Money Market – Indian Economy Notes

The money market is a market for short-term funds that deal in monetary assets with maturities of up to one year. These assets are near-perfect substitutes for money. It is a market where low-risk, unsecured, short-term debt instruments with high liquidity are issued and actively traded on a daily basis. It has no physical location and is carried out over the phone and via the internet.

What is a Money Market?

• The money market refers to the short-term financial market. It meets the needs for funds for a period of up to 364 days (i.e., short-term).
• Money markets play an important role in providing a channel for equilibrating short-term demand for and supply of funds, thus facilitating the conduct of monetary policy.
• It enables the raising of short-term funds to meet temporary cash shortages and obligations, as well as the temporary deployment of excess funds to earn returns.
• The Reserve Bank of India (RBI), Commercial Banks, Non-Banking Finance Companies, State Governments, Large Corporate Houses, and Mutual Funds are the major participants in the market.
• The money market instruments commonly used are: call money, certificates of deposit, treasury bills, other short-term government securities transactions, bankers' acceptances/commercial bills, commercial paper, and inter-corporate funds.

Money Market Instruments

Treasury Bills

• A Treasury bill is essentially a short-term borrowing instrument issued by the Government of India that matures in less than a year.
• They are also known as Zero-Coupon Bonds, and they are issued on behalf of the Central Government by the Reserve Bank of India to meet its short-term funding needs.
• Treasury bills take the form of a promissory note. They are highly liquid, have a guaranteed yield, and have a low risk of default.
• They are issued at a lower price than their face value and repaid at the same price.
• The difference between the price at which treasury bills are issued and their redemption value is the interest receivable on them, and it is referred to as the discount.
• Treasury bills are available for a minimum purchase price of Rs. 25000 and in multiples thereof.

Example:

• Assume an investor pays Rs. 96,000 for a 91-day Treasury bill with a face value of Rs. 100,000.
• The investor receives Rs. 100,000 for holding the bill until it matures.
• The difference of Rs. 4,000 between the proceeds received at maturity and the amount paid to purchase the bill represents the interest he received.

Commercial Paper

• Commercial paper is a short-term unsecured promissory note with a fixed maturity period that is negotiable and transferable by endorsement and delivery.
• It is issued by large and creditworthy companies in order to raise short-term funds at lower interest rates than the market.
• It usually matures between 15 days and a year.
• Commercial paper is a viable alternative to bank borrowing for large corporations that are usually considered to be financially strong.
• It is purchased at a discount and redeemed at face value.
• Commercial paper was created to provide short-term funds for seasonal and working capital needs. Companies use this instrument for bridge financing.

Example:

• Assume a company requires long-term financing to purchase some machinery.
• To raise long-term funds in the capital market, the company must incur floatation costs (costs associated with floating an issue include brokerage, commission, the printing of applications, and advertising, among other things).
• Commercial paper proceeds are used to cover floatation costs. This is referred to as Bridge Financing.

Call Money

• Call money is a type of short-term finance that is repayable on demand and has a maturity period ranging from one day to fifteen days. It is used for inter-bank transactions.
• Commercial banks are required to keep a minimum cash balance, known as the cash reserve ratio.
• The Reserve Bank of India modifies the cash reserve ratio on a regular basis, which affects the number of funds available for lending by commercial banks.
• Call money is a method for banks to borrow from one another in order to maintain the cash reserve ratio.
• The call rate is the interest rate paid on call money loans. It is a highly volatile rate that fluctuates from day to day, and sometimes even hour to hour.
• Call rates have an inverse relationship with other short-term money market instruments such as certificates of deposit and commercial paper.
• When call money rates rise, other sources of finance, such as commercial paper and certificates of deposit, become less expensive in comparison, allowing banks to raise funds from these sources.

Certificate of Deposit

• Certificates of deposit (CD) are unsecured, negotiable, short-term instruments in bearer form that are issued by commercial banks and development financial institutions.
• They can be issued to individuals, corporations, and businesses during times of tight liquidity, when bank deposit growth is slow but credit demand is high.
• They aid in the mobilization of large sums of money for short periods of time.

Commercial Bill

• A commercial bill is a bill of exchange used to finance a company's working capital needs.
• It is a short-term, negotiable, self-liquidating instrument used to fund credit sales of firms.
• When goods are sold on credit, the buyer becomes obligated to make payment on a future date.
• The seller could either wait until the specified date or use a bill of exchange.
• The bill is drawn by the seller (drawer) of the goods and accepted by the buyer (drawee).
• When a bill is accepted, it becomes a marketable instrument known as a trade bill.
• If the seller requires funds before the bill matures, these bills can be discounted with a bank.
• A commercial bill is created when a trade bill is accepted by a commercial bank.

Money Market – Functions

• Through financial transactions, money markets maintain an equilibrium between the demand and supply of money and short-term funds.
• It promotes economic growth by ensuring the availability of funds to various sectors of the economy such as industry, agriculture, and service sector, among others.
• The money market provides sufficient finance to trade and industry, as well as a platform for discounting bills of exchange for them.
• The money market allows the Reserve Bank of India (RBI) to implement monetary policy.
• It assists the government in financing its deficits through non-inflationary means. Treasury bills are issued by the government to raise funds for short-term loans.
• It enables the allocation of short-term funds via money market instruments and interbank transactions.

Money Market – Importance

• The money market is more important in the financing industry, financing trade, bank self-sufficiency, and effective monetary policy implementation.
• The money market promotes economic growth and assists the government in allocating resources effectively.

Money Market – Limitations

Absence of Integration

• The Indian money market is divided into two sectors: organized and unorganized.
• The legal financial institutions backed by the RBI are part of the organized sector whereas various institutions such as indigenous bankers, village money lenders, and traders are included in the unorganized sector.
• There is a lack of integration between these two segments.

Variable interest rates

• Variable interest rates exist in the Indian money market, particularly among banks. These rates differ for lending, borrowing, and government activities.
• Investors are perplexed by the abundance of interest rates.

Inadequate Funds or Resources

• Due to the seasonal nature of the Indian economy, financial resources are frequently in short supply.
• People's lower income, lower savings, and lack of banking habits are some of the reasons for this.

Shortage of Investment Instruments

• Various investment instruments such as Treasury Bills, Commercial Bills, Certificates of Deposit, Commercial Papers, and so on are used in the Indian money market.
• However, given the size of the population and market, these instruments are insufficient.

Shortage of Commercial Bills

• It has been observed that in the Indian money market, where many banks keep large sums of money for liquidity purposes, the use of commercial bills is extremely limited.
• Similarly, because a large number of transactions are preferred in cash, the scope for commercial bills is limited.

Lack of a Systematized Banking System

Despite the fact that India has a vast network of commercial banks, the banking system suffers from major flaws such as NPAs, massive losses, and inefficient operations.

Fewer Dealers

• There are fewer short-term asset dealers who can act as intermediaries between the government and the banking system.
• The lower the number of dealers, the slower the contact between the end lender and end borrowers.

Conclusion

• The money market provides the government with non-inflationary sources of funding.
• Short-term loans can be raised by issuing treasury bills. However, this does not result in price increases.
• The term "money market" refers to all organizations and institutions that deal with or facilitate dealings in short-term debt instruments.
• These institutions include the Reserve Bank of India, commercial banks, cooperative banks, non-banking financial companies such as LIC, GIG, and UTI, as well as special institutions such as the Discount and Finance House of India (DFHI).