Financial Development and Monetary Policy free essay sample

These papers present research in progress of the staff members of RBI and are disseminated to elicit comments and further debate. The views expressed in these papers are those of authors and not that of RBI. Comments and observations may please be forwarded to authors. Citation and use of such papers should take into account its provisional character. Copyright: Reserve Bank of India 2013 Financial Development and Monetary Policy Transmission Across Financial Markets: What Do Daily Data tell for India? 1 Partha Ray 2 and Edwin Prabu 3 This paper seeks to address two questions In Indian context. First, what is the nature of integration among different segments of Indian financial markets? Second, what has been the influence of monetary policy on different segments of financial markets? As far as domestic financial integration is concerned, the study finds that the money market segment is fairly integrated. At the next level, among the constituents of the domestic financial markets, G-sec and corporate bond market are somewhat integrated. There is, however, limited evidence of integration between the money market and stock market. Using daily data over January 2005 – November 2012, the paper constructs a structural Vector autoregression (SVAR) model and studies the financial markets microstructure and monetary policy transmission in India related to four key segments, viz. , money, bonds (GSec and corporate debt), forex and stock market. While the transmission of monetary policy to money market is found to be fast and efficient and the effects on bond and forex market are on expected lines, the impact of monetary policy to stock market is limited. The nature of monetary policy transmission, however, tends to vary, depending on the extent of liquidity (i. e. , whether there is surplus or deficit liquidity). JEL Classification: C32, E52, F41 Keywords: Monetary Policy, Structural Vector autoregression, impulse responses 1 The authors are indebted to Shri Deepak Mohanty, Shri K U B Rao, Dr. Himanshu Joshi and Shri Anand Shankar for their comments on an earlier draft of the paper. The authors are also indebted for the comments of the participants of an internal seminar at the Department of Economic and Policy Research on November 30, 2012 where they have had the privilege to present an earlier version of the paper. Usual disclaimer applies. The paper reflects personal views of the authors and not necessarily of the institution(s) to which they belong. 2 Director, Department of Economic and Policy Research, currently on sabbatical to Indian Institute of Management, Calcutta as Professor of Economics; email. 3   Assistant Adviser, Department of Economic and Policy Research; email:    1 Introduction The process of financial development in any emerging economy would invlove the intimately interlinked developments of both financial institutions as well as financial markets. It is well-known that transmission of monetary policy, to begin with, takes place via financial markets. Financial market developments and extent of market integration across various segments of domestic financial markets play a key role in this context. The more integrated financial markets are, in all likelihood the more would be the strength of monetary transmission across financial markets. Empirically, however, the locomotion from microstructure to macro behaviour is essentially couched in terms of some aggregation. Two issues are important her e. First, the level of aggregation could dictate the nature of market. Illustratively, when the market for fruits is formed by aggregating apples and oranges, there is indeed some loss of information but the investigator still goes for it to discern broader trends. Thus, tension of inferring about the woods without missing the trees is inherent in any investigation on market integration. Second, there is yet another issue that is important in this regard, viz. presence of regulation. Illustratively, even if the quality of rice could be reasonably homogenous across all India, in presence of government regulation restricting movement of rice across states, market for rice will be segmented across India. Thus, in terms of first principles, level of aggregation and extent of regulation may determine the degree of market integration. 4 While both these issues are important for financial markets, one would expect the flow of information (as well as the products) would be much smooth in financial markets than their real counterparts. After all, most of the financial products are virtual and geographical distance and transport cost will have little relevance for financial markets. Thus, the law of one price (in the form of equality of risk adjusted returns) has a higher probability of getting validated for financial markets. Nevertheless, financial transactions are highly leveraged hence the possibility of regulation leading to market segmentation will be accordingly high in financial markets. At this stage one may segregate between two levels of integration – (a) among different segments of domestic financial markets, and (b) among a specific segment of domestic financial market and its global / foreign counterpart. Both these Ayuso and Blanco (1999) rightly noted, â€Å"†¦perfect cross-market integration is generally understood as a situation in which there is no barrier of any kind to cross-border financial transactions, such as tariffs, taxes, restrictions on the trading of foreign assets, information costs or any other cost that makes it more difficult to trade across countries than within them. With perfect cross-market integration there are no cross-market arbitrage opportunities and the law of one price – i. e. , portfolios with the same payoffs should have the same price in different markets– holds†. 4 2 types of integration are on the rise with the increasing trends in globalization. It has been rightly observed: â€Å"The progressive globalisation of financial institutions and services over the last two decades has led to a complex web of interconnected markets, institutions, services and products. Institutions transcended borders; markets became accessible in real time and financial services were available from everywhere. In short, financial markets and institutions declared ‘death of distance’ and ‘conquest of location’ † (Subbarao, 2009). How integrated are the segments of Indian financial markets? What is the relationship of financial markets with monetary policy actions? What has been the inter-temporal behaviour of financial market integration? The present paper seeks to answer some of these questions in Indian specifics in recent period. In particular, it concentrates on the first type of financial integration, viz. , among different segments of domestic financial markets. Specifically, it seeks to address two questions: ? ? What is the nature of integration among different segments of Indian financial markets? and What has been the influence of monetary policy on different segments of financial markets? There are three discerning features of the study. First, it uses daily data over a fairly recent period, viz. , January 2005 – November 2012 to decipher the extent of financial market integration. Second, it seeks to probe into the mechanism of monetary policy transmission across various segments of financial markets viz. , money, G-Sec, corporate debt, forex, and equity. Third, given the short run nature of the data (notwithstanding the number of observations), it uses structural vector autoregression models to discern econometrically robust conclusions. A scan of the existing literature on financial market integration in India reveals that most of them concluded in favour of increasing but partial integration among the different segments of the financial markets. At the same time, because of low frequency of data most of these studies covered a period in which there was regime change with respect to monetary policy operating procedure. It is here that our study makes a departure and concentrates on a focused and recent period (i. e. , January 2005 November 2012), which is free from such issues. In some sense, it is less likely to be subjected to, what in generic term may be called as, the â€Å"Lucas Critique†. 5 We choose to ignore the credit market for two reasons. First, there is a large literature on credit channel of monetary policy looking into transmission of monetary policy to credit market in India (e. g. , Pandit et al, 2006). Second, credit market has a number of regulatory restrictions that may allow only partial integration with other financial markets. At the same time, we are aware of two specific limitations of the study. First, high frequency data are often more noisy and hence signal extraction could be difficult. But monetary policy also functions in such a noisy data environment, and hence, a priori, a high frequency model is expected to be more useful. Second, ours is a story of integration among different segments of financial markets and impact of monetary policy on them. We are, thus, quite contracted in our focus – we do not consider variables such as output, prices, or even fiscal policy, all of which could impact financial markets and monetary policy decisions. Put differently, we are confined to a partial equilibrium model where the market players in a particular segment of the financial market are concerned only with what is happening in other segments and monetary policy. But such a caricatured world might perhaps capture the very short-run and may be representative of the behaviour of the typical financial market player on a day-to-day basis. In the financial markets, where it is often joked that, â€Å"a long term investment is a short term investment that failed†, we thought our emphasis on the day-to-day activities may not be entirely misplaced. Rest of the paper is organized as follows. Section 2 gives a bird’s eye review of the relevant literature. While issues related to financial market microstructure in India are discussed in section 3, some stylized facts on inter-temporal behaviour of rates in different segments of the financial markets are taken up in section 4. Section 5 is devoted to the extent of market integration and its relationship with monetary policy. The econometric results are discussed in section 6. Section 7 concludes the paper. 2. Received Literature: A Synoptic Review There have been two distinct trands of literature on financial markets integration, viz. , domestic and international. Typically the studies on international financial market integration look into the movement of a similar type of market across different countries; for example, the relationship between Sensex and Nasdaq would be classified as a study on international stock market integration. Such studies typically would use the covered / uncovered interest parity condition to formalize the law of one price across geographical or political boundaries. In this paper we refrain from studying this issue. Instead our primary interest is confined to the extent of 6 See for example, Kaminsky and Schmukler (2002), Moosa and Bhatti (1997) or Fratzscher (2001) on financial market integration across different global territories. Kaminsky and Schmukler (2002) suggested that equity prices tend to be more internationally connected than interest rates. Moosa and Bhatti (1997) found high level of integration between goods and financial markets of Japan and six Asian countries by testing uncovered interest parity (U IP) and ex ante purchasing power parity (PPP). In this line Hansda and Ray (2002) found that prices of dually listed stocks at different stock exchanges like BSE or Nasdaq are highly related. Also see Raj and Dhal (2008) on this issue of stock market integration in India and abroad. 4 integration across different segments of domestic financial markets – that is to say we confine our attention to issues like how does a change in call money rate influence the yield on a ten year G-Sec. We will have a quick rundown of the studies done in the Indian context. In terms of methodology, most of these studies probe into the issue of existence of a co-integrating relationship between a subset of interest rate / yield variables in the different segments of the financial market. Dhal and Bhoi (1998) in one the early studies on the subject studied the extent of domestic financial market in the initial years of reforms (viz. , over April 1993 – March 1998). Using monthly data, they found that although fully competitive environment was yet to emerge, several segments of the financial market have achieved operational efficiency. In particular, Indias financial markets were getting increasingly integrated at the short-end of the market, such as, money market, credit market, Government securities market. However, capital market is least integrated with the rest of the financial sector; there were also early indications about integration of money market and forex market. However, integration of domestic and overseas financial markets has not been found to be robust. Similar results are obtained by others as well (e. g. , Pattnaik and Vasudevan, 1999). Nag and Mitra (1999) got similar results using the technique of Artificial Neural Network. Using monthly data from January 1993 to December 2002, Jain and Bhanumurthy (2005) examined the issue of financial market integration. In particular, they tested for existence of a cointegrating relationship between 91-day Treasury bill rates, call money rates and Indian Rupee/US dollar exchange rate (ER) as a measure of returns in the domestic financial markets and the LIBOR (used as the measure for the foreign interest rate). The study found that there was a strong integration of the domestic call money market with the LIBOR. Though, the study found that there is a long-term co-movement between domestic foreign exchange market and LIBOR, it is statistically insignificant. As the Government securities market in India was still in the development stage within the sample period, it was not found to be integrated with the global markets. RBI (2007) delved into the issue of financial market integration in detail. From the correlation structure of the rates in different segments of the financial market, the evidence of growing integration of financial markets beginning 2000 comes out. Interestingly, while in the money market segment, there is evidence of stronger correlation among interest rates in the more recent period 2000-06 than the earlier period 1993-2000, the sharp improvement in correlation between the reverse repo rate and money market rates in the recent period implies enhanced effectiveness of monetary policy transmission. The equity market, however, appeared to be segmented with relatively low and negative correlation with money market segments. Thus, it concluded, â€Å"Domestic financial market integration in India has been largely 5 facilitated by wide-ranging financial sector reforms introduced since the early 1990s. Financial markets in India have acquired greater depth and liquidity; in the process, various market segments have also become better integrated over the years† (p. 312). Bhattacharyya and Sensarma (2007) examined the efficacy and robustness of alternative monetary policy instruments in transmitting the policy signals and its impact on different segments of the financial market in India. Employing a Structural VAR model with monthly data over a 10-year period (April 1996 – March 2006), they segregated the whole period into pre-liquidity adjustment facility (LAF) and post-LAF and tried to ascertain the relative importance of alternative instruments like Bank rate, CRR or the repo rate. They found â€Å"increasing evidence of market integration between the money, the foreign exchange and the government securities market, particularly at the short-end; although the term structure turned out to be somewhat segmented, transmission across the yield curve was in evidence†. Using monthly data, Singh (2011) in a recent study examined the passthrough as well as asymmetric response of policy interest rates to financial markets for the period March 2001 through October 2011. Using the framework of distributed lag model, the study found that short end of the financial market display a significantly high instantaneous pass-through in response to changes in the monetary policy rates. The study also finds that the prevailing liquidity conditions in financial markets also play an important role in conditioning the pass-through of policy rate changes to short end of the financial market. However, the bank deposit and lending rates exhibit relatively longer lags in transmission. The study also found significant asymmetry of transmission of policy rate changes during the surplus and deficit liquidity conditions, particularly at short end of financial markets using the VAR model. 7 To analyze the dynamic effects of monetary policy shocks on financial markets, RBI (2011) constructed an SVAR model with the following variables, viz. , policy rates (Repo, Reverse Repo, corridor width); overnight money market rate (call money, weighted average of call money, CBLO and market repo rates), CD/CP rates; and bond market (91-day t-bill rate). The model has been estimated using weekly data separately in liquidity deficit (Net LAF is negative between December 2006 and November 2008) and liquidity surplus (Net LAF is positive between April 2001 and December 2006, and December 2008 and May 2010) conditions. The 7 In the context of monetary transmission channel for India, using quarterly structural vector auto regression (SVAR) model, Mohanty (2012) finds that policy rate increase have negative effect on output growth with a lag of two quarters and a moderating impact on inflation with a lag of three quarters; he overall impact persists through 8-10 quarters. 6 identification conditions are as follows. First, Central bank does not respond contemporaneously to shocks to financial market rates. Second, policy rates are determined independent of corridor width. Third, overnight money markets respond immediately to changes in policy rates and other rates with a lag. Fourth, CP/CD rates are sensitive to policy rates and overnight m oney market movements. Fifth, bond yields are sensitive to policy rates and money market movements. In such a framework, the empirical exercise indicate that, â€Å"though the impact of the interest rate channel of monetary transmission varies across the segments of the financial market, it is the strongest in the money market (RBI, 2011; p. 48-49)†. The monetary transmission turned out to be substantially more effective in a deficit liquidity situation than in a surplus liquidity situation. To sum up, most of these studies using cointegration related technique tried to discern the market integration patterns over a fairly long period time in which the monetary policy operating procedure might have undergone changes. In spirit our study is very to the model developed in RBI (2011) and we develop a structural VAR (SVAR) model using high frequency data. But as a prelude to construction and discussion of such a SVAR model, we delve into the generic issues related to financial market microstructure. 3. Financial Market Development in India As a prelude to answer the two questions raised in the introduction, this section gives some details on financial markets microstructure in India. Our attention is confined to four key segments, viz. money, bonds (G-Sec and corporate debt), forex and stock markets. In the last two decades of economic reforms, the financial markets in India has come a long way from being a underdeveloped market to a reasonably well developed, transparent and an efficient market. The Government of India, the Reserve Bank of India (RBI) and Securities and Exchange Board of India (SEBI) all have taken a proactive role in the development of financial markets within their respective domains. Money Market Walter Bagehot started his book Lombard Street (1873) with, â€Å"A notion revails that the Money Market is something so impalpable that it can only be spoken of in very abstract words and that therefore books on it must always be exceedingly difficult. But I maintain that the Money Market is as concrete and real as anything else† (Para 1. 1). He was perhaps emphasising the opaqueness of the money market. Money market, being the overnight market, is crucial for the RBI, as its monetary policy is first transmitted to it. Money market is the key link in the transmission mechanism of monetary policy to financial markets and finally to the 7 market economy. The call money market, however, continued to show high volatility on account of the predominant lending by non-banks and chronic borrowing by banks. The high volatility in the call money market also inhibited the proper risk management and pricing of instruments. With the introduction of collateralised money market segments, the share of call money market has reduced in the recent year. Currently, the share of call money market in aggregate money market transactions is around 29. 0 per cent only. 8 Collateralised Borrowing and Lending Obligations (CBLO) The CBLO in some sense is unique to the Indian money market. This product was developed by the central counterparty, the Clearing Corporation of India Limited ( CCIL) and was introduced on January 20, 2003. The facility was introduced with a view to provide avenues for non-banks and banks to manage their day-to-day liquidity. CBLO is a discounted instrument available in electronic book entry form for the maturity period ranging from one day to 90 days. Transactions are backed by collaterals in the form of Central government securities and treasury bills with a residual maturity of six months. CCIL acts as the Central Counter party and members borrow and lend funds through the anonymous trading system. Since the CBLO is collateralized, the rates in the CBLO market are, in general, below the call money market rate. With the development of CBLO market, there has been substantial migration from uncollateralised market to it. Currently, the CBLO market accounts for around 51. 6 per cent of the market share in the money market. Market Repo Market repo is another facility for banks and non-banks to manage their shortterm liquidity mismatches. Market repo operates outside the RBI’s liquidity Adjustment Facility (LAF) and transactions are backed by collaterals. The collaterals accepted in the market repo facility are central government dated Securities, treasury bills and state government securities. Earlier, market repos were permitted only among banks and PDs. In order to broaden the repo market, the RBI allowed all non-bank entities maintaining subsidiary general ledger (SGL) account to participate in the market. Further, the RBI also allowed NBFCs, MFs, Housing Finance Companies (HFCs) and insurance companies not holding SGL accounts to undertake repo transactions from March 2003, through their ‘gilt account’ maintained with the custodians. The measures taken by the RBI have widened and deepened the money market in terms of instruments and participants, enhanced transparency and improved the signalling mechanism of monetary policy while ensuring financial stability† (RBI 2007, Table 2). The overnight interest rates in the money market have more or less remained within the informal corridor of LAF. 8 The stability in c all money rates also helped to improve integration of various money market segments and thereby effective transmission of policy signals (Mohanty 2010). 8 During bulk of the period under study, the Indian monetary policy was operated through a repo (injection of liquidity) and a reverse repo (absorption of liquidity) by the RBI, where the unwritten objective of the RBI was to keep the call money rate within this informal corridor of repo and reverse repo rates. The details are explained in section 5 of the paper. 9 Table 2 : Key Features of Money Market for November 2012 Features Players Call Market ? SCBs excluding ? RRBs, Co-operative Banks and ? ? PDs. No 8. 04 19. 7 CBLO SCBs, FIs, Insurance ? Companies, MFs, PDs, NBFCs, Non government provident funds and Corporates Yes 7. 96 51. 4 Market Repo SCBs, Insurance companies, MFs, PDs, NBFCs and HFCs Yes 7. 97 28. 9 Presence of Collateral Interest Rate (%) Share in Money Market Average Daily Volume (%) Source: Compiled from various RBI publications. Bond Market From the standpoint of the issuer, there are two distinct constituents of the bond market, viz. , Government securities market and corporate debt market. In deference to their distinctness and differing degree of development in India, we will discuss them separately. Government Securities Market Prior to 1990s, the government securities market was underdeveloped and constrained on account of unlimited automatic monetization of the central government budget deficits, interest rate on government securities were administered and were kept low to ensure low cost of government borrowing (RBI, 2007). Further, the market for government securities was a captive one where the players were mainly financial intermediaries such as banks and LICs, who had to invest in government securities to fulfil high statutory reserve requirements. The first major reform was the introduction of auction based system for issuance of government securities in 1992, which signalled the transaction to a market related interest rate system. The abolition of automatic monetization through ad-hoc treasury bills and the introduction of ways and means advances (WMA) system from April 1997 also provided operational autonomy and greater market orientation for government securities (RBI, 2007). The statutory liquidity ratio (SLR), which signifies the captive market for government securities, was decreased from the peak rate of 38. per cent of net demand and time liabilities (NDTL) in February 1992 to 25 per cent in October 1997. Right now, the SLR has been further reduced to 23 per cent of NDTL for banks. 10 The RBI has introduced the primary dealers (PDs) as market makers in the GSec market. PDs ensures the success of the G-Sec auction in the primary market through underwriting but also act as market makers in the secondary market by provid ing continuous two-way quotes. The PD system also facilitates open market operations of the RBI, besides taking over the responsibility of market making from the RBI (RBI, 2007). The various reforms initiated by the RBI have ensured successful completion of market borrowing programmes of both the central government and the state governments. The daily volatility of the yields has been declining indicating, inter alia, maturity of the government securities market (Gopinath, 2008). With the issuance of long-term securities, the yield curve has emerged for across 30 year maturity (Chart 1). â€Å"Thus the government securities market in India has witnessed a transition to an increasingly broad-based market, characterized by an efficient auction process and an active secondary market† (Mohan, 2007). Notwithstanding these improvements, the government securities market continued to be illiquid at the long end. Further, the major investors in the government securities are institutional investors, who hold securities to maturity, on account of statutory prescriptions, which makes the market illiquid. With the permission to FIIs to invest in dated government securities and Tbills with certain specified limits, the secondary market is expected to be more liquid. Chart 1: Government Securities – Yield Curves 1. 1: Period: March 2005 to March 2009 1. : Period: March 2010 to November 2012 Source: FIMMDA. 11 Corporate Bond Market A well–developed bond market is important to ensure a well-integrated financial system. Before the 1990s, the corporate bond market was dormant on account of control on the interest rates for corporate bonds as well as limited issuances in the market were also dominated by public sector companies (issuers) and banks (buyers) (Rajaram, et al 2011). T he first reform in the corporate bond market was the abolition of ceiling interest rate for corporate bonds on May 1992. Thought, the primary issuances have been significant, most of these were accounted for by public sector financial institutions and were issued on a private placement basis to institutional investors. The secondary market, therefore, has not developed commensurately and market liquidity has been an issue (Reddy, 2007). Major reforms have started in the corporate bond market following the recommendation of the High Level Committee on Corporate Bonds and Securitisation (Government of India, 2005) on corporate debt market in India. The corporate bond market in India continues to be nascent despite measures taken from time to time over the past fifteen years based on the recommendations of several official committees. However, in recent years, the corporate bond market has shown significant growth in terms of outstanding stock and volumes traded in the secondary market (Table 3). Much of the increase in volumes has come in the OTC segment of the corporate bonds as reported in the reporting platform developed by the Fixed Income, Money and Derivatives Market Association (FIMMDA). Table 3: Secondary Market Transactions in Domestic Bonds (Rs. billion) Outright Transactions in Transactions Total Share of Government securities in corporate Transactions corporate Bonds in bonds bonds in Central State Total total bonds Govt. Govt. Securities Securities 2004-05 8852. 2 264. 7 9116. 9 2005-06 6735. 0 200. 7 6935. 7 2006-07 7566. 6 125. 5 7692. 0 2007-08 14785. 4 157. 5 14942. 8 958. 9 15,902 6. 0 2008-09 19645. 9 352. 5 19998. 4 1,481. 60 21,480 6. 9 2009-10 25218. 9 764. 3 25983. 2 4,012. 00 29,995 13. 4 2010-11 25926. 7 483. 3 26410. 6,052. 74 32,463 18. 6 Source: RBI and SEBI. Forex Market The Indian forex exchange market was virtually nonexistent from the 1950s to 1970s as India was using trade controls to foster import substitution. The origin of forex market can be traced to the year 1978, when banks in India were allowed to 12 undertake intra-day trade in foreign exchange (RBI 2007). But the market was very limited as India followed a fixed exchange rate syste m. In the 1990s, as in other segments of financial markets, various reforms were taken in the foreign exchange market. The introduction of market-based exchange rate regime in 1993, adoption of current account convertibility in 1994, and substantial liberalization of capital account over the years were the most important reforms in the forex market. The RBI and the Government implemented various committees’ recommendations towards relaxation of restrictions to vitalize the foreign exchange market. The reforms in the forex market were focused on dismantling controls, developing the institutional framework and increasing the instruments for effective functioning, enhancing transparency and liberalizing the conduct of foreign exchange business (RBI 2007).