Monetary transmission strengthened during Q4 of 2010-11 with interest rates firming up gradually across the spectrum as liquidity remained in deficit mode. The policy transmission to deposit and lending rates is visible in the current base rate regime. Asset prices, including property prices, generally remained range bound. Equity markets experienced orderly correction in Q4 of 2010-11. The rupee exhibited two-way movements against the US dollar without any intervention or active capital account management. Going forward, the financial markets need to brace up to the geopolitical risks in MENA, default risks in the Euro zone and movements in cross-border capital flows.

Global portfolio rebalancing to impact domestic financial markets

V.1 The year 2010-11 was marked by periods of volatility and tranquility in the Indian financial markets. With global uncertainties rising, volatility may aggravate further, partly from building up of speculative positions in global commodity markets. Portfolio choices are also governed by the geopolitical developments in the MENA region and availability of easy liquidity in certain advanced economies. An additional source of uncertainty for the global financial markets is the sovereign and banking sector default risks in parts of Europe (Chart V.1a) There could, however, be a rebalancing of investors’ portfolio if economic recovery in major advanced economies gains traction and causes a quicker-than-anticipated withdrawal of monetary accommodation. With rise in global equity markets (Chart V.1b) there may be a shift in investors’ preference away from the EME markets to those of the advanced economies, particularly the US.

V.2 While credit spreads shrank markedly during Q4 of 2010-11, bond yields in advanced economies firmed up reflecting the post-crisis rise in debt to GDP ratio as well as incipient signs of inflationary concerns. Apart from food prices, the rising expectations of increased crude oil prices following the geo-political risks in MENA raised inflationary expectations especially in EMEs. The initial reaction to the downside risks associated with the natural calamity hit Japanese economy has subsequently given rise to the expectations of boost in demand for its reconstruction.

Global uncertainties and anti-inflationary monetary policy stance impacting Indian markets, but orderly conditions prevail

V.3 Global uncertainties as well as domestic developments impacted Indian financial markets. The Indian markets, however, remained largely orderly, despite the challenges posed by persistent inflation and high current account deficit.

V.4 Call rate firmed up in step with the policy rates and remained above the upper bound of the LAF corridor for a major part of Q4 of 2010- 11, due to frictions caused by skewed SLR holdings (Chart V.2a). While issuances and rates on certificates of deposits (CDs) continued to increase during the quarter reflecting banks’ efforts to mobilise more funds, issuance of commercial paper (CP) moderated on account of the strong credit growth, even as the rates continued to be high reflecting general liquidity stress (Chart V.2b). The yield curve for government securities (G-sec) further flattened during Q4 in response to policy rate hike expectations and liquidity tightness.

V.5 The Indian rupee appreciated moderately against the US dollar. Stock markets remained volatile for the greater part of Q4, weighed by domestic and global concerns, but appreciated towards the close of the quarter on the back of strong foreign portfolio inflows. Returns in the Indian equity markets were relatively lower than most other EMEs (Table V.1). Prices in the housing market continued the rising trend during the third quarter of 2010-11.

Money market rates reflect liquidity conditions

V.6 The money market was generally orderly although liquidity conditions remained in deficit mode during the fourth quarter of 2010-11. Reflecting the high credit demand, high currency growth, and unspent surplus balance in the government account as also the hikes in policy rates by the Reserve Bank, the call rates mostly remained above the repo rate during Q4 (Chart V.2a, Table V.2). The rates in the collateralised segments also rose in line with the trend in the call money market.

V.7 Transaction volumes in the collateralised borrowing and lending obligation (CBLO) and market repo segments were higher during Q4 than Q3 of 2010-11 (Table V.3). The collateralised segment of the money market remained predominant, accounting for more than 80 per cent of the total volume of transactions during 2010-11.

V.8 With strong credit growth not matched by commensurate deposit growth, banks increasingly financed their advances by raising CDs at higher rates. During surplus liquidity situations, when the CP rates are lower than the Base Rates, corporates take greater recourse to the CPs. They, however, prefer bank financing, once the CP rates rise above the Base Rate. Leasing-finance and manufacturing companies continue to be the major issuers of CPs (Table V.4).

V.9 The primary yields on Treasury Bills (TBs) firmed up during Q4 of 2010-11 in line with the spike in short-term interest rates (Table V.5).

V.10 Annualised volatility of one year interest rate swaps increased during Q4 of 2010-11 (Chart V.3). This may reflect market uncertainties on future short-term money market rates.

The yield curve responds to monetary actions and lower budgeted borrowings

V.11 Responding to the persistently high inflation and tightening liquidity conditions, G-sec yields, both in the primary and secondary markets, firmed up during January 2011, but moderated thereafter. A lower-than-expected fiscal deficit and market borrowing programme for the first half of 2011-12 improved market sentiments. Yields eased in March 2011 in response to announcement of auctioning of unutilised investment limits for FIIs for GSec and corporate debt. The flattening of yield curve despite inflationary pressures may have been aided by policy rate hikes and temporarily lower issuances (Chart V.4a).

V.12 In the primary market, investors’ sentiment remained positive, as reflected in the sustained bid-cover ratio, which stood in the range of 1.39-3.87 during the year and 1.69-3.25 during the fourth quarter. More long dated securities were issued to take advantage of the yield curve movements (Table V.6). The spreads on five-year corporate bonds over the corresponding government bond yield widened during the fourth quarter of 2010-11 on the back of tight liquidity conditions (Chart V.4b).

V.13 Interest Rate Futures (IRF) on 91-day TBs were permitted by the Reserve Bank in March 2011. These futures will be cash settled with the final settlement price based on the weighted average price/yield obtained in the weekly auctions on the date of expiry of the contract. This is likely to enhance liquidity and also to provide more options for the financial markets to hedge interest rate risks through exchanges.

Deposit and lending rates transmit the anti-inflationary policy stance

V.14 Stronger transmission is evident as banks continued to increase both the lending rates and deposit rates across maturity spectrums. Deposit rates have risen rapidly to accommodate fast rise in credit and to offset the tight liquidity environment during 2010-11. Scheduled commercial banks (SCBs) raised their deposit rates in the range of 25-500 basis points between end-March 2010 and end-March 2011 across maturities. The deposit rates for 1-3 years maturity increased by 50-125 basis points during the fourth quarter (Table V.7). Several banks reviewed and increased their base rates by 75-125 basis points between July 2010 and March 2011. Base rates of 64 major banks with a credit share of around 98 per cent ruled in the range of 8.0-9.5 per cent in March 2011, reflecting greater convergence since base rates became operational effective July 1, 2010.

Exchange rate remains orderly and flexible

V.15 The rupee remained stable during the fourth quarter of 2010-11, without any intervention or active capital account management. It exhibited two-way movement against major international currencies except Euro. There was a modest appreciation against the US dollar since mid-February 2011 (Chart V.5a). While the turnover in inter-bank segment of the foreign exchange market remained volatile, the turnover in the merchant segment increased in Q4 of 2010-11.

V.16 Volumes in the exchange traded currency derivatives increased during Q4 of 2010-11 (Chart V.5b). The growth in volumes particularly for currency futures and options has been supported by retail participation and companies. In fact, the monthly trend of turnover in OTC forwards and swap involving rupee remained sluggish during this period. While turnover in the merchant segment decreased from USD 93 billion in October 2010 to USD 64 billion in March 2011 (up to March 25), the turnover in the interbank segment declined from USD 418 billion to USD 367 billion for the corresponding period.

Equity markets underperform, remain volatile

V.17 Reflecting several macroeconomic uncertainties, Indian equity markets underachieved and remained volatile during Q4 of 2010-11. Markets lost much of the valuation gains made during the last four months of 2010, when they outperformed most of the international markets. During Q4 of 2010-11, the BSE Sensex has been the worst performer amongst the major equity indices. Slowdown of net equity investment by the FIIs in India largely contributed to the decline (Chart V.6a). In terms of the coefficient of variation, the volatility of Sensex between end-December 2010 and end-March 2011 at 3.95 per cent is much higher than the 2.0 per cent of the MSCI emerging market index and 1.9 per cent of the MSCI world index. The equity derivatives segment had gone up substantially over the year and currently constitutes almost 90 per cent of the overall investments. FII investments accounted for 19.8 per cent of the total investments in derivatives (Chart V.6b)

V.18 The activity in the primary segment of the domestic capital market remained buoyant during the first three quarters of 2010-11, but moderated during Q4. However, resources raised through public issuances were higher during 2010-11 than the previous year (Table V.9). During the year, resource mobilisation by mutual funds turned negative, owing to high volatility in the market, surfacing of risks in the real sector, lower retail investments possibly on account of higher returns on competing instruments (bank deposits in particular) and also due to lower corporate support to the MFs.

Asset price concerns remain as housing prices remain firm

V.19 Property prices continued to rise in most cities during Q3 of 2010-11, as reflected in the Reserve Bank’s Quarterly House Price Index (HPI) based on data in respect of seven cities collected from the Department of Registration and Stamps (DRS) of the respective State Governments. However, the indices for Delhi and Chennai witnessed a decline during this period (Chart V.7).

Macro-factors may determine financial market movements ahead

V.20 Going forward, macroeconomic factors may dominate financial markets movements in 2011-12. Macro-risks are large and uncertainty abounds on how they might play out. Global commodity markets are witnessing firming up of prices. Even though several hedge funds have booked profits in the global commodity markets in mid-March 2011 following the Japan earthquake, a fresh wave of speculation has arisen immediately after profit-booking as a result of MENA region event risk.

V.21 Domestic debt markets are likely to be conditioned by evolving fiscal and monetary policy considerations as well as possible hardening of global yields. However, the path of fiscal consolidation embarked upon by the Government could help to ease the pressure on long-term bond yields in the G-Sec market, if inflationary expectations are reined in. Sustained growth momentum could, however, continue to exert pressure on interest rates through high demand for credit. The risk of volatile portfolio flows impacting asset prices and exchange rate remains in the face of growing uncertainties in the global markets. The expected change in operating procedures could help improve the transmission of monetary policy on an enduring basis, enabling interest rate channel to work better.