Money and Capital Market - Literature review Example

Money and Capital Market Name Institution of Affiliation Letter of Transmittal Name Student of ....... ........ ........ September 20, 2012 Professor ......... ......... ......... ......... Dear Professor ...... I submit herewith the paper entitled "Money and Capital Market" as part of my study program at ......... The paper is divided among two parts as instructed, with two countries under focus - India and Australia - written from the money market perspective. Sincerely, Name ……. Table of Contents Letter of Transmittal 2 Executive Summary 4 Money is the financial market’s important component and has attained altogether new connotations as it is now being considered as a commodity. Money market is a very interesting market to delve into. Different countries have different structures governing the money market, but the essence of all revolves around the instruments that the market is composed of – bills of credit, short-term mortgages, repurchase agreements, and many more. Borrower, lender and interest rates, however, are at the center stage of this market. This paper looks into what this market is and how do interest rates influence the market. In context are discussed two countries – India and Australia. 4 Introduction 5 Historical Background 6 Historical money market interest rates and other basic market information 6 India 6 Australia 8 Interest Rate Trends 9 India 9 Australia 11 References 12 Executive Summary Money is the financial market’s important component and has attained altogether new connotations as it is now being considered as a commodity. Money market is a very interesting market to delve into. Different countries have different structures governing the money market, but the essence of all revolves around the instruments that the market is composed of – bills of credit, short-term mortgages, repurchase agreements, and many more. Borrower, lender and interest rates, however, are at the center stage of this market. This paper looks into what this market is and how do interest rates influence the market. In context are discussed two countries – India and Australia. Introduction Money is a commodity and financial market's important component with regard to assets involved in buying, lending, selling and short-term borrowing for a year or less with original maturities. Money market trading done is wholesale and over the counter and several instruments that exist includes commercial paper, treasury bills, deposits, bills of exchange, banker’s acceptances, short-term mortgages, repurchase agreements, asset-backed securities, and federal funds (Fabozzi, et al, 2002). All instruments bear maturities, credit risks, and maturities and structure that differ from each other. For global financial system, money market is the source of liquidity funding. Central banks consider money market a fulcrum that enables them to conduct monetary operations. In all the money market is responsible for the smooth conduct of three functions. One, for short-term fund demand and supply, it provides a mechanism which is equilibrating. Two, investment and borrowing requirements of lenders and borrowers are fulfilled by it particularly in case of short-term funds. And three, for central bank it acts as an interventional avenue for influencing financial system's cost and quantum of liquidity (Sinha, n.d.) Initially the birth of money market took place because of surplus funds which the parties had, while cash was needed by others. As on date, it also incorporates cash instruments. Dealers in credit or money and financial institutions are what money market consists of. The dealers either lend or borrow for short-term; not for more than 13 months. But the core strength of money market lies in interbanking lending; a process in which bank either lend or borrow from each other through instruments like repurchase agreement, commercial paper and other related instruments. The primary functions of the money market include money transfers of large sums, money transfer to a deficient party from the one with surplus funds, implementation of monetary policy and more importantly determine interest rates on the short-term basis. Historical Background Historical money market interest rates and other basic market information India The Indian money market comprises of both organised and unorganised sector, which include indigenous bankers, chit funds, and moneylenders to cite the former. The later comprises of Reserve Bank of India, development banks, public sector banks, private banks and financial institutions like Unit Trust of India (UTI), Life Insurance Corporation (LIC) of India, IDBI, International Financial Corporation and co-operatives. It is a market for both long and short-term where financial instrument mature both in an overnight manner and after a year too. The market is diverse and there are sub-markets within the main money market. A particular type of credit is dealt with by a specific sub-market. Again, the money market in India provides an equilibrium mechanism for supply and demand of short-term funds and an opportunity for both borrowers and lenders in the market. Reserve Bank of India has an authority over the organised money market, in which banks listed above are involved. RBI is the biggest money market regulator in the country. Financial market always goes into a flutter whenever RBI releases data and interest rates from time to time. RBI does not have any control over the unorganised money market and this sector has not even been integrated with the market in a systematic manner. The RBI initiated a number of reforms in the money market since 1991, pursuant to the recommendations of the Narasimham Committee Report on the Working of the Financial System in India and Sukhmoy Chakravarty Committee on the Review of the Working of the Monetary system. The idea was to streamline the money market to an extent by meeting then objectives efficiently. Based on the recommendations the ceiling rate on short-notice and interbank call money and bank advances was reduced. Subsequently, the minimum lending rate of public sector development financial institutions and commercial banks saw a reduction of 7.5 percent until 2005-2006 from what it was in 1990-1991 (Datt and Sundharam, 2010). The ultimate aim of India's monetary policy has been price stability and growth and this policy has not changed much over the years. But RBI has been modifying its intermediate and operational objectives every now and then so as to meet the expectations of a changing financial and economic environment. The post-1990 initiatives have acted as a boon to the financial markets in the country, the greatest feature of which has been interest rate deregulation. This has enabled the nation to have an innovative look at the monetary market and introduce instruments that are driven by market-based monetary policy. With these innovations, according to Mohan (2006), there was less stability in the money demand and short-term interest rate disequilibrium. Critics argue that money market in India has come of age through the last 20 years (Kumar, 2008). The Indian money market is real interest rate-dependent, which means it relies on inflation adjusted interest rate. The market in India is free from interest rate ceilings but certain institutional factors and structural barriers trigger market distortions in the country's money market. Other interest rates, apart from call market rates, do not change in India in the short run. And since there is a disparity prevalent in the Indian money market, it is difficult to trace a definite income path. Besides this the market is linked by way of covered interest arbitrage to the Foreign Exchange Market wherein the forward premium serves the purpose of a bridge between foreign and domestic interest rates. Covered interest rate parity was studied by Varma (1997) and demonstrated a structural break in this market in 1995 September; a point from which he argued CIP became effective. The structural break, he opined, owed its origin to the foreign exchange-Indian money market interplay. Pot-1995 CIP underwent a number of deviations as analysed by Varma by carefully studying certificate of deposit, treasury bill, commercial paper and call money rate. Varma used a mix of constructed and actual rates corresponding to different maturities. Australia Money market in Australia is a liquid and deep market where borrowers or lenders can deal in large sums of money through short-term loans, discount securities and bank bills. There is an efficient and cost-effective mechanism in place for this. In Australia it is the expectations of the cash rate that determine interest rates in money markets (RBA, 2007). The Reserve Bank of Australia has efficiently responded to the Australian money market pressures. It has done so through domestic dealing operations by modifying the same. Debelle (2008b) has argued that RBA has been able to accomplish this because of the flexible framework that Australian open market operation are known for. The daily open market flexibility helps RBA offset flows between the government and the private banking sector. In Australia, there is an official and an unofficial money market. Furthermore, the country deals in two types of funds i.e., same-day funds and next-day funds. The former are also known as exchange settlement funds. In Australia’s official money market the participants include the dealers, trading banks, and the RBA. Dealer are vested with an important role to play in official money market' daily functioning, particularly in case of same-day funds. Trading banks, on the other hand, are authorised to and meant for clearing check. Behaviour of banks is determined by a number of factors which include access to rediscounting, reserve requirements, and availability of same-day fund which are lent to dealers. The real demand for money is determined on the basis of an assumption that it has a negative relation with the nominal interest rate and a positive relation with the income. Individuals have a tendency to spend more during high output phases. Increased transaction requirements imply greater need for keeping real money balances (McCallum, 1993). Interest Rate Trends India India has multiplicity of interest rates, which means interest rates in the country follow multilevel approach. The interest rates differ from period to period and from bank to bank. Not only that, they also different from one borrower to another. The pattern is similar in both unorganised and organised banking sector. This way in Indian money market many interest rates prevail. Part of it is attributed to the absence of an organised bill market in India. This is despite two attempts by RBI – one in 1952 (Bill Market Scheme) and 1970 (New Bill Market Scheme) – but still the trend could not be organised in the Indian bill market. One specific reason attributed for this is that there is a seasonality attached to the Indian money market; a fact driven mostly by agricultural operations as the Indian economy is predominantly agricultural in nature. The typical agricultural season starts from October and ends in March, a period during which the demand for money market is more than rest of the seasons. This is further complicated by the absence of integration between several segments into which money market is divided. These segments are either not tightly connected to each other or lack synergy between them (Akrani, 2010). This leads to lack of reliability and strength in the money market. There are a number of irregularities lurking between bank lending rates and money market rates, and also money market rates and central bank policy rates (Prachi, et al, 2012). Recently, Cash Reserve Ratio was cut by 0.25 percent by RBI, a move that invited mixed response in the country which has been demanding interest rate reduction so that it could trigger growth. RBI's move aimed at unlocking rupees 17,000 crore (rupee being the Indian currency where I USD equals 54.2948 rupees) into the system. The interest rates prevailing during the current year have created a challenging condition in the country with regard to the cost and availability of credit, more importantly for the SMEs. In terms of short-term borrowing and lending, RBI has been maintaining a stiff and unchanged posture which, during current inflation, makes both difficult (Business Standard, 2012). The current repo rate at which banks borrow money from the central bank stands unchanged at 8 percent. The reverse repo rate is 7 percent. The State Bank of India, the largest nationalised bank in India has offered a cut in its minimum lending interest rate. The cut has been of 25 basis points, which translates into 9.75 percent interest rate to be applicable from September 20, 2012 (Reuters, 2012) . Australia For around 22 years i.e., 1990-2012, the interest rate in Australia averaged 5.58 percent. In January 1990 it reached 17.50 - an all time high till date, and in April 2009 it reached an all time low of 3.00 percent. Interest rate decisions in Australia are taken by Reserve Bank of Australia's Board. Cash rate in Australia is the official interest rate. This is the rate charged between financial intermediaries on overnight loans, is demand and supply-driven and determined by the money market. On September 14 this year, interest rates were held unchanged at 3.50 percent by Australia's central bank. This, despite a global outlook that is weakening, is considered to be a good domestic indicator. According to Australia's Monetary Policy Decision Governor, Glenn Stevens, there is a downside risk associated with the outlook because more than average growth is expected in global GDP. The growth in Australia has been, according to Stevens, going by the trend, complemented by resource sector's large capital spending. Not only that the job market seems fine, there has been moderate growth in labour market, and unemployment fairly low (Tradingeconomics.com, 2012). Analysts say that Australia is in a position to cut interest rates further and even afford a delay till later this year on a return to a budget surplus. This is in case there is deterioration in the global outlook. International Monetary Fund (IMF) echoes the same statement. IMF has opined that Australian dollar is running strong and inflation is with accommodative range, which is why the scope for a further cut (Health, 2012). The IMF report predicts a 3.25 percent growth in Australian economy this year, which is somewhere near the forecast done a year ago; an aspect of Australian economy that gets RBA a pat on its back by IMF for its capacity and credibility. References Akrani, G., (2010). Indian Money Market - Features, Drawbacks and Recent Reforms. http://kalyan-city.blogspot.in/2010/09/indian-money-market-features-drawbacks.html. Retrieved September 19, 2012. Business-Standard.com. (2012). India Inc disappointed with RBI not cutting key interest rates: RBI left rates unchanged, cut CRR by 0.25% in its monetary policy review today. http://www.business-standard.com/india/news/india-inc-disappointedrbi-not-cutting-key-interest-rates/187148/on. Retrieved September 19, 2012. Datt, R., & Sundharam, K.P.M., (2010). "49". Indian Economy (Sixty one ed.). S. Chand & Co. Ltd.. p. 865. Debelle G (2008b), ‘Market Operations in the Past Year’, speech to 2008 FTA Congress, Melbourne, 31 October. Frank J. Fabozzi, F.J., Mann, S.V., Choudhry, M.,(2002). The Global Money Markets, Wiley Finance, Wiley & Sons. Health, M., (2012). Australia Has Scope to Cut Rates, Delay Surplus Return, IMF Says. http://www.businessweek.com/news/2012-09-20/australia-has-scope-to-cut-rates-delay-surplus-return-imf-says Retrieved September 20, 2012. In.Reuters.com., (2012). Indian stocks to watch-Sept 20. http://in.reuters.com/article/2012/09/20/markets-india-stocks-pre-open-idINL4E8KK1VG20120920. Retrieved September 19, 2012. Kumar, M.S., (2008). The Indian Money Market. http://www.primeacademy.com/thu_14_2_08.pdf. Retrieved September 19, 2012. McCallum, Bennett T., and James G. Hoehn. (1983). “Instrument Choice for Money Stock Control with Contemporaneous and Lagged Reserve Accounting.” Journal of Money, Credit, and Banking 15: 96-101. Mohan, (2006). In Money Market http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/77574.pdf. Retrieved September 19, 2012. Prachi, M., Montiel, P., and Spilimbergo, A., (2012), “Monetary Transmission in Low-Income Countries: Effectiveness and Policy Implications”, IMF Working Paper No. 10/223, IMF Economic Review, 60(2). Reserve Bank of Australia (2007), ‘Box C: Reserve Bank Open Market Operations’, Statement on Monetary Policy, November, pp 59–61. Sinha, A., (n.d.). What are the functions and importance of Money Market? http://www.preservearticles.com/201012281812/functions-and-importance-of-money-market.html. Retrieved September 19, 2012. Tradingeconomics.com, (2012). Australia Interest Rate. http://www.tradingeconomics.com/australia/interest-rate. Retrieved September 19, 2012. Varma, J.R., (1997), Indian money market: market structure, covered parity and term structure. The ICFAI Journal of Applied Finance, 3(2),1-10. Read More