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It recommended, inter alia, liberalisation of current account transactions leading to current account convertibility; compositional shift in capital flows away from debt to non debt creating flows; strict regulation of external commercial borrowings, especially short-term debt; discouraging volatile elements of flows from non-resident Indians; gradual liberalisation of outflows; and disintermediation of Government in the flow of external assistance. The Committee also recommended the introduction of a market-determined exchange rate regime while emphasing the need to contain current account deficit within limits. The policy framework for external sector based on the Rangarajan Committee Report was implemented along with policy changes in trade, industrial and financial sector. Under trade policy, there has been a virtual elimination of licensing, a progressive shift of restricted items of imports to Open General Licence (OGL) and lowering of tariff barriers. Industrial policy has been characterised by delicensing, removal of monopoly clauses defining large industrial houses and removal of most reservations for public sector enterprises. The reforms in the area of financial sector were guided by recommendations of Narasimham Committee. Alongside the deregulation of the banking industry including entry for new private sector banks, the general thrust of monetary policy has been towards reduction in pre-emptions, greater recourse to open market operations, deregulation of interest rates and widening and deepening of financial markets. … Performance of various sectors clearly suggests that the growth of real GDP during the current year (1998-99) would be about 6.5 per cent - an impressive figure, especially in the current international environment. As regards prices, we have an impressive record of maintaining a modest single digit annual inflation rate during the eighties and most of nineties. However, during the current year, the annual inflation rate has been a little over 8 per cent on a point to point basis as at September 12, 1998. The principal sources of current inflation lie in the primary articles group within which major contributions were from fruits and vegetable, oilseeds and cereals. The price situation seems largely to reflect shortage of supplies of certain primary articles and perhaps attributable to seasonal factors. There were some concerns earlier in the current year that interest rates could harden significantly due to the large borrowing programme of the Government. However, most of the market borrowing requirement of the Government of this year has already been met with only a very marginal increase in yields on Government paper. Moreover, the genuine credit requirement of the productive sectors would be comfortably met by the significant accretion in bank deposits. During the eighties the average current account deficit was of the order of 2.0 per cent of GDP. Even when we faced the Gulf crisis we had a current account deficit of a mere 3.2 per cent. Since then, it has remained well below two per cent. … Since then, it has remained well below two per cent. In 1997-98, despite large uncertainties, the current account deficit remained modest at about 1.7 per cent of GDP. In 1998-99, the relative low level of oil prices in international markets and trends in invisible receipts should help maintain the current account deficit at a sustainable level of about 2 per cent of GDP. This order of current account deficit is clearly sustainable and we expect it to be financed by capital flows. In addition, we do have the comfort of reasonable level of foreign currency reserves, which we would not hesitate to use to curb speculative activities and ensure orderly conditions in the market. During 1997-98, we added $ 3 billion to our foreign currency assets despite payments of over $ 2 billion effected directly from reserves under FCNRA deposits scheme and repayments to the IMF. During 1998-99 also, despite all the turbulence, we have increased our foreign currency assets marginally from $ 25,975 million as at end-March 1998 to $ 26,135 million as on September 18, 1998. We fully recognise that the uncertain international financial and economic situation poses considerable policy challenges. Of late, there have been some unfavourable developments in the Russian economy and in a few Latin American countries. The developments in the industrial countries, in particular Japan, are also being closely watched as they impact not only the current account, but also on capital flows.

The large current account and fiscal imbalances in the US also find its reflection in the savings-investment mismatches that have risen substantially in the present decade. The private net savings in the US has declined from 8 per cent of GDP in the 1980s to less than 2 per cent in 2005. (ii) Surpluses in the Emerging economies Contrary to the US that has fed the domestic demand, in Asia and other emerging economies, growth since the late 1990s has been led by external demand. The current account has recorded large surpluses since 1999, particularly for China and other East Asian emerging market economies (EMEs) (Indonesia, Malaysia, Taiwan, Thailand). Surpluses of two island economies viz. Hong Kong and Singapore have also increased significantly. India too registered current account surpluses between 2001 and 2004, albeit small. In the post Asian crisis period the savings rate in most East Asian EMEs, which has generally remained higher than the industrialized countries exhibited a modest decline. Investment rates, however, showed sharp declines resulting in the widening of the savings investment gap in the EMEs (Table 2). India, however, remains an exception to this trend, and still continues to have a negative savings investment gap. … Hence small exchange rate changes can scarcely be expected to help significantly in effecting changes in the current account (Mohan, 2005). Thus, the following issues assume importance Will the recent developments see some domestic correction in the US, leading to a decline in its CAD? Are there chances of investment increasing in the Asian countries and whether this would reduce their surplus? Can exchange rate adjustments contribute significantly towards correcting current account imbalances? Further Efforts Notwithstanding the progress that has been made towards correcting imbalances, further efforts are desirable—with every country doing its part—to help reduce medium-term risks associated with the imbalances. The US will have to try to curb household and government borrowings and strengthen national savings, without hurting recovery and excessive dollar depreciation. The focus of fiscal consolidation in the US has to remain on the expenditure side, though revenue measures aimed at broadening the revenue base and tax system with greater emphasis on consumption tax rather than income tax cannot be ruled out (WEO, September 2006). With the housing market slowing down in the US, some increase in private savings is expected. This will be further helped by policy initiatives such as introduction of health savings accounts that would raise incentives for household savings and passing of pension legislation. The Euro area needs to pursue structural reforms, especially product and labour market policies, to boost domestic demand and broad base the recovery. Japan has started recovering finally. … The speed at which the US current account ultimately returns towards balance, the triggers that drive that adjustment, and the way in which the burden of adjustment is allocated across the rest of the world have enormous implications for the global exchange rates. Private corporates and financial intermediaries are bound to get exposed to exchange rate risks if these variables exhibit substantial fluctuations, though the impact might be less than other EMEs. Third, any reversal of global capital flows from emerging and developing economies in the case of realignment of interest rates and slow investment growth on account of higher interest rates with the tightening of monetary policy stance by major central banks remain the other downside risks. Fourth, domestic developments exhibit strength and resilence with some down side risks. There is a pick-up in the momentum of growth which also appears to be spreading across all constituent sectors of the economy. Domestic financial markets have exhibited stable and orderly conditions. In the external sector, there are signs of abiding strength and the current account deficit has been well-managed so far. On the other hand, there are indications of growing demand pressures and potential risks from rapid credit growth and strains on credit quality. High levels of monetary expansion and the evolution of the liquidity situation will need to be continuously monitored for any signs of risks to inflation. The elevated levels of asset prices also represent a risk to the outlook for macroeconomic and financial stability.

The unification of the exchange rate of the Indian rupee was an important step towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the IMF. Capital account liberalisation started as a part of wide-ranging reforms beginning in the early 1990s. The Rangarajan Committee recommended, inter alia, liberalisation of current account transactions leading to current account convertibility; need to contain current account deficit within limits; compositional shift in capital flows away from debt to non-debt creating flows; strict regulation of external commercial borrowings, especially short-term debt; discouraging volatile elements of flows from non-resident Indians; gradual liberalisation of outflows; and disintermediation of Government in the flow of external assistance. A credible macroeconomic, structural and stabilisation programme encompassing trade, industry, foreign investment, exchange rate, public finance and the financial sector was put in place creating an environment conducive for the expansion of trade and investment. It was recognised that trade policies, exchange rate policies and industrial policies should form part of an integrated policy framework if the aim was to improve the overall productivity, competitiveness and efficiency of the economic system, in general, and the external sector, in particular. With the onset of structural reforms in 1991-92, accompanied initially by severe import compression measures and determined efforts to encourage repatriation of capital, there was a turnaround in the second half of 1991-92. … The benchmark for our competitiveness in future is not our past but the emerging best in the field globally. Third, progressive reductions in peak tariff rates on imports have provided Indian industry access to new technology and inputs. The positive developments in the external sector enable a further rationalisation of tariffs with a view moving to a single, uniform rate on imports and further simplifying procedures in line with best global practices. The current external environment, including the level of the foreign exchange reserves, enables such a move to be made with minimal downside risks. Fourth, in the current international context, movements in national current account balances are increasingly being recognised as manifestations of the global imbalances. The empirical evidence indicates that even current account deficits, which appear optimising from an inter-temporal perspective or are on account of private sector imbalances, run the risk of sharp reversals. Hence, the need to keep current account deficits within manageable limits – an approach followed by India in its external sector management since the early 1990s. In this regard, It is necessary to recognise the significance of approach to the Eleventh Five Year Plan 'towards faster and more inclusive growth' adopted by the National Development Council last week (9th December, 2006). It is gratifying to note that the average CAD-GDP ratio indicated is 2.8 per cent for the target growth rate of 9 per cent, thus ensuring continued comfortable level of current account deficit, as we move forward. … It is gratifying to note that the average CAD-GDP ratio indicated is 2.8 per cent for the target growth rate of 9 per cent, thus ensuring continued comfortable level of current account deficit, as we move forward. Fifth, the current account deficit being the mirror image of the absorptive capacity of the economy should truly reflect the interplay of productive activities and the domestic absorption. Looking at the current account deficits from the angle of macroeconomic management, one should really view the current account, which, represents the demand and supply of goods and services and reflect the domestic fundamentals of growth and employment. Keeping these issues in mind, current account deficit (CAD) has to be viewed in two ways: (i) a conventional measure including all current account flows, and (ii) an adjusted measure of CAD, where workers' remittances are excluded from the current account as these represent broadly the exogenous component not driven essentially by the current pace of domestic activities and employment. The current account deficit, in a conventional sense, remained at a moderate level during last three Plans. However, an adjusted measure of CAD indicates that rapid expansion in domestic economic activities in the recent years has been reflected in higher absorption through external sector. In this light, the indicative CAD over the eleventh Five-Year Plan reflects significantly higher absorptive capacity than what the CAD to GDP ratios indicate.

This deficit is, in turn, financed by capital inflows, which over the past several years, had been large and stable enough to more than offset the current account deficit. For a few months during the 2008-09 financial crisis, the position was reversed and, when that happened, the Rupee behaved much like it did over the past several weeks (Chart 1). Between July 2008 and February 2009, the Rupee depreciated by nearly 17 per cent. Essentially, when capital stops coming in, the current account drives the exchange rate and, naturally, the pressure is to depreciate in the face of the deficit. With the kind of volatility we have seen in global capital flows over this period, virtually all EME currencies faced pressure to depreciate. However, the eventual magnitude of change reflected differences between countries in current account conditions as well as policy responses. For the past few years, the exchange rate regime in India has been what might be best described as a "bounded float". There are virtually no restrictions on Foreign Direct Investment (FDI), except for limits on specific sectors, and portfolio investment in equities. However, there are restrictions on debt inflows, driven by considerations of external stability. These limits relate to quantity, tenor and pricing. Short-term debt is the least preferred, because it is seen as most vulnerable to sudden reversals, while long-term debt, despite risk concerns, is seen as contributing to the resource flow into infrastructure, so is viewed more favourably. … There has been a long-standing debate on the merits and de-merits of this exchange rate policy, which has returned to centre-stage in the wake of recent developments. Time does not permit me to go into it here, but it is important to point out that the different policy responses we saw across EMEs to the volatility in capital inflows were largely the outcome of their exchange rate policy framework. Countries that orient their exchange rate regimes to export competitiveness typically have current account surpluses. This is a characteristic of the Asian EMEs and, in this sense, India is a significant exception to the Asian rule. These surpluses are reflected in a build-up of foreign exchange reserves, which may be further enhanced by large inflows of capital and the further accumulation of reserves to prevent currency appreciation, which undermines competitiveness in the short run. In the current global context, when capital inflows stop, reserves built up from current account surpluses provide the capacity to manage exchange rates in the face of external pressure. India has large reserves, of course, over $300 billion, but because we have a current account deficit, the reserves are essentially counterbalanced against our external liability position. In an extreme scenario, if there is a large outflow of capital, the adequacy of reserves will be judged by the economy's ability to finance the current account deficit and, over and above that, meet short-term claims without any disruption or loss of confidence. … In an extreme scenario, if there is a large outflow of capital, the adequacy of reserves will be judged by the economy's ability to finance the current account deficit and, over and above that, meet short-term claims without any disruption or loss of confidence. In light of this, the value and use of reserves in the Indian context must be viewed somewhat differently than in the context of a structurally current account surplus economy. Reserves essentially provide comfort to external counterparties that we have the capacity to meet our obligations. While the recent sharp depreciation has in certain quarters led to an assessment of "helplessness" in dealing with the kind of global turbulence we are seeing today, our strategic behavior should not be misconstrued as an inability to lean against the wind. Consider the following alternatives. Not using reserves to prevent currency depreciation poses the risk that the exchange rate will spiral out of control, reinforced by self-fulfilling expectations. On the other hand, using them up in large quantities to prevent depreciation may result in a deterioration of confidence in the economy's ability to meet even its short-term external obligations. Since both outcomes are undesirable, the appropriate policy response is to find a balance that avoids either. That balance can be found in precisely the structural capital controls that I referred to earlier. Resisting currency depreciation is best done by increasing the supply of foreign currency by expanding market participation. This, in essence, has been our response.

The Committee recommended the introduction of a market-determined exchange rate regime while emphasising the need to contain current account deficit within limits. It recommended, inter alia, liberalisation of current account transactions leading to current account convertibility; compositional shift in capital flows away from debt to non debt creating flows; strict regulation of external commercial borrowings, especially short-term debt; discouraging volatile elements of flows from non-resident Indians; full freedom for outflows associated with inflows (i.e. principal, interest, dividend, profit and sale proceeds) gradual liberalisation of other outflows; and dissociation of Government in the intermediation of flow of external assistance. The policy framework for the external sector based on the Rangarajan Committee Report was implemented along with policy changes in trade, industrial and financial sectors. Under trade policy, there has been a virtual elimination of licensing, a progressive shift of restricted items of imports to Open General Licence (OGL), and lowering of tariff barriers. Industrial policy has been characterised by delicensing, removal of monopoly clauses defining large industrial houses and removal of most reservations for public sector enterprises. The reforms in the area of financial sector were guided by recommendations of the Narasimham Committee (1991) appointed by Government. Alongside the deregulation of the banking industry including entry for new private sector banks, the general thrust of monetary policy has been towards reduction in pre-emptions, greater recourse to open market operations, deregulation of interest rates and widening and deepening of financial markets. … The objectives and purposes of exchange rate management are to ensure that economic fundamentals are reflected in the external value of the rupee as evidenced in the sustainable current account deficit. Subject to this general objective, the conduct of exchange rate policy is guided by three major purposes.First, to reduce excess volatility in exchange rates, while ensuring that the movements are orderly and calibrated. Second, to help maintain an adequate level of foreign exchange reserves. Third, to help eliminate market constraints with a view to the development of a healthy foreign exchange market.Basically, the policy is aimed at preventing of destabilising speculation in the market while facilitating foreign exchange transactions at market rates for all permissible purposes.Reserve Bank of India makes sales and purchases of foreign currency in the forex market, basically to even out lumpy demand or supply in the thin forex market; large lumpiness in demand is mainly on account of oil imports and external debt servicing on Government account. Such sales and purchases are not governed by a predetermined target or band around the exchange rate.MonitoringThe RBI closely monitors the foreign currency mismatch and open foreign currency and gold positions of banks. The foreign currency/gold maturity mismatch limits and open foreign currency positions are vetted by RBI. The open foreign currency position is applicable for all currencies put together using shorthand method, i.e. the higher of the total short or long positions. No limits have been placed for individual currencies. … The generalisations are somewhat narrowly focussed on the external sector and not the broader macro-policy issues such as implications for monetary management and exchange rate policy.First, the current account deficit represents the use of external resources in a country. Capital inflows to finance such deficits are welcome for their role in financing investment, and thereby sustaining long-term development. At the same time, it should be apparent that a large current account deficit implies correspondingly a large dependence on such capital inflows. The developing countries are vulnerable in many spheres and hence such large dependence has a potential for destability. The issue is not whether there are inflows or outflows at a point of time, since a fall in inflows is enough to cause a crisis when there is large dependence. It is precisely with this view that India resisted the urge to allow current account deficit to exceed around 2 per cent of GDP in India. No doubt, the level of normal capital flows or sustainable current account deficit is contextual – to the country concerned, level of development, extent of external sector and even geo-political considerations. Briefly stated, for developing countries, non-volatile flows are ensured only if current account deficit is sustainable and policy makers need to constantly review the sustainability. Second, there is a trade-off in the short run between financial stability and efficiency which all policy makers are aware of.

Rangarajan, 1993) set the broad agenda in this regard. The Committee recommended, inter alia, the introduction of a market-determined exchange rate regime within limits; liberalisation of current account transactions leading to current account convertibility; compositional shift in capital flows away from debt to non debt creating flows; strict regulation of external commercial borrowings, especially short-term debt; discouraging volatile elements of flows from non-resident Indians; full freedom for outflows associated with inflows (i.e., principal, interest, dividend, profit and sale proceeds) and gradual liberalisation of other outflows; and dissociation of Government in the intermediation of flow of external assistance, as in the 1980s, receipts on capital account and external financing were confined to external assistance through multilateral and bilateral sources. The sequence of events in the subsequent years generally followed these recommendations. In 1993, exchange rate of rupee was made market determined; close on the heels of this important step, India accepted Article VIII of the Articles of Agreement of the International Monetary Fund in August 1994 and adopted the current account convertibility. In June 2000 a legal framework, with implementation of FEMA, has also been put into effect to ensure convertibility on the current account. As emphasized by the Rangarajan Committee that there could be capital outflows from residents in the guise of current account transactions after current account convertibility, certain safeguards were also built into the system after FEMA came into effect. … As emphasized by the Rangarajan Committee that there could be capital outflows from residents in the guise of current account transactions after current account convertibility, certain safeguards were also built into the system after FEMA came into effect. For example: First, the requirement of repatriation and surrender of export proceeds was continued, with provision of Exchange Earners Foreign Currency (EEFC) account for use by exchange earners. Second, all authorized dealers were allowed to sell foreign exchange for underlying current account transactions supported by documentary evidence. Third, a proactive approach in the development of money, government securities and forex markets has been adopted. Fourth, effort has been made to improve the information base on transactions in the forex markets with respect to its nature and magnitude through reports and statements. The insistence on adequate and timely reporting requirements from authorised dealers for various foreign exchange transactions also helped in simplification and liberalisation process. Fifth, as a general rule, genuine hedging of exposures under specified conditions is allowed. This consistent approach has lent credibility to the liberalisation process of both current and capital account transactions. In 1997, the Tarapore Committee on Capital Account Convertibility (CAC), constituted by the Reserve Bank, had indicated the preconditions for Capital Account Convertibility. The three crucial preconditions were fiscal consolidation, a mandated inflation target and, strengthening of the financial system. … Liberalised remittance of USD 25,000 p.a. by Resident Individual: In order to provide hassle free remittance facility based on a declaration resident individuals were allowed in early 2004 to remit upto USD 25,000 per annum for any permitted purpose both under current and capital account or combination of both. Resident individuals were also permitted to acquire property overseas and open accounts with banks outside India. Students: Indian students studying abroad are treated as Non-Resident Indians. As non-residents, they are eligible for all the facilities available to NRIs, in addition to remittance facilities presently available to students as residents. Procedural Simplifications No liberalisation effort is complete unless the customers or the end-users of the forex market can access the same through simple and transparent procedures. A number of initiatives have been taken towards procedural simplification with an objective of reducing the transaction cost. In the case of individuals, foreign exchange for current account transactions such as education, medical, travel, emigration, maintenance of close relatives abroad can be drawn from the Authorised dealer based on simple declaration up to certain indicated limits. Having regard to the liberalised approach in trade matters, specific steps were taken to allow exporters greater flexibility and freedom in the matter of seeking regulatory compliances. The system of self write off and self extension of due date for export realisation for exporters was introduced followed by raising the threshold limit for GR declaration. Similarly, the simplifications of procedures for import remittances have also been introduced.

The outlook for debt markets cannot be divorced from outlook for the economy as a whole. The GDP growth has averaged close to 6 per cent in eighties and nineties and the market-analysts’ consensus for this year that it would be around 7 per cent while we in RBI place it around 6.5 to 7 per cent. Inflation has been on down trend and moderate in the range of 4 to 6 percent in the last five years and most analysts expect inflation in the current year to be in the range of 5 to 5.5, close to about 4.5 percent mentioned in RBI’s latest monetary policy. The interest rates have been generally on the down turn in the last few years, and currently prime lending rates are around 12 percent – close to market expectations. By and large, the interest rates have been stable with general inclination towards south, till recently. The exchange rate has been among the most stable and the exchange market continues to be characterised by non-volatile conditions by global standards.The current account deficit is universally expected to continue to be below 2 percent of GDP. Foreign currency reserves are high at $ 35 billion and have been rising every year in the last three years. The trend may continue this year also. The growth with stability was possible inspite of the well-known domestic and international uncertainties. … There is a clear distinction between the current and capital account. Under the new system, all current account payments except those notified by the Government are eligible for appropriate foreign currency in respect of genuine transactions from the Authorised Dealers without any restrictions. The surrender requirements in respect of exports of goods and services continue to operate. The Reserve Bank however, would have the necessary regulatory jurisdiction over capital account transactions. To this extent, further action in regard to capital account liberalisation appears to have been put by Government squarely in the court of the Reserve Bank of India. It must be noted that the new legal framework keeps the option of reimposing controls, capital or current account if it becomes necessary. Thus, the Central Government is vested with the power to suspend and revoke any permission granted if the Government is satisfied that circumstances warrant such actions, in public interest. Capital Account Convertibility - Further Steps The committee on Capital Account Convertibility (CAC), with Dr.S.S.Tarapore as Chairman, which submitted its Report in May 1997, observed that although there were benefits of a more open capital account, international experience showed that a more open capital account could also impose tremendous pressures on the financial system. Hence, the committee indicated certain signposts or preconditions for capital account convertibility in India. The three crucial preconditions were fiscal consolidation, a mandated inflation target and above all, strengthening of the financial system. … The generalisations are somewhat narrowly focussed on the external sector and not the broader macro-policy issues such as implications for monetary management and exchange rate policy. First, the current account deficit represents the use of external resources in a country. Capital inflows to finance such deficits are welcome for their role in financing investment, and thereby sustaining long-term development. At the same time, it should be apparent that a large current account deficit implies correspondingly a large dependence on such capital inflows. The developing countries are vulnerable in many spheres and hence such large dependence has a potential for destability. The issue is not whether there are inflows or outflows at a point of time, since a fall in inflows is enough to cause a crisis when there is large dependence. It is precisely with this view that India resisted the urge to allow current account deficit to exceed around 2 per cent of GDP in India. No doubt, the level of normal capital flows or sustainable current account deficit is contextual – to the country concerned, level of development, extent of external sector and even geo-political considerations. Briefly stated, for developing countries, non-volatile flows are ensured only if current account deficit is sustainable and policy makers need to constantly review the sustainability. Second, there is a trade-off in the short run between financial stability and efficiency which all policy makers are aware of.

A dual exchange rate system was introduced in March 1992 which was unified in March 1993. Subsequently, India moved to current account convertibility in August 1994 by liberalising various transactions relating to merchandise trade and invisibles. The impact of policy changes was reflected in lower CAD and its comfortable financing in subsequent years. India could manage the external shocks that emanated from the East Asian crisis in 1997 and subsequently, the rise in international oil prices and bursting of dotcom bubble in 1999-2000. Indeed, the Indian economy remained relatively insulated from the East Asian crisis owing to the reforms undertaken in previous years and proactive and timely policy measures initiated by the Reserve Bank to minimise the contagion effect. Monetary tightening coupled with flexible exchange rate and steps to bolster reserves through issuance of Resurgent India Bonds (RIBs) helped in stabilizing the BoP. The BoP came under some stress again in the first half of 2000-01 due to a sharp rise in oil prices and increase in interest rates in advanced countries. At the same time, India’s software exports got a boost following the demands to address the Y2K challenges. This also encouraged migration of Indian software engineers to the advanced countries. As a result, the surplus in the services exports and remittance account of the BoP increased sharply which more than offset the deficit in the trade account. … Foreign Investment (FDI+FPI) 0.1 0.0 0.9 2.5 3.6 5. Others -0.2 0.0 -0.1 -0.1 -1.1 6. Change in Foreign Exchange Reserves* 0.0 0.2 -1.0 -3.0 -0.4 *: (-) implies increase and (+) implies decrease Concluding Remarks With the gradual external liberalisation of Indian economy, not only the size of BoP has increased manifold, but the pattern of current and capital account has changed. Even though the reform process has strengthened resilience of India’s external sector, at the same time vulnerabilities arise with greater exposure of the economy to the rest of world through liberalised trade and investment environment. India’s current account particularly remains vulnerable to developments in the trade account. It is evident from the size of trade deficit growing from 0.5 per cent of GDP during 1951-55 to 8.7 per cent during 2007-12. In 2011-12, the current account deficit has widened to a record 4.2 per cent of GDP (Chart 7). Over the years, current account derived some resilience from surplus generated by invisibles, particularly software exports and private transfers, but trade deficit continues to dictate the overall trend in the current account. Whenever trade account worsens reflecting downswings in the global business cycle or rise in international oil prices, the current account also comes under stress as is evident in the present context. … Whenever trade account worsens reflecting downswings in the global business cycle or rise in international oil prices, the current account also comes under stress as is evident in the present context. Going forward, since India’s linkage with the world economy, in terms of trade and finance, is likely to grow further, it is important that resilience in its trade account is built up mainly by promoting productivity based export competitiveness and improving domestic fundamentals that are supportive of least costly non-debt creating flows, particularly foreign direct investment (FDI). In this context, I make a few suggestions. First, the current level of CAD is far above the level sustainable for India. As per estimates, at a nominal growth rate of about 13 per cent, the sustainable current account to GDP ratio is 2.3 per cent (Rangarajan, 2012)5. Reserve Bank’s own research shows that economy can sustain CAD of about 2.5 per cent of GDP under a scenario of slower growth (RBI, 2012).6 A slowing global economy and protracted high levels of unemployment in advanced economies make it difficult to boost services exports in the short run. If the slowdown continues, it could also have an adverse impact on inward remittances. Hence, there is a need to reduce imports and boost merchandise exports to bring the CAD to sustainable levels. Second, structural policy measures are needed to reduce vulnerability emanating from high oil and gold imports.

I. SOURCES AND EFFECTS OF INTEREST RATE RISK 1. Interest rate risk is the exposure of a bank's financial condition to adverse movements in interest rates. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value. However, excessive interest rate risk can pose a significant threat to a bank's earnings and capital base. Changes in interest rates affect a bank's earnings by changing its net interest income and the level of other interest-sensitive income and operating expenses. Changes in interest rates also affect the underlying value of the bank's assets, liabilities and off-balance sheet instruments because the present value of future cash flows (and in some cases, the cash flows themselves) change when interest rates change. Accordingly, an effective risk management process that maintains interest rate risk within prudent levels is essential to the safety and soundness of banks. 2. Before setting out some principles for interest rate risk management, a brief introduction to the sources and effects of interest rate risk might be helpful. Thus, the following sections describe the primary forms of interest rate risk to which banks are typically exposed. These include repricing risk, yield curve risk, basis risk and optionality, each of which is discussed in greater detail below. These sections also describe the two most common perspectives for assessing a bank's interest rate risk exposure: the earnings perspective and the economic value perspective. … While all of a bank's holdings should receive appropriate treatment, measurement systems should evaluate such concentrations with particular rigour. Interest rate risk measurement systems should also provide rigorous treatment of those instruments which might significantly affect a bank's aggregate position, even if they do not represent a major concentration. Instruments with significant embedded or explicit option characteristics should receive special attention. 4. A number of techniques are available for measuring the interest rate risk exposure of both earnings and economic value. Their complexity ranges from simple calculations to static simulations using current holdings to highly sophisticated dynamic modelling techniques that reflect potential future business and business decisions. 5. The simplest techniques for measuring a bank's interest rate risk exposure begin with a maturity/repricing schedule that distributes interest-sensitive assets, liabilities and OBS positions into "time bands" according to their maturity (if fixed rate) or time remaining to their next repricing (if floating rate). These schedules can be used to generate simple indicators of the interest rate risk sensitivity of both earnings and economic value to changing interest rates. When this approach is used to assess the interest rate risk of current earnings, it is typically referred to as gap analysis. The size of the gap for a given time band - that is, assets minus liabilities plus OBS exposures that reprice or mature within that time band - gives an indication of the bank's repricing risk exposure. 6. … 3. The focus of supervisors' quantitative analysis can either be the impact of interest rate changes on current earnings or on the economic value of the banks' portfolio. In conducting their analysis information about average yields on assets and liabilities in each time band may be useful and supervisors may wish to collect such information in addition to pure position data. 4. Depending on their overall approach, supervisors may conduct their analysis of interest rate risk either on a case by case basis or as part of a broader system designed to identify outliers with apparently excessive risk-taking. 5. By conducting an assessment of interest rate risk using the proposed framework, supervisors may gain more insight into an institution's risk profile than with a reporting system that reduces the complexity of interest rate risk to a single number. In doing so, supervisors can become more familiar with the sensitivity of risk measures to changes in the underlying assumptions, and the evaluation process may produce as many insights as the quantitative result itself. 6. Regardless of the extent of a supervisor's own independent quantitative analysis, a, bank's own interest rate risk measure, whether reported as part of a basic supervisory reporting system or reviewed as part of an individual assessment of a bank's risk management, is an important consideration in the supervisory process.

That continues to be our resolve and that is the way we are going to go forward. Meanwhile, both the Reserve Bank and the government will try to see how to adjust the current account deficit. Adjustment in the current account deficit inevitably by its very nature takes time. But sending out the right signal that we are making an effort to adjust itself will make financing of the current account deficit easier. Sudhir Agarwal: Do you think the repo rate high also can be an option in case these measures are not sufficient? Dr. D. Subbarao: I do not want to comment on one particular instrument, but there is a lot of arsenal with the Reserve Bank. We will use all of that as might be necessary, as might be warranted by the situation. Moderator: Thank you. Our next question is from the line of Prithviraj Srinivas from HSBC. Please go ahead. Prithviraj Srinivas: I have two quick questions; the first one is what needs to happen more specifically on the global and domestic front before you expect to see the degree of stabilization of exchange rates that would allow for a roll back of liquidity measures? … Simon Flint: Governor, yesterday, in your statement to the press, you suggested that because of the large current account deficit, the rupee depreciation in some senses would be warranted. And on the other hand you do have some economists, I think including some in the Ministry of Finance who have argued that if you compare the present value of the rupee to the real effective exchange rate, let us say which prevailed over 2004-2005, then the rupee is actually overshooting and is now undervalued. So I guess can you give us a sense of where you see rupee today relative to its fair value? Dr. D. Subbarao: Thank you for that question. Actually my answer to your very well argued question is quite short, which is that the Reserve Bank does not take a position on the level of the exchange rate. The depreciation of the currency has costs for the economy, but that is a different matter. We do not take a position on the exchange rate; there are various ways of calculating it including the way that you have indicated from the Ministry of Finance. All we said yesterday was that because of the current account deficit, the rupee would have depreciated and that has not happened because we have been able to finance it, and now that there is capital flow issues, those strains are coming into play, and the rupee is depreciating. Moderator: The next question from the line of Kumar Rachapudi from ANZ Bank. … So rate hike would really dent the sentiments of the FII investors looking at investing in the equities. And given the fact that India per se is more equity funded economy, what in your view would be more essential? Dr. D. Subbarao: Thank you for that question. That question occurred to me several times over the years, in particular in the last one week. And I have asked our staff to please give me an answer and they wrote me a paper indicating the link between monetary policy and the current account deficit. I am trying to absorb that and I have some synopsis of that paper in front of me, but this forum is not very appropriate for a lengthy discussion on that. But in the Reserve Bank’s view monetary policy will have an impact on the current account deficit through a variety of channels. Pankit Shah: So just to put it very shortly, do rate hikes in your view actually help the currency to appreciate or do rate hikes help the currency to depreciate? Dr. D. Subbarao: At the moment, we have not resorted to rate calibration for this purpose. If and when we do that it will be because we have determined that rate adjustment will have an impact on currency. Moderator: Thank you. The next question is from the line of Soumya Kanti Ghosh from SBI. Please go ahead. Soumya Kanti Ghosh: I have two questions; one question is a continuation from my question last time.

The current account remained in surplus consecutively over the past three years, the current account in the first quarter of 2004-05 also posting a surplus of US $ 1.9 billion. Overall Assessment The pick-up in investment activity and significant growth in non-food credit appear to be broad based and are not temporary phenomena. As the magnitude and persistence of supply shock was partly unanticipated, demand management seems to invite closer attention, particularly for stabilising inflationary expectations in a credible manner. While the Reserve Bank will continue to pursue stability, the markets should be prepared for the uncertainties. Challenges for the rest of the year would broadly remain the same as in the first half of the year with equal weight being given to maintaining growth momentum and stabilizing inflationary expectations. Stance of Monetary Policy The overall stance of monetary policy for 2004-05 will be provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy, while placing equal emphasis on price stability. RBI to pursue an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the momentum of growth. RBI to consider measures in a calibrated manner, in response to evolving circumstances with a view to stabilising inflationary expectations. Financial Sector Reforms and Monetary Policy Measures Bank Rate kept unchanged at 6.0 per cent. Repo Rate increased by 25 basis points to 4.75 per cent. … Overall, therefore, the choice of a specific interest rate stance by a country/region seems to have been largely guided by its own domestic economic considerations. Another major downside risk facing the global economy continues to emanate from global imbalances and the associated possibility of disruptive currency adjustments and persistent structural problems in the euro area and Japan. Forex Market Remains Stable The Indian forex market generally witnessed orderly conditions during the current financial year so far (April-October 2004). The exchange rate of the rupee, which was Rs.43.39 per US dollar at end-March 2004, depreciated by 5.2 per cent to Rs.45.77 per US dollar by October 21, 2004. It also depreciated by 7.9 per cent against Euro, by 4.3 per cent against Pound sterling and by 1.9 per cent against Japanese yen during the period. Reserve Increases Foreign exchange reserves increased by US $ 7.6 billion from US $ 113.0 billion at end-March 2004 to US $ 120.6 billion as on October 21, 2004. Governor indicated that the overall approach to the management of India’s foreign exchange reserves in recent years has reflected the changing composition of the balance of payments (BoP), and has endeavoured to reflect the ‘liquidity risks’ associated with different types of flows and other requirements. Taking these factors into account, India’s foreign exchange reserves are at present comfortable and consistent with the rate of growth, the share of the external sector in the economy and the size of risk-adjusted capital flows. … During the second quarter of 2004-05, however, there are indications that the continuing uptrend in imports may result in the current account being only marginally in surplus assuming continued robust growth of merchandise exports and invisible earnings. Net capital inflows have moderated from the level recorded in the first quarter. While it is difficult to anticipate the behaviour of capital flows in the wake of the global geopolitical uncertainties, the positive sentiment on India should augur well for continued buoyancy, but some moderation should not be ruled out in view of turning of the global interest rate cycle. Overall Assessment Governor observed that a striking development during the year relates to growth of non-food credit in the first half, which is traditionally a slack season for credit off-take. A review of developments so far in the current year confirms that there has been a revival of investment activity. To the extent manufacturing industry is showing signs of robust growth, he felt that the credit needs will witness higher growth than that in the past. As a result of the current policy thrust, credit to agriculture is also picking up from its low base and could initiate greater credit penetration by displacing non-institutional lenders. The fast growing housing and consumer credit sectors also represent some degree of higher penetration, but the quality of lending needs to be ensured.

Eventually, this pulled down the investment rate which has exhibited deceleration since 2012-13. Reversing this trend is critical to achieve higher growth. The current account deficit (CAD) in the country’s balance of payments (BoP) determines how much of foreign savings or net capital inflows into the country can be absorbed or used for growth. Exports earn foreign exchange while imports have to be paid for in foreign exchange. A country like India relies on the rest of the world for imports of items we don’t produce such as crude oil and items such as machinery, equipment and technology in which other nations either have a comparative advantage or they closely hold. For India, imports typically exceed exports and hence earnings of foreign exchange are not sufficient for covering import payments. The gap has to be filled by borrowing from abroad which, however, has to be serviced through principal and interest payments. If debt servicing exceeds our earnings, we have to either reduce imports and stifle our growth prospects or default on debt payments and face international isolation. Our experience has been that India can sustain a current account deficit of 2.5-3.0 per cent without getting into an external sector crisis. In fact, in a telling reminder of this fact, a record increase in oil prices and high gold imports took the current account deficit above this Plimsoll line and to historically high levels during 2011-13. … This is evident from the changing structure of the population. A key indicator is the total fertility rate – the average number of children born to a woman over her lifetime. As per the findings of India’s latest National Family Health Survey (2019-21), the total fertility rate (TFR) of 2.0 (down from 2.2 in 2015-16 and 2.7 in 2005-06) has fallen below the replacement level for the first time. According to the United Nations (UN), a generation with a total fertility rate6 lower than 2.1 is not producing enough children to replace itself. Such a situation results in an outright reduction in the population of that country. On the other hand, the life expectancy of Indians has been rising and is likely to increase from the current level of about 70 years to about 82 years by 2099. A comparison of the ratio India’s working-age7 population (WAP) to the total population with that of other countries, viz., China, Brazil, USA, and Japan, shows that India stands at an advantageous position. The working-age populations of these countries have started declining already while India's WAP ratio will increase till 2045, even exceeding that of China by 2030. Making the most of this demographic dividend is India’s opportunity as well as a challenge. (ii) Manufacturing Another engine for take-off is manufacturing. … As stated earlier, the Indian economy contracted by 6.6 per cent in 2020-21. In the first quarter of that year when the first wave of the pandemic raged, GDP contracted by 24 per cent, among the steepest in the world. If a trend line is fitted to the level of India’s GDP and extended up to 2021-22 at the compound annual growth rate (CAGR) of 6.6 per cent that prevailed over 2013-20, a comparison for this trend GDP with the actual GDP in 2020-21 and 2021-22 will give a rough measure of the output lost to the pandemic. Recovering this lost output may take several years – this I will regard as the first most important challenge. The second challenge is India’s infrastructure gap. India’s per capita investment in infrastructure is one of the lowest in the world (US $ 88.6 in constant 2015 dollars). Infrastructure investment by India is currently around 4.6 per cent of GDP. If India were to invest in infrastructure to the tune of 6 per cent of GDP, it will achieve a GDP level of US $ 7.5 trillion by 2030, as estimated by the Global Infrastructure Hub10, and the infrastructure gap will close. This is also consistent with our target of becoming a US$ 5 trillion economy by 2027.

12. Since the 1990s, the gross domestic savings rate has risen steadily from an average of 23% to an estimated high of 36.9% in 2007-08 before it declined and was 33.7% in 2009-10. The decline in savings in India has been due to public sector saving less as revenue deficits widened, as also private corporate sector saving less as retained earnings could not keep the pace of growth seen earlier. Household saving rate has stagnated and larger public spending has not translated into higher savings by private agents. More importantly, financial saving of the households has moderated to 9.7% of GDP in 2010-11 from 12.1% of GDP in the preceding year. High inflation, low bank deposit rates, volatile equity markets and increasing leverage by households affected the rate of financial saving. With construction activity starting to slow down, the physical savings of the households could also be at risk. 13. Falling savings is a matter of concern if India is to grow at an envisaged rate of 9% per annum during the Twelfth Plan. If ICOR remains unchanged from 4.5 that has been realized so far in the Eleventh Plan, it would need an investment rate of 40.5%. Assuming current account deficit (CAD) averages 2% of GDP in this period, as wider average CAD could risk sustainability, then a saving rate of 38.5% becomes necessary. … Assuming current account deficit (CAD) averages 2% of GDP in this period, as wider average CAD could risk sustainability, then a saving rate of 38.5% becomes necessary. Banks need to play their role in unlocking financial saving if we hope to step up the aggregate saving rate by 5 per cent from the current level to realize this target. The current economic situation is putting pressure on both corporate profitability and the public finances. As savings in these two sectors are unlikely to grow as rapidly as in the past, household savings, especially its financial saving holds the key to India’s growth story. It is in the hands of the banks to live up to the challenge and the opportunity they face from this macro-arithmetic. 14. Banks have large business opportunities. Of the `10.4 trillion households’ saving pool in financial 2010-11, nearly 42% was in the form of bank deposits. This pool could grow rapidly allowing banks significant expansion opportunities in wholesale and retail banking. Also, much of Indians' physical savings is still locked up in unproductive physical assets—such as houses and gold and banks can help households slowly convert a large part of these into financial assets. So while banks may be focusing on corporate banking to boost its asset side, it should not miss the opportunities that the liabilities side of business provide and should aggressively protect its turf by gearing up for competition from non-bank financial institutions. … This behaviour was in evidence in India too. III.1 Saving deposit rate degregulation is good for banks and the economy 20. However, competitive spirit is getting rekindled, at least in India, where financial sector reforms are back on the forefront. The Reserve Bank in its October 2011 policy set the tone for increased competition by deregulating the saving deposit rate. It has also charted out a course for entry of new private sector banks and also given a clear indication that foreign banks are encouraged to come by setting up a bank subsidiary. RBI has also given a carte blanche to domestic scheduled commercial banks (other than RRBs) to set up new branches in Tier 2 centres. While global financial system still faces considerable risk, I think the time has come for banks in India to live with those risks by factoring those in and get to the task of providing banking services. 21. Increased competition is desirable for banks as well as economy. Take the instance of the long-awaited reform of deregulating saving bank deposit interest rates. The measure would go a long way in encouraging thrift behaviour in the economy, helping it grow faster. It is possible that it may temporarily affect banks’ net interest margins, especially in case of the high CASA banks.

Under Indian conditions, however, there are some additional questions. For instance, which is the correct risk-free interest rate to be compared while calculating interest rate differentials? Should we consider the 91-Day T-Bill rate or some other short-term rate? The theoretical forward premia could vary depending on the interest rate chosen. In the quest for answers to some questions, dilemmas do arise. Objectives and Purposes of Exchange Rate Management 4. The main objective of India's exchange rate policy is to ensure that economic fundamentals are reflected in the external value of the rupee. Subject to this predominant objective, the conduct of exchange rate policy is guided by three major purposes. First, to reduce excess volatility in exchange rates, while ensuring that the market correction of overvalued or undervalued exchange rate is orderly and calibrated. Second, to help maintain an adequate level of foreign exchange reserves. Third, to help eliminate market constraints with a view to the development of a healthy foreign exchange market. Let us relate the above approach to the current context. Current Context 5. The elements of continuity, contextual response and change would be present in the conduct of any policy, including the exchange rate policy. In this address, I would be focusing on the contextual response. After all, exchange rate policy will form part of the overall macroeconomic policy and will, therefore, have to be subservient to overall macroeconomic targets. … After all, exchange rate policy will form part of the overall macroeconomic policy and will, therefore, have to be subservient to overall macroeconomic targets. The conduct of exchange rate policy during 1996-97 was primarily guided by market conditions resulting from the contraction in the current account deficit and resurgence of capital inflows. Foreign exchange reserves (including gold) scaled a peak of US$ 26.4 billion by end-March 1997, without sacrificing exchange rate stability. In regard to 1997-98, the exchange rate policy needs to be seen in the context of the Monetary Policy Statement of April 15, 1997. The Statement indicates, given the real GDP growth for 1997-98 of 6.0 - 7.0 per cent, the expansion in M3 would be sought to be maintained in the range of 15.0 - 15.5 per cent to keep the inflation rate at around 6.0 per cent. Monetary policy would, in other words, continue to be directed towards maintaining a stable financial environment in relation to price, interest rate and exchange rate. 6. Against these broad parameters, we have to look at the variables that have a bearing on contemporary exchange rate management. Some of the crucial variables at this juncture apart from price stability and money supply which are always dominant are, in my view, the revenue and expenditure position of the Government, the oil pool deficit, the buoyancy in industrial activity, the progress in infrastructure sector, and the developments in trade and capital flows. Besides, leads and lags operate, affecting the market. … The overvaluation has got exacerbated with the sharp appreciation of the US $ against other major currencies, viz., the DM and the Yen. The relative 'cheapening' of imports may not have resulted in increasing imports and larger current account deficits. This is because imports are relatively less responsive to exchange rate changes and are more sensitive to the level of economic activity. There could be a potential larger current account deficit as industrial activity rebounds - even at the present exchange rates and if oil demand picks up, a correction cannot be ruled out. The optimal size of the external current account deficit, of course, depends upon the degree of openness of the economy. In the Indian context, the ratio of current receipts to GDP of 15 per cent, as at present, could sustain a current account deficit of the order of two per cent of GDP and would still enable a decline in the debt service ratio from the present level of 25 per cent. A current account deficit of two per cent of GDP in conjunction with the domestic saving rate of 25-26 per cent could ensure an investment rate of around 28 per cent which, even with ICOR of around 4.0 should be able to sustain a real GDP growth of seven per cent per annum. Since 1991-92, however, the current account deficit has averaged around only one per cent of GDP. Thus, enlargement of current account deficit beyond the present level is sustainable. Volatility 8.

Such a low interest rate environment coupled with luxuriant supply of liquidity, created enabling environment for excessive leverage and risk taking. This financial syndrome was a classical case of “’too much’ and ‘too little’ – too much liquidity, too much leverage, too much complex financial engineering, too little return for risk, too little understanding of risks”. This syndrome of too much of arcane rocket science and financial alchemy in the financial sector, almost entirely for its own sake to almost complete exclusion of the needs of the real sector, created a massive ‘financial sector – real sector imbalance’ which, being, intrinsically unsustainable, culminated eventually into the now-all-too-familiar apocalyptic denouement. 3. Significantly, the above pre-2007 story of massive and unprecedented current account imbalances was almost replicated in the current on-going eurozone crisis with large and persistent current account imbalances between the core, proxied by Germany, and the Netherlands, and the crisis-hit periphery, with the surpluses of the core being almost mirror image of the current account deficits of the periphery. Indeed, it is noteworthy that current account surpluses of the core increased dramatically after the launch of the single currency because of significant depreciation of the real exchange rate in the core and appreciation of the real exchange rate in the periphery. … Indeed, it is noteworthy that current account surpluses of the core increased dramatically after the launch of the single currency because of significant depreciation of the real exchange rate in the core and appreciation of the real exchange rate in the periphery. Such large, and persistent, current account imbalances between the core and the periphery would not have been possible but for the explicit moral hazard of fixed and stable exchange rates created by the single currency because the respective national currencies of the periphery would have depreciated in real terms resulting in timely automatic rebalancing of the current account imbalances ! Incidentally, but significantly, these current account imbalances between the ‘core’ and the ‘periphery’ are, to an extent, the result of post-1999 fiscal convergence to fiscal divergence story in the eurozone for, unless, net private savings offset it, fiscal deficit typically tends to spill over into current account deficit and, therefore, post-euro launch, there ought to have been a credible, effective and functioning institutional enforcement mechanism to ensure ongoing compliance on Maastricht fiscal parameters. Of course, this post-1999 fiscal convergence to fiscal divergence story in the ‘periphery’ would not have mattered if, like in the case of Japan, net private savings more than offset the comparable net public dissaving (fiscal deficit) of -9.5% ! So the way out of the current crisis is unwinding these imbalances through higher productivity and competitiveness in the periphery relative to the core. … So the way out of the current crisis is unwinding these imbalances through higher productivity and competitiveness in the periphery relative to the core. This is exactly what happened post-crisis in the case of unwinding of the imbalances between China, on the one hand, and the United States, on the other, with the United States current account deficit halving from almost 6% in 2007 to 3% currently and that of China’s current account surplus shrinking steeply from 10% in 2007 to 2.6% currently ! Thus, in the framework of “unearned - unshared prosperity”, it was the case of ‘unearned’ prosperity for the ‘deficit’ periphery and ‘unshared’ prosperity for the ‘surplus’ core ! But as in the case of China and the United States, there is some good news that real wages in Germany have gone up by 3% and those in Greece have gone down by 7%. Going forward, this then holds the promise of unwinding such imbalances by export of goods and services from the ‘periphery’ and import of goods and services by the ‘core’. 4. As I said, these large and persistent current account imbalances represented ‘unearned’ prosperity for deficit reserve currency countries and ‘unshared’ prosperity for surplus countries. Such a global economic order was inherently unsustainable, and unstable, from the word go.

Policy rates in the US reached one per cent in 2002, and were held around these levels for an extended period, longer than was probably necessary (Taylor, 2009; Yellen, 2009). Excessively loose monetary policy led to excess liquidity and consequent low interest rates worldwide; and the burst of financial innovation during this period amplified and accelerated the consequences of excess liquidity and rapid credit expansion (de Larosiere Report, 2009). What is interesting about this episode is that, despite the persistent accommodative monetary policy, the accompanying strong worldwide macroeconomic growth did not result in measured inflationary pressures in goods and most services. Consequently, central banks in advanced economies, particularly in the US, did not withdraw monetary accommodation for an extended period. The excess liquidity worldwide did show up in rising asset prices, and later in commodity prices, particularly oil. It was only then that measured inflation did start rising and central banks began to tighten monetary policy, though belatedly. With significant increases in both investment and consumption, along with declining savings,2 aggregate demand exceeded domestic output in the US for an extended period, leading to persistent and increasing current account deficits, as the domestic savings investment imbalance grew. This large excess demand of the US was supplied by the rest of the world, especially China, which provided goods and services at relatively low cost, leading to corresponding current account surpluses in China and elsewhere. The surpluses generated by the oil exporting countries added to the emerging global imbalances. … The surpluses generated by the oil exporting countries added to the emerging global imbalances. Large current account surpluses in China and other EMEs and equivalent deficits in the US and elsewhere are often attributed to the exchange rate policies in China, other EMEs and oil exporters. Given the fact that the US demand exceeded output, it is apparent that the US current deficit would have continued at its elevated levels. In the event of a more flexible exchange rate policy in China, the sources of imports for the US would have been some countries other than China. Although the lack of exchange rate flexibility in the Asian EMEs and oil exporters did contribute to the emergence of global imbalances, it can not fully explain the large and growing current account deficits in the US, particularly since Europe as a whole did not exhibit current account deficits at the same time. Accommodative monetary policy and the corresponding existence of low interest rates for an extended period encouraged the active search for higher yields by a host of market participants. Thus capital flows to Emerging Market Economies (EMEs) surged in search of higher yields, but could not be absorbed by these economies in the presence of either large current account surpluses or only small deficits, largely ending up as official reserves. These reserves were recycled into US government securities and those of the government sponsored mortgage entities such as Fannie Mae and Freddie Mac. … Thus, the causes for the current crisis reflect the interaction of monetary policy, the choice of exchange rate regime in a number of countries and important changes within the financial system itself (de Larosiere Report, 2009; BIS, 2008), along with lax regulation arising from the belief in efficient markets and light touch regulation. To recap, low interest rates, together with increasing and excessive optimism about the future pushed up asset prices, from stock prices to housing prices. Low interest rates and limited volatility prompted the search for yield down the credit quality curve, and underestimation of risks led to creation and purchase of riskier assets. Central banks, focused on measured consumer price inflation and aggregate activity, while neglecting asset price movements, did not perceive the full implications of the growing risks until it was too late (IMF, 2009). II. Shortcomings in Financial Regulation and Supervision There have been calls for fundamental rethinking on macro-economic, monetary and financial sector policies to meet the new challenges and realities, which perhaps represent a structural shift in the international financial architecture demanding potentially enhanced degree of coordination among monetary authorities and regulators. A review of the policies relating to financial regulation, in a way, needs to address both the acute policy dilemmas in the short run and a fundamental re-think on broader frameworks of financial and economic policies over the medium-term (Reddy, 2008).

For what happened was unprecedented in that with monetary policy focused only on traditional CPI, interest rates were kept low in spite of exploding prices of assets like real estate/property, credit assets, equity and commodities. And this was all made possible because of the huge current account surpluses in China and other EMEs, and huge private capital inflows into EMEs in excess of their current account deficit, getting recycled back as official capital flows into government bonds of reserve currency countries, especially the USA, resulting in compression of long term yields which, in turn, translated into lower long term interest rates even for the riskier asset classes mentioned above. This chasing of yield, due to global savings glut, in turn, led to a veritable credit bubble, characterized by unprecedented underpricing of risk as reflected in the all-time-low risk premia with junk bond spreads becoming indistinguishable from investment grade debt ! Such a low interest rate environment coupled with luxuriant supply of liquidity, created enabling environment for excessive leverage and risk taking so much so that American household debt exceeded the country's GDP! In fact, in the US, in particular, the financial sector, instead of being a means to an end of sub-serving the real sector, ended up being an end in itself. … Any deviant behaviour/conduct, inconsistent with the cosmic harmonious balance and equilibrium, will invite and inflict extremely retributive backlash; the more severe and prolonged the disequilibrium and imbalance, the more wrenching and excruciating will be the resulting pain as is currently being experienced. But the sobering chastising that the world has experienced in the current financial crisis, should stand us in good stead going forward provided all the lessons have been unforgettably learnt, imbibed, assimilated and completely internalized ! 4. In refreshing contrast, India ran modest current account surpluses to modest current account deficits with only the latest current account deficit at 2.6 % of GDP due to the impact of the ongoing global recession. Thus, in the post-economic reforms period, through its macro economic policies, India demonstrated that it is committed to, and believes in, ‘earned’ and ‘shared’ prosperity in our economic relations with the rest of the world through sustainable and balanced current account. 5. The current global economic recession, the worst since the Great Depression, was caused by the apocalyptic global financial melt down and not the other way round which traditionally has so far been the case, where typically it was economic recession that preceded and precipitated financial crises. … The underlying idea is that current account deficit subsumes fiscal deficit in the sense that high fiscal deficit essentially connotes high public sector dis-saving which can be offset by private sector and house hold sector savings. It is significant in this context to note that Indian economy has been characterized by increasing domestic savings rate financing investment, with domestic savings rate reaching a high of about 38 % of GDP in financing investment of 39% of GDP in 2007-08. 11. Both the Government and the Reserve Bank of India responded to the challenge in close coordination and consultation. The main plank of the government response was fiscal stimulus while the Reserve Bank's action comprised well-calibrated timely monetary accommodation and counter-cyclical regulatory measures. But, not without reasons, concerns have been voiced and, legitimately so, whether going forward the externalities of the global financial crisis will lead to going slow on the financial sector reforms agenda in India. These concerns essentially owe themselves to the ongoing debate in the West where it is apprehended that the pendulum may swing from lax and liberal regulation to policy backlash and regulatory over-kill. But I may assure that we in India have no reason to be defensive about our commitment to, and pursuit of, the financial sector reforms agenda for the simple reason that crisis, or no crisis, we have, in India, been able to deliver credible and effective regulation and supervision of the financial system.

The US has been virtually alone among the OECD countries in pursuing an aggressive and flexible countercyclical monetary and fiscal policy – cuts in policy interest rates have been the largest and the swing in structural government balance from a surplus of 0.6 per cent of GDP in 2000 to a deficit of 5.1 per cent in 2003 is the largest in three decades. Global growth will continue to be led by the US, but significant downside risks could emanate from the emergence of the record current account and fiscal deficits of the US. While the depreciation of the US dollar has so far been relatively orderly, further and substantial depreciation remains a danger to global recovery in the shadow of the twin deficits. History suggests that even an orderly adjustment in key exchange rates is likely to be associated with a slowdown in US growth – and, if growth in the rest of the world remains weak, in global growth as well (IMF, 2003). The continuing dependence of the world on the US heightens the risks of disorderly adjustment, particularly if it translates into an off-setting appreciation of the euro. In contrast to the mid-1980s, when the US ran current account deficits of similar order as in 2003, neither Europe nor Japan is in a position today to pick up the slack. Looking ahead, it is unlikely that the US can provide the degree of support to the global economy that it has in the past. … Quantitative easing of monetary policy has kept short-term interest rates at zero, but has not been aggressive enough to end deflation. The build-up of public debt and pressures from population aging necessitate a medium-term strategy to impart sustainability to fiscal policy. Overall, global macroeconomic imbalances and the associated misalignment of the G-3 currencies remain the most serious threat to a broad-based and robust recovery. This has implications for the pattern of capital flows. In contrast to preceding years, the US current account deficit has been financed primarily by sale of government and corporate paper rather than equity inflows. The bulk of these investments has been by central banks, particularly those in Asia. This is clearly unsustainable and adjustments will be needed to achieve medium-term stability. An eventual narrowing of the US current account deficit will require emerging economies to share in the adjustment to prevent an undue burden on the euro area. A current issue of concern is the practice of greater flexibility in the exchange rate regimes of these countries, and the resulting efforts on the real economy. Studies have shown that greater volatility in developing countries’ real exchange rates has been associated with greater misalignment in G-3 countries with disruptive effect on both trade and finance channels. This emerges as a major source of uncertainty for the conduct of monetary policy. … This emerges as a major source of uncertainty for the conduct of monetary policy. The current imbalances in the world where Asian countries are financing Western countries, particularly the US, could have their roots in longer term demographic imbalances. The long-term demographics facing the world, which have an effect on the savings rate are not encouraging. The demographics in Europe, Japan and the US are against high saving rates. The median ages in Japan, Europe and the US are 4l, 40 and 35 years, respectively. Current trends indicate that the median age in Japan will increase to 50 by 2025. The situation in the US may not turn adverse due to their flexible immigration policies. Within Asia, India and China can expect their savings rate to increase further, given that the private savings of these two countries are among the highest in the world, and in view of their favourable demographics over the next 20 years. Countries like India and China, which account for a large proportion of world population, also have low urbanisation levels of 30 to 35 per cent and will be moving to 50 to 55 per cent in the next 20 to 30 years. This would necessitate higher infrastructure investment requiring higher capital inflows and a higher current account deficit. Thus, if the Asian countries are to run large capital account surpluses and current account deficits, the situation in the US and Europe would meet reversal.

Pramod Gupta: Okay, thank you. Moderator: Thank you. The next question is from the line of Devika Mehndiratta from Credit Suisse, Singapore. Please go ahead. Devika Mehndiratta: Good afternoon. Thank you for taking my questions. My first question is that the call rate can be close to the floor of the corridor sometimes, even if banks are borrowing from the RBI's repo window. So when you say that the repo rate will be the operational rate going forward, does it mean that you would like to see the call rate at the top end of the corridor or does it mean that it is necessary so long as banks are net borrowers at the repo window even if it is for small net borrowings and secondly just wanted your view on how you think fixed investments are picking up because the capital goods IT sub-index has been quite volatile in recent months? Thank you so much. Shyamala Gopinath: What you are saying is that there could be situations when banks would be borrowing from the repo window, but still the call rate will be at the reverse repo rate or at the lower end. How the call rates move during any day would depend on daily liquidity situations and the special liquidity requirement of individual banks. So there may be like we do see some banks borrowing at repo rate and a lot of them depositing funds in the Reserve Bank. … My question is that this year you were estimating that capital inflows would likely be just enough to care of the current account deficit. My question is that in that case, how would you think of expanding RBI’s balance sheet especially if RBI is not buying government bonds as well through OMO operations and my second question would be that last quarter you had mentioned that one of the reasons for your calibrated approach has been to encourage supply side response to curb inflation. Would you think that now with a more aggressive liquidity tightening and rate tightening, there could be a negative impact from the supply side? Dr. Subir Gokarn: On the first question Samiran, I think it is not entirely a correct assessment that you have indicated which is that the capital inflows will just about cover the current account. We pointed out to potential risks on either side of this that is there is a risk under uncertain global conditions that we might not have an adequate cushion which includes the question about balance sheet expansion and on the other side, there is also the risk of excess. But in the baseline actually you take off these two extreme situations and we do expect that we should have enough capital flows. … So that obviously pre-supposes some expansion in the balance sheet which has been explained during the course of various other questions that we would have to expand the Reserve Bank’s balance sheet and we have the instruments for that and to support 8.5% growth also, we have put out 20% credit growth which also would be supplemented by the non-banking sector, both, as the domestic capital market and from the external flows. I think that should be adequate to support 8.5% growth. Varda Pandey: The other characteristic of the current account deficit that I wish to point out was that the real effective exchange rate has appreciated very sharply which is sort of in contrast with what we saw in times of the earlier episode of current account deficit. What would you say about that? Deepak Mohanty: The real rate again is determined mostly by capital flows because what we have seen in the past experience that, it is again capital flows which have had stronger influence. This is true globally also. And if you look at the real effective - exchange rate now - because we take the broad basket which we have put out in the policy - the 36 country - you do not see a very large appreciation there. Because the nominal rate more or less is 1.5. But 6 country again the appreciation is little larger this financial year - about 3.5. But compared to the nominal rate appreciation is less.

4. The MPC reviewed the surveys conducted by the Reserve Bank to gauge consumer confidence, households’ inflation expectations, corporate sector performance, credit conditions, the outlook for the industrial, services and infrastructure sectors, and the projections of professional forecasters. The MPC also reviewed in detail staff’s macroeconomic projections, and alternative scenarios around various risks to the outlook. Drawing on the above and after extensive discussions on the stance of monetary policy, the MPC adopted the resolution that is set out below. Resolution 5. On the basis of an assessment of the current and evolving macroeconomic situation at its meeting today, the Monetary Policy Committee (MPC) decided to: keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.5 per cent. Consequently, the reverse repo rate under the LAF remains at 6.25 per cent, and the marginal standing facility (MSF) rate and the Bank Rate at 6.75 per cent. The decision of the MPC is consistent with the stance of calibrated tightening of monetary policy in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4 per cent within a band of +/- 2 per cent, while supporting growth. The main considerations underlying the decision are set out in the statement below. Assessment 6. Since the last MPC meeting in October 2018, global economic activity has shown increasing signs of weakness on rising trade tensions. … Thus, a policy response is called for. If there is no policy action in response to such a major favourable shock, MPC would run the risk of being considered neither current nor relevant! With inflation forecast coming down by around 120 basis points and quarterly growth forecasts marginally revised downward opening up output gap going forward, there is hardly any justification in retaining calibrated tightening stance. In my opinion, this would be the right time to cut the rate and bring the unduly high real interest rates in the country back to around 2 per cent. It was, however, unfortunate that in October 2018, MPC had changed its stance to calibrated tightening with 5:1 majority despite my unsuccessful persuasion to maintain neutral stance. As a result, any rate cut is off the table for now and any such action would not be advisable at this point. The best we can do under the circumstance is to hold the rate, but change the stance to neutral to take care of all possible uncertainties. We should not deny any possibility of either a rate cut or a rate hike in the near future depending on data coming in.43. … We should not deny any possibility of either a rate cut or a rate hike in the near future depending on data coming in.43. More specific reasons for my vote on the rate and the stance are: While the MPC resolution points largely to the upside risks to the RBI’s inflation forecasts, there are downside risks that cannot be overlooked: Oil price uncertainties are on both the directions; Qatar has opted out of OPEC and it can set a trend for others; OPEC meeting can go either way; the ultimate impact on oil prices would be determined by faithful implementation of its decision by all members; and role of USA in this matter cannot be ignored. Similarly, Federal Reserve has practically changed its stance on rate hikes in future. Moreover, the USA economy is not likely to be very strong over time consistently. Fiscal slippage is possible but the extent of it may not warrant any panic because its impact on inflation may not be significant and will be felt, if at all, with a considerable lag. Real interest rate in the economy is very high. Even ignoring the issues concerning upward bias in the current measurement of inflation, it is substantially in excess of 200 basis points and is one of the highest in the world.

Because our staff who have done the analysis have told me that rate action by itself would not have resulted in the necessary transmission of the policy rate to the banks’ lending rate, so we had to do a CRR action on top of a rate action. The last thing I want to say is about the guidance that we have given. We have said that there is a scope for a rate reduction going forward, indeed for the larger monetary easing going forward but the space is quite limited. Limited because of how we see the inflation trajectory, a number of upside risks to inflation. Most importantly, the suppressed inflation that will come off coal prices, electricity prices might be adjusted in the next few months. Depending on how much they are adjusted and when that will have implications for the trajectory of inflation. By far the biggest risk to inflation trajectory, to monetary policy and indeed to the macroeconomic management will be the current account deficit which for the first half of this year was 4.7%. The second half is likely to be higher and this year’s currency account deficit is likely to be significantly higher than last year’s current account deficit. So we have to take into account the implications of the size of the current account deficit in our monetary policy action. I will stop there. Thank you very much. Alpana Killawala We can start the questions, Laveena. … Tushar Poddar I also wanted to ask a question on the issue of the current account deficit. You have rightly flagged that it is one of the key macro risks for the economy and something that you will take into account in your monetary policy. Now, we know the relation between the fiscal deficit and the current account deficit is pretty clear. My question is, can and should monetary policy be setting interest rates to meet a current account deficit objective? And I ask that because as you said, the RBI has one instrument, which is the interest rate, and it has multiple objectives. So, are we adding now to that suite of objectives by including the current account deficit? Does that not complicate your ability to meet any of those objectives or should you not segregate fiscal policy to deal with current account deficit and monetary policy to deal with the growth inflation tradeoff? Dr. D. Subbarao That is really a seminar topic, Tushar. So, it is difficult to assign instruments to each policy in the real world of policy making. So, as much as price stability is the main concern of monetary policy, we have to be sensitive to growth concerns, to external sector concerns because they have implications for price stability and that is what we were trying to convey yesterday that current account deficit has macro economic implications, but it has importantly implications for the price situation for inflation movements and therefore for monetary policy. … Typically the financial savings have come down much faster and I would want to believe that the difference in investment and savings is showing up in the current account deficit. In such a scenario cutting rates again provides more disincentives for financial savings and at the same point in time we are trying to revive investment, which will lead to this gap widening further, and therefore I would want to believe that the current account deficit will again go up higher than the current levels. So, if we are so concerned about the current account deficit does it not make sense to revive savings and lower investments rather than lowering savings and increasing investments? My second question would be on the open market operations. We typically have seen OMOs being conducted only at the long end of the curve. Do you think consistently doing OMOs at the longer end of the curve actually distorts the yield curve and kind of makes it much more difficult to predict on the longer end because a lot depends on the OMOs and the choice of securities. Dr. D. Subbarao Thank you very much for those two very clear questions. First, on the impact of a monetary easing yesterday on the current account deficit.

Besides, the overall balance of payments has been in surplus for most of the years and consequently the country’s foreign exchange reserves have increased significantly. This suggests that tariff reductions could be carried out faster than envisaged earlier, without posing any significant risk to the balance of payments. Current Account Dynamics in an Open Economy The modest current account surpluses in recent two years, viz., 2001-02 and 2002-03, are often attributed to cyclical factors such as subdued domestic demand at home and abroad. Over a longer period, current account dynamics reflect inter-temporal smoothing of consumption and, therefore, can be attributed to gaps between domestic savings and investment. Savings behaviour, in turn, is the result of evolving demographic patterns. Regional demographic trends indicate that the current account surpluses witnessed by India and other economies in recent period may not be temporary. Given the higher share of the aged in their population, advanced economies are projected to experience a substantial decline in their saving rates relative to investment in the coming decades, which would then be reflected in current account deficits. These regions will switch to importing capital. Increasingly, it would be the moderate and the low performers among the developing countries which would emerge as exporters of international capital. India is entering the second stage of demographic transition and over the next half-century, a significant increase in both saving rates and share of working age population is expected. … India is entering the second stage of demographic transition and over the next half-century, a significant increase in both saving rates and share of working age population is expected. An important dimension of the current account dynamics is the spillover of fiscal deficits to the external sector. More often than not, it is the fiscal deficit of the public sector that tends to be associated with large current account imbalances. The link between fiscal deficits and current account balance implies that if the private sector is in balance, the government deficit will be fully reflected in the current account deficit. The results of cross-country causal relationship between current account balances and fiscal deficits suggest that for developing countries the causality runs from fiscal deficits to current account deficits. In India, the current juxtaposition of high fiscal deficits and low current account deficits or even surpluses reflects mainly high private sector savings, especially that of the household sector, coupled with sluggishness in investment demand. The spillover of fiscal deficits to current account deficits could easily occur in the event of a pick-up in investment demand. Thus, it underlines the importance of fiscal consolidation to avoid any spillover to external imbalances. Invisibles surpluses have played an important role during the 1990s in providing resilience to India’s current account. Buoyant workers’ remittances and a dramatic rise in exports of software and other IT-related services have been the key sources of the growing strength of India’s invisible earnings. … In more recent times, on a day-to-day basis, it is capital flows that influence the exchange rate and interest rate arithmetic of the financial markets. An analysis of the complexities, challenges and vulnerabilities faced by the emerging market economies in the conduct of exchange rate policy reveals that the weight of experience seems to be clearly in favour of intermediate regimes with country-specific features, no targets for the level of the exchange rate, exchange market interventions to ensure orderly rate movements, and a combination of interest rates and exchange rate interventions to counter extreme market turbulence. In general, emerging market economies have accumulated massive foreign exchange reserves as a circuit-breaker for situations where unidirectional expectations become self-fulfilling. It is a combination of these strategies that will guide monetary authorities through the impossible trinity of a fixed exchange rate, open capital account and an independent monetary policy. Recent experience has highlighted the need for developing countries to keep a continuous vigil on market developments, and the importance of building adequate safety nets that can withstand the effects of unexpected shocks and market uncertainties. The important message that comes out from the analysis of various episodes of volatility and the policy responses is that flexibility and pragmatism are needed in exchange rate policy in developing countries, rather than adherence to strict theoretical rules.

The process of interest rate deregulation was carried out gradually, and banks were given increasing autonomy in decision making along with the cessation of credit allocation. The monetisation of fiscal deficits was first reduced and then eliminated, with government financing being done increasingly through debt auctions entailing the discovery of risk free interest rates in the economy. Current account convertibility was introduced in the early 1990s enabling the adoption of a market-determined exchange rate. The capital account has also been liberalised gradually, but is not fully open, entailing intervention in the forex market by the Reserve Bank to contain excess volatility. The financial sector reforms, designed to improve cost efficiency through price signals have, in turn, facilitated the conduct of monetary policy through indirect market-based instruments and improved fiscal-monetary coordination. On the fiscal side, this process was further strengthened through the implementation of the Fiscal Responsibility and Budget Management Act (FRBM) Act, 2003, under which the Central Government was mandated to eliminate the revenue deficit and reduce its fiscal deficit to 3 per cent of GDP by 2008-09 and the Reserve Bank was prohibited from participating in the primary government securities market from April 2006. Whereas the main objective of financial sector reforms has been the enhancement of efficiency of the financial system, a concomitant goal was also to impart stability in a new market oriented environment.   Development of financial markets has therefore been a key component of this process. … Therefore, the Dutch Disease syndrome has so far been managed by way of reserves build-up and sterilisation, the former preventing excessive nominal appreciation and the latter preventing higher inflation. However, the issue remains how long and to what extent such an exchange rate management strategy would work given the fact that we are faced with large and continuing capital flows apart from strengthening current receipts on account of remittances and software exports. This issue has assumed increased importance over the last couple of years with increased capital flows arising from the higher sustained growth performance of the economy and significant enhancement of international confidence in the Indian economy. Large capital inflows in recent years, far in excess of the current account surplus, have, therefore, necessitated a certain amount of capital account management, along with intervention in the forex market to curb volatility in the exchange rate (Mohan, 2007a). Management of volatility in financial markets and implications for the conduct of monetary operations will continue to need attention. Greater inflows will inevitably exert pressure on the Reserve Bank’s ability to manage the impossible trinity of independent monetary policy, open capital account and a managed exchange rate, keeping in view that the impact of exchange rate fluctuations on the real sector in developing economies is much higher than in mature economies, particularly in labour intensive low technology price sensitive goods. … Greater inflows will inevitably exert pressure on the Reserve Bank’s ability to manage the impossible trinity of independent monetary policy, open capital account and a managed exchange rate, keeping in view that the impact of exchange rate fluctuations on the real sector in developing economies is much higher than in mature economies, particularly in labour intensive low technology price sensitive goods. To what extent is the current account balance a good guide to evaluation of the appropriate level of an exchange rate? To what extent should the capital account influence the exchange rate? What are the implications of large current account deficits for the real economy? Are they sustainable and, if not, what are the implications for financial stability in developing countries? India always had a modest current account deficit though, because of remittances and service exports, the trade deficit has widened significantly in recent years. These are the issues that monetary policy will have to continue to deal with while addressing the impact of capital flows. References Acharya, Shankar (2005) : “Thirty Years of Tax Reform in India”, Economic and Political Weekly, May 14. Ball L., Sheridan N.. (2003) :“Does inflation Targeting Matter?”. NBER Working Paper No 9577. Bhattacharyya, I and P. Ray (2007): “How do we assess Monetary Policy Stance? Characterization of a Narrative Monetary Measure for India”, special issue on Money, Banking and Finance, Economic and Political Weekly, March 31, 2007.

These large and persistent imbalances represented “unearned” prosperity for deficit reserve currency countries and “unshared” prosperity for surplus countries. Such a global economic order was inherently unsustainable and unstable from the word go. In other words, the only sustainable and durable global economic growth model would be where growth and prosperity are both “earned” and “shared”. In fact, the whole thing can be likened to cosmic balance/equilibrium/harmony where stars, suns, planets, all orbit within the inviolable discipline of their elliptical orbits which do not permit deviant behaviour beyond the shortest and the longest distance from the suns and stars of the orbiting planets! Any deviant behaviour/conduct, inconsistent with the cosmic harmonious balance and equilibrium, will invite and inflict extremely retributive backlash; the more severe and prolonged the disequilibrium and imbalance, the more wrenching and excruciating will be the resulting pain as is currently being experienced. In refreshing contrast, India ran modest current account surpluses to modest current account deficits with only the latest current account deficit at 2.6% of GDP due to the impact of the ongoing global recession. Thus, in the post-economic reforms period, through its macro economic policies, India demonstrated that it is committed to, and believes in, “earned” and “shared” prosperity in our economic relations with the rest of the world through sustainable and balanced current account. … Significantly, even now the rural demand continues to remain robust, especially for autos, two wheelers, tractors and FMCGs. This was all made possible because of public spending under National Rural Employment Guarantee Programme, Rural Self-Employment Programme and Rural Road Construction Programme under flagship Government sponsored schemes. Indeed, as a critical complement to this effort, financial inclusion initiative driven by leveraging smart card and bio-metric technology, also played a pivotal role. Besides, going forward, with 400 million odd mobile phone subscribers in India, mobile banking has tremendous potential for spreading banking and financial services to rural and semi-urban areas and further economic empowerment of the rural sector. Inevitably, the fiscal policy had to respond commensurately and Government delivered three fiscal stimulus packages, as a result of which the fiscal deficit rose from 2.7% of GDP in 2007-08 to 6.2% of GDP in 2008-09 and is projected to rise to 6.8% in 2009-10. But, this is not a cause for concern primarily because we need to look at fiscal deficit not in isolation but in conjunction with current account deficit. Thus, even though the fiscal deficit is 6.2%, the current account deficit at 2.6% is below 3%, a level which is considered sustainable. The underlying idea is that current account deficit subsumes fiscal deficit in the sense that high fiscal deficit essentially connotes high public sector dis-saving which can be offset by private sector and house hold sector savings. … The underlying idea is that current account deficit subsumes fiscal deficit in the sense that high fiscal deficit essentially connotes high public sector dis-saving which can be offset by private sector and house hold sector savings. It is significant in this context to note that Indian economy has been characterized by increasing domestic savings rate financing investment, with domestic savings rate reaching a high of about 38% of GDP in financing investment of 39% of GDP in 2007-08. Both the Government and the Reserve Bank of India responded to the challenge in close coordination and consultation. The main plank of the government response was fiscal stimulus while the Reserve Bank's action comprised monetary accommodation and counter cyclical regulatory measures. Monetary measures The monetary measures have comprised three elements: Monetary easing by cutting policy rates, provision of rupee liquidity, forex liquidity and ensuring availability of credit for productive purposes. Reduction in key policy rates • The repo rate was reduced by 425 basis points from 9.0 per cent in October 2008 to the current rate of 4.75 per cent. Similarly the reverse repo rate was reduced by 275 basis points from 6.0 per cent to 3.25 per cent. Provision of Rupee liquidity • The Cash Reserve Ratio (CRR) was reduced from 9% to 5% of Net Demand and Time Liability (NDTL).

But also I think we have shown the capacity of the system to raise money if need be. As of yesterday the FCNR(B) deposits plus capital raising by the banks had reached 12 billion but the point more generally is that international markets are open to borrowers in India and I think we have shown that whatever current account deficit is we can finance it if necessary from outside money. We have also had substantial equity inflows. Again, I do not want to be too complacent about any kind of flows because what comes in can go out, but nevertheless I think that the picture has changed little from what it was in May when our current account deficit was blowing out and there was a lot of concern about it. Moderator: Thank you. The next question is from the line of Simon Flint from Dymon Asia. Please go ahead. Simon Flint: If I may ask Dr. Rajan, I wanted to know your opinion of interest rates moving in general, I mean, in a sense used by Woodford, Goodhart and others in central banking literature. And how might one apply the intuition of this interest rates smoothing literature to the current Indian situation? Dr. Raghuram Rajan: You need to be more explicit, what do you have in mind, what do you mean by interest rates smoothing? Simon Flint: I suppose if there was a model which told you interest rates should be at an X per cent. … Simon Flint: I suppose if there was a model which told you interest rates should be at an X per cent. And that X per cent could be 100 or 200 basis points above the current or below the current interest rate. You might want to move less than that the model told you to move, maybe for two or three reasons. First of all, there is some uncertainty in your forecast; maybe you think there is something inherently good about having a kind of predictable path on the interest rates. And thirdly and finally, maybe you want to minimize financial market volatility that might be inherent in having interest rate which responds relatively strictly to model. That was the kind of thing I was driving at. Dr. Raghuram Rajan: I think that is a reasonable question. I think another way of asking the question is whether we have a path of interest rates in mind having started on a process. And the answer to that is no, that it is not that we are trying to take baby steps towards some longer-term interest rate goal we have in mind. … Raghuram Rajan: Let me just quickly say that we do not have a value of the rupee in mind. I think there are so many forces at play that it would be very hard for me to say this is the value and stick to it. But that said, let me ask Mr. Deepak Mohanty to perhaps answer the rest of your question. Shri Deepak Mohanty: As was earlier mentioned by Governor, because the current account itself is also coming down to more sustainable levels, the way that we see it, and with the outlook on the economy also improving, that we can see that capital flows could also hold on. Because we see that other component of capital flow except the debt flows are normal or near normal, only the pressure is coming more on the debt side. But we have taken steps on that side, because in terms of the NRI deposits that we have a swap window open and we are getting substantial flows. So as long as the current account can be financed with the normal capital flows, so there should be more stability in the exchange rate, but at the same time as Governor mentioned that we do not have a value for exchange rate, that what is the number that one is really targeting at. Dr. Raghuram Rajan: As far as tapering goes, we will figure out what we need to do based on the events at that point.

It must be recognised that these low positions inspite of recent impressive performance are due to the very low base from where the region began its commendable achievement in economic growth since the ‘eighties.In particular, the financial imbalances of the government in the region were and continue to be among the worst among all regions. The additional problem besides the large size of fiscal deficit was the revenue deficit that reduced the public sector savings. That the region recorded one of the lowest rate of saving is often a reflection of this dissaving of the government revenue account. The banking presence in terms of bank credit to GDP ratio in the region is also one of the lowest. The region is one of the least indebted region in the world in terms of external debt, but in view of its low base of export of goods and services the debt service ratio is not as comfortable. The official development assistance in the region has been declining despite it already being one of the least recipient regions. The long-term private capital and FDI inflows have been growing at a relatively slow rate and continue to be the least among the regions. Furthermore, the region has significantly lagged behind in the field of infrastructure, social provisions and working of the institutional set-up. And this does not augur well for the medium and long-term growth prospects of the region. … Most of the remittances with the possible exception of Nepal appear to be from the Gulf and South-East Asia, indicating a weak intra-regional remittance flows in South Asia. However, the data on worker’s remittances needs to be interpreted with some caution as it may not fully capture intra-regional flows. Exchange Rate Arrangements and Movements According to International Monetary Fund’s (IMF) publication on Exchange Arrangements and Exchange Restrictions (2000) Bangladesh and Maldives peg their currencies to a trade-weighted basket of currencies. In Maldives, however, the currency has remained stable vis-à-vis US dollar since October 1994. Pakistan pegs its currency to the US dollar. On the other hand, Sri Lanka follows a system of crawling peg against the US dollar within a band of 2.0 percent. In respect of India, however, exchange rate is determined by demand and supply conditions in the market. The currencies of Nepal and Bhutan are pegged to the Indian Rupee.It is useful to analyse the movement in the quarterly average exchange rates per US dollar of these countries during 1991 to 2000. The movements in the exchange rates are similar to a large extent, except perhaps Maldives that follows a relatively fixed rate to US dollar (Graph). … The movements in the exchange rates are similar to a large extent, except perhaps Maldives that follows a relatively fixed rate to US dollar (Graph). The correlation coefficients between the quarterly average exchange rate per US dollar of Indian Rupee and the corresponding exchange rates of other six South Asian countries for the period is estimated to range from 0.95 (Bangladesh) to 1.0 (Bhutan and Nepal), barring 0.79 with Maldives (See Table-1). In other words, the movements in the exchange rates of South Asian countries vis-à-vis US dollar are noticeably similar. Current and Capital Account Convertibility In terms of current account, Bangladesh, India, Nepal, Pakistan and Sri Lanka have adopted Article VIII of the IMF while Bhutan and Maldives are still classified under Article XIV. Basically, a member country embracing Article VIII undertakes to avoid restrictions on current payments and discriminatory currency practices. Article XIV facilitates countries to avail of transitional arrangements that permit them to impose restrictions on the current account. Bangladesh and Bhutan, however, still have some bilateral payments arrangements. As regards receipts from exports as well as invisible transactions, Bangladesh, Bhutan, India, Nepal and Pakistan have repatriation requirements (which refers to obligation of exporters to bring back export proceeds into the country) while only Bangladesh, Bhutan and India of these countries have imposed surrender requirements (refers to regulation requiring recipient of repatriated export proceeds to sell the foreign exchange proceeds to central bank or commercial bank or Authorised Dealers as the case may be).

So there is clearly evidence that there were monetary excesses during the period leading up to the housing boom” (Taylor, op.cit.). Taylor also finds some evidence (though not conclusive) that rate decisions of the European Central Bank (ECB) were also affected by the US Fed monetary policy decisions, though they did not go as far down the policy rate curve as the US Fed did. Excessively loose monetary policy in the post dot com period boosted consumption and investment in the US and, as Taylor argues, it was made with purposeful and careful consideration by monetary policy makers. As might be expected, with such low nominal and real interest rates, asset prices also recorded strong gains, particularly in housing and real estate, providing further impetus to consumption and investment through wealth effects. Thus, aggregate demand consistently exceeded domestic output in the US and, given the macroeconomic identity, this was mirrored in large and growing current account deficits in the US over the period (Table 1). The large domestic demand of the US was met by the rest of the world, especially China and other East Asian economies, which provided goods and services at relatively low costs leading to growing surpluses in these countries. Sustained current account surpluses in some of these EMEs also reflected the lessons learnt from the Asian financial crisis. … The surpluses of East Asian exporters, particularly China, rose significantly from 2004 onwards, as did those of the oil exporters (Table 1). In fact, Taylor (op. cit.) argues that the sharp hike in oil and other commodity prices in early 2008 was indeed related to the very sharp policy rate cut in late 2007 after the sub-prime crisis emerged. It would be interesting to explore the outcome had the exchange rate policies in China and other EMEs been more flexible. The availability of low priced consumer goods and services from EMEs was worldwide. Yet, it can be observed that the Euro area as a whole did not exhibit large current account deficits throughout the current decade. In fact, it exhibited a surplus except for a minor deficit in 2008. Thus it is difficult to argue that the US large current account deficit was caused by China’s exchange rate policy. The existence of excess demand for an extended period in the U.S. was more influenced by its own macroeconomic and monetary policies, and may have continued even with more flexible exchange rate policies in China. In the event of a more flexible exchange rate policy in China, the sources of imports for the US would have been some countries other than China. Thus, it is most likely that the US current account deficit would have been as large as it was – only the surplus counterpart countries might have been somewhat different. … Thus, it is most likely that the US current account deficit would have been as large as it was – only the surplus counterpart countries might have been somewhat different. The perceived lack of exchange rate flexibility in the Asian EMEs cannot, therefore, fully explain the large and growing current account deficits in the US. The fact that many continental European countries continue to exhibit surpluses or modest deficits reinforces this point. Apart from creating large global imbalances, accommodative monetary policy and the existence of very low interest rates for an extended period encouraged the search for yield, and relaxation of lending standards. Even as financial imbalances were building up, macroeconomic stability was maintained. Relatively stable growth and low inflation have been witnessed in the major advanced economies since the early 1990s and the period has been dubbed as the Great Moderation. The stable macroeconomic environment encouraged underpricing of risks. Financial innovations, regulatory arbitrage, lending malpractices, excessive use of the originate and distribute model, securitisation of sub-prime loans and their bundling into AAA tranches on the back of ratings, all combined to result in the observed excessive leverage of financial market entities. Components of the Crisis Most of the crises over the past few decades have had their roots in developing and emerging countries, often resulting from abrupt reversals in capital flows, and from loose domestic monetary and fiscal policies. In contrast, the current ongoing global financial crisis has had its roots in the US.

Earlier, the position was that we would try and wean ourselves away from the use of that instrument and focus only on policy rates. But, we are now using it (CRR) actively. The same criterion applies to any measure that might relate to capital inflows, whether quantity restrictions or price restrictions. There is, currently, no proposal to use either of these but if the situation warrants, we will not deny ourselves the opportunity of using them. What is your estimate of the current account deficit for 2010-11? We have not put out a formal assessment but we do not see any threat. In any event, we do expect that capital inflows will be more than adequate to cover the current account deficit. We have to decide on how we are going to manage the balance of payment surplus. There is no intervention in the exchange rate market with an exchange rate target in mind. Look at the exchange rate movement during the last couple of years — from a bottom of around Rs 52 (a dollar) to a top of Rs 39. Such a wide variation does not suggest management of the exchange rate. Volatility may be managed but the levels over this period of time have not. At the same time, we cannot ignore the fact that massive swings in the exchange rate are disruptive, as many stakeholders do not have the capacity to mitigate foreign exchange risk. … At the same time, we cannot ignore the fact that massive swings in the exchange rate are disruptive, as many stakeholders do not have the capacity to mitigate foreign exchange risk. Developments like foreign exchange futures obviously help and we are moving further down that road. RBI has projected 7.5 per cent GDP growth and then talked about unbalanced growth. How do you reconcile the two? If you focus on the aggregate, the number looks reasonable. But, when you look at the disaggregated picture, it is still an unbalanced recovery. There is still a relatively high dependence on government spending. What this tells you is that the private sector is yet to provide full comfort in terms of its participation in the recovery process. So, that is a risk. Similarly, some sectors such as consumer durables and automobiles are doing very well, while others are sluggish. Again, this suggests a narrow set of drivers and there are risks inherent in that. We do not overplay the risks, but we cannot ignore these either. It is quite likely that our stance would have been different if we had much greater comfort in the broad-basing of the recovery. RBI has made money more expensive without hiking rates. Was the central bank a bit too hawkish? The objective (of the 75 basis point CRR hike) was to extract excess liquidity from the system. That’s because we are looking at a situation where food inflation is clearly a problem. … If the factors you are talking about take the economy above the trend, the risks of overheating develop and from a macro-economic stability perspective, we have to address those. Our focus is on whether this is being done within the overall capacity of the economy to sustain that growth rate. If growth is above trend, we need to find ways of dampening. There is some difficulty, of course, in identifying what the sustainable trend is in such a dynamic and volatile environment. This is an ongoing analytical objective This is your first monetary policy. What are your first impressions about RBI? The process is very intense and the amount of information and analysis that comes in is much larger than I appreciated as an outsider. What I have discovered is that the density of information and the amount of processing is huge. So, the confidence in the correctness of the decision is far more than it would have been, based on the data that I had available to me on the outside. It’s an extremely consultative process, both internally and externally, with RBI staff from many departments, banks and other market participants. The rigour of the process was a revelation; I did not appreciate it from the outside.

Internationally there will be increased pressure for rapidly and more deeply integrating domestic and global markets. External Sector Management It is generally appreciated that the RBI has distinguished itself in regard to external sector management, whether it was meeting the balance of payment crisis in 1991, or managing the transition to a liberalised exchange rate, unified exchange rate, current account convertibility and capital account liberalisation. The basic parameters set for itself in terms of current account deficit, market-determined but non-volatile exchange rate, containing debt especially short-term, well sequenced liberalisation of capital account, and building up as well as managing adequate foreign exchange assets have all been met and often exceeded, despite several international and domestic uncertainties. In all this, the Government's own actions have provided active support in achieving these objectives. Perhaps an ideal starting point could be the replacement of the Foreign Exchange Regulation Act (FERA) by Foreign Exchange Management Act (FEMA) with effect from the beginning of this month. The philosophy of foreign exchange management has shifted from that of conservation of foreign exchange to one of facilitating trade and payments as well as developing financial markets. This definitive shift in the objectives of foreign exchange management will automatically get reflected in the operations of the Reserve Bank. Under the new system, all current account payments except those notified by the government are eligible for appropriate foreign currency in respect of genuine transactions from the Authorised Dealers without any restrictions. … Under the new system, all current account payments except those notified by the government are eligible for appropriate foreign currency in respect of genuine transactions from the Authorised Dealers without any restrictions. The surrender requirements in respect of exports of goods and services continue to operate. The Reserve Bank however, would have the necessary regulatory jurisdiction over capital account transactions. To this extent, further action in regard to capital account liberalisation appears to have been put by government squarely in the court of RBI. On the current account, RBI will have to closely monitor the trends in imports given the liberalised environment, the growth in exports, particularly export of services, and private inward remittances. Overall, the impact of possible increased investment activity in the future, particularly in infrastructure, on the level of current account would have to be assessed. In doing so, the fact that the combined share of exports and imports has gone up from about 13 percent of GDP in the latter half of eighties to over 20 percent in the recent period as well as the sharp increases in capital flows and the level of reserves could be kept in view. In this background, and on the assumption of sustainable level of non-volatile capital flows, the possibility of an acceptable band of sustainable current account deficit may need to be conceptualised. … In this background, and on the assumption of sustainable level of non-volatile capital flows, the possibility of an acceptable band of sustainable current account deficit may need to be conceptualised. Similarly, the level and the composition of the capital flows would also change and the stability of these will be impacted less by capital controls and more by the domestic policies as well as transparency practices and standards and codes, though international factors would continue to be critical. As regards exchange rate management, the unfolding events with reference to fiscal policy, financial sector, especially financial markets and International Financial Architecture would determine the course of policy. Perhaps the biggest dilemma for RBI as for many central banks would be reconciling monetary and external sector management. Regulatory and Supervisory Functions Significant improvements have been made in the quality of performance of regulatory and supervisory functions by the RBI. Admittedly, the level of our compliance with international practices, is one of the best among the peers. Attention is being paid by my fellow Deputy Governor, Mr.S.P. Talwar to several contemporary issues such as, relative roles of onsite and off-site supervision, functional versus institutional regulation, relative stress on internal management, market discipline and regulatory prescriptions, consolidated approach to supervision, etc. Several legislative initiatives have also been taken up with Government, covering procedural law, debt recovery systems, Credit Information Bureau, Deposit Insurance, etc. Progress in these is critical for effectiveness of RBI in the regulatory sphere.

Given the then prevalent RBI’s obligation to buy and sell unlimited amounts of the intervention currency arising from the banks’ merchant purchases, its quotes for buying/selling effectively became the fulcrum around which the market was operated. The RBI performed a market-clearing role on a day-to-day basis, which naturally introduced some variability in the size of reserves. Incidentally, certain categories of current and capital account transactions on behalf of the Government were directly routed through the reserves account.Rangarajan Committee The recommendations of the High Level Committee on Balance of Payments (Chairman: Shri C. Rangarajan) provided the basic framework for policy changes in external sector, encompassing exchange rate management and, current and capital account liberalisation. The Report indicated the transition path also. Accordingly, the Liberalised Exchange Rate Management System involving dual exchange rate system was instituted in March 1992, no doubt, in conjunction with other measures of liberalisation in the areas of trade, industry and foreign investment. The dual exchange rate system was essentially a transitional stage leading to the ultimate convergence of the dual rates made effective from March 1, 1993. This unification of exchange rates brought about the era of market determined exchange rate regime of rupee, based on demand and supply in the forex market. It also marks an important step in the progress towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund. … It also marks an important step in the progress towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund. The appointment of a 14 member Expert Group on Foreign Exchange (Sodhani Committee) in November 1994 was a follow up step to the above measures, for the development of the foreign exchange market in India. The Group studied the market in great detail and in its Report of June, 1995 came up with far-reaching recommendations to develop, deepen and widen the forex market as also to introduce various products, ensure risk management and enable efficiency in the forex market by removing restrictions, introducing new products and tightening internal control and risk management systems.Sodhani Committee The Sodhani Committee had made 33 recommendations and of these, 25 recommendations called for action on the part of the RBI. RBI has accepted and implemented in full or to some degree, 20 out of the 25 recommendations. In the process, the banks have been accorded significant initiative and freedom to participate in the forex market. … Also, the decision, to hedge or not to hedge exposure depending on expectations and forward premia, itself affects the forward premia as also the spot rate. Exporters can also delay payments or receive funds earlier, subject to conditions on repatriation and surrender, depending upon the interest on rupee credit, the premia and interest rate overseas. Similarly, decision to draw bills on sight/usance basis is influenced by spot market expectations and domestic interest rates. The freedom to avail of pre/post-shipment credit in forex and switch between rupee and foreign currency credit has also integrated the money and forex markets. Further, banks were allowed to grant foreign currency loans out of FCNR (B) liabilities and this too facilitated integration as such foreign currency demarcated loans did not have any use restriction. The integration is also achieved through banks swapping/unswapping FCNR (B) deposits. If the liquidity is considerable and call rates are easy, banks consider deployment either in forex, government or money/repo market. This decision also affects the premia. Gradually, with the opening up of the capital account, the forward premia is getting aligned with the interest rate differential. However, the fact remains that free movement in capital account is only a necessary condition for full development of forward and other forex derivatives market. The sufficient condition is provided by a deep and liquid money market with a well-defined yield curve in place.