C O N T E N T S C O N T E N T S Managing Director's Message Money Market Milestones Foreign Exchange Market Derivatives Interest Rate Movement 98 Speeches Government Securities Market Primary Market Analysis Key Macroeconomic Indicators Outstanding Government Debt Domestic CCIL Indices World Technical Analysis Statistics Briefing Article Summary 18 26 29 51 53 54 64 34 Market Roundup 69 71 78 76 10 Policymaking from a “macroprudential” perspective in emerging market economies Interpreting Currency Movements during the Crisis Managing Public Debt and Its Financial Stability Implications What's New Reports More on CDS Article 3 5 Key Personnel Corporate Bonds World Economic Outlook - Update 107 115 119 128 131 124
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C O N T E N T SC O N T E N T S
Managing Director's Message
Money Market
Milestones
Foreign Exchange Market
Derivatives
Interest Rate Movement
98
Speeches
Government Securities Market
Primary Market Analysis
Key Macroeconomic Indicators
Outstanding Government Debt
Domestic
CCIL Indices
World
Technical Analysis
Statistics
Briefing
Article Summary
18
26
29
51
53
54
64
34Market Roundup
69
71
78
76
10
Policymaking from a “macroprudential” perspective in emerging
market economiesInterpreting Currency Movements during the Crisis
Managing Public Debt and Its Financial Stability Implications
What's New
Reports
More on CDS
Article
3
5
Key Personnel
Corporate Bonds
World Economic Outlook - Update
107
115
119
128
131
124
The tight liquidity condition of the previous
month continued in Jan'11, albeit at a little
milder scale, with RBI supporting the market
with LAF repo inflows. The average infusion in
LAF Repo window during the month was
93,071.75crores vis-à-vis 1,21,935crore in
Dec'10. Inflation clearly continues to be the
dominant concern for all policy makers. After
some moderation between August and
November 2010, inflation rose again in
December 2010 on the back of sharp increase in
the prices of primary food articles and the
recent spurt in global oil prices. Non-food
manufacturing inflation has remained sticky,
reflecting both buoyant demand conditions
and rising costs. Real GDP in India increased
by 8.9 per cent during the first half of 2010-11,
reflecting strong domestic demand, especially
private consumption and investment, and
improving external demand. Although on a
cumulative basis, the IIP grew by 9.5 per cent
during April-November 2010, it has been
volatile in the current financial year with
growth rates ranging between 2.7 per cent and
16.6 per cent. The average daily call rate
moderated from 6.7 per cent during December
2010 to about 6.5 per cent in January 2011. At
the longer end, 10-year government security
yield, which had generally remained above 8
per cent during most of October-November
2010 on account of inflationary pressures and
persistent liquidity tightness, also softened in
the second half of December 2010. However,
the yield on 10-year G-sec moved up again to
8.2 per cent by January 21, 2011, reflecting
both liquidity conditions and inflationary
expectations. India's Current Account deficit
(CAD) has widened significantly. Although
recent trade data suggest moderation of the
trade deficit in the latter part of the year,
overall CAD for 2010-11 is expected to be about
3.5 per cent of GDP. A CAD of this magnitude is
not desirable. On the basis of the macro-
economic issues persisting in the economy, the
RBI increased the repo rate under the liquidity
adjustment facility (LAF) by 25 basis points
from 6.25 per cent to 6.5 per cent with and the
reverse repo rate by 25 basis points from 5.25
per cent to 5.50 per cent with immediate effect.
As a fallout of liquidity situation, CCIL activity
was mixed - in Jan'11, daily outright volumes
declined marginally to 7497crores from
7541crores, daily market repo volumes
showed a decline at 11541crores from
12993crores, daily Forex volume increased to
US$17.41billion from US$15.59billion and daily
CBLO volume showed a marginal increase to
44815crores from 43784crores. The situation
is expected to improve with the RBI monetary
policy measures.
` `
`
`
`
`
` `
(Y. S. S. Kapdi)
MANAGING DIRECTOR'S MESSAGE
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2.1 CDS spread models: some finer points
2.1.1 Term Structure of CDS spreads
2.1.1.1 Relationship between conditional
and unconditional default probabilities.
as estimated at inception.
unconditional
conditional upon no default in the first two
2.1.1.2 Calculating CDS spreads from
default probabilities.
2.1.1.3 Term Structure
In the article published in the January 2011 issue of
Rakshitra, I had referred to the relationship
between
i. Unconditional and conditional default
probabilities; and
ii. Conditional default probabilities and
CDS spreads for different maturities.
These relationships are derived once again from the
principles arbitrage free pricing, described in the
earlier article, and are elaborated below.
We earlier defined unconditional default
probability as the probability of default before the
end of n year, Let x =
unconditional probability of default before the end
of the i year, i=1,2,3……n.
With this notation, it is easy to see that the
probability of default in the 3
year is x -x . However, the conditional probability
of default in the third year brings in another factor:
namely, there should be no default in the first two
years. This probability is, by definition, (1 -x ).
Therefore the probability of default in the 3 year,
(or
) is
= (x -x ) * (1 -x )
More generally =(x ) *(1 x )
(i.e. unconditional probability of default
multiplied by the probability of no default in
earlier years).
Default probabilities can be combined with
recovery rates (say R) to calculate CDS spreads,
once again applying the principle of arbitrage-free
pricing. Let us assume the spread to be say “s”% p.a.
For the seller of the protection the inflow in any
year is (s * probability of survival of bond without
the occurrence of a Credit Event, before the end of
that year) -- for simplicity's sake, we assume that the
Event occurs only at the end of a year.
For year i (i= I to n), this will be s * (1 )
We also need to calculate, for each year, the likely
outflows assuming a recovery rate of R. For year i,
this will be
R *(1 )
It can be readily seen that given default
probabilities and recovery rates, we can now
calculate “s”, the CDS spread, by equating the
present values of the likely inflows and outflows.
The relationship between probabilities of default
and spreads also leads to the concept of the term
th
th
rd
rd
i
3 2
2
2,3
2,3 3 2 2
(i -1),i i x (i-1) (i-1)
(i-1), i
(i 1),i
y
y
y
y
y
A. V. Rajwade*
* is a Forex and Management ConsultantShri. A. V. Rajwade
MORE ON CDS
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structure of CDS spreads and hence their implied
forward prices.
“Basis” is the term commonly used to refer to the
difference between the model derived and actual
spreads. In active markets, this difference arises
because of demand supply imbalances as also more
fundamental factors. Some of the latter are
discussed below:
i. The funding cost of the holder of the risky
bond who is buying credit protection-and
how much it differs from the risk free rate.
To that extent, the buyer is likely to pay less
than the credit premium embedded in bond
pricing.
ii. While, in theory, the holder of the bond
would be entitled to the accrued interest at
the time of the occurrence of the Credit
Event, in practice the protection buyer may
not get it (or, more precisely, the recovery
percentage on the accrued interest), even
while it will be factored in the cash
settlement.
iii. If the underlying risk is on a portfolio of
bonds (see paragraph 2.3 ii below), the bond
to be delivered on occurrence of the Credit
Event may well be the cheapest-to-deliver
(CTD) out of the portfolio.
iv. Perhaps the most important reason is that
the credit premium in the bond market has
generally been more than the actual
experience of default probabilities and
recovery percentages. To be sure, in
speculative markets sometimes the basis
(CDS spread-credit premium in the bond
market) is positive as well.
Another point worth noting is that standard
pricing models use the swap rate as a proxy for risk
free rate.
While the traditional practice was that the credit
protection buyer pays the spread quarterly in
arrears, increasingly a practice is coming into vogue
that a portion of the spread is paid upfront and
only the balance quarterly in arrears. This too is a
contributing factor to the existence of “basis” as,
should a Credit Event occur, given the spread paid
upfront, only the balance which is yet to accrue will
not be payable by the protection buyer. The actual
spread the buyer would be willing to pay therefore
may be less than the model price.
Whatever the practices in western markets, we
obviously need to adapt them for our conditions,
in particular in two respects:
i. Our swap rate has been generally below the
G-Sec yields and we should not therefore
use the swap as a proxy for the risk free rate
to calculate spreads.
ii. It should also be noted that CDS spreads in
western markets are generally derived from
credit spreads on LIBOR-linked floating
rate bonds. (This is the reason why the
Reference Price is generally 100%: floating
rate bonds have practically no price risk
arising from interest rate fluctuations). We
do not have a LIBOR-linked floating rate
benchmark, nor many floating rate
corporate bonds. CDS spreads would
therefore need to be modeled from prices
of fixed rate bonds and hence the need to
use the full market price (marked-to-
2.1.2 “Basis”
2.1.3 Risk Free Rate
2.1.4 Spread Payments
2.1.5 Some issues for conditions in India
market for changes in risk free rate), as the
Reference Price as I have argued in the
earlier article. In fact, the model discussed
in that article is based on an “asset swap” -
swap between the cash flow of a risky bond
and a credit risk free, fixed interest rate
bond.
Many variations of the basic product have been
introduced in the market. Some of them are
described in the subsequent paragraphs. We also
discuss the features of another credit derivative
namely a total return swap (TRS), sometimes also
referred to as the total rate of return swap (TROR)
swap.
DCS differs from the plain vanilla CDS in that it
protects the counterparty credit risk exposure
inherent in other OTC derivatives like currency,
interest rate or commodity swaps, or bought
options, hereafter referred as the underlying
derivative:
Such exposure arises from failure of the
counterparty and has two elements:
• MTM value of the underlying derivative
(which keeps changing with time), if positive
to the DCS protection buyer; and
This first exposure could be hedged at a fixed
(known) credit spread by buying a DCS. How
would the writer or seller of the DCS price and
hedge the swap?
I n p r i n c i p l e , t h e s e l l e r f a c e s t w o
risks/uncertainties:
The basic principles of pricing/hedging the first of
these risks have been discussed earlier. As for the
second, it could be hedged by entering into a
derivative contract with payoffs identical to the
underlying derivative whose credit exposure is
being hedged through the DCS - and the cost
structured in the credit spread on the DCS.
The Contingent Payment would be the MTM value
of the underlying derivative when the Credit Event
occurs - although the underlying derivative
transaction may not have matured. (The standard
ISDA Master Agreements covering interest
rate/currency derivatives give the non-defaulting
party the right to terminate the contract on
occurrence of specified events. The protection
buyer under a DCS would obviously need to make
sure that these events are identical to the Credit
Event which would trigger the Contingent
Payment under the DCS.)
Why would the protection buyer prefer to buy a
DCS rather than terminating the contract? There
may be several reasons:
2.1.6 Variations
2.2 Dynamic credit swap (DCS) (also known
as “credit intermediation swap”)
• The potential exposure in replacement costs.
The second may be insignificant if the
underlying derivative has a liquid market, but
it can be material for complex structures in ill-
liquid markets.
• The occurrence of a Credit Event, namely
failure of the counterparty; and
• The MTM value of the derivative when the
failure occurs.
• The relationship with the counterparty to the
underlying derivative could be harmed by a
cancellation, which the protection buyer may
like to avoid.
• A Credit Event allowing termination may not
have occurred, but is apprehended.
• There may be a minimum MTM when alone
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termination is permitted by the Agreement.
• There may be time intervals specified for
payment of MTM margins.
• The cost of buying protection may be lower
than the credit spread factored in pricing the
underlying derivative.
• A cap on the Contingent Payment;
• Contingent Payment to be MTM, less a fixed
amount (which the protection buyer may well
have recovered as margin when the underlying
derivative contract was entered into);
• MTM changes between margin recovery dates;
etc.
In fact, in order to meet the requirement of
different DCS buyers, contracts can provide for
different payoffs:
All these variations will have lower costs than a
plain vanilla DCS.
The problems of pricing/hedging DCS get more
complex when the positive MTM of the underlying
exposure is strongly correlated to the probability of
occurrence of the Credit Event or counterparty
default. To elaborate the point by using a simple
example, consider that the counterparty credit
exposure to be hedged under the DCS is that on a
forward contract under which the protection buyer
is to receive a given amount of foreign currency and
pay a fixed amount of the counterparty's domestic
currency, on maturity of the contract. The credit
exposure arises if the domestic currency falls
against the foreign currency. But this may itself
weaken the credit quality of the counterparty
because of worsening economic prospects and/or
macro-economic measures taken by the authorities
to counter the fall of the domestic currency!
i. Binary or digital CDS: the payoff is fixed,
generally based on historical recovery rates;
ii. Basket CDS: the Reference Obligation is a
portfolio of bond/debt exposures. The
Contingent Payment falls due on occurrence
of the “n”th default (n can be 1 also),
whereafter the CDS gets terminated.
Sometimes, a CDS specifies that for triggering
the Contingent Payment on occurrence of the
Credit Event, any one of a number of specified
bonds could be delivered. The buyer of the
CDS would obviously deliver the cheapest to
deliver bond.
iii. Contingent default swap: Payment is triggered
only when two Events occur, the first being the
Credit Event relating to the Reference Entity,
and the second one independent of it-for
example the level of the stock market.
Obviously such swaps would be cheaper to
buy than the plain vanilla CDS with a single
Credit Event.
iv. CDS on a portfolio of bonds represented in an
Index: as the market for CDS has grown,
Credit Indices of credit spreads have been
structured (with equal weights for all CDSs in
the Index) and are accepted by the market. The
index can be used as the credit spread to buy or
sell a CDS on all the underlying bonds. Such
CDSs have two features:
a. The notional on each bond is equal; and
b. The spread payment by the buyer comes
down proportionately when a Credit
Event occurs in relation to any of the
bonds in the Index.
2.3 Other variations
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2.4 Derivatives on CDS: Forwards and
Options
Once a liquid market in CDS got established,
forwards and options also started getting priced
and quoted. The forward contract on CDS
commits the counterparties to enter into a CDS
contract for a specified notional, maturity and
spread at the price agreed now.
This can be arrived at from the spreads for different
maturities-buy longer maturity, sell shorter
maturity CDS (or vice versa) to arrive at the forward
price. The shorter maturity CDS will coincide with
the maturity of the forward contract, and the
longer maturity with the maturity of the CDS
underlying the forward contract.
The parameters of the call and put options will
include
(i) The notional principal;
(ii) The maturity of the option; and
(iii) The exercise price by way of spread on the
CDS.
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Policymaking from a “macroprudential”
perspective in emerging market economies:
Ramon Moreno; BIS Working Papers No
336, Monetary and Economic Department,
January 2011
The landscape for financial stability in emerging
market economies (EMEs) has changed
considerably since the first half of 2009. Capital
flows are back, and given current account surpluses
and efforts to manage exchange rates, foreign
reserves are rising. This could lead to an increase in
aggregate demand with a concomitant risk of
inflation; and an increase in bank credit growth
and asset prices, increasing financial fragility.
Rapid credit growth can mean deterioration in
credit quality over time, disguised by rapid
economic growth that may prove transitory. Credit
growth could also be associated with growing risks
of spillovers or contagion, either due to common
exposure to risky sectors or networks linking
financial institutions. The risks would be amplified
by booms in the prices of leveraged assets. Risks
could materialise in the event of sudden capital
inflow reversals. Raising interest rates is the
standard response to deal with an increase in
aggregate demand, but it could attract more capital
inflows and lead to appreciation pressures.
Furthermore, whether interest rate policy is an
appropriate instrument to deal with the financial
stability implications of bank credit growth and
asset prices is still the subject of debate.
Policymakers in EMEs have sought to limit these
risks during the extended period of expansion in
the 2000s by using what are traditionally seen as
“monetary” or “micro prudential” tools but that
are now applied with a “macroprudential”
perspective. The form of intervention can broadly
be classified into measures to control capital
inflows, foreign exchange market intervention and
foreign reserve accumulation, measures to
strengthen bank balance sheets and capital &
measures to maintain the quality of credit or to
influence credit growth or allocation.
Many central banks value a regime of floating
exchange rates because it reminds financial markets
of foreign exchange risk - and so creates the right
incentives for risk management. Hence such a
regime is seen as having macroprudential benefits.
But even under floating, central banks intervene in
foreign exchange markets to dampen exchange rate
volatility, or to accumulate foreign reserves.
With regards to measures to strengthen bank
balance sheets and capital, steps taken have
included limits to net open positions of financial
institutions, more stringent requirements on
foreign currency lending, rules for liquidity risks,
rules regarding currency and maturity mismatches,
capital requirements, & loan-loss provisioning
requirements.
As far as measures to maintain the quality of credit
or to influence credit growth or allocation are
concerned, loan-to-value (LTV) ceilings on
mortgage loans have been used in a number of
EMEs to limit credit risks; debt-to-income or debt
service-to-income rules, that would tend to ensure
credit flows to those with a greater ability to repay,
have also been used.
Since the mid-1980s, most direct controls on bank
lending have been dismantled because they
undermined the efficiency of financial
intermediation. Nevertheless, several countries
have used credit ceilings more recently, and China
has used window guidance , involv ing
ARTICLE SUMMARY
ARTICLE SUMMARY
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consultations between the authorities and the
banks, to curtail lending. However, reserve
requirements are less costly to authorities and are
less distortionary than controls on bank lending,
although there are well-known drawbacks. Other
measures include taxes on lending & targeting
certain sectors for adjustments.
Sudden changes in capital inflows have been a
major contributor to financial instability in the
EMEs over several decades. While foreign currency
borrowing has generally been liberalised, a number
of EMEs still impose restrictions. India
traditionally has maintained restrictions that seek
to encourage FDI and limit external borrowing,
particularly short-term. However, some central
banks see disadvantages in capital controls or do
not consider them feasible. Capital controls
involve significant tradeoffs. They can help
contain financial stability risks; alternatively they
can cause distortions and impair financial
development.
A macroprudential view introduces an additional
dimension to the discussion of economic
stabilisation policies by focusing not only on
inflation, but also considering the possible effects
of capital inflows on credit, asset prices, risk-taking
behaviour and ultimately financial stability.
Supplementary instruments sometimes directly
influence the quantity of financing as well as its
cost, which may imply that they may be less
“market-friendly” as well as more effective than
interest rate policy.
Experience with crises has led to a number of
indicators or analysis that can guide policy
responses by shedding light on resilience,
imbalances and systemic risks; such as Indicators of
resilience of financial system, indicators of
macroeconomic or financial imbalances, and
indicators of systemic risks.
Interpreting data and assessing risks in EMEs also
poses challenges. There are still difficulties in
assessing credit risk in individual financial
institutions, notably from fast-growing sectors,
such as consumer and mortgage lending, due to
incomplete default history data. Furthermore,
systemic risks are not fully understood.
Information on interbank exposures may also be
limited or not easily analysed. Deregulation and
deepening of financial markets further accentuate
these challenges. Much of the discussion regarding
the timing of macroprudential measures pertains
to how these measures should be applied over the
cycle, partly because regulatory provisions are often
procyclical. From a risk-management perspective,
supplementary tools ideally would be imposed
early and in a manner that takes into account risks
should economic conditions deteriorate.
The Basel Committee on Banking Supervision is
taking a number of steps to mitigate procyclicality.
These include assessing and dampening the
cyclicality of minimum capital requirements,
encouraging forward-looking provisioning,
adopting a regulatory framework for capital
conservation and countercyclical buffers, and
introducing a minimum leverage ratio.
Apart from the steps taken by the Basel Committee,
procyclicality can be further countered by
supplementary macroprudential measures,
particularly when capital has been at its maximum
for an extended period and there are signs of
continued booms in credit and asset prices. Indeed,
s o m e a u t h o r i t i e s h a v e i m p l e m e n t e d
macroprudential measures in a way that counters
the cycle.
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Supplementary tools are generally seen as
enhancing banking sector resilience to shocks, but
their perceived effectiveness in curbing credit
growth appears to vary. Partly reflecting
uncertainties about the effects of supplementary or
macroprudential instruments, the authorities
appear to behave pragmatically when applying
such tools. In particular, they appear to assess the
effectiveness of measures adopted and adjust rates
or coverage if this appears to be necessary. In some
cases, however, the settings for what are
i n c r e a s i n g l y r e c o g n i s e d a s p o s s i b l e
macroprudential tools are still based on
microprudential norms. It will be difficult to
change this until theoretical and empirical research
clarifies how these settings should be adjusted to
take into account macroprudential risks.
The use of macroprudential instruments raises the
question of how these instruments might be related
to interest rate policy. Both interest rates and
macroprudential instruments are ways to influence
financial conditions. Such instruments can
strengthen or weaken how the policy rate is
ultimately reflected in the availability and cost of
financing faced by borrowers. However, as both
ultimately affect the availability and cost of
financing, they can also be viewed as substitutes.
How much interest rates and macroprudential
instruments will be used will depend in part on the
extent to which macroeconomic and financial
stability considerations coincide, and the relative
effectiveness of these instruments. Under a fixed
exchange regime, policymakers will have no
interest rate tool and would have to rely exclusively
on supplementary tools. The development or
condition of the financial system may also have a
bearing on the types of instruments used.
Over the medium term, the use of supplementary
and macroprudential tools raises issues of financial
development and efficiency. Many supplementary
tools have been abandoned in advanced economies
because of the heavy costs imposed on the financial
system and distortions in resource allocation. On
the other hand, recent experience showed clearly
that market discipline is not enough to guarantee
financial stability. The crisis has prompted a
reassessment of how these two competing
considerations should be balanced.
Another concern is that the focus on
supplementary tools, including capital controls,
could draw attention away from the need for sound
macroeconomic policies. A number of central
banks take the view that there is no substitute for
conservative fiscal, monetary and regulatory
policies in order to prevent fluctuations in global
capital flows from causing severe disruptions in
EMEs.
Source: www.bis.org
The financial turmoil of 2008-2010 observed very
sharp changes in the currencies of advanced and
emerging market economies against the US dollar
(USD). However, the currency movements against
the USD has been largely heterogeneous across the
world which can be explained by size of countries'
financial liabilities against the U.S., size of a
country's FX reserves and size of countries' current
account positions in line with Fratzcher (2009)
findings of a safe-haven story in which the global
Interpreting Currency Movements during
the Crisis: What's the Role of Interest Rate
Differentials? - (Nicoletta Batini and
Thomas Dowling)
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nature of the slowdown led investors to believe that
negative shocks originating in the U.S. would affect
foreign markets even more acutely. However
Kohler (2010) argues that exchange rate
movements during this crisis were characterized by
both safe-heaven effects and carry trade that
resulted from interest rate differentials.
The paper tries to analyze currency movements and
its drivers during the financial crisis of 2008-2010
using an adaptation of the Uncovered Interest
Parity (UIP) condition. The paper also investigates
the relationship between exchange rate movements
and monetary policy and its heterogeneous
character during the crisis by assessing the
contribution of monetary policy news in the U.S.
to exchange rate developments in five inflation-
targeting advanced economies (Australia, Canada,
the Euro Area, New Zealand, and the United
Kingdom) and three inflation-targeting EMEs
(Brazil, Chile and Mexico) during the crisis.
Employing instantaneous forward interest rate
differentials for each country in an adapted UIP
framework, the paper decomposes exchange rate
movements into changes attributable to monetary
policy and a residual and tries to determine the
interaction between interest rates and exchanges
rates.
The paper finds that the early stages of the crisis
were marked by sharp depreciation of currencies
worldwide against USD but then from late 2008
early 2009, these currencies began appreciating
near to pre-crisis level by the end of the first quarter
of 2010
. The depreciation phase of the currencies
during the 2008-2010 financial and economic crisis
was largely dominated by safe-haven effects rather
than carry trade activity or other return
considerations. This movement is attributable to
the widening between such rates, the Fed's open
commitment to prolonged easing, and the lowering
of the Fed Funds rates.
The UIP decomposition results suggest that in the
majority of countries, the initial depreciating phase
against the USD cannot be explained in terms of
changes in expected relative real interest rates. The
decomposition suggests that the depreciating phase
was the result of a portfolio shock which is in line
with the view of most commentators at the time
that saw the U.S. dollar's strength as a sign of real
panic and risk aversion. The wave of initial
depreciations came in a staged fashion likely
reflecting markets' sentiments about the strength
and sequence with which the financial and
economic crisis originating in the US would hit
individual countries. Over the period, the USD
nominal effective exchange rate strengthened
substantially as short-term capital flew out of all the
sample currencies into the USD.
By contrast, the appreciating phase of some
currencies (EUR, BRL, CLP and MXN) can be
largely explained through changes in expected
nominal rate differentials with the Fed Funds rate.
The Fed slashed its policy rate practically to zero
(0.125 %) in Dec'08 and soon after, most central
banks moved to an emphasis on supporting
economic growth from a focus on inflation and
started cutting their policy rates rapidly. In line
with the UIP logic, the resulting downward
cumulative revisions to the nominal forward
differentials between such rates and the Fed Funds
rate sparked upward expectations of exchange rate
changes in these countries. Over this period of
appreciation, changes in the expectations of
nominal rate differentials explain 100% of changes
-
-
as the U.S. economy slid further into
recession
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ARTICLE SUMMARY
in the euro, the Brazilian real, and the Mexican
peso, and around 70% of the fluctuation on the
Chilean peso while 30% ((Brazil, Mexico), 60%
(Chile) to 100% (Euro Area) of these revisions
relates in the real interest rate component of the
nominal differential i.e. expectation about
monetary policy factors. However, risk rather than
return considerations seem to have been behind the
small appreciation of sterling, or the stronger
appreciations of the Canadian and New Zealand
dollars. All these countries made clear
commitments to particularly low levels of policy
rates ruling out revisions to nominal rate
differentials vis-à-vis the Fed Funds rate going
forward.
In emerging market economy countries-with the
exception of Chile-the largest daily changes in
expectations in exchange rates during the crisis
seem to have been driven by changes in forward
differentials. In case of Brazil, the entire exchange
rate appreciation against the USD can be
rationalized through revisions to forward
differentials of which almost 30% can be ascribed
to monetary policy news however in case of
movements of the peso seem uncorrelated to shifts
in expectations of the monetary policy rate or in
inflation expectations relative to the U.S.
The results also show that the depreciation phase of
the currencies was largely dominated by safe haven
effects rather than carry trade activity or other
return considerations. However in some countries,
the appreciation that began at the end of 2008
seems largely to reflect downward movement in the
cumulative revisions to nominal forward
differentials, suggesting carry trade. Typically,
countries with greater financial exposure to the US
and/or with foreign reserves below a cross-country
average and/or with higher-than-average current
account deficits have experienced significantly
larger depreciations against the USD (averaging
about 22.5 % between July 2008 and February
2009).
Thus in advanced countries the largest daily
changes in expected exchange rates seems to have
been dominated by changes in investors' sentiment
toward those countries' currencies against the USD
(portfolio shocks), and hence to be risk-related. In
other words cumulative revisions to nominal
forward interest rate differentials for most chosen
dates are unable to explain the large appreciation /
depreciation seen in their bilateral with the USD
over these dates. However the Fed's emergency cut
of 50 basis points in Fed Fund rates to 1.5% on
October 8, 2008, however, surprised most currency
markets, both emerging and advanced, and seems
responsible for large FX trading on that day.
Source: www.imf.org
Sovereign debt has traditionally received much
attention as a crucial component of a country's
macroeconomic and financial policy framework.
The recently heightened attention on sovereign risk
from policy makers and financial markets stems
from the realization that how debt is managed
considerably influences the soundness and
solvency of the overall public sector balance sheet.
Debt management is also perceived as an important
factor that underpins the credibility and
reputation of a sovereign, and conditions the
Managing Public Debt and Its Financial
Stability Implications (Udaibir S. Das,
Michael Papapioannou, Guilherme Pedras,
Faisal Ahmed, and Jay Surti)
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stability of debt capital markets and the financial
institutions that hold public debt. The sharp
increase in debt levels in developed countries and
the recent contagion fears in Euro Area countries
through the banking systems have reinforced this
perception.
This paper explores how the debt and debt
management contribute to financial stability.
Recently studies explicitly acknowledged the role
of the proper management of domestic public debt
in promoting macroeconomic-financial stability.
An analytical model explains a financial crisis in
emerging markets as a function of the balance sheet
vulnerabilities of different sectors of the economy
to exogenous shocks and the way in which such
sector-specific vulnerabilities spill over to other
sectors. Clearly, however, unsustainable domestic
debt levels caused by factors such as expansionary
fiscal policy, under fixed-exchange rates or
exchange rate bond arrangements, can also lead to
currency crises, with large, discrete devaluations
and substantial macroeconomic dislocation.
At a strategic level, debt management plays a vital
role in securing the economic benefits of a sound
policy framework in several ways representing
optimization in the cost-risk space within the
constraints set by macroeconomic policy. The
improvement in the debt structure can be an
essential complement to fiscal consolidation in
ensuring a robust recovery in a post crisis
environment and such improvements, when
implemented opportunistically, can strengthen the
effectiveness managing public debt of counter-
cyclical macroeconomic policy going forward, at a
relatively low cost. The improvement measures
include substitution of debt denominated in
domestic currency for foreign currency or foreign
currencylinked debt; an extension of the maturity
profile of the debt portfolio at a reasonable cost; the
assignment of maturity brackets that avoid a
bunching of refinancing need; and a widening of
the investor base through attracting foreign
investors into the domestic debt market. The task is
operationally complex and requires debt managers
to make difficult trade-offs.
In an ideal world, debt managers would be able to
issue the low-cost paper demanded by foreign
investors through a liability structure in which
their exit is negatively-or weakly- correlated with
macroeconomic risk factors or exit triggers for
other investors. If this is not possible, the low
issuance cost may come at a heavy price in terms of
riskiness of the debt sold to foreign investors.
Depending on the country and the point in the
business cycle, this could be very risky. The volume
and nature of foreign investors' presence in the
domestic debt market needs to be carefully assessed
in raising and managing public debt. In addition to
strategic improvements through a long-term plan
of action, debt managers play an important role in
s t a b i l i z i n g m a r k e t s t h ro u g h t a c t i c a l
decisions/interventions in the market.
The linkage between government finances and
financial stability becomes painfully apparent
during recessions triggered by a financial crisis. It is
especially apparent for banks, which typically (need
to) hold an adequate quantity of government paper
due to several reasons: to conserve on equity capital
funding cost, as the risk weight on this investment
is typically nil; to meet the regulatory and internal
risk limits on liquidity buffers; and to meet
regulatory constraints concerning asset classes
eligible for investment of regulatory capital
instruments. In an upswing, the quality of financial
ARTICLE SUMMARY
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institutions' exposure to the government is high, as
public bonds carry low default, extension, and
liquidity risk. While in a downswing, especially in
the case of a recession triggered by a financial sector
dislocation, maintenance of the asset quality of the
government's liabilities, although far more elusive,
is much more critical in containing adverse
developments in the real and financial sectors
In general, the presence of a well-functioning
government debt market helps build and develop
efficient financial markets and inhibits the
sovereign's ability to conduct effective
countercyclical macroeconomic-financial policy. A
sound financial market allows a country's savings
to be channeled into investments in a more
effective way. More efficient financial markets also
allow for longer-term loans for individuals and
companies and help boost investment in a more
stable way, allowing the financial system to
promote an efficient allocation of capital and
transformation of maturities. Market participants
typically reassess the risk of public liabilities with
potentially rapid and substantial ratings
downgrades, which limit borrowing capacity
because of the narrowing of the investor base and
the increase in issuance cost. It also exacerbates
pressure on financial institutions' balance sheets,
incomes, and capital reserves, particularly where
marking to market of government securities in
financial institutions' portfolios implies
reductions in income and through an increase in
the risk weight - for banks using advanced Internal
Ratings Based (IRB) methodologies under Basel-II -
a reduction in capital. Finally, from an investors'
perspective, market pessimism can narrow the
investor base for the sovereign's issues, which may
translate into reduced liquidity of public debt.
Analytically, financial stability can be viewed as a
function of the level of the debt stock, the debt
profile, the investor base, the stage of development
of the capital market, and institutional factors.
Higher levels of debt trigger policies for mitigating
possible higher inflation rates and the sovereign's
credibility becomes less ensured in the eyes of
international investors, which could result in
higher volatility caused by difficulties in
refinancing government debt, which in turn could
trigger wider financial instability. The higher stock
also entails a higher probability of affecting the
prices of financial assets, correspondingly
influencing the soundness of the financial sector
balance sheet.
Debt structures relying heavily on short-term
instruments are sources of vulnerability because
short average maturities entail high rollover and
refinancing risk and adverse fiscal impact. Debt
structures that are too short or allow for bumps in
the maturity profile can potentially generate
confidence crises, fueled by investors' concerns that
the government will not have sufficient funds to
redeem maturing bonds when they fall due.
Depending on the extent of these fears, they could
translate into lower demand for the country's
instruments in auctions, thus triggering a self-
fulfilling prophecy.
The maturity of a debt structure is instrumental for
financial stability. As the short-term debt involves
higher refinancing risk which could pose a higher
risk to the financial stability of the country, a fixed-
rate and long-term bond portfolio could be the
ideal debt structure. However, fixed rate bonds pose
less risk to the government but may represent a
higher risk to the investor as longer-term debt may
represent higher value at risk (VaR) for the debt
.
ARTICLE SUMMARY
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ARTICLE SUMMARY
holder. If individual investors, in search of higher
profits, increase their exposure to interest rate risk
and there is a hike in interest rates, the market as a
whole may suffer, because the unwinding of
positions by some institutions may trigger VaR
thresholds for others. Therefore debt managers
should be aware of and try to monitor this risk and
to combat this situation. During the same period,
the government increases issuance of floating rate
bonds.
As the investor base usually comprises banks,
mutual funds, pension funds, and foreign and
retail investors, the debt managers must strike the
right balance between meeting the specific needs of
each of these groups of investors and reducing the
costs to the government. They can play a
preemptive role in developing the investor base
further, by issuing instruments targeted at a
specific group of investors and by working on
increasing a specific group's participation in the
debt or in particular instruments. The inclusion of
foreign investors in the investor base can reduce
vulnerabilities associated with public debt as they
are usually less risk averse and tend to hold longer-
term instruments. However, countries with a high
concentration of foreign investors are more
susceptible to financial crises, given that such
investors are less committed to these assets.
Other institutional aspects for financial stability
are efficient risk-free benchmark instruments, a
well defined legal framework, proper coordination
between debt management and monetary policy,
transparent communicational setup and risk
mitigation policies. The issuance of an efficient
“risk-free” yield curve can serve as a reference point
for pricing other instruments issued by financial
enterprises or corporations and thus reduces
systemic risks stemming from the financial sector.
Such benchmark instruments can serve as efficient
collateral for operations in the financial market
that reduces the transaction risk of institutions
which can use these instruments to offset credit
risk. A well-defined legal framework and proper
coordination between debt management and
monetary policy results in better signaling of
government intentions and increases transparency.
Concluding the paper suggests that the a debt
management strategy should be carefully analyzed
by debt managers and policy makers in terms of
their impact on the government's balance sheet,
macroeconomic developments, and the financial
system.
Source: www.imf.org
BRIEFING
WHAT'S NEW
InternationalDevelopments
• The People's Bank of China raised the reserve ratios by 50 basis points
starting January 20, the fourth increase in two months.
• The Bank of Korea raised the seven-day repurchase rate by a quarter of a
percentage point to 2.75% and announced plans to freeze utility costs and
cut food tariffs.
• Federal Reserve Chairman Ben S. Bernanke said the central bank is doing its
best to minimize the burden of regulations on smaller banks that don't pose
risks to the financial system.
• Federal Reserve policy makers said that improvements in the economy
didn't meet the threshold for scaling back their plans to purchase $600
billion in bonds.
• European Central Bank President Jean-Claude Trichet said the central bank
can't be relied on to offset government irresponsibility and called for “more
ambitious” efforts to reform fiscal rules.
• The European Central Bank threw Portugal a temporary lifeline by buying
up its bonds, as market and peer pressure mounted for Lisbon to seek an
international bailout soon.
• Brazil's central bank set reserve requirements on short dollar positions held
by local banks in its third attempt since October to stem a rally in the
currency.
• Standard & Poor's cut Japan's long-term sovereign debt rating for the first
time since 2002, saying the country's government lacked a coherent plan to
tackle its mounting debt. It reduced the rating by one notch to AA minus -
three levels below the highest possible rating.
• Standard & Poor's and Moody's investor service warned that US will loose its
'AAA' rating if its national debt kept growing.
• China ($14.8 trillion economy) over took the US ($14.6 trillion economy) as
the world's biggest economy when measured in terms of purchasing power.
• The U.S. GDP grew at a 3.2% annual rate in the fourth quarter of 2010 as
consumer spending climbed by the most in more than four years.
• China's growth accelerated to 9.80% in the fourth quarter as industrial
production and retail sales picked up, adding pressure on policy makers to
keep raising interest rates. The economy expanded 10.30% in 2010, the
fastest pace in three years. CPI eased to 4.60% in December but rose 3.30%
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for 2010 as a whole, breaching the government target of 3%.
• As per the Office for National Statistics, British GDP fell 0.50% after
increasing 0.70% in the previous quarter.
• As per the European Union's statistics office, GDP in the euro region rose
0.30% in the third quarter instead of 0.40% reported on December 2, 2010.
Euro-area consumer prices rose 2.2% in December from a year earlier after
increasing 1.9% in November.
• German GDP jumped 3.60% in 2010, the most since data for a reunified
Germany began in 1992, after slumping 4.70% in 2009.
• The IMF raised its forecast for global economic growth this year to 4.40%.
Expansion next year is projected to reach 4.50%.
• Capital inflows, a driving force of the recovery in emerging countries, now
pose risks to global growth as they can trigger abrupt currency fluctuations
that may do lasting damage to some nations, the World Bank said. It left its
growth forecast for the world's economy this year unchanged at 3.3%, from a
revised 3.9% in 2010.
• According to the IMF, Europe has yet to allay investor “skepticism” about
the sustainability of the region's debt, and any spread of the crisis would
cloud global economic prospects.
• The Basel Committee on Banking Supervision has stated that debt securities
of banks must be capable of being written off or converted into common
stock in a crisis if they were to count towards a lender's capital before any
public money was used.
• Prime Minister Jose Socrates said that Portugal had no plans to seek aid,
while the Bank of Portugal forecast the economy would shrink 1.3% this year
as austerity measures crushed internal demand - in sharp contrast to the
government's projection that exports would help GDP to grow 0.2%.
• European Parliament members proposed more automatic sanctions on high-
deficit nations.
• Japan plans to buy bonds issued by Europe's financial-aid funds, its finance
minister said, joining China in assisting the region as it battles against a
fund- raising crisis that prompted bailouts of Ireland and Greece.
• The U.S. trade deficit unexpectedly shrank 0.30% to $38.3 billion in
November as growing global demand and a weaker dollar help boost overseas
sales.
• China reported a less-than-forecast $13.1 billion trade surplus for December.
InternationalDevelopments
WHAT'S NEW
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WHAT'S NEW
• China's foreign-exchange reserves climbed 18.70% to a world-record $2.85
trillion at the end of 2010 from a year earlier and domestic lending exceeded
the government's full-year target.
• Japan's current account surplus narrowed 15.7% from a year earlier to about
$11 billion in November, the first decline in three months after import
growth accelerated.
• Japan's deflation eased in December as consumer prices declined 0.4% from a
year earlier and the job market strengthened, supporting the central bank's
view that the economy may pick up this quarter.
• As per the Office for National Statistics, consumer prices in the UK rose
3.7% from a year earlier after a 3.3% increase in November.
• European inflation accelerated 2.20%, the fastest pace in more than two years
in December, led by surging energy costs.
• US President Barack Obama and Chinese President Hu Jintao vowed to work
to find common ground as the two countries announced $45 billion in
export deals.
• U.S. Treasury Secretary Timothy F. Geithner said the Obama administration
will continue to press China to allow the yuan to rise so that companies
around the world can compete fairly.
• China said that it would welcome assurances on the safety of its financial
assets in the United States.
• US Treasury secretary Timothy F Geithner said China needs to strengthen the
'substantially undervalued' yuan because it puts other countries at a
competitive disadvantage.
• The yuan exchange rate is not the main cause of the trade imbalance between
China and the US, the Chinese foreign ministry said while adding that China
was committed to proceeding with yuan exchange rate reform.
• The United States may hit the legal limit on its ability to borrow by March 31
and faces serious consequences unless the Congress acts by then to raise it,
Treasury Secretary Timothy Geithner said.
• Japan's top government spokesman said the country's fiscal situation is
“approaching the edge of a cliff”.
• China will let companies invest overseas in yuan in the latest move to expand
the currency's international role and curb dependence on the dollar.
• France, Germany, the U.S. and the U.K. need to control their spending on
InternationalDevelopments
WHAT'S NEW
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• India's fiscal deficit during April-December 2010 was 1,71,249 crore and
represented a decline of 44.75% over the fiscal deficit of 3,09,980 crores in
April-December 2009. The fiscal deficit during accounted for 44.90% of the
budgeted estimates of 3,81,408 crore for 2010-11.
• India's export grew by 36.40% in December 2010 to $22.50 billion from
$16.49 billion in December 2009, while imports declined by 11.10% to $25.13
billion from $28.25 billion in December 2009. The trade deficit for April-
December 2010 at $82.02 billion was higher than the $80.13 billion during the
corresponding period in the previous year.
• The Index of Industrial Production (IIP) registered a growth of 2.70% in
November 2010 compared with 11.30% in November 2009. The IIP for
October was revised upwards to 11.30% from 10.80%. The IIP registered a
growth of 9.50% in April-November 2010 compared to 7.40% in the previous
year.
• The Index of Six core industries having a combined weight of 26.70% in the
IIP, registered a growth of 6.6% (provisional) in December 2010 compared to
6.20% registered in December 2009. During April-December 2010-11, six core
industries registered a growth of 5.3% (provisional) as against 4.7% during the
corresponding period of the previous year.
• India's holding of US Treasury Securities at the end of November 2010 stood
at $40.7 billion vis-à-vis $41.1 billion at the end of October 2010.
• The annual rate of inflation, based on monthly WPI, stood at 8.43% for the
month of December 2010 as compared to 7.48% (provisional) for the previous
month and 6.90% during the corresponding month of the previous year.
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Indian Economy
pensions and health care to keep their debt burdens stable over the long
term, Moody's Investors Service said.
• The U.K. economy faces a 20 percent chance of slipping into another
recession as rising unemployment and faster inflation weigh on growth, the
Centre for Economics and Business Research said.
• Japan's government raised its assessment of the economy for the first time
since June, as global demand encourages companies to step up output.
• As per the World Bank, higher food prices pose a major threat to the global
economy and social stability but policymakers must not over-regulate
commodity markets.
• World food prices rose to a record in December on higher sugar, grain and
oilseed costs, the United Nations said, exceeding levels reached in 2008.
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WHAT'S NEW
• The wholesale-price index rose 8.43% in December from a year earlier after a
7.48% increase in November.
• India's annual inflation rate based on consumer price index (CPI) for
industrial workers surged to 9.47% in December from 8.33% in November as
food items became costlier.
• India received FDI of $1.6 billion in November 2010, down 7% from the
$1.72 in same month last year.
• FDI inflow in the services sector dipped by 30% to $2.16 billion in April-
October this fiscal.
• Import of sensitive products increased 14% to 40,499 crore in the April-
October 2010 period and amounted to 4.6% of the country's total imports
during the period.
• Direct tax collections in the first nine months (April-December) of the
current financial year increased 19.47% to touch 2,98,958 crore, compared
with 2,50,232 crore in the corresponding period of 2009-10.
• Finance Minister, Mr Pranab Mukherjee, raised the collections targets for
direct tax by 4% to 4.47 lakh crore and for indirect tax by 7% to 3.37 lakh
crore for the current financial year.
• Finance minister Pranab Mukherjee said that India's economic growth may
have climbed back to a higher trajectory but main concerns now are inflation
and capital inflows.
• Finance minister Pranab Mukherjee said the “normal monsoons” this year
would help the agriculture sector to expand at a spectacular 6% this financial
year, up from a meager 0.2% last fiscal.
• The finance ministry said the average annual inflation during the current
fiscal will jump to 9%, which is more than double the figure of 3.8% recorded
a year ago.
• Petroleum Minister Murli Deora said that the government has indefinitely
deferred a hike in diesel rates despite soaring crude oil prices to prevent a
further increase in prices, particularly of food items.
• The Prime minister's economic panel said inflation, is likely to come down to
7% for December and decline further to 6-6.5% by the end of this fiscal as
against the earlier estimate of 5.50%.
• Chief economic advisor Kaushik Basu said that India's fast-growing economy
will have to live with a spike of up to 2% in the annual headline inflation rate,
translating into a new comfort range of 6-7% for inflation for the long-term
against last-decade's around 5%.
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WHAT'S NEW
• Crisil in its report titled “'India-Raising the Growth Bar” said that India's
domestic demand will enable it to maintain 8.4% annual growth over the next
five years. If some supply-side issues are addressed, it can sustain a 10%
growth.
• Investment bank Nomura in its India 2011 strategy note titled 'Under the
Weather', nudged down the GDP growth forecast for India to 8% for the year
to March 2012 from 8.10%.
• As per analysts with the Royal Bank of Scotland, India is not ready for 9%
growth in current circumstances and the recent decline in WPI inflation
should not be equated with decline in prices.
• Goldman Sachs said that the high deficit number supports the view that
rising current account deficit being financed by short-term capital flows
remains the biggest risk to India's growth story.
• BNP Paribas expects that 2011 is likely to be a year of two halves for India:
muted performance by the market in the first half and strong recovery in the
second half.
• IMF expects Indian economy to grow by 8.8% during the current financial
year, up from 7.4% a year ago, mainly driven by robust growth in farm sector
and pick up in consumption.
• Data released by the US Department of Commerce show that India's exports
to the US were more or less unaffected by recession.
• Marking a robust year for deal activities, mergers and acquisitions involving
Indian companies trebled to $68.3 billion in 2010 compared with the
previous year, according to global consultancy Ernst & Young.
• The government announced a 14-point menu to tame food inflation but said
it has limited leverage over vegetables and fruit.
• Concerns over rising food prices has led Standard Chartered Bank to revise its
outlook on India's inflation to 8.3% from 7%, while Citi now estimates
December inflation to touch 8.4% compared with its earlier estimate of 7.5%.
• The Prime Minister's Economic Advisory Council (PMEAC) revised upward
the March-end inflation forecast to 7% from 6.5% estimated earlier.
• Sebi has allowed stock exchanges to introduce derivatives contracts in global
indices in their equity derivatives segments.
• The government has directed all retirement funds to trade in debt
instruments on exchanges compulsorily and has set a deadline of February 28
for pension funds to report all bond purchases on BSE, NSE, or with the
FIMMDA.
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WHAT'S NEW
• Shri Anand Sinha took over as the Deputy Governor of the Reserve Bank of
India.
• From January 3, 2011, the Reserve Bank of India will place on its website, the
public engagement schedule of the Governor and the Deputy Governors.
• RBI has asked banks to allow only one transaction at ATM machines for one
entry of PIN (Personal Identification Number).
• Banks have been permitted to change the benchmark and methodology used
in the computation of Base Rate for a further period of six months i.e. upto
June 30, 2011.
• The deadline for adoption of security issues and risk mitigation measures
related to card not present transactions has been extended by one month upto
January 31, 2011.
• RBI notified the prudential guidelines for parallel run and prudential floor
for capital adequacy and market discipline under the New Capital Adequacy
Framework (NCAF).
• The guidelines on listing and rating requirements pertaining to non-SLR
securities would not be applicable to banks' investments in Non-Convertible
Debentures (NCDs) of maturity up to one year.
• RBI has decided to extend the scope of 'Speed Clearing' to cover all transaction
codes, other than those relating to government cheques.
• RBI has notified the modifications in the regulatory framework for core
investment companies (CICs).
• RBI issued the directions for monitoring of end use of funds.
• Banks have been directed not to issue Tier 1 or Tier 2 capital instruments with
'step-up option'.
• RBI notified the modified norms regarding opening of small accounts.
• RBI has allowed more participants in the currency futures and the exchange
traded currency options market.
• India has voluntarily asked the IMF and the World Bank to conduct a
comprehensive and in-depth analysis of the country's financial sector, Finance
Minister Pranab Mukherjee said.
• The World Bank has raised its single-country loan exposure limit for India to
$17.5 billion from $15.5 billion.
• The Budget session of Parliament will begin on February 21 and the Union
Budget for 2011-12 will be presented on February 28.
Reserve Bank of India:(Source: http://rbi.org.in)
Indian Economy
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WHAT'S NEW
• RBI has notified the revised service charge structure for cheque collection
effective from April 1, 2011.
• RBI has decided to extend the timings for Centralised Funds Management
System (CFMS).
• Central Processing Centres (CPCs)/Service branches have been directed not to
have direct interface with customers.
• UCBs have been directed to follow “Settlement Date” accounting for
recording both outright and ready forward purchase and sale transactions in
Government Securities.
• RBI released the draft guidelines on advanced measurement approach (AMA)
for calculating operational risk capital charge.
• RBI released on its website the “Discussion Paper on Presence of Foreign Banks
in India”.
• RBI released on its website the report of the sub-committee of its Central Board
of Directors under the Chairmanship of Shri Y H Malegam to study issues and
concerns in the micro finance institutions sector.
• RBI has given certain relaxations to banks in its present restructuring
guidelines in order to enable them to extend credit support to micro finance
institutions (MFIs).
• RBI has invited views/comments of all stakeholders and the public at large on
the Malegam Committee report on microfinance institutions (MFIs).
• RBI has placed on its website the report of the Working Group on information
security, electronic banking, technology risk management, and cyber frauds.
• RBI has launched the twelfth round of its 'Order Books, Inventories and
Capacity Utilization Survey'.
• RBI has launched the 53rd round of the Industrial Outlook Survey for
reference period Jan-Mar 2011.
• The exposure of State Co-operative Banks & Central Co-operative Banks to
housing finance would henceforth be limited to 5% of their total assets.
• NBFCs have been directed to make a general provision at 0.25% of the
outstanding standard assets.
• RBI notified the modified prudential guidelines on restructuring of advances
by AIFIs.
• RBI has entered into a Supplementary Agreement under Section 21A of the
Reserve Bank of India Act, 1934 with the Government of Jammu & Kashmir.
Reserve Bank of India:(Source: http://rbi.org.in)
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REPORTS
World Economic Outlook - Update
Global activity expanded at an annualized rate of
just over 3½ percent in the third quarter of 2010
owing to better than forecast in the October 2010
WEO, owing to stronger-than expected
consumption in the United States and Japan.
Growth in emerging and developing economies
remained robust in the third quarter, buoyed by
we l l - en t renched pr i v a t e demand , s t i l l
accommodative policy stances, and resurgent
capital inflows.
Activity in the advanced economies is projected to
expand by 2½ percent during 2011-12, which is still
sluggish considering the depth of the 2009
recession and insufficient to make a significant
dent in high unemployment rates. In both 2011
and 2012, growth in emerging and developing
economies is expected to remain buoyant at 6½
percent, a modest slowdown from the 7% growth
registered last year. Developing Asia continues to
grow most rapidly, but other emerging regions are
also expected to continue their strong rebound.
Prices for both oil and non-oil commodities rose
considerably in 2010, in response to strong global
demand but also to supply shocks for selected
commodities. Upward pressure on prices is
expected to persist in 2011, due to continued robust
demand and a sluggish supply response to
tightening market conditions. As a result, the IMF's
baseline petroleum price projection for 2011 is now
$90 per barrel. Consumer prices in emerging
economies are projected to rise 6 percent this year,
while that for advanced economies inflation is
expected to remain at 1½ percent this year.
Downside risks arise from the possibility of
tensions in the euro area periphery spreading to the
core of Europe; the lack of progress in formulating
medium-term fiscal consolidation plans in major
advanced economies; the continued weakness of
the U.S. real estate market; high commodity prices;
and overheating and the potential for boom-bust
cycles in emerging markets. On the upside, there are
risks from stronger-than-expected business
investment rebounds in major advanced
economies. Another downside risk stems from
insufficient progress in developing medium-term
fiscal consolidation plans in large advanced
economies. In emerging economies, key risks relate
to overheating, a rapid rise of inflation pressures,
and the possibility of a hard landing. In the near
term, upside risks to growth have risen, driven by
accommodative policies, strong terms-of-trade
gains for commodity exporters, and resurgent
capital inflows.
In the advanced economies, there is a need for
continued progress to repair and reform financial
systems. In the near term, emerging signs of a
handoff from public to private demand in many
large advanced economies suggests that countries
can push forward in formulating and
i m p l e m e n t i n g c r e d i b l e m e d i u m - t e rm
consolidation plans. At the same time, monetary
accommodation needs to continue in the advanced
REPORTS
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REPORTS
economies. Monetary tightening should begin or
continue in emerging economies where
overheating pressures are starting to emerge.
Further, prudential measures to keep increases in
credit or asset markets from becoming excessive
should also be considered. For emerging countries,
with real effective rates close to pre-crisis levels,
allowing the currency to appreciate would help
combat overheating pressures and facilitate a
healthy rebalancing from external to domestic
demand. In other countries where the currency is
above levels consistent with medium-term
fundamentals, fiscal adjustment can help lower
interest rates and restrain domestic demand.
Source: www.imf.org
D i l e m m a s i n C e n t r a l B a n k
Communication: Some Reflections Based
on Recent Experience; Second Business
Standard Annual Lecture delivered by Dr.
Duvvuri Subbarao, Governor, Reserve Bank
of India, at New Delhi on January 7, 2011
Dr. Subbarao begins by stating that it is standard
practice for central banks these days to indicate
the policy rates, the rationale behind the policy
action, the expected outcomes, and oftentimes to
give forward guidance on future policy actions.
While communicating policy after it is made is the
standard mode of communication, central banks
are also increasingly taking to communication
before policy action-the market does not like
unexpected news, and that surprises should be
avoided unless surprise is, in rare circumstances,
part of the strategy itself.
According to him, sometimes, communication,
instead of being a vehicle for policy, can be the
policy itself. Communication can be a potentially
powerful tool for getting feedback when the
implications and the impact of proposed policy
are uncertain. He also states that eliciting views
and feedback is now standard practice for most
policy decisions of the Reserve Bank of India
(RBI).
Yet another factor that has motivated central
banks into placing larger emphasis on
communication is their hard earned autonomy in
the years before the crisis. Central banks have
i n c r e a s i n g l y e m b r a c e d m o r e o p e n
communication to counter the criticism that an
autonomous central bank comprising unelected
decision makers was inconsistent with a
democratic structure.
Dr. Subbarao puts forward some of the
communication dilemmas and challenges faced
by the RBI in the recent period. He states that by
the time of the second quarter review in early
November 2010, the RBI had already raised policy
interest rates five times. The central issue before
this policy review was whether it should continue
on the tightening spree or pause before resuming
tightening later on. Inside the Reserve Bank, the
view was that within the policy trajectory, it did
not matter if one paused briefly as long as the RBI
remained committed to the eventual outcome.
T h e d i l e m m a t h e n b o i l e d d o w n t o
communicating to the market that the RBI action
should be interpreted only as a comma and not a
full stop.
Central banks have learnt that giving forward
guidance on the policy trajectory is an effective
way of managing market expectations; but the
forward guidance is typically conditional on
certain expected macroeconomic developments.
The dilemma then is how precisely is the
conditionality to be communicated, and how to
ensure that the market does not ignore the
conditionality and interpret the guidance as an
irrevocable commitment.
Dr. Subbarao pointed out the additional dilemma
in differentiating between 'neutral' & 'normal'
target policy rates. Another frequent dilemma
faced by the RBI is about how much of the
uncertainty surrounding a policy decision should
be communicated. He puts forward an example
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for illustration. The Reserve Bank conducts a
quarterly inflation expectations survey based on a
sample of respondents, since September 2005. By
2009 there was a growing view within the Reserve
Bank that the results of the survey should be
'communicated' to the public on the principle
that, as far as possible, there should be no
information asymmetry between the public and
the RBI. The real communication dilemma
emerged over the question whether the RBI will be
able to convey the arms length relationship
between the 'Reserve Bank' and the 'Reserve Bank
Survey', and make the broader public appreciate
that the survey results are the opinion of the
respondents and not of the Reserve Bank.
According to Dr. Subbarao, communication
dilemmas arise not just in the domain of monetary
policy but also with respect to other dimensions of
the Reserve Bank's work, for instance on the
guidelines over the issuance of new banking
licenses. With respect to Basel III framework, Dr.
Subbarao feels that the communication challenge
is to educate the market on the Basel III notion of
buffers and their manner of use so that these
safeguards function the way they are intended to.
The second communication challenge comes from
the 'comply or explain' framework under which
countries have the option to deviate from certain
components of the package and explain why they
have deviated. The concern really is that the
market, known for its unfailing ruthlessness, will
penalize any deviation, and the communication
challenge for regulators is to persuade the markets
to evaluate the country's compliance based on the
explanation.
The Basel Committee on Banking Supervision
(BCBS) and the Financial Stability Board (FSB) are
currently engaged in devising a framework for
regulating and supervising systemically important
financial institutions (SIFIs). Under the
arrangement presently under discussion, SIFIs will
be pre-identified on the basis of some defined
criteria and subjected to graded prudential
surcharges and other safeguards. These are
intended to eliminate the moral hazard, reduce
their systemic risk potential, and should it become
inevitable, allow them to fail in an orderly
manner. The intent is to pre-identify SIFIs for the
purpose of greater supervision but not to disclose
the list as that would accentuate the moral hazard.
The dilemma is how the market might actually
respond to this deliberate non-transparency.
Dr. Subbarao continues that greater transparency
is not always better communication and white
noise often complicates understanding; and that
central banks may sometimes withhold
information for strategic reasons. However, he
argues that the RBI has, however, progressively
moved towards greater disclosure in line with
international best practices, and is among 68
central banks from around the world to have
adopted the Special Data Dissemination
Standards (SDDS) template for publication of
detailed data on foreign exchange reserves,
including some information on currency
composition, investment pattern and forward
positions.
Dr. Subbarao feels that the media has been an
effective intermediary between the Reserve Bank
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SPEECHES
and its stakeholders; however, there are ways in
which it can become even more effective. He
suggests that the media will probably be more
effective and value adding if it allows time for
digesting the news and thinks through before
'analysis and interpretation', and does some
research before coming out with 'opinion'. Also,
more stringent quality control will make the
media a more useful and effective 'news
intermediator'. The media has a responsibility also
for broad basing its reporting; and should opt for
restraint instead of sensationalism.
In his conclusion, Dr. Subbarao states that it is the
continuing endeavour of the RBI to communicate
in a clear manner so as to minimize scope for
misinterpretation; in an effective manner so that
the diverse target groups get the relevant
information and message; and also in an honest
and consistent manner such that people can link
its policies and action to past trends and future
projections.
Source: www.rbi.org.in
Centrality of banks in the financial system:
Address by Shyamala Gopinath, Deputy
Governor, RBI at the 12th FIMMDA-PDAI
Annual Conference, Udaipur, January 8,
2011.
The main focus of the Shyamala Gopinath speech
was on the emerging post-crisis regulatory
landscape for the financial sector i.e. Basel III
framework for banks, OTC derivative markets,
etc. She said that recent crisis was about the
centrality of banks as the supporting lifelines of
financial markets. There is a clear recognition of
the inadequacies of the regulatory approach based
on the assumption of self-contained, well
functioning markets which ignored the risks these
markets passed on to the banking system.
She mentioned two kind of financial system i.e.
bank-based and market based financial systems.
The bank-based system highlights the positive role
of banks in leveraging informational advantage
about the firms for capital allocation and ensuring
better credit discipline. In contrast, the market-
based system highlights the growth enhancing role
of well-functioning markets in fostering greater
innovation; enhancing greater market discipline
and corporate governance. Market based systems
were supposed to reduce the problem of moral
hazard inherent in bank-based systems. However,
it is increasingly being recognized that any system
is essentially an interplay of dynamic interaction
between banks and markets and right
interpretation of this interplay would be critical
for addressing systemic stability.
The two major factors which accentuated the crisis
is banks' increasing interdependence on the
capital markets because of blurring of lines
between commercial banking and investment
banking and increased recourse to 'originate and
distribute' model of asset creation and increased
reliance on wholesale, market linked funding of
balance sheets through unregulated repo market.
There was an entire set of market microstructure
which facilitated the above transition the rating
agencies, accounting standards & legal
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documentation practices. The end result of the
banks' increasing reliance on capital markets and
capital market intermediaries was an explosion in
the total size of financial markets. On the other
hand, as major market participants, it is the banks
which create and enhance market liquidity by
virtue of their participation without which it
would be difficult to envisage the success of
markets. Even the central counter parties (CCPs),
which guarantee market transactions and assume
counterparty risks through novation, ultimately
depend on banks to for the settlement guarantee
funds.
Now there is generally accepted consensus on
improving the quality of capital of banks and the
new Basel norms prescribe a higher portion of
pure equity. There are also proposals for a new
form of instruments - contingent capital - which
would be nothing but a convertible debt security
that would automatically convert into equity as
the institution's financial condition weakened.
This mandatory conversion feature means that the
debt security would not default and thus
bankruptcy would be avoided.
In India, banks balance sheets are relatively less
aligned with capital market both on the asset side
as well as liability side. Capital in the form of
subordinated debt and other non-equity
instruments constitutes only around 38 per cent of
total capital. Also, there are prudential limits on
banks' reliance on short-term funding markets.
The overnight unsecured market for funds is
restricted only to banks and primary dealers (PD)
and for these too there are limits on both lending
as well as borrowing. Inter-bank liabilities in all
forms for any bank have to be within 200 percent
of its net-worth. Access to collateralized segments
such as market repo and CBLO is contingent on
the availability of securities, which is floored by
the SLR requirements. On the asset side,
investment activities of banks are based on
following fundamental guiding principles: (i)
Nature of different credit exposures is different
and all exposures cannot be treated on par (ii)
Underlying intent and spirit of a particular
transaction is more relevant than the form (iii)
Contamination risks arising from off-balance
sheet activities need to be contained.
She admitted that it is impossible to have a
straightjacket framework for scope and nature of
banks' involvement with market-based systems
such as corporate bond market, securitization,
issuance of Irrevocable Payment Commitments by
banks to stock exchanges, issue of structured forex
derivatives by banks and Credit Default Swap
(CDS).
In her conclusion, Shyamala Gopinath said that
the migration from the conventional bank based
model to a market based model has not
diminished the importance of banks in the
financial system. In fact, with higher growth in the
financial markets, the responsibilities cast on the
banks are on the increase. She underlined seven
broad issues that need to be addressed in the
Indian context going forward: (i) How to
strengthen capital requirements for market risk
when most banks are on Standardised Approach?
(ii) How to strike a balance in regard to fee-based
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revenue streams of banks? (iii) How to address
conflicts of interest in banks' lending
relationships and capital market activities? (iv)
How to strengthen the rating regime? (v) How to
address excessive collateralisation of balance
sheets? (vi) How to increase the appetite for credit
risk among non-bank institutional investors? (vii)
How to encourage true market development
without the support of banks?
www.rbi.org.in
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MARKET ROUND-UP
MARKET OVERVIEW
Macro-economic Overview
Domestic
• Fiscal stimulus announced by the government and Pay Commission awards enabled the economy to
achieve a smart recovery on both savings and investment fronts in 2009-10. Data published by the Central
Statistical Organization shows that gross capital formation - a proxy for investment - stood at 36.5% of
GDP in 2009-10 as against 34.5% in 2008-09. Despite a decrease in household savings, a rise in public and
private corporate savings pushed the overall savings rate to 33.7% in 2009-10 from 32.2% in the year
before. According to the quick estimates, the economy grew 8% during 2009-10, higher than 7.4%
provisionally estimated earlier, driven by stronger performance in manufacturing (8.8%), financing,
insurance, real estate & business services (9.2%), transport, storage and communication (15%),
community, social and personal services (11.8%). The numbers have been revised following the change
the wholesale price index with base year 2004-05 and also subsequent revision in the index of industrial
production. The country's per capita income also, grew by 14.5% to 46,492 in 2009-10 from 40,605 in
the year-ago period.
in
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• RBI, in its Third Quarter Review of Monetary Policy 2010-11, retained the baseline projection of real GDP
growth at 8.5% with an upside bias. IMF too revised up its projection for the Indian economy to 8.8%
during 2011 from 7.4% a year ago following robust growth in farm sector and pick up in consumption, at
the same time, raising concerns over rising prices.
• RBI started to publish data on sectoral
deployment of credit for the month.
These data are collected on a monthly
basis from select 47 scheduled
commercial banks accounting for about
95% of the total non-food credit
deployed by all scheduled commercial
banks. It shows that all major sectors,
except agriculture, recorded accelerated credit growth in December'10, both on a y-o-y and financial year
basis.
• The government's fiscal deficit in the April-December period of 2010-11 has come down by 45% to 1.71
lakh crore (drop of 15,273 crore from November'10), compared to the 3.09 lakh crore in the same period
last fiscal. Better-than-expected income from spectrum auction and a growing tax kitty are the prime
reasons for the fall in deficit figures. Besides, the government has also cut down on its expenditure further
narrowing the gap between its revenue and expenses. In absolute terms, expenditure by the government
during the three quarters rose by 11% to 7.87 lakh crore from 7.07 lakh crore in the period a year ago,
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Sectoral Deployment of Credit - December-2010
Year on Year Variation(%)
Financial Year BasisVariation (%)Sector
2009 2010 2009-10 2010-11
Non-Food Credit 11.5 23.1 5.9 11.6
Industry 15.7 27.4 11.8 14.5
Services 11.5 25.0 2.4 13.8
Agriculture 20.3 21.0 2.8 1.2
which got overshadowed by impressive growth in revenues that went up by almost 50% at 5.84 lakh crore
till December as against same period last fiscal. The government collected 3.91 lakh crore in taxes during
the nine-month period, which was 73.2% of the Budgetary target for the entire fiscal. Meanwhile, non-tax
revenue in April-December'10, stood at 1.93 lakh crore, 130.4% of the Budget estimate for the entire
fiscal, primarily on account of higher realization from the auction of spectrum. Banking on healthy
growth in direct taxes collections, the finance minister raised the revenue collection target for financial
year by 20, 000 crore to 4.5 lakh crore.
• According to the data provided by the Commerce Ministry, the country's goods exports have shot up by
36.3% in December'10 to $22.50 billion, the highest in 33 months. Imports, on the contrary, fell by 10.9%
to $25.13 billion, the lowest in the last 14 months. This resulted in trade deficit narrowing to $2.63
billion, the lowest in the last three years. The reasons for the good show by exporters were market
diversification, better demand even in traditional destinations such as the US and Europe, competitive
pricing of items with help from Government incentives as well as better marketing. Oil imports in
December fell 16% to $6.93 billion where as non-oil imports, including capital goods were up 9% to $18.2
billion. The Third Quarter Review of Monetary Policy 2010-11 expressed concern over the widening
current account deficit
(CAD) which is expected to
be almost 3.5% of GDP.
P e r s i s t e n t r i s e i n
commodity prices may pose
further risk for both the
CAD and inflation. The
combined r i sks f rom
inflation, the CAD and
fiscal situation could
contribute to an increase in
u n c e r t a i n t y a b o u t
economic stability.
• Output of six key infrastructure sectors expanded 6.6% in December'10, higher than an upwardly revised
growth of 3% in November, igniting expectations of a better factory output. The better performance in
infrastructure was driven by the robust crude oil (15.8%) and petroleum refinery sectors (8.3%). Finished
steel output rose more than 11%, but cement production contracted 2.2%, indicating a slack in
construction activity.
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Trend in Export and Import during 2010-11 (Amt. in USD Million)
Month ExportGrowth
(%)Import
Growth(%)
TradeBalance
2009-10 178665 286985 -108320
Apr-10 17278 38.5 28022 45.0 -10744
May-10 16023 30.1 26553 32.5 -10530
Jun-10 19452 43.0 25831 12.2 -6379
Jul-10 16013 11.7 26510 22.0 -10497
Aug-10 16644 22.5 29679 32.3 -13035
Sep-10 18023 23.2 27141 26.4 -9118
Oct-10 17960 21.3 27689 9.1 -9729
Nov-10 18895 26.5 27796 12.1 -8901
Dec-10 22500 36.3 25130 -10.9 -2630
2010-11 162788 244351 -81563
• Direct tax collections in the first nine months (April-December) of the current financial year increased
19.47% to touch 2.99 lakh crore (69.53% of the Budgeted target), compared with 2.50 lakh crore in the
corresponding period of 2009-10. During the period under consideration, collections from corporation
tax jumped 22.07%, where as collections of personal income-tax, including securities transaction tax
(STT), residual fringe benefit tax and banking cash transaction tax increased by 10.96%. The mop-up from
STT increased 11.97% to 5,117 crore
from 4,570 crore last year. The
government's direct tax collection
figures are now expected to go up by
an additional 20,000 crore from the
budget target of 4.3 lakh crore on
the back of rising corporate income
and improved tax compliance by
salaried individuals.
• The Centre has, during April-December, achieved three-fourths of the indirect taxes collection target for
2010-11. Overall, indirect tax collections grew 42.8% during April-December'10, at 2.37 lakh crore ( 1.66
lakh crore). Net indirect tax collections in December'10, grew 45.9% to 29,437 crore ( 20,175 crore),
higher than the collection of 27,495 crore in previous month. While customs duty collections grew
75.7%, excise duty collection for the same month grew 29.5%. Service tax collections grew 27% in
December'10, to 5,154 crore ( 4,057 crore). Boosted by higher revenue mop-up, the government has
upped indirect tax collection estimates by 7% for this fiscal, from the Budget target of 3.15 lakh crore.
Source: RBI Annual Report, Bulletin, Weekly Statistics, SEBI & CCILNotes:Yearly figures are as in March-end* : Base: 1980-81=100*** : Base : 1981-82=100**: Figure as at March-end****: Figures are cumulative for the yearQ.E : Quick EstimateR.E : Revised EstimateA.E : Advance EstimateB.E.: Budget Estimate#Turnover Ratio=(Central Government Securities Volumes for 12 months/Market Capitialisationduring the month)*100
Percentage figures in brackets denote y-o-y growth^ Turnover Ratio as on January 31, 2011(1) At 1993-94 pricesμ: Base year 2001$ :
.+: Grand Total¥: Excluding acquisition cost of RBI stake in SBI ( 35,531 crores)
`GDP for Jul-Sep 2010 (Q2 2010-11). GDP for Jul-Sep 2009 (Q2 2009-10): 1,108,537 Crore -(8.7%)
: GDP data till 2008-09 are calculated taking 1999-00 prices as the base.¤: Base Rate relates to five major banks since July 1, 2010. Earlier figures relate to Benchmark PrimeLending Rate (BPLR).ø: Inflation data till 2009-10 are calculated taking 1993-94 as base
*Turnover Ratio has been calculated as 12 months cumulative trading value as a percentage of market capitalization of respective security. Note: Prices used for calculating MarketCapitalization are Weighted Average prices as on January 31, 2011. In case of non availability Weighted Average prices, CCIL Model prices as on are used.January 31, 2011
January 31, 2011 December 31, 2010 January 29, 2010
3.90
4.40
4.90
5.40
5.90
6.40
6.90
7.40
7.90
8.40
0.5 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Tenor
(%)
January 31, 2011 December 31, 2010 January 29, 2010
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CHART 27: TEN YEAR YIELD MOVEMENT
TABLE : YIELD MOVEMENT TEN YEAR BENCHMARK - % G.S. 2066 OF 7.80 20
Date WAY
3-Jan-11 7.9501
4-Jan-11 8.0550
5-Jan-11 8.0476
6-Jan-11 8.0897
7-Jan-11 8.1851
10-Jan-11 8.2337
11-Jan-11 8.1970
12-Jan-11 8.1911
13-Jan-11 8.1365
14-Jan-11 8.1747
17-Jan-11 8.2365
18-Jan-11 8.1950
19-Jan-11 8.1591
20-Jan-11 8.1485
21-Jan-11 8.1526
24-Jan-11 8.1987
25-Jan-11 8.1648
27-Jan-11 8.1220
28-Jan-11 8.1237
31-Jan-11 8.1452
7.30
7.50
7.70
7.90
8.10
8.30
Feb/1
0
Mar/
10
Apr/
10
May/1
0
Jun/1
0
Jul/1
0
Aug/1
0
Sep/1
0
Oct/10
Nov/1
0
Dec/1
0
Jan/1
1
(%)
10-year Yield
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CHART 28: YIELD MOVEMENT
TABLE 67: SPREAD ON STATE GOVERNMENT SECURITIES (SDLs)
Note: Spread has been calculated on the basis of deals settled through CCIL taking into account only outright deals of 5 Crore andabove. The methodology and other information on the spread can be requested from Economic Research Department, CCIL
`
State TradesTraded Volume
(` Crore)Average Spread (bps)
ANDHRA PRADESH 47 3501.60 30.59
BIHAR 22 4740.40 31.87
GOA 1 188.60 35.08
GUJARAT 47 4401.60 33.50
HARYANA 4 1600.00 32.60
JAMMU AND KASHMIR 5 592.30 30.86
JHARKHAND 1 100.00 36.28
KERALA 6 273.40 29.16
MADHYA PRADESH 7 1152.20 33.32
MAHARASTRA 101 6625.80 31.78
MANIPUR 3 507.50 31.48
PUNJAB 2 100.00 28.70
RAJASTHAN 10 407.10 28.13
TAMIL NADU 17 978.10 33.15
UTTAR PRADESH 30 3941.30 29.43
UTTARAKHAND 2 147.90 28.23
WEST BENGAL 29 2743.70 29.09
Total 334 32001.50 31.43
0.0000
0.0500
0.1000
0.1500
0.2000
0.2500
0.5 5 10 15 20 25 30
Years to Maturity
Ch
ange
inyi
eld
(bp
s)
Change (bps)
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Note: Weighted Average yield of most liquid security for each tenor is considered.
TABLE 68: YIELD SPREADS
YTM Change in YTM(bps) Spread over 1 year(bps)Change in