This paper seeks to address two questions In Indian context. First, what is the nature of integration among different segments of Indian financial markets? Second, what has been the influence of monetary policy on different segments of financial markets? As far as domestic financial integration is concerned, the study finds that the money market segment is fairly integrated. At the next level, among the constituents of the domestic financial markets, G-sec and corporate bond market are somewhat integrated. There is, however, limited evidence of integration between the money market and stock market. Using daily data over January 2005 November 2012, the paper constructs a structural Vector autoregression (SVAR) model and studies the financial markets microstructure and monetary policy transmission in India related to four key segments, viz., money, bonds (G-Sec and corporate debt), forex and stock market. While the transmission of monetary policy to money market is found to be fast and efficient and the effects on bond and forex market are on expected lines, the impact of monetary policy to stock market is limited. The nature of monetary policy transmission, however, tends to vary, depending on the extent of liquidity (i.e., whether there is surplus or deficit liquidity).
JEL Classification: C32, E52, F41
Keywords: Monetary Policy, Structural Vector autoregression, impulse responses
Introduction
The process of financial development in any emerging economy would invlove the intimately interlinked developments of both financial institutions as well as financial markets. It is well-known that transmission of monetary policy, to begin with, takes place via financial markets. Financial market developments and extent of market integration across various segments of domestic financial markets play a key role in this context. The more integrated financial markets are, in all likelihood the more would be the strength of monetary transmission across financial markets.
Empirically, however, the locomotion from microstructure to macro behaviour is essentially couched in terms of some aggregation. Two issues are important here.First, the level of aggregation could dictate the nature of market. Illustratively, when the market for fruits is formed by aggregating apples and oranges, there is indeed some loss of information but the investigator still goes for it to discern broader trends. Thus, tension of inferring about the woods without missing the trees is inherent in any investigation on market integration. Second, there is yet another issue that is important in this regard, viz., presence of regulation. Illustratively, even if the quality of rice could be reasonably homogenous across all India, in presence of government regulation restricting movement of rice across states, market for rice will be segmented across India. Thus, in terms of first principles, level of aggregation and extent of regulation may determine the degree of market integration.4
While both these issues are important for financial markets, one would expect the flow of information (as well as the products) would be much smooth in financial markets than their real counterparts. After all, most of the financial products are virtual and geographical distance and transport cost will have little relevance for financial markets. Thus, the law of one price (in the form of equality of risk adjusted returns) has a higher probability of getting validated for financial markets. Nevertheless, financial transactions are highly leveraged – hence the possibility of regulation leading to market segmentation will be accordingly high in financial markets.
At this stage one may segregate between two levels of integration (a) among different segments of domestic financial markets, and (b) among a specific segment of domestic financial market and its global / foreign counterpart. Both these types of integration are on the rise with the increasing trends in globalization. It has been rightly observed:
The progressive globalisation of financial institutions and services over the last two decades has led to a complex web of interconnected markets, institutions, services and products. Institutions transcended borders; markets became accessible in real time and financial services were available from everywhere. In short, financial markets and institutions declared ˜death of distance™ and ˜conquest of location™ (Subbarao, 2009).
How integrated are the segments of Indian financial markets? What is the relationship of financial markets with monetary policy actions? What has been the inter-temporal behaviour of financial market integration? The present paper seeks to answer some of these questions in Indian specifics in recent period. In particular, it concentrates on the first type of financial integration, viz., among different segments of domestic financial markets. Specifically, it seeks to address two questions:
- What is the nature of integration among different segments of Indian financial markets? and
- What has been the influence of monetary policy on different segments of financial markets?
There are three discerning features of the study. First, it uses daily data over a fairly recent period, viz., January 2005 November 2012 to decipher the extent of financial market integration. Second, it seeks to probe into the mechanism of monetary policy transmission across various segments of financial markets viz., money, G-Sec, corporate debt, forex, and equity.5 Third, given the short run nature of the data (notwithstanding the number of observations), it uses structural vector autoregression models to discern econometrically robust conclusions.
A scan of the existing literature on financial market integration in India reveals that most of them concluded in favour of increasing but partial integration among the different segments of the financial markets. At the same time, because of low frequency of data most of these studies covered a period in which there was regime change with respect to monetary policy operating procedure. It is here that our study makes a departure and concentrates on a focused and recent period (i.e., January 2005 – November 2012), which is free from such issues. In some sense, it is less likely to be subjected to, what in generic term may be called as, the Lucas Critique.
At the same time, we are aware of two specific limitations of the study. First, high frequency data are often more noisy and hence signal extraction could be difficult. But monetary policy also functions in such a noisy data environment, and hence, a priori, a high frequency model is expected to be more useful. Second, ours is a story of integration among different segments of financial markets and impact of monetary policy on them. We are, thus, quite contracted in our focus we do not consider variables such as output, prices, or even fiscal policy, all of which could impact financial markets and monetary policy decisions. Put differently, we are confined to a partial equilibrium model where the market players in a particular segment of the financial market are concerned only with what is happening in other segments and monetary policy. But such a caricatured world might perhaps capture the very short-run and may be representative of the behaviour of the typical financial market player on a day-to-day basis. In the financial markets, where it is often joked that, a long term investment is a short term investment that failed, we thought our emphasis on the day-to-day activities may not be entirely misplaced.
Rest of the paper is organized as follows. Section 2 gives a bird ™s eye review of the relevant literature. While issues related to financial market microstructure in India are discussed in section 3, some stylized facts on inter-temporal behaviour of rates in different segments of the financial markets are taken up in section 4. Section 5 is devoted to the extent of market integration and its relationship with monetary policy. The econometric results are discussed in section 6. Section 7 concludes the paper.
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