NiSM CONVOCATION ADDRESS Dr. C. Rangarajan Chairman, Economic Advisory Council to the Prime MinisterNiSM 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 705Phone: +91-22-66735100-05 | Fax: +91-22-66735110 | www.nism.ac.in
DR. C. RANGARAJAN, structure of the Indian economy. After obtaining his EconomicChairman, 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 theleading economist of India who contribution was particularly United States, he taught at thehas 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 ofHe has held several important economic policy to achieve Pennsylvania and the Graduatepositions which include growth with price stability, for School of BusinessGovernor of Reserve Bank of moving the exchange rate Administration, New YorkIndia and Governor of Andhra regime to a largely market University. In India, he taught atPradesh. 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, NewChairman, Economic Advisory account. He also initiated far- Delhi, and for well over a decadeCouncil to the Prime Minister, a Report of the Twelfth Finance reaching reforms in Indias and a half, at the Indian Instituteposition 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 the2008-09 when he was a Member fiscal decentralization in India included deregulation of interest International Food Policyof 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 hisChairman 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 theCommission, a constitutional Governor of the Reserve Bank of service and introduction of nation, Dr. Rangarajan wascommission set up every five India during 1992-1997 at a time information technology in awarded Padma Vibhushan inyears to determine the sharing of when India embarked on wide- banking operations. 2002, the second highest civiliantax revenues between the central ranging economic reforms which award in India.and the state governments. The fundamentally altered the
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. Indias 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 soft2 3
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 to4 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 to6 7
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 emerging8 9
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.10 11
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.12 13
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