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What are Money Market Instruments?

By convention, the term "Money Market" refers to the market for short-term requirement and deployment of funds. Money market instruments are those instruments, which have a maturity period of less than one year.The most active part of the money market is the market for overnight call and term money between banks and institutions and repo transactions. Call Money / Repo are very shortterm Money Market products. The below mentioned instruments are normally termed as money market instruments: The slice of the financial market where instruments with high liquidity and very short maturities are traded is called money market. This is a generic definition. Who uses money market? The players who indulge in short term from several days to less than a year. It is mainly used for borrowing and lending over this short term. Due to the highly liquid nature of the securities and short maturities, money market is perceived as a safe place to lock in money. The participants in the financial market perceive a thin line, differentiating between the capital market and the money market. In money market, there is borrowing and lending for periods of a year or less. Capital market refers to stock markets where the common stocks are traded, and bond markets where bonds are issued and traded. This is in sharp contrast to money markets which provide short term debt financing and investment. Money market instruments are characterised by high degree of safety of the principal. Treasury bills are highly liquid short-term instruments that yield attractive returns. Short term borrowing instruments of the Central Government, it is a promise to pay a said sum after expiry of a specified period. It is a zero-risk instrument available in both primary and secondary markets. Commercial paper is a short-term unsecured promissory note issued by corporates and financial institutions. Issued at discount to the face value, they yield attractive returns. The Government of India securities are sovereign coupon bearing instruments that are issued by the Government of India. They are available both for short-term and long tenures. Certificate of deposit is short-term borrowings that are more like bank term deposit accounts. They are transferable by endorsement and are to be stamped. Investors


can also consider money market funds. These invest in government securities, certificates of deposits, commercial paper of companies, and other highly liquid and low-risk securities. These funds are required by law to invest in low risk securities. Investors with low risk appetite can opt for money market funds. Money market instrument meets the short-term requirements of borrowers and provides liquidity to lenders. Short-term surplus funds at the disposal of institutions and individuals are bid by borrowers, who could be in the same category. Debt instrument which have a maturity of less than one year at the time of issue are called money market instruments. These instruments are highly liquid and have negligible risk. The major money market instruments are Treasury bills, certificates of deposit, commercial paper, and repos. The money market is dominated by the government, financial institutions, banks, and corporate. Individual investors scarcely participate in the money market directly. A brief description of money market instruments is given below.

1) Certificate of Deposit (CD) 2) Commercial Paper (C.P) 3) Inter Bank Participation Certificates 4) Inter Bank term Money 5) Treasury Bills 6) Bill Rediscounting 7) Call/ Notice/ Term Money



What Constitutes the Money Market in India?
Money market refers to the market for short term assets that are close substitutes of money, usually with maturities of less than a year. A well functioning money market provides a relatively safe and steady income-yielding avenue, for short term investment of funds both for banks and corporates and allows the investor institutions to optimize the yield on temporary surplus funds. The RBI is a regular player in the money market and intervenes to regulate the liquidity and interest rates in the conduct of monetary policy to achieve the broad objective of price stability, efficient allocation of credit and a stable foreign exchange market. As per definition given by RBI the money market is "the centre for dealings, mainly shortterm character, in money assets. It meets the short-term requirements of borrower and provides liquidity or cash to the lenders. It is the place where short-term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising Institutions, individuals and also the Government itself" The main segments of the money market are the call/notice money, term money, commercial bills, treasury bills, commercial paper and certificate deposits. Mr.G. Crowther in his treatise "An Outline of Money defines money market as "the collective name given to the various firms and institutions that deal in the various grades of near-money". The money market is as concrete as any other market and one could see it in operation in London's Lambard Street or New York's Wall Street. Typical of any other commodity market, there is very close relationship between different segments of the money market, (like bankers' Call Money market, commercial paper, treasury bills) that the one is affected by the other. In other words different segments of the money-market are broadly integrated.

Call /Notice-Money Market
The most active segment of the money market has been the call money market, where the day to day imbalances in the funds position of scheduled commercial banks are eased out. The call notice money market has graduated into a broad and vibrant institution . Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is "Call Money". When money is borrowed or lent



for more than a day and up to 14 days, it is "Notice Money". No collateral security is required to cover these transactions. The entry into this field is restricted by RBI. Commercial Banks, Co-operative Banks and Primary Dealers are allowed to borrow and lend in this market. Specified All-India Financial Institutions, Mutual Funds, and certain specified entities are allowed to access to Call/Notice money market only as lenders. Reserve Bank of India has recently taken steps to make the call/notice money market completely inter-bank market. Hence the non-bank entities will not be allowed access to this market beyond December 31, 2000. From May 1, 1989, the interest rates in the call and the notice money market are market determined. Interest rates in this market are highly sensitive to the demand - supply factors. Within one fortnight, rates are known to have moved from a low of 1 - 2 per cent to dizzy heights of over 140 per cent per annum. Large intra-day variations are also not uncommon. Hence there is a high degree of interest rate risk for participants. In view of the short tenure of such transactions, both the borrowers and the lenders are required to have current accounts with the Reserve Bank of India. This will facilitate quick and timely debit and credit operations. The call market enables the banks and institutions to even out their day to day deficits and surpluses of money. Banks especially access the call market to borrow/lend money for adjusting their cash reserve requirements (CRR). The lenders having steady inflow of funds (e.g. LIC, UTI) look at the call market as an outlet for deploying funds on short term basis.

Inter-Bank Term Money
Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days. The market in this segment is presently not very deep. The declining spread in lending operations, the volatility in the call money market with accompanying risks in running asset/liability mismatches, the growing desire for fixed interest rate borrowing by corporates, the move towards fuller integration between forex and money markets, etc. are all the driving forces for the development of the term money market. These, coupled with the proposals for rationalisation of reserve requirements and stringent guidelines by regulators/managements of institutions, in the asset/liability and interest rate risk management, should stimulate the evolution



of term money market sooner than later. The DFHI (Discount & Finance House of India), as a major player in the market, is putting in all efforts to activate this market. Treasury Bills. The Treasury bills are short-term money market instrument that mature in a year or less than that. The purchase price is less than the face value. At maturity the government pays the Treasury Bill holder the full face value. The Treasury Bills are marketable, affordable and risk free. The security attached to the treasury bills comes at the cost of very low returns. Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction. Types Treasury bills (T-bills) offer short-term investment opportunities, generally up to one year. They are thus useful in managing short-term liquidity. At present, the Government of India issues three types of treasury bills through auctions, namely, 91-day, 182-day and 364-day. There are no treasury bills issued by State Governments. Amount Treasury bills are available for a minimum amount of Rs.25,000 and in multiples of Rs. 25,000. Treasury bills are issued at a discount and are redeemed at par. Treasury bills are also issued under the Market Stabilization Scheme (MSS). Auctions While 91-day T-bills are auctioned every week on Wednesdays, 182-day and 364day T-bills are auctioned every alternate week on Wednesdays. The Reserve Bank of India issues a quarterly calendar of T-bill auctions which is available at the Banks’ website. It also announces the exact dates of auction, the amount to be auctioned and payment dates by issuing press releases prior to every auction.



Type of T-bills 91-day 182-day

Day of Auction Wednesday Wednesday of non-reporting week

Day of Payment* Following Friday Following Friday

364-day Wednesday of reporting week Following Friday * If the day of payment falls on a holiday, the payment is made on the day after the holiday.

The salient features of the auction system of T-Bills are :
• • • • •

The 14/91/182/364-days bills are issued for a minimum value of Rs.25,000 and multiples thereof. They are issued at a discount to face value. Any person in India including individuals, firms, companies, corporate bodies, trusts and institutions can purchase the bills. The bills are eligible securities for SLR purposes. All bids above a cut-off price are accepted and bidders are permitted to place multiple bids quoting different prices at each auction. Till November 6, 1998, all types of T-Bills auctions were conducted by means of 'Multiple Price Auction'. However, since November 6, 1998, auction of 91-days TBills are being conducted by means of 'Uniform Price Auction'. In the case of 'Multiple Price Auction' method successful bidders pay their own bid prices, whereas under 'Uniform Price Auction' method, all successful bidders pay an uniform price, i.e. the cut-off price emerged in the auction. The bills are generally issued in the form of SGL - entries in the books of Reserve Bank of India. The SGL holdings can be transferred by issuing a SGL transfer form. For non-SGL account holders, RBI has been issuing the bills in scrip form.



French Auction or Multiple Price Auction System After receiving written bids at various levels of yield expectations, a particular yield is decided as the cut-off rate of the security in question. Auction participants (bidders) who bid at yield levels lower than the yield determined as cut-off get full allotment although at a premium. The premium is equal to the yield differential expressed in rupee terms. The yield differential is the difference between the cutoff yield and the yield at which the bid is made. All bids made at yield levels higher than that determined as cut-off yield get entirely rejected. Dutch Auction or Uniform Price Auction System This system of auction is exactly identical to that of the French Auction System as far as the price discovery mechanism part is concerned. The difference is observed only at the stage of payment obligation. After determination of the market related cut-off rate, allotment is made to all the bidders at a uniform price. The concept of premium on account of yield differential does not exist here.

Other Instruments
New money market instruments like Certificates of Deposits (CDs) and Commercial Paper (CPs) were introduced in 1989-90 to give greater flexibility to investors in the deployment of their short-term surplus funds

Certificates of Deposit
Certificates of Deposit (CDs) - introduced since June 1989 - are negotiable term deposit certificates issued by a commercial banks/Financial Institutions at discount to face value at market rates, with maturity ranging from 15 days to one year. Certificate of Deposit: The certificates of deposit are basically time deposits that are issued by the commercial banks with maturity periods ranging from 3 months to five years. The return on the certificate of deposit is higher than the Treasury Bills because it assumes a higher level of risk. Advantages of Certificate of Deposit as a money market instrument 1. Since one can know the returns from before, the certificates of deposits are considered much safe. 2. One can earn more as compared to depositing money in savings account.


3. The Federal Insurance Corporation guarantees the investments in the certificate of deposit. Disadvantages of Certificate of deposit as a money market instrument: 1. As compared to other investments the returns is less. 2. The money is tied along with the long maturity period of the Certificate of Deposit. Huge penalties are paid if one gets out of it before maturity.

Being securities in the form of promissory notes, transfer of title is easy, by endorsement and delivery. Further, they are governed by the Negotiable Instruments Act. As these certificates are the liabilities of commercial banks/financial institutions, they make sound investments. DFHI trades in these instruments in the secondary market. The market for these instruments, is not very deep, but quite often CDs are available in the secondary market. DFHI is always willing to buy these instruments thereby lending liquidity to the market. Salient features :
• • • • • • •

CDs can be issued to individuals, corporations, companies, trusts, funds, associates, etc. NRIs can subscribe to CDs on non-repatriable basis. CDs attract stamp duty as applicable to negotiable instruments. Banks have to maintain SLR and CRR on the issue price of CDs. No ceiling on the amount to be issued. The minimum issue size of CDs is Rs.5 lakhs and multiples thereof. CDs are transferable by endorsement and delivery. The minimum lock-in-period for CDs is 15 days.

CDs are issued by Banks, when the deposit growth is sluggish and credit demand is high and a tightening trend in call rate is evident. CDs are generally considered high cost liabilities and banks have recourse to them only under tight liquidity conditions. CPs enable highly rated corporate borrowers to diversify their sources of shortterm borrowings and raise a part of their requirement at competitive rates from the market. The introduction of Commercial Paper (CP) in January 1990 as an


additional money market instrument was the first step towards securitisation of commercial bank's advances into marketable instruments.

Commercial Papers are unsecured debts of corporates. They are issued in the form of promissory notes, redeemable at par to the holder at maturity. Only corporates who get an investment grade rating can issue CPs, as per RBI rules. Though CPs are issued by corporates, they could be good investments, if proper caution is exercised. The market is generally segmented into the PSU CPs, i.e. those issued by public sector unit and the private sector CPs. CPs issued by top rated corporates are considered as sound investments. DFHI trades in these certificates. It will buy these certificates, subject to its perception of the instrument and will also be offering them for sale subject to availability of stock. Commercial Papers - Salient Features
• • • •

• • • • • •

CPs are issued by companies in the form of usance promissory note, redeemable at par to the holder on maturity. The tangible net worth of the issuing company should be not less than Rs.4 crores. Working capital (fund based) limit of the company should not be less than Rs.4 crores. Credit rating should be at least equivalent of P2/A2/PP2/Ind.D.2 or higher from any approved rating agencies and should be more than 2 months old on the date of issue of CP. Corporates are allowed to issue CP up to 100% of their fund based working capital limits. It is issued at a discount to face value. CP attracts stamp duty. CP can be issued for maturities between 15 days and less than one year from the date of issue. CP may be issued in the multiples of Rs.5 lakh. No prior approval of RBI is needed to issue CP and underwriting the issue is not mandatory.



All expenses (such as dealers' fees, rating agency fee and charges for provision of stand-by facilities) for issue of CP are to be borne by the issuing company,

The purpose of introduction of CP was to release the pressure on bank funds for small and medium sized borrowers and at the same time allowing highly rated companies to borrow directly from the market. As in the case of CDs, the secondary market in CP has not developed to a large extent.

Commercial Bills
Commercial Paper is short-term loan that is issued by a corporation use for financing accounts receivable and inventories. Commercial Papers have higher denominations as compared to the Treasury Bills and the Certificate of Deposit. The maturity period of Commercial Papers are a maximum of 9 months. They are very safe since the financial situation of the corporation can be anticipated over a few months. The concept of raising money through commercial paper was know to the US markets since 20th century. On our country though it was introduced in 1990, the RBI constantly watching the growth of the CP market and it is modifying the guidelines from time to time. For further development of CP market, the stamp duty on CP should be abolished since there is no stamp duty in US, UK and France and RBI has to relax the stringent Credit Rating norms from the present Credit rating P2 of CRISIL to P3, since credit rating is not compulsory in many countries like US, UK and France.The denominations of CP should be reduced further for the growth of secondary market for CP.



Commercial Paper policy changes: Jan 1990 July July July June July Sep. Feb. Oct. Oct. 1990 1991 1992 1994 1995 1996 1997 2000 2004 Tangible Net 10 Crore 5 4 Crore Worth Crore WCFBL* 25 Crore 15 10 5 4 Crore Crore Crore Crore Minimum Size 1 Crore 50 25 5 Lakh Lakh Lakh Maximum Size 20% of 30% 75% 75% of 100% of 100% of Should MPBF** of of Cash Cash WCFBL not MPBF MPBF Credit Credit exceed Compone Compone WCFBL nt nt Denominations 25 Lakh 10 5 Lakh 5 Lakh Lakh Maturity 91days - 3 15 days 7days Period 6 months months – 1 year - One – 1year Yr. Credit Rating P1+ by CRISIL P2 or Equal grade by other agencies Other Measures

Bills of exchange are negotiable instruments drawn by the seller (drawer) on the buyer (drawee) for the value of the goods delivered to him. Such bills are called trade bills. When trade bills are accepted by commercial banks, they are called commercial bills. If the seller wishes to give some period for payment, the bill would be payable at a future date (usance bill). During the currency of the bill, if


the seller is in need of funds, he may approach his bank for discounting the bill. One of the methods of providing credit to customers by bank is by discounting commercial bills at a prescribed discount rate. The bank will receive the maturity proceeds (face value) of discounted bill from the drawee. In the meanwhile, if the bank is in need of funds, it can rediscount the bill already discounted by it in the commercial bill rediscount market at the market related rediscount rate. (The RBI introduced the Bill Market Scheme in 1952 and a new scheme called the Bill Rediscounting Scheme in November 1970). With a view to eliminating movement of papers and facilitating multiple rediscounting, the RBI introduced an innovative instrument known as "Derivative Usance Promissory Notes" backed by such eligible commercial bills for required amounts and usance period (up to 90 days). Government has exempted stamp duty on derivative usance promissory notes. This has indeed simplified and streamlined the bill rediscounting by Institutions and made commercial bill an active instrument in the secondary money market. Rediscounting institutions have also advantages in that the derivative usance promissory note, being a negotiable instrument issued by a bank, is good security for investment. It is transferable by endorsement and delivery and hence is liquid. Thanks to the existence of a secondary market the rediscounting institution can further discount the bills anytime it wishes prior to the date of maturity. In the bill rediscounting market, it is possible to acquire bills having balance maturity period of different days upto 90 days. Bills thus provide a smooth glide from call/overnight lending to short term lending with security, liquidity and competitive return on investment. As some banks were using the facility of rediscounting commercial bills and derivative usance promissory notes for as short a period as one day merely a substitute for call money, RBI has since restricted such rediscounting for a minimum period of 15 days. The eligibility criteria prescribed by the Reserve Bank of India for rediscounting commercial bill inter-alia are that the bill should arise out of genuine commercial transaction evidencing sale of goods and the maturity date of the bill should not be more than 90 days from the date of rediscounting. RBI has widened the entry regulation for Bill Market by selectively allowing, besides banks and PDs, Co-op Banks, mutual funds and financial institutions. DFHI trades in these instruments by rediscounting Derivative Usance Promissory Notes (DPNs) drawn by commercial banks. DPNs which are sold to investors may also be purchased by DFHI.



Derivative Usance Promissory Notes"(DUPN)
IT is an innovative instrument issued by the RBI to eliminate movement of papers and facilitating easy rediscounting. DUPN is backed by up to 90 days Usance commercial bills. Government has exempted stamp duty on DUPN to simplify and steam-line the instrument and to make it an active instrument in the secondary market. The minimum rediscounting period is 15 days Bill Rediscounting The RBI introduced the Bills Market Scheme (BMS) in 1952 which was later modified into the New Bills Market Scheme (NBMS). Under this scheme commercial banks can rediscount the bills which were originally discounted by them with approved institutions (viz., Commercial Banks, Dvelopment Financial Institutions, Mutual Funds, Primary Dealers etc.) Multiple Rediscounting The individual bills can be substituted by Derivative Usance Promissory Notes (DUPN) of the equal aggregate amount and maturity which are drawn by the issuing bank to eliminate movement of papers and to facilitate multiple rediscounting. DUPNs are exempt from stamp duty and are negotiable instruments

Ready Forward Contracts (REPOS)
Ready forward or Repos or Buyback deal is a transaction in which two parties agree to sell and repurchase the same security. Under such an arrangement, the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a prefixed price. For the purchaser of the security, it becomes a Reverse Repo deal. In simple terms, it is recognised as a buy back arrangement. In a standard ready forward transaction when a bank sells its securities to a buyer it simultaneously enters into a contract with him (the buyer) to repurchase them on a predetermined date and price in the future. Both sale and repurchase prices of securities are determined prior to entering into the deal. In return for the securities,


the bank receives cash from the buyer of the securities. It is a combination of securities trading (involving a purchase and sale transaction) and money market operation (lending and borrowing). The repo-rate represents the borrowing/lending rate for use of the money in the intervening period. As the inflow of cash from the ready forward transaction is used to meet temporary cash requirement, such a transaction in essence is a short term cash management technique. The motivation for the banks and other organizations to enter into a ready forward transaction is that it can finance the purchase of securities or otherwise fund its requirements at relatively competitive rates. On account of this reason the ready forward transaction is purely a money lending operation. Under ready forward deal the seller of the security is the borrower and the buyer is the lender of funds. Such a transaction offers benefits both to the seller and the buyer. Seller gets the funds at a specified interest rate and thus hedges himself against volatile rates without parting with his security permanently (thereby avoiding any distressed sale) and the buyer gets the security to meet his SLR requirements. In addition to pure funding reasons, the ready forward transactions are often also resorted to manage short term SLR mismatches. Internationally, Repos are versatile instruments and used extensively in money market operations. While inter-bank Repos were being allowed prior to 1992 subject to certain regulations, there were large scale violation of laid down guidelines leading to the 'securities scam' in 1992; this led Government and RBI to clamp down severe restrictions on the usage of this facility by the different market participants. With the plugging of loophole in the operation, the conditions have been relaxed gradually. RBI has prescribed that following factors have to be considered while performing repo: 1. purchase and sale price should be in alignment with the ongoing market rates 2. no sale of securities should be effected unless the securities are actually held by the seller in his own investment portfolio. 3. Immediately on sale, the corresponding amount should be reduced from the investment account of the seller. 4. The securities under repo should be marked to market on the balance sheet date.



The relaxations over the years made by RBI with regard to repo transactions are: i. ii. iii. iv. In addition to Treasury Bills, all central and State Government securities are eligible for repo. Besides banks, PDs are allowed to undertake both repo/reverse repo transactions. RBI has further widened the scope of participation in the repo market to all the entities having SGL and Current with RBI, Mumbai, thus increasing the number of eligible non-bank participants to 64. It was indicated in the 'Mid-Term Review' of October 1998 that in line with the suggestion of the Narasimham Committe II, the Reserve Bank will move towards a pure inter-bank (including PDs) call/notice money market. In view of this non-bank entities will be allowed to borrow and lend only through Repo and Reverse Repo. Hence permission of such entities to participate in call/notice money market will be withdrawn from December 2000. In terms of instruments, repos have also been permitted in PSU bonds and private corporate debt securities provided they are held in dematerialised from in a depository and the transactions are done in a recognised stock exchange.


Apart from inter-bank repos RBI has been using this instrument effectively for its liquidity management, both for absorbing liquidity and also for injecting funds into the system. Thus, Repos and Reverse Repo are resorted to by the RBI as a tool of liquidity control in the system. With a view to absorbing surplus liquidity from the system in a flexible way and to prevent interest rate arbitraging, RBI introduced a system of daily fixed rate repos from November 29, 1997. Reserve Bank of India was earlier providing liquidity support to PDs through the reverse repo route. This procedure was also subsequently dispensed with and Reserve Bank of India began giving liquidity support to PDs through their holdings in SGL A/C. The liquidity support is presently given to the Primary Dealers for a fixed quantum and at the Bank Rate based on their bidding commitment and also on their past performance. For any additional liquidity requirements Primary Dealers are allowed to participate in the reverse repo auction under the Liquidity Adjustment Facility along with Banks, introduced by RBI in June 2000.



The major players in the repo and reverse repurchase market tend to be banks who have substantially huge portfolios of government securities. Besides these players, primary dealers who often hold large inventories of tradable government securities are also active players in the repo and reverse repo market.

Banker's Acceptance:
It is a short-term credit investment. It is guaranteed by a bank to make payments. The Banker's Acceptance is traded in the Secondary market. The banker's acceptance is mostly used to finance exports, imports and other transactions in goods. The banker's acceptance need not be held till the maturity date but the holder has the option to sell it off in the secondary market whenever he finds it suitable.

TREASURY BILLS AND INFLATION CONTROL Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the RBI Treasury. These securities were first issued in 1997. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 7-year, 10-year and 20-year maturities. 30-year TIPS are no longer offered. In addition to their value for a borrower who desires protection against inflation, TIPS can also be a useful information source for policy makers: the interest-rate differential between TIPS and conventional Treasury bonds is what borrowers are willing to give up in order to avoid inflation risk. Therefore, changes in this differential are usually taken to indicate that market expectations about inflation over the term of the bonds have changed. The interest payments from these securities are taxed for federal income tax purposes in the year payments are received (payments are semi-annual, or every six months). The inflation


adjustment credited to the bonds is also taxable each year. This tax treatment means that even though these bonds are intended to protect the holder from inflation, the cash flows by the bonds are actually inversely related to inflation until the bond matures. For example, during a period of no inflation, the cash flows will be exactly the same as for a normal bond, and the holder will receive the coupon payment minus the taxes on the coupon payment. During a period of high inflation, the holder will receive the same equivalent cash flow (in purchasing power terms), and will then have to pay additional taxes on the inflation adjusted principal. The details of this tax treatment can have unexpected repercussions. By comparing a TIPS bond with a standard nominal Treasury bond across the same maturity dates, investors may calculate the bond market's expected inflation rate by applying Fisher's equation.

Sometimes appropriate market structures have developed only after central banks and governments have taken the lead. For example, Reserve bank of India realized quite early in its existence that a well functioning money market-dealing in treasury bills, commercial paper, overnight funds, and the like-would assist the implementation of monetary policy as well as the overall efficiency of the economy. But although the banking system as such had been well developed for many decades, an active money market emerged only after a series of RBI From the viewpoint of monetary control, and therefore inflation control, the development of the Canadian money market had two particularly desirable features. In the first place, the money market's developmentprovided an avenue for increased reliance on price-related methods of monetary management-broadly speaking, open market operations. And in this process, reliance on jawboning and on bank liquidity ratios to influence commercial banks' extension of credit became less and less-to the point that these features now have no role in India Secondly, the broadening of outlets for the placement of government debt-to include the money market as well as the bond market-helped to provide a first line of assurance that government deficit financing would not impinge upon monetary control. In general, in the absence of broad and resilient financial markets through which to absorb financing demands, the central bank would find it very difficult to deflect direct pressure from government Monetary Policy and the Control of Inflation deficits on its balance sheet and therefore on inflation of the monetary base.



To deflect the pressure by, for example, imposing higher bankreserve requirements in cash, or in government securities, is not an adequate solution. At the very least it causes problems for the efficiency and competitiveness of the deposit-taking part of the financial system. A better solution would be for the government to pay an interest rate sufficiently high that it attracts willing lenders, and without pumping up the money supply. In general, if credit of various kinds really has to be subsidized or channelled preferentially, the subsidy should be out in the open and not financed through what is in effect a tax (and therefore fiscal, not monetary, policy) on the intermediation of savings through the banking system. A related issue with implications for controlling inflation is the importance of developing at an early stage a workable system of prudential oversight for financial institutions, including determining which institutions will have access to the lender-of-lastresort facility for liquidity purposes. This, too, is a separate topic of discussion in a later session. Its importance for inflation control is to remove a potential constraint on the conduct of monetary policy. The presence of distressed institutions may inhibit monetary discipline, for fear of precipitating a crisis in the financial system or of disrupting the flow of investment finance to the non-financial sector,