"In an environment where banks are undertaking non-bank activities and development financial institutions (DFIs) are planning to undertake banking functions, a more homogeneous set of players is expected to emerge in the call money market. This is expected to facilitate introduction of longer and variable term-repos. A well developed repos-market is also essential to make the call money market purely inter-bank", the RBI said in its Report on Currency and Finance (1999-2000).

Recent reforms in the Money market included permission for the entry of additional participants in the inter-bank call money market, and steps to develop a term-money market with exemption on inter-bank liabilities from the cash reserve ratio (CRR) and statutory liquidity ratio (SLR) stipulations and introduction of new instruments. The RBI also started repos, both on an auction and fixed-interest rate basis for liquidity management. Since June 5, 2000, the newly introduced liquidity adjustment facility (LAF) has been effectively used to influence short-term rates by modulating day-to-day liquidity conditions. The transition to LAF was facilitated by the experiment with the interim liquidity adjustment facility (LFAF) from April'1999 that provided a mechanism for liquidity management through a combination of repos, export credit refinance and collaterised lending facilities.

"The linkage between the call market and the forex market is found to be more pronounced during episodes of volatile exchange market conditions. This clearly is discernible in the second half of the nineties. It would be, however, necessary to note at this juncture that while the hike in call rates during volatile forex market conditions partly resulted from the introduction of monetary measures to tighten the liquidity conditions in the face of disorderly developments in the market, to some extent it also reflected the short-positions taken by market agents in domestic currency against long positions in the dollars in anticipation of higher profits through depreciation of the rupee", RBI said.

The Report added that volatility in the call money market reflects the significant adjustment that occurs in the money market in response to liquidity changes and gaps in the foreign exchange market. Excess demand conditions in the foreign exchange market and the attendant depreciation of the domestic currency affect bank liquidity.

"Unsure of the extent of depreciation, exporters often delay repatriation of proceeds, while importers rush for cover. So long as money markets rate are lower than the rates implied by the forward premia, arbitage opportunities exist between the money and foreign exchange markets", RBI explained.

Banks could fund foreign currency positions by withdrawing from the inter-bank call money market and liquidating excess investments in government securities markets. On the other hand, banks without a retail base, which fund their assets largely through the inter-bank call money market are especially squeezed as they face higher borrowing costs along with a sharp increase in the demand for foreign currency.

During prolonged volatile conditions, banks begin to liquidate investments in commercial paper (CPs), typically issued at sub-PLR levels. As credit is often a first change for retail banks, the need for mobilisation of funds, initially through high-cost certificates of deposit (CDs) and thereafter through high cost retail deposits, contributes to upward pressures on interest rates, initially at the short end and thereafter across the spectrum", noted RBI.