The developments in the Indian financial markets in September and October following the death of Lehman Brothers in New York on September 15, 2008 were quite unprecedented. One was the sudden change in conditions in the money market. Call money rates shot up immediately after September 15. Despite swift action by the RBI, the tightness persisted through the month of October. Rates kept going above the RBI’s policy rate corridor reflecting the tightness in the money market. The call rate consistently breached the ceiling of the repo rate of 9 per cent to attain values beyond 15 per cent. There was a huge amount of borrowing from the RBI. On some days, the RBI ended up lending an unprecedented Rs 90,000 crore in repo transactions.

At the same time, there was a huge pressure in the rupee-dollar market. The rupee depreciated sharply. The RBI attempted to prevent an even bigger depreciation of the rupee by selling dollars. It sold $18.6 billion in the foreign exchange market in October alone. This, of course, had the undesirable effect of sucking liquidity out of the economy at a time when the economy was already facing huge liquidity shortages and call money rates were shooting up. Another interesting element of the story is the corroborating evidence provided by the rupee-dollar forward market. Firms, or banks lending to them, taking dollars out of India appear to have planned to bring the money back to India. To lock in the price at which they would bring money back after a month, they sold the dollars forward. The one month forward, which is usually a premium, suddenly fell sharply into negative territory. Similar discounts appeared on the three month and six month forward markets.

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