Dr. C. Rangarajan's Speech at NISM Convocation 2011 on September 9, 2011.

1. NiSM
CONVOCATION
ADDRESS
Dr. C. Rangarajan
Chairman, Economic Advisory Council to the Prime Minister
NiSM
NATIONAL INSTITUTE OF
SECURITIES MARKETS
An Educational initiative by SEBI
2011
NATIONAL INSTITUTE OF SECURITIES MARKETS, NISM Bhavan
Plot No. 82, Sector - 17, Vashi, Navi Mumbai - 400 705
Phone: +91-22-66735100-05 | Fax: +91-22-66735110 | www.nism.ac.in

2. DR. C. RANGARAJAN, structure of the Indian economy. After obtaining his Economic
Chairman, Economic Advisory He was actively involved in the Honours Degree from Madras,
Council to the Prime Minister design and implementation of he obtained his Ph.D. from the
Dr. C. Rangarajan is a the reform agenda. His University of Pennsylvania. In the
leading economist of India who contribution was particularly United States, he taught at the
has played a key role both as an noted for making monetary Wharton School of Finance &
academic and a policy maker. policy a flexible instrument of Commerce, University of
He has held several important economic policy to achieve Pennsylvania and the Graduate
positions which include growth with price stability, for School of Business
Governor of Reserve Bank of moving the exchange rate Administration, New York
India and Governor of Andhra regime to a largely market University. In India, he taught at
Pradesh. determined system, and for Loyola College, Madras,
making the Indian rupee University of Rajasthan, the
Dr. C. Rangarajan is currently
convertible on the current Indian Statistical Institute, New
Chairman, Economic Advisory
account. He also initiated far- Delhi, and for well over a decade
Council to the Prime Minister, a Report of the Twelfth Finance
reaching reforms in India's and a half, at the Indian Institute
position he has held since Commission was regarded as
financial sector to make banks of Management, Ahmedabad.
January, 2005, except during being path-breaking in furthering
competitive and efficient. These He was for a time Fellow at the
2008-09 when he was a Member fiscal decentralization in India
included deregulation of interest International Food Policy
of Parliament (Rajya Sabha). and for laying the foundation for
rates, introduction of prudential Research Institute, Washington.
Prior to this, he was fiscal consolidation.
norms and credible regulation, In recognition of his
Chairman of the Twelfth Finance D r. R a n g a r a j a n w a s upgradation of standards of distinguished service to the
Commission, a constitutional Governor of the Reserve Bank of service and introduction of nation, Dr. Rangarajan was
commission set up every five India during 1992-1997 at a time information technology in awarded 'Padma Vibhushan' in
years to determine the sharing of when India embarked on wide- banking operations. 2002, the second highest civilian
tax revenues between the central ranging economic reforms which
award in India.
and the state governments. The fundamentally altered the

3. SOME ISSUES IN REGULATION income countries. Market touch' regulation were
AND CAPITAL FLOWS capitalization as ratio of GDP in investment banks, hedge funds
Dr. C. Rangarajan - Chairman, Economic Advisory Council to the Prime Minister India stood at 55.7 per cent as and rating agencies.
of 2008. The resource The second failure lies in the
It gives me great pleasure to The securities markets in India
mobilization in the primary imperfect understanding of the
be in your midst at the first have made enormous progress
market has increased implications of various derivative
convocation of the National in developing sophisticated
dramatically, rising six fold products. In one sense,
Institute of Securities Markets instruments and modern market
between 2000 and 2010. SEBI derivative products are a natural
(NISM). I am told that every mechanisms. The key strengths
must continue to remain active corollary of financial
year about 50,000 new of the Indian capital market
and promote a safe, transparent development. They meet a felt
professionals enter the securities include a fully automated
and efficient market. And in this need. However, if the derivative
markets in our country. But as of trading system on all stock
task, you who are graduating products become too complex
now, there is no specialized exchanges, a wide range of
today can play a facilitating role. to discern where the risk lies,
curriculum in the Indian products, an integrated platform
FAILURE IN REGULATION they become a major source of
Education System to train young for trading in both cash and
Regulation has emerged as concern. Rating agencies in the
people for these jobs. Much of derivatives and a nationwide
a major concern in the wake of present crisis were irresponsible
the learning is by way of on-the- network of trading. The market
the international financial crisis. in creating a booming market in
job-learning. It is in this context regulator SEBI has provided
What stands out glaringly in the suspect derivative products.
that NISM through its long-term effective leadership by putting in
current crisis is the regulatory Quite clearly, there was a
education programs fills an place sound regulations in
failure in the advanced mismatch between financial
important gap in the development respect of intermediaries,
countries. The regulatory failure innovation and the ability of the
of the securities markets in India. trading mechanisms, settlement
was twofold. First, some parts regulators to monitor them. It is
Let me at the outset congratulate cycles, risk management,
of the financial system were ironic that such a regulatory
all of you who are graduating derivative trading and takeover
either loosely regulated or were failure should have occurred at
today. An exciting career awaits of companies. India's market
not regulated at all, a factor a time when intense discussions
all of you. Please maintain always capitalization to GDP ratio has
which led to “regulatory were being held in Basle and
a professional approach with high risen from levels close to low
arbitrage” with funds moving elsewhere to put in place a
ethical standards and by so doing income countries to levels
more towards the unregulated sound regulatory framework.
you will serve the Country best. substantially higher than middle
segments. Examples of 'soft
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4. ELEMENTS OF regulators of different financial system should have a singleincrease the short-term profitability
REFORMED REGULATION jurisdictions. In fact, there is a regulator or multiple regulators. Theof the financial sector rather than to
The current financial crisis has proposal to prevent financial recent experience does not provide increase the ability of financial
thus exposed the weaknesses of institutions, particularly banks, an unique answer. U.K. which had a markets to perform better their
the regulatory framework in the growing beyond a certain size single regulator ran into problems, essential functions of managing risk
advanced countries. There is a so that the dilemma of “too big while Canada which also had a and allocating capital. It would be
considerable degree of consensus to fail” can be avoided. single regulator did not suffer from inappropriate to classify most of the
on how the regulatory framework 3| Institutions may be required to the crisis. financial innovations introduced in
should be reshaped. Some of the set up buffers in good times to the last few decades as useless.
REGULATION
key elements that should be be drawn down in bad times. The financial products satisfy a
AND INNOVATION
integral to a reformed regulatory This may entail varying capital certain demand. There is no
The financial sector today is
structure are: adequacy and provisioning argument that the regulatory system
perhaps inherently more volatile and
requirements according to the must be restructured to discourage
1| The regulatory framework vulnerable than before. The very
phase of the business cycle. excessive risk taking and leveraging.
should cover all segments of the factors that have contributed to the
They may be allowed to rise However a growing economy like
financial markets. The rigour of growth to the financial sector may
and fall with the business cycle. India needs more rather than less
regulation must be uniform well have contributed to increased
financial innovations. Too little
among all segments to avoid 4| Excessive leverage in fragility. Close inter-dependence
regulation can potentially harm
“regulatory arbitrage”, institutions may be contained among markets and market
consumers and may encourage
2| Systemically important financial through additional supplements participants have increased the
financial instability but too much of it
institutions should receive to the risk based capital ratio. potential for adverse events to
can impede financial innovations
special attention. Apart from Most countries are convinced that spread quickly. They have increased
which are badly needed. In short,
additional regulatory obligations, the reform of the regulatory significantly the scope for and
the policy makers must strike an
such institutions may be structure along these lines is very speed of contagion. Some question
appropriate balance between the
required to conform to stricter much needed. However, there is whether the new financial products
need for financial innovation and the
and enhanced prudential norms. no consensus on measures such serve any economically useful
need for regulation to ensure growth
Large institutions having as levying a generalized tax on purposes. It has been argued that
with stability in the real and financial
operations across countries may financial transactions. There is also much of the recent innovations in
markets
require coordinated oversight of no consensus on whether the the financial system have sought to
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5. CAPITAL FLOWS real and financial markets which from banks and markets take full advantage of the
AND THEIR IMPACT later will have to be reversed. abroad. NRI deposits are conditions prevailing in
Let me now turn to the issue This reversal will not be without deposits made in Indian banks international capital markets.
of capital flows. Capital flows in cost. Even when capital flows by non-resident Indians. NRI deposits no longer play a
general are welcome in are not ‘hot’ or volatile, several Countries normally prefer long dominant role.
developing economies. They all consequences follow. Some of term and durable funds. It is
add to the productive capacity of these concerns include from this angle foreign direct
the country. They also lead to the excessive money supply and the investment is the most desired
development of financial consequent pressure on prices, form of capital flows in all
markets. Such flows are also impact on nominal and real countries. While portfolio flows
viewed as vehicles for the exchange rate, increase in can fluctuate from year to year,
transfer of technology and consumption and possible very rarely does the stock get
management skills. In effect, deterioration in the current reduced. Net negative flows
international capital markets try account. during a year are uncommon. It
to distribute the available world Capital flows into a country however happened in 2008-09
savings among countries, with through a variety of channels. In in India. There is an organic link
countries showing high India, we normally classify them between foreign direct
productivity growth attracting into four broad categories. investment and FII channel.
more capital. However the These are Foreign Direct Foreign direct investors also
problem with capital flows is Investments, Portfolio Flows, need some exit route. It is found
their size and volatility. When the Loans and NRI Deposits. that in recent years 20 to 30 per
capital flows are large and that Foreign direct investment cent of the FII inflows in India
too with a high degree of includes equity investment have been towards the
fluctuation, they have a bearing above a particular level in Indian subscription of Initial Public
on macro economic stability. If companies. Portfolio flows are Offerings (IPO). They thus
capital flows are volatile or investments made by foreign contribute directly to increasing
temporary, the economy will institutional investors in stock the productive capacity. External
have to go through a whole market securities. Loans include commercial borrowing provides
adjustment process, in both the borrowings by Indian entities an opportunity to Indian firms to
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6. VOLATILITY IN case of most of the countries QUANTUM OF market economies increased 10
CAPITAL FLOWS affected by it, the most volatile CAPITAL FLOWS fold to reach $ 700 billion. This
Capital flows can be due to flow was bank credit. It was the The position with respect to trend was reversed temporarily
a combination of “push” and sudden withdrawal of bank capital flows as far as emerging in 2008. Overall net inflows to
“pull” factors. “Push” factors are credit that put many of the economies like India are emerging market economies fell
those conditions that prevail in countries in East Asia in great concerned has changed by about 75 per cent to around $
the host country. If the difficulty. Coming back to India, dramatically over the last two 200 billion in 2008 but these
investment prospects are some analysis has been done of decades. Prior to 1990-91, our flows have quickly rebounded
deemed to be low or if interest FII flows in the wake of the major concern was to mobilize since mid 2009. Net inflows to
rates are low in the host country, Lehman crisis of Sept. 2008. enough capital flows to finance emerging Asia returned to the
they “push” capital out. On the During the month of October the current account deficit. The pre-crisis peak levels in the first
other hand, the “pull” factors are 2008, gross equity sale were crisis of 1991 exploded because 3 quarters of 2010. We see a
the conditions that prevail in the Rs. 68310 crores. However of our inability to finance a similar pattern in India too. 2007-
receiving countries. Capital flows some FIIs still felt that the current account deficit of the 08 was an unusual year when
to those countries which are outlook for investment in India order of 3.1 per cent of the GDP . there was a heavy influx of
deemed to be attractive for was good. In that very month, FII That position has changed. capital and the RBI added
investment because of either purchases amounted to Thanks to the development of almost $ 100 billion to the
high growth prospects or high Rs. 52014 crores. Putting these the international capital markets, reserves. Overall capital flows
profitability. Capital flows tend to together, the exit by foreigners today emerging economies fell to a single digit in 2008-09
be more permanent, if they are from the Indian equity market in including India are able to attract but they have recovered in
influenced by the “pull” factors. this once-in-a-century crisis was large capital inflows. While subsequent years. In 2010-11
Rs. 16296 crores. Adding up talking of the need for controls net capital flows amounted to $
Different forms of capital
across October, November and on capital flows, we should bear 62 billion.
flows do fluctuate from year to
December 2008 the overall net in mind the benefits that
year. It is the desire of countries
sale by foreigners amounted to countries have derived as a
to avoid volatile flows. It is
6 per cent of their holdings at the result of the development of
normally assumed that FII
end of Sept. 2008. Thus even in international capital markets.
inflows are more volatile than
the worst scenario, the outflows
other forms. However, in the From 2002 to 2007 private
have been modest.
1997 East Asian Crisis in the net financial flows to emerging
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7. POLICY OPTIONS but this will imply a cost which CAPITAL CONTROLS capital controls can be imposed
When the inflows are large, will depend on the return on Capital controls to check and these may even be deemed
there are three options open to foreign exchange reserves and inflows take a variety of forms. as advisable. However, IMF’s
the policymakers. The first the cost of borrowing. One has One generalized instrument to advice was directed to countries
option is to let the capital flows to balance the ‘self insurance’ check particularly short term which have more or less
pass through the foreign benefit of reserves with the cost. flows has been the Tobin tax. adopted full capital account
exchange markets fully. This will The third option is to use capital Under this system, a small tax is convertibility. Countries like
have the effect of making the controls to restrict the inflows levied on all foreign exchange India do not fall in this category.
domestic currency appreciate, and to stimulate the outflows. transactions. In some ways this Even with respect to foreign
with possible adverse Capital controls are not that easy is a blunt instrument which direct investment, we have
consequences on the country’s to monitor. However, as a makes no discrimination sector specific restrictions. While
exports. This will be particularly temporary measure, restrictions between one type of flow and external commercial borrowing
uncomfortable, if the country on some forms of capital inflows another type. More importantly, it has been made easier, prior
was experiencing already a have been attempted by several will clutter the foreign exchange sanction from the Central Bank
current account deficit. The countries. In fact, the response market. It may also make the is required beyond specified
second option is to absorb the to large capital inflows is always collection of tax itself very limit. FII investment in debt has
inflows into reserves. If in the form of a mixture of the cumbersome. However, several also limits. The Indian scenario
unsterilised, these inflows will three options. The policy countries have imposed is thus different.
lead to an expansion of money makers may let the domestic restrictions, both price based
supply causing prices to rise. currency appreciate to some and quantitative, on specific
Domestic inflation has its own extent, absorb some part of the types of transactions. These
implications. Apart from this, flows into reserves and impose may not be characterized as
with prices rising, the real some controls on capital inflows. Tobin tax. Apart from direct
effective exchange rate will rise, It is impossible to maintain quantitative controls, reserve
even when nominal exchange simultaneously free capital flows, requirements have been used as
rate remains unchanged. If fixed exchange rate and tools for curbing capital inflows.
sterilized, some of the autonomy in domestic monetary IMF has recently recognized that
consequences of the reserve policy. One out of the three in certain specific circumstances
accumulation can be moderated pillars has to give way.
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8. CAPITAL FLOWS AND flows, domestic economic whole was 2.6 per cent of GDP .
CURRENT ACCOUNT policies must be deemed to be So far we have had no problems
appropriate by external in financing the current account
DEFICIT
investors. To this extent deficit. Even in 2010-11, capital
As mentioned earlier, there
domestic policies are subject to flows were adequate to cover
has been a dramatic change in
external oversight. However, current account deficit and add
the quantum and composition of
capital flows have their own to the reserves $ 15 billion.
capital flows to India. In 1990-
dynamics. They flow towards Given the current trends in the
91, total capital flows amounted
countries which grow fast in an world economy and the behavior
to $ 7.1 billion. Almost all of this
environment of low inflation and of International capital markets,
was in the form of debt. Much of
modest fiscal deficit. In some efforts must be made to keep
it was also official. To come to a
ways, these are also our the CAD around the
more recent period, total capital
domestic goals. India’s balance manageable level of 2.5 per cent
flows increased from $ 10.8
of payment position in the post of the GDP This itself will mean
.
billion in 2002-03 to 45.2 billion
liberalization period has been a larger inflow of capital in
in 2006-07 and further to $ 106.6
strong. India’s current account absolute amount, as our GDP
billion in 2007-08. In 2009-10,
deficit remained low till 2008-09. keeps increasing. For this
the total capital flows are
Since then, it has started reason, we need to be proactive
estimated at $ 53.6 billion.
climbing and the current in attracting capital flows. So
Looking at the composition of
account deficit stood at 2.8 per long as our economy grows at a
capital flows in 2009-10 it is
cent of GDP in 2009-10. In the rate exceeding 8 per cent and
seen that foreign direct
first half of 2010-11, the current our inflation and fiscal deficit
investment amounted to $ 19.7
account deficit remained very remain at modest levels, we
billion. Portfolio flows stood at $
high at 3.7 per cent of the GDP . should not face any problem in
32.4 billion, and loans at $ 12.2
However, in the second half, financing the current account
billion. The composition has
exports picked up strongly while deficit. However, over a longer
definitely shifted towards non
import growth was weaker. It is time horizon of a decade or
debt creating private flows.
now estimated that the current more we should try to achieve a
To attract and retain capital account deficit for the year as a balance in our current account.
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