Q. No.1. What is Call Money Market? Discuss its nature & Working in India.

Ans:- Market in which brokers and dealers borrow money to satisfy their credit needs, either to
finance their own inventory of securities or to cover their customers' margin accounts.

CALL MONEY MARKET OPERATIONS IN INDIA 

The money market is a market for short-term financial assets that are close substitutes of
money. The most important feature of a money market instrument is that it is liquid and can be
turned over quickly at low cost and provides an avenue for equilibrating the short-term surplus
funds of lenders and the requirements of borrowers. The call/notice money market forms an
important segment of the Indian money market. Under call money market, funds are transacted
on overnight basis and under notice money market, funds are transacted for the period between
2 days and 14 days. 
Banks borrow in this money market for the following propose. 
• To fill the gaps or temporary mismatches in funds 
• To meet the CRR & SLR Mandatory requirements as stipulated by the Central bank 
• To meet sudden demand for funds arising out of large outflows 
Thus call money usually serves the role of equilibrating the short-term liquidity position of banks 

Participants 
Participants in call/notice money market currently include banks, Primary Dealers (PDs),
development finance institutions, insurance companies and select mutual funds. Of these,
banks and PDs can operate both as borrowers and lenders in the market. But non-bank
institutions (such as all-India FIs, select Insurance Companies or Mutual Funds), which have
been given specific permission to operate in call/notice money market can, however, operate as
lenders only. No new non-bank institutions are permitted to operate (i.e., lend) in the call/notice
money market with effect from May 5, 2001. In case any eligible institution has genuine difficulty
in deploying its excess liquidity, RBI may consider providing temporary permission to lend a
higher amount in call/notice money market for a specific period on a case-by-case basis. 
Effective from Aug 06, 2005 non-bank participants except Primary Dealers are to discontinue
participate, to make the call money market pure inter-bank market. 
Prudential norms of RBI 
Lending of scheduled commercial banks, on a fortnightly average basis, should not exceed 25
per cent of their capital fund. However, banks are allowed to lend a maximum of 50% on any
day, during a fortnight. 
Borrowings by scheduled commercial banks should not exceed 100 per cent of their capital fund
or 2 per cent of aggregate deposits, whichever is higher. However, banks are allowed to borrow
a maximum of 125 per cent of their capital fund on any day, during a fortnight. 
Interest Rate 
Eligible participants are free to decide on interest rates in call/notice money market.
The call money market is an integral part of the Indian Money Market, where the day-to-day
surplus funds (mostly of banks) are traded. The loans are of short-term duration varying from 1
to 14 days. The money that is lent for one day in this market is known as "Call Money", and if it
exceeds one day (but less than 15 days) it is referred to as "Notice Money". Term 
Money refers to Money lent for 15 days or more in the Inter Bank Market. 

Banks borrow in this money market for the following purpose: 

• To fill the gaps or temporary mismatches in funds 

• To meet the CRR & SLR mandatory requirements as stipulated by the Central bank 

• To meet sudden demand for funds arising out of large outflows.

Thus call money usually serves the role of equilibrating the short-term liquidity position of banks 

Call Money Market Participants :

1.Those who can both borrow as well as lend in the market - RBI (through LAF) Banks, PDs 

2.Those who can only lend Financial institutions-LIC, UTI, GIC, IDBI, NABARD, ICICI and
mutual funds etc.

Reserve Bank of India has framed a time schedule to phase out the second category out of Call
Money Market and make Call Money market as exclusive market for Bank/s & PD/s.

The most active segment of the money market has been the call money market, where the day
to day imbalances in the funds position of scheduled commercial banks are eased out. The call
notice money market has graduated into a broad and vibrant institution.

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
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.
The entry into this field is restricted by RBI. Commercial Banks, Co-operative Banks and
Primary Dealers are allowed to borrow and lend in this market. Specified All-India Financial
Institutions, Mutual Funds, and certain specified entities are allowed to access to Call/Notice
money market only as lenders. Reserve Bank of India has recently taken steps to make the 
call/notice money market completely inter-bank market. Hence the non-bank entities will not be
allowed access to this market beyond December 31, 2000.

From May 1, 1989, the interest rates in the call and the notice money market are market
determined. Interest rates in this market are highly sensitive to the demand - supply factors.
Within one fortnight, rates are known to have moved from a low of 1 - 2 per cent to dizzy heights
of over 140 per cent per annum. Large intra-day variations are also not uncommon. Hence there
is a high degree of interest rate risk for participants. In view of the short tenure of such
transactions, both the borrowers and the lenders are required to have current accounts with the
Reserve Bank of India. This will facilitate quick and timely debit and credit operations. The call
market enables the banks and institutions to even out their day to day deficits and surpluses of 
money. Banks especially access the call market to borrow/lend money for adjusting their cash
reserve requirements (CRR). 
The lenders having steady inflow of funds (e.g. LIC, UTI) look at the call market as an outlet for
deploying funds on short term basis. The overnight call money or the inter-bank money market
rate is presumably the most closely watched variable in day-to-day conduct of monetary
operations and often serves as an operating target for policy purposes. The choice of operating
tactics from quantity to rate based targeting, following the IS/LM based analysis of Poole (1970),
has been largely accepted in favour of interest rate targeting, because of the diminished link
between monetary aggregates and economic objectives of monetary policy as a result of the
fast pace of financial innovations. Most central banks, therefore, presently use indirect
instruments in an attempt to maintain the short term interest rate at a desirable level with the
use of appropriate liquidity management practices. The most common of these instruments of
liquidity management is the central banks’ repo facility which enables modulation of the
marginal liquidity on a day to day basis so as to ensure stable conditions in the money market
and, particularly, to maintain the short term money market rate as close as possible to the
official/policy rate. Changes in the short-term policy rate made by central banks provide signals
to markets, and various segments of the financial system, therefore, respond by adjusting
interest rates/returns depending on their sensitivity and the efficacy of the transmission 
mechanism. Economic implications for investment and spending decisions of producers and
households follow as usual, thereby affecting the working of the real sector viz., changing
aggregate demand and supply, and eventually inflation and growth in the economy. It is,
therefore, clear that the interest rate stance of a central bank and its implications for economic 
activity and inflation play an important role in the conduct of monetary policy.The objective of the
paper is, therefore, to assess the volatility pattern of the call money rate in India during the last
three years and to estimate its sensitivity vis-à-vis the Reserve Bank of India’s liquidity
adjustment facility (LAF) auction decisions for the purpose of eliciting underlying market
characteristics. Attempt is made to provide evidence, albeit indirectly, on how regulatory
changes related to other instruments in the money market may have affected the functioning of
the interbank call money market. Finally, some evidence is also offered on the link between
money market volatility and interest sensitive financial markets, particularly the government
securities market.The remainder of the paper is structured as follows. Section I provides an
overview of liquidity management in India while cross-country experience is set out in Section II.
Data used in the analysis are explained in Section III. Methodology used and the empirical
analysis are presented in Section IV and concluding observations are given in Section

V.THERE seems to be a role reversal of sorts in the inter-bank call money market. Excepting a
few big fish, most 
nationalised banks, traditionally lenders in the overnight lending and borrowing market, have
turned borrowers. With a large portion of their funds locked in government securities, many
public-sector banks are now facing dearth of liquidity in patches, say bankers. 
" We have even borrowed up to Rs 600-700 crore on a particular day'', said an official in a
public-sector banker. 
The increased demand for funds seems to be due to a combination of factors - - a pick-up in
credit disbursal witnessed over the past month, being the prominent among them. Other
requirements are more routine needs such as fulfilment of statutory norms, the cash reserve
requirement, deposit redemption and asset-liability management of these banks. 
" With demand for large funds coming from the oil sector over the past 6-8 weeks, we have
been resorting to borrowing in the call money market as a stop-gap arrangement for funding
needs,'' confided the treasury head of a public-sector bank. The rates in the call money market
had been low and `attractive' in the 5.50-5.60 per cent range, much lower than the average
cost of funds at 6.75 per cent, he added. 
Public-sector banks are locked into their holdings in government securities at the moment. Said
the treasury head of a nationalised bank: "We had bought these govt. sectors at higher prices
and therefore it does not make sense to sell them now and book losses when the market is
dull.'' 
With prices dropping in the govt. sectors market over the past fortnight as much as Rs 5-10,
public sector banks are sitting on depreciation in the value of their holding. On an average 40-45
per cent of most nationalised banks' balance sheets were invested in `zero-risk' government
securities, said a debt market analyst. However, the liquidity in the system has not vanished 
over-night. Bankers are keeping their fingers crossed with the hope that g-sec prices will rise
once again on quelling of tensions in West Asia. 
If and when g-sec prices rise again, the banks can sell their stocks, realise funds plus book
profits. Meanwhile, there have also been some unusual lenders in the call money market which
include private-sector banks, who are by nature borrowers. "Having sold our positions in g-secs
over the past fortnight, we are now sitting on pots of cash, which have to be lent out,'' said the
trading head of a private sector. 
Call money rates ruled at around 7.75-8% last week. Demand remained modest despite a
scheduled auction of Rs 5,000 crore and was adequately matched by available supplies.
Consequently, call rates were steady. 
Also, as liquidity was aided by RBI’s reported intervention in the forex market (buying dollars),
inter-bank rates remained supported at around the current levels. The average repo numbers at
the liquidity adjustment facility window stood at Rs 12,149 crore against Rs 13,332 crore 
previously, while the average reverse repo figure was up at Rs 210 crore against Rs 171 crore
of the previous week. The cumulative collateralised borrowing and lending obligation volumes
for the week fell to Rs 72,994 crore from Rs 97,246 crore. 
The overnight weighted average yield was lower at 7.2366% against 7.2439% in the previous
week. Inter-bank rates would re-align in case RBI tightens rates in the policy review.
Rates on the call money market ended in a range of 7.7-7.9%, down from the previous closing
levels of 7.8-8%. RBI mopped up bids worth only Rs 210 crore through the reverse repo
operations at the second session of liquidity adjustment. 
On the other hand, the central bank infused funds worth Rs 12,115 crore through the repo
operations under both sessions. The bond market did witness some improvement in volumes on
Tuesday, while prices rose by almost 20 paise. Traders expected the inflation to soften in the
weeks ahead, and interest rates to rise at a slower pace, after the government 
cut import duty on some items. The yield on the benchmark 8.07% 2017 bond ended at 7.87%,
lower than the previous close of 7.9%.Traders widely expect a 25 basis point increase in
interest rates when RBI announces its quarterly policy review on January 
31. The government reduced import duties on a variety of items late on Monday after annual
inflation hit a two-year high of 6.12%,breaking above the central bank’s estimate of 5-5.5% at
March-end. 

Q No. 2. Explain various theories that discuss relationship between financial

system and economic development .

Ans. The economic development in India followed a socialist-inspired policies for most

of its independent history, including state-ownership of many sectors; extensive
regulation and red tape known as "Licence Raj"; and isolation from the world economy.
Since the mid-1980s, India has slowly opened up its markets through Economic
Liberalisation. After more fundamental reforms since 1991 and their renewal in the
2000s, India has progressed towards a free market economy.

In the late 2000s, India's growth has reached 7.5%, which will double the average
income in a decade. Analysts say that if India pushed more fundamental market
reforms, it could sustain the rate and even reach the government's 2011 target of 10%.
States have large responsibilities over their economies.

The economic growth has been driven by the expansion of services that have been
growing consistently faster than other sectors. It is argued that the pattern of Indian
development has been a specific one and that the country may be able to skip the
intermediate industrialization-led phase in the transformation of its economic structure.
Serious concerns have been raised about the jobless nature of the economic growth. 

The progress of economic reforms in India is followed closely. The World

Bank suggests that the most important priorities are public sector reform, infrastructure,
agricultural and rural development, removal of labor regulations, reforms in lagging
states, and HIV/AIDS. For 2010, India ranked 133 rd in Ease of Doing Business Index,
which is setback as compared with China 89th and Brazil 129th.

India is 15th  in services sector. Service Industry employs 23% of the work force and is
growing quickly, with a growth rate of 7.5% in 1991–2000. It has the largest share in the
GDP, accounting for 57% in 2010.  Business services (information technology, enabled
services, business process outsourcing) are among the fastest growing sectors
contributing to one third of the total output of services in 2000. The growth in the IT
sector is to increase specialisation and availability of a large pool of low cost, highly
skilled, educated and English-speaking workers on the supply side and on the demand
side, has increased demand from foreign consumers interested in India's service
exports or those looking to outsource their operations. India’s IT industry, despite
contributing significantly to its balance of payments, accounts for only about 1% of the
total GDP or 1/50th of the total services.

The ITES-BPO sector has become a big employment generator especially amongst

young college graduates.
Since liberalisation, the government has approved significant banking reforms. While
some of these relate to nationalised banks and other reforms have opened up the
banking and insurance sectors to private and foreign players.

Currently, in 2007, banking in India is generally mature in terms of supply, product

range and reach-even, though reach in rural India still remains a challenge for the
private sector and foreign banks. The RBI is an autonomous body, with minimal
pressure from the government.

Currently, India has 88 scheduled commercial banks (SCBs) — 28 public sector banks
(that is with the GOI holding a stake), 29 private banks (these do not have government
stake; they may be publicly listed and traded on stock exchanges) and 31 foreign
banks.

Q No. 3:- How have the trends in the banking changes in India during the period of
Liberalisation?

Ans:- The three major changes in the banking sector after liberalization are:

 Step to increase the cash outflow through reduction in the statutory liquidity and cash
reserve ratio.
 Nationalized banks including SBI were allowed to sell stakes to private sector and
private investors were allowed to enter the banking domain. Foreign banks were given
greater access to the domestic market, both as subsidiaries and branches, provided the
foreign banks maintained a minimum assigned capital and would be governed by the
same rules and regulations governing domestic banks.
 Banks were given greater freedom to leverage the capital markets and determine their
asset portfolios. The banks were allowed to provide advances against equity provided
as collateral and provide bank guarantees to the broking community.
 In the first week of August 2005, Reserve Bank of India (RBI), country’s central bank,
issued a list of 391 under-banked districts in India with population per branch more than
the national average of 16,000. The list was part of a policy directive issued by the central
bank to all commercial banks asking them to work out their branch expansion strategies
“keeping in mind the developmental needs of unbanked regions.” The directive called for
greater emphasis to be given to under-banked regions while seeking licenses for bank
branches.
 The policy directive (including the list of under-banked districts) was posted at the RBI’s
website. However, the document was removed from its website the very next day. No
explanations were given by the central bank on why the document was removed from the
website. Apparently, the document was removed at the behest of Finance Ministry’s
pressure as it expected to fuel a strong public reaction that may imperil the ongoing move
towards greater banking sector liberalization. This speaks volumes about the present-day
discourse on transparency and accountability in economic policy-making.
 If 391 districts out of a total 602 districts in India are under-banked, it raises several
policy issues which cannot be suppressed by keeping public in dark about the ground
realities of the banking sector. On the contrary, such an anomaly could only be addressed
through wider public consultation and debate.
 According to the RBI’s list, states such as Uttar Pradesh, Madhya Pradesh and Bihar have
the maximum number of under-banked districts in the country (see Table 1) while states
and union territories such as Goa and Chandigarh do not have any under-banked districts.
Interestingly, some of the under-banked districts also include prominent industrial cities
such as Surat in Gujarat.
  
 Table 1: Number of Under-banked Districts in India
  
 Andhra Pradesh           13            Karnataka                  7               Orissa                   22
 Arunachal Pradesh       11            Kerala                        1               Pondicherry             1
 Assam                         22            Madhya Pradesh      43               Punjab                     1
 Bihar                           37            Maharashtra             26               Rajasthan              25
 Chhattisgarh                15            Manipur                     8               Sikkim                     1
 Gujarat                        12            Meghalaya                  3               Tamil Nadu           14
 Jammu & Kashmir         4            Mizoram                     2               Uttar Pradesh        63
 Jharkhand                    18            Nagaland                  11               West Bengal          16
  
 No one can deny the fact that rapid increase in bank branches took place in the post-1969
period when India nationalized its banking sector. There were several objectives behind
the bank nationalization strategy including the transformation of class banking into mass
banking and to reach out to neglected sectors such as agriculture and small scale
industries. At the time of nationalization, there were only 89 scheduled commercial banks
with 8262 branches throughout the country. But in March 2004, the number of scheduled
commercial banks increased to 290 and the branch network increased to 69071. With
such a rapid increase in bank branches, the population covered per branch, which was
64000 in 1969, also decreased to 16000 in 2004.
 Even the proponents of banking sector liberalization admit that such a rapid expansion of
bank branches, with more than half of the branches opened in rural areas, after
nationalization was unparalleled in the recent economic history of any other developing
country. No doubt, the banking system under the nationalization regime was not perfect
as it failed to meet the banking needs of remote rural areas and small borrowers but at
least a serious effort was made to spread banking services both geographically and
functionally. No one can deny that there was corruption, lack of transparency
and bureaucratic control which affected the functional efficiency of the banking
system. But despite all these operational and other problems, the positive thing about that
regime was that the entire banking system was subservient to theneeds of the real
economy; which is certainly not the case in the post-liberalization period.
 In the post-liberalization period, one finds that the rural bank branches are being closed
down (from 32939 in March 1997 to 32227 in 2004) in order to meet the profitability
criteria, while there has been a rapid growth in the bank branches in the urban,
metropolitan areas (from 8390 in March 1997 to 9750 in 2004). However, there are
several regional disparities. For instance, Uttar Pradesh, Bihar and the entire North-
eastern region witnessed a decline in the number of branches in the post-liberalization
period. Whereas states such as Delhi, Haryana, Punjab and Maharashtra have witnessed a
steep hike in the bank branches. Delhi, for instance, witnessed a jump of more than 30
per cent in bank branches, from 1256 branches in 1997 to 1639 in 2004.
 More importantly, the banking sector under the post-liberalization period is witnessing a
secular decline in rural credit. The rural credit went down from 15.7 per cent in 1992 to
11.8 per cent in 2002 (see Table 2).
 Table 2: Decline in Rural Credit
  
                                 Year                     Percentage of Rural Credit to Total Credit
                                    
                                 1992                                                     15.7
                                 1993                                                     14.8
                                 1994                                                     14.7
                                 1995                                                     12.8
                                 1996                                                     12.3
                                 1997                                                     12.3
                                 1998                                                     12.3
                                 1999                                                     11.9
                                 2000                                                     11.5
                                 2001                                                     11.0
                                 2002                                                     11.8
 According to a recent study by the Associated Chambers of Commerce and Industry of
India (Assocham), an influential business lobby group, the regular fall in rural credit in
the last decade led to an adverse development in the agricultural sector, and also
increased the apathy of institutionalized finance for the farming community.
 While putting the onus on the banking sector liberalization program on the poor
performance of agricultural sector, the Assocham study pointed out that while the
banking sector garnered deposits exceeding Rs. 1000000 million from the farming
 community in the last decade, the credit extended to them did not even touch Rs. 500000
million. The study also noted that out of 27 state-owned banks and as many banks in the
private sector, only five public sector banking institutions and two from the private sector
met the required 18 per cent agricultural credit extension target to the farming community
between 1992 and 2002. Further the study found that credit allocation towards
metropolitan region increased from 44.84 per cent in 1990-91 to 61 per cent by the end of
2003-04, thereby revealing a clear urban bias in the credit allocation.
 Given the fact that the bias towards urban areas is expected to grow as Indian credit
markets are driven by consumer loans and just 20 cities contribute over three-fourths of
new assets creation, this anomaly needs to be addressed by policy makers.
 In this context, it is also important to highlight that much-touted microcredit programs
launched by self-helf groups and NGOs are no substitute for the bank lending provided
by commercial and regional rural banks in India. At best, microcredit programs can
complement, not substitute, the growing credit needs of farmers, rural entrepreneurs,
small enterprises and informal sectors of economy.
 In the post-liberalization period, one also finds that the lending to small and medium
enterprises (SMEs) has declined from 15 per cent in 1991 to 11 per cent in 2003. SMEs
are the engines of India’s economic growth, together they contribute 40 per
cent of India’s total production, 34 per cent of exports and are the second largest
employer after agriculture. The growing neglect of bank lending to SMEs can have
adverse implications on economic growth and employment.
 At the consumer level too, small borrowers and depositors are facing the burnt of
liberalization policies. Banks are charging higher fees from customers and it is becoming
more expensive to maintain a bank account.
 In the light of these developments, it remains to be seen whether commercial banks
would follow the RBI’s directive of providing banking services to unbanked regions or
pursue their narrow commercial interests. As the recent experience shows, it is highly
unlikely that the commercial interests of banks would match with the developmental
needs of unbanked regions of the country. Rather than expecting banks to voluntarily
open branches in rural and remote regions, the RBI should issue strict guidelines to
ensure that banking services are made accessible to unbanked regions and people at large.

Q. No. 4:- Explain administered and Market Determined Interest Rates both
using the Indian and International Markets?

Ans:- Benchmarking of Administered Interest Rates:The current schemes of small savings in

India serve a dual purpose: (i) of providing an instrument for the small savers from rural and
semi urban areas and (ii) towards borrowing requirements of the Government. As such, these
savings are mobilised with incentives like higher interest rate than other competing instruments
and in some cases with tax concessions. Further, the interest rates on such small saving
schemes are administered by the Government considering various factors and are not generally
revised quite often. As tax incentives are available to these schemes, income-tax payers from
urban areas also have substantial investments in these schemes thus, in some way creating a
distortion among small saving schemes.The Gupta Committee felt the need for revision of
interest rates of these saving schemes because the other commercial interest rates have been
freed from administrative control and are market determined. Therefore, the Committee felt
that the small savings rates should be in alignment with commercial rates and without affecting
adversely the small savings collections.

Current Status

At present, there are ten small saving instruments with varied maturities ranging from less than
one year to 15 years carrying different interest rates. On some instruments, interest is
calculated on a quarterly basis, on some on annual basis and some on compounding basis.
Further, one instrument is a bearer instrument, which is out of alignment in salient features
with other instruments. Further, certain schemes enjoy the facility of withdrawal after a
prescribed lock in period and certain schemes have to be held to maturity. The small saving
schemes [including Public Provident Fund (PPF)] account for nearly 26.0 per cent of the total
liabilities of the central government. According to Budget Estimate of 2000-01, the average
interest cost of these schemes was around 12.22 per cent vis-à-vis 9.99 per cent on the total
borrowings. The fiscal concessions given to these schemes also differ. Under the Income Tax
Act, investment in small saving instruments enjoys two types of tax concessions (i) exemption
of interest income from direct tax under Section 80-L and Section 10 of IT Act. While Union
Budget reviews the limits on interest income on instruments under Section 80-L, in the case of
instruments under Section 10, the entire interest income on these instruments is exempt from
income tax; and (ii) Tax rebate at a rate of 20.0 per cent an investment under Section 88 with a
limit reviewed regularly in the Budget.

Issues

If the fiscal concessions available to small saving schemes are factored into the rates of return
offered on them, the effective rates of return on these instruments naturally become higher
than the nominal rates of return. Further, with in-built tax concessions the effective cost of
borrowings to the Government becomes higher. The higher the tax rebate, the higher the cost
of funds. Further, the fiscal concessions create distortion in the effective yields across
instruments and the interest to maturity structure of small saving instruments gets vitiated. It
was also noticed that instruments with a similar maturity have different tax concessions,
thereby differing in effective rates.

With financial sector reforms, interest rates on several financial instruments are market
determined. Banks which play an important role in the credit markets have been given freedom
for fixing the interest rates on deposits (excepting saving deposit rate) and on loans and
advances. The yield on government securities is also market determined through auction
system. Unlike the above, interest rates on small savings are still administered and are not in
alignment with interest rates on competing instruments. Further, the monetary policy stance of
the RBI does not seep to these saving instruments. If interest rate channel for monetary policy
transmission is to evolve, all the interest rates in the economy should respond to monetary
policy changes.

Issues in Benchmarking

As interest is a future income it is argued that the interest income should at least preserve the
value of the principal in future and also generate additional income to the saver. In this context,
fixing interest rate factoring inflation expectations becomes valid. This ensures a positive real
rate of return to the investors. Since various risks are involved in a competitive market, the
interest rates should have a margin over a risk free asset. This brings in the importance of
linking the interest rate of small saving instrument to return on risk free instrument besides
inflation expectation. The question then arises what could be the benchmark for these schemes
and whether the benchmark rate should be a leading rate or following rate. The leading rate is
likely to influence other rates and benchmarking to such a rate has in built expectations;
whereas, in linking to a following rate, the prevailing rate is used. Ideally, the benchmark should
evolve from the market and other interest rates should be linked to such benchmark rate.
There are various issues that come up while finding out a benchmark which serves as a
reference rate.

A good reference rate should be a stable rate; stability here is defined as less volatility. Other
rates when linked to such stable rate also do not fluctuate widely. The crucial issue here is
whether interest rates have to be linked to ex post indicators or lead indicators. Some argue
that, linking to ex post indicators is not desirable as they will not be able to influence the
investor’s preferences. As such, lead indicators become ideal choice in this context.

The present Committee while recognising the need for revision in interest rates have also
discussed choice of reference rate to which the interest rate on small savings can be linked.
There are various options available as benchmark rates. The Committee reviewed these options
individually.

Inflation as a Benchmark

The simplest way of benchmarking is linking to the current inflation rate. Many measures are
available for measurement of inflation like Wholesale Price Index (WPI) (on a point-to-point
basis and on average basis), Consumer Price Index (CPI) or national income deflator. The
availability of these indices also differs from weekly to quarterly. The basic premise for linking
with inflation is to ensure a positive real rate of interest to the investors.

As argued by several researchers that the measurement of real interest rate should use
expected inflation rather than current inflation. However, the problem in this context is about
measuring inflation expectation. The assessment of inflation expectations is difficult because of
methodological problems besides the choice of a suitable index for the measurement of
inflation viz. Wholesale Price Index or Consumer Price Index or GDP deflector. The inflation
expectations can be assessed either through econometric techniques or by surveys. One simple
way which many researchers use is to treat the current inflation rate as the expected inflation
in the next period. Some feel that inflation expectations can be measured by distributed lag
model wherein the expected inflation is derived as weighted average inflation with higher
weight attached to the recent past inflation or the contemporaneous inflation and weights
decline with the lags. However, it may be recognised that a 5 year weighted index on annual
basis may give a different inflation expectation from the one measured through half yearly
inflation rates. Therefore, in the lagged scheme, the length of the lag becomes subjective.
Depending upon the lagged structure, the benchmark rate could be different. This shows that
real interest rates which are derived as nominal interest rates minus the inflation expectation
may not be credible. Because of this, some members felt that the present inflation rate is
simpler and a better measure of future inflation expectations.

Inflation expectations may be suitable for small saving schemes with a maturity of more than
one year but do not serve for linking to the postal savings bank deposits because of the fact
that inflation expectations do not change much in short period. Further, if inflation is volatile,
by linking to inflation, the volatility in inflation gets translated into the saving instruments also.
In such case, savers may not like to build this volatility in their investment decisions. Thus, there
are difficulties associated with linking inflation rates with small saving instruments viz.
estimation of credible measure of expected inflation, artificial fixation of real interest rate and
derivation of term structure of interest rates on small saving instruments.

Yields on Government Securities as Benchmark

As small savings are borrowings by the Government on long-term basis, it is logical that their
yields also should correspond to yields on government securities. Besides this, as small savings
are not as liquid as dated securities some compensation for the illiquid characteristic may have
to be given to the small savings. While considering the acceptance of yields on government
securities as benchmark rates for fixing interest rates on small saving schemes, a comparative
risk assessment of both the instruments viz. small saving instrument and government dated
securities is needed. Though, they are perfectly comparable in respect of counterparty risk,
they are not comparable in regard to liquidity and price risk. Government dated securities on
account of active secondary market are inherently more liquid vis-à-vis small saving
instruments and also carry more price risk unless held till maturity. The major criticism in
adopting yield on government securities as benchmark is that the secondary market yield
emanate from low levels of secondary market transactions reflecting low levels of liquidity
particularly at higher end. The positive aspect in this regard is that the yield is market
determined, though al beit a thin market. Since the small savings schemes are of various
maturities, the yields on similar type of maturities, in the government securities can be used;
for e.g. for fixing the interest rates on provident funds the yield on government securities of 15
year maturity can be used.

Bank Deposit Rates as Benchmark

The Gupta Committee analysing this benchmarking with market determined interest rates
suggested that interest rates offered by banks and financial institutions may be considered for
benchmarking the small savings schemes. Since the interest rates on deposits except in the case
of savings bank are deregulated bankers are given freedom to fix the interest rates on deposits.
As such, the interest rates on bank deposits can be viewed as market determined. However,
there is no conclusive evidence regarding the direction of causality among these rates i.e.
whether bank deposit rates determine the interest rates on postal deposits or vice versa.
However, since they are not traded in the sense of tradability of government securities some
felt that linking to government securities will not be advantageous.

Besides being a market determined interest rate, the market share of the instrument is also
important for ascertaining what could be the benchmark. For e.g. if the administered market
segment is relatively larger in volume with large number of savers than the non-administered
segment, then administered rates can act as benchmark for market interest rates. This is
because in order to survive, the non-administered segment has to offer interest rates higher
than the prevailing in the administered segment. Further, it needs to be seen whether a single
benchmark is sufficient to act as a reference rate for all the small saving schemes with different
maturities or there could be different reference rates for different maturities. In this context, it
was suggested that small saving schemes could be bifurcated into two broad categories: the
first category consisting of post office saving bank, post office term deposits/ recurring deposits
etc. and the second consisting of National Savings Scheme, National Savings Certificate, PPF etc.
For benchmarking the interest rates in first category, it was suggested that the rates on such
schemes could be aligned with movements in deposit rates in the banking system because
these schemes are akin to bank deposits.

Average Yield Curve as Benchmark

Since, the movements on yield curve are susceptible to various shocks, it is suggested that the
average of yield curves for a particular period can be considered for benchmark. For example,
in the United States, interest rates on small savings bond are based on 90.0 per cent of the six
month average of five year treasury securities. In some other cases, variable investment yield is
used to benchmark the small saving investment; the range varies between 85.0 per cent and
90.0 per cent. Considering all these factors for the purposes of benchmarking of small savings
(i) conversion of yield of government dated securities into par yield (b) a six month averaging of
par yield so derived and (ii) appropriate adjustment for price and liquidity risks on the part yield
derived as above may need to be undertaken.

One view is that the relevant interest rates on a zero coupon yield curve can be a benchmark
for these small saving schemes. For e.g. the interest rate on the zero coupon yield curve minus
transaction costs of the small savings could be the interest rate on the small savings scheme of
that maturity.

For the second category as long term savings do not generate current income but takes the role
of social security, it is suggested that the yield on government securities or bond rate can be
used as benchmark. However, there are difficulties in adopting this, as market instruments
carry market rates and long-term savings cannot be compared to market instruments per se.
Secondly, as long term saving schemes remain illiquid till maturity, they cannot be compared
with market securities, which are liquid in nature and generate current incomes.

Bank Rate as a Benchmark

A good benchmark rate is one which leads the other interest rates in the economy. If such a
rate is also a policy variable then the benchmark not only has credibility but also reflect the
policy changes. At present, a transmission mechanism of the monetary policy stance is through
the interest rates and in this context, RBI is developing the necessary instruments towards this
end. Bank Rate is activated, and reliance on indirect instruments rather than direct instruments
in the conduct of monetary policy has increased. The daily liquidity management by the RBI is
conducted through repos and OMOs and for the medium term Bank Rate is used to affect the
cost of funds in the system. The repo rates are market determined through auction system and
as such the quantity and rate reflect the liquidity conditions prevailing in the market. In the case
of Bank Rate as it affects the cost of funds, the general interest rates in the economy react to
changes in the Bank Rate. Further, Bank Rate gives a positive real interest rate because it is
slightly higher than the inflation rate. Changes in the Bank Rate are contemplated by RBI taking
into account the macroeconomic developments, developments in various financial markets and
inflation. As such, though it is policy variable in the hands of RBI, changes in the Bank Rate
reflect changes in the macroeconomic environment and in that sense it can also be treated as a
market related interest rate. Besides the above, Bank Rate changes effect the interest rates of
the banking system including deposit rates. However, some observers feel that as Bank Rate is
an administered rate of the monetary authority and not a market determined rate in the strict
sense it may not be proper to link up the interest rate on long term savings to Bank Rate.
However, the savings deposits with the post office will not be necessarily affected by the
changes in the Bank Rate at present causing distortion in the interest rate structure of similar
instruments.

The repo/reverse repo rate evolving through the Liquidity Adjustment Facility (LAF), which is an
effective mechanism for absorbing, and/or injecting liquidity on a day-to-day basis in a more
flexible manner will provide a corridor for the call money market. As the call money market in
future will be purely an inter-bank market a transmission mechanism of the monetary policy
through interest rates will be established at a future date. As such, it is suggested that the Bank
Rate be treated as benchmark for linking the interest rates on small savings schemes. The
margins over the Bank Rate will have to be fixed according to the maturity of the scheme. For
schemes with maturity of less than one year, the average Bank Rate in the previous year can be
the interest rate. For maturity of one to five years, Bank Rate plus one percentage point and for
all instruments of maturity more than five years it could be Bank Rate plus 3.0 percentage
point. This will ensure a real rate of return to the investors between 1.0 – 4.0 per cent, which is
in accordance with the real rates of interests in the international markets. These rates can be
reset every year.

Critical Evaluation of Different Benchmarks

It is argued that in the context of benchmarking, stability in the benchmark rates should be an
important issue. Stable rate would be that one which would fluctuate within a narrow range
and having a low coefficient of variation. The stability could be tested based on a long-term
time series, or through moving average. For testing interest rates for stability as defined above,
various interest rate series were tested and compared through descriptive statistics. Among the
market related rates, government securities of 10-year maturity appear to be more stable both
in terms of range and coefficient of variation. The result was robust if one uses three or six
months moving average for the monthly series. Compared to government securities of 10-year
maturity, other interest rates as well as different inflation rates appear to be volatile.
Incidentally, it may be noted that inflation measured in terms of both WPI and CPI moved in a
wider range. However, three month and six month moving averages marginally narrowed the
respective ranges. It may be interesting to note that between April 1998 and March 2001 the
market determined rates like bank deposit rate and lending rate are found to be stable whereas
in the case of G.10 the variability was larger. During this period, the variations in inflation rates
though reduced are still higher than some of the nominal interest rates. Thus, stability of the
rates varied over time (sample bias) and are changing over their respective order with respect
to variability. Although, stability of rates is an important factor for benchmarking, it may be
kept in mind that the ultimate variation in the small saving rate would depend upon the way it
is benchmarked to the market related rate. For e.g. if an instrument is given an interest rate of
5.0 percentage point over half the rate of inflation during the given period, this would induce
half the variation in inflation on the rate of saving instrument during the specific period.
Therefore, even though, some of the nominal rates appear more stable than inflation rates, by
devising appropriate rules, it is possible to have an inflation rate based benchmark that would
have the same variation as some of the nominal rates currently enjoy. Thus, as far as choice of
benchmark is concerned variation in rate is not important per se but would depend upon the
way it is smoothened.

For benchmarking however, framing up of any linear rule based on the market determined rate
would leave the correlation between that rate and the small saving rate uneffected. Further
analysis revealed that deposit rates, lending rates, average inflation rates (based on CPI) and
the yield rates on securities of 10-year maturity are well aligned. Although, no instrument
among the market determined rates emerged uniformly superior in terms of its strength of
relation with small saving rates, deposit rate, lending rate and yield on 10 year government
dated securities appeared to be better than others. It is interesting to note that after April 1998
the correlation of six months moving average of Bank Rate with most of the rates of small
saving appeared to be high giving possible direction that Bank Rate can also be viewed as a
benchmark for interest rate on small savings.

It was observed that if interest rates are benchmarked to inflation, in whatever manner
inflation is measured, there need not be any tax rebate or concessions on interest income as
the benchmark can be set appropriately. However, it may be noted that benchmarking need
not remove large distortions in the effective interest rates arising due to differential fiscal
concessions and therefore prescribing benchmark becomes difficult.

Options

A possible option before arriving at a benchmark for the small savings interest rate is the
removal of fiscal concessions to these schemes. This makes the small savings cost effective as
there is a level playing and then benchmark can automatically evolve. Perhaps, there could be a
marginal fall in the collections of small savings once the tax incentives are withdrawn but the
experience so far with Kisan Vikas Patra amply demonstrates that only higher nominal returns
matter but not the tax incentives attached.

As the monetary policy changes effect the savings and investment decisions in the economy, it
is necessary that the savings generated in the economy are captured in the monetary
aggregates which are closely monitored by the central bank for its policy formulation. At
present, the broad money supply aggregate (M3) does not take into account the post office
savings schemes and therefore, monetary policy actions do not directly reflect in these
instruments. It may be mentioned here that these instruments on the recommendation of Dr.
Y.V. Reddy Committee on “Money supply compilation” are being included in the liquidity
aggregates.

One can also think about giving the investor a choice between fixed rate and floating rate.
Choosing floating rates will enhance the ability of the investors in exploiting the financial
markets for returns on their savings. If this happens a financial structure will evolve wherein
investors trying to maximise their returns on their savings will have a host of instruments and
opt for such instruments to their advantage. In such a case, there is a likelihood that
government’s borrowing requirements may be through such funds rather than the present
small saving schemes. The liquidity funds which offer competitive rates for mobilising these
saving in turn will invest in the borrowings of the government through securities. In this
scenario the deposits with post offices will melt into bank deposits and other contractual
savings will then be social security funds. The long-term savings schemes like Provident Fund
etc. which will give a positive real rate of return can take care of social security needs of the
investors.

Summary and Conclusions

The Committee has to critically examine the various features of different saving instruments
and decide whether interest rates of these schemes should be market related or benchmarked
to a reference rate. Before attempting such a thing, it will be better if the schemes be
rationalised by removing the distortions in the features of the schemes. The first step towards
this end could be to differentiate between small saving schemes which essentially cater to park
savings for a short/medium term and schemes which are by nature akin to social security funds.
All the tax benefits to the former schemes may be withdrawn, whereas schemes in second
category may continue to have the tax benefits. After carefully examining different reference
rates in the light of their market relatedness, stability and other properties, all the schemes in
the second category may be linked to Bank Rate with a positive spread as Bank Rate is a policy
signalling variable and determines the general interest rates in the economy or to yield on
government securities. The benchmark can be reset at the beginning every financial year by
taking the average bank rate or average yield on government securities in the preceding year.
For small saving schemes, for less than one year, a suitable benchmark like an average repo
rate or bank deposit rate can be considered.