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Q.1. Bring out an overview of Indian financial system post 1950 period .
Ans: Financial System of any country consists of financial markets, financial intermediation and
financial instruments or financial products. This paper discusses the meaning of finance and
Indian Financial System and focus on the financial markets, financial intermediaries and
financial instruments. The brief review on various money market instruments are also covered in
this study.
The term "finance" in our simple understanding it is perceived as equivalent to 'Money'. We read
about Money and banking in Economics, about Monetary Theory and Practice and about "Public
Finance". But finance exactly is not money, it is the source of providing funds for a particular
activity. Thus public finance does not mean the money with the Government, but it refers to
sources of raising revenue for the activities and functions of a Government. Here some of the
definitions of the word 'finance', both as a source and as an activity i.e. as a noun and a verb.

The American Heritage® Dictionary of the English Language, Fourth Edition defines the term as
under-
1:"The science of the management of money and other assets.";
2: "The management of money, banking, investments, and credit. ";
3: "finances Monetary resources; funds, especially those of a government or corporate body"
4: "The supplying of funds or capital."

Finance as a function (i.e. verb) is defined by the same dictionary as under-

1:"To provide or raise the funds or capital for": financed a new car
2: "To supply funds to": financing a daughter through law school.
3: "To furnish credit to".

Another English Dictionary, "WordNet ® 1.6, © 1997Princeton University " defines the term as
under-

1:"the commercial activity of providing funds and capital"

2: "the branch of economics that studies the management of money and other assets"
3: "the management of money and credit and banking and investments"

The same dictionary also defines the term as a function in similar words as under-

1: "obtain or provide money for;" " Can we finance the addition to our home?"
2:"sell or provide on credit "

All definitions listed above refer to finance as a source of funding an activity. In this respect
providing or securing finance by itself is a distinct activity or function, which results in Financial
Management, Financial Services and Financial Institutions. Finance therefore represents the
resources by way funds needed for a particular activity. We thus speak of 'finance' only in
relation to a proposed activity. Finance goes with commerce, business, banking etc. Finance is
also referred to as "Funds" or "Capital", when referring to the financial needs of a corporate
body. When we study finance as a subject for generalising its profile and attributes, we
distinguish between 'personal finance" and "corporate finance" i.e. resources needed personally
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by an individual for his family and individual needs and resources needed by a business
organization to carry on its functions intended for the achievement of its corporate goals.

INDIAN FINANCIAL SYSTEM

The economic development of a nation is reflected by the progress of the various economic
units, broadly classified into corporate sector, government and household sector. While
performing their activities these units will be placed in a surplus/deficit/balanced budgetary
situations.

There are areas or people with surplus funds and there are those with a deficit. A financial
system or financial sector functions as an intermediary and facilitates the flow of funds from the
areas of surplus to the areas of deficit. A Financial System is a composition of various
institutions, markets, regulations and laws, practices, money manager, analysts, transactions
and claims and liabilities.

Financial System;

The word "system", in the term "financial system", implies a set of complex and closely
connected or interlined institutions, agents, practices, markets, transactions, claims, and
liabilities in the economy. The financial system is concerned about money, credit and finance-
the three terms are intimately related yet are somewhat different from each other. Indian
financial system consists of financial market, financial instruments and financial intermediation.
These are briefly discussed below;

FINANCIAL MARKETS

A Financial Market can be defined as the market in which financial assets are created or
transferred. As against a real transaction that involves exchange of money for real goods or
services, a financial transaction involves creation or transfer of a financial asset. Financial
Assets or Financial Instruments represents a claim to the payment of a sum of money sometime
in the future and /or periodic payment in the form of interest or dividend.

Money Market- The money market ifs a wholesale debt market for low-risk, highly-liquid, short-
term instrument. Funds are available in this market for periods ranging from a single day up to
a year. This market is dominated mostly by government, banks and financial institutions.

Capital Market - The capital market is designed to finance the long-term investments. The
transactions taking place in this market will be for periods over a year.

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Forex Market - The Forex market deals with the multicurrency requirements, which are met by
the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of
funds takes place in this market. This is one of the most developed and integrated market
across the globe.

Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium
and long-term loans to corporate and individuals.

Constituents of a Financial System

FINANCIAL INTERMEDIATION

Having designed the instrument, the issuer should then ensure that these financial assets reach
the ultimate investor in order to garner the requisite amount. When the borrower of funds
approaches the financial market to raise funds, mere issue of securities will not
suffice. Adequate information of the issue, issuer and the security should be passed on to take
place. There should be a proper channel within the financial system to ensure such transfer. To
serve this purpose, Financial intermediaries came into existence. Financial intermediation in
the organized sector is conducted by a widerange of institutions functioning under the overall
surveillance of the Reserve Bank of India. In the initial stages, the role of the intermediary was
mostly related to ensure transfer of funds from the lender to the borrower. This service was
offered by banks, FIs, brokers, and dealers. However, as the financial system widened along
with the developments taking place in the financial markets, the scope of its operations also
widened. Some of the important intermediaries operating ink the financial markets include;
investment bankers, underwriters, stock exchanges, registrars, depositories, custodians,
portfolio managers, mutual funds, financial advertisers financial consultants, primary dealers,
satellite dealers, self regulatory organizations, etc. Though the markets are different, there may
be a few intermediaries offering their services in move than one market e.g.
underwriter. However, the services offered by them vary from one market to another.

Intermediary Market Role

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Secondary Market to
Stock Exchange Capital Market
securities

Capital Market, Credit Corporate advisory

Investment Bankers
Market services, Issue of securities

Capital Market, Money Subscribe to unsubscribed

Underwriters
Market portion of securities

Issue securities to the

Registrars, Depositories, investors on behalf of the
Capital Market
Custodians company and handle share
transfer activity

Primary Dealers Satellite Market making in

Money Market
Dealers government securities

Ensure exchange ink

Forex Dealers Forex Market
currencies

FINANCIAL INSTRUMENTS

Money Market Instruments

The money market can be defined as a market for short-term money and financial assets that
are near substitutes for money. The term short-term means generally a period upto one year
and near substitutes to money is used to denote any financial asset which can be quickly
converted into money with minimum transaction cost.

Some of the important money market instruments are briefly discussed below;

1. Call/Notice Money
2. Treasury Bills
3. Term Money
4. Certificate of Deposit
5. Commercial Papers

1. Call /Notice-Money Market

Call/Notice money is the money borrowed or lent on demand for a very short period. When
money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays

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and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on
the next working day, (irrespective of the number of intervening holidays) is "Call Money". When
money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money". No
collateral security is required to cover these transactions.

2. Inter-Bank Term Money

Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money
market. The entry restrictions are the same as those for Call/Notice Money except that, as per
existing regulations, the specified entities are not allowed to lend beyond 14 days.

3. Treasury Bills.

Treasury Bills are short term (up to one year) borrowing instruments of the union government. It
is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry
of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They
are issued at a discount to the face value, and on maturity the face value is paid to the holder.
The rate of discount and the corresponding issue price are determined at each auction.

4. Certificate of Deposits

Certificates of Deposit (CDs) is a negotiable money market instrument nd issued in

dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other
eligible financial institution for a specified time period. Guidelines for issue of CDs are presently
governed by various directives issued by the Reserve Bank of India, as amended from time to
time. CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks
(RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have
been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI.
Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs
within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments
viz., term money, term deposits, commercial papers and intercorporate deposits should not
exceed 100 per cent of its net owned funds, as per the latest audited balance sheet.

5. Commercial Paper

CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the
debt obligation is transformed into an instrument. CP is thus an unsecured promissory note
privately placed with investors at a discount rate to face value determined by market forces. CP
is freely negotiable by endorsement and delivery. A company shall be eligible to issue CP
provided - (a) the tangible net worth of the company, as per the latest audited balance sheet, is
not less than Rs. 4 crore; (b) the working capital (fund-based) limit of the company from the
banking system is not less than Rs.4 crore and (c) the borrowal account of the company is
classified as a Standard Asset by the financing bank/s. The minimum maturity period of CP is 7
days. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other
agencies. (for more details visit www.indianmba.com faculty column)
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Capital Market Instruments

Hybrid Instruments

Hybrid instruments have both the features of equity and debenture. This kind of instruments is
called as hybrid instruments. Examples are convertible debentures, warrants etc.

Conclusion

In India money market is regulated by Reserve bank of India (www.rbi.org.in) and Securities
Exchange Board of India (SEBI) [www.sebi.gov.in ] regulates capital market. Capital market
consists of primary market and secondary market. All Initial Public Offerings comes under the
primary market and all secondary market transactions deals in secondary market. Secondary
market refers to a market where securities are traded after being initially offered to the public in
the primary market and/or listed on the Stock Exchange. Secondary market comprises of equity
markets and the debt markets. In the secondary market transactions BSE and NSE plays a
great role in exchange of capital market instruments.

Q.2. Explain latest monetary policy of RBI

Ans:

The Monetary Policy for 2010-11 is set against a rather complex economic backdrop. Although
the situation is more reassuring than it was a quarter ago, uncertainty about the shape and pace
of global recovery persists. Private spending in advanced economies continues to be
constrained and inflation remains generally subdued making it likely that fiscal and monetary
stimuli in these economies will continue for an extended period. Emerging market economies
(EMEs) are significantly ahead on the recovery curve, but some of them are also facing
inflationary pressures.

2. India’s growth-inflation dynamics are in contrast to the overall global scenario. The economy
is recovering rapidly from the growth slowdown but inflationary pressures, which were triggered
by supply side factors, are now developing into a wider inflationary process. As the domestic
balance of risks shifts from growth slowdown to inflation, our policy stance must recognise and
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respond to this transition. While global policy co-ordination was critical in dealing with a
worldwide crisis, the exit process will necessarily be differentiated on the basis of the
macroeconomic condition in each country. India’s rapid turnaround after the crisis induced
slowdown evidences the resilience of our economy and our financial sector. However, this
should not divert us from the need to bring back into focus the twin challenges of
macroeconomic stability and financial sector development.

3. This statement is organised in two parts. Part A covers Monetary Policy and is divided
into four Sections: Section I provides an overview of global and domestic macroeconomic
developments; Section II sets out the outlook and projections for growth, inflation and monetary
aggregates; Section III explains the stance of monetary policy; and Section IV specifies the
monetary measures.Part B covers Developmental and Regulatory Policies and is organised into
six sections: Financial Stability (Section I), Interest Rate Policy (Section II), Financial Markets
(Section III), Credit Delivery and Financial Inclusion (Section IV), Regulatory and Supervisory
Measures for Commercial Banks (Section V) and Institutional Developments (Section VI).

4. Part A of this Statement should be read and understood together with the detailed review
in Macroeconomic and Monetary Developments released yesterday by the Reserve Bank.

Part A. Monetary Policy

I. The State of the Economy

Global Economy

5. The global economy continues to recover amidst ongoing policy support and improving
financial market conditions. The recovery process is led by EMEs, especially those in Asia, as
growth remains weak in advanced economies. The global economy continues to face several
challenges such as high levels of unemployment, which are close to 10 per cent in the US and
the Euro area. Despite signs of renewed activity in manufacturing and initial improvement in
retail sales, the prospects of economic recovery in Europe are clouded by the acute fiscal
strains in some countries.

6. Core measures of inflation in major advanced economies are still moderating as the
output gap persists and unemployment remains high. Inflation expectations also remain well-
anchored. In contrast, core measures of inflation in EMEs, especially in Asia, have been rising.
This has prompted central banks in some EMEs to begin phasing out their accommodative
monetary policies.

Domestic Economy

7. The Reserve Bank had projected the real GDP growth for 2009-10 at 7.5 per cent. The
advance estimates released by the Central Statistical Organisation (CSO) in early February
2010 placed the real GDP growth during 2009-10 at 7.2 per cent. The final real GDP growth for
2009-10 may settle between 7.2 and 7.5 per cent.

8. The uptrend in industrial activity continues. The index of industrial production (IIP)
recorded a growth of 17.6 per cent in December 2009, 16.7 per cent in January 2010 and 15.1
per cent in February 2010. The recovery has also become more broad-based with 14 out of 17
industry groups recording accelerated growth during April 2009-February 2010. The sharp pick-
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up in the growth of the capital goods sector, in double digits since September 2009, points to
the revival of investment activity. After a continuous decline for eleven months, imports
expanded by 2.6 per cent in November 2009, 32.4 per cent in December 2009, 35.5 per cent in
January 2010 and 66.4 per cent in February 2010. The acceleration in non-oil imports since
November 2009 further evidences recovery in domestic demand. After contracting for twelve
straight months, exports have turned around since October 2009 reflecting revival of external
demand. Various lead indicators of service sector activity also suggest increased economic
activity. On the whole, the economic recovery, which began around the second quarter of 2009-
10, has since shown sustained improvement.

9. A sharp recovery of growth during 2009-10 despite the worst south-west monsoon since
1972 attests to the resilience of the Indian economy. On the demand side, the contribution of
various components to growth in 2009-10 was as follows: private consumption (36 per cent),
government consumption (14 per cent), fixed investments (26 per cent) and net exports (20 per
cent). The monetary and fiscal stimulus measures initiated in the wake of the global financial
crisis played an important role, first in mitigating the adverse impact from contagion and then in
ensuring that the economy recovered quickly.

10. However, the developments on the inflation front are worrisome. The headline inflation,
as measured by year-on-year variation in Wholesale Price Index (WPI), accelerated from 0.5
per cent in September 2009 to 9.9 per cent in March 2010, exceeding the Reserve Bank’s
baseline projection of 8.5 per cent for March 2010 set out in the Third Quarter Review. Year-on-
year WPI non-food manufactured products (weight: 52.2 per cent) inflation, which was (-) 0.4
per cent in November 2009, turned marginally positive to 0.7 per cent in December 2009 and
rose sharply thereafter to 3.3 per cent in January 2010 and further to 4.7 per cent in March
2010. Year-on-year fuel price inflation also surged from (-) 0.7 per cent in November 2009 to 5.9
per cent in December 2009, to 8.1 per cent in January 2010 and further to 12.7 per cent in
March 2010. Despite some seasonal moderation, food price inflation remains elevated.

11. Clearly, WPI inflation is no longer driven by supply side factors alone. The contribution of
non-food items to overall WPI inflation, which was negative at (-) 0.4 per cent in November 2009
rose sharply to 53.3 per cent by March 2010. Consumer price index (CPI) based measures of
inflation were in the range of 14.9-16.9 per cent in January/February 2010. Thus, inflationary
pressures have accentuated since the Third Quarter Review in January 2010. What was initially
a process driven by food prices has now become more generalised.

12. Growth in monetary and credit aggregates during 2009-10 remained broadly in line with
the projections set out in the Third Quarter Review in January 2010. Non-food bank credit
expanded steadily during the second half of the year. Consequently, the year-on-year non-food
credit growth recovered from its intra-year low of 10.3 per cent in October 2009 to 16.9 per cent
by March 2010. The increase in bank credit was also supplemented by higher flow of financial
resources from other sources. Reserve Bank’s estimates show that the total flow of financial
resources from banks, domestic non-bank and external sources to the commercial sector during
2009-10 at Rs.9,71,000 crore, was higher than the amount of Rs.8,34,000 crore in the previous
year.

13. Scheduled commercial banks (SCBs) raised their deposit rates by 25-50 basis points
between February and April 2010 so far, signalling a reversal in the trend of reduction in deposit
rates. On the lending side, the benchmark prime lending rates (BPLRs) of SCBs have remained
unchanged since July 2009 following reductions in the range of 25-100 basis points between
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March and June 2009. However, data from select banks suggest that the weighted average
yield on advances, which is a proxy measure for effective lending rates, is projected to decline
from 10.8 per cent in March 2009 to 10.1 per cent by March 2010. The Base Rate system of
loan pricing, which will replace the BPLR system with effect from July 1, 2010, is expected to
facilitate better pricing of loans, enhance transparency in lending rates and improve the
assessment of monetary policy transmission.

14. Financial markets functioned normally through the year. Surplus liquidity that prevailed
throughout the year declined towards the end of the year consistent with the monetary policy
stance. The Reserve Bank absorbed about Rs.1,00,000 crore on a daily average basis under
the liquidity adjustment facility (LAF) during the current financial year up to February 12, 2010,
i.e., before the first stage of increase in the cash reserve ratio (CRR) came into effect. During
February 27- March 31, 2010, the average daily absorption of surplus liquidity declined to
around Rs. 38,200 crore reflecting the increase in the CRR, year-end advance tax outflows and
higher credit demand from the private sector. However, as the overall liquidity remained in
surplus, overnight interest rates generally stayed close to the lower bound of the LAF rate
corridor.

15. The large market borrowing by the Government put upward pressure on the yields on
government securities during 2009-10. However, this was contained by active liquidity
management by the Reserve Bank. Lower credit demand by the private sector also cushioned
the yield. Equity markets generally remained firm during the year with intermittent corrections in
line with the global pattern. Resource mobilisation through public issues increased sharply.
Housing prices rebounded during 2009-10. According to the Reserve Bank’s survey, they
surpassed their pre-crisis peak levels in Mumbai.

16. During 2009-10, the Central Government raised Rs.3,98,411 crore (net) through the
market borrowing programme while the state governments mobilised Rs.1,14,883 crore (net).
This large borrowing was managed in a non-disruptive manner through a combination of active
liquidity management measures such as front-loading of the borrowing calendar, unwinding of
securities under the market stabilisation scheme (MSS) and open market operation (OMO)
purchases.

17. The Union Budget for 2010-11 has begun the process of fiscal consolidation by
budgeting lower fiscal deficit (5.5 per cent of GDP in 2010-11 as compared with 6.7 per cent in
2009-10) and revenue deficit (4.0 per cent of GDP in 2010-11 as compared with 5.3 per cent in
2009-10). As a result, the net market borrowing requirement of the Central Government in 2010-
11 is budgeted lower at Rs.3,45,010 crore as compared with that in the previous year.

18. Historically, fiscal deficits have been financed by a combination of market borrowings and
other sources. However, in 2009-10 and 2010-11, reliance on market borrowings for financing
the fiscal deficit increased in relative terms. The large market borrowing in 2009-10 was
facilitated by the unwinding of MSS securities and OMO purchases, as a result of which fresh
issuance of securities constituted 63.0 per cent of the total budgeted market borrowings.
However in 2010-11, almost the entire budgeted borrowings will be funded by fresh issuance of
securities. Therefore, notwithstanding the lower budgeted net borrowings, fresh issuance of
securities in 2010-11 will be Rs.3,42,300 crore, higher than the corresponding figure of
Rs.2,51,000 crore last year. The large government borrowing in 2009-10 was also facilitated by
sluggish private credit demand and comfortable liquidity conditions. However, going forward,
private credit demand is expected to pick up further. Meanwhile, inflationary pressures have
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also made it imperative for the Reserve Bank to absorb surplus liquidity from the system. Thus,
managing the borrowings of the Government during 2010-11 will be a bigger challenge than it
was last year.

19. The current account deficit during April-December 2009 was US$ 30 billion as compared
with US$ 28 billion for the corresponding period of 2008. Net capital inflows at US$ 42 billion
were also substantially higher than US$ 7 billion in the corresponding period last year.
Consequently, on a balance of payments basis (i.e., excluding valuation effects), foreign
exchange reserves increased by US$ 11 billion as against a decline of US$ 20 billion during the
corresponding period a year ago. Foreign exchange reserves stood at US$ 279 billion as on
March 31, 2010. The six-currency trade-based real effective exchange rate (REER) (1993-
94=100) appreciated by 15.5 per cent during 2009-10 up to February as against 10.4 per cent
depreciation in the corresponding period of the previous year.

II. Outlook and Projections

Global Outlook

Growth

20. In its World Economic Outlook Update for January 2010, the International Monetary Fund
(IMF) projected that global growth will recover from (-) 0.8 per cent in 2009 to 3.9 per cent in
2010 and further to 4.3 per cent in 2011. Organisation for Economic Co-operation and
Development’s (OECD) composite leading indicators (CLIs) in February 2010 continued to
signal an improvement in economic activity for the advanced economies. Three major factors
that have contributed to the improved global outlook are the massive monetary and fiscal
support, improvement in confidence and a strong recovery in EMEs.

21. US GDP rose by 5.6 per cent on an annualised basis during Q4 of 2009. However,
household spending remains constrained by high unemployment at 9.7 per cent. Though
business fixed investment is turning around and housing starts are picking up, investment in
commercial real estate is declining. Growth in the euro area, on a quarter-on-quarter basis, was
0.1 per cent in Q4 of 2009. It may remain moderate in 2010 because of the ongoing process of
balance sheet adjustment in various sectors, dampened investment, low capacity utilisation and
low consumption. Though exports are improving and the decline in business fixed investment is
moderating, several euro-zone governments are faced with high and unsustainable fiscal
imbalances which could have implications for medium and long-term interest rates. In Japan,
improved prospects on account of exports have been offset by the levelling off of public
investment and rise in unemployment.

22. Amongst EMEs, China continues to grow at a rapid pace, led mainly by domestic
demand. Malaysia and Thailand have recovered to register positive growth in the second half of
2009. Indonesia recorded positive growth throughout 2009.

Inflation

23. Globally, headline inflation rates rose between November 2009 and January 2010,
softened in February 2010 on account of moderation of food, metal and crude prices and again
rose marginally in some major economies in March 2010. Core inflation continued to decline in
the US on account of substantial resource slack. Inflation expectations in advanced countries
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also remain stable. Though inflation has started rising in several EMEs, India is a significant
outlier with inflation rates much higher than in other EMEs.

Domestic Outlook

Growth

24. The Indian economy is firmly on the recovery path. Exports have been expanding since
October 2009, a trend that is expected to continue. The industrial sector recovery is increasingly
becoming broad-based and is expected to take firmer hold going forward on the back of rising
domestic and external demand.

25. Surveys generally support the perception of a consolidating recovery. According to the
Reserve Bank’s quarterly industrial outlook survey, although the business expectation index
(BEI) showed seasonal moderation from 120.6 in Q4 of 2009-10 to 119.8 in Q1 of 2010-11, it
was much higher in comparison with the level of 96.4 a year ago. The improved performance of
the industrial sector is also reflected in the improved profitability in the corporate sector. Service
sector activities have shown buoyancy, especially during the latter half of 2009-10. The leading
indicators of various sectors such as tourist arrivals, commercial vehicles production and traffic
at major ports show significant improvement. A sustained increase in bank credit and in the
financial resources raised by the commercial sector from non-bank sources also suggest that
the recovery is gaining momentum.

26. On balance, under the assumption of a normal monsoon and sustenance of good
performance of the industrial and services sectors on the back of rising domestic and external
demand, for policy purposes the baseline projection of real GDP growth for 2010-11 is placed at
8.0 per cent with an upside bias (Chart 1).

Inflation

27. Headline WPI inflation, which moderated in the first half of 2009-10, firmed up in the
second half of the year. It accelerated from 1.5 per cent in October 2009 to 9.9 per cent by
March 2010. The deficient south-west monsoon rainfall accentuated the pressure on food

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prices. This, combined with the firming up of global commodity prices from their low levels in
early 2009 and incipient demand side pressures, led to acceleration in the overall inflation rate –
both of the WPI and the CPIs.

28. The Reserve Bank’s baseline projection of WPI inflation for March 2010 was 8.5 per
cent. However, some subsequent developments on both supply and demand sides pushed up
inflation. Enhancement of excise duty and restoration of the basic customs duty on crude
petroleum and petroleum products and the increase in prices of iron ore and coal had a
significant impact on WPI inflation. In addition, demand side pressures also re-emerged as
reflected in the sharp increase in non-food manufactured products inflation from 0.7 per cent to
4.7 per cent between December 2009 and March 2010.

29. There have been significant changes in the drivers of inflation in recent months. First,
while there are some signs of seasonal moderation in food prices, overall food inflation
continues at an elevated level. It is likely that structural shortage of certain agricultural
commodities such as pulses, edible oils and milk could reduce the pace of food price
moderation. Second, the firming up of global commodity prices poses upside risks to inflation.
Third, the Reserve Bank’s industrial outlook survey shows that corporates are increasingly
regaining their pricing power in many sectors. As the recovery gains further momentum, the
demand pressures are expected to accentuate. Fourth, the Reserve Bank’s quarterly inflation
expectations survey for households indicates that household inflation expectations have
remained at an elevated level.

30. Going forward, three major uncertainties cloud the outlook for inflation. First, the
prospects of the monsoon in 2010-11 are not yet clear. Second, crude prices continue to be
volatile. Third, there is evidence of demand side pressures building up. On balance, keeping in
view domestic demand-supply balance and the global trend in commodity prices, the baseline
projection for WPI inflation for March 2011 is placed at 5.5 per cent (Chart 2).

31. It would be the endeavour of the Reserve Bank to ensure price stability and anchor
inflation expectations. In pursuit of these objectives, the Reserve Bank will continue to monitor
an array of measures of inflation, both overall and disaggregated components, in the context of
the evolving macroeconomic situation to assess the underlying inflationary pressures.

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32. Notwithstanding the current inflation scenario, it is important to recognise that in the last
decade, the average inflation rate, measured both in terms of WPI and CPI, had moderated to
about 5 per cent from the historical trend rate of about 7.5 per cent. Against this background,
the conduct of monetary policy will continue to condition and contain perception of inflation in
the range of 4.0-4.5 per cent. This will be in line with the medium-term objective of 3.0 per cent
inflation consistent with India’s broader integration into the global economy.

Monetary Aggregates

33. During 2009-10, money supply (M3) growth decelerated from over 20.0 per cent at the
beginning of the financial year to 16.4 per cent in February 2010 before increasing to 16.8 per
cent by March 2010, slightly above the Reserve Bank’s indicative projection of 16.5 per cent.
This was reflected in non-food credit growth of 16.9 per cent, above the indicative projection of
16.0 per cent.

34. Keeping in view the need to balance the resource demand to meet credit offtake by the
private sector and government borrowings, monetary projections have been made consistent
with the growth and inflation outlook. For policy purposes, M3 growth for 2010-11 is placed at
17.0 per cent. Consistent with this, aggregate deposits of SCBs are projected to grow by 18.0
per cent. The growth in non-food credit of SCBs is placed at 20.0 per cent. As always, these
numbers are provided as indicative projections and not as targets.

Risk Factors

35. While the indicative projections of growth and inflation for 2010-11 may appear
reassuring, the following major downside risks to growth and upside risks to inflation need to be
recognised:

First, uncertainty persists about the pace and shape of global recovery. Fiscal stimulus
measures played a major role in the recovery process in many countries by compensating for
the fall in private demand. Private demand in major advanced economies continues to be weak
due to high unemployment rates, weak income growth and tight credit conditions. There is a risk
that once the impact of public spending wanes, the recovery process will be stalled. Therefore,
the prospects of sustaining the recovery hinge strongly on the revival of private consumption
and investment. While recovery in India is expected to be driven predominantly by domestic
demand, significant trade, financial and sentiment linkages indicate that a sluggish and
uncertain global environment can adversely impact the Indian economy.

Second, if the global recovery does gain momentum, commodity and energy prices, which have
been on the rise during the last one year, may harden further. Increase in global commodity
prices could, therefore, add to inflationary pressures.

Third, from the perspective of both domestic demand and inflation management, the 2010
south-west monsoon is a critical factor. The current assessment of softening of domestic
inflation around mid-2010 is contingent on a normal monsoon and moderation in food prices.
Any unfavourable pattern in spatial and temporal distribution of rainfall could exacerbate food
inflation. In the current context, an unfavourable monsoon could also impose a fiscal burden and
dampen rural consumer and investment demand.

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Fourth, it is unlikely that the large monetary expansion in advanced economies will be unwound
in the near future. Accommodative monetary policies in the advanced economies, coupled with
better growth prospects in EMEs including India, are expected to trigger large capital flows into
the EMEs. While the absorptive capacity of the Indian economy has been increasing, excessive
flows pose a challenge for exchange rate and monetary management. The rupee has
appreciated sharply in real terms over the past one year. Pressures from higher capital flows
combined with the prevailing rate of inflation will only reinforce that tendency. Both exporters,
whose prospects are just beginning to turn, and producers, who compete with imports in
domestic markets, are getting increasingly concerned about the external sector dynamics.

36. Our exchange rate policy is not guided by a fixed or pre-announced target or band. Our
policy has been to retain the flexibility to intervene in the market to manage excessive volatility
and disruptions to the macroeconomic situation. Recent experience has underscored the issue
of large and often volatile capital flows influencing exchange rate movements against the grain
of economic fundamentals and current account balances. There is, therefore, a need to be
vigilant against the build-up of sharp and volatile exchange rate movements and its potentially
harmful impact on the real economy.

37. The resumption of the process of fiscal consolidation has been a significant positive
development. This will help avoid crowding out of private sector credit demand and facilitate
better monetary management. However, the overall size of the government borrowing
programme is still very large and can exert pressure on interest rates. Going forward, fiscal
consolidation has to shift from one-off gains to structural improvements on both tax and
expenditure sides, and focus increasingly on the quality of fiscal consolidation.

III. The Policy Stance

38. In the wake of the global economic crisis, the Reserve Bank pursued an accommodative
monetary policy beginning mid-September 2008. This policy instilled confidence in market
participants, mitigated the adverse impact of the global financial crisis on the economy and
ensured that the economy started recovering ahead of most other economies. However, in view
of the rising food inflation and the risk of it impinging on inflationary expectations, the Reserve
Bank embarked on the first phase of exit from the expansionary monetary policy by terminating
some sector-specific liquidity facilities and restoring the statutory liquidity ratio (SLR) of
scheduled commercial banks to its pre-crisis level in the Second Quarter Review of October
2009.

39. The process was carried forward by the second phase of exit when the Reserve Bank
announced a 75 basis points increase in the CRR in the Third Quarter Review of January 2010.
As inflation continued to increase, driven significantly by the prices of non-food manufactured
goods, and exceeded the Reserve Bank’s baseline projection of 8.5 per cent for March 2010
(made in the Third Quarter Review), the Reserve Bank responded expeditiously with a mid-
cycle increase of 25 basis points each in the policy repo rate and the reverse repo rate under
the LAF on March 19, 2010.

40. The monetary policy response in India since October 2009 has been calibrated to India’s
specific macroeconomic conditions. Accordingly, our policy stance for 2010-11 has been guided
by the following three major considerations:

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First, recovery is consolidating. The quick rebound of growth during 2009-10 despite failure of
monsoon rainfall suggests that the Indian economy has become resilient. Growth in 2010-11 is
projected to be higher and more broad-based than in 2009-10. In its Third Quarter Review in
January 2010, the Reserve Bank had indicated that our main monetary policy instruments are at
levels that are more consistent with a crisis situation than with a fast recovering economy. In the
emerging scenario, lower policy rates can complicate the inflation outlook and impair inflationary
expectations, particularly given the recent escalation in the prices of non-food manufactured
items. Despite the increase of 25 basis points each in the repo rate and the reverse repo rate,
our real policy rates are still negative. With the recovery now firmly in place, we need to move in
a calibrated manner in the direction of normalising our policy instruments.

Second, inflationary pressures have accentuated in the recent period. More importantly,
inflation, which was earlier driven entirely by supply side factors, is now getting increasingly
generalised. There is already some evidence that the pricing power of corporates has returned.
With the growth expected to accelerate further in the next year, capacity constraints will re-
emerge, which are expected to exert further pressure on prices. Inflation expectations also
remain at an elevated level. There is, therefore, a need to ensure that demand side inflation
does not become entrenched.

Third, notwithstanding lower budgeted government borrowings in 2010-11 than in the year
before, fresh issuance of securities will be 36.3 per cent higher than in the previous year. This
presents a dilemma for the Reserve Bank. While monetary policy considerations demand that
surplus liquidity should be absorbed, debt management considerations warrant supportive
liquidity conditions. The Reserve Bank, therefore, has to do a fine balancing act and ensure that
while absorbing excess liquidity, the government borrowing programme is not hampered.

41. Against this backdrop, the stance of monetary policy of the Reserve Bank is intended to:

• Anchor inflation expectations, while being prepared to respond appropriately, swiftly and
effectively to further build-up of inflationary pressures.
• Actively manage liquidity to ensure that the growth in demand for credit by both the
private and public sectors is satisfied in a non-disruptive way.
• Maintain an interest rate regime consistent with price, output and financial stability.

IV. Monetary Measures

42. On the basis of the current assessment and in line with the policy stance as outlined in
Section III, the Reserve Bank announces the following policy measures:

Bank Rate

43. The Bank Rate has been retained at 6.0 per cent.

Repo Rate

44. It has been decided to:

• increase the repo rate under the Liquidity Adjustment Facility (LAF) by 25 basis points from 5.0
per cent to 5.25 per cent with immediate effect.

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Reverse Repo Rate

45. It has been decided to:

• increase the reverse repo rate under the LAF by 25 basis points from 3.5 per cent to 3.75 per
cent with immediate effect.

Cash Reserve Ratio

46. It has been decided to:

• increase the cash reserve ratio (CRR) of scheduled banks by 25 basis points from 5.75 per cent
to 6.0 per cent of their net demand and time liabilities (NDTL) effective the fortnight beginning
April 24, 2010.

47. As a result of the increase in the CRR, about Rs. 12,500 crore of excess liquidity will be
absorbed from the system.

48. The Reserve Bank will continue to monitor macroeconomic conditions, particularly the price
situation, closely and take further action as warranted.

Expected Outcomes

49. The expected outcomes of the actions are:

(i) Inflation will be contained and inflationary expectations will be anchored.

(ii) The recovery process will be sustained.
(iii) Government borrowing requirements and the private credit demand will be met.
(iv) Policy instruments will be further aligned in a manner consistent with the evolving state of
the economy.

Q.3. Explain the recent SEBI guidelines for merchant bankers

Ans: SEBI Guidelines for Merchant Bankers:

Merchant banking has been statutorily brought within the framework of the Securities and
Exchange Board of India under SEBI (Merchant Bankers) Regulations, 1992.

1) In terms of guidelines issued during April 1990, all merchant bankers will require
authorization by SEBI to carry out business.

The Criteria for Authorization Includes:

(a) Professional qualification in finance, law or business management;

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(b) Infrastructure like adequate office space, equipment and manpower;

(c) Employment of two persons who have the experience to conduct business of merchant
bankers;

(d) Capital adequacy;

(e) Past track record, experience, general expectation and fairness in all transactions.

2) SEBI issued further guidelines classifying the merchant bankers in four categories based on
the nature and range of activities and their responsibilities to SEBI investors and issue of
securities. SEBI has issued revised guidelines on December 22, 1992 classifying the activities
of merchant bankers as follows:

· The first category consists of merchant bankers who carry on any activity of issue
management which will inter alia consists of preparation of prospects and other information
relating to the issue, determining financial structuring tie-up of financiers and final allotment and
refined of subscription and to act in the capacity of managers, advisor or consultant to an issue,
portfolio manager and underwriter.

· The second category consists of those authorized to act in the capacity of co-manager/
advisor, consultant underwriter to an issue or portfolio manager.

· The third category consists of those authorized to act as underwriter, advisor or consultant to
an issue.

· The fourth category consists of merchant bankers who act as advisor or consultant to an issue.

· Minimum net worth for first category is Rs.1crore, second category Rs.50 lakhs, third category
Rs.20 lakhs.

(3) As initial authorization fee, an annual fee and renewal fee may be collected by SEBI.

(4) All issues must be managed at least at one authorized banker, functioning as the sole
manager or the Lead Managers. But for issue over Rs. 100 cr. and above, the number of Lead
Managers may go up to a maximum of four; the specific responsibilities of each Lead Manager
must be submitted to SEBI prior to the issue.

(5) The lead merchant banker holding a certificate under category I shall accept a minimum
underwriting obligation of 5% of the total underwriting commitment or Rs.25 lakhs whichever is
less.

(6) Each merchant banker is required to furnish to the SEBI half yearly unaudited financial
results when required by it with a view to monitor the capital adequacy of the merchant banker.

(7) SEBI has prescribed a code of conduct to the merchant bankers. The bankers must perform
his duties with highest standards of integrity and fairness in all his dealings. He will render at all
times high standards of service, exercise due diligence, ensure proper care and exercise
independent professional judgment. The merchant banker and his personnel will act in an ethic

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manner in all dealings with the investors, clients and fellow bankers. All merchant bankers must
adhere to the code of conduct.

(8) The above guidelines will be administered by SEBI and it will supervise the activities of
merchant bankers.

(9) SEBI has been vested with power to suspend or cancel the authorization in case of violation
of the guidelines.

(10) To ensure transparency and accountability in the operation of merchant banker and to
protect the investors, a number of obligations and responsibilities have been imposed on them.
It has been decided to ask merchant bankers to enter into agreement with corporate body
setting out their mutual right, liabilities and obligations relating to an issue particularly on
disclosure, allotment and refund, maintenance of books of accounts and submission of half
yearly reports to SEBI.

(11) Inspections shall be conducted by SEBI to ensure that provisions of the regulations are
properly complied with and to investigate complaints from customers. It is obligatory on the part
of merchant bankers to furnish all the details bought by the investigating team.

The regulations, however, indicate that the Board would give reasonable notice to merchant
bankers before undertaking inspection. On the basis of inspection report, the Board will
communicate the contents of the report to concerned merchant banker to give him/her an
opportunity to put forth his or her submissions. On receipt of the explanations, if any of the
merchant bankers the SEBI would advise merchant bankers to take any measures that it may
deem fit and to comply with the provisions of the regulations.

The notification procedure relating to the action to be initiated against merchant banks in case of
difficulty has been detailed out. The regulations empower SEBI to take action against defaulting
bankers such as suspension/ cancellation of registration. In case of deliberate manipulation or
price rigging or cornering activities or deterioration in the financial position, the Board is
empowered to cancel the registration of the merchant banker. Under the regulation, the SEBI is
empowered to suspend a registration of a member banker in case the merchant banker
furnishes wrong or false information, fails to resolve the complaints of the investors etc. The
penalty of suspension or cancellation of registration can be imposed by SEBI only after holding
an enquiry and giving sufficient opportunity to the merchant banker being heard. Any merchant
banker aggrieved by an order of SEBI can however, appeal to the Union Government.

In September, 1997, SEBI brought about some major changes in SEBI (Merchant Bankers)
Rules and Regulations, 1992. Accordingly, only corporate bodies will be allowed to function as
merchant bankers. Moreover, the multiple categories of merchant bankers shall be abolished
and there will be just one entity viz. Merchant Banker.

The merchant bankers presently functioning as Merchant Bankers Category II, III and IV shall
have an option to either upgrade themselves as Merchant Bankers (Presently Merchant Banker
Category I) or seek separate registration as underwriters or Portfolio Managers. Under
respective regulations, the merchant bankers will be prohibited from carrying out fund- based
activity other than those related exclusively to capital markets. In effect, the activities
undertaken by NBFCS such as accepting deposits, leasing and bill discounting would not be
allowed to be undertaken by a merchant banker.
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