptances are traded at discounts from face value in the secondary market. Contrary to the name, Eurodollars have very little to do with the euro or European countries. Eurodollars are U.S.-dollar denominated deposits at banks outside of the United States. This market evolved in Europe (specifically London), hence the name, but Eurodollars can be held anywhere outside the United States.

The Eurodollar market is relatively free of regulation; therefore, banks can operate on narrower margins than their counterparts in the United States. As a result, the Eurodollar market has expanded largely as a way of circumventing regulatory costs.

The average Eurodollar deposit is very large (in the millions) and has a maturity of less than six months. A variation on the Eurodollar time deposit is the Eurodollar certificate of deposit. A Eurodollar CD is basically the same as a domestic CD, except that it's the liability of a non-U.S. bank. Because Eurodollar CDs are typically less liquid, they tend to offer higher yields.

Repo Is short for repurchase agreement. Those who deal in government securities use repos as a form of overnight borrowing. A dealer or other holder of government securities (usually T-bills) sells the securities to a lender and agrees to repurchase them at an agreed future date at an agreed price. They are usually very short-term, from overnight to 30 days or more. This short-term maturity and government backing means repos provide lenders with extremely low risk.

Repo - The reverse repo is the complete opposite of a repo. In this case, a dealer buys government securities from an investor and then sells them back at a later date for a higher price

Repo - exactly the same as a repo except the term of the loan is greater than 30 days.

Treasury bill (TB) A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks).

T-bills are issued through a competitive bidding process at a discount from par, which means that rather than paying fixed interest payments like conventional bonds, the appreciation of the bond provides the return to the holder.

RECENT REFORMS IN INDIAN 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. Reforms made in the Indian Money Market are:-

1. Deregulation of the Interest Rate: 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.

2. Money Market Mutual Fund (MMMFs): In order to provide additional shortterm 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.

3. Establishment of the DFHI: 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.

4. Liquidity Adjustment Facility (LAF): 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.

5. Electronic Transactions: 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.

6. Establishment of the CCIL: 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.

7. Development of New Market Instruments: The government has consistently tried to introduce new short-term investment instruments. Examples: Treasury Bills of various duration, Commercial papers, 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.

ROLE OF THE MONEY MARKET IN THE MONETARY TRANSMISSION MECHANISM

The money market forms the first and foremost link in the transmission of monetary policy impulses to the real economy. Policy interventions by the central bank along with its market operations influence the decisions of households and firms through the monetary policy transmission mechanism. The key to this mechanism is the total claim of the economy on the central bank, commonly known as the monetary base or high-powered money in the economy. Among the constituents of the monetary base, the most important constituent is bank reserves, i.e., the claims that banks hold in the form of deposits with the central bank. The banks need for these reserves depends on the overall level of economic activity.

This is governed by several factors: (i) banks hold such reserves in proportion to the volume of deposits in many countries, known as reserve requirements, which influence their ability to extend credit and create deposits, thereby limiting the volume of transactions to be handled by the bank; (ii) banks ability to make loans (asset of the bank) depends on its ability to mobilise deposits (liability of the bank) as total assets and liabilities of the bank need to match and expand/contract together; and (iii) banks need to hold balances at the central bank for settlement of claims within the banking system as these transactions are settled through the accounts of banks maintained with the central bank. Therefore, the daily functioning of a modern economy and its financial system creates a demand for central bank reserves which increases along with an expansion in overall economic activity (Friedman, 2000b).

The central banks power to conduct monetary policy stems from its role as a monopolist, as the sole supplier of bank reserves, in the market for bank reserves. The most common procedure by which central banks influence the outstanding supply of bank reserves is through open market operations that is, by buying or selling government securities in the market. When a central bank buys (sells) securities, it credits (debits) the reserve account of the seller (buyer) bank. This increases (decreases) the total volume of reserves that the banking system collectively holds. Expansion (contraction) of the total volume of reserves in this way matters because banks can exchange reserves for other remunerative assets. Since reserves earn low interest, and in many countries remain unremunerated, banks typically would exchange them for some interest bearing asset such as Treasury Bill or other short-term debt instruments. If the banking system has excess (inadequate) reserves, banks would seek to buy (sell) such instruments.

If there is a general increase (decrease) in demand for securities, it would result in increased (decline) in security prices and decline (increase) in interest rates. The resulting lower (higher) interest rates on short-term debt instruments mean a reduced (enhanced) opportunity cost of holding low interest reserves. Only when market interest rates fall (rise) to the level at which banks collectively are willing to hold all of the reserves that the central bank has supplied will the financial system reach equilibrium. Hence, an expansionary

(contractionary) open market operation creates downward (upward) pressure on short-term interest rates not only because the central bank itself is a buyer (seller), but also because it leads banks to buy (sell) securities. In this way, the central bank can easily influence interest rates on shortterm debt instruments. In the presence of a regular term structure of interest rates and without market segmentation, such policy impulses get transmitted to the longer end of the maturity spectrum, thereby influencing long-term interest rates, which have a bearing on households consumption and savings decisions and hence on aggregate demand.

INTERFACE BETWEEN MONETARY POLICY ANNOUNCEMENTS AND FINANCIAL MARKET BEHAVIOUR

The effectiveness of monetary policy hinges on the ability of the monetary authority to communicate with the public in a clear and transparent manner. In this regard, the signalling of policy assumes key importance as it conveys the stance of monetary policy. While the signalling mechanisms in developed countries are quite robust, they tend to be weak in emerging market economies, particularly in the wake of market segmentation and absence of a well-defined transmission mechanism.

Financial markets are typically characterised by asymmetric information, where some agents are better informed than others that gets reflected in the problems of moral hazard and adverse selection. Seminal research on the economic theory of information has demonstrated that better-informed agents in a market could credibly signal (transmit) their information to less informed agents, so as to avoid some of the problems associated with adverse selection and improve the market outcome. The effectiveness of monetary policy is strongly related to the signalling of policy, the reason being that important variables such as the exchange rate and long-term interest rates reflect expectations about future monetary policy.

Monetary policy signals are peroxided by changes in the CRR, the Bank Rate and the LAF reverse repo rate. The impact of these signalling instruments of monetary policy is considered on four segments of the financial market, viz., money market (call money rate), stock market (BSE Sensex), foreign exchange market (3-month forward premium) and the government securities market (yield on 1-year G-sec).

Impulse response analysis is used to study the impact of a one standard error shocking each policy indicator on the various financial market segments. The study reveals that an increase in the CRR raises the call money rate instantly because of the news effect and also over time through the liquidity effect as more resources get impounded causing tightness in liquidity conditions. This is also the case for forward premium and yields on government securities. It has more of an instantaneous news impact in the stock market by depressing the market sentiment.

An increase in the Bank Rate, as the signalling mechanism of policy stance over the medium-term, appears to have an instantaneous effect on call, government securities and forward premium because of the news effect. The long-term impact, however, gets muted as refinance at the Bank Rate is formula driven and not adequate to have a liquidity impact. In the stock market, hardening of the Bank Rate is construed as restrictive monetary policy, which dampens the market sentiment.

NEED FOR MONEY MARKET

If the money market is well developed and broad based in a country, it greatly helps in the economic development of a country. The central bank can use its monetary policy effectively and can bring desired changes in the economy for the industrial and commercial progress in the country. The importance of money market is given, in brief, as under:

(I) Financing Industry: A well-developed money market helps the industries to secure short term loans for meeting their working capital requirements. It thus saves a number of industrial units from becoming sick.

(II) Financing trade: An outward and a well-knit money market system play an important role in financing the domestic as well as international trade. The traders can get short term finance from banks by discounting bills of exchange. The acceptance houses and discount market help in financing foreign trade.

(III) Profitable investment: The money market helps the commercial banks to earn profit by investing their surplus funds in the purchase of. Treasury bills and bills of exchange, these short term credit instruments are not only safe but also highly liquid. The banks can easily convert them into cash at a short notice.

(IV) Self sufficiency of banks: The money market is useful for the commercial banks themselves. If the commercial banks are at any time in need of funds, they can meet their requirements by recalling their old short term loans from the money market.

(V) Effective implementation of monetary policy: The well-developed money market helps the central bank in shaping and controlling the flow of money in the country. The central bank mops up excess short term liquidity through the sale of treasury bills and injects liquidity by purchase of treasury bills.

(VI) Encourages economic growth: If the money market is well organized, it safeguards the liquidity and safety of financial asset this encourages the twin functions of economic growth, savings and investments.

(VII) To help government: The organized money market helps the government of a country to borrow funds through the sale of Treasury bills at low rate of interest The government thus would not go for deficit financing through the printing of notes and issuing of more money which generally leads to rise in an increase in general prices.

DRAWBACKS OF MONEY MARKET

Low Transaction Limits Money market funds permit very few free transactions per month, so that the funds can be invested in higher tenure papers and thereby earn higher interest for the investor. For instance, most money market funds allow only 3 to 5 checks to be issued per month, beyond which charges could be levied. The way out is to have the money market fund as a secondary account in which the investor doesnt need to access his funds for a considerable amount of time. The primary account should be a checking account which allows many more transactions per month even though no interest is paid on such an account.

Low Interest Rates When compared to other market linked investments or even term deposits or government securities, many money market funds offer much lower interests, since their main priority is to preserve the capital and maintain the net asset value at $1. First, one can purchase this fund from a brokerage firm which might be able to negotiate for better rates on your behalf on account of the higher volume of business they generate. Second, you should have a reasonable mix of high returns and low risk in your total investment portfolio. This will help in averaging out the low return investments and give you a better overall return on investment. High Fees Unlike many savings and checking accounts which have the option of negotiation for getting a charge free product, most money market funds have high annual fees which eat away a large portion of your investment upfront. The solution to this is to scout around for the fund which offers the best rate, so that the impact of the annual fees can be reduced

Proper allocation of resources In the money market, the demand for and supply of loan able funds are brought at equilibrium the savings of the community are converted into investment which leads to pro allocation of resources in the country.

Absence of Integration 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.

Multiple rate of interest In the Indian money market, especially the banks, there exists too many rates of interests. These rates vary for lending, borrowing, government activities, etc. Many rates of interests create confusion among the investors.

Insufficient Funds or Resources 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.

Shortage of Investment Instruments 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.

Shortage of Commercial Bill 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. Lack of Organized Banking System In India even though 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 absence of the organized banking system is major problem for Indian money market.

Less number of Dealers 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 Tc 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.

MONEY MARKET AND FINANCIAL WORLD

The money available to consumers, investors, etc., to spend or invest in products as the money supply of the market.

High money supply high ----- increase demand for products in the Product market ----- inflection (rising prices)

To enable the monetary authorities to guard against this kind of inflection, a few options are available where use is made of the money market , two of which Are ---- selling money market instruments, & increasing interest rates by offering less money

CONCLUSION

As money market is very important to the financial system, especially the economic growth, there is need to review and understand the changes in the money market so that the right responses can be given while confronting with the financial crisis. The objectives of this project are to review the money markets and the securities in India and to understand an importance of money markets that affect the economic growth.

BIBILOGRAPHY

www.google.com www.investopedia.com www.wikipedia.com