Money Market Conundrums

Initially, the Reserve Bank of India (RBI) was almost unanimously lauded for removing reserve requirements on inter-bank liabilities (IBL), but subsequently pilloried because it clarified that, as per the law, the minimum cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) on total liabilities should not be less than 3 per cent and 25 per cent, respectively. This clarification was labeled as second thoughts and the most respected columnist on the monetary and banking scenario, while referring to my column of April 25, 1997 has said: As if on cue the RBI ... took away by one hand some of what it gave by the other. I would submit that such criticism is somewhat unfair to me and blatantly unfair to the RBI. Market participants are fully aware that statutory minimum reserve requirements apply to total liabilities. The RBI circulars are replete with this specific clarification and it is uncharitable of market participants and commentators to claim to be oblivious of this stipulation. It is bemoaned that a bank which has its entire portfolio comprising IBL will have to maintain the minimum statutory reserve requirements as per the law. No attention is given to imprudent reliance by such a bank on the inter-bank market. Surely, it cannot be claimed that the RBI had not done its homework right.

There has to be life in the money market after this saga on reserve requirements and it is necessary to focus attention on some vital issues. The central problem of the Indian money market is that it is uni-directional and interest rates gyrate upwards to stratospheric levels and then plunge to rock-bottom levels. Again, for a smoothly functioning money market there should not be chronic borrowers or lenders. Borrowers specialising in wholesale activity need to ensure that there are alternative sources of borrowing when the money market turns tight; it is in this context that it is essential that the RBI expeditiously puts in place a set of prudential norms on asset-liability mismatches and prudent limits on IBL.

The regulators face an unenviable task as there will now be a strong incentive for borrowing banks to duck the reserve requirements by routing outside liabilities through primary dealers (PDs) who, for purposes of IBL are treated as banks. Financial Institutions (FIs) are already planning such placements. Again, those non-participant entities, who have bulk lendable resources, are required to route their transaction through PDs. Thus, PDs would increasingly become the conduit for circumventing reserve requirements. The recent measures have placed the PDs in the position of a nut in a nut-cracker; whatever, the PDs do, they are in for trouble. In effect, under the present regime there would emerge a strong incentive to circumvent reserve requirements. There is the well-known saying that risk-takers are rule breakers. I do not share the view of some observers that in view of these problems the RBI may reverse its measure on IBL. My own perception is that the RBI has crossed the Rubicon and there is no going back and, therefore, the RBI has to put its regulatory/supervisory system on red alert. More importantly, the RBI should work towards an early reduction in overall reserve requirements.

The money market is a continuum from a day to a year and the interest rates as all instruments in this maturity spectrum should be consistent taking into account maturity, liquidity and risk. Operations in the securities market and other markets impinge on the money market. The prolonged period during which call money rates remained at rates of 1-2 per cent or even lower is a cause for worry. Lending in the inter-bank market would be unremunerative and borrowers would undertake unwarranted risks in view of the law spreads. It is, therefore, necessary to take steps to ensure that a viable yield curve develops in the money market. One of the essential requirements of a stable money market is that there should be a reasonable level of liquidity for the fulcrum instrument, which necessarily has to be government paper. If the 91-day Treasury bill is kept at an artificially low level of a little over 6 per cent, the three-month term market is unlikely to be priced much higher, but at this rate it is unlikely that there would be much activity in fact, lenders who rushed in to place term money a few days ago at 5-7 per cent will live to rue their error of judgement.

A pertinent question arises as to how money market rates are to be kept on an even keel. The borrowing programme has so far this year been conducted with great perception with the RBI avoiding volatility at the long end-of the primary market. The interest rates on government paper at the short end, however, need to rise substantially and very quickly. Pegging on the bank rate of 11 per cent, the call money rate should oscillate in a reasonable range around that rate and the 91-day Treasury bill rate needs to be raised from 6.25 per cent to around 9.0 per cent i.e. 2 percentage points below bank rate, with the auction amount raised to Rs 500 crore. The 364-day Treasury bill rate could be about one percentage point below bank rate. The other short-term rates such as certificates of deposits (CDs) and commercial paper (CP) would automatically fall in place. It is then that bank rate will become truly effective as a signalling instrument.

The RBI could, instead of providing a general refinance facility to each bank, provide a liquidity adjustment facility to the market which would provide for some liquidity against the collateral of government securities; this facility could be provided two-way Repos and reverse Repos across the maturity structure. To prevent arbitrage, the rates could be flexible and there could be small changes from time to time to reflect the demand and supply of funds at different maturities. Ultimately, it is only after a smooth yield curve on government securities emerges that a term money market would develop. In the absence of such a yield curve on government securities, an active term money market would remain a pipe-dream. It is in this context that the development of the money market and the securities market needs to be reviewed and discussed in an integrated manner rather than in demarcated segments. It is only through such integration that a proper term money market would develop. Developing institutions and markets are the hardest part of financial sector reform. Attacking the RBI for the statutory minimum reserve requirements is only an ungrateful response by market participants and commentators.