I Do What I Do - kamalludhani.files.wordpress.com · necessary so that we stuck to timelines, and then roll out the measures after engaging with stakeholders, including the public.

IDOWHATIDO

RAGHURAMG.RAJAN

CONTENTS

Introduction

SECTIONI:RBIDAYS

1. SETTINGTHESTAGE

I.StatementonTakingOffice,4September2013

II.TheFivePillarsofRBI’sFinancialSectorPolicies

2. HAWKS,DOVES,OROWLS

I.FightingInflation

II.Dosanomics

III.TheFightagainstInflation:AMeasureofOurInstitutionalDevelopment

IV.DebatewithoutTheoryorEvidence

3. MAKINGTHEBANKINGSECTORMORECOMPETITIVE

I.CompetitionintheBankingSector:OpportunitiesandChallenges

II.Interesting,Profitable,andChallenging:BankinginIndiaToday

4. BROADENINGANDDEEPENINGMARKETS

I.StrengtheningOurDebtMarkets

5. FINANCIALINCLUSION

I.FinancialInclusion:Technology,Institutions,andPolicies

II.TheChangingParadigmforFinancialInclusion

6. THERESOLUTIONOFDISTRESS

I.SavingCredit

II.ResolvingStressintheBankingSystem

7. THEECONOMYANDOTHERISSUES

I.FilteringOuttheRealIndia

II.MacroeconomicAdvice

III.FinanceandOpportunityinIndia

IV.Democracy,Inclusion,andProsperity

V.MakeinIndia,LargelyforIndia

VI.ToleranceandRespect:EssentialsforEconomicProgress

VII.WordsMatterbutSoDoesIntent

8. INTERNATIONALISSUES

I.CompetitiveMonetaryEasing:IsItYesterdayOnceMore?

9. RBIMATTERS

I.RemarksonRBI’s80thAnniversary

II.Year-endLettertoRBIStaff,31December2015

III.FinancialSectorLegislativeReformsCommitteeReport(FSLRC):WhattoDoandWhen?

IV.TheIndependenceoftheCentralBank

V.MessagetoRBIStaff

SECTIONII:THEGLOBALFINANCIALCRISIS

I.RiskyBusiness:SkewedIncentivesforInvestmentManagersMayBeAddingtoGlobalFinancialRisk

II.FinancialConditions,AssetManagement,andPoliticalRisks:TryingtoMakeSenseofOurTimes

III.TheCreditCrisisandCycle-proofRegulation

IV.TheTrueLessonsoftheGreatRecession

SECTIONIII:OCCASIONALPIECES

I.CapitalismDoesNotRhymewithColonialism

II.CleverSolution:ButWillItWork?

III.AssumeAnarchy?

IV.OdiousorJustMalodorous?

V.AidandGrowth:ThePolicyChallenge

VI.DebtReliefandGrowth

VII.TheGreatGameAgain?

Notes

Index

AbouttheBook

AbouttheAuthor

Copyright

E

INTRODUCTION

arly in my tenure as the Governor of the Reserve Bank of India (RBI),KrishanChopraofHarperCollins askedme towrite abook.He suggested

puttingtogethereditedversionsofmypastarticlesandspeechesunderdifferentthemes.IpleadedthatIwasextremelybusy,andsimplydidnothavethetime.As my term came to an end, however, I realized time would be less of aconstraint. In the speeches I gavewhile at theRBI, I had been describing thereforms we were undertaking and the rationale behind them, both to buildconfidenceamongstinvestorsandtogetsupportfromthepublic.IfIcouldlinkthe speeches together in a book with commentary about what prompted eachspeech,Icouldgivetheyouthofthecountryafeelfortheexcitementofworkingatthecentralbank.Ihopedthiswouldattractafewintotheareaofeconomicsand finance,where India really needsmoregoodpeople.Moreover, if I coulddescribetheoverallrationaleforwhathadbeendone,completedreformscouldstandabetterchanceofnotbeingreversed,whileincompletereformscouldbefinished.

I did not want to intrude on my successor’s initial engagement with thepublic, so I determined to stay silent on India for a year. This book will bepublishedafterthatyearisover.Also,whileIhavetriedtoexplainmyrationaleforvariousspeechesandactionsthroughlinkingcommentary,IhaverespectedtheprivacyofconversationsIhadwithvariouspublicfigures.Ihavealsoaddeda short selection of some speeches and articles that Iwrote, primarilywhile Iwas theChiefEconomistat theInternationalMonetaryFund,butalsowhileatChicago’sBoothSchoolofBusinessbeforeIjoinedtheRBI.

Thetitleofthisbookreflectstheserendipitousnatureofpubliclife.Ienjoyedthe give-and-take of press conferences after monetary policy meetings,especiallybecause I knewmostof the reporters.Asonepress conferencewas

ending, I was asked (yet again) by a familiar face whether I was dovish likeYellenorhawkishlikeVolcker.Iunderstoodwhatthereporterwasasking,butIwantedtopushbackontheattempttopigeonholemeintoexistingstereotypes.Somewhatjokingly,IstartedinaJamesBond-ishvein,‘MynameisRaghuramRajan…’Tomyhorror,mid-sentenceIrealizedIdidnotknowhowtoendinaway thatdidnot revealmoreonmonetarypolicy than I intended.SowithTVcamerastrainedonme,Iendedlamely‘…andIdowhatIdo’.Forsomereason,thatsentencebecamethefinancialpressheadlinethenextday,withthedetailsofourmonetarypolicyrelegatedtotheinsidecolumns.Thecommentaryonsocialmedia even reached my usually supportive daughter, who emphasized hernegativereactiontomyunwittingsentencewithrepeatedthumbs-downemojis!

In a sense, though, the headline was apt. Two different governments hadlargely given me free rein at the Reserve Bank, reposing their trust in me.KnowingIhadathree-yearterm,Icouldpushhardforchange.Eventually,theusual opposition from vested interests would build up, but I hoped the RBIwouldcompletemuchoftheneededreformsbythen.Andindeeditdid.

Icameintoofficeduringthecurrencycrisis,whenIndiawastermedoneoftheFragileFive.Somyfirsttaskwasstabilization.Butrightfromthebeginning,I realized that the prospect of financial sector reforms would be an aid tostabilization. With India making the transition from low-income to middle-incomecountry,theneedforthesereformswasclear.Ofcourse,reformsareanongoing process, and they can be reversed.Thiswaswhy itwas important toembodythereformsinnewinstitutionalmechanisms,aswellasbuildownershipofreformswithintheRBIandamongstexternalstakeholders.

Andthatbringsmetoteamwork.Thiswasnotmyfirstjobinmanagement.ButIbecameheadofanorganizationof17,000people,withassetsofmorethan$400billion.Howdoesonemanagesuchalargeorganization?Obviouslywithhelp.Ihavealwaysfoundthatthesinglemostimportanttaskinmanagementistopickgooddeputies,andImanagedtogetverygoodones.Myrolewastosettheoverallagenda(ofcourse,inconsultationwiththem),gettheconcurrenceofthe government, drawout the vast experience ofmy colleagues to fill out thedetails and rule out inadvisable steps, push and prod the organization where

necessary so that we stuck to timelines, and then roll out the measures afterengagingwithstakeholders,includingthepublic.

Wedidnotundertakereformsbystealth.Whilethefullimportofsomeoftheactions we took may not have been obvious early on, making it harder foropposition to crystallize, the roadmap for much of what we did was set byvarious RBI-appointed committees, advertised in public speeches, and thenimplemented after discussion with stakeholders. We were always willing tolistentoalternativeproposalsfromthem,butanysuggestionhadtopassmytestof economic or financial commonsense, and my colleagues’ test of meetingsensible central and commercial banking practice, before it was accepted. Byandlarge,thesedualfiltershelpedusscreenoutunhelpfulsuggestions.

Our reformswere guided by the need to increase the role ofmarkets andimprovecompetition,toensurewehadtherightregulationsandtheregulationswere enforced in a predictable and transparent way, and to do all this in ameasuredbutsteadywaysothatthesystemcouldadjust.AsIwillexplain,thisis broadly how we dealt with issues ranging from inflation management toresolving distressed loans. Throughout, our attempt was to institutionalizeprocesses so that they would be both predictable and enduring. India isbecoming a large middle income country, too complex and varied to becontrolledcentrally.Thegovernmentwillneedtowithdrawfromoccupyingthecommandingheightsoftheeconomy,confiningitselftoprovidingpublicgoodsand thegoverning framework,and leavingeconomicactivity to thepeople.Toharnesstheircollectiveenergy,Indiawillneedmanysuchreformsintheyearstocomeifitistogrowrapidlyinasustainableandequitableway.

Myspeecheswereanessentialpartof thestabilizationand reformprocess,allowingmetoexplaintherationaleforchangetoinvestorsandthepublic,flagthebuildingblocksof the reform, anddraw inopinion leaders into thedebatewhile the specific regulations were being drafted. The additional value ofdescribingwhatwe intended to do and delivering on it repeatedlywas that itallowedtheRBItogetcreditfortheintendedreformfromthemarketatthetimeofannouncement,muchbeforethetimeofdelivery.Thiscouldprovecrucialifmarketsbecamevolatileagain.Also,manyspeechestriedtoeducatethebroader

public on the underlying finance and economics. If someone got drawn by aspeech into learningmore, thatwasonemorestep towardsspreading financialandeconomicliteracy–Ihadwhateveryteacherwants,anationalplatform,oneItriedtouseeffectivelyandresponsibly.

Ialsousedmyspeechestopartlyfulfilanother importantrole theRBIhas,thatofmanagingmacroeconomicriskforthecountry.Thisobjective,aswewillsee, led to speeches that proved more controversial, perhaps because I wasspeakingoutsidetheusualareasofcentralbankingandregulation,andperhapsbecause some of my warnings were surprisingly seen as challenges to thegovernment. Nevertheless, I saw these speeches as part of the Governor’sresponsibility as the primary technocratmanagingmacroeconomic risk for thecountry.

Being an academic, I wrote all my speeches myself. My wife, Radhika,sufferedthroughearlydraftsofmanyspeeches,offeringconstructivecriticism.IthenhadtherelevantsubjectmatterexpertattheRBIlookatthespeechtocheckforaccuracy,followedbyareadfrommyveryableexecutiveassistant(first,theever-dependableVivekAggarwalwhowas succeededbyVaibhavChaturvedi).Finally, after Alpana Killawala, our Chief General Manager forCommunications,tookapassscreeningforpossiblepoliticalcontroversy,Imadefinaltouchesanddeliveredthespeech.

Press attention was always intense, even in locales that the press weresupposed to be excluded from – someone presentwould always bewilling tospeak to the press or post on social media. Much of the press attention wasperhapsinitiallyinthehopethatIwouldoffertit-bitsonthedirectionoffuturemonetarypolicy,butasthepressrealizedIdidnotspeakonnewpolicyoutsidemonetarypolicymeetings,Iliketobelievethattheycamebecausethespeecheswere interesting.Atanyrate,pressattentionwasadouble-edgedsword,aswewill see. While it allowed me to get the RBI’s messages out easily, amisunderstood speech or misinterpreted comment could make headlines andcreate unnecessary frictions. I saw this as an unavoidable cost of publicengagement, but I did sometimes question whether the misinterpretation wasaccidentalordeliberate.

ThejobofGovernorisprobablythemostfulfillingjobanyIndianeconomistcouldaspirefor.ThereweremanydayswhenIwenthometiredbuthappythatwe had really made a difference. There are very few jobs in publicadministrationwhereonecansaythisbecauseoneisalwayshemmedinbytheneedtogettheconcurrenceofotherorganizations,andturfbattlesmakeithardtomove forward.At theRBI,onmany issues thedecisionwasours, andoursalone, so progress was feasible and continuous. This also meant that the jobweighedconstantlyonmymind,forIhadtokeepaskingwhatmorewecoulddo, given the possibilities were endless. Putting a policy economist in theGovernor’sjobislikelettingakidlooseinacandyshop!

Thisisnottosaythatthejobwasalwayseasyorenjoyable.WhileIenjoyeda good understanding with the political leadership – meeting regularly andcordially firstwith PrimeMinisterDrManmohanSingh andFinanceMinisterChidambaram, and then when the government changed, with Prime MinisterNarendraModiandFinanceMinisterJaitley–andwhilesomebureaucratswerea delight to work with, the least pleasant aspect of my job was dealing withbureaucratswhoweretryingtoundercuttheReserveBanksoastoexpandtheirturf. In my last speech as Governor (see later), I offered suggestions to thegovernmentonhowtoreducetheseunproductivefrictions.

Anypublicjobinvolvesbothunduepraiseandunfaircriticism.It ishumannature to think the latter dominates the former.Yet it is also the latter that isprobably more useful in helping you sharpen your message. Much of thematerialinthesespeechesisanimplicitresponsetocritics,anattempttoexplainwhy they do not have the full picture. To the extent that the criticism helpedfurtherpublicunderstandingthroughtheclarifyingspeechesIgaveinresponse,ithadasilver lining.Butoverandabove theamplerewardsfromthesenseofpersonalfulfilmentthejobaffords,Icontinuetobepleasantlyover-compensatedby the many students who tell me that they have been inspired to studyeconomicsandfinance,theunknownpassengersonplaneswhothankmeformywork,andevenbythesecurityofficerwhostampsmyboardingcardasIleaveIndiaandasksmewhenIamcomingbacktoworkinthecountry.

AsIindicatedearlier,thisisnota‘tell-all’.Beforeendingthisintroduction,

thereisoneissue,however,onwhichIhavebeenaskedmanyquestions,whichIhaveresolutelyrefusedtoansweruntilmyperiodofsilenceisover,andthatisthe demonetization that was announced in India in November 2016. Thequestions,whichhavereportedlyalsobeenaskedbyparliamentarycommittees,includewhenIknewaboutthepossibilityofdemonetizationandwhatmyviewonitwas.Thepress,quotinggovernmentsources,havevariouslyreportedthatIwasagainst it (in theearlydaysof thedemonetizationprocess)and that Iwas‘onboard’(inthemostrecentreports).

MyonlypubliccommentaryontheissueofdemonetizationwasinresponsetoaquestioninAugust2014attheLalitDoshiMemorialLecture(seelater).Atthat time, the matter had not been broached by the government. As theHindustanTimesreported*

InAugust, at theannualLalitDoshimemorial lecture,Rajan said, ‘I amnotquite sure ifwhatyoumeant is demonetise theoldnotes and introducenewnotes instead. In thepast, demonetisationhasbeenthoughtofasawayofgettingblackmoneyoutofcirculation.Becausepeoplethenhavetocomeandsay‘howdoIhavethis10croresincashsittinginmysafeandtheyhavetoexplainwheretheygot themoney from. It isoftencitedasa solution.Unfortunately,mysense is, theclever findwaysaroundit.’

Rajansaid,‘Blackmoneyhoardersfindwaystodividetheirhoardintomanysmallerpieces.Youfind thatpeoplewhohaven’t thoughtof away toconvertblack towhite, throw it into thehundi insometemples.Ithinktherearewaysarounddemonetisation.Itisnotthateasytoflushouttheblackmoney.’

A fair amountofunaccountedcash is typically in the formofgoldand thereforeevenharder tocatch, said Rajan, adding that he would focus more on incentives that lead to generation and theretentionofblackmoney.Therewerealotofincentivesontaxesandthecurrenttaxrateinthecountrywasforthemostpartreasonable,headded.

Giventhatvariousstanceshavebeenattributedtome,includinginParliament,letmeclarify.IwasaskedbythegovernmentinFebruary2016formyviewsondemonetization,whichIgaveorally.Althoughtheremightbelong-termbenefits,Ifelt thelikelyshort-termeconomiccostswouldoutweighthem,andfelt therewerepotentiallybetteralternativestoachievethemaingoals.Imadetheseviewsknowninnouncertainterms.Iwasthenaskedtoprepareanote,whichtheRBIput together andhanded to thegovernment. It outlined thepotential costs and

benefits of demonetization, as well as alternatives that could achieve similaraims.Ifthegovernment,onweighingtheprosandcons,stilldecidedtogoaheadwithdemonetization,thenoteoutlinedthepreparationthatwouldbeneeded,andthe time that preparationwould take. The RBI flaggedwhatwould happen ifpreparationwasinadequate.

Thegovernmentthensetupacommitteetoconsidertheissues.Thedeputygovernorinchargeofcurrencyattendedthesemeetings.AtnopointduringmytermwastheRBIaskedtomakeadecisionondemonetization.

Enoughsaid.Letmeconcludethisintroductionwiththanks.MywifewasmyconstantsupportinMumbai,asshehasbeenallourlifetogether.Shecouldbereliedupontokeepmyfeetfirmlytetheredtotheground,evenwhilegivingmethe advice I needed. My children, who came home occasionally during theholidays, endured the absence of their parents, and helped giveme a sense ofnormalcy at home after being ‘The Governor’ in the office. My parents andparents-in-lawwereanunconditionalsourceofcomfort,asalways.Ioweadebttomycolleaguesat theRBI,whoworked tirelesslywithme,and receivedmyfamilywithwarmth into theirmidst. And, finally, I thankKrishan Chopra ofHarperCollins,withoutwhoseperseverance thisbookwouldnothave seen thelightofday,SiddheshInamdarforhiscarefulediting,andRajinderGanjuforhistypesetting.

SectionI

RBIDAYS

CHAPTER1

SETTINGTHESTAGE

I

Itookoverasthe23rdGovernoroftheReserveBankofIndiaon4September2013.Therupeehadbeen in free fall in August, inflation and the current account deficit were high. Even though MrChidambaram,whohadbeenbroughtbackasFinanceMinisterin2012whenMrPranabMukherjeebecamethePresidentofIndia,hadtakenanaxetothefiscaldeficit,itwasstilllarge.WithelectionsloominginMay2014,andthepossibilityofahungparliament,investorsweregettingnervous.TheywerequicktolabelIndiaoneofthe‘FragileFive’emergingmarketsduringthemarketvolatilitythatfollowedFedChairmanBenBernanke’shintinMay2013thattheFedwaslikelytostarttheprocessofnormalizationofmonetarypolicy.Havingexperienced theworstof that ‘TaperTantrum’whileatNorthBlock,andhavingseenmeasureaftermeasuretostabilizethecurrencyfallflat,Ithoughtitwastime togoallout. Iwanted to send themessage that Indiahad strong institutions like theRBI thatcouldpushreformsforwardevenwhenParliamentwasstalled,andinternationalinvestorsshouldnotwriteIndiaoff.

Mypredecessor,GovernorSubbarao,wasgraciousenoughtoallowmetospendmostofAugust2013 at theRBI, talking tomy to-be colleagues and collecting possible ideas for reformmeasures.TherewereplentyofideasfloatingaroundinthecorridorsoftheReserveBank,belyingitsreputationfor staid conservatism. Where necessary, these were discussed with my colleagues in the financeministry.Iwantedtosendfourmessages.First,wehadtopresentafaçadeofconfidencetoassurethepublic and investors that the RBI knew what had to be done. Second, we would emphasize ourcommitmenttobringingdowninflation,whichmyfriend,theMexicancentralbankgovernor,AgustinCarstens, advisedme,was in his long experience the bestway to stabilize the currency. Third,wewould signal the RBI could be bold and farsighted when the need arose – evidenced by the largenumber of measures that were announced, and our ability to look beyond the currency turmoil todiscuss, for instance, the eventual internationalization of the rupee. Looking beyond the immediateproblemswould also suggestwewere not overly pre-occupiedwith the current volatility. Finally, Iwanted set standards for transparencyandpredictability, transparency throughclear communication,andpredictabilitybylayingoutwhatweattheRBIintendedtodo,sothatwecouldbeheldtoit.

Myinitialstatement,whichIreadoutonnationalTV,isreproducedherealmostinitsentirety,withonlythedescriptionofsomeofthedetailedmeasuresdropped.

GStatementonTakingOffice,4September2013

ood evening. I took charge this afternoon as the 23rd Governor of theReserveBankof India.These are not easy times, and the economy faces

challenges.At the same time, India is a fundamentally sound economywith abrightfuture.Our tasktodayis tobuildabridgeto thefuture,over thestormywaves produced by global financialmarkets. I have every confidencewewillsucceed in doing that. Today I want to articulate some first steps, concreteactionswewilltake,aswellassomeintentionstotakeactionsbasedonplanswewillformulate.

Before I turn to specifics, let me repeat what I said on the day I wasappointed.TheReserveBank isagreat institutionwitha traditionof integrity,independence,andprofessionalism.IcongratulateDrSubbaraoonhisleadershipinguidingthebankthroughverydifficulttimes,andIlookforwardtoworkingwiththemanydedicatedemployeesoftheRBItofurthersomeoftheimportantinitiatives he started. I have been touched by thewarmthwithwhich theRBIstaffhavewelcomedme.

TotheexistingtraditionsoftheRBI,whichwillbethebedrockofourwork,wewill emphasize two other traditions that become important in these times:transparencyandpredictability.Atatimewhenfinancialmarketarevolatile,andthereissomedomesticpoliticaluncertaintybecauseofimpendingelections,theReserveBankofIndiashouldbeabeaconofstabilityastoitsobjectives.Thatisnot to saywewill never surprisemarketswith actions.A central bank shouldneversay‘Never’!Butthepublicshouldhaveaclearframeworkastowherewearegoing,andunderstandhowourpolicyactionsfitintothatframework.Keytoall this is communication, and I want to underscore communication with thisstatementonmyfirstdayinoffice.

MONETARYPOLICY

We will be making the first monetary policy statement of my term on 20September. I havepostponed theoriginally set date a bit so that betweennowandthen,Ihaveenoughtimetoconsiderallmajordevelopmentsintherequired

detail.Iwillleaveadetailedexplanationofourpolicystancetillthen,butletmeemphasizethattheRBItakesitsmandatefromtheRBIActof1934,whichsaystheReserveBankforIndiawasconstituted

‘to regulate the issue ofBank notes and the keeping of reserveswith a view to securingmonetarystability in India and generally to operate the currency and credit system of the country to itsadvantage;’

Theprimaryroleofthecentralbank,astheActsuggests,ismonetarystability,thatis,tosustainconfidenceinthevalueofthecountry’smoney.Ultimately,thismeanslowandstableexpectationsofinflation,whetherthatinflationstemsfromdomestic sources or from changes in the value of the currency, from supplyconstraints or demand pressures. I have asked Deputy Governor Urjit Patel,togetherwithapanelhewillconstituteofoutsideexpertsandRBIstaff,tocomeupwith suggestions in threemonths on what needs to be done to revise andstrengthen our monetary policy framework. A number of past committees,including theFinancial SectorLegislativeReformsCommittee (FSLRC), haveopinedonthis,andtheirviewswillalsobeconsideredcarefully.

INCLUSIVEDEVELOPMENT

ItalkedabouttheprimaryroleoftheRBIaspreservingthepurchasingpowerofthe rupee, but we have two other important mandates; inclusive growth anddevelopment,aswellasfinancialstability.

As the central bank of a developing country, we have additional tools togenerategrowth–wecanacceleratefinancialdevelopmentandinclusion.Ruralareas,especiallyourvillages,aswellassmallandmediumindustriesacrossthecountry,havebeenimportantenginesofgrowthevenaslargecompanygrowthhas slowed. But access to finance is still hard for the poor, and for rural andsmall and medium industries. We need faster, broad-based, inclusive growthleadingtoarapidfallinpoverty.

TheIndianpublicwouldbenefitfrommorecompetitionbetweenbanks,andbanks would benefit from more freedom in decision making. The RBI willshortly issue the necessary circular to completely free bank branching for

domestic scheduled commercial banks in every part of the country.No longerwillawell-runscheduleddomesticcommercialbankhavetoapproachtheRBIfor permission to open a branch. We will, of course, require banks to fulfilcertaininclusioncriteriainunderservedareasinproportiontotheirexpansioninurban areas, and we will restrain improperly managed banks from expandinguntil theyconvincesupervisorsoftheirstability.Butbranchingwillbefreeforallscheduleddomesticcommercialbanksexceptthepoorlymanaged.

There has been a fair amount of public attention devoted to new banklicences.TheRBIwillgiveoutnewbanklicencesassoonasconsistentwiththehighest standards of transparency and diligence. We are in the process ofconstituting an external committee. Dr Bimal Jalan, an illustrious formerGovernor, has agreed to chair it, and the committee will be composed ofindividuals with impeccable reputations. This committee will screen licenceapplicants after an initial compilation of applications by the RBI staff. Theexternal committee will make recommendations to the RBI Governor andDeputyGovernors,andwewillproposethefinalslatetotheCommitteeoftheRBICentralBoard. I hope to announce the licenceswithin, or soon after, thetermofDeputyGovernorAnandSinha,whohasbeenshepherdingtheprocess.HistermexpiresinJanuary2014.

Wewillnotstopwiththeselicences.TheRBIhasputanexcellentdocumentonitswebsiteexploringthepossibilityofdifferentiatedlicencesforsmallbanksandwholesalebanks,thepossibilityofcontinuousor‘on-tap’licensing,andthepossibilityofconvertinglargeurbanco-operativebanksintocommercialbanks.WewillpursuethesecreativeideasoftheRBIstaffandcomeupwithadetailedroadmapofthenecessaryreformsandregulationsforfreeingentryandmakingthelicensingprocessmorefrequentafterwegetcommentsfromstakeholders.

Finally,ourbankshaveanumberofobligationsthatpre-emptlending,andinfact, allow what Dr Rakesh Mohan, an illustrious former Deputy Governor,called‘lazybanking’.OneofthemandatesfortheRBIintheActistoensuretheflowofcredittotheproductivesectorsoftheeconomy.Inthiscontext,weneedto reduce the requirement for banks to invest in government securities in acalibratedway,towhatisstrictlyneededfromaprudentialperspective.

Wealsosubjectourbankstoavarietyofprioritysectorlendingrequirements.Ibelievethereisaroleforsuchamandateinadevelopingcountry–itisusefulto nudge banks into areas they would otherwise not venture into. But thatmandateshouldadjust to theneedsof theeconomy,andshouldbeexecutedinthe most efficient way possible. Let us remember that the goal is greaterfinancial access in all parts of the country, rather than meeting bureaucraticnorms.IamaskingDrNachiketMortoheadacommitteethatwillassesseveryaspectofourapproachtofinancialinclusiontosuggestthewayforward.Intheseways,wewillfurtherthedevelopmentmissionoftheRBI.

RUPEEINTERNATIONALIZATIONANDCAPITALINFLOWS

Thismightbeastrangetimetotalkaboutrupeeinternationalization,butwehaveto think beyond the next fewmonths.As our trade expands,wewill push formoresettlementinrupees.Thiswillalsomeanthatwewillhavetoopenupourfinancialmarketsmoreforthosewhoreceiverupeestoinvestthembackin.Weintendtocontinuethepathofsteadyliberalization.

TheRBIwants to help our banks bring in safemoney to fund our currentaccount deficit. The Reserve Bank of India has been receiving requests frombankstoconsideraspecialconcessionalwindowforswappingForeignCurrencyNon-Resident (FCNR) deposits that will be mobilized following the recentrelaxationspermittedbythebank.WewilloffersuchawindowtothebankstoswapthefreshFCNRdollarfunds,mobilizedforaminimumtenorofthreeyearsandover,atafixedrateof3.5percentperannumforthetenorofthedeposit.

Further,basedagainonrequestsreceivedfrombanks,wehavedecidedthatthe current overseas borrowing limit of 50 per cent of the unimpaired Tier Icapitalwillbe raised to100percentand that theborrowingsmobilizedunderthis provision can be swapped with the RBI at the option of the bank at aconcessionalrateof100basispointsbelowtheongoingswaprateprevailinginthemarket.

Theaboveschemeswillbeopenupto30November2013.TheRBIreservestherighttoclosetheschemeearlierwithduenotice.

FINANCIALINFRASTRUCTURE

Finance thrives when financial infrastructure is strong. The RBI has beenworkinghardtoimprovethefinancialinfrastructureofthecountry–ithasmadetremendousadvances,forexample,instrengtheningthepaymentandsettlementsystemsinthecountry.Similarly,ithasbeenworkingonimprovinginformationsharingthroughagenciessuchascreditbureausandratingagencies.Iproposetocarryonsuchwork,whichwillbeextremelyimportanttoenhancethesafetyandspeedofflowsaswellasthequalityandquantityoflendinginthecountry.

On the retail side, I particularly want to emphasize the use of the uniqueidentity, Aadhaar, in building individual credit histories. This will be thefoundationofarevolutioninretailcredit.

For micro, small and medium firms (MSMEs), we intend to facilitateElectronic Bill Factoring Exchanges, whereby MSME bills against largecompaniescanbeacceptedelectronicallyandauctionedsothatMSMEsarepaidpromptly. This was a proposal in the report of my Committee on FinancialSectorreformsin2008,andIintendtoseeitcarriedout.

Financeisnotjustaboutlending,itisaboutrecoveringloansalso.Wehaveto improve the efficiency of the recovery system, especially at a time ofeconomicuncertaintylikethepresent.Recoveryshouldbefocusedonefficiencyandfairness–preservingthevalueofunderlyingvaluableassetsandjobswherepossible,evenwhileredeployingunviableassetstonewusesandcompensatingemployees fairly. All this should be done while ensuring that contractualpriorities are met. The system has to be tolerant of genuine difficulty whilecomingdownhardonmismanagementorfraud.Promotersdonothaveadivineright to stay in charge regardless of howbadly theymismanage an enterprise,nordotheyhavetherighttousethebankingsystemtorecapitalizetheirfailedventures.

Most immediately, we need to accelerate the working of Debt RecoveryTribunalsandAssetReconstructionCompanies.DeputyGovernorAnandSinhaandIwillbeexaminingthenecessarysteps.

IhaveaskedDeputyGovernorDrChakrabartytotakeacloselookatrisingNonPerformingAssets (NPAs)and the restructuring/recoveryprocess,andwetoo will be taking next steps shortly. RBI proposes to collect credit data and

examinelargecommonexposuresacrossbanks.Thiswillenablethecreationofacentral repositoryon largecredits,whichwewill sharewith thebanks.Thiswill enable banks themselves to be aware of building leverage and commonexposures.

While the resumption of stalled projects and stronger growthwill alleviatesome of the banking system difficulties,wewill encourage banks to clean uptheir balance sheets, and commit to a capital-raising programme wherenecessary.Thebadloanproblemisnotalarmingyet,butitwillonlyfesterandgrowifleftunaddressed.

We will also follow the FSLRC suggestion of setting up an enhancedresolutionstructureforfinancialfirms.Theworkinggrouponresolutionregimesfor financial institutions is looking at this and we will examine itsrecommendationsandtakeactionsoonafter.

This is part ofmy short-term time table for theReserveBank. It involvesconsiderablechange,andchangeisrisky.ButasIndiadevelops,notchangingisevenriskier.Wehavetokeepwhatisgoodaboutoursystem,ofwhichthereisatremendousamount,evenwhileactingdifferentlywherewarranted.TheRBIhasalways changedwhen needed, not following the latest fad, but doing what isnecessary. I intend toworkwithmyexcellent colleaguesat theReserveBank,theseniormanagementofwhichisrepresentedaroundthistable,toachievethechangeweneed.

Finally, a personal note: Any entrant to the central bank governorshipprobablystartsat theheightoftheirpopularity.SomeoftheactionsI takewillnotbepopular.Thegovernorshipof theCentralBank isnotmeant towinonevotesorFacebook‘likes’.ButIhope todo theright thing,nomatterwhat thecriticism,evenwhilelookingtolearnfromthecriticism–RudyardKiplingputitbetterwhenhemusedabout the requirementsofan idealcentralbanker inhispoem‘If’:

Ifyoucantrustyourselfwhenallmendoubtyou,Butmakeallowancefortheirdoubtingtoo:

Kipling’sreferenceto‘men’onlydatestheselines,buthiswordsareclear.We will fill in details of what we have announced shortly, and lay out a

broaderroadmapofreformssoonafter.Appropriatenotificationswillbeissuedshortly.As this is underway,wewill turn topreparing themid-quarterpolicystatement.

II

Myopeningstatement,whichmadeheadlinesintheIndianpapersthenextday,hadthedesiredeffect–apublic,desperateforgoodnews,startedbelievingthattheReserveBankcouldprovidesome.Therupeestabilizedasinvestorsregainedconfidence.

Whilemanyelementsof thepackagewere important,onewasparticularlymemorablebecause Iwasinitiallyagainstit.IthadbeenpresentedtomewhenIwasinthefinanceministryinNorthBlock.Essentially,bankerstoldustheywouldbringplentyofdollarsinasthree-yearforeigncurrencynon-resident (FCNR) deposits, which they would convert to rupees and invest in India. In return, theywantedacheaprateatwhichtheycouldconvertrupeesbackintodollarsthreeyearshence.SolongastheReserveBankcouldbetrustedtoprovidetheforwarddollars,thiswasagreatdealforthebanks–theygotrupeeinterestincomeandaguaranteedcheappriceatwhichtheycouldswapmaturingrupeesbackintodollars.

IdidnotthinkmuchofthisschemewhenIfirstheardofit,dismissingitasyetanothercleverploybybankerstogetasubsidyfromacountryintrouble.Butitrefusedtogoaway,andmyoldcolleaguesatthefinanceministrythoughtitworthatryasthecrisisofconfidenceworsened.

Itoobecamemorefavourableafterthinkingcarefullyaboutit.First,Iweighedthebalanceofrisks.Ifwedidnotmovetherupeebacktofundamentalvalue,everyone-rupeeriseinthedollar-rupeeratewouldcostsusRs40,000croresmoreinimportcosts.AssumingtherupeewasundervaluedbyRs3foracoupleofyears,thiswouldmeanalossoflakhsofcrorestonationalincome.Incontrast,evenifthe scheme was wildly successful in attracting inflows, the payout would only be in the tens ofthousandsof crores.Of course, theremight be cheaperwaysof restoring confidencebut itwasnotclearwhattheywere.Andtimewasoftheessence.

Discussions with colleagues at the RBI had thrown up another rationale. The bankers whoproposedtheschemeweresayingthatifthemoneycamein,therupeewouldappreciate,anditwouldcostuslesstooffertheforwardsubsidy.Thiswasself-servingandnotquiteright.WhatwasrightwasthatifwechangedthenarrativeonIndia,andtherupeecontinuedappreciatingbetweenthepointwhenthemoneycameinandthepointwecoveredourliabilitiestothebankersinforwardmarkets,itwouldcost us significantly less. In fact, we might even make money on the deal. But what if the rupeeplungedafterthedollarsflowedin?Therewerenocertaintieshere.

Thebottomlinewasthattheschemewasameasuredrisk,withaprobabilitythattheRBIwouldlosemoney, a certainty that the bankerswouldmakemoney, but also a reasonable chance that thecountrywouldbesignificantlybetteroff.Policymakingisaboutdecidinginthefaceofuncertainty,after weighing the alternatives as best as one can. Having obtained the concurrence of the financeministry,theRBIGovernorhadtodecide.Ichosetogoaheadwithit.

TheFCNRschemedrewin$26billion,morethananyofusanticipated.But,equally important,confidence picked up, the rupee continued strengthening beyond when the money came in, partlybecausetheglobalinvestormoodaswellasIndianelectoralprojectionsalsochanged,andwecoveredourforwardswapscheaply.Therupeebecameoneofthemoststableemergingmarketcurrenciesforawhile.

Ofcourse,inhindsightitseemslikeitwastheobviousthingtodobecauseitworked.Therealityis

I

we will never know for certain whether it was the key! Perhaps it was the other elements of thepackage such as the determinationwe expressed on controlling inflation, perhaps itwas everythingtogether. Autobiographies are always written as if the author had it all mapped out with perfectforesight, ignoringtherisksanduncertaintiesat that time.Thismisleads,asmuchas thosebeautifulphotographs of a past holiday abstract from the heat, themosquitoes, and the lack of connectivity.Policymakinginvariablyinvolvestakingmeasuredrisksinthefaceofuncertainty,foronehasneitherapriortemplatenortheluxuryofindecision.

Asanaside,thatinitialspeechalsohadsomeunintendedcollateraleffects.Ibecamea‘rockstar’central bank governor, the James Bond or Ranbir Kapoor of central banking, depending on whichpaper you read – thiswas an image I tried hard to downplay because not onlywas it far from theprosaicreality,butalsoIwantedthefocustobeontheRBI’sinnovativebutreliablework.Perhapsthearticle that did the most to ensure I would have a fan following was a send-up of the incominggovernorbythecourageousthoughrisquécolumnistShobhaaDé.Yearsintomyterm,Ifinallymetherandhercharmingdaughteratanofficialparty,andIwasdelightedtofindthatshewasasembarrassedasIwasaboutmeetinginpersonafterherpiece.Wehadagoodlaughaboutit.Kindlingthepress’sinterestunsheathedadouble-edgedsword,aswewillseelater,butitwasbyandlargeahelpfulpartofmymission.

With the currencymore stable, attention could now shift to other reforms. These reformswereoftendiscussedthreadbareintheSeniorManagementCommitteeoftheReserveBank,wheregroupsmade presentations on proposed directions, and the entire senior staff consisting of the Governor,DeputyGovernors,andExecutiveDirectorsdebatedtheissues.Avarietyofveryusefulideascameupin thesediscussions,which sometimes tookon thecharacterof auniversity seminar,withargumentand counter-argument. Unlike a university seminar, however, we needed decisions at the end ofmeetings!Themeetingswerealsoawaytokeepallourseniorstaffabreastofimportantdevelopments,and for them tohaveownershipof the reforms (both to the financial systemand theRBI’s internalfunctioning).

I got a chance to articulate our thinking on 15 November 2013 at the Bankcon Conference. Istressedfivepillarsaroundwhichourreformeffortswerestructured.Thisthenbecameaneasywaytoexplainourstrategytothemanyvisitorswehad,aswellastoorganizethinkingwithintheRBI.Inthespeechesandtextsthatarereproducedhere,Ihaveeditedtheoriginaltextonlytoeliminaterepetitionortoimproveclarity.

TheFivePillarsofRBI’sFinancialSectorPolicies

want to focus on what we at the Reserve Bank are doing to improve thefinancial system. We plan to build the Reserve Bank’s developmental

measuresoverthenextfewquartersonfivepillars.Theseare:

1. Clarifyingandstrengtheningthemonetarypolicyframework.

2. Strengthening banking structure through new entry, branch expansion,encouragingnewvarietiesofbanks,andmovingforeignbanksintobetterregulatedorganizationalforms.

3. Broadening and deepening financial markets and increasing theirliquidityandresiliencesothattheycanhelpallocateandabsorbtherisksentailedinfinancingIndia’sgrowth.

4. Expanding access to finance to small and medium enterprises, theunorganized sector, the poor, and remote and underserved areas of thecountry through technology, new business practices, and neworganizationalstructures;thatis,financialinclusion.

5. Improving the system’s ability to deal with corporate distress andfinancial institution distress by strengthening real and financialrestructuringaswellasdebtrecovery.

Letmeelaborateoneachofthesemeasuresalittle.First, we are among the large countries with the highest consumer price

inflationintheworld,eventhoughgrowthisweakerthanwewouldlikeittobe.Muchof the inflation isconcentrated infoodandservices.Ourhouseholdsareturningtogoldbecausetheyfindfinancialinvestmentsunattractive.Atthesametime, many industrial corporations are complaining about high interest ratesbecause theycannotpass through theirhighercosts intohigherprices for theirproducts.

We can spend a long time debating the sources of this inflation. Butultimately, inflation comes from demand exceeding supply, and it can becurtailedonlybybringingbothinbalance.Weneedtoreducedemandsomewhatwithout having serious adverse effects on investment and supply. This is abalancingact,whichrequirestheReserveBanktoactfirmlysothattheeconomyis disinflating, even while allowing the weak economy more time than onewouldnormallyallowforittoreachacomfortablelevelofinflation.Theweakstateoftheeconomy,aswellasthegoodkharifandrabiharvest,willgeneratedisinflationaryforces thatwillhelp,andweawaitdata toseehowtheseforcesareplayingout.Nosingledatapointornumberwilldetermineournextmove.

I think themarketunderstandswhatweare trying todo.Butwedoneedamorecarefullyspelledoutmonetarypolicy framework thanwehavecurrently.Action on the framework will follow the submission of the Dr Urjit PatelCommitteereport,whichisexpectedbyend-December2013.

Second,wehavealreadyannouncedmeasurestofreebankbranching,andtoincentivizeforeignbankstoincorporatedomestically.Goingforward,wehavetogiveourpublicsectorbanks,whichareanationalasset, themeans to improvetheir competitiveness. Many of them have made enormous strides in the lastdecade–forinstance,theextenttowhichtheyhavedigitizedtheiroperationsisextremelypraiseworthy–butbecausecompetitioninthebankingsectorislikelytoincreaseinthenextfewyears,theycannotrestontheirlaurels.Inthecomingmonths, we will discuss with stakeholders in public sector banks about whatneedstobedonetofurtherimprovetheirstability,efficiencyandproductivity.

Third,weneed toenlistmarkets in theaidofbanking.Liquidmarketswillhelpbanksoffloadriskstheyshouldnotbear,suchasinterestrateorexchangerisk. They will also allow banks to sell assets that they have no comparativeadvantage in holding, such as long-term loans to completed infrastructureprojects, which are better held by infrastructure funds, pension funds, andinsurancecompanies.Liquidmarketswillhelppromotersraiseequitywhich issorelyneededintheIndianeconomytoabsorbtherisksthatbanksotherwiseendupabsorbing.Ratherthanseeingmarketsasbeinginimicaltothedevelopmentof thebankingsector,wehavetosee themascomplementary–ofcourse, thisrequiresyoubankerstobuildonyourriskmanagementcapabilitiessothatyoucanusemarketseffectively.

Inthecomingweeks,wewillrolloutmorerecommendationsoftheGandhiCommittee report to improve the liquidity and depth of the governmentsecurities (G-Sec)market.Wewill then turn tomoneymarkets and corporatedebt markets. We will introduce new variants of interest rate futures andproducts like inflation-indexed certificates, and work to improve liquidity inderivativemarkets.

Fourth,wehavetoreacheveryone,howeverremoteorsmall,withfinancialservices.Financialinclusiondoesnotjustmeancreditforproductivepurposes,it

meanscreditforhealthcareemergenciesortopaylumpyschoolorcollegefees.It means a safe means of remunerated savings, and an easy way to makepaymentsandremittances. Itmeans insuranceandpensions. Itmeansfinancialliteracyandconsumerprotection.

Wehavemadegreatstridesininclusion,butwearestillsomedistancefromour goal.We have adopted a branch-based strategy for inclusion, but it is notenough.Toomany poor people in so-called ‘over-banked’ urban areas still donothaveaccess tobankingservices.Wehavemanyexperimentsunderway touse technology,mobilephones,newproductssuchasmobilewallets,andnewentitiessuchasbusinesscorrespondentstolinkpeopleuptotheformalfinancialsystem.MuchaswithcellphoneswherewecreatedafrugalIndianmodel,weneed a frugal, trustworthy, and effective Indianmodel for financial inclusion.TheDrNachiketMorCommittee ishelpingus think throughpossiblemodels,andIamhopefulthatwhenweoutlinemeasuresbasedonitsrecommendations,ourfinebanks,Non-BankFinanceCompanies(NBFCs),informationtechnologycompaniesandmobileplayerswillrisetotheoccasion.Atamoredetailedlevel,we have set up committees like the SambamurthyCommittee to advise us onhow to expand mobile banking in India through encrypted SMS-based fundstransferinanytypeofhandset.

Ishouldemphasizetheneedforbanksliketheonesrepresentedinthisroomtomovebeyondsimplyopeningbankaccountstoensuringthatpoorcustomersareconfidentandcomfortableenoughtousethem.Innovationinreachingouttothe underserved customer, rather than simply posting higher numbers inbranchesorbankaccountsopened,hastobepartofourefforts.

Andlastbutnotleast,wehavetodealbetterwithdistress;Thenatural,andworst,wayforabankmanagementwithlimitedtenuretodealwithdistressisto‘extendandpretend’–toevergreentheloan,hopeitrecoversbymiracle,orthatone’ssuccessorhastodealwithit.Thenaturalincentiveforapromotertodealwithdistressistoholdontoequityandcontroldespitehavingnorealequityleft,and to stand in the way of all efforts to resolve the underlying project whilehoping for an ‘act of God’ to bail him out. Not all bankers and promoterssuccumbtothesenaturalincentives,buttoomanydo.

Wehave toensure that the system recognizes financialdistressearly, takesstepstoresolveit,andensuresfairrecoveryforlendersandinvestors.Wecouldwish for a more effective judicial process or a better bankruptcy system, butwhileweawaitthat,wehavetoimprovethefunctioningofwhatwehave.Inthenext few weeks, we will announce measures to incentivize early recognition,betterresolution,andfairrecoveryofdistressedloans.Wewillfocusonputtingrealassetsbacktoworkintheirbestuse.Hereagain,youbankershaveacriticalroletoplaybyfightingthenaturalincentivesthatarebuiltintothesystem.Youhavetohelpthosewithgenuinedifficultywhilebeingfirmwiththosewhoaretrying to milk the system. The RBI will help you with every means at ourdisposal.

Let me conclude.We are going through a period of great cynicism aboutwhat Indiacando.Thatcynicismdoesnot justpermeate the foreignpressandtheir audiences, but also infects our domestic debate. Every policy is greetedwith suspicionand scrutinized for evidenceofmalfeasance.Withnoupside tomakingdecisions,itisnowonderthatdecisionmakinghasslowed.Thesolution,however,cannotcomethroughinactionbutthroughaction,actionthatis,andisseentobe,purposeful,unbiased,andeffective.Nodoubtmistakeswillbemade,but if the weight of clean actions builds up, the miasma of suspicion thatpervadesoursocietytodaywillebb.TheReserveBankofIndiaintendstoplayitspartinmakingthishappen.

CHAPTER2

HAWKS,DOVES,OROWLS

I

My initial focuswas, of course, on inflation.Whenever youwant to embark on a set of actions inpubliclifeinIndia,ithelpstohaveareportrecommendingtheactions.Thereportindicatesthatwisepeople have thought deeply about the problem, andhelps give the actions legitimacy.Onmonetarypolicy, our go-to reportwas theDrUrjit PatelCommittee report,which I described inmy openingstatement.Myhope,whichIsharedwithDrPatel,wasthatwewouldgetaroadmapmuchliketheDrSukhamoyChakravartyreportwasformonetarypolicyinthe1980s,andIwasnotdisappointed.Mytaskwasnowtofigureouthowtoimplementrecommendationsthatcouldbeimplemented,andhowtomodifywhatcouldnot.

Oneimportantrecommendationwasseeminglyinnocuousandtechnical.WemovedfromtargetingWholesalePrice Index (WPI) inflation,whichwas notwhat the consumer experienced, to targetingConsumerPriceIndex(CPI)inflation,whichwasmorecloselyrelatedtotheinflationinthebasketofgoods they bought in their daily lives. This step was a fundamental change in monetary policy –consumerprice inflationhadbeenmuchhigher thanwholesaleprice inflation for some time,whichmeant that interest rateswouldhave to gohigher and stayhigher for longer ifwehad to curbCPIinflation.Wouldourindustrialists,whohadbenefitedfromtheeraofcheapnegativerealinterestrates,understandthatthaterawasover,andthatthemuchabusedsaverwouldnowgetabetterdeal?Wouldtheindustrialistsprotest?

Anotherimportantstepwastoembarkontheroadtotargetinginflation.WesetoutonaglidepathtobringdowninflationintothetargetrangesuggestedbytheUrjitPatelCommitteeReport,withclearmilestoneseveryyear.Wemeteachmilestonewehadsetforourselves,eventhoughmanythoughtitwouldbeimpossible.Aswemetmilestones,wepressedforaformalinflationmanagementagreementwith the government, in an attempt to institutionalize and make more credible the fight againstinflation.Withthegoodofficesofmandarinsinthefinanceministry,thisagreementwassigned.

We also modernized our liquidity operations, including how we conducted money marketoperations,withtheintentofdeepeningourmoneymarkets.Termreposandtermreversereposwereintroduced, and eventually, we announced a move away from the practice of keeping the entirebanking system in liquidity deficit, which seemed to create unnecessary problems in the moneymarkets,tokeepingitliquidityneutral.

Finally, togetherwith thegovernment,wedesigned the framework foran independentmonetarypolicycommittee,whichwouldtakeoverthesettingofpolicyfromtheGovernor.Acommitteewould

A

bringmoremindstobearonpolicysetting,preservecontinuityincaseamemberhadtoquitorretire,andbelesssubjecttopoliticalpressure,whichwaswhyIsupportedthismovestrongly.IwasthelastGovernortosetpolicyindividually(albeitwithfullconsultationwithmycolleagues).TheGovernmentnominateditsappointeestothemonetarypolicycommitteesoonafterIleftoffice,andmysuccessorDrUrjitPatel’sfirstpolicywaswiththefullmonetarypolicycommittee.

IsettheparametersofourfightagainstinflationinaspeechtotheFixedIncomeMoneyMarketandDerivativesAssociationofIndia(FIMMDA)inFebruary2014.Isoughttopinpointthesourcesofinflation,especiallyfoodinflation,andwhybringingitundercontrolwasinthefarmer’sinterest.Thiswas an extremely important point to make to the then governing UPA regime, which had aconstituencythatbelievedsignificantlyhigherfoodpriceswereinthefarmers’interest.

More generally, theway to fight inflation, given the inconclusive skirmisheswehad had in therecentpast,wastosignalthatweweredeterminedtobringitundercontrol.ButwealsoneededtodoitinawaythatcouldbetoleratedbytheIndianeconomy,whichhasmanypeoplewithminimalcushionsagainstadversity–Ifeltrightfromthebeginningthatdoinga‘Volcker’,thatis,raisinginterestratessohighthatdemandcollapsed,wassimplynotrightfortheIndianeconomy.However,IwassurethattheheavilyindebtedinterestswouldsoongathertoopposetheRBI’sagenda,andthatanygovernment’stolerancefortightmonetarypolicywouldwane.Sowehadtoshowresultsquickly.Myspeechesoninflationtriedtoexplainourstancetothegeneralpublic,evenwhiletryingtobuildpublicsupportinanenvironmentthatwasscepticalthattheRBIcouldcontrolinflation.

FightingInflation

syouknow,theReserveBankofIndiawasconstituted‘toregulatetheissueofBanknotesandthekeepingofreserveswithaviewtosecuringmonetary

stabilityinIndiaandgenerallytooperatethecurrencyandcreditsystemofthecountry to its advantage’. Implicit in thesewords are the corepurposesof theRBI: to foster monetary and financial stability conducive to sustainableeconomicgrowth, and to ensure the development of an efficient and inclusivefinancialsystem.

Note that theRBI iscommitted togetting thestrongestgrowthpossibleforIndia– there isnodifferencebetweenusand the financeministryon this.Webelieve thebestwaywecan foster sustainablegrowth in the current situation,otherthanthroughdevelopingthefinancialsector,isthroughmonetarystability–bybringingdowninflationoverareasonableperiodoftime.Morespecifically,weintendtobringCPIinflationdownto8percentbyJanuary2015and6percentbyJanuary2016.

There are a number of points here that need elaborating. First, are wechoosingtotackleinflationattheexpenseofgrowth?Mostpeoplebelievethereis a short-run trade-offbetweengrowthand inflation.By raising interest rates,theRBIcausesbankstoraiseratesandthuslowersdemand;firmsdonotborrowas much to invest when rates are higher and individuals stop buying durablegoodsagainstcreditand,instead,turntosave.Lowerdemandgrowthleadstoabettermatchbetweendemandandsupply,andthuslowerinflationforthegoodsbeingproduced.

Relatedly,iflowerratesgeneratehigherdemandandhigherpricesforgoods,peoplemayproducemoreof thosegoods,believing that theyaregettingmorerevenues. But because all goods are going up in price, high inflation reduceswhattheycanbuyoutoftherevenues.Followingthesaying,‘Youcanfoolallthepeoplesomeof the time’,burstsof inflationcangenerategrowth forsometime.Thus,intheshortrun,theargumentgoes,higherinflationleadstohighergrowth.

Butas thepublicgetsused to thehigher levelof inflation, theonlyway tofool the public again is to generate yet higher inflation. The result is aninflationary spiral which creates tremendous costs for the public. Therefore,economistshaveargued–andanumberofNobelprizeshavebeengivenfortheideas contained in the previous paragraphs – that the bestway for the centralbanktogenerategrowthinthelongrunisforittokeepinflationlowandsteady.

Andifthepublicstartsexpectingthatinflationwillstaylow,thecentralbankcancutinterestratessignificantly,thusencouragingdemandandgrowth.Indeed,thereasontheMalaysianCentralBankcankeeprateslowtodaytofostergrowthis because it has fought the battle against inflation and convinced its citizensthat,ifneedbe,itwillsmotetheinflationarybeastagainifitrearsitshead.

Put differently, in order to generate sustainable growth, we have to fightinflationfirst.Letmealsoaddthatgreaterpublicfaiththatinflationwillbelowwilladdstabilitytoourcurrency,andpreventthekindofgyrationswesawlastsummer.Exchangeratestabilityiscentraltobusinessinterests.

Ifwehavetobringdowninflation,wehavetostarttoday.Wecannotwaittillthe public’s expectations of higher inflation get more entrenched, and the

inflationary spiral gainsmomentum.This iswhywe have raised interest ratesthreetimessinceSeptember.

Butwhataboutindustrialistswhotellustocutrates?Ihaveyettomeetanindustrialistwhodoesnotwantlowerrates,whateverthelevelofrates.Butwilla lowerpolicyinterestratetodaygivehimmoreincentivetoinvest?Weat theRBI think not. First, we don’t believe the primary factor holding backinvestment todayishighinterestrates.Second,evenifwecutpolicyrates,wedon’tbelievebanks,whoarepayinghigherdepositrates,willcut their lendingrates.Thereasonisthatthedepositor,givenherhighinflationaryexpectations,willnotsettleforlessthantheratesbanksarepayingher.Inflationisplacingafloorondepositrates,andthusonlendingrates.

Currently, therefore,wedonotbelieve thepolicyrate isata levelwhere itcanaffectdemandsignificantly,onewayortheother.Wedobelieve,however,that as inflation comes down because of the weak economy and strong foodproduction,thepolicyratewillbecomeastrongerinfluenceonbankinterestratesetting,andwillstartinfluencingdemand.

Amoreimportantsourceofourinfluencetoday,however,isexpectations.Ifpeoplebelieveweareseriousaboutinflation,andtheirexpectationsofinflationstartcomingdown,inflationwillalsocomedown.Ofcourse,manypeopleformexpectationssimplybyextrapolatingthemostrecentormostsalientexperiencetheyhave.Sowealsoneedtotakeadvantageofthecurrentepisodeoffoodpricedisinflationtobringdownexpectations–yetanotherreasonforactingnow.

Letusturnfromansweringthosewhowantustogoslowtothosewhowantustodomore.Ifwethinkinflationissoimportant,whydon’twe‘doaVolcker’andtryandbringdowninflationquicklybyraisingratesskyhigh?Ofcourse,ifwedoraisepolicyratessubstantially,bankswillalsohavetoraiseratestomatchus. While this may lead to a collapse in demand and bring inflation downquickly,itwillcausesignificantdamagetotheeconomy–rememberthesevererecession Volcker’s Fed brought about and the Savings and Loan Crisis thatfollowed?

A developing country is not in the same resilient position as the UnitedStates.Ratherthanadministershocktherapytoaweakeconomy,theRBIprefers

todis-inflateovertimeratherthanabruptly,whilebeingpreparedtodowhatisnecessaryiftheeconomydeviatesfromtheprojectedinflationpath.Asofnow,webelievetherateisappropriatelyset.

Thenthereare thosewhobelievewearemovingtooindependently.AllwehavedonethusfaristoadoptthereasonablesuggestionofthePatelCommitteethat we focus on CPI inflation rather than WPI inflation as our primaryobjective.ThePatelCommitteehasalsosuggestedatimehorizontoglidedownto 6 per cent inflation that seems doable without extreme hardship. If theeventualdecisionofthegovernment,inconsultationwiththeReserveBank,istoadopt the recommendations of the Mistry Committee, the Committee onFinancialSectorReforms,theFinancialSectorLegislativeReformsCommittee(FSLRC) and the Patel Committee, and focus on some form of an inflationobjective,itwouldbegoodforthemedium-terminflationtargettobesetbytheexecutiveorlegislature,advisedbytheReserveBank.

ThePatelCommitteereportisoutthereforpubliccommentanddebate,andoncewecollectandanalysecomments,wewill takeaninternalviewandthenstart deliberationswith the government.All this said, international experiencesuggests that, ideally, once the central bank’s objective is given, and theoperational target fixed, the government should leave the technocrats in thecentralbanktodotheirjob.

Finally, does the Patel Committee intend to turn the RBI into inflation‘nutters’ focused on bringing down inflation to the exclusion of all else,including financial stability? Of course not! Medium-term flexible inflationtargetingmeansthatthemonetarypolicycommitteefocusesoninflationoverthemediumterm,beingconcernedabouttoohigh,aswellastoolow,inflation.

Thatmeansitmaybewillingtooverlooktemporaryinflationspikes(suchasthis November’s inflation numbers) but also raise rates when sustained lowinterestratesandlowinflationincreasethreatstofinancialstability–becauseafinancial crisis could lead to deflation. In other words, the monetary policycommitteewillnotputonblinkersandseejusttheinflationnumber.Anumberofemergingmarketshaveadoptedsomeformoftargeting,while‘non-targeters’like the Federal Reserve target inflation in all but name, including putting a

numbertoitsgoalofpricestability.In the remaining time, I want to present one more issue that has many

commentators exercised – they say the real problem is food inflation, howdoyouexpecttobringitdownthroughthepolicyrate?ThesimpleanswertosuchcriticsisthatcoreCPIinflation,whichexcludesfoodandenergy,hasalsobeenvery high, reflecting the high inflation in services. Bringing that down iscentrallywithin theRBI’s ambit. But Iwill argue thatmonetary policy is notirrelevantevenincontrollingfoodinflation,thoughclearly,thegovernmentalsohasanimportantroletoplay.

1.ROLEOFFOODPRICESINTHEHIGHINFLATIONEXPERIENCEOFRECENTYEARS

Headline inflation measured by the new CPI has remained in double digitsduringApril2012toJanuary2014,averaging10percentoverthisperiod.Foodinflation,whichhasaweightof47.6percent in the index,hascontributedthelargest share of headline inflation. Food inflation itself has stayed in doubledigitsthroughoutthisperiod,edgingdownto9.9percentonlyinJanuary2014.

2.WHYAREFOODPRICESHIGH?

Althoughdomesticproductionhasincreasedsteadily,barringreversalsin2009-10and2012-13,thishasnotbeenreflectedinasofteningoffoodprices.Letustryandunderstandwhy.

GROWINGPROSPERITYANDDIETARYSHIFTS

Data on household consumption expenditure show that the share of food inoverallconsumptionhasbeendecliningduring the lastdecade,butatamilderpace than the significant relative increase in food prices. This suggests thatdemandisrelativelylesselastictopricechanges.Despitethedeclineinoverallconsumption share, per capita food consumption in real terms has increased,particularlyinruralareas.Therehasalsobeenadistinctshiftindietarypatternstowardsprotein-richitemsandotherhighvaluefoods.Theseitems,inturn,havebeen contributing significantly to overall food price increases in the recentperiod.

OTHERPOSSIBLECAUSESOFHIGHFOODPRICEINFLATION

A.MINIMUMSUPPORTPRICE

Oneobviouscauseforhigherfoodpriceinflationthatanalystshavepointedtoishigherminimumsupportprices(MSP).Theminimumsupportpriceissetbythegovernmenton therecommendationsof theCommissiononAgriculturalCostsandPrices(CACP),basedonavarietyoffactorsincludingprimarilythecostofproductionandpricetrendsinthemarket(domesticandinternational).ThecropscoveredunderMSPschemeconstitutemorethanathirdofthecategory‘primaryarticles’intheWPI.Sinceminimumsupportpricesareintendedtobeafloorformarketprices,andhavesometimesdirectlysetthemarketpricewhenincreaseshavebeensubstantial,forkeycropstherateofpriceinflationseemstorelatetotheincreaseinMSPinrecentyears.

Anotherwayofsayingthisisthattherehasbeenashiftintherelativepriceofagriculturalcommodities,engineeredbytheriseinMSPs.Iftheideaistogetmorefoodproductiontomeettherisingdemandwedocumented,thisseemstobejustwhatisneeded.IfweplottheratioofWPIoffoodtoWPIofnon-fooditems over time, it suggests an appreciable improvement in terms of trade foragriculture.

ButwhenwelookattheratioofchangesininputcostoverthechangesintheoutputpriceofagriculturalcommoditiesreceivedonthebasisofCACPdata,ithasremainedflat,indicatingthatthegainsfromMSPincreaseshavenotaccruedtothefarmsector infullmeasurebecausethecostsof inputshavebeenrising.This may indicate why production growth has not been stronger.What couldexplainthis?

One explanation could be that MSPs also drive input costs, so increasingMSPsislikeadogchasingitstail–itcannevercatchit.Anothercouldbethatsince rice andwheat are the primary food commodities procured at theMSP,production is distorted towards rice and wheat, leading to a sub-optimalproductionmix by farmers – toomuch rice andwheat, and too little of otherneededcommodities.BoththeseexplanationswouldsuggesttheneedformoremoderationasthegovernmentsetstheMSPsincomingmonths.

It is useful, though, to look at the details of the cost increases. Prices ofagricultural inputs, including wages, have recorded a sharp increase during

2008-09through2012-13incomparisonwiththeprecedingfiveyears(2004-05to 2007-08). Perhaps the most significant increase has been in rural wages.Nominal rural wages have grown at a sharp pace during the last five years.BecausesomanyIndianworkersareatsubsistencewages,higherfoodpricesdodriveruralwageshigher,andthereissomeevidenceforthisbefore2007.From2007 onwards, however, econometric tests suggest causality has flowed fromwagestoprices,underscoringtheroleofruralwagesasamajordeterminantinfoodpriceincreases.Sowhyhasruralwagegrowthbeensostrong?

B.MAHATMAGANDHINATIONALRURALEMPLOYMENTGUARANTEEACT(MGNREGA)

A sharp pickup in ruralwageswas seen after the rural employment guaranteeprogramme(assuring100daysofemploymenttoeveryhouseholdwhoseadultmembersvolunteertodounskilledmanualwork)wasenacted.MGNREGAmayhave contributed to the bargaining power of rural workers, but carefuleconometricstudiessuggestthatitaccountsforonlyasmallfractionoftheruralwage increase, and indeed, any effect is waning. That said, the indexation ofMGNREGAwagessuggests itseffects inpushingruralwage inflationwillnotdisappearentirely.

C.RURALLIQUIDITYANDCREDIT

Therehasbeen an increase in liquidity flowing to the agricultural sector, bothfromlandsales,aswellasfromariseinagriculturalcredit.Moreavailabilityoffundstothefarmerhasfosteredsubstantialprivateinvestmentinagriculture,butmayalsohavepushedupruralwages.

D.LABOURSHIFTINGTOCONSTRUCTION

The labour force has beenmoving fromagriculture to non-agriculture sectors,particularly construction. This would have the effect of pulling up rurallabourers’wages(duetoscarcity),especiallyinthelaboursupplyingstates.Totalagriculturallabourdeclinedfrom259millionin2004-05to231millionin2012-12.Agriculture,whichaccountedfor60percentoftotalemploymentin1999-2000,nowaccountsforlessthan50percent.

E.FEMALEPARTICIPATION

Oneof themore interestingpossibleexplanationsfor therise inruralwages isthechangingfemaleparticipationinruralmarkets.Thefemaleparticipationrateis down in all the age categories. Improved living standards could lead ruralfamiliestowithdrawwomenfromthelabourforce.Also,higherprosperitycouldleadtogreaterinvestmentineducatinggirls(fortheagegroup10to24)againleadingtolowerparticipationintheworkforce.

3.TOSUMMARIZE

Insumthen,whenweexaminefoodinflation,asubstantialportionstemsfromanincreaseinfoodproductioncosts,primarilyruralwageinflation.Someofthatisan increase inrealwages,neededtoattract labour toagriculture,awayfromconstruction,education,householdwork,orMGNREGA.

If,however,wageselsewherealsogoup,thenecessaryshiftinrelativewagestokeepagriculturalworkattractivewillnottakeplace,andwewillcontinuetohaveawagespiral.Also,someoftheagriculturalwagegrowthmaybebecauseofmore liquidity flowing into rural areas. Somewhat paradoxically, to containfoodinflationandgetastrongincreaseinfoodproduction,weneedto

(i) Containtheriseinwageselsewheresothatrelativewagesinagriculturecanrisewithouttoomuchoverallincreaseinwages.

(ii) Containanyunwarrantedriseinruralwagesaswellastheriseinotheragriculturalinputcosts(thoughnotthroughsubsidies)sothatthefarmergetsahigherreturn.

(iii) Allowfoodpricestobedeterminedbythemarketanduseminimumsupportpricestoprovideonlyalowerlevelofsupportsothatproductiondecisionsdonotgetdistortedorthepricewagespiralaccentuated.ThismeanslimitingthepaceofMSPincreasesgoingforward.

(iv) Reducethewedgebetweenwhatthefarmergetsandwhatispaidbythehouseholdbyreducingtherole,number,andmonopolypowerofmiddlemen(amendAgriculturalProduceMarketCommittee–APMC–Acts),aswellasbyimprovinglogistics.

(v) Improvefarmproductivitythroughtechnologyextension,irrigation,etc.

Note that of these steps, monetary policy has a direct role in (i) and (ii) byslowingthedemandfor labouraswellasanchoringinflationexpectations,andtherebymoderatingwage bargaining. Indeed,with the slowdown in the urbaneconomy,thereissomeevidencenowthatruralwagegrowthisslowing.

Finally,ourfoodpriceshavelargelycaughtupwithglobalprices.Giventhatglobalfoodpriceshavebeenmoderating,suchmoderationshouldfeedthroughto domestic food prices – provided we do not intervene to prevent the feed-throughofglobalprices,anddonotinterveneinlimitingexportsorimports.

LetmeemphasizethattheRBIwelcomesruralprosperityandwantstohelpincreaseruralproductivitythroughappropriatecreditandinvestment.Butrecentinflationhasnothelped strengthen thehandof the farmer, so the fight againstinflationisalsointhefarmer’sinterest.

Tosumup,

Asprosperityhasincreasedthedemandforfood,wehaveneededmorefoodproduction(orimports).Higher agricultural commodity prices should have incentivized farmerstoproducesignificantlymore.They have, but not enough. Part of the reason may be that farmerearningsarebeingeatenawaybyhighercosts,mostimportantofwhichiswages.Tolimittheriseinruralwages,giventhatithastoriserelativetootherwagestoattractlabourintoagriculture,wageselsewhereshouldnotriseasmuch.Monetary policy is an appropriate tool with which to limit the rise inwages,especiallyurbanones.The slowdown in ruralwagegrowthmaybepartly the consequenceoftighterpolicylimitingwageriseelsewhere.Ofcourse,monetarypolicy’seffectivenessincontainingotherpriceand

wage increases (suchas servicesprices,whicharean importantpartoftheCPIindex)isfarlesscontroversial.

TheRBIbelievesitsfightagainstinflationwillhavetraction,despitefoodbeinganimportantcomponentoftheCPI.

I

II

AsItalkedtopeoplearoundthecountry,Idiscoveredthatasinflationcamedownandbankslowereddeposit rates, saverswereunhappy– even though inflationhad fallenmuchmore than the rates ondeposits.Earlier,theyargued,theygotpaid10percentontheirfixeddepositsatbanks,nowtheygot8percent.Wasthatfair?Ihadtoexplainthatitwasindeed,becauseinflationhadcomedownfaster,sotherealreturns(intermsofgoodsandservicestheycouldpurchase)ontheirsavingswerenowhigher.Toillustratethepoint,IgavewaytomyinnerteacherintheC.D.DeshmukhLecturedeliveredattheNCAER in January 2016. The press soon termed this ‘Dosanomics’, though it was really just anexample.

Dosanomics

ndustrialistsgrumbleabouthigh rateswhile retireescomplainabout the lowrates theyget todayondeposits.Bothoverstate theircase, though,asIhave

said repeatedly, the way to resolve their differences is to bring CPI inflationsteadilydown.

The typical letter I get (from the retiree) goes, ‘I used to get 10 per centearlieronaone-yearfixeddeposit,nowIbarelyget8percent’,pleasetellbankstopaymemoreelse Iwon’tbeable tomakeendsmeet’.The truth is that theretiree is gettingmore todaybuthedoesnot realize it, becausehe is focusingonlyon thenominal interesthegetsandnoton theunderlying inflationwhichhascomedownevenmoresharply,fromabout10percentto5.5percent.

Toseethis,letusindulgeinDosaeconomics.Saythepensionerwantstobuydosasandatthebeginningoftheperiod,theycostRs50perdosa.LetussayhehassavingsofRs1,00,000.Hecouldbuy2,000dosaswiththemoneytoday,buthewantsmorebyinvesting.

At10percent interest,hegetsRs10,000afteroneyearplushisprincipal.With dosas having gone up by 10 per cent in price toRs 55, he can buy 182dosasapproximatelywiththeRs10,000interest.

Nowwhat happenswhen inflation comes down?At 8 per cent interest, hegetsRs8,000 in interest.Withdosashavinggoneupby5.5per cent inprice,eachdosacostsRs52.75,sohecannowbuyonly152dosasapproximatelywith

the interest payment. So the pensioner seems right to complain: with lowerinterestpayments,hecannowbuyless.

Butwaitaminute.Remember,hegetshisprincipalbackalsoandthattoohasto be adjusted for inflation. In the high inflation period, it was worth 1,818dosas,inthelowinflationperiod,itisworth1,896dosas.Sointhehighinflationperiod,principalplus interestareworth2,000dosas together,while in the lowinflationperioditisworth2,048dosas.Heisabout2.5percentbetteroffsavinginthelowinflationperiodintermsofdosas.

Thisisalong-windedwayofsayingthatinflationisthesilentkillerbecauseiteats intopensioners’principal,evenwhile theyaredeludedbyhighnominalinterest rates into thinkingtheyaregettinganadequatereturn. Indeed,with10percentreturnand10percent inflation, thedeposit isnotgivingyouanyrealreturnnetofinflation,whichiswhyyoucanbuyonly2,000dosasafterayearofsaving,thesameasyoucouldbuyimmediatelytoday.Incontrast,wheninflationis5.5percentbuttheinterestrateyouaregettingis8percent,youareearningarealrateof2.5percent,whichmeans2.5percentmoredosas,aswehaveseen.SowhileIsympathizewithpensioners,theycertainlyarebetterofftodaythaninthepast.

I

III

CPIinflationwas4.39percentinSeptember2016whenIendedmyterm,downfrom10.5percentinSeptember2013inthebeginningofmyterm.*Wewerewellonourwaytomeetingthethirdsignpostonourglidepath,5percentinflationbyMarch2017(whichwasindeedachievedbymysuccessor).AsIendedmytenure,Ithoughtitwasveryimportanttocommunicateonceagainthereasonswhywefoughtinflation,andwhythebattlecouldneverbefullyover,andwhythefightneededtocontinue.Iwanted to explain why the fight was important for sustainable growth, and why we hadinstitutionalizedthefight throughamonetarypolicyframeworkagreedwith thegovernment,andanindependentmonetarypolicycommitteeappointed largelyby thegovernment.Thiswas ina speechdeliveredattheTataInstituteofFundamentalResearch(TIFR)on20June2016.

TheFightagainstInflation:AMeasureofOurInstitutionalDevelopment

nmyspeechtoday,IthoughtIwoulddescribeoureffortstobuildadifferentkindofinstitution,notonethatdelvesintothedeepestrealmsofouterspaceor

into the tiniest constituents of an atom, but one that attempts to controlsomethingthataffectsyourdailylife;inflation.ThereareparallelsbetweentheinstitutionbuildingyouhavedoneatTIFR,andwhatwearesettinguptocontrolinflation, thoughclearlyoureffortsaremuchlesstiedtoinvestigatingtheveryfabric of the universe and more towards influencing human behaviour.Ultimately,bothrequireafundamentalchangeinmindset.

THECOSTSOFINFLATION

HighinflationhasbeenwithusinIndiaforthelastfourdecades.Mostrecently,wehaveexperiencedanaverageofmorethan9percentinflationbetween2006and2013.

What are the costs of havinghigh inflation?Clearly, everyoneunderstandsthecostsofhyperinflation,whenpricesarerisingeveryminute.Moneyisthenahotpotatothatnoonewantstohold,withpeoplerushingstraightfromthebankto the shops to buy goods in case theirmoney loses value along theway.Aspeople lose faith inmoney,barterofgoods forgoodsor servicesbecomes the

norm,makingtransactingsignificantlymoredifficult.Forinstance,howmuchofaphysics lecturewouldyouhave topay a taxi driver todriveyou toBandra;moreoverwould the taxi driver accept a physics lecture in payment?; perhapsyou would have to lecture a student, and get the student to sing to the taxidriver…yougetthepoint,transactingbecomesdifficultashyperinflationrendersmoneyworthless.

Hyperinflation also has redistributive effects, destroying themiddle class’ssavingsheldinbondsanddeposits.ThehorrorsofhyperinflationinAustriaandGermanyinthe1920sstillmakescaryreading.

So,clearly,noonewantshyperinflation.Butwhat if inflationwereonly15per cent per year?Haven’t countries grown fast over a period of time despitehighinflation?Theanswerisyes,butperhapstheycouldhavegrownfasterwithlow inflation. After all, the variability of inflation increases with its level, asdoesthedispersionofpricesfromtheirfundamentalvalueintheeconomy.Thismakespricesignalsmoreconfusing–isthepriceofmywidgetgoingupbecauseofhighdemandorbecauseofhighgeneralized inflation? In the formercase, Ican sell more if I produce more, in the latter case I will be left with unsoldinventory.Productionandinvestmentthereforebecomemorerisky.

Moreover, high and variable inflation causes lenders to demand a higherfixedinterestratetocompensatefortheriskthatinflationwillmovearound(theso-calledinflationriskpremium),thusraisingthecostoffinance.Thelong-termnominal (and real) interest rates savers require rise, thus making some long-durationprojectsprohibitivelycostly.

These effects kick in only when inflation is noticeably high. So it islegitimate to ask, ‘At what threshold level of inflation does it start hurtinggrowth?’Unfortunately, thisquestion ishard toanswer–developingcountriestypically have higher inflation, and developing countries also have highergrowth. So one might well find a positive correlation between inflation andgrowth,thoughthisdoesnotmeanmoreinflationcausesmoregrowth.Forthisreason,theliteratureonestimatingthresholdeffectsbeyondwhichinflationhurtsgrowthisbothvastaswellasinconclusive.Moststudiesfindthatdouble-digitinflationisharmfulforgrowthbutarefuzzieraboutwhereinthesingledigitsthe

precisethresholdlies.

THEINFLATIONTARGET

Nevertheless, given the limited evidence, why do most countries set theirinflationtargetinthelowsingledigits–2to5percentratherthan7to10percent?Threereasonscometomind.First,evenifinflationisatamoderatelevelthatdoesnothurtoverallgrowth, theconsequencesof inflationarenotevenlydistributed. While higher inflation might help a rich, highly indebted,industrialistbecausehisdebtcomesdownrelativetosalesrevenues,ithurtsthepoordailywageworker,whosewageisnotindexedtoinflation.Second,higherinflation ismorevariable.This raises thechanceofbreachinganygivenrangearoundthetargetifitissetatahigherlevel.Totheextentthatahighertargetiscloser to the threshold where the consequences on growth are adverse, thismakesitmorelikelythecountrywillexceedthethresholdandexperiencelowergrowth. Third, inflation could feed on itself at higher levels – the higher thetarget,themorechancesofenteringregionswhereinflationspiralsupwards.

Thereceivedwisdominmonetaryeconomicstodayisthereforethatacentralbankservestheeconomyandthecauseofgrowthbestbykeepinginflationlowandstablearound the target it isgivenby thegovernment.Thiscontrastswiththe earlier prevailing view in economics that by pumping up demand throughdramatic interest rate cuts, the central bank could generate sustained growth,albeit with some inflation. That view proved hopelessly optimistic about thepowersofthecentralbank.

Put differently, when people say ‘Inflation is low, you can now turn tostimulatinggrowth’,theyreallydonotunderstandthatthesearetwosidesofthesamecoin.TheRBIalwayssetsthepolicyrateaslowasitcan,consistentwithmeetingitsinflationobjective.Indeed,thefactthatinflationisfairlyclosetotheupperboundofourtargetzonetodaysuggestswehavenotbeenoverlyhawkish,and were wise to disregard advice in the past to cut more deeply. If a criticbelieves interest rates are excessively high, he either has to argue thegovernment-setinflationtargetshouldbehigherthanitistoday,orthattheRBIis excessivelypessimistic about thepathof future inflation.Hecannothave it

bothways,wantlowerinflationaswellaslowerpolicyrates.At the same time, theRBI does not focus on inflation to the exclusion of

growth.Ifinflationrisessharply,forinstance,becauseofasharpriseinthepriceof oil, itwould not be sensible for a central bank to bring inflationwithin itstargetbandimmediatelybyraisinginterestratessohighastokillalleconomicactivity. Instead, itmakes sense to bring inflation back under control over themedium term, that is, thenext twoyearsor so,by raising rates steadily to thepointwherethebankthinksitwouldbeenoughtobringinflationbackwithinthetargetrange.Letmeemphasizethatthisisnotapredictionofeitherthepathofoilpricesoraforecastofourmonetaryactions,lestIreadinthepapertomorrow‘RBItoraiserates’.Moregenerally,theextendedglidepathoverwhichwearebringing inflation in check appropriately balances inflation and the need forreasonablegrowth.

ARGUMENTSAGAINSTWHATWEAREDOING

There aremanywho believewe are totallymisguided in our actions. Letmefocusonfourcriticisms.First,wefocusonthewrongindexofinflation.Second,we have killed private investment by keeping rates too high. Somewhatcontradictorily,we are also hurting the pensioner by cutting rates too sharply.Third,monetarypolicyhasnoeffectsoninflationwhentheeconomyissupplyconstrained,soweshouldabandonourattempttocontrolit.Fourth,thecentralbank has little control over inflation when government spending dominates(whatinthejargoniscalled‘fiscaldominance’).

THEWRONGINDEX

Historically,theRBItargetedavarietyofindicators,puttingalotofweightonthe Wholesale Price Inflation (WPI). Theoretically, reliance onWPI has twoproblems.First,whatthecommoncitizenexperiencesisretailinflation,thatis,Consumer Price Inflation (CPI). Sincemonetary policy ‘works’ by containingthe public’s inflation expectations and thus wage demands, Consumer PriceInflation is what matters. Second,WPI contains a lot of tradedmanufacturedgoods and commodity inputs in the basket, whose price is determinedinternationally.A lowWPIcould result from low international inflation,while

domesticcomponentsofinflationsuchaseducationandhealthcareservicesaswellasretailmarginsandnon-tradedfoodareinflatingmerrilytopushupCPI.By focusing onWPI,we could be deluded into thinkingwe control inflation,even though it stems largely from the actions of central banks elsewhere. Indoing so we neglect CPI, which is whatmatters to our commonman, and ismoretheconsequenceofdomesticmonetarypolicy.

THEEFFECTIVEREALINTERESTRATE,INVESTMENTS,ANDSAVINGS

Ofcourse,onereasoncriticsmayadvocateafocusonWPIisbecauseitislowtoday,andthuswouldmeanlowpolicyrates.Thisisshort-sightedreasoningforwhen commodity prices andglobal inflationpicks up,WPI couldwell exceedCPI [Author’s note: This, in fact, was the case at the time this book was puttogether].Thereis,however,amoresubtleargument;therealinterestrateisthedifferencebetweentheinterestrateaborrowerpaysandinflation–itisthetruecostofborrowingintermsofgoodslikewidgetsordosas.Ifpolicyinterestratesare set to control CPI, theymay be too high formanufacturerswho see theirproduct prices appreciating only at the WPI rate. I am sympathetic to theargument,but Ialso think theconcern isoverblown.Even ifmanufacturersdonot havemuch pricing power because of global competition, their commoditysuppliershaveevenless.Soametalproducerbenefitsfromthefallincoalandoreprices,eventhoughtheymaynotgetashigharealizationonmetalsalesasinthepast.Thetruemeasureofinflationforthemistheinflationintheirprofits,whichislikelysignificantlygreaterthansuggestedbyWPI.

Aseconderrorthatismadeistoattributeallcomponentsoftheinterestratepaid by the borrower to monetary policy. For heavily indebted borrowers,however, a large component of the interest rate they pay is the credit riskpremiumbankschargefortheriskthattheymaynotgetrepaid.ThiscreditriskpremiumislargelyindependentofwheretheRBIsetsitspolicyrate.

Sowhensomeoneberatesusbecauseheavilyindebtedindustrialistsborrowat14percentinterestwithWPIat0.5percent,theymaketwoimportanterrorsin saying the real interest rate is13.5per cent.First, 7.5per cent is the creditspreadbankschargefortheriskofdefault,andwouldnotbesignificantlylower

if we cut the policy rate (at 6.5 per cent today) by another 100 basis points.Second, the inflation thatmatters to the industrialist is not the 0.5 per cent atwhich theiroutputpricesare inflating,but the4percentatwhich theirprofitsareinflating(becausecostsarefallingat5percentannually).Therealrisk-freeinterestratetheyexperienceis2.5percent,alittlehigherthanelsewhereintheworld,butnot themostsignificantfactorstanding in thewayof investment. Itwould be far more effective for borrowers to bring down their rates byimproving their repayment behaviour and thus bringing down the credit riskpremiumthantotryandpushtheRBItolowerratesunduly.

The policy rate in effect plays a balancing act. As important as realborrowingratesareforthemanufacturer,realdepositratesareforthesaver.Inthe last decade, savers have experienced negative real rates over extendedperiodsastheCPIhasexceededdepositinterestrates.Thismeansthatwhateverinteresttheygethasbeenmorethanwipedoutbytheerosionintheirprincipal’spurchasing power due to inflation. Savers intuitively understand this, and hadbeenshiftingtoinvestinginrealassetslikegoldandrealestate,andawayfromfinancial assets like deposits. This meant that India needed to borrow fromabroadtofundinvestment,whichledtoagrowingunsustainablecurrentaccountdeficit.

In recent years, aswe fought against inflation,we cut the policy rate onlywhenwe thought depositors could expect a reasonable positive real return ontheir financial savings. This has helped increase household financial savingsrelativetotheirsavingsinrealassets,andhelpedbringdownthecurrentaccountdeficit.Atthesametime,Idogetalotofheart-rendinglettersfrompensionerscomplainingabout thecut indeposit rates.Thetruth is theyarebetteroffnowthaninthepast,asItriedtoexplaininapreviouslecture,butIcanunderstandwhytheyareupsetwhentheyseetheirinterestincomediminishing.

The bottom line is that in controlling inflation, monetary policy makerseffectivelyendupbalancing the interestsofboth investorsandsaversover thebusinesscycle.Atoneofmy talks, an industrialist clamoured for a4per centrateonhisborrowing.WhenIaskedhimifhewoulddepositatthatrateinasafebank,leavealoneinvestinoneofhisriskyfriends,hesaid‘No!’Nevertheless,

heinsistedonourcuttingratessignificantly.Unfortunately,policymakersdonothavetheluxuryofinconsistency.

SUPPLYCONSTRAINTS

FoodinflationhascontributedsignificantlytoCPIinflation,butsohasinflationinserviceslikeeducationandhealthcare.Someargue,rightly,thatitishardforthe RBI to directly control food demand throughmonetary policy. Then theyproceed,incorrectly,tosayweshouldnotbotheraboutcontrollingCPIinflation.Thereality is thatwhile it ishardforus tocontrol fooddemand,especiallyofessential foods, and only the government can influence food supply througheffective management, we can control demand for other, more discretionary,items in the consumption basket through tighter monetary policy. To preventsustained food inflation from becoming generalized inflation through higherwage increases, we have to reduce inflation in other items. Indeed, overallheadlineinflationmayhavestayedbelow6percentrecentlyeveninperiodsofhighfoodinflation,preciselybecauseothercomponentsoftheCPIbasketsuchas‘clothingandfootwear’areinflatingmoreslowly.

FISCALDOMINANCE

Finally, one reason the RBI was historically reluctant to lock itself into aninflation-focused framework is because it feared government overspendingwouldmake its task impossible.Thepossibilityof fiscaldominance,however,onlymeans that given the inflation objective set by the government, both thegovernmentandtheRBIhavearoletoplay.Ifthegovernmentoverspends,thecentral bank has to compensate with tighter policy to achieve the inflationobjective. So long as this is commonly understood, an inflation-focusedframeworkmeans better coordination between the government and the centralbankastheygotowardsthecommongoalofmacrostability.IcertainlybelievethattheresponsiblerecentbudgetdidcreateroomfortheRBItoeaseinApril.

PRAGMATICINFLATIONFOCUS

AsyouwillunderstandfromallthatIhavebeensaying,monetarypolicyunderan inflation-focused framework tries to balance various interests as we bring

inflation under control. In doing so, we have to have a pragmatic rather thandoctrinairemindset.Forexample,emergingmarketscanexperiencesignificantcapital inflows that can affect exchange rate volatility as well as financialstability. A doctrinaire mindset would adopt a hands-off approach, while thepragmaticmindsetwouldpermitinterventiontoreducevolatilityandinstability.Nevertheless, the pragmatic mind would also recognize that the best way toobtainexchangeratestabilityistobringinflationdowntoalevelcommensuratewithglobalinflation.

Similarly, while financial stability considerations are not explicitly in theRBI’sobjectives,theymaketheirwayinbecausetheRBIhastokeepgrowthinmind while controlling inflation. So if the RBI’s monetary policies arecontributing to a credit or asset price bubble that could lead to a systemicmeltdown and growth collapse, the RBI will have to resort to correctivemonetary policy if macro-prudential policy alternatives are likely to proveineffective.

THETRANSITIONTOLOWINFLATION

Theperiodwhen ahigh inflation economymoves to low inflation is never aneasyone.Afteryearsofhighinflation,thepublic’sexpectationsofinflationhavebeenslowtoadjustdownwards.Asaresult,theyhavebeenlesswillingtoadjusttheir interest expectations downwards. Household financial savings areincreasing rapidly as a fraction of overall household savings, but not yetsignificantly as a fraction of GDP. Some frictions in the interest rate-settingmarketdonotalsohelp.Evenwhilepolicyratesaredown,theratespaidbythegovernmentonsmallsavingsaresignificantlyhigherthanbankdepositrates,asaretheeffectiveratesontaxfreebonds.Iamgladthegovernmenthasdecidedtolink the rates on small savings to government bond rates, but these rateswillcontinuouslyhavetobeexaminedtoensuretheydonotformahighfloorbelowwhichbankscannotcutdepositrates.Allinall,banklendingrateshavemoveddown,butnotcommensuratewithpolicyratecuts.

The wrong thing to do at such times is to change course. As soon aseconomic policy becomes painful, clever economists always suggest new

unorthodox, painless pathways. This is not a problem specific to emergingmarkets,butbecomesespeciallyacutesinceeveryemergingmarketthinksit isunique,and the lawsofeconomicsoperatedifferentlyhere.Flipping throughabook of cartoons by that great economist, R.K. Laxman, I found one thatindicatedthesolutionforeveryillin1997,whenthecartoonwaspublished,asnow, is for theRBI to cut interest ratesby ahundredbasispoints.Argumentschange,butcleversolutionsdonot.

Decades of studying macroeconomic policy tells me to be very wary ofeconomistswhosayyoucanhaveitallifonlyyoutrysomethingoutofthebox.Argentina, Brazil, and Venezuela tried unorthodox policies with depressinglyorthodoxconsequences.Ratherthanexperimentwithmacro-policy,whichbringsmacrorisksthatourunprotectedpoorcanillafford,bettertobeunorthodoxonmicroeconomic policy such as those that define the business and bankingenvironment.Notonlydowehavelesschanceofdoingdamageifwegowrong,butinnovativepolicymayopennewpathsaroundoldbottlenecks.Specifically,on its part the RBI has been adopting more liberal attitudes towards banklicensing, towards financial inclusion, and towards payment technologies andinstitutionsinordertofostergrowth.

INSTITUTIONBUILDING

Letmereturntoinstitutionbuilding.Wehadgottenusedtodecadesofmoderateto high inflation, with industrialists and governments paying negative realinterest rates and the burdenof the hidden inflation tax fallingon themiddle-classsaverandthepoor.Whatishappeningtodayistrulyrevolutionary–weareabandoning theways of the past that benefited the few at the expense of themany.Aswemovetowardsembedding institutions that result insustained lowinflationandpositiverealinterestrates,thisrequiresallconstituenciestomakeadjustments. For example, if industrialists want significantly lower rates, theyhavetosupporteffortstoimproveloanrecoverysothatbanksandbondmarketsfeelcomfortablewithlowcreditspreads.Thecentralandstategovernmentshavetocontinueonthepathoffiscalconsolidationsothattheyborrowlessandthusspend less on interest payments. Households will have to adjust to receiving

lowernominalratesondeposits,butmustrecognizethattheyarealsoreceivinghigher real rateswhichgives their savingshigherpurchasingpower.Theywillfinditworthwhiletosavemoretofinancetheenormousinvestmentneedsofthecountry.

Adjustmentisdifficultandpainfulintheshortrun.Wemustnotgetdivertedaswebuildtheinstitutionsnecessarytosecurealowinflationfuture,especiallybecause we seem to be making headway. The government has taken themomentous stepofboth settingaCPI-based inflationobjective for theRBIaswellasaframeworkforsettingupanindependentmonetarypolicycommittee.In thedaysahead,anewGovernor, aswell as themembersof thecommittee,will bepicked. I am sure theywill internalize the frameworks and institutionsthathavebeensetup,andshouldproducealowinflationfutureforIndia.

The rewardswill bemany.Our currencyhas been stable as investors havegained confidence in our monetary policy goals, and this stability will onlyimprove aswemeet our inflation goals. Foreign capital inflowswill bemorereliable and increase in the longer maturity buckets, including in rupeeinvestments. Thiswill expand the pool of capital available for our banks andcorporations.Thegovernmentwillbeable toborrowat low rates, andwillbeable to extend the maturity of its debt. The poor will not sufferdisproportionatelyduetoboutsofsharpinflation,andthemiddleclasswillnotseeitssavingseroded.Allthisawaitsusaswestaythecourse.

W

IV

Irarelyexpressedinpublicmydeeperconcernthatsomeofthecriticismwasfromquartersthatweremotivatedbytheirinterestsratherthaneconomiclogic.Butinmylastspeechoninflation,deliveredattheRBIonStatisticsDay,26July2016,Iwonderedwhyuninformedcriticsweregettingsomuchairtime.Anexcerptfromthatspeechfollows,whichendswelcomingtheinstitutionalizationofthefightagainstinflation.Perhaps,yearsfromnow,wewillwonderwhyanyofthiswasworthdebating.

DebatewithoutTheoryorEvidence

hy is it that as we seem to be bringing inflation under control, publicvoicestoabandonthefightareloud?Whyisthedebateuninfluencedby

the data? I don’t know for sure but let me hazard a guess; is it possible thepolitical economy of inflation is different from the receivedwisdomweweretaughtinclassasstudents?

Specifically, despite all the political breast-beating about inflation andworriesaboutitsperniciouseffectontheweakersectionsofsociety,thereseemstobe surprisingly littlepublicanxietyabout inflationso longas it stays in thehigh single digits. Industrialists welcome negative real rates of interest forobviousreasons–itkeepstheircostoffundinglow.Manymiddle-classsaversvalue thehighnominal interest rates on their fixeddeposits, not realizing thattheir principal is eroding significantly everyyear.TheKeynesian economist ishappybecausemonetarypolicyisextremelyaccommodative.Theanalystscheerevery cut in interest rates, no matter the consequences to inflation, becausemarketsareassumedtohaveaPavlovianpositiveresponsetoratecuts.Eventhepoorareinuredtotheirfateofseeingrealincomeserode,andareonlyaggrievedwhenthepriceofsomefoodstapleskyrockets.Interestingly,short-termspikesinfoodstaplesarenotreallycontrollablebymonetarypolicy,whichthenleadstothe incorrect generalization that since monetary policy cannot control thepolitically most important aspects of inflation, it cannot control inflation ingeneral.

With no powerful and vocal political constituency getting agitated about

generalized inflation so long as it is only moderately high, opponents ofdisinflationarypoliciesarefreetoframethedebateastheywish.Thepersuasiveway is toclaim that interest rates arehurtinggrowth.Theargument ishard torefute because there is always some sympathetic borrower who is payingseemingly excessive rates. The high prevailing borrowing rate of some smallborrower–say15percenttoday–isheldoutasExhibitAofthecentralbank’sinconsideratepolicies,nevermindthattheratechargedincludesthepolicyrateof6.5percentplusanadditionalspreadof8.5percent,consistingofadefaultriskpremium,a termpremium,an inflation riskpremium,and thecommercialbank’scompensationforcosts,noneofwhicharedirectlyaffectedbythepolicyrate.

Thepressisconstantlyurgedtoframethedebateasinflationversusgrowth,andwithinflationstillonlymoderatelyhigh,onlytheexcessivelyconservativecentral bank couldbe against growth!Nevermind that overly accommodativepolicy todaywill set up inflation for the future; nevermind that the last fortyyearsofeconomictheoryandpracticesuggeststhat thebestwaycentralbankscansupportgrowthoverthemediumtermisbykeepinginflationlowandstable.

Thereality,ofcourse,isthathighinflationisnotstable.AswehaveseeninIndia’sownpast,andinotheremergingmarkets,moderatelyhighinflationtendsquickly to become very high inflation. The currency then becomes volatile,leading occasionally to external stress. After all, one of the reasons we weretermedtheFragileFiveinthesummerof2013wasbecauseofourhighinflation.Moreover,thesavereventuallyrecognizesthathighinflationerodesthevalueofhisfinancialsavingsandswitchestorealassetslikegold.Sincewedonotminegoldinthecountry,thisalsoputspressureonthecurrentaccount.

In sum, the fragilities associated with high inflation accumulate, andeventually could lead to crisis. However, the belief that there is a strongpowerfuldomesticconstituencyagainst inflation inIndia,whichwasdrummedintoourheadsasstudents,maybeamyth,certainlyatmoderatelyhighlevelsofinflation.Without any political push back as inflation rises,what is to ensuremacroeconomicstability?

Unlikemore authoritarianAsian economies that used severe administrative

measures to deal with bouts of high inflation during their growth phase, ourdemocratic structure rightlydoesnotpermit suchmeasures.So it isbetter thatwetackleinflationupfrontbybuildingthenecessaryinstitutions.Perhapsthisiswhysuccessivegovernments,intheirwisdom,havegiventheRBIameasureofindependence.Certainly,suchconcernswouldsupportthecurrentgovernment’sdecisiontoenshrineitscommitmenttolowinflationthroughaformalinflationtargetandthecreationofamonetarypolicycommittee.

Postscript:Nowthatthegovernmenthassetupamonetarypolicycommitteeandgivenitaninflationtarget,itwouldbeappropriateforcurrentandfuturegovernmentstolettheappointedexpertsonthecommitteedecide.

CHAPTER3

MAKINGTHEBANKINGSECTORMORE

COMPETITIVE

I

Thesecondof thefivepillarswas tocreateamorecompetitiveandvibrantbankingsystem.LiberaleconomistsinIndiathoughthebestwaytofixthestate-ownedportionofthebankingsystemwastoprivatize it.So longas thepublic sectorbanks (PSBs)hadanumbilicalcordattached to thecentralgovernmenttreasury,theywouldnothavethedisciplinetoreform,orsotheyargued.Othersfeltthatso long as governance in the public sector banking system was improved, there was no need forprivatization. Public sector banks could be an important vehicle to implement the government’smandatesintendedtoachieveinclusionanddevelopmentgoals.

Myownperspectivewassomewhereinthemiddle.Ididnotbelieveprivatizationwouldbeeasyorfix the problems of all public sector banks. Perhaps one could start by privatizing one bank anddrawing lessons from it – IDBI Bank was often mentioned as a possible candidate becauseprivatization did not require legislative change.Be that as itmay, I also feltmany of the potentialbenefitsofprivatizationcouldbeachievedifPSBgovernancecouldbeimprovedsubstantially.Atthesame time, I did not believe that itwas possible to force governmentmandates only on the publicsector banks, especially as the banking sector became increasingly competitive. If the governmentwere, however, to pay banks for carrying out itsmandates, therewas no reasonwhy private sectorbanks could not participate. At any rate, knowing that there was little appetite in either the UPAgovernmentortheNDAgovernmentfortheliberalagenda,wholesaleprivatizationwasoffthetable.Withintheparameterssetbythegovernment,theRBIhadtodothebestjobitcouldinreformingthebankingsector.

InadditiontoworkingwiththegovernmentonPSBreform,myfocuswasonfreeingupentryintothebankingsystem,especiallyfornewbanksthatmighttargetunderservedclients,sothattherewouldbemorecompetitionandbetterserviceforallcustomers.IntheAnnualDaylectureattheCompetitionCommissionofIndiaon20May2014,IgotachancetoexplaintheRBI’sstrategy.Idiscussedthetwograndbargainsthatunderlaythepast,andwhythathadtochange.Manyofthepossibilitiesdiscussedin this speech were later translated into policy action. The work on banking reform was led by asuccessionofveryabledeputygovernors,AnandSinha,R.Gandhi,andN.S.Vishwanathan,aidedbyexecutivedirectorsofthecalibreofB.MahapatraandSudarshanSen.

C

CompetitionintheBankingSector:OpportunitiesandChallenges

ompetition is the life force of amodern economy – it replaces dated andinefficient methods while preserving valuable traditions; it rewards the

innovative and energetic and punishes the merely connected; it destroys thestabilityofthestatusquowhilegivinghopetotheyoungandtheoutsider.Truecompetitioneliminatestheneedforplanners,forasgravityguideswaterthroughthe shortest path, competition naturally guides the economy to the mostproductiveroute.

Healthycompetitionisnotjustthebestwaytogrowbutalsothebestwaytoincludeallcitizens;whatbetterwaytogetneededservicestoapoorhousewifethantoencourageproviderstocompeteforhermoney?Whatbetterwaytoupliftamemberofabackwardcommunity than forprivateemployers tocompete tohireherforagoodjob?

Healthy growth-inducing inclusive competition does not, however, emergeonitsown.Withoutintervention,wegetthecompetitionofthejungle,wherethestrong prey on theweak. Such competition only encourages a certain kind ofwinner,onewhoisadaptedtothejungleratherthantheworldwewanttolivein.In contrast, healthy competition needs the helping hand of the government; toensure the playing field is level, that entry barriers are low, that there arereasonable rules of the game and clear enforcement of contracts, and that allparticipantshavethebasiccapabilitiessuchaseducationandskillstocompete.

Governments have historically found it difficult to ensure such healthycompetitionbecauseinterventionhastobejustright.Governmentstypicallyaretemptedtogobeyondinterveningtocreateafaircompetitiveenvironment,andinsteadhaveturnedtodeterminingwinnersandlosersthemselves.Thistypicallyhas not worked out well. With this caveat, the creation of a healthier, morecompetitive environment in India could be the government’s most importantcontributiontosustainableeconomicgrowthinIndiaoverthemediumterm.AndtheCompetitionCommissionwillbeacentralplayerinthisendeavour.Whether

inquestioningexistinggovernmentmonopoliesor theexcessivemarketpowerofprivateplayers,youwillbeakeyinstitutionintheyearstocome.Andforthesakeofourcountry,Iwishyoutheverybestofsuccess.

Today,Iwanttofocusonthecomingcompetitiveenvironmentinthebankingsector.AttheReserveBankofIndia,wehavespentafewmonthsthinkingabouthowweseethatshapingup,andIwanttosharethatvisionwithyou.Myintenthereistofurtherthedebateratherthantoannounceanyfinaldecisions.

THEGRANDBARGAINS

The degree of competition in the banking sector in India is best seen as theproduct of twograndbargains.The firstwasbetween successivegovernmentsand the banks, whereby banks got privileged access to low-cost demand andtimedeposits,tothecentralbank’sliquidityfacilities,aswellassomeprotectionfrom competition, in return for accepting obligations such as financing thegovernment(throughtheStatutoryLiquidityRatioorSLR),helpinginmonetarytransmission (through maintaining the Cash Reserve Ratio or CRR), openingbranchesinunbankedareasandmakingloanstotheprioritysector.

Thesecondgrandbargainwasbetween thepublicsectorbanks (PSBs)andthe government,whereby these banks undertook special services and risks forthe government, and were compensated in part, by the government standingbehindthepublicsectorbanks.AsIndiahasdeveloped,boththesebargainsarecomingunderpressure.Anditisdevelopmentandcompetitionthatisbreakingthemdown.

Today,theinvestmentneedsoftheeconomy,especiallylong-terminvestmentin areas like infrastructure, have increased. The government can no longerundertaketheseinvestments.Privateentrepreneurshavebeenaskedtotakethemup.Tocreatespaceforfinancingtheseinvestments,thegovernmenthastopre-emptlessofthebankingsystem’sassets.Butthenatureoffinancingrequiredisalsochanging.Privateinvestmentisrisky,sotherehastobemorerisk-absorbingfinancing such as from corporate bond markets and from equity markets. Asmoresourcesoffinancingemerge,notonlywillbanksnolongerbeabletohaveamonopolyoverfinancingcorporationsandhouseholds, theywillalsohaveto

competeforthebestclients,whocanaccessdomesticandinternationalmarkets.Similarly,depositfinancingwillnolongerbeascheap,asbankswillhaveto

compete with financial markets and real assets such as housing for thehousehold’s savings. As households become more sophisticated, they will beunwilling to leave a lot ofmoney in low-interest-bearing accounts.Of course,householdswillstillbewillingtoacceptlowinterestratesinreturnforliquidity.Soprivilegedaccesstothecentralbank’sliquiditywindowswillallowbankstoofferhouseholdstheseliquidityservicessafelyandgetarent,butthisadvantagewillalsobecomeerodedasnewpaymentsinstitutionsandtechnologiesemerge.

The first grand bargain – cheap deposits in return for financing thegovernment – is therefore being threatened fromboth sides.Depositswill notcontinue to be cheap, while the government cannot continue to pre-emptfinancingatthescaleithasinthepastifwearetohaveamodernentrepreneurialeconomy. This is yet another reason why fiscal discipline will be central tosustainablegrowthgoingforward.

Publicsectorbanks(PSBs)are,ifanything,inaworsepositionthanprivatesectorbanks,whichiswhythesecondbargainisalsounderthreat.Aslow-riskenterprisesmigratetofinancingfromthemarkets,banksareleftbothwithverylargeriskyinfrastructureprojectsandwithlendingtosmall-andmedium-sizedfirms. The alternative to taking these risks is to plunge into very competitiveretail lending, so public sector banksmay have little option, especially if thegovernment pushes them to lend to infrastructure.Many of the projects beingfinanced today, however, require sophisticated project evaluation skills andcarefuldesignofthecapitalstructure.Successfullendingrequiresthelendertoact tosecurehispositionat thefirstsignof trouble,otherwisetheslowbankerends up providing the loss cover formore agile bankers, or for unscrupulouspromoters.Tosurvive in thechangingbusinessof lending,publicsectorbanksneedtohavestrongcapabilities,undertakecarefulprojectmonitoring,andmovequicklytorectifyproblemswhennecessary.

In the past, PSBs had the best talent. But today, past hiring freezes havedecimatedtheirmiddle-managementranks,andprivatebankshavealsopoachedtalented personnel fromPSBs.PSBsneed to be able to recruit laterally,while

retaining the talent they have, but to do so they need to be able to promiseemployees responsibility as well as the freedom of action. Unfortunately,employeeactionsinpublicsectorbanksareconstrainedbygovernmentrulesandsecond-guessed by vigilance authorities, even while pay is limited. It will behardforpublicsectorbankstocompetefortalent.If,inaddition,thesebanksareaskedtomakesub-optimaldecisionsinwhatisdeemedthepublicinterest,theirperformancewillsuffermorethaninthepast.Thiswillmakeithardforthemtoraisefunds,especiallycapital.Withthegovernmentstrappedforfunds,itsabilitytosupport thecapitalneedsofpublic sectorbanksaspartof thesecondgrandbargainisalsocomingintoquestion.

Wecannotgobackwards to revive the twobargains– thatmeansreversingdevelopmentandbottling thegenieofcompetition,neitherofwhichwouldbedesirablefortheeconomyeveniffeasible.Instead,thebestapproachmaybetodevelop the financial sector by increasing competition and variety, evenwhilegivingbanks,especiallypublicsectorbanks,agreaterabilitytocompete.Letmebemorespecific.

INCREASINGCOMPETITIONINBANKING

TheReserveBank of India is committed to freeing entry in banking.We justannouncedtwonewcommercialbanklicencesafterarigorousvettingprocess.We are examining this experience, and aftermaking appropriate changes,willannounce a more regular process of giving licences – what has been termedlicencesontap.

Becauseof thepublic’s trust inbanksandthepresenceofuniversaldepositinsurance, we have to be careful in giving out the normal commercial banklicences. To be absolutely confident of the capabilities and integrity ofapplicants,wegive licencesonly to thosewhohaveaproven track recordandreasonable capital. But what of those who have no track record or no largecapitalbasebutdohavecapabilities?Andwhatofthosewhoseevalueindoingonlyonepartofthebankingbusinesssuchaspayments?

TheRBIcantakemoreofachancewithnewplayersiftheygetthelicencetoopen only a small bank or to conduct only one segment of banking business.

Such differentiated licences – licences with restrictions on the geographicalreachortheproductsofferedbyanewbank–cangeneratemoreorganizationalvarietyandefficiency.Smallbanks tend tobebetteratcatering to localneeds,includingneedsofsmallandmediumbusinesses.Apaymentsbank,whichwilltake deposits and offer payment and remittance services but be constrained toinvestall its funds insafe instrumentssuchasgovernmentsecurities,couldbevery synergistic with other existing services. For example, the proposed PostBankcould start asapaymentbank,makinguseofpostofficeoutlets to raisedepositsandmakepayments.

Key in any new structure is that there should be no arbitrage possibilitieshurtingthecurrentbankingsystem.Today,acommercialbankcanconvertitselfinto a payment bank bymaintaining 100 per cent SLRmargins.Of course, itmay not want to, because it seeks to make more money through corporatelending, but this possibility indicates regulations will not favour a paymentsbankunduly.Someofmycolleaguesbelieveapaymentsbankwillbeunviable,whileothersbelievethatitwillskimthecreamofbankingbusinessawayfromregularcommercialbanks.Wecandebate this issuefora longtime,orwecanexperiment by allowing a few payments banks and monitoring theirperformance.TheRBIproposestodiscussfurtherstepswithstakeholdersinthisregard.

Ifpaymentsbanksaresuccessful,theywillallowustosteadilyreducesomeof theobligationswe imposeoncommercialbanks.For instance, aspaymentsbanks hold government securities for liquidity purposes, we can reduce thequantity of government securitieswe ask commercial banks to hold as part ofSLR.

Whileontheissueofbankobligations,thereisanareawheretheydoseemtobeatadisadvantagevis-à-visotherfinancialinstitutions–intheraisingandlending of long-term money. This becomes especially important forinfrastructure,wherebankscanbeessentialinearlystageconstructionfinancing.Since construction lasts for five to seven years, banks should be able to raiselong tenormoneyfor thesepurposes.But if theyraisesuchmoney today, theyimmediately become subject to CRR and SLR requirements, and any lending

theydoattractsfurtherprioritysectorobligations.Totheextentthatbanksraiselong-termbondsanduseitforinfrastructurefinancing,couldwerelievethemofsuch obligations? This will immediately put them on par with other financialinstitutionssuchasinsurancecompaniesandfinancecompaniesinfundinglong-terminfrastructure.

Theprioritysectorobligationwillprobablybenecessaryforsomemoretimeinadevelopingcountry likeours, thoughweneed todeliberatemoreonwhatsectors should constitute priority as the economy develops. But even withoutenteringthispotentiallycontentiousdebate,canweallowbankstofulfilexistingnorms more efficiently? For instance, if one bank is more efficient at rurallending,can itover-achieve itsobligationsand then ‘sell’ itsexcess toanotherbankthatisanunderachiever?Weareexaminingsuchpossibilities.

Finally,wehavehadonly limitedsuccess inachieving inclusionwhen it isseen as a mandate. Banks sometimes open branches in remote areas but theofficers that staff them do not really reach out to the local population; banksopenno-frillsaccountsbutmanyliedormant…Therealityisthatifthemandateisunprofitable,bankswill findways toavoid them.Notall formsof inclusioncan be made profitable, but we should give banks the freedom to try newapproaches,perhapsdrawinginotherinstitutionsthatcantraversethelastmiletotheunderservedwherenecessary.TheRBIwillcomeoutwithnewrelaxationson business correspondents shortly. Also, some of the entities that becomepayments banksmay be very well suited to support or substitute commercialbanksinreachingremoteareas.

Insum,then,wecanincreasecompetitioninthebankingsectorwhile,atthesametime,strengtheningbanksbyreducingtheburdenofobligationsonthem.Inthisway,theywillbeabletocontributetosustainablegrowthevenafterthebreakdownofthefirstgrandbargain.

FREEINGPUBLICSECTORBANKSTOCOMPETE

Letusturnnexttothepublicsectorbanks.Therearewell-managedpublicsectorbanksacrosstheworld,andeveninIndiatoday.Soprivatizationisnotnecessarytoimprovethecompetitivenessofthepublicsector.Butachangeingovernance,

management, and operational and compensation flexibility are almost surelyneededinIndiatoimprovethefunctioningofmostPSBs,astheDrP.J.NayakCommitteehasjustreiterated.

A number of eminently practicable suggestions have beenmade to reformPSBs, such as creating a holding company to hold government PSB shares,increasingthelengthofPSBCEOtenures,breakingupthepositionofChairmanand CEO, bringing more independent professionals on bank boards andempoweringboardswiththetaskofselectingtheCEO,becomingmoreselectiveincasesthatarefollowedupforvigilanceinvestigations…

Weneedtoexamineall theseideascarefully,manyofwhichwillhelpgivepublic sector banks the flexibility to compete in the new environment. Let usremember thatwhat is at stake is not just the tremendous amount of nationalvalue that is represented by public sector banks but future financing andinvestmentinoureconomy.

If public sectorbanksbecomecompetitive, andespecially if theydo sobydistancingthemselvesfromtheinfluenceofthegovernmentwithoutsacrificingtheir‘public’character,theywillbeabletoraisemoneymuchmoreeasilyfromthemarkets.Indeed,thebetterperformerswillbeabletoraisemore,unlikethecurrent situation where the not-so-good performers have a greater call on thepublic purse. Competition will improve efficiency. The second grand bargainwillalsobecomeirrelevant.

CONCLUSION

Thebankingsectorisonthecuspofrevolutionarychange.Inthenextfewyears,I hope we will see a much more varied set of banking institutions usinginformation and technology to their fullest, a healthy public sector bankingsystem,distantfromgovernmentinfluencebutnotfromthepublicpurpose,anddeep and liquid financial markets that will not only compete with, but alsosupport,thebanks.Suchavisionisnotjustapossibility,itisanecessityifwearetofinancetheenormousneedsoftherealeconomy.AsIndiaresumesitspathtostrongandsustainablegrowth,itistheRBI’sfirmconvictionthattheIndianbankingsectorwillbeasupportivepartnereveryinchoftheway.

T

II

AttheFICCI-IBAAnnualBankingConferenceon16August2016,Iwentoversomeofthereformswehadintroduced.Aswewillsee,bankershadbecomefocusedoncleaningupthebaddebtontheirbooks.Whilethiswasimportant,Iurgedthebankingsectortolookahead,beyondtheproblemsofbaddebts, to focusingongrowth. Iaddressed,onceagain, thechallenges facedbyPublicSectorBanks,andwhattheyneededtodo.

Interesting,Profitable,andChallenging:BankinginIndiaToday

hese are interesting, profitable, and challenging times for the financialsector. Interesting because the level of competition is going to increase

manifold, both for customers as well as for talent, transforming even thesleepiest areas in financial services. Profitable because new technologies,information,andnewtechniqueswillopenupvastlynewbusinessopportunitiesand customers. Challenging because competition and novelty constitute aparticularlyvolatilemixintermsofrisk.Inthistalk,Iwillspeakabouthowweseetheseaspectsatthecentralbank.

INTERESTINGANDPROFITABLE

Overthenextyear,seventeennewnichebankswillbeginbusiness.Inaddition,licensing for universal banks is now on tap, so fit and proper applicantswithinnovativebusinessplansandgoodtrackrecordswillenter.Fintechwill throwup a variety of newways of accessing the customer and serving her, so newinstitutions that we have little awareness of today will soon be a source ofcompetition. These will finally draw customer sectors, firms, and individualswithoutaccesstodayintotheformalfinancialsystem.Thosecustomersthatarealreadybeingservedwillbespoiledforchoice.

Fortheserviceprovider,eventhoughgreatercompetitionwilltendtoreducespreads, new customers and new needswill increase volumes.Moreover, riskand cost reduction through information technology and risk management

techniques will tend to increase effective risk-adjusted spreads. In sum then,despite increased competition, profitability can increase. The comparativeadvantageofbanksmay lie in theiraccess to lowercostdeposit financing, thedatatheyhaveoncustomers,thereachoftheirnetwork,theirabilitytomanageandwarehouserisks,andtheirabilitytoaccessliquidityfromthecentralbank.Theseshouldthenbethebasisfortheproductstheyfocuson.

Perhaps a couple of examples would be useful. India will have enormousproject financingneeds in thecomingdays.Eventhoughbankersareveryriskaverse today, and few projects are coming up for financing, this will changesoon.Whatisinthepipelineistrulyenormous–airports,railwaylines,powerplants, roads,manufacturing plants, etc. Bankerswill remember the period ofirrational exuberance in 2007-08 when they lent without asking too manyquestions.Iamhopefulthatthistimewillbedifferent.

Herearewaysitcanbedifferentandriskslowered.First,significantlymorein-houseexpertisecanbebroughttoprojectevaluation,includingunderstandingdemandprojectionsfortheproject’soutput,likelycompetition,andtheexpertiseandreliabilityofthepromoter.Bankerswillhavetodevelopindustryknowledgeinkeyareassinceconsultantscanbebiased.

Second,realriskshavetobemitigatedwherepossible,andsharedwherenot.Realriskmitigationrequiresensuringthatkeypermissionsfor landacquisitionandconstructionareinplaceupfront,whilekeyinputsandcustomersaretiedupthrough purchase agreements. Where these risks cannot be mitigated, theyshould be shared contractually between the promoter and financiers, or atransparent arbitration system agreed upon. So, for instance, if demand fallsbelow projections, perhaps an agreement among promoters and financiers canindicatewhennewequitywillbebroughtinandbywhom.

This leads to the third element of project structuring – an appropriatelyflexiblecapitalstructure.Thecapitalstructurehastoberelatedtoresidualrisksof the project. Themore the risks, themore the equity component should be(genuinepromoterequity,notfakeborrowedequity,ofcourse),andthegreatertheflexibilityinthedebtstructure.Promotersshouldbeincentivizedtodeliver,with significant rewards for on-time execution and debt repayment. Where

possible, corporate debt markets, either through direct issues or securitizedprojectloanportfolios,shouldbeusedtoabsorbsomeoftheinitialprojectrisk.More such arm’s length debt should typically refinance bank debt whenconstruction is over. Some of themeasures taken to strengthen corporate debtmarkets,includingthenewbankruptcycode,shouldmakeallthispossible.

Fourth, financiers should put in a robust system of projectmonitoring andappraisal, including,wherepossible, careful real-timemonitoringof costs.Forexample, canproject input costs bemonitored and comparedwith comparableinputs elsewhere using IT, so that suspicious transactions suggesting over-invoicingareflagged?

Andfinally,theincentivestructureforbankersshouldbeworkedoutsothattheyevaluate,design,andmonitorprojectscarefully,andgetsignificantrewardsiftheseworkout.Thismeansthatevenwhilecommitteesmaytakethefinalloandecision, some senior banker ought to put her name on the proposal, takingresponsibility for recommending the loan. IT systemswithin banks should beabletopullupoverallperformancerecordsofloansrecommendedbyindividualbankerseasily,andthisshouldbeaninputintotheirpromotion.

Note that none of this is really futuristic, but it requires a much strongermarriage between information technology and financial engineering, with animportantroleforpracticalindustryknowledgeandincentivedesign.Therearealsoinputstomakingprojectloansmoreprofitable–suchastheavailabilityofCurrentandSavingsAccountsdeposits–thatwillaccruetothebanksthatbuildout theirITtoaccessandservethebroadersavercheaplyandeffectively.Fewbankshavethein-housetalenttodoallthisnow,butpreparationisimperative.

AnareaofmoreintensiveuseofITandanalysisiscustomerloans,whichismysecondexample.Itseemstodaythat,havingabandonedprojectloans,everybankistargetingtheretailcustomer.Clearly,therisksinthisherdingwillmountovertime,asbankscompeteforlessandlesscreditworthycustomers.Butsomeofthisriskcanbemitigatediftheydosufficientduediligence.

Newmeansofcreditevaluationareemerging.Forexample,somelendersareexaminingnotjustcredithistoriesfromthecreditbureaubutminingtheirowndataandalsodatafromsocialmediapostsbytheapplicanttoseehowreliable

they might be. Various forms of crowdfunding, intermediated by peer-to-peerlenders, also claim superior credit evaluation. Of course, much of the hooplasurrounding these new forms of lending has yet to be tested by a seriousdownturn, and it is unclear how responsibilities for recovery will devolvebetweenintermediaryandinvestoratsuchtimes.

Nevertheless, in this Information Age, not only are there more data withwhichtodeterminealoanapplicant’screditworthiness,itisalsopossibletotracktheir behaviour for early warning signs of stress. Furthermore, in thisinterconnectedworld,aborrower’sinabilitytohideadverseinformationsuchasdefaultwhentaggedbyauniqueIDconstitutesabigincentivetorepay.

Importantly, banks no longer have amonopoly over all credit-related data;someITcompaniesmaydoabetterjobinpullingtogethereventhebank’sdata,inadditiontotrawlingforotheravailabledata,andanalysingitalltomakebetterlending and monitoring decisions. Loan applications and decisions are nowbeingmade entirely online, without a borrower having to step into a branch.AlliancesbetweenITcompaniesandbanksarelikelytoincreasesignificantly.

The bottom line is that competition is increasing, and ways of deliveringfinancialservicesarechangingtremendously.Bankshavetodiscoverstrategiesto use their traditional, although eroding, advantages such as convenience,information, and trust to remain on the competitive frontier. Competition andinnovation constitute a particularly volatile mix in terms of risk challengingbanks’traditionalriskmanagementcapabilities.Theyarealsoachallengetotheregulator,whowantsthebestforthecustomer(andthereforewantstoencouragecompetitionandexperimentation),whilemaintainingsystemicstability(andthuswantstounderstandrisksbeforetheygettoolargeorwidespread).

THEAUTHORITIES’DILEMMA

Before turning to how the banks should respond to these competitive andtechnologicalforces, letusaskhowtheseforcesaffect theregulatorycompact.Ideally,theauthoritiesshouldensuretheiractionsareinstitution,ownership,andtechnology neutral so as to ensure that the most efficient customer-orientedsolutions emerge through competition.However, if the authorities deliberately

skew the playing field towards some category of institutions and away fromothers,competitionmaynotproducethemostefficientoutcome.

BanksinIndiahavebeensubjecttothegrandbargain,wherebytheygetthebenefits of raising low-cost insured deposits, liquidity support and closeregulationbythecentralbank(Iamsuresomeofyouseethisasacost)inreturnfor maintaining reserves with the central bank, holding government bonds tomeetSLRrequirements,andlendingtotheprioritysector.

Inaddition,publicsectorbanksarefurthersubject togovernmentmandatessuch as opening PMJDY accounts, or makingMUDRA loans [Author’s note:These were loans to small andmedium enterprises]. They are also subject tohiring mandates, in particular the need to hire through open all-India examsrather than from specific campuses or from the local community, and tomeetvarious government diversity mandates. In part compensation, public sectorbanksdogetmoregovernmentdepositsandbusiness,andarebackedbythefullfaith andcredit of thegovernment.While it isunclearwhether the costof themandatesoutweighthebenefits,theydoskewthecompetitivelandscape.

Authorities like the central bank and the government should, over themedium term, reduce the differences in regulatory treatment between publicsectorbanksandprivate sectorbanks, andmoregenerally,betweenbanks andotherfinancialinstitutions.

Someof thedifferencesbetweenpublicsectorbanksandprivatebankscanbe mitigated if the government pays an adequate price for mandates. If, forexample, when every direct benefit transfer is paid a remunerative price, allbanks have an incentive to undertake the business and open basic customeraccounts.Themost efficientbankwill garnermorebusiness, and thepaymentcanbegraduallyreducedovertime,commensuratewiththeaccruedefficiencies.

Someofthemandateswillalsobecomelesscostlywithnewtechniques.Forexample,banksare findingways tomakeMSME loansmore remunerativebydecreasingtransactionscosts.Similartechniquescouldbebroughttoagriculturalloans,especiallyasfarmproductivityincreases.Wideruseofcreditinformationbureausandcollateralregistriesshouldalsohelpimprovecreditevaluationandlowerthecostofrepossession.Thisshouldmakeiteasiertomeetprioritysector

norms.Thecosthasbeenfurtherreducedthroughtheintroductionof tradeablepriority sector lending certificates,whereby themost efficient lenders can selltheir over-performance, while the inefficient ones can compensate forunderperformancebybuyingcertificates.

Nevertheless,over time,differencesshouldbereducedfurther.This iswhy,for example, the Reserve Bank has been reducing Statutory Liquidity Ratiorequirements steadily, and allowed over half of the SLR holdings tomeet theBasel-mandated Liquidity Coverage Ratio. But we are also trying to shapemandatestonewtechnologiesandapproaches.Forexample,itismandatedthataquarterofabank’sbranchesshouldbeopenedinunderservedareas.Butwhatexactlyqualifiesasabranch?Couldweacceptalternativedefinitionsofabranchsolongastheymeettheneedsofthepopulationforaregularoutletforbankingbusiness? Of course, all villages would love to have a full service brick andmortarbankbranch.However,ifthecostiscurrentlyprohibitive,canweacceptalternatives that do much of what is needed? An internal RBI committee islookingattheseissues.

Insum,mandatesshouldincreasinglybepaidfor,andarebecomingeasiertoachieveastheinstitutionalandtechnologicalunderpinningsoffinancialservicesimprove.Ascompetitionincreases,however,theauthoritiesshouldaskhowlongmandates should continue, and keep targeting them better towards the trulyunderserved.Theyshouldalsowithdrawanypreferentialtreatment,totheextentfeasible,atacommensuratepace.

Let me now turn to how banks respond to the emerging competitivechallenges.Iwilltalkspecificallyaboutpublicsectorbanks,whichperhapsfacethegreatestchallenges.

CHALLENGESFACEDBYPUBLICSECTORBANKS

Themostpressingtaskforpublicsectorbanksistocleanuptheirbalancesheets,aprocesswhichiswellunderway.Aparalleltaskistoimprovetheirgovernanceand management. Equally important is to fill out the ranks of middlemanagementthathavebeenthinnedoutbyretirements,andtorecruittalentwithexpertise in project evaluation, risk management, and IT, including cyber

security.

(i)Governance

The Bank Board Bureau (BBB), composed of eminent personalities withintegrityanddomainexperience,hastakenoverpartoftheappointmentsprocessin public sector banks. There are twoways the government still plays a role.First, the final decision on appointments is taken by the AppointmentsCommitteeof theCabinet.Second,appointmentsofnon-officialdirectorsontobank boards still lie outside theBBB.As theBBBgains experience, itwouldmakesensetoallowthesedecisionsalsotobetakenbyit.

Over time, as the bank boards are professionalized, executive appointmentdecisions should devolve from the BBB to the boards themselves, while theBBB–asittransformsintotheBankInvestmentCompany(BIC),thecustodianforthegovernment’sstakeinbanks–shouldfocusonlyonappointingdirectorstorepresentthegovernmentstakeonthebankboards.Itisimportantthatbankboards be freed to determine their strategies. Too much coaching by centralauthoritieswill lead toasameness inpublicsectorbanks thatsuccessiveGyanSangams[Author’snote:Anannualgovernmentconferencetodeliberatepublicsectorbankstrategy]havecriticized.

Managementeffortstotightenpracticesarealsoneeded.Fartoomanyloansare done without adequate due diligence and without adequate follow up.Collateralwhenofferedisnotperfected,assetsgivenunderpersonalguaranteesnottracked,andpost-loanmonitoringoftheaccountcanbelax.Thelessonsoftherecentpastshouldbetakenseriously,andmanagementpracticestightened.Amorestringentapproachtoevaluatingandrecoveringlargeloanswillgivebankmanagement the credibility when they go to their staff with plans for costrationalization.

(ii)Talent

The middle-management ranks of public sector banks are being thinned byretirements. In addition, they need experts in specific areas like project

evaluationandriskmanagement.Atthesametime,bankshavetoreducebloatedcoststructures.Allpublicsectorentitiesacrosstheworldtendtopaymorethantheprivate sector to lower level employees, and less than theprivate sector tohigher level employees. Thismakes it hard for them to attract top talent, butmakesiteasiertoattractgoodpeopleatlowerlevels.

Ratherthanseeingtheseasdifficulties,perhapstheycanbeopportunities.IntheRBI,wefindthatourcompensationpackagesenableustoattractveryhighlyqualifiedapplicantsattheClassIIIlevel.Perhapspartofthesolutionistoenablesuchnewhires,with technologyand training, todofarmoreresponsibleworkthantheyweregiveninthepast,andgivethemabrighterprospectofmovementuptheofficerranks.Bankscanalsousetheopportunityofferedbyretirementstoreorienthiring towards theskills theyneed,and toofferattractive rapidcareerprogression supported by strong training programmes to new hires – withthinningmiddlemanagement,themixofexperienceandcapabilitiesshouldshifttowardscapabilities.

And to get talent in specialized areas like project evaluation, riskmanagement, and IT, they may have to hire laterally in small doses. Whilecontractual hires are currently permitted, better personnel would be attractedonly by a strong prospect of career progression internally.Bankswill have tothinkabouthowtoenablethis.

One of the difficulties public sector banks have is court judgments thatprohibithiringfromspecificcampuses.Thisleadstoanomalieslikethepublic-sector-bank-supportedNational InstituteofBankManagementsendingmostofitshighqualitygraduates toworkforprivatesectorbanks.Publicsectorbankscanpetitionthecourtstoallowsomemodicumofcampushire,especiallywhenthe campus chooses openly through a national exam.Another alternative is tomakebankentranceexamsmuch lessonerous to take,withapplications, tests,and results, wherever possible, available quickly and online. The banks thenhaveaneasier taskofpersuadingstudentsonelitecampuses to take theexam.WearefollowingthislattercourseattheRBI.

To have local information, be comfortable with local culture, be locallyaccepted, and be competitive in low-cost rural areas, PSBswill have to have

morefreedomtohirelocally,andpaywagescommensuratewiththelocallabourmarket. Alternatively, they will have to be much more effective in usingtechnology to reduce costs. Finally, as banks adopted differentiated strategies,they should move away from common compensation structures and commonpromotionschemesacrossallpublicsectorbanks.

Whileoneof thestrengthsof thepublicsectorsometimesis theabsenceofpayandpromotionthatisverysensitivetoperformance,toolittlesensitivitycanalsobeaproblemashighperformersgetdemotivated,and theslothfularenotpenalized. An increased emphasis on performance evaluation, includingidentifying low performers with the intent of helping them improve, may bewarranted.Inaddition,rewardslikeEmployeeStockOwnershipPlans(ESOPs)thatgiveall employeesa stake in the futureof thebankmaybehelpful.WithPSB shares trading at such low levels, a small allocation to employees todaymaybe a strong source ofmotivation, and can be a large source ofwealth asperformanceimproves.

(iii)Customers

Public sector banks enjoy trust with customers. An emphasis on customerservice and customer-centric advice may allow them to recapture low-costcustomerdepositsthataremigratingelsewhere.PublicsectorbanksshouldtaketheleadinemphasizingtheRBI’sfive-pointCharterofConsumerRights.Whileitisunderstandablethatwithstressedbalancesheetspublicsectorbanksdonotwant tomake toomany loans to sectors indifficulty, it is less clearwhy theirdepositgrowthisfaltering,forthelow-costdepositfranchisewillbethekeytotheirfuturesuccess.

(iv)Structure

Somebanksmaybebestofffocusingonlocalactivity,andineffect,becomingsmallfinancebanks.Othersmaybebestoffmergingwithotherbankssoastoobtainscaleandgeographicdiversification.Asbanksgetcleanedup,and theirboards are strengthened, their boards should focus on appropriate structure as

partofanoverallrethinkonstrategy.Noneofthesechangesareeasy,buttheyarealsonotimpossible.Itrequires

workwiththeunions,persuadingthemoftheneedforchangethatbenefitsall,especially the long-term future of the bank. Since each bank has differentchallenges and probably different solutions, as these solutions emerge it mayalso be the occasion to rethink the collective bargaining approach across thepublicsectorbankuniversethatnowprevails.

BACKTOTHEAUTHORITIES

Today, a variety of authorities – Parliament, the Department of FinancialServices, the Bank Board Bureau, the board of the bank, the vigilanceauthorities,andofcoursevariousregulatorsandsupervisorsincludingtheRBI–monitortheperformanceofthepublicsectorbanks.Withsomanyoverlappingconstituenciestosatisfy,itisawonderthatbankmanagementhastimetodevotetothemanagementofthebank.Itisimportantthatwestreamlineandreducetheoverlapsbetweenthejurisdictionsoftheauthorities,andspecifycleartriggersorsituationswhereoneauthority’soversightisinvoked.

Inparticular,wehavetomovemuchofthegovernancetothebank’sboard,with the government exercising its control through its board representatives(chosen by the BBB), keeping inmind the best interests of the bank and theinterestsofminorityshareholders.Whereverpossible,publicsectorbankboardsshouldbeboundby thesamerulesasprivate sectorbankboards–one reasonwhytheRBIhasrecentlywithdrawntheCalendarofReviewsPSBswereaskedtofollow.Similarly,boardmembershipofpublicsectorbanksshouldpayaswellasprivatesectorbanksiftheyaretoattractdecenttalent.

Asboardstakedecisions,theDepartmentofFinancialServicescouldmoveto(i)aprogrammerole:forexample,ensuringgovernmentprogrammessuchasPMJDY are well designed, appropriately remunerated to banks, and progressmonitored (ii) a coordinating role: for example, ensuring financial institutionsjoin a common KYC registry and (iii) a developmental role: revitalizinginstitutions like the Debt Recovery Tribunals through appropriate legislation.The RBI would perform a purely regulatory role, and withdraw its

representativesonbankboards–thiswillrequirelegislativechange.Overtime,the RBI should also empower boards more, for instance, offering broadguidelinesoncompensationtoboardsbutnotrequiringeverytopcompensationpackagebeapproved.

Givenstrongoversightfromthebank’sboard,theCVCandCAGwouldgetinvolvedonlyinextraordinarysituationswherethereisevidenceofmalfeasance,andnotwhenlegitimatebusinessjudgmenthasgonewrong.

Ihave focusedon thechallengespublic sectorbanks facemeeting thenewcompetitive environment, aswell as some possible solutions.These should beviewedasopeningadiscussionratherthantheformalviewsoftheRBI.ThatIhavenotdiscussedthechallengesprivatebankswillfaceisnotbecauseIthinkthey are perfectly positioned but because they are not as constrained as thepublic sector banks.But before I end, letme emphasize an immediate area ofactionforall.

Withchangesintechnology,cybersecurity,bothatthebanklevelandatthesystemlevel,hasbecomeveryimportant.Ithinkitwouldbeoverlycomplacentforanyoneofustosaywearewellpreparedtomeetallcyberthreats.Achillingstatement by an IT expert is ‘We have all been hacked, the only question iswhetheryouknowitoryoudon’t’.Whilethestatementmaybealarmist,itisanantidotetocomplacency.Weallhavetoexamineoursecurityculture.Toomanyaccess points are left unmonitored, toomany people share passwords or haveeasilypenetratedpasswords,toolittlesurveillanceismaintainedofvendorsandthesoftwaretheycreate.TheRBIisworkingonupgradingthecapabilitiesofitsinspectorstoundertakebanksystemauditaswellastodetectvulnerabilitiesinthem.TheRBIisalsointheprocessofsettingupanITsubsidiary,whichwillbeable to recruit directly from industry, and will give the Reserve Bank betterability tomanage and supervise technology. Iwould urge all of you to take afreshlookatyoursystems,andmoreimportant,ofthecyberculturewithinyourbank.

Postscript:Manyof thesuggestions in this speecharestill relevant. Inparticular, thegovernanceofpublicsectorbankscanbeimprovedonlywhenthegovernmentdistancesitselffullyfromthebanks,creates a transparent and professionalized process for appointing its directors on the boards (not

dominated by governing party favourites or current or retired government bureaucrats), and allowsbankboardsbothautonomyaswellasaccountabilityinpickingandcompensatingbankmanagement.Unless public sector banks are run like normal corporations, they will not be competitive in themedium term. I have a simplemetric of progress here:Wewill havemoved significantly towardslimiting interference in public sector banks when the Department of Financial Services (whichoverseespublicsectorfinancialfirms)isfinallycloseddown,anditsbankingfunctionstakenoverbybankboardsandtheBankBoardBureau.

I

CHAPTER4

BROADENINGANDDEEPENINGMARKETS

I

Aswegainedconfidencethatthevolatilityengenderedbythe‘TaperTantrum’insummer2013wouldnot re-emerge, we could focus on broadening and deepening our debt, derivatives, and exchangemarkets. Once again, liberal economists wanted a ‘big bang’ removal of all constraints on marketparticipation.Thiswas all verywell in an economy that hadwell-functioning institutions such as abankruptcy procedure, so that those who took excessive risks would get their just deserts. In aneconomywheresuchinstitutionswereintheprocessofbeingdeveloped,a‘bigbang’reformentaileduncertain benefits and likely costs. I preferred to follow the RBI’s traditional course of steadyliberalization,onlyaskingquestionsofmycolleaguescontinuallyofwhat the rationalebehind ruleswere,andurgingthemtoupthepaceofchange.

In these reforms, Deputy Governor H.R. Khan was a pillar of strength, both with his intimateknowledge of the markets, and with his determination that the RBI needed to liberalize steadily.ExecutiveDirectors likeG.Padmanabhan,ChandanSinha,G.Mahalingam,RajeshwarRao, andR.Kanungo provided strong support. A speech to the Foreign ExchangeDealersAssociation of India(FEDAI)on26August2016summarizesourthinkingandwhatwedid.

StrengtheningOurDebtMarkets

want to speak today about debtmarkets and associatedderivatives;whyweneed them to be deep and liquid, why, in addition to central and state

governments,weneed riskier firmsandprojects tobe able to access thebondmarketsforfunds,whyweneedtoencourageproductinnovation,andfinallythedilemmas that regulators like theRBI face. In theprocess, I hope to touchonsome of our recent successes, as well as failures, and our ambitions for thefuture.

Therearethreeimportantreasonswhydebtmarketshavebecomealotmoreattractiveinrecentmonths.First,wefinallyhaveaframeworkthatcommitsus

tolowandstableinflation.Yes,July’sinflationreadingwasahigh6.07percent,butIhavenodoubtthatinflationwillfallinthemonthsahead.Thekeypointisthat market participants know that the Monetary Policy Committee has tomaintainlowandstableinflation,certainlyoverthenextfiveyearsforwhichitsremit has been set, and itwill dowhat it takes. This lowers the inflation riskpremium,andthusreducesthenominalfixedinterestrateforeveryone,fromthegovernmenttotheriskiestborrower.Inthisregard,IamconfidentthatDrUrjitPatel, who hasworked closelywithme onmonetary policy for the last threeyears, will ably guide the Monetary Policy Committee going forward inachievingourinflationobjectives.

Aseconddevelopmenthasbeenthereluctanceofpublicsectorbanks(PSBs)to lend, and together with private sector banks, the reluctance to fully passthrough past policy rate cuts into bank lending rates. Short-termmarket rates,however, have seen full pass-through. No wonder highly rated firms arebypassing banks to borrow from the commercial paper (CP) markets, withoutstandingcommercialpaperhavingmorethandoubledinthelasttwoyearstoover3lakhcrores.

Butwhatoflowerratedfirms?Unfortunately,thedifficultyofdebtrecoveryinIndiahasmeantthatcreditspreadsarewiderthanelsewhere.Thisiswherethethird notable development comes in. Recent reforms of the Securitization andReconstruction of Financial Assets and Enforcement of Security Interest(SARFAESI)ActandDebtRecoveryTribunalsaswellas thenewBankruptcyCodewillhelpenhancetheprospectsofrepayment,thusreducingcreditspreads.

Given these developments, what should the objectives of fixed incomemarketregulationbe?

THEOBJECTIVESOFMARKETREGULATION

As a developing country regulator, the RBI is focused on enhancing growthwhilemaintainingstability. In thepast, thishasmeant that theRBIhasmovedcautiouslyon liberalizing fixed incomeandderivativesmarkets.What is thereaboutthesemarketsforcentralbankstoworryabout?

Typically, three issues. We have always worried that markets attract

speculators,andthat in thinmarkets, thespeculativeelementcanmovemarketpricesawayfromfundamentals.Thisiscertainlyaconcern,butweshouldalsoremember that not all speculators think the sameway. So long as there is noconcertedmovetomanipulatemarkets(andthisconcertedmanipulationcanbeprevented by regulation), the varied opinions of speculators can provideliquidity,whichinturncanmakethemarketsmoreimmunetomanipulation.Inotherwords,excessivefearofspeculationinmarketsisself-fulfilling–itrendersmarketsilliquidandpronetomanipulation.

Second,marketscanbeasourceofcompetitionforestablishedinstitutionalplayers. For instance, as I noted above, high quality corporate credits canmigrate from banks to debt markets. This may push banks into higher risklending.Once again, there ismerit in these concerns.However, toomuch canalsobemadeofthem.Afterall,banksaresupposedtolendtoriskierclientsthatneedmonitoringandhand-holding,whilemarketsaresupposedtolendtoclientswhodonotneedsuchattention.Moreover,theprobleminIndiaistoomuchriskendsuponbankbalancesheets,eitherdirectlyorindirectly.Forexample,Non-BankFinanceCompanies(NBFCs)aresupposedtotakeongreaterrisk,suchasloans to real estate developers, because their liabilities are longer term. Inactuality, though, many have substantial borrowings from banks. It would bebetterfromtheperspectiveofsystemicriskiftheyreplacedbankfinancingwithmarket borrowing. More generally, some of the very large single and groupexposuresofbanksshouldbebroughtdownbyforcinglargeborrowerstoraisemoremarketfinancing.

Third, we worry about unbridled innovation that attempts to get aroundprudentialandsupervisorynormsandendsupcreatinguncertainvaluationsandsystemicrisk.Forinstance,thefixedincomeproductsandderivativesstructuredaround housingmortgage pools in theUnited States became hard to value ashouse prices turned down. This was a primary factor in the Global FinancialCrisis. Once again, though, financial innovation has been useful in openingcredit to thehithertounderserved– theunfortunatelynamed‘junk’bondshaveindeed facilitated the growth of a variety of enterprises and sectors, mostrecentlyshaleoil.While regulatorshave toweighcarefully thebenefitsversus

the systemic risks posed by every new product, we cannot simply ban allinnovationjustbecauseitmakesusfeelsafer.

The broader point is that a measured and well-signalled liberalization offixedincomeandderivativemarketswillprobablyallowustoreapthebenefitsofdeeperandmore liquidmarkets,whileminimizing the risksassociatedwithspeculation,competition,andinnovation.Overthelastfewyears,wehavehadto proceed somewhat cautiously on market development because we worriedaboutcreatingvulnerabilitieswhenglobalfinancialmarketswerefragile.Butasmacroeconomic stability has strengthened, the movement has always beenforward.Yesterday’sannouncementsofadditionalmarket reformsweresimplythenextstepsinsteady,measuredliberalization.Letmeexplain.

PARTICIPATION

Greater participation adds liquidity. Over the years, we have tried to enhanceparticipation.

Most recently, even though retail investors form a small part of the globalfixedincomemarket,weareworkingtoenhancetheiraccesstotheinstitution-dominated screen-based NDS-OM market [Author’s note: A market forgovernment bonds hosted by the RBI] so that they can trade governmentsecurities,andalsosothattheycanusetheirde-materializedaccountstodoso.However, inmarkets thatrequiresophisticatedunderstanding,suchascomplexderivatives,wecontinuetobecarefulaboutbroadeningretailaccess.

We can bemore relaxed about institutional participation. Foreign PortfolioInvestors (FPIs)will nowhave direct access to a variety ofmarkets includingNDS-OM , corporate bond trading and perhaps other market segments goingforward.

One reasonwe limited institutionalparticipation in thepastwas topreventspeculation.So,forexample,werequiredparticipantstobelonganunderlyingexchangeasset,saydollars,inorderforthemtotakeashortpositioninfinancialmarkets, and vice-versa. But sometimes the volume of importers hedgingprospective imports by buying dollars forward far outweighs the volume ofexporters,whohedgefuturereceiptsbysellingdollarsforward.Tosatisfythenet

demand for forwarddollar hedging, typically banks have taken the other side.However,toensurebankstability,wehavelimitedtheextentofopenpositionsthatbankscanhold.

There is a cost to these limits. Every time the market gets imbalanced,exchange rates have to move substantially to equalize temporary imbalancesbetween demand and supply, even if unwarranted by medium-termfundamentals.Thisputsmorepressureonthecentralbanktointervene.

Wecancertainlyincreasebankopenpositionlimits,andwilldosoovertime,but itwould not be prudent to place all the exchange risk on banks.A betteroption would be to allow more players to hold open positions without anunderlying, with some limits so that we do not get excessive speculation orattemptsatmanipulationbysingle traders.Thiscanrectifymarket imbalances,improving exchange market liquidity and depth, without imposing largedemands on banks or on the RBI. The RBI took a fundamental step in thisdirection yesterday by allowing a moderate open position to all marketparticipants.Basedonexperience,theRBIwilldecidefurthermoves.

Finally, not all participation adds to liquidity and depth in Indianmarkets.For example, some foreign organizations have suggested allowing trading ofdomestically issued Indian securities abroad, only reporting the tradesdomestically.Unfortunately,thiscouldsubtracttradingonIndianexchanges,andthereby diminish liquidity.We have suggested to such organizations that theyeither conduct their trades on the Indian exchanges, or that they direct theirclients to Masala bonds [Author’s note: These are rupee-denominated bondsissued in foreign locales thatarediscussed later in the speech].The former isstillunderdiscussion.

INNOVATION

Financial innovation is sometimes seen in a bleak light as away to evade oravoid taxes and regulations. Properly done, however, financial innovation cansliceanddiceriskssothattheyareplacedontherightshoulders.Oneexampleofsuchaninstrumentisinterestratefutures,whereafteranoverhaulin2013-14,thelasttwelvemonths’averagedailytradingvolumewasclosetoRs23billion

(despitefallinginrecentmonths).Aninvestor,bank,orcorporationcanusetheIRFmarket to gain or shed interest exposures as they desire. The key to thesuccessofthismarkethasbeentoallowthedesignoftherelevantinstrumenttobe governed by market participants, while ensuring regulatory concerns aresatisfied. We are proceeding in a similar way with money market futurescontracts.

Notallinnovativeinstrumentshavebeensuccessful.InflationIndexedBonds(IIBs) tied to the Wholesale Price Index (WPI) have not been very popularbecausetheRBIhasmovedawayfromafocusontheWPItoafocusonCPI.Even the market for CPI indexed IIBs has been lukewarm. The moderateinvestorinterestperhapsreflectsthedisinflationaryenvironment,whereinflationprotection is less sought after. Also, unlike the more tax-protected GoldMonetization Bonds, the CPI indexed IIBs are not fully tax protected againstinflation. Going forward, a level playing field on taxes is warranted for allinstruments, so that instruments do not gain favour simply because they getbettertaxtreatment.

The lesson from these examples is that financial innovation needs support,not to create tax or regulatory arbitrage, but so that appealing features areencouraged. Innovation also requires tinkering, tomodifywhat does notworkuntilsomethingmoreappealingcanbefound–thefirstversionsofInterestRateFutureswerenotattractive,but laterversionshavesucceeded.This iswhy theRBI has moved to a sandbox approach, where we are liberal towards earlyproductinnovationssolongastheyarenotclearlyproblematic,regulatingmorecarefullyonlywheninterestpicksupandtheproductlookslikeitmightbecomeofsystemicimportance.

Finally, an important function for the regulator in encouraging financialinnovation is to create the necessary infrastructure. For instance, a number offinancial contracts are structured off benchmarks. RBI has encouraged thesettingupoftheFinancialBenchmarksIndiaPvt.Ltdwhichisbuildingaseriesofmarketbenchmarks.Iamhopeful that thesewillsoonbeusedininnovativefinancialcontracts.

INTERNATIONALIZATION

Asacurrentaccountdeficitcountry,Indianeedsfinancingfromabroad.Ideally,wewouldliketoattractriskcapital,whichisinshortsupplyinthiscountry.Thismeans encouraging Foreign Direct Investment, as well as equity investment.Foreign investors can also help deepen debt and derivative markets as theycontributetopricediscoveryandliquidity.

Not all domestic entities should issue claims held by foreign investors.Ideally, of course, companies should be left to make decisions about whatcurrency they borrow in, and how much they hedge, but given our weakbankruptcysystem,thereismoralhazardbuiltintounhedgedforeignborrowing– if the rupee appreciates, the promoter takes all the upside associated withpaying the low dollar interest rate and the now-lower principal, if the rupeedepreciates, the occasional unscrupulous promoter goes to his Indian bankersandasksthemtobailhimout.Thisiswhytheissuanceofshort-termdollaroryen-denominated debt by infrastructure companies, if left unhedged, could beseverelyproblematicincaseofrupeedepreciation.

Therefore,wehaveencouragedcompaniesthatdonothaveforeignexchangeearningstoeitherissuelong-termdollarbonds,fullyhedgedshortertermbonds,orrupee-denominatedMasalabondsabroad.ThefirstissuesrecentlyofMasalaBonds reflect a coming of age of Indian debt that has been insufficientlyremarkedupon–forthefirsttimeinrecentdecades,therupee’svalueistrustedenough in international markets that corporations can issue there in domesticcurrency.Going forward,wehopeamorevibrantMasalabondmarket abroadwillcomplementavibrantdomesticcorporatebondmarket.

EventhoughFDIflowsareenoughtocoverourcurrentaccountdeficit,weare also encouraging inflows into the debt markets to improve depth andliquidity.Wehave progressively expandedFPI limits in government debt, andrecently specified how these limitswill expand for the foreseeable future.Wehave also opened up investment in state government debt, and laid out themedium-term plan for those limits also. In general, our aim is to liberalizesteadily,butinathoughtfulway,continuouslyaskinghowfurtherliberalizationwillstrengthenourdomesticmarkets.

Wehavenotbeenpersuadedbyeverymarketplea.Forexample,anumberofinvestment banks want a dollar-denominated G-Sec issued internationally –ostensiblytocreateabenchmarkdollaryieldcurveforIndianinstruments.WhileIagreesuchaninstrumentwouldbeattractiveforinvestorsintheyield-starvedworld, I am not persuaded it is useful for India.Whenmuch of the emergingworldwouldlovetomovefromissuingdollardebttoissuinginitsowncurrencyso as to avoid currency risk, I don’t seewhywe shouldmove the otherway.Instead, let us build out an international quasi-sovereign rupee yield curve, sothat rupee issuances can be priced easily. It iswith this inmind thatwe haveallowedbanks to issueMasalabondsyesterday,withbankbondsbeingagoodquasi-sovereignproxy.

LIQUIDITY

Ofcourse,notallpartsoftherupeeyieldcurveareliquid,eveninthedomesticG-Secmarket.Attheveryshortend,wearetryingtobringmoreliquidityandbetterpricingthroughtheauctioningoftermrepos.Atthelongerend,wehavebeentryingtofocusonmoreilliquidsecuritiesinouropenmarketoperationssothat the term curve evens out. We are also proposing to encourage marketmakinginspecificG-Secinstrumentsbyinvolvingprimarydealers.

Onewaytobringliquiditytocorporatedebtistoenablethemtobeusedascollateralinrepotransactionswiththecentralbank,withappropriatehaircuts,ofcourse. As banks become able to borrow against their high quality corporatebonds,yieldswill fall, andmore issuerswill come to themarket.With this inmind,wehaveinitiatedtheprocesswiththegovernmenttoamendtheRBIActto allow the RBI to conduct repos of corporate bonds with banks and otherfinancialinstitutions.

RATINGS,CONTINGENTSUPPORT,ANDSUPPLY

The ratings put out by credit rating agencies are important in assuring arm’slength investors about corporate credit quality. In order for their ratings to beaccurate, agencies need both up-to-date information, aswell as good analysis.Agencies have asked the RBI to give them information about corporate bankborrowings. Since these are available from the credit information bureaus

(CIBs), the RBI has suggested the credit-rating agencies becomemembers ofCIBs. I do hope that incidentswhere a highly rated corporate bond plummetswithout warning into default will become increasingly rare as rating agenciesexerciseduediligence.

Some have argued that the easy access to bank cash credit keeps largecorporations from going to the money and bond markets for funds. Thisphenomenon also raises bank exposures to single names or groups, increasingtheir risk concentration. While, as suggested earlier, we are seeing somemovementofcorporationstothemoneyandbondmarketsinthisperiodofbankstress,wewillnudgecorporationsfurtherbyimposinghigherprovisioningandcapital requirements for banks on such corporate lending when exposuresbecomelarge.

Many of the measures proposed so far will enhance the attractiveness ofhighly rated corporate bonds to investors.But infrastructure projects that needsubstantialamountsoffinancingmaynotstartouthighlyrated.Toenablesuchentities to issue, we have allowed banks to offer credit enhancement to suchbonds. We have been careful to set the capital requirement for such creditenhancementcommensuratewiththeriskbanksaretakingonsothatthereisnoarbitrage.Yesterday’s announcedmeasures shouldmake it easier for banks toofferappropriateamountsofcreditenhancement.

Onearea thatneedsgreaterclarification isobligationsofstategovernmentsas well as state-government guaranteed obligations. In order for stategovernmentobligationstohavezeroriskweight,andhavethehighestrating,itisimportantthattherebenoexplicitorimplicitdefaultorrestructuringofsuchobligations.Whilearestructuringmayseemlikeawaytopostponeobligations,itsramifications,notjustfortheyieldthemarketwilldemandoftheparticularstate government issuer in the future but also for the yields on obligations ofother stategovernments, are largeenough that suchactions shouldcontinue toremain‘unthinkable’.

REGULATIONS

Weareconsciousofthelimitationsplacedonnettingofderivativecontracts,and

thus the higher associated capital requirements on banks. The issue has beentakenupwiththegovernment,andwehopetoamendtheRBIActtomakesuchnetting possible. As with the tax issues associated with securitization, whichhaverecentlybeenaddressedbythegovernment,resolvingthisissueshouldleadtosubstantialmarketactivity.

Finally, while the RBI is a liberalizer, we have to be careful not to relaxprudentialregulationssimplybecauseanentityoractivityisdeemedofnationalimportance. Dispensation on prudential regulation is the wrong instrument tofavoursuchactivities.Anationallyimportantactivitysuchasinfrastructuremaybeveryrisky.Torequirelowerprovisions,ortoallowhigherleverageorECBsforsuchactivities,mayincreasesystemicrisk.Inthelongrun,theactivitymaybedamagedbytheregulatorydispensation(toomanyinfrastructureprojectsthatdonothavedollarearningswillbefinancedwithdollaroryenloansandcannotrepay)andstabilitymayalsobecompromised.ItisfarbetterforthegovernmenttodirectlysubsidizesuchactivitiesifitdeemsthemimportantthanfortheRBItosacrificesystemicstabilityonthealtarofnationalimportance.

CONCLUSION

Let me conclude. While the RBI has been cautious in reforming during therecent period of global market turmoil, it has not stood still. Market reformshaveproceededatasteadymeasuredpace.Observersmaybeimpatient,butmybelief is that steady and irreversible reform and ‘mini Bangs’ like yesterday’sratherthan‘BigBang’istheneedofthehour.Asglobalconditionsbecomelessuncertain,thepaceofreformcanpickup.Thelessonswehavelearntduringthisperiodonwhatworkswillbeinvaluablethen.

T

CHAPTER5

FINANCIALINCLUSION

I

Financial inclusion was the fourth pillar of our strategy. I believed it was critical for sustainablegrowth,as isclear in thespeeches Igaveon thepoliticaleconomyofourdevelopment (reproducedlater).IntheGadgilLecturedeliveredon13February2014,Isetoutsomeofwhatweintendedtodo,basedontheDrNachiketMorCommitteereport,whichhadjustbeensubmittedtotheRBI.

FinancialInclusion:Technology,InstitutionsandPolicies

heDrNachiketMorCommitteeReport has given theRBImuch food forthought on the issues of financial inclusion. I want to reflect on the

recommendations,evenwhileputtingsomeadditionalissuesonthetable.Financialinclusionisabout(a)thebroadeningoffinancialservicestothose

peoplewhodonothaveaccesstofinancialservicessector;(b)thedeepeningoffinancial services for people who have minimal financial services; and (c)greaterfinancialliteracyandconsumerprotectionsothatthosewhoareofferedthe products can make appropriate choices. The imperative for financialinclusion is both a moral one as well as one based on economic efficiency.Shouldwe not give everyone that is capable the tools and resources to betterthemselves,andindoingso,betterthecountry?

Lastweek,ImetwithsomemembersofElaBhatt’sSelf-EmployedWomen’sAssociation.Inaroomfullofpoorbutconfidentwomenentrepreneurs,IaskedhowmanyborrowedfrommoneylendersbeforetheycametoSEWA.Abouthalfthewomenraisedtheirhands.Whenaskedhowmanythoughtofapproachinga

regularbankbeforetheycametoSEWA’scooperativebank,notoneraisedherhand.Interestingly,manyofthemsaidthattheloanfromSEWAfreedthemfromthe moneylender’s high interest rate, which gave them enough to serviceSEWA’s loan fully even while focusing on other productive activities. I haveheardthisfromothermicro-entrepreneurs–thehighestreturninitialinvestmentis often to free oneself of the clutches of the moneylender. Despite this highreturnfromthedeliveryofcredittothepoor,anddespitemuchofourfinancialinclusion efforts being focused on credit, we still reach too few of the targetpopulation.Sothereismuchmoretobeachieved.

Wehavetriedtoeffectinclusioninthepastthroughmandates–whetheritbethroughdirectiononbranchopeningoron lending toprioritysectors.Thatwearestillfarshortofourgoalshasledsomecriticstosuggestweshouldabandonmandatesbecause themarketwill takecareofneeds; if thepoorhavedemandforfinancialservices,thecriticssay,providerswillemergetosupplyit.Marketsdorespondtoneed,andcompetitionisaveryhealthyforceforimprovement,butmarket functioning can be impeded by poor infrastructure, uneven regulation,naturalorregulatorymonopolies,andevencartelization.

While enlisting competitive forces wherever possible to compete for thebottomofthepyramid’sbusiness,asadevelopmentcentralbankwealsoneedtoofferasupportivehand.Byputtinginplacetherightinfrastructureandenablingregulation,wehavetoencouragethedevelopmentof theproducts, institutions,andnetworksthatwillfosterinclusion.

Letusstartwithproducts.Wehavebeentryingfordecadestoexpandcredit.Wehavefocusedmuchlessoneasingpaymentsandremittancesoronexpandingremunerative savings vehicles or on providing easy-to-understand insuranceagainst emergencies. Perhaps we should try to expand financial inclusion byencouraging these other products, and allow credit to follow them rather thanlead.Indeed,manysuccessfulorganizationsworkingwiththepoorestofthepoortrytogetthemtoputasidesomemoneyassavings,nomatterhowlittle,beforegivingthemloans.Someofourself-helpgroups(SHGs)workonthisprinciple.Notonlydoes thesavingshabit,onceinculcated,allowthecustomertohandletheburdenofrepaymentbetter,itmayalsoleadtobettercreditallocation.With

the power of information technology, perhaps the analysis of the savings andpaymentpatternsofaclientcanindicatewhichoneofthemisreadytousecreditwell.

One roadblock to access, even to something as simple as a universal basicsavings account, is Know Your Customer (KYC) requirements. Experts haveemphasized the need tomake it far simpler to open basic accounts, and havesuggestedminimizingtherequireddocumentation.Inanefforttodoso,theDrNachiket Mor Committee recommends requiring proof of only a permanentaddress.ThisisneverthelessmoreonerousthancurrentRBInorms,whichallowanapplicant toself-certifyheraddressandotherdetails foraccountsbelowRs50,000. But despite the RBI’s exhortations, few banks have reduced theirdemand for documentation – they fear that they will be held responsible ifsomethinggoeswrong,nomatterwhattheregulatorynorms.Theacceptanceofthird-partyKYCcertificationisparticularlydifficult.

Today,stringentKYCnormskeeptoomanyoutofthebankingsystem,andleadtounnecessaryharassmentforothers.Banksmayadopt thesenormsmorebecauseofregulatoryorlegalliabilitythantosafeguardagainsttruecriminalorterroristactivity.Can’twedobetter?Somebankerssuggestthatbymonitoringactivitypatterns inaccountscarefully,evenwhileputtingsome limitsonbasicaccounts (such as holding a large value cheque for a few days before it iscashed),muchofthesuspiciousactivitycanbedetectedandstopped.Couldweallow a commercial bank some regulatory dispensation in case there isminormischiefinsomelowvalueaccounts,providedthebankhasareliablesysteminplacetodetectgreatermischief?Couldthegainsineasingwidespreadaccesstosafeaccountsoutweighthecostsofminorfraud?Howcanwegetentitieswithinthe system to rely on each other’s KYC, without the process having to becontinuouslyrepeated?Howcantechnologyassistineffectivelyaddressingtheaboveissues?Thesearequestionswehavetoexamineandaddress.

The broader issue is whether through sophisticated state-of-the-arttechnology,wecanoffercustomersproductsthataresimple,lowcost,andeasyto use. We have done this with mobile phones, can we do it with banking?Payments may be another obvious product. I should note that our payments

infrastructure in India is very advanced.We have three large RBI technologycentres devoted to supporting payments and robust payment and settlementnetworks for both large value and small transactions.We have introduced anadditional factor of authentication for all e-commerce transactions – whichmakesthesetransactionsmoresecure–andareswiftlymovingtoChipandPINtechnology for credit card transactions. SMS alerts for bank and credit cardtransactionsareanimportantadvancerelativetoeventheUnitedStates,wherethieves find iteasy tobill thousandsofdollars toyourcreditcardevenbeforeyouknowitisstolen.Allthismeansthatwehavetheinfrastructuretoprovidecheapandsafepaymentsandremittances.Whatweneedarenon-governmentalplayers to utilize this infrastructure to provide the products and access thatpeoplewant.

Withover900millionmobilephones,thepotentialformobilebankingasadelivery channel for financial services is a big opportunity in India.We haveconsciously adopted the bank-led model for mobile banking, while the non-banks,includingmobilenetworkoperators,havebeenpermittedtoissuemobilewallets,wherecashwithdrawalisnotpermittedasofnow.Thekeytocheapanduniversalpaymentsandremittanceswillbe ifwecan findasafeway toallowfundstobefreelytransferredbetweenbankaccountsandmobilewallets,aswellascashedoutofmobilewallets,throughamuchlargerandubiquitousnetworkof business correspondents. The Dr Nachiket Mor Committee suggests thecreationofPaymentBanksasasteptowardsthisgoal.Othersuggestionsincludeinteroperablebusinesscorrespondentswhowillgetthescaleeconomiestoserveinremotelocations,andtheusageofNBFCsasbankingcorrespondents.Wewillexamineallthis.

Inthemeantime,interestingsolutionsareemerging.Cashingoutisimportantfor remittances, because we have a large recipient population in the country,mostofwhomdonothaveaccesstoformalbankingservices.Wehaverecentlyapprovedthein-principlesettingupofapaymentsystemwhichwillfacilitatethefunds transfer from bank account holders to those without accounts throughATMs.Essentially,thesendercanhavethemoneywithdrawnfromhisaccountthroughanATMtransaction.Theintermediaryprocessesthepayment,andsends

a code to the recipient on hismobile that allows him towithdraw themoneyfromanynearbybank’sATM.Thesystemwilltakecareofnecessarysafeguardsofcustomeridentification,transactionvalidation,velocitychecks,etc.Weneedmoresuchinnovativeproducts,someofwhichmobilecompaniesareproviding.

InIndia,despitethehighmobiledensity,itisalsoarealitythatmostofthehandsets are very basic ones andmany of themobile connections are prepaidsubscriptions.Theseareimportantconstraints.Wehaveagreatopportunityforbanksandtelecomserviceproviderstocometogethertodelivermobilebankingservicesofallkindsinaseamlessandsecuremannertotheircustomers.Inthenextfewmonths,wewillacceleratethedialoguebetweenkeyplayers.

Oneofthedifficultiesthepoorandsmallbusinesseshaveinaccessingcreditisthelackofinformationaboutthem,bothupfrontastheyarebeingevaluatedforcredit,andafterlendingwherethelenderhastomonitorthem.Ifsavingsandpayments products are sold widely, and information, including payments tomobilecompanies,utilitycompanies,aswellasthegovernment,collected,thentheexcludedcanbuildinformationrecordsthatwillhelpthemaccesscredit.If,inaddition,negativeinformationondefaultsissharedinafairandresponsibleway through the financial network, every individual borrower will havesomethingatstake–theircredithistory–whichcanservetoencouragetimelyrepayment.This,inturn,canimprovethewillingnessofbankstolend.

Finally, letme turn toconsumer literacyandprotection.Aswe reachmoreandmoreofthepopulation,wehavetobesurethattheyunderstandtheproductstheyarebeingsoldandhavetheinformationtomakesensibledecisions.Caveatemptororletthebuyerbewareistypicallythestandardusedinfinancialmarkets– that is, so long as the buyer is not actively misled, she is responsible forresearchingherproductchoicesandmakingpurchasedecisions.Whilethisputsalotofburdenonthebuyertododuediligence,italsogivesheralotoffreedomtomakechoices,includingofcoursethefreedomtomakebadchoices.

Butwithpoorlyinformedandunsophisticatedinvestors,weshouldconsidertheDrNachiketMorCommittee’s recommendationof setting someguidelineson what products are suitable for different categories of investors. Broadlyspeaking,themorecomplicatedtheproductthemoresophisticatedshouldbethe

targetcustomer.Shouldwemovetoanormwhereasuiteofsimpleproductsispre-approved for dissemination to all, but as products get more complicated,financial sector providers bearmore andmore responsibility to show that thebuyerwassophisticatedand/orappropriatelycounselledbeforeshepurchased?

Ofcourse,thelongerrunanswerisforcustomerstobecomemoresavvy.Canthetechnologysectorhelpeducatepeopleinfinancialmatters?Afterall,financeisnotsomethingmostpeoplelearninschools,butitissomethingtheyencountereverydayintheworld.Lowcostbuthighqualitydistancefinanceeducationissomething the country verymuch needs andwe look to entrepreneurs here tothinkofinnovativewaystoprovideit.

BeforeIconclude,onecaveat.Technologycanmagnifythereachoffinancefor bad purposes aswell as good.Many of youmust receive frequent emails,purportedlyfromme,informingyouofalargesumofmoneythatawaitsyouattheRBI,andurgingyoutosendmeyouraccountdetailssothatIcantransferthemoneytoyou.LetmeassureyouthattheRBIdoesnotgiveoutmoney,Idonotsendtheseemails,andifyoudofallforsuchemails,youwilllosealotofmoneytocrooksandberemindedoftheadage–ifanythinglookstoogoodtobetrue,itprobablyisnottrue.

Ofcourse, technologycanalsoofferanswers tocheckfraud.Canweenlistsocialmedia inenabling thepublic to identifyfraudandhelpregulation?Howcanwedothisinaresponsibleway?Again,thesearequestionsatthispoint,butIamsurewewillfindtheanswers.

Letmeconclude.Technology,withitscapacitytoreducetransactioncosts,iskey to enabling the largevolume low-ticket transaction that is at the centreoffinancial inclusion.By collecting and processing large volumes of data easily,technology can also improve the quality of financial decision making. Whenproducts have network effects, technology can ensure not just interoperability,keytoobtainingthebenefitsofnetworking,butalsosecurity,keytomaintainingtheconfidenceofpeopleandpreventingthemfromwithdrawingfromtheformalfinancial systemonce again. I sincerely hope the successful ICT industrywillpartner with the finance industry to revolutionize financial inclusion in thiscountry.

W

II

IsummarizedwhatweweredoingoninclusioninaspeechinHyderabadon18July2016deliveredtotheNationalSeminaronEquity,Access,andInclusion.Duringmyterm,Iwastryingtomoveusawayfromabelief thatmandates to thepublic sectorbankswould solve theproblemof inclusion.Everyuncompensatedunprofitablemandatewaseffectiveonlysolongasthebureaucracyandtheregulatormonitoredthebanksclosely.However,ifbankscouldgamethemonitorandavoidthemandate,theywould.Thiswasunderstandablesince,ultimately,weheldevenpublicsectorbankCEOsresponsibleforprofits.

Toendthiscatandmousegame,Iwantedustofocusmoreoncreatinganenablingenvironmentwherethepoorcustomerwasseenasattractive,andworthserving,evenwhilewehadsafeguardsinplacetopreventherfrombeingexploited.Ihavetoadmitoursuccessherewasmixed–evenastheRBItriedtocreatetheenablingenvironment,thegovernmentseemedmoreconvincedthatmandatesliketheJanDhanYojanaandtheMudrascheme(forsmall loans)wouldworkbetter.Ofcourse, thetwocouldco-exist.Thegovernmentwasprobablyrightthatintheshortrun,thepublicsectorbankscouldbepushedtodeliverspecificmandates.So,forexample,theycouldbeenlistedtoopenaccountsforthepoor.However,forsustainablebroad-basedinclusion,wherebanksgobeyondthemandatetoactuallyservethepoorcustomerwell,wehavetocreatetherightenvironmentwhereinclusionisanattractive, thoughnotexploitative,proposition.So,forexample, it is important tocompensatebanksadequatelyforthetransferofgovernment-provideddirectbenefitsintonewlyopenedaccounts.Iftheaccounts are evenmoderatelyprofitable as a result, bankswouldhave the incentive to improve thequality of their service and compete for the poor customer. In this vein, while supporting thegovernment’sagendawealsopushedforachangeintheenvironmentforinclusion.

TheChangingParadigmforFinancialInclusion

hataretheeconomicimpedimentstogreaterfinancialinclusion?Perhapsthemostimportantistheeconomicconditionoftheexcluded.Worldover,

the poor, the small, and the remote are excluded. It is not just because thefinancial system is underdeveloped, but because they are hard to serviceprofitably.Nevertheless,thisisnotareasontoabandonhope,buttoaskhowwecan overcome the impediments in the way of inclusion. The best way tocharacterize the impediments are through the acronym IIT: Information,Incentives,andTransactionCosts.

IIT

The excluded may live in remote areas or may belong to communities orsegmentsof society thatundertakeeconomicactivity informally– theydonotmaintainrecordsorhavesignedcontractsordocumentation.Theyoftendonotown property or have regular established sources of income. As a result, abanker, especially if as is typical, he is not from the local region, will havedifficultygettingsufficientinformationtoofferfinancialproducts.

Asecondconcernisincentives.Forexample,loansareeasilyavailableonlyif the lender thinkshewillbe repaid.When the legal systemdoesnot enforcerepayment quickly or cheaply, and when the borrower does not have anycollateral topledge, thelendermightbelievethathewillfinditdifficult togetrepaid.

Thethirdimpedimentistransactionscosts.Sincethesizeoftransactionsbythe poor, or by micro farmers or enterprises is small, the fixed costs intransactingarerelativelyhigh.IttakesasmuchtimehelpingaclientfillouttheformsandtoprovidethenecessarydocumentationifheisapplyingforaloanforRs10,000asittakestohelpanotheroneborrowRs10lakhs.Abankerwhoisconscious of the bottom line would naturally focus on the large client inpreferencetothetinyone.

HOWDOESTHEMONEYLENDERMANAGE?

Oneoftheprimarymotivationsforthecountrytopushfinancialinclusionistofree the excluded from the clutches of the moneylender. How does themoneylenderboldly lendwherenobankerdares to lend?Becausehedoesnotsufferthesameimpediments!Comingfromthelocalcommunity,thesahukariswell informedonwhateveryone’s sourcesof incomeandwealthare,andhowmuch theycan repay.He isquitecapableofusing ruthlessmethods toenforcerepayment.Moreover,theborrowerknowsthatifhedefaultsonthesahukar,heloses his lender of last resort. So the borrower has strong incentives to pay.Finally, because the sahukar lives nearby and uses minimal documentation –afterall,heisnotgoingtousethecourtstoforcerepayment–loansareeasilyandquicklyobtained.Inanemergencyorifthepoorneedtoborrowonadailybasis,therearefewmorereadilyavailablealternativesthanthemoneylender.No

wonderhehassomanyinhisclutches.How thenshouldpublicpolicyapproach thisproblem? Iwillnowdescribe

three approaches: mandates and subventions, transforming institutions, andmovingawayfromcredit.

APPROACH1:MANDATESANDSUBVENTIONS

One approach is to push formal institutions into reaching out to the excluded,even if it is unprofitable. This is why, for example, we mandate that banksallocateacertainfractionoftheirloanstothe‘prioritysector’andthattheyopen25 per cent of their branches in unbanked areas. There are also interestsubventionsthataremadeavailableforloanstoparticularsectors.Furthermore,bankshavebeenurgedtoopenbankaccountsforallunderthePradhanMantriJanDhanYojana(PMJDY),whiletodaytheyarebeingexhortedtomakeloanstosmallbusinessesundertheMudraScheme.

Because therearepositive socialbenefits to financial inclusion thatarenotcaptured by the service provider (what economists call ‘externalities’), suchmandates are reasonable from a societal perspective. For instance, the higherfamilialandcommunitystatusafarmworkergetsfromstartingherownpoultryfarmandcontributingtothefamilyincomemay,onnet,outweighthecoststhebankincursonmakingthe loan.Thebankcannotmonetize thestatusbenefits,but a government candecide thosebenefits areworthgenerating andmandatethem.

Inasimilarvein,theremaybenetworkbenefitsfromuniversalaccess–forinstance, direct transfer of benefits is easier when the vast majority ofbeneficiaries have a bank account, and the accounts themselves will be usedheavily when account-to-account transfers are made easier through mobilephones via the soon-to-be-introduced Unified Payment Interface (UPI).Mandated account-opening essentially creates the universal network with itsassociatedpositivenetworkexternalities.

Thereare,however,anumberofrisksemanatingfrommandates.Thefirstisthatthereisnomarkettestofusefulness,andindeed,thesemaynotbepossible–how does onemeasure the value of the enhanced social status of the poultry

farmer? Somandates are driven by the beliefs of the political leadership, andmaypersistalongtimeeveniftheyarenoteffective.Furthermore,somevestedinterests may benefit from specific mandates and push for their perpetuationlongaftertheyhaveceasedbeinguseful.Bankersthemselves,seeinglittleprofitin obeying themandate,will try and ‘achieve’ it at least cost by targeting themost accessible and least risky in the eligible category, and evenmislabellingnormal activity so that it fits in the eligible list. Finally, some mandates fallprimarilyonthepublicsectorbanks.Ascompetitionreducestheirprofitability,theircapacitytocarryoutmandatesandstillearnenoughtosurvivediminishes.

SowhileacknowledgingthevalueofmandatesattheRBI,wehavetriedtomake themmoreeffective.Forexample, the listof sectorseligible forprioritysector treatment has been revised, with an emphasis on targeting the trulyexcluded.Specifically,theshareofadjustednetbankcredit(ANBC)thathastogotosmallandmarginalfarmers(includingsharecroppers)issetat8percentforMarch2017,andthatformicroenterprisessetat7.5percent.At thesametime, the scope forbanks tomeetpriority sectornormswithout lending to thetruly excluded has been reduced. For example, large loans to firms producingagricultural products no longer qualify.Also, banks are now required tomeettheirtargetsattheendofeveryquarter,ratherthanattheendoftheyear,whichreduces the scope for window-dressing with short-term end-of-year credit.Finally,PrioritySectorLendingCertificates,whichallowa lender to ‘sell’anyover-achievement in particular categories to otherswho are deficient, are nowbeing traded, thusencouraging thosewhohaveabetter capacity tomake suchloans to do so. All in all, the priority sector mandate is now not only bettertargetedatthetrulyexcluded,butwillbedeliveredmoreefficiently.

Mandates are not costless. Rather than forcing banks to recover costs byovercharging ordinary customers, or by demanding recapitalization by thegovernment, better tobring the costs into theopenbypaying for themandatewhereverpossible.So,forinstance,accountsorcashmachinesopenedinremoteareascouldattractafixedsubsidy,whichwouldbepaidtoanyonewhodeliversthem. Not only will the cost of the mandate become transparent and will beborne by the authorities, thus incentivizing them to make sensible decisions

about how long to impose themandate, themandate can be delivered by themost efficient serviceproviders, attractedby the subsidy.This iswhy theRBItodayexplicitlysubsidizescashrecyclingmachinessetupinunderservedareas,andwhy central and state governments are paying banks formaintaining andservicingspecifiedaccounts.Goingforward,narrowtargetingofmandatestothetrulyunderservedandexplicitpaymentforfulfillingthemandatesothattheyaredeliveredbythemostefficientshouldbethenorm.

APPROACH2:CREATINGTHERIGHTINSTITUTIONS

AsIarguedearlier,themoneylenderisparticularlyeffectivebecauseheknowstheneighbourhoodand itspeople, andcanmakeagoodassessmentofwho iscreditworthy. A large national bank with a local branch suffers from twoinfirmities.First,thebranchmanagerhastypicallybeenrecruitedthroughanall-Indiaexam,isfromadifferentstate,andisnotintimatelyfamiliarwiththelocalpeople. While many good branch managers do indeed learn about thecommunity,somedonot.Thehighersocio-economicstatusofbankofficersalsocreates a distancewith the poorer segments of the community, and their highsalarymakesmanybranchesinremoteareaseconomicallyunviableeveniftheycouldsolicitbusinessintelligently.Finally,giventhattheexcludeddonothaveformaldocuments,bankmanagers in largebankswithbureaucraticcentralizedprocedures find it hard toprovide effective service–howdoesone convey toheadofficetherationaleforaloantoanintelligent,enthusiastictribalwhowantstosetupasmallshop,butwhohasnoformaleducationortrackrecord?

Localfinancialinstitutions,withlocalcontrolandstaffedbyknowledgeablelocal people, could be more effective at providing financial services to theexcluded.HDFCBank,forexample,hasbeenverysuccessfulgrowingits loanportfolioinKashmirbyrecruitinglocalyouthasloanofficers.Certainly,thisisalso the obvious lesson to be drawn from the success of microfinanceinstitutions, who combine their local knowledge with stronger incentives forrepaymentthroughpeerpressureandfrequentcollectionofrepayments.Indeed,thiswasalsotherationaleforlocalareabanksandregionalruralbanks,andisastrongfeatureinthecooperativemovement.

Yet,while there have been somegrand successes among these institutions,eachformhassomedeficiencies.Microfinanceinstitutionsdonothaveaccesstolow-cost deposit financing, though securitization of loans has been a growingavenueoffinance.Localareabankscouldnotexpandoutoftheirarea,exposingthem to thegeographicalconcentration risks.Regional ruralbanksagitated forparityinsalarystructureswithparentscheduledcommercialbanks,andhavingachievedparity,findthattheircostsarenotoptimallysuitedfortheclienteletheyneedtoservice.Therearesomeverysuccessfulcooperativebanks,onparwithanyuniversalbank,butfartoomanysufferfromgovernanceproblems.TheRBIhasbeenengaged inbringingstrongergovernance tourbancooperativebanks,butsplitsupervisionwithstateauthoritieslimitshowmuchitcando.

To provide an alternative institutional avenue for these categories ofinstitutions tofulfill theirmission, theRBIhascreatedanewinstitutioncalledthe small finance bank,where ‘small’ refers to the kind of customer the bankdealswith,notitssize.With75percentoftheloansmandatedtobebelowRs25lakhs,thesmallfinancebankisintendedtoprovideservicestotheexcluded.Thus far, the licenceshavebeen largelygiven tomicrofinance institutions andonelocalareabank,butthereisnoreasonwhythesecannotbegiventoregionalruralbanksandcooperativesinthefuture.Thehopeisthattheseinstitutionswillmaintaina lowcost structure, augmentedby technology, toprovideamenuoffinancialservicestotheexcluded.

New institutions can also help ease the flow of credit. For instance, creditinformationbureaushavehelped tremendously insolvingboth the informationandincentiveprobleminretailcredit.Whenanindividualknowsthatadefaultwillspoiltheircreditratingandcutofffutureaccesstocredit,theyhavestrongincentivestomaketimelypayments.InruralIndia,weneedtoexpandthereachofcreditbureaus, includingbybringingborrowingunder self-helpgroups intotheir ambit. The use of Aadhaar in identifying individuals will also helpeliminateduplicaterecords,whilemakingexistingrecordsmoreaccurate.Goingforward,bytheendoftheyear,theCreditInformationBureauofIndiawillstartproviding individualswithonefreecredit reportayear,so that theycanchecktheircredit ratingandpetition if theyseepossiblediscrepancies.An important

proposal by the government is to give small businesses ‘Udyog Aadhaar’numbers,whichareunique IDs tied toboth theentityaswellas thepromoter.Such IDscouldallowsmall firms tobuild credithistorieswithcreditbureaus,especiallyasthehistoriesaretiedtospecificpromoters.

Land isoften the singlemostvaluable sourceofwealth in rural areas.Thedigitizationoflandrecords,accompaniedbyaguaranteeofcertificatesoffinalownershipbythestategovernment,asproposedinRajasthan,willeasetheuseof land as collateral against which funds can be borrowed. Even a formalrecognitionofsharecroppingagreements,asinthepattasregisteredbythestategovernmentinAndhraPradesh,couldeaseaccesstocreditforsharecroppers.

Asafinalexample,MSMEsgetsqueezedallthetimebytheirlargebuyers,whopayafter longdelays.Allwouldbebetteroff if theMSMEcould sell itsclaimonthelargebuyerinthemarket.TheMSMEwouldgetitsmoneyquickly,while themarketwould get a claim on the better rated large buyer instead ofholding a claim on the MSME. All this will happen as the three Trade-Receivables Discounting Systems (TReDS) which the RBI has licensed, startlater this financial year. The key is to reduce transaction costs by automatingalmost every aspect of the transaction so that even the smallest MSMEs canbenefit.

APPROACH3:DON’TSTARTWITHCREDIT

Wehavebeentryingfordecades toexpandcredit.Wehavefocusedmuchlesson easing payments and remittances, on expanding remunerative savingsvehicles, or onproviding easy-to-obtain insurance against crop failures. In theemergingfinancialinclusionparadigm,thegovernmentandtheRBIaretryingtoexpandinclusionbyencouragingtheseotherproducts,allowingcredittofollowthemrather than lead. Indeed,manysuccessfulorganizationsworkingwith thepoorest of the poor try to get them to put aside some money as savings, nomatter how little, before giving them loans. Some of our self-help groups(SHGs)workonthisprinciple.Notonlydoesthesavingshabit,onceinculcated,allowthecustomertohandletheburdenofrepaymentbetter,itmayalsoleadtobettercreditallocation.

Easypaymentsandcashoutwillmakeformalsavingsmoreattractive.Today,avillagerwhoputsmoneyintoabankhastoeithertrudgethe‘lastmiles’tothebank branch to take out her money, or wait for an itinerant bankingcorrespondent to come by. We are engaged in strengthening the network ofbankingcorrespondents;bycreatingaregistryofbankingcorrespondents,givingthemtheabilitytotakeandgivecashonbehalfofanybankthroughtheAadhaarEnabled Payment System (whichwill also give them adequate remuneration),and requiring that they are adequately trained in providing financial services.Cash-in-cash-out points will expand soon as the Postal Payment Bank andtelecom-affiliatedpaymentbanksmakepostofficesand telephonekiosksentrypointsintothefinancialsystem.Perhaps,mostinterestingly,transfersfrombankaccounttobankaccountwillbecomeeasierinafewweeksviamobilethroughthe Unified Payment Interface. A villager needing to pay a shopkeeper onlyneedstoknowthelatter’salias–[email protected],writesthepaymentamount,putsinhispassword,andpresses‘send’and the payment is made, with both getting messages to that effect. Neitherneedstovisitthebanktotakeoutordepositmoney,nopoint-of-salemachineisneeded.With the price of smartphones falling sharply,we are on the verge ofsolvingthelast-mileproblem.

With the power of information technology, perhaps the analysis of thesavingsandpaymentpatternsofaclientcanindicatewhichoneofthemisreadytousecreditwell.Smallbusinesses,whichusetheservicesofanonlineinternetplatformtosell,canestablishaverifiablerecordofrevenuesthatcanformthebasis for loans. Indeed, we are encouraged by the emergence of full-serviceentitiesthathelpthesmallbusinesswithmarketingandlogistics,whiletyingupwitha financecompany toprovide thebusinesswithcredit.Thiswillhelp thecarpet seller from Srinagar advertise his wares to the world, even whileexpanding his business. We also propose to encourage peer-to-peer lendingplatformswithlight-touchregulation,anticipatingthattheymayhaveinnovativeapproachestogatheringtheinformationnecessarytolend.

SOMEISSUES

Having highlighted the various approaches to expand inclusion, let me nowfocusonsomeimportantissuesthatariseinmanagingtheprocess.Theseare1)Know your customer requirements 2) Encouraging competition to preventexploitation 3) Ensuring some flexibility and forgiveness in financialarrangements 4) The need for skilling and support 5) Encouraging financialliteracyandensuringconsumerprotection.

KNOWYOURCUSTOMER

Missing basic documentation is often an impediment to obtaining financialservices. Knowing this, the Reserve Bank has steadily eased the requireddocumentationforbasicfinancialservices.Forinstance,recognizingthatproofof address isdifficult, especially for thosemoving location,RBI requiresonlyonedocumentshowingpermanentaddressbepresented.Currentaddresscanbeself-certified by the account owner, preventing the considerable problemscustomers facewhen theymigrate inside thecountry.Unfortunately, theRBI’sinstructionssometimesdonotpercolate toeverybankbranch–which leads tounnecessary harassment for consumers, as vividly described by a columnistrecently.Goingforward,wehaveaskedtheIndianBanks’Associationtodevisecommonaccount forms,whereminimumRBI requirementswill beprintedonthebackoftheform.Itwill,forinstance,becomeclearthataverybasicaccountwith some restrictions on amounts and transactions can be obtained with noofficial documents whatsoever. [Author’s note: KYC requirements weresubsequentlydisplayedprominentlyontheRBIwebsite].

COMPETITIONTOPREVENTEXPLOITATION

AsIhaveargued,theexcludedaretypicallyrisky,aswellascostlytoservice.Atthe same time, they are also liable to exploitation because they have so littleaccess.Exploitationmaycomefromamoneylenderwhochargesusuriousrates,orabankerdemandingpersonalgratificationforgivingagovernment-subsidizedloan.Thefundamentalwaytodealwithexploitation is to increasecompetitionamongstsuppliersof financial services.Regulationcanhelp,butweshouldbecareful that regulation does not shut out competition, thus enhancingexploitation.

Considertwoexamples:Politicians are rightfully concerned about the poor being charged usurious

rates.Sotheyoftenaskregulatorstosetinterestrateceilings.Ofcourse,acleverregulated lender can avoid interest rate ceilings through hidden and not-so-hiddenfees formaking the loan.But letusassume theevencleverer regulatorcanferretoutsuchpractices(notalwaysavalidassumption).Nevertheless,thereisstillaproblem.Thelenderhastorecoupnotjustthecredit-riskmarginwhichcompensateshimforthehigherdefaultriskoflendingtothoseontheeconomicedge,butalsothefixedcostsofmaking,monitoring,andrecoveringsmallloans.If theinterestrateceilingisset toolow,theregulatedlenderwillnotbother tolendsinceitisnotworthhiswhile.Withcompetitionfromtheregulatedstifled,the poor borrower is left to the tender mercies of the rapacious, unregulatedmoneylender.SointerestrateceilingshavetohaveaGoldilocksquality–notsohigh that they allow theuninformedpoor to be exploited, andnot so low thattheykillanyincentivetheregulatedmighthavetolend.ThisistheverythinlinethattheRBIhasbeenfollowinginsettinginterestrateceilingsformicrofinancefirms. As institutional frameworks develop to reduce risk in lending, and ascompetitionamongst lenders increases,wecanlower themaximumchargeablerate.

Ina similarvein,our regulationssometimeprohibit the takingofcollateralfor loans below a certain size to certain borrowers such as students or smallbusinesses.However,iflendersarenotforcedtolend,theprohibitionontakingcollateralmayleadtoborrowerswhocanindeedoffercollateralbeingdeniedaloan.Theimpossibletrinitysuggeststhatyoucannotlimitinterestrates,prohibitthe takingofcollateral,andstillexpect theborrower tohavethesamelevelofaccess to loans.Putdifferently,unless a regulationmandates lending,which itrarelydoes,thereisalwaysariskthatceilingsoninterestratesorprohibitionsontaking collateralwill cut off institutional lending to some of the eligible.Ourregulationsmustbesetbearingthisinmind.

Onereasonablecompromisebetweenprotecting thepoorandensuring theyhave access is to allow only unsecured or collateral-free loans to qualify forprioritysectortreatmentorinterestsubventions,buttoalsoallowinstitutionsto

take collateral if offered on ordinary loans, provided they have a policy ofcharging lower rates on such secured loans.While this may force some whohave collateral to pledge it even if they do not have to do so under currentregulations(albeitwithsomecompensationintermsofalowerborrowingrate),itmitigates the greater evil of thosewhohave collateral to offer beingdeniedcreditaltogether.Thisiscertainlyanissuewehavetoreflecton.

FLEXIBILITYANDFORGIVENESS

Whenpeoplecomplainaboutthehighcostofcredittosmallbusinesses,theydonotrealizethebiggestcomponentofinterestcostsisthecreditriskmargin,nottherealpolicyrate.Thecreditriskmarginisnotunderthecontrolofthecentralbank, it has to be brought down by focusing on improving the lendinginstitutional infrastructure, as I have argued earlier. However, even though asystemthatallowsforstrongenforcementof repayment reduces thecredit riskmarginlenderscharge,italsoimposeslargercostsonunfortunateborrowers.So,forexample,shouldastudentwhochosethewrongcollegeforstudiesandendeduphavingtopaybackhugeloanswithonlyamediocrejobbepenalizedforlife?Weneedasystemthathassomeflexibilityinrepayment,sothatthosewhomakebadchoicesorhavebadluckcangetsomerelief.Atthesametime,theyshouldnotescapeallresponsibility,elsewewillseepeopleborrowingexcessivelyandmisusingtheproceeds,knowingtheycangetawayscot-free.

Keepingthisinmind,ourmastercircularonnaturalcalamitiesallowsbanksto restructure agricultural loanswithout classifying themNPA, provided thereare widespread crop losses in the local area. This prevents individuals fromexploiting the system, while giving collective relief when the area is hit.Similarly,wehaveadvocated that student loansbe structuredwith anoptionalmoratorium period, so that a borrower can survive periods of unemploymentwithoutbeingpermanentlylabelledadefaulter.Goingforward,weshouldacceptthepossibilityofindividuals,includingfarmers,declaringbankruptcyandbeingrelievedoftheirdebts,providedthisremedyisusedsparingly,andtheindividualchoosesbankruptcyasalastchoice,knowinghewillloseassetsandbeexcludedfromborrowingforaperiod.

SKILLINGANDSUPPORT

Thereisawidelyperpetuatedmyththataccesstofinancialservicesisallthatisnecessarytosetapoorfarmworkeronherwaytoriches.Thisissimplynottrue.Clearly,accesstoinstitutionalcreditcanhelpherpaybackamoneylender,andthusgivehersomerelief.Access toabankaccountcanallowher toputasidesomesavings,whichprotectsthemfromthedemandsofneedyrelatives.Buttogenerate income in a sustainableway, she needs help – in acquiring the skillsnecessary toraisechickenorcowsorgrowflowers, inmarketing thatproduct,andinlearninghowtomanagefunds.Often,creditofferedwithoutsuchsupportsimplydrivesherfurtherintodebt.

Sometimes, people learn from neighbours as clusters start undertaking anactivity.Sometimespeoplealreadyknowamarketableskillandonlylackcreditto buy the necessary raw material to produce or expand. More commonly,however,thosewhowanttoencouragemicro-entrepreneurshiphavetoworkona variety of supporting actions other than just credit, especially skilling.Fortunately, in India we have a flourishing NGOmovement that often workswith the government to provide the necessary support – as in the Jivika rurallivelihoods programme in Bihar. Increasingly, some banks have adopted aholistic approach to support as they encouragemicro-entrepreneurship.As thegovernment’sSkillIndiaprogrammeexpands,itwillproducemorepeoplewhocan use credit well. Stronger linkages between the programme and financialinstitutionswillhavetobebuilt.

FINANCIALLITERACYANDCONSUMERPROTECTION

Finally, as the excluded are drawn into formal financial services, they willencounter aggressive selling and in some cases outright mis-selling. At theReserveBank,weareconsciousofourneedtoexpandfinancialliteracysothatthe consumer is more aware. In the coming weeks, we will be launching anationwidecampaign trying to impart somebasicmessagesonsoundfinancialpractice.Wearealsolookingtohavefinancialeducationincludedintheschoolcurriculumacrossthecountry.

In2015, theRBIcameoutwith fiveprinciples thatbankshad to follow in

dealingwithcustomers.WeaskedbankstoimplementthisCharterofConsumerRights, and asked them to appoint an internal ombudsman to monitor thegrievance redressal process.We nowwill examine how banks are faring, andwhether further regulations are needed to strengthen consumer protection.Wewillespeciallyfocusonmis-sellingofthird-partyproductssuchasinsurance,aswell as the extension of adequate grievance redressal to rural areas, includingthroughtheRBI’sombudsmanscheme.

CONCLUSION

Thecountryhascomealongwayintheprocessoffinancialinclusion,butstillhasawaytogo.Wearesteadilymovingfrommandates,subsidies,andrelianceon the public sector banks for inclusion to creating enabling frameworks thatmakeitattractiveforallfinancialinstitutionstotargettheexcluded,evenwhilethe interests of the excluded are protected through education, competition andregulation. I am confident that in the foreseeable future,wewill bring formalfinancialservicestoeveryIndianwhowantsthem.Financialinclusionwillbeanimportantelement inensuringaccessandequity,necessarybuildingblocks forthesustainablegrowthofourcountry.

CHAPTER6

THERESOLUTIONOFDISTRESS

I

Thepillarwherewemadetheleastprogress,despitetheinvolvementofthebestandthebrightestintheRBI,wasingettingthebankstorecognizefinancialdistressanddealwithit.Thiswasalsotheareawhere the prevailingmindsetwas shapedmost by the existingweak institutional structure,makingchangeveryhardwithoutchanginginstitutions.

Theproblemwasmostacute in thepublic sectorbanks,whichhad thegreatest riskappetites in2007-09whenmanyofthebadloansweremade.Thepublicperceptionwasthatmuchoftheproblemwas due to corruption, but while this could be true of some banks where the bad loans reallyaccelerated in the termsof specificCEOs, I became convinced that therewere other, perhapsmoreimportant, causes. These included the irrational exuberance and the tolerance for high promoterleverage among bankers after the successful lending experience in the period before the globalfinancial crisis, the slowdown in government permissions in the wake of scandals post 2011, themindsetofbankersvis-à-vispromoters,andthelackofinstrumentsforrecoverywhendistresshit.

Wecoulddo littleabout thepast,andpublicsectorbankers (with theexceptionofa fewCEOs)werebecomingcautiousaboutlendinginanycase,giventhepilingbadloanproblems.Wecouldurgethegovernment repeatedly todealwithprojectsheldupbecauseofgovernment inaction,but resultsheretoowereoutsideourcontrol.Wherewecouldhavemoreeffectwasinchangingthemindsetofbankers,andgiving themmore instruments toactvis-à-vis largepromoters.The intentherewasnotpunishment – recognizing that public sector bank credit growthwas slowing, Iwanted to focus onputtingprojectsbackontracksothateconomicactivitywouldnotbehampered.Instead,theintentwastoensurethateveryoneabsorbedafairshareofthelosses,andthesedidnotfallentirelyonthebanks.Asforfraudulentpromoters,Ifelttheinvestigativeagenciesshouldproceedagainstthemseparately,buttheirprojectsandworkersshouldnotbepunishedforpromotermalfeasance.

Letmeexplaintheproblemofmindsetswithanexample.Irememberearlyinmytermaplaneridein which an articulate and competent public sector bank CEO happened to sit next to me. As wediscussed the banking system, he described one notorious but prominent promoter who had beenplayingoffonebankagainstanotherinanattempttokeephisfailingenterpriseafloat.Thebankertoldmethatthepromoterhadpromisedhimrepaymentoutoffundsthatwerearrivingbuthaddivertedthefundstoanotherenterprise.Whenhegottoknowofthis,thebankertoldmethathewasangrierthanhehadeverbeenbeforeinhisprofessionallife.‘Whatdidyoudo?’Iaskedthebanker.‘Icuthiscreditlineby20percent,’cametheanswer.Ididnotknowwhethertolaughorcry.

Inmost countrieswith a strong financial system, broken promises by an incompetent borrowerwouldbemetwithacompletecut-offofcredit,andtheinitiationofrecoverymeasures.InIndia,theworst thisangrybankerwaswilling todowas tocut future lendingbyameasly20percent!Manypromoterscamefromrichstoriedfamilies,werewell-connectedanddominatedthesocietypages.Toask the banker to get toughwith the promoterwas to ask him to take on an icon of society. Somebankerscoulddothiswithease,manycouldnot.

Butthereweretwootherimpedimentsintakingactiontorestructuredistressedprojectstoputthembackontrack.First,despitehavingsomeofthemostdraconianlawsonthebooksinanycountryonrecoveringsecureddebt, theselawswereeffectiveonlyagainstsmallpromoters,notagainstwealthypromoterswhocouldhirethebestlawyerstoplaythejudicialsystemtostymietherecoveryprocess.Second, bankers were always fearful of the investigative agencies, who could question a purelycommercial decisionwhere debtwaswritten down, and thus ruin the banker’s hope of a quiet andhonourableretirement.Thismadebankersveryreluctanttoagreetothedeepsignificantrestructuringthatwasneededtosetprojectsbackontrack–whytaketheriskwhenretirementwasonlysixmonthsaway.

Whatthismeantwasacollectivereluctancetorecognizetheproblem–indeed,whenItookover,wewereonlystartingtoimplementasystemtomeasuretheaggregateexposureofthebankingsystemtospecificpromotersandthestatusofthoseloans.Effectively,thismeantastrongdesireonthepartofbothbankersandpromoterstorepeatedlypushthebadloanproblemintothefuture,whichmeanttheproblemhadalreadygrowntoasignificantsize.Thiswassomethingweneededtochange.Thefirststepwastogivebankersmoreinstrumentstodealwithdistress.Thesecondwastostoptheregulatoracquiescingtotheproblembyengaginginregulatoryforbearance(thatis,agreeingtoturnablindeyeto non-performing loans).The thirdwas to force disclosure and provisioning for bad loans, so thateveryoneknewtheextentoftheproblem,anditdidnotgrowtoanalarmingsizesightunseen.Thatwouldalsoensurethatthegovernmentcouldbudgetadequatelyforthegrowingholeinpublicsectorbankbalancesheets,andnotbesurprisedsuddenly.

Myspeechesandcommentaryinthisareawereintendedtolayoutareasofaction,butalsosendamoresubtlemessage.Thepromoterswerenotabovethelaw,andshouldbetreatedastheydeserved–somewithcompassionbecauseofgenuinedifficultiesoutsidetheircontrol,andotherswithharshness.Iespeciallycriticizedpromoterswholivedthegoodlifeevenwhiletheyhadbledtheircompaniesdry.Thiswasasmuchamessagetothepromotersandbankersastomyownjuniorstaff–topmanagementattheRBIwouldbackthemiftheydidtheirjobs.

Our staff worked hard and creatively to create resolution mechanisms and some incentive forpromoters to pay back in a system where they had little incentive to do so and banks had everyincentivetoextendandpretend.Despiteaslowandunevenlegalsystem,anddespitetheabsenceofafunctioning bankruptcy code during my term, we did manage to force banks to start recognizingproblems,anddidbringsomepromoterstothetabletopay.FollowingourrepresentationtothePrimeMinister, the investigative agencies started proceeding on cases of outright fraud with additionalvigour.However,allthisisstillworkinprogress,andmuchneedstobedone.

MyfirstmajortalkonthesubjectwastheKurienLectureinNovember2014.

ASavingCredit

tatimewhendemandforbankcreditisweak,evenwhilewearelikelytohave enormous demand for it if investment picks up, we have to ask if

India’ssystemofcreditishealthy.Unfortunately,theansweristhatitisnot.Weneedfundamentalreformsstartingwithachangeinmindset.ApubliclectureinthememoryofagreatIndianwhodidmuchtochangeourmindsetsisaperfectplacetomakethecase.

THEDEBTCONTRACT

Theflowofcreditreliesonthesanctityofthedebtcontract.Adebtcontractisone where a borrower, be it a small farmer or the promoter of a largepetrochemical plant, raises money with the promise to repay interest andprincipal according to a specified schedule. If the borrower cannot meet hispromise, he is in default. In the standard debt contract through the course ofhistoryandacrosstheworld,defaultmeanstheborrowerhastomakesubstantialsacrifices,elsehewouldhaveno incentive to repay.For instance,adefaultingbanker in Barcelona in mediaeval times was given time to repay his debts,duringwhichhewasputonadietofbreadandwater.Attheendoftheperiod,ifhecouldnotpayhewasbeheaded.Punishmentsbecamelessharshovertime.Ifyou defaulted in Victorian England, you went to debtor’s prison. Today, theborrower typically only forfeits the assets that have been financed, andsometimespersonalpropertytooifheisnotprotectedbylimitedliability,unlesshehasactedfraudulently.

Why should the lender not share in the losses to the full extent? That isbecause he is not a full managing partner in the enterprise. In return for notsharinginthelargeprofitsiftheenterprisedoeswell,thelenderisabsolvedfromsharing the losses when it does badly, to the extent possible. By agreeing toprotect the lender from ‘downside’ risk, the borrower gets cheaper financing,which allows him to retainmore of the ‘upside’ generated if his enterprise issuccessful. Moreover, he can get money from total strangers, who have nointimate knowledge of his enterprise or his management capabilities, fully

reassuredbythefactthattheycanseizethehardcollateralthatisavailableiftheborrower defaults. This is why banks offer to finance your car or home loantodayatjustover10percent,justacoupleofpercentagepointsoverthepolicyrate.

VIOLATINGTHESPIRITOFDEBT

The problem Iwant to focus on in this lecture is that the sanctity of the debtcontracthasbeencontinuouslyerodedinIndiainrecentyears,notbythesmallborrowerbutbythelargeborrower.Andthishastochangeifwearetogetbanksto finance the enormous infrastructure needs and industrial growth that thiscountryaimstoattain.

Therealityisthattoomanylargeborrowersdonotseethelender,typicallyabank, as holding a senior debt claim that overrides all other claimswhen theborrowergetsintotrouble,butasholdingaclaimjuniortotheborrower’sownequityclaim.Inmuchoftheglobe,whenalargeborrowerdefaults,heiscontriteand desperate to show that the lender should continue to trust him withmanagementoftheenterprise.InIndia,toomanylargeborrowersinsistontheirdivineright tostayincontroldespite theirunwillingness toput innewmoney.Thefirmanditsmanyworkers,aswellaspastbankloans,are thehostages inthis game of chicken – the promoter threatens to run the enterprise into thegroundunlessthegovernment,banks,andregulatorsmaketheconcessionsthatarenecessarytokeepitalive.Andiftheenterpriseregainshealth,thepromoterretains all the upside, forgetting the help he got from the government or thebanks–afterall,banksshouldbehappytheygotsomeoftheirmoneyback!Nowondergovernmentministersworryaboutacountrywherewehavemanysickcompaniesbutno‘sick’promoters.

LetmeemphasizethatIdonot intendinanywaytocastaspersionsonthemajorityofIndianbusinesspeoplewhotreatcreditorsfairly.Ialsodon’twanttoargueagainstrisktakinginbusiness.Ifbusinessdoesnottakerisks,wewillnotgetarchitecturalmarvelslikeournewinternationalairports,the‘developed-for-India’ low-cost business model in the telecom sector, or our world-classrefineries.Risk takinginevitablymeans thepossibilityofdefault.Aneconomy

wherethereisnodefaultisaneconomywherepromotersandbanksaretakingtoo little risk. What I am warning against is the uneven sharing of risk andreturnsinenterprise,againstallcontractualnormsestablishedtheworldover–wherepromoters have a classof ‘super’ equitywhich retains all theupside ingoodtimesandverylittleofthedownsideinbadtimes,whilecreditors,typicallypublic sectorbanks, hold ‘junior’ debt andget noneof the fat returns ingoodtimeswhileabsorbingmuchofthelossesinbadtimes.

WHYDOESITHAPPEN?

Whydowehavethisstateofaffairs?Themostobviousreasonisthatthesystemprotectsthelargeborrowerandhisdivinerighttostayincontrol.

Thisisnotforwantoflaws.TheDebtsRecoveryTribunals(DRTs)weresetup under the Recovery of Debts Due to Banks and Financial Institutions(RDDBFI)Act,1993tohelpbanksandfinancialinstitutionsrecovertheirduesspeedilywithout being subject to the lengthy procedures of usual civil courts.TheSecuritizationandReconstructionofFinancialAssets andEnforcementofSecurityInterests(SARFAESI)Act,2002wentastepfurtherbyenablingbanksandsomefinancialinstitutionstoenforcetheirsecurityinterestandrecoverdueseven without approaching the DRTs. Yet the amount banks recover fromdefaulted debt is both meagre and long delayed. The amount recovered fromcases decided in 2013-14 under DRTs was Rs 30,590 crores while theoutstandingvalueofdebtsoughttoberecoveredwasahugeRs2,36,600crores.Thusrecoverywasonly13percentoftheamountatstake.Worse,eventhoughthelawindicatesthatcasesbeforetheDRTshouldbedisposedoffinsixmonths,onlyaboutafourthofthecasespendingatthebeginningoftheyeararedisposedoffduringtheyear–suggestingafour-yearwaitevenifthetribunalsfocusonlyon old cases.However, in 2013-14, the number of new cases filed during theyearwereaboutoneandahalftimesthecasesdisposedoffduringtheyear.Thusbacklogsanddelaysaregrowing,notcomingdown.

Whyisthishappening?ThejudgmentsoftheDRTscanbeappealedtoDebtRecovery Appellate Tribunals, and while there are thirty-three of the former,thereareonlyfiveofthelatter.Andeventhoughsection18oftheRDDBFIAct

isintendedtopreventhigherconstitutionalcourtsfrominterveningroutinelyinDRT and DRAT judgments, the honourable Supreme Court lamented on 22January2013intheUnionofIndiavstheDRTBarAssociationcasethat

‘It is a matter of serious concern that despite the pronouncements of this Court, the High Courtscontinuetoignoretheavailabilityofstatutoryremediesunder theRDDBFIActandSARFAESIActandexercise jurisdictionunderArticle226forpassingorderswhichhaveseriousadverse impactontherightofbanksandotherfinancialinstitutionstorecovertheirdues.’

The consequences of the delays in obtaining judgments because of repeatedprotractedappealsimpliesthatwhenrecoveryactuallytakesplace,theenterprisehasusuallybeenstrippedcleanofvalue.Thepresentvalueofwhatthebankcanhopetorecoverisapittance.Thisskewsbargainingpowertowardstheborrowerwhocancommandthefinestlegalbrainstoworkforhiminrepeatedappeals,ortheborrowerwhohastheinfluencetoobtainstaysfromlocalcourts–typicallythe largeborrower.Facedwith thisasymmetryofpower,banksare tempted tocave inand take theunfairdeal theborroweroffers.Thebank’sdebtbecomesjunior debt and the promoter’s equity becomes super equity. The promoterenjoysrisklesscapitalism–eveninthesetimesofveryslowgrowth,howmanylargepromotershavelosttheirhomesorhavehadtocurbtheirlifestylesdespiteofferingpersonalguaranteestolenders?

Thepublicbelievesthelargepromotermakesmerrybecauseofsweetdealsbetweenhimandthebanker.Whiletheseviewshavegainedcurrencybecauseofrecent revelations of possible corruption in banks, my sense is that Occam’sRazor suggests a more relevant explanation – the system renders the bankerhelplessvis-à-vis thelargeandinfluentialpromoter.Whileweshouldnotslowoureffortstobringbettergovernanceandmoretransparencytobanking,wealsoneedtofocusonreformingthesystem.

Who pays for this one-way bet large promoters enjoy? Clearly, the hardworking savers and taxpayers of this country! As just one measure, the totalwrite-offs of loans made by the commercial banks in the last five years is1,61,018crores,whichis1.27percentofGDP.Ofcourse,someofthisamountwillberecovered,butgiventhesizeofstressedassetsinthesystem,therewill

bemorewrite-offstocome.Toputtheseamountsinperspective–thousandsofcroresoftenbecomemeaninglesstothelayperson–1.27percentofGDPwouldhaveallowed1.5millionof thepoorestchildren togetafulluniversitydegreefromthetopprivateuniversitiesinthecountry,allexpensespaid.

THECONSEQUENCES

Letmeemphasizeagain that Iamnotworriedasmuchabout lossesstemmingfrom business risk as I am about the sharing of those losses – because,ultimately, one consequence of skewed and unfair sharing is to make creditcostlier and less available.Thepromoterwhomisuses the systemensures thatbanks then charge a premium for business loans. The average interest rate onloanstothepowersectortodayis13.7percentevenwhilethepolicyrateis8percent.Thedifference,alsoknownasthecreditriskpremium,of5.7percentislargely compensation banks demand for the risk of default and non-payment.Since the unscrupulous promoter hides among the scrupulous ones, everybusinesspersonistaintedbythebadeggsinthebasket.Evencomparingtherateon the power sector loanwith the average rate available on the home loan of10.7percent,itisobviousthatevengoodpowersectorfirmsarepayingmuchmore than the averagehousehold because of bankworries aboutwhether theywill recover loans. Reforms that lower this 300 basis-point risk premium ofpowersector loansvis-à-vishomeloanswouldhavelargebeneficialeffectsonthe cost of finance, perhaps as much or more than any monetary policyaccommodation.

Asecondconsequenceisthatthelawbecomesmoredraconianinanattemptto force payment. The SARFAESI Act of 2002 is, by the standards of mostcountries, very pro-creditor as it is written. This was probably an attempt bylegislatorstoreducetheburdenonDRTsandforcepromoterstopay.Butitsfullforceisfeltbythesmallentrepreneurwhodoesnothavethewherewithaltohireexpensivelawyersormovethecourts,evenwhiletheinfluentialpromoteronceagainescapesitsrigour.Thesmallentrepreneur’sassetsarerepossessedquicklyand sold, extinguishingmany a promising business that could dowith a littlesupportfrombankers.

A draconian law does perhaps as much damage as a weak law, not justbecauseitresultsinalossofvalueondefaultbutalsobecauseitdiminishestheincentivetotakerisk.Forthinkofamediaevalbusinessmanwhoknowshewillbe imprisonedorevenbeheaded ifhedefaults.What incentivewillhehave toengageininnovativebutriskybusiness?Isitanywonderthatbusinesswasveryconservative then? Indeed, Viral Acharya of NYU and KrishnamurthiSubramanian of ISB show in a compelling study that innovation is lower incountrieswithmuchstrictercreditorrights.Orputdifferently,thesolutiontoourcurrentproblemsisnottomakethelawsevenmoredraconianbuttoseehowwecangetmoreequitableandefficiency-enhancingsharingoflossesondefault.

Afinalconsequenceoftheinequitablesharingoflossesindistressisthatitbringsthewholefreeenterprisesystemintodisrepute.Whensomebusinessmenenjoyaprivilegedexistence,riskingotherpeople’smoneybutnevertheirown,the public and their representatives get angry. I have met numerousparliamentarianswhoareoutragedatthecurrentstateofaffairs.Iftheresolutionoftheseissuesistakenoutoftherealmofthecommercialintotherealmofthepolitical,itwillsetbackindustrialgrowth.Reformsthereforeassumeurgency.

Whatweneedisamorebalancedsystem,onethatforcesthelargeborrowertosharemorepain,whilebeingalittlemorefriendlytothesmallborrower.Thesystemshouldshutdownbusinessesthathavenohopeofcreatingvalue,whilereviving and preserving those that can add value. And the system shouldpreserve the priority of contracts, giving creditors a greater share and greatercontrolwhentheenterprise isunable topay,whilerequiringpromoters togiveupmore.

ABETTERBALANCE

Howdoweachievethisbetterbalance?

Letusstartwithbettercapitalstructures.Thereasonsomanyprojectsarein trouble today is because theywere structured upfrontwith too littleequity,sometimesborrowedbythepromoterfromelsewhere.Andsomepromoters findways to take out the equity as soon as the project gets

going,sotherereallyisnocushionwhenbadtimeshit.Lendersshouldinsist onmore real equity up front, andmonitor the project closely toensure it stays in. Promoters should not try and financemega projectswithtinysliversofequity.Wealsoneedtoencouragemoreinstitutionalinvestors, who have the wherewithal to monitor promoters, to bringequitycapitalintoprojects.Banks need to reactmore quickly and in a concertedway to borrowerdistress. The longer the delay in dealing with the borrower’s financialdistress, the greater the loss in enterprise value. Some banks aremoreagile(andhavebetterlawyers),sothepromotercontinuesservicingthemwhiledefaultingonotherbanks.Intheabsenceofanefficientbankruptcyprocessthatbringslenderstogether,theRBIhasmandatedtheformationofaJointLendingForum(JLF)oflenderswhenthefirstsignsofdistressare perceived. The JLF is required to find a way to deal with thedistressed enterprise quickly, with options ranging from liquidation torestructuring.Inthisway,wehopetocoordinatelendersandpreventtheborrowerfromplayingoneoffagainsttheother.The government’s plan to expand the number of DRTs and DRATs istimely,andwillbemosteffectiveifalsoaccompaniedbyanexpansioninfacilities,trainedpersonnel,andelectronicfilingandtrackingofcases,assuggestedbytheSupremeCourt.Also

Some monetary incentives to tribunals for bringing down theaveragedurationofcases,withoutcompromisingondueprocess,couldbecontemplated.Somelimiton thenumberofstayseachpartycanaskforcouldalsobethoughtof.Appeals to theDRATshouldnotbe amatterof course. Indeed,DRATsshouldrequireborrowerappellantstodepositaportionofthemoneyorderedtobepaidbytheDRTaslaiddowninthelawasamatterofcourse,ratherthanroutinelywaivingsuchdepositsasisreportedtobethecurrentpractice.Itisworthexaminingifappellantsshouldbemadetopaythereal

costsofdelayoutoftheirownpocketsifunsuccessful,wherethecostsincludetheinterestcostsofpostponedpayments.

AssuggestedbytheSupremeCourt,ConstitutionalCourtsshouldrespectthespiritof the lawsandentertainfewerappeals. It ishardtoseewhatpoints of law or judicial administration are raised by the standardcommercial case, and routine judicial intervention favours therecalcitrantborrowerattheexpenseofthelender.

ChallengingtheordersofDRTandDRATbeforecourtsshouldbemade costlier for the appellants. Courts should require them todeposit the undisputed portion of the loan before admitting thecasesothatroutinefrivolousappealsdiminish.

Thesystemalsoneedsprofessionalturnaroundagentswhocanstepininthe place of promoters.Asset ReconstructionCompanies (ARCs)weremeant to do this, but they need more capital and better managementcapabilities. Also, there is a requirement that they hand the enterprisebacktotheoriginalpromoteroncetheyhavegeneratedenoughvaluetorepaytheoriginaldebts.Sucharequirementismisconceivedandneedstoberepealed,elseARCshavelittleincentivetospendeffortandmoneyto turn around firms. They will simply be liquidators, as they havelargelyproventobesofar.IshouldmentionthattheRBIisopentomorefirmsapplyingforlicencesasARCs.The government is working on a new bankruptcy law, which is verymuch needed. Properly structured, this will help bring clarity,predictability,andfairnesstotherestructuringprocess.

FLEXIBILITYNOTFORBEARANCE

Finally,letmeendonacurrentconcernthatpertainstotheRBI’sregulationthatisnotunrelatedtotheissuesdiscussedinthislecture.Today,alargenumberofindustriesaregettingtogetherwithbankstoclamourforregulatoryforbearance.TheywanttheRBItobe‘realistic’andpostponeanyrecognitionofbadloans.

This isshort-sighted,especiallyonthepartof thebanks.Today, themarketdoesnotdistinguishmuchbetweennon-performingloansandrestructuredloans,

preferring to call them both stressed loans and discounting bank valueaccordingly.MutilatingShakespeare,anNPAbyanyothernamesmellsasbad!Indeed,becauseforbearancemakesbankbalancesheetsopaque,theymaysmellworse to analysts and investors. The fundamental lesson of every situation ofbanking stress in recent years across the world is to recognize and flag theproblemloansquicklyanddealwiththem.Soregulatoryforbearance,whichisaeuphemism for regulators collaboratingwithbanks to hideproblems andpushthemintothefuture,isabadidea.

Moreover,forbearanceallowsbankstopostponeprovisioningforbadloans.Sowheneventuallythehiddenbadloanscannotbedisguisedanymore,thehitto the bank’s income and balance sheet is larger and more unexpected. Thiscouldprecipitateinvestoranxietyaboutthestateofthebank,andinthecaseofpublicsectorbanks,leaveabiggerholeforthegovernmenttofill.Theseareyetmore reasons toend forbearance.Orputdifferently, forbearance isostrich-likebehaviour,hopingtheproblemwillgoaway.Itisnotrealismbutnaiveté,forthelessonfromacrosstheworldis that theproblemsonlygetworseasoneburiesone’sheadinthesand.

At thesametime, thebankshavealsobeenaskingtheregulatorforgreaterflexibilitytorestructureloanssoastoalignthemwiththeproject’scashflows,andfortheabilitytotakeequitysoastogetsomeupsideindistressedprojects.These are more legitimate requests as they imply a desire to deal moreeffectivelywith distress. The regulator has been reluctant to afford banks thisflexibility in the past because it has been misused by bank management.Nevertheless,recognizingthatitcannotmicromanagetheresolutionofdistress,theRBIisexploringwaystoallowbanksmoreflexibilityinrestructuring.Thisisariskwearepreparedtotakeifitallowsmoreprojectstobesetonthetracktorecovery.

Insum,theRBIopposesforbearancewhichsimplypushesproblemsintothefuture,while it will allowmore flexibility so that problem loans can be dealtwitheffectivelytoday.Letusalsobeclearthatwewillbewatchfulformisuseofflexibilityandwilldealseverelywithitifitoccurs.

CONCLUSION

Let me conclude. Perhaps the reason we have been so willing to protect theborroweragainst thecreditor is that thehatedmoneylender looms large inourcollectivepsyche.Butthelargeborrowertodayisnotahelplessilliteratepeasantandthelendertodayistypicallynotthesahukarbutthepublicsectorbank–inother words, we are the lender.When the large promoter defaults wilfully ordoesnotcooperateinrepaymenttothepublicsectorbank,herobseachoneofustaxpayers, even while making it costlier to fund the new investment oureconomyneeds.

Thesolutionisnotmoredraconianlaws,whichthelargeborrowermaywellcircumventandwhichmayentrapthesmallborrower,butamoretimelyandfairapplication of current laws.We also need new institutions such as bankruptcycourtsand turnaroundagents.Finally,weneedachange inmindset,where thewillfulornon-cooperativedefaulter isnotlionizedasacaptainofindustry,butjustlychastizedasafreeloaderonthehardworkingpeopleofthiscountry.IamsurethatisachangeinmindsetthatDrVergheseKurienwouldapproveof.

O

II

In the absence of a functioning bankruptcy code, the RBI put together a number of schemes tofacilitatebankresolutionofdistress.Werepeatedlyre-examinedtheschemestoseehowtheycouldbetweaked to facilitate resolution. Unfortunately, with the exception of a few hard-charging andconscientiousbankers, thegeneralmoodamong thebankerswas tocontinue toextendandpretend.They feared they would be held accountable for any concession they made, and constantly (andperhapsunderstandably)avoidedtakingdecisions.Inthisenvironment,theideaofabadbank,fundedby the government, that would take the loans off their books, kept cropping up. I just saw this asshiftingloansfromonegovernmentpocket(thepublicsectorbanks)toanother(thebadbank)anddidnotseehowitwouldimprovematters.Indeed,ifthebadbankwereinthepublicsector,thereluctancetoactwouldmerelybeshiftedtothebadbank.Whynotinsteadinfusethecapitalthatwouldbegiventothebadbankdirectlyintothepublicsectorbanks?Alternatively,ifthebadbankweretobeintheprivatesector,thereluctanceofpublicsectorbankstosellloanstothebadbankatasignificanthaircutwouldstillprevail.Onceagain,itwouldsolvenothing.

Aswe foundbanks reluctant to recognizeproblems,wedecidednot just to end forbearancebutalsotoforcethemtocleanuptheirbalancesheets.TheAssetQualityReview,initiatedin2015,wasthe first major exercise of this nature in India, ably led by Deputy Governor Mundra. I wouldespeciallyhighlighttheroleoftwoextremelypoliteandself-effacingbuttough-as-nailsladies,ChiefGeneralManagerParvathySundarandExecutiveDirectorMeenaHemchandra,whoreallyenergizedtheir staff and assured them of their support at every turn. The young team they put together wastireless,andmademeawareonceagainofwhatwearecapableofifweputourmindstoit.

Every situation of banking sector stress I have ever studiedwas fixed only by recognizing theproblem,resolvingthebadloans,andrecapitalizingthebanks.Indiawasnoexception,butonceagaintherewereabunchofcriticswhoclaimedthatcleaningupthebadloanproblemwaswhatledtotheslowingofcreditbythepublicsectorbanks.InaspeechinJune2016inBengaluru,Imadethecasefor the clean-up once again by asking these critics to actually look at data, which showed theslowdown started before the clean-up, probably as banks became aware of the magnitude of theproblem.

ResolvingStressintheBankingSystem

rdinarily, in a city like Bengaluru, we would talk about startups. Today,however,Iwanttotalkabouttheresolutionoffinancialdistress.Iwantto

refutetheargumentthatmonetarypolicyhasbeentootight.Instead,Iwillarguethat the slowdown in credit growth has been largely because of stress in thepublicsectorbanking,whichwillnotbefixedbyacutininterestrates.Instead,

whatisrequiredisaclean-upofthebalancesheetsofpublicsectorbanks,whichiswhatisunderwayandneedstobetakentoitslogicalconclusion.Specifically,I will describe what we have been doing in India to change the culturesurroundingtheloancontract.Tostart,letuslookatpublicsectorcreditgrowthcomparedwith thegrowth increditby thenewprivatebanks[Author’snote: Ihave omitted the charts this talk was based on, but they are available athttps://rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1009]

PUBLICSECTORLENDINGVSPRIVATESECTORLENDING

The data indicate public sector bank non-food credit growth has been fallingrelative to credit growth from the new private sector banks since early 2014.This is reflected not only in credit to industry but also in micro and smallenterprisecredit.Therelativeslowdownincreditgrowth,albeitnotsodramatic,is also seen in agriculture, thoughgrowth ispickinguponceagain.Wheneverone sees a slowdown in lending, one could conclude there is no demand forcredit–firmsarenotinvesting.Butwhatweseehereisaslowdowninlendingbypublicsectorbanksvis-à-visprivatesectorbanks.Whyisthat?

Theimmediateconclusiononeshoulddrawisthatthisissomethingaffectingcreditsupplyfromthepublicsectorbanksspecifically,perhapsitisthelackofbankcapital.Yetifwelookatretailloangrowth,andspecificallyhousingloans,publicsectorbankloangrowthapproachesprivatesectorbankgrowth.Thelackof capital therefore cannot be the culprit. Rather than an across-the-boardshrinkageofpublicsectorlending,thereseemstobeashrinkageincertainareasofhighcreditexposure,specificallyinloanstoindustryandtosmallenterprises.The more appropriate conclusion then is that public sector banks have beenshrinking exposure to infrastructure and industry risk right from early 2014becauseofmountingdistressontheirpastloans.Privatesectorbanks,manyofwhich did not have these past exposures, were more willing to service themountingdemandfromboththeirtraditionalborrowers,aswellassomeofthosecorporatesdeniedbythepublicsectorbanks.Given,however,thatpublicsectorbanks aremuch bigger than private sector banks, private sector banks cannotsubstitute fully for the slowdown in public sector bank credit.We absolutely

needtogetpublicsectorbanksbackintolendingtoindustryandinfrastructure,elsecreditandgrowthwillsufferastheeconomypicksup.

These data refute another argumentmade by thosewhodo not look at theevidence – that stress in the corporateworld is because of high interest rates.Interest rates setbyprivatebanksareusuallyequalorhigher than rates setbypublicsectorbanks.Yettheircreditgrowthdoesnotseemtohavesuffered.Thelogicalconclusionthereforemustbethatitisnotthelevelofinterestratesthatisthe problem. Instead, stress is because of the loans already on PSB balancesheets,andtheirunwillingnesstolendmoretothosesectorstowhichtheyhavehighexposure.

Therearetwosourcesofdistressedloans–thefundamentalsoftheborrowernotbeinggood,andtheabilityofthelendertocollectbeingweak.Bothareatworkinthecurrentdistress.

THESOURCESOFLENDINGDISTRESS:BADFUNDAMENTALS

Whyhavebadloansbeenmade?Anumberoftheseloansweremadein2007-08.Economicgrowthwasstrongandthepossibilitieslimitless.Depositgrowthinpublicsectorbankswasrapid,andanumberofinfrastructureprojectssuchaspowerplantshadbeencompletedontimeandwithinbudget.Itisatsuchtimesthatbanksmakemistakes.Theyextrapolatepastgrowthandperformancetothefuture. So they are willing to accept higher leverage in projects, and lesspromoter equity. Indeed, sometimes banks signed up to lend based on projectreports by the promoter’s investment bank, without doing their own duediligence. One promoter told me about how he was pursued then by bankswaving cheque books, asking him to name the amount hewanted.This is thehistoricphenomenonofirrationalexuberance,commonacrosscountriesatsuchaphaseinthecycle.

Theproblemisthatgrowthdoesnotalwaystakeplaceasexpected.Theyearsof strong global growth before the global financial crisis were followed by aslowdown,which extendedeven to India, showinghowmuchmore integratedwehadbecomewiththeworld.Strongdemandprojectionsforvariousprojectswere shown to be increasingly unrealistic as domestic demand slowed down.

Moreover, a variety of governance problems coupled with the fear ofinvestigation slowed down bureaucratic decision making in Delhi, andpermissionsforinfrastructureprojectsbecamehardtoget.Projectcostoverrunsescalated for stalled projects and they became increasingly unable to servicedebt.

Iamnotsayingthat therewasnomalfeasance–thecountry’s investigativeagenciesarelookingintosomecasessuchasthosewhereundueinfluencewasused in getting loans, orwhere actual fraud has been committed by divertingfunds out of a company, either through over-invoicing imports sourced via apromoter-owned subsidiary abroad or exporting to related shell companiesabroadandthenclaimingtheydefaulted.Iamsayingthat,typically,therewerefactors other than malfeasance at play, and a number of genuine committedentrepreneurs are in trouble, as are banks that made reasonable businessdecisionsgivenwhattheyknewthen.

THESOURCESOFLENDINGDISTRESS:POORMONITORINGANDCOLLECTION

Thetruthis,evensensiblelendingwillentaildefault.Abankerwholendswiththeintentofneverexperiencingadefaultisprobablyover-conservativeandwilllendtotoofewprojects,thushurtinggrowth.Butsensiblelendingmeanscarefulassessment up front of project prospects,which I have arguedmay have beenmarred by irrational exuberance or excessive dependence on evaluations byothers.Deficienciesinevaluationcanbesomewhatcompensatedforbycarefulpost-lending monitoring, including careful documentation and perfection ofcollateral,aswellasensuringassetsbackingpromoterguaranteesareregisteredandtracked.Unfortunately,toomanyprojectswereleftweaklymonitored,evenascostsincreased.Banksmayhaveexpectedtheleadbanktoexerciseadequateduediligence,butthisdidnotalwayshappen.Moreover,asaprojectwentintodistress, private banks were sometimes more agile in securing their positionswithadditionalcollateralfromthepromoter,orgettingrepaid,evenwhilepublicsectorbankscontinuedsupportingprojectswithfreshloans.Promotersastutelystoppedinfusingequity,andsometimesevenstoppedputtingineffort,knowingtheprojectwasunlikelytorepaygiventhedebtoverhang.

Theprocessforcollection,despitelawslikeSARFAESIintendedtospeedupsecureddebt collection, has beenprolonged and costly, especiallywhenbanksfacelarge,well-connectedpromoters.Thegovernmenthasproposedreformstothejudicialprocess,includingspeedingupthefunctioningoftheDebtRecoveryTribunals,whichshouldmakeiteasierforbankstocollect,butthoselegislativereformsarebeforeParliament.Knowingthatbankswouldfindithardtocollect,somepromotersencouraged themto‘double-up’byexpanding thescaleof theproject,eventhoughtheinitialscalewasunabletoservicedebt.Ofcourse,theunscrupulous among the promoters continued to divert money from theexpandedlending,increasingthesizeoftheproblemonbankbalancesheets.

Theinefficientloanrecoverysystemthengivespromoterstremendouspowerover lenders. Not only can they play one lender off against another bythreateningtodivertpaymentstothefavouredbank,theycanalsorefusetopayunless the lenderbrings inmoremoney, especially if the lender fears the loanbecomingaNon-PerformingAsset.Sometimespromoterscanoffermiserlyone-timesettlements(OTS)knowingthatthesystemwillensurethebankshavelittleabilitytocollectevensecuredloans,andthattooafteryears.Effectively,loansinsuchasystembecomeimplicitequity,withatoughpromoterenjoyingtheupsideingood times, and forcingbanks toabsorb losses inbad times, evenwhileheholdsontohisequity.

CLEANINGUPTHEBANKS:PRINCIPLES

Theworldover,therearethreecardinalruleswhenfacedwithincipientdistress.1) Viability does not depend on the debt outstanding, but on economic value.Debtmayhavetobewrittendowntocorrespondtowhatisviable.

Becauseofchangedcircumstances,demandmaybe lowerandprojectcashflows may be significantly lower than projected earlier. The project haseconomic value when completed – in the sense that operating cash flows arepositive,butmuchlessthantheinterestonthedebtitcarries.Ifthedebtisnotwritten down, the project continues as an NPA, even while the promoter,knowing it cannot repay, loses interest. If neglected, the project may stopgenerating any cash flows and the assets may depreciate rapidly. Excessive

indebtednesscandestroyvalue.2)Completeprojectsthatareviable,evenifitrequiresadditionalfundsinfusion.

Stalledprojectsdonotgetanybetterovertime.Iftherearesmallinvestmentsneededtocompletetheproject,andthepromoterhasnofunds,itmaystillmakesense to lend to the project, even while writing down the overall debt.Essentially, thenewloanmakes itpossible togenerateoperatingcashflows toservicesomedebt,evenifnotalltheoutstandingdebt.3) Don’t throw good money after bad money simply because there is anunreliablepromisethatdebtwillbecomeserviceable.

This is theoppositeof (2). If theproject isunviable,doubling itssizedoesnotmakeitanymoreviable.Promotersthathaveover-borrowedoftenproposean increase in scale so that thebank’soutstandingdebt andnew loanswill allbecome serviceable.Perhaps itwouldbebetter for thebank towrite down itsloans to the initial project, rather than going deeper into the hole because thepromoter may incur new cost overruns as he expands. An incompetent orunreliablepromoterwillremainsoevenwhenscaleexpands.

BANKMORALHAZARD

Unfortunately, the incentives built into the public sector banking system havemade it more difficult for public sector bank executives to follow theseprinciples(Ishouldaddthatsomeprivatesectorbankexecutiveshavealsonotbeen immune on occasion). The short tenure of managers means they areunwilling to recognize losses immediately, andmorewilling topostpone themintothefuturefortheirsuccessorstodealwith.Suchdistortedincentivesleadtooverlendingtoor‘ever-green’unviableprojects.Unfortunately,also,thetaintofNPAimmediatelymakesthemreluctanttolendtoaprojectevenifit isviable,for fear that the investigativeagencieswillnotbuy their rationale for lending.The absence of sound and well-documented loan evaluation and monitoringpracticesbybanksmakessuchanoutcomemorelikely.Soexcessivelendingtobadprojectsandtoolittlelendingtoviableonescancoexist.

THEREGULATOR’SDILEMMA

For the regulator who wants the banking system to clean up so it can start

lending again, this creates a variety of objectives, which can be somewhatconflicting.First,wewantbanks to recognize loandistressanddisclose it,notpaper over it by ever-greeningunviable projects.Loan classification ismerelygood accounting – it reflects what the true value of the loan might be. It isaccompanied by provisioning, which ensures the bank sets aside a buffer toabsorb likely losses. If the losses do notmaterialize, the bank canwrite backprovisioning to profits. If the losses domaterialize, the bankdoes not have tosuddenlydeclareabigloss,itcansetthelossesagainsttheprudentialprovisionsithasmade.Thusthebankbalancesheetthenrepresentsatrueandfairpictureofthebank’shealth,asabankbalancesheetismeantto.

Second, we want them to be realistic about the project’s cash generatingcapacity,andstructurelendingandrepaymenttomatchthat.

Third,wewantthemtocontinuelendingtoviableprojects,eveniftheyhadtoberestructuredinthepastandareNPAs.

TheproblemisthatanyforbearanceinlabellingloansNPAsonrestructuringmakes it easier to avoiddisclosure and indulge in ever-greening.On theotherhand,strictdisclosureandclassificationrulescouldimplyacessationoflendingto even viable projects. There are no clean solutions here given the kind ofincentives in the system, and given the absence of an operational bankruptcycodeinIndia.Therefore,theRBIhashadtoadoptapragmaticapproachtotheclean-up,creatingnewenablingprocesses.

THERBI’SAPPROACH

Ourfirsttaskwastomakesurethatallbankshadinformationonwhohadlenttoaborrower.Sowecreatedalargeloandatabase(CRILC)thatincludedallloansoverRs5crores,whichwesharedwithallthebanks.TheCRILCdataincludedthestatusofeachloan–reflectingwhetheritwasperforming,alreadyanNPAorgoingtowardsNPA.Thatdatabaseallowedbankstoidentifyearlywarningsignsofdistressinaborrowersuchashabituallatepaymentstoasegmentoflenders.

ThenextstepwastocoordinatethelendersthroughaJointLenders’Forum(JLF)oncesuchearlysignalswereseen.TheJLFwastaskedwithdecidingonanapproach for resolution,muchasabankruptcy forumdoes. Incentiveswere

given to banks for reaching quick decisions.We have also tried to make theforummore effective by reducing the need for everyone to agree, evenwhilegivingthosewhoareunconvincedbythejointdecisiontheopportunitytoexit.

Wealsowantedtostoprestructuringofunviableprojectsbybankswhowantto avoid recognizing losses – so we ended the ability of banks to restructureprojectswithoutcallingthemNPAinApril2015.Atthesametime,anumberoflong-duration projects such as roads had been structured with overly rapidrequiredrepayments,eventhoughcashflowscontinuedtobeavailabledecadesfromnow.Soweallowedsuchprojectpaymentstoberestructuredthroughthe5/25 scheme provided the long dated future cash flows could be reliablyestablished. Of course, there was always the possibility of banks using thisscheme to evergreen, so we have monitored how it works in practice, andcontinuetweakingtheschemewherenecessarysothatitachievesitsobjectives.

Becausepromoterswereoftenunabletobringinnewfunds,andbecausethejudicialsystemoftenprotects thosewithequityownership, togetherwithSEBIwe introduced theStrategicDebtRestructuring (SDR) scheme so as to enablebankstodisplaceweakpromotersbyconvertingdebttoequity.Wedidnotwantbankstoownprojectsindefinitely,soweindicatedatimelinebywhichtheyhadtofindanewpromoter.

All these new tools (including some I do not have the space to describe)effectively created a resolution system that replicated an out-of-courtbankruptcy.Banksnowhadthepowertoresolvedistress,sowecouldpushthemtoexercisethesepowersbyrequiringrecognition.ThisiswhattheAssetQualityReview,completedinOctober2015andsubsequentlysharedwithbanks,soughtto accomplish. Since then banks have classified existing distressed loansappropriately, and since March 2016 are looking at their weak-but-not-yet-distressedportfoliofornecessaryactions.Thereisachangeinculture,andbankshave been quite willing to get into the spirit of the AQR. Many have gonesignificantlybeyondourindicationsinwhattheyhavecleanedupbythequarterendingMarch2016.Ofcourse,once thebankshaveproperlyclassifiedanon-performingloanandprovisionedagainstit,theirincentivetoever-greenoravoidwritingdownthedebttoappropriatelevelsisdiminished.

Nevertheless, clean-up isongoingwork.TheSDRschemedealtwithweakpromoters. But some promoters are competent even while their projects areoverly indebted. The ‘Scheme for Sustainable Structuring of Stressed Assets’(S4A)isanoptionalframeworkfortheresolutionoflargestressedaccounts.TheS4A envisages determination of the sustainable debt level for a stressedborrower, and bifurcation of the outstanding debt into sustainable debt andequity/quasi-equity instruments which are expected to provide upside to thelenders when the borrower turns around. Thus capable-but-over-indebtedpromoters have some incentive to perform, and because the project is notdeemedanNPA ifadequateprovisionsaremade,public sectorbankscontinuelendingtoitifnecessary.

Mostrecently,thegovernmentiscontemplatingafundtolendintodistressedsituations,withsignificantparticipationbythirdparties,sothatnewloanscanbemade toviabledistressedprojects.Provideddecisionmaking isnotdominatedbybankswhosevery loansaredistressed, thiscouldbeaneffectivevehicle tospeedupresolution.

WHYSOMANYSCHEMESANDWHYTHECONSTANTTINKERING

The sources of borrower distress are many, and we have sought to providelenders with a menu of options to deal with it, even while limiting theirdiscretion to paper over the problem. Effectively the RBI has been trying tocreateanentirelynewbadloanresolutionprocessintheabsenceofaneffectivebankruptcy system.We have had to tinker, since each scheme’s effectiveness,while seemingly obviouswhen designing, has to bemonitored in light of thedistortedincentivesinthesystem.Aswelearn,wehaveadaptedregulation.Ourobjectiveisnottobetheoreticalbuttobepragmatic,evenwhilesubjectingthesystemtoincreasingdisciplineandtransparency.

Thegoodnews is thatbanksaregetting into thespiritof theclean-up,andpursuingreluctantpromoterstotakethenecessarystepstorehabilitateprojects.Indebted promoters are being forced to sell assets to repay lenders. We willshortly license a number of new Asset Reconstruction Companies (ARCs) toprovideadeepermarketforstressedassets.Wearealsoworkingonaframework

to enhance efficiency and transparency of price discovery in sale of stressedassetsbybanks toARCs.Bank investors,after initiallygettingalarmedby thesizeofthedisclosures,havebidupPSBbankshares.Totheextentthatthesearestilltradingatafractionofbookvalue,thereisstillroomforupwardvaluationifthebankscanimprovetheprospectsofrecovery.Thenewschemes,aswellastheimprovingeconomy,shouldhelp.

FRAUDANDWILFULDEFAULT

Evenwhilewemakeiteasierforcommittedpromoterstorestructurewhentheyexperiencebadluckorunforeseenproblems,weshouldreducetheabilityofthefraudsterorthewilfuldefaulter,whocanpaybutsimplyisdisinclinedtodoso,orthefraudster,togetaway.Thisiswhyitisextremelyimportantthatbanksdonot use the new flexible schemes for promoters who habitually misuse thesystem(everyoneknowswhotheseare)orforfraudsters.Thethreatoflabellingapromoterawilfuldefaultercouldbeeffectiveintheformercase,andwehavecoordinatedwithSEBItoincreasepenaltiesforwilfuldefaulters.Forfraudsters,quick and effective investigation by the investigative agencies is extremelyimportant.Weshouldsendthemessagethatnoonecangetaway,andIamgladthatthePrimeMinister’sOfficeispushingprosecutionoflargefrauds.TheRBIhassetupafraudmonitoringcelltocoordinatetheearlyreportingoffraudcasesto the investigative agencies. And for those who have divertedmoney out oftheir companies, especially into highly visible assets abroad, a stern messagesentbybankerssittingtogetherwithinvestigativeagenciesshouldhelpsendthemessagethatthealternativestorepaymentcanbeharsh.

BANKRISKAVERSION

Bankers often argue that the easiest people to label in a fraud are the bankersthemselves,whooftencouldbevictimsratherthanperpetrators.Similarly,theyaccuse the vigilance authorities of excessive zeal when loans go bad, ofimmediatelysuspectingbankersofmalfeasancewhenthebadloancouldbeanunintended consequence of sensible risk taking. Unfortunately, all too often,such investigations also uncover sloppy due diligence or loan monitoring bybankers. After the fact, it is hard to distinguish sensible risk taking from

carelessness or from corruption. While the vigilance authorities continuouslyattempttoreassurebankersthattheyarenotvigilantes, thebankersthemselvesknow that their own enthusiasm and deficiencies can expose them tounwarrantedaccusationsofcorruption.

Certainly, part of the solution is for bankers to pull up their socks. Butanotherpartof thesolution is tonot labelabankerbasedon theoutcomeofasingleloanbutinsteadlookforapatternacrossloans.Abankerwhomakesanexcessivenumberofbadloanscomparedtohiscohortdeserves,attheveryleast,tobequestioned.Butthebankerwhomakestheoccasionalbadloanamidstalotofgoodonesprobablyneedstoberewarded.Suchpattern-basedmonitoringbybankauthorities,withseriouspunishmentthroughvigilanceactiononlyifthereis evidence of money changing hands, could control malfeasance whilerewarding risk taking. This does require some changes in the current system,including de-emphasizing the committee-based approach to loan approval inbanks,whichappearstodiffuseresponsibilityforloandecisions.

WHATRESPONSIBILITYDOESTHERBIHAVE?

Bankers sometimes turnaroundandaccuse regulatorsof creating thebad loanproblem.Thetruthisbankers,promoters,andcircumstancescreatethebadloanproblem.Theregulatorcannotsubstituteforthebanker’scommercialdecisionsor micromanage them or even investigate them when they are being made.Instead, inmost situations, the regulator can at best warn about poor lendingpracticeswhentheyarebeingundertaken,anddemandbanksholdadequateriskbuffers. The important duty of the regulator is to force timely recognition ofNPAsandtheirdisclosurewhentheyhappen.Forbearancemaybeareasonablebutriskyregulatorystrategywhenthere issomehopethatgrowthwillpickupsoon and the system will recover on its own. Everyone – banker, promoter,investors,andgovernmentofficials–oftenurgesuchastrategybecauseitkicksthe problem down the road, hopefully for someone else to deal with. Thedownsideisthatwhengrowthdoesnotpickup,thebadloanproblemisbigger,anddealingwithitismoredifficult.Itiswhenthebadloanproblemisallowedto accumulate through forbearance or non-recognition that regulators have the

difficulttaskofbringingthesystembackontrack.ThatistheproblemwehavehadtodealwithattheRBI.

AsIhaveshownyou,theconsequencesinceearly2014ofthepastbuild-upof stressed loans was a slowdown in public sector bank lending in certainsectors.ThecessationofRBIforbearanceandtheAssetQualityReviewinmid2015were thereforenot responsible for theslowdown. Instead,highdistressedexposuresincertainsectorswerealreadyoccupyingPSBmanagementattentionandholdingthemback.Theonlywayforthemtosupplytheeconomy’sneedforcredit, which is essential for higher economic growth, was to clean up andrecapitalize.

Thesilverliningmessageintheslowercreditgrowthisthatbankshavenotbeenlendingindiscriminatelyinanattempttoreducethesizeofstressedassetsinanexpandedoverallbalancesheet,andthisbodeswellforfutureslippages.Insum,tothequestionofwhatcomesfirst,clean-uporgrowth,Ithinktheanswerisunambiguously‘Clean-up!’Indeed,thisisthelessonfromeveryothercountrythat has faced financial stress. It is important, therefore, that the clean-upproceeds to its conclusion, without any resort to regulatory forbearance onceagain.

Sometimes,easiermonetarypolicyisproposedasananswertoreducingthebaddebtproblem.Fortheheavilyindebtedpromoter,however,easiermonetarypolicy will typically bring no relief. Even with lower policy rates, the bank,whichistypicallynotmadewholeevenifitgrabsalltheborrower’scashflows,hasnoincentivetoreducetheinterestratetheborrowercanpay.Andfewbanksarecompetingfor thatborrower’sbusiness,so there isnocompetition to forcedownloanrates.Thebottomlineisthateasiermonetarypolicyisnoanswertoseriousdistress,contrarytowidespreadbelief.

WHATCANTHEGOVERNMENTDO?

Thegovernmentisintheprocessofspeedingupthedebtrecoveryprocess,andcreating a new bankruptcy system. These are important steps to improve theresolution process. In the near term, however, two actions will pay largedividends.

Thefirstistoimprovethegovernanceofpublicsectorbankssothatwearenot facedwith this situationagain.Thegovernment, through the Indradhanushinitiative, has sent a clear signal that it wants tomake sure that public sectorbanks, once healthy, stay healthy. Breaking up the post of Chairman andManagingDirector,strengtheningboardandmanagementappointmentsthroughthe Banks Board Bureau, decentralizing more decisions to the professionalboard,findingwaystoincentivizemanagement,allthesewillhelpimproveloanevaluation,monitoringandrepayment.

The second is to infuse bank capital, with some of the infusion related tostronger performance, so that better banks have more room to grow. Capitalinfusion into weak banks should ideally accompany an improvement ingovernance,butgiventheneedforabsorbingthelossesassociatedwithbalancesheetclean-up,better thatgovernmentcapitalbeinfusedquickly.Governmentsaresometimesreluctant to infusebankcapitalbecausetherearesomanymorepressing demands for funds. Yet, there are few higher return activities thancapitalizing the public sector banks so that they can support credit growth.Finally, the Economic Survey has suggested the RBI should capitalize publicsector banks. This seems a non-transparent way of proceeding, getting thebankingregulatoronceagainintothebusinessofowningbanks,withattendantconflictsofinterest.

Better that theRBIpay thegovernment themaximumdividend that it can,retainingjustenoughsurplusbuffersthatareconsistentwithgoodcentralbankrisk-managementpractice.Indeed,thisiswhatwedo,andinthelastthreeyears,wehavepaidalloursurplustothegovernment.Separately,thegovernmentcaninfuse capital into the banks. The two decisions need not be linked.Alternatively,alesseffectiveformofcapital,ifthegovernmentcannotbuybankequitydirectlywithcash,isforittoissuethebanks‘GovernmentCapitalizationBonds’inexchangeforequity.Thebankswouldholdthebondsontheirbalancesheet. This would tie up part of their balance sheet, but would certainly becapital.

Postscript:Iwouldnotchangeanythinginthisspeechtoday.Theneedforactiononeveryone’spartisas urgent as ever, though the instruments to effect that action have grown. The NDA government

amendedthevariousactsgoverningdebtrecoverytomakethemlesseasytogame,andalsoenactedanewbankruptcycode.Further,itamendedtheworkingofdebtrecoverytribunals.TheseareimportantstepsforwardinrectifyingthebalancebetweenborrowerandlenderinIndia.However,theoperationaleffectivenessofthesechangesneedstobetracked,andfurtheramendmentsenactedifnecessary,untilwehavearesolutionsystemthatworksinarapid,fairandtransparentway.

CHAPTER7

THEECONOMYANDOTHERISSUES

I

TheGovernoroftheReserveBankismuchmorethanjustaregulatororacentralbanker.SincetheRBI is both the lender of last resort, as well as the custodian of the country’s foreign exchangereserves,theGovernoristheprimarymanagerofmacroeconomicriskinthecountry.IftheGovernortakesthisroleseriously,he(orshe)hastowarnwhenhefearstheeconomyisindangerofgoingdownthewrongpath.Asanapolitical technocrat,hecanneitherbeacheerleaderfor thegovernment,norcanhebeanunconstrainedcritic.This isafine line to tread,andtheGovernorhas topickboth theissueshespeakson,aswellasthetoneofhiscommentary,verycarefully.

Themistakeonallsidesistotreat theRBIGovernorasjustanotherbureaucrat.If theGovernortakesthismistakenview,heendsupbeingsubservienttothecentralandstategovernments,andnotoffering an independent technocratic perspective that could keep the nation from straying intoeconomic distress. The RBI Governor has to understand his role, and know it occasionally entailswarningofmacroeconomicrisksfromgovernmentactionsorsaying‘No!’firmly.

Every government tests what the RBIGovernorwill acquiesce to, and ideally, it will not pushbeyond a point, knowing that the RBI’s cautions are worth heeding. If the government takes themistakenviewthattheRBIGovernorisjustanotherbureaucrat,itwillbedispleasedwhenitseestheGovernordeviatingfromtheusuallydeferentialbehaviourofbureaucrats,anditwillstrivetocuthimdowntosize.Thisdoesnotservethecountryeither.

Iwasdeterminednottoneglectmyresponsibilitiesasnationalriskmanager,evenwhiletryingtoexplaintothegovernmentofthedaywhythiswasanecessaryrole.WhereIhaddirectresponsibility,this meant saying no in private occasionally, even while offering safer alternatives for what thegovernment intended. Where I had indirect responsibility, this meant advising or counselling inprivate,andoccasionally,whentheissuemeritedanationaldebate,speakinginpublic.Ofcourse,mypastexperienceasChiefEconomistoftheInternationalMonetaryFund,wheremyjobwastoidentifymacroeconomic risksacrossavarietyofcountries,gavemeauniquecross-countryperspective,andheightenedmysenseofresponsibility.

I also felt this responsibility froma different source.Because of the relentless press attention, Irealized thatmany young peoplewhowere looking for a rolemodel now saw theGovernor of theReserve Bank as one they wanted to learn from and imitate. I felt I had to display the highestprofessionalintegrity,overandabovetheobviouslynecessarypersonalintegrity,ifIweretodischargemyresponsibilitytotheseyouth.

I

WhiletheGovernorhastowarnaboutriskswherenecessary,heisnotanagentfortheopposition.Hecontinuestobeanessentialpartofthecountry’sadministration,andhisobjectiveshavetobethebroadergovernmentobjectivesofsustainablegrowthanddevelopment.Thedangerinacountrythatisunusedtolegitimatewordsofcaution,andapressthatisaccustomedtodeferencefrombureaucrats,isthatitmaymisinterpretthisrole.AnewnarrativemayformaroundtheGovernor.Hecancometobeseenbythepressandsocialmediaasacritic,andeveryspeechorcommentofhisisthenscrutinizedfor evidence that supports the narrative. Should the Governor disappear from public view and notspeakforfearofmisinterpretation,orshouldhetaketheriskinordertodischargehisresponsibilities?Ichosethelatter,inpartbecauseIthoughtitwasextremelyimportantthatourcountryshouldsteerastable path when surrounded by so much global risk, and in part because I thought young people(includingmyownyoungerstaffattheRBI)shouldrealizethatitisimportanttospeakupwhenone’sresponsibilitiesdemandit.Idid,however,meetregularlywiththegovernmenttosharemyviewsandlistentoitspointofview,andalwaysleftfeelingthattherewasmutualunderstanding.

Given my risk manager’s perspective, and given that we were recovering from the currencyturmoil,inmyfirstspeechontheeconomyItriedtotalkupwhatwasgoingoninIndia.However,Ialsohadtorespect thedharmaof thecentralbanker,andnot indulgeinexcessivehype.Indeed, thisswing from excessive euphoria to excessive pessimism and back was the subject of my speech atHarvardBusinessSchoolinOctober2013.

FilteringOuttheRealIndia

ndian cricket fans aremanic-depressive in their treatment of their favouriteteams.Theyelevateplayerstogod-likestatuswhentheirteamperformswell,

ignoring obviousweaknesses; butwhen it loses, as any teammust, the fall isequallysteepandeveryweaknessisdissected.Infact,theteamisneverasgoodasfansmakeitouttobewhenitwins,norasbadasitismadeouttobewhenitloses.Itsweaknessesexistedinvictory,too,butwereoverlooked.

SuchbipolarbehaviourseemstoapplytoassessmentsofIndia’seconomyaswell, with foreign analysts joining Indians in similar swings between over-exuberance and self-flagellation. A few years ago, India could do no wrong.Commentators talkedof ‘Chindia’, elevating India’s performance to that of itsnorthernneighbour.Today,Indiacandonoright.

Indiadoeshaveitsproblems.AnnualGDPgrowthslowedsignificantlyinthelastquarterto4.4percent,inflationishigh,andthecurrentaccountandbudgetdeficits last year were too large. Every commentator today highlights India’spoor infrastructure, excessive regulation, small manufacturing sector, and a

workforcewithinadequateeducationandskills.These are indeed deficiencies, and they must be fixed if India is to grow

stronglyandstably.But thesamedeficienciesexistedwhenIndiawasgrowingfast.Tounderstandwhatneedstobedoneintheshortrun,wemustunderstandwhatdampenedtheIndiansuccessstory.

In part, India’s slowdown paradoxically reflects the substantial fiscal andmonetary stimulus that its policy makers, like those in all major emergingmarkets,injectedintoitseconomyintheaftermathofthe2008financialcrisis.Theresultinggrowthspurtledtoinflation,especiallybecausetheworlddidnotslide into a second Great Depression, as was originally feared. So monetarypolicy has had to be tight, with high interest rates contributing to slowinginvestmentandconsumption.

Moreover,India’sinstitutionsforacquiringland,allocatingnaturalresources,andgrantingclearanceswereoverwhelmedduringtheperiodofstronggrowth.Strong growth increased the scarcity and value of resources such as land ormineralwealth.Totheextent that thesewerecheapinthepast, therewaslittlereward to misallocating them. Growth, however, increased the rents tocorruption.

Similarly, industrialdevelopmentledtogrowingencroachmentonfarmlandand forests and the displacement of farmers and tribals. India is a developingcountry with a civil society possessed of first-world sensibilities. Protestsorganized by politicians and activists led to new environmental laws and landacquisitionlawsthataimtomakedevelopmentsustainable.Overtime,Indiawilllearntostreamlinethenewlawstomakethemmorefunctional,butintheshortrun a side effect has been more bureaucratic impediments to investment. Sogrowth, as well as the reaction to that unbridled growth, created a greaterpossibilityofcorruption.

Fortunately,avibrantdemocracylikeIndiahasitsownchecksandbalances.India’sinvestigativeagencies,judiciary,andpressstartedexaminingallegationsoflarge-scalecorruption.Theunfortunatesideeffectastheclean-upproceededwasthatbureaucraticdecisionmakingbecamemoreriskaverse,andmanylargeprojectscametoagrindinghalt.

Onlynow,asthegovernmentcreatesnewinstitutionstoacceleratedecisionmakingandimplementtransparentprocesses,aretheseprojectsbeingclearedtoproceed.Oncerestarted, itwill taketimefor theseprojects tobecompleted,atwhichpointoutputgrowthwillincreasesignificantly.

The combination of excessive (with the benefit of hindsight) post-crisisstimulusandstallinglargeprojectshadotherconsequencessuchashighinternaland external deficits. The post-crisis fiscal-stimulus packages sent thegovernmentbudgetdeficitsoaringfromwhathadbeenaveryresponsiblelevelin2007-08ofaround2.5percenttoover6percent.Similarly,aslargeminingprojects stalled, India had to resort to higher imports of coal and scrap iron,whileitsexportsofironoredwindled.

An increase in gold imports placed further pressure on the current accountbalance.Newly rich consumers in rural areas increasingly put their savings ingold, a familiar store of value,whilewealthyurban consumers,worried aboutinflation,also turned tobuyinggold. Ironically,had theyboughtAppleshares,rather than a commodity (nomatter how fungible, liquid, and investible it is),theirpurchaseswouldhavebeen treatedasa foreign investment rather thanasaddingtotheexternaldeficit.

Forthemostpart,India’scurrentgrowthslowdownanditsfiscalandcurrentaccount deficits are not structural problems. They are all fixable bymeans ofmodest reforms.This isnot tosay thatambitiousreformisnotgood,or isnotwarranted to sustain growth for the next decade. But India does not need tobecomeamanufacturinggiantovernighttofixitscurrentproblems.

Theimmediatetasksaremoremundane,butalsomorefeasibleones:clearingprojects, reducing poorly targeted subsidies, and findingmoreways to narrowthe current account deficit and ease its financing. Over the last year, thegovernmenthasbeenpursuingthisagenda,whichisalreadyshowingsomeearlyresults. For example, the external deficit is narrowing sharply on the back ofhigherexportsandlowerimports.ThegovernmentandtheReserveBanksaiditwouldbe$70billionthisfiscalyear,downfrom$88billionlastfiscalyear,butrecentdatasuggestsitcouldbelowerstill.

This leads me to another point. Because analysts keep looking for major

structural reforms to fix the deeper economic challenges, they ignore smallersteps or dismiss them as ‘band aids’. But strategically placed small steps –strategicincrementalismforwantofabetterterm–takentogethercandealwiththeimmediateproblems,thusbuyingtimeandeconomicandpoliticalspaceforthemajorstructuralreforms.

Putdifferently,when theIndianauthoritiessaid theywouldbring thefiscaldeficitbelow5.3percentlastyear,noonebelievedthem.Thefinaloutturnwas4.9percent.Similarly,whileweprojecttheCADtocomedownto3.7percentthisyear, I thinkwecouldbepleasantlysurprised.Notall theactionswehavetakenarepretty,andnotallaresustainable,buttheyhavedonethejob.

Indeed, despite its shortcomings, India’sGDPwill probablygrowby5-5.5percentthisyear–notgreat,butcertainlynotbadforwhatislikelytobealowpoint in economic performance. The monsoon has been good and will spurconsumption, especially in rural areas, which are already growing strongly,owingtoimprovementsinroadtransportandcommunicationsconnectivity.

The banking sector has undoubtedly experienced an increase in bad loans,often owing to investment projects that are not unviable but only delayed.Asthese projects come onstream, theywill generate the revenue needed to repayloans.India’sbankshavethecapitaltoabsorblossesinthemeantime.

Likewise, India’s finances are stronger than in the typical emerging-marketcountry, let alone an emerging-market country in crisis. India’s overall publicdebt/GDPratiohasbeenonadecliningtrend,from73.2percentin2006-07to66percentin2012-13(andthecentralgovernment’sdebt/GDPratioisonly46per cent). Moreover, the debt is denominated in rupees and has an averagematurityofmorethannineyears.

India’sexternaldebtburdenisevenmorefavourable,atonly21.2percentofGDP(muchof itowedbytheprivatesector),whileshort-termexternaldebt isonly5.2percentofGDP.India’sforeign-exchangereservesstandat$278billion(about15percentofGDP),enoughtofinancetheentirecurrentaccountdeficitfor several years. Even if you count all of trade credit as well as maturingdeposits held by overseas Indians as short-term debt, India’s reserves can paythemalldownandstillhavemoneyleftover.

That said, India can do better – much better. The path to a more open,competitive,efficient,andhumaneeconomywillsurelybebumpyintheyearstocome.But,intheshortterm,thereismuchlow-hangingfruittobeplucked.

For instance, we are committed to developing our financial system, andcarefullyexpandingaccesstofinancecanbeasourceoftremendousgrowthinthe years to come.We are also embarked on large infrastructure projects. Forexample, the Delhi-Mumbai Industrial Corridor, a project with Japanesecollaboration entailing over $90 billion in investment, will link Delhi toMumbai’sports,coveringanoveralllengthof1,483kmandpassingthroughsixstates.This projectwill have ninemega industrial zones of about 200-250 sq.km.,highspeedfreightlines,threeports,sixairports,asix-laneintersection-freeexpresswayconnectingthecountry’spoliticalandfinancialcapitals,anda4,000MWpowerplant.WehavealreadyseenasignificantboosttoeconomicactivityasIndiabuiltouttheGoldenQuadrilateralhighwaysystem,theboostfromtheDelhi-MumbaiIndustrialCorridorcanonlybeimagined.ThebestofIndiaisyettocome.

Back to thecricketinganalogy, India isanopenargumentativesociety.Butwearepronetomoodswings,perhapsmoresothanothersocieties,perhapsinpart driven by our excitable, competitive and very young press. Stripping outboththeeuphoriaandthedespairfromwhatissaidaboutIndia–andfromwhatweIndianssayaboutourselves–willprobablybringusclosertothetruth.

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II

Wewere impartial in advising all governments about the virtues ofmacroeconomic stability. In theGadgilLecturegivenon13February2014,IgavetheUPAgovernment,whichwasgoingtopresentitslastbudget, theusualRBIcautiononmaintainingfiscaldiscipline,includingurgingit toaddressthevexingissueofoilsubsidies.IofferedsimilaradvicetotheNDAgovernmentalso.

MacroeconomicAdvice

et me offer a quick recap of the macroeconomic situation. Growth isstabilizingon thebackofagoodharvest, strengtheningexports,andsome

earlysignsofresumptionoflargestalledprojects.However,growthisstillveryweak. We have to work to ensure macroeconomic stability, which meansstrengthening growth, especially through investment, maintaining a moderatecurrent account deficit, achieving a fiscal deficit consistent with thegovernment’sfiscalroadmap,andreducinginflation.Thegovernmenthastobecommendedfor itsefforts torevivegrowth,narrowthecurrentaccountdeficit,andmeetfiscaltargets.Ihavenodoubtthatthefiscaldeficitfor2013-14willbecloseto,orbelow,thefinanceminister’sredline.

Going forward, however, we need to continue on the path of fiscalconsolidation constantly improving the sustainability and quality of fiscaladjustment. It is very important that we spend money on needed publicinvestment,evenwhilereducingmisdirectedsubsidiesandentitlements.

Good fiscal control will help us in our fight against inflation. So willmoderation in agricultural support price inflation,whichwill ensure that thesepricesonlyprovideabaselinelevelofsupportwhenthefarmeris indifficulty,without displacing market prices. Accurate market prices, together with gooddisseminationof data on sowingpatterns, cando a far better job than supportprices in directing agricultural production to where it is most valuable andneeded.

Somewhatparadoxically,raisingenergypricestomarketlevelswillalsoleadto lower inflation over the medium term, the horizon over which the RBI is

tryingtocontaininflation.Thereasonisthathigherpriceswillreduceexcessiveconsumption,reducesubsidiesandfiscaldeficits,andincentivizeinvestmentandcompetition, even while allowing prices to be determined by an increasinglystable and plentifully supplied globalmarket for energy. The consequences ofinappropriateorinadequatepriceadjustmentswillbethattheReserveBankwillhavetobearmoreoftheburdenincombatinginflation.

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III

I receivednumerous invitations tospeak, themajorityofwhichI turneddown.But Icouldnot turndowneveryrequest,andgaveaspeechonaverageonceamonth–laterIrealizedthiswasnotdifferentfrom the frequency with which the Fed Chairman spoke in public. In India, however, the 24x7channels,hungryfornews,ensuredthatnospeechwentuncovered,nomatterhowminortheoccasionor remote the location.Givenpresspresence, I couldnot repeat speeches (the less therewasanewmessage to report, the more likely the press might ‘make’ news by latching on to somethingperipheral),norcould Ispeakonmonetarypolicyor financialsector reforms ineveryspeech.Whatbetterwaytospeakonsomethingdifferentthantogobacktomyresearchonthepoliticaleconomyofreformsandgrowth,especiallyifitcouldcontributetothepublicdebateaswellastheRBI’smission?IntheLalitDoshiMemorialLectureinAugust2014,IlinkedtheenvironmentwelivedininIndiatotheneedforfurtheringoureffortsonfinancialinclusion.

FinanceandOpportunityinIndia

eareapproachingthe67thanniversaryofourIndependence.Sixty-sevenyears is a long time in the life ofman– indeed, it is about the average

Indian’s lifeexpectancytoday.Sincelifeexpectancywasshorterat thetimeofIndependence,itissafetosaythatmostIndiansbornjustafterIndependencearenownomore.Itisusefultotakestockatsuchatime.Didweachievethedreamsofourfoundingfathersforfreedom’sfirstchildren?Orhavewefallenwoefullyshort?Whatmoredoweneedtodo?

Clearly,ourfoundingfatherswantedpoliticalfreedomforthepeopleofIndia– freedom todeterminewhowewouldbegovernedby, aswell as freedomofthought,expression,belief,faith,andworship.Theywantedjusticeandequality,ofstatusandopportunity.Andtheywantedustobefreefrompoverty.

We have made substantial progress in achieving political freedom. Ourdemocracy has matured, with people confidently choosing to vote outgovernments that lose touch with their needs. Our institutions protecting thefreedom to vote have grown stronger, with the Election Commission and theforcesof lawandorder ensuring free and largely fair elections throughout thecountry. Political parties, NGOs, the press, and individuals exert checks and

balancesonpublicpolicy.Andthejudiciaryhastakenimportantstepstoprotectindividualfreedom.

Oureconomyisalsofarricher thanitwasat the timeof independenceandpoverty has come down substantially. Of course, some countries like SouthKorea that were in a similar situation then are far better off today but manyothers have done far worse. Indeed, one of the advantages of a vibrantdemocracy is that it gives people an eject button which prevents governancefrom getting too bad. Democracy has probably ensured more stable andequitableeconomicgrowththananauthoritarianregimemighthave.

Yet a dispassionate view of both our democracy and our economy wouldsuggestsomeconcerns.Evenasourdemocracyandoureconomyhavebecomemore vibrant, an important issue in the recent election was whether we hadsubstitutedthecronysocialismofthepastwithcronycapitalism,wheretherichand the influential are alleged to have received land, natural resources andspectruminreturnforpayoffs tovenalpoliticians.Bykilling transparencyandcompetition, crony capitalism is harmful to free enterprise, opportunity, andeconomicgrowth.Andbysubstitutingspecialinterestsforthepublicinterest,itisharmfultodemocraticexpression.Ifthereissometruthtotheseperceptionsofcronycapitalism,anaturalquestioniswhypeopletolerateit.Whydotheyvoteforthevenalpoliticianwhoperpetuatesit?

AHYPOTHESISONTHEPERSISTENCEOFCRONYCAPITALISM

Onewidelyheldhypothesisisthatourcountrysuffersfromwantofa‘fewgoodmen’ inpolitics.Thisviewisunfair to themanyupstandingpeople inpolitics.Butevenassuming it is true,everysooftenwesee theemergenceofagroup,usually upper-middle-class professionals, who want to clean up politics. Butwhen these ‘good’ people stand for election, they tend to lose their deposits.Doestheelectoratereallynotwantsqueakycleangovernment?

Apartfromtheconceitthathighmoralslieonlywiththeuppermiddleclass,the error in this hypothesis may be in believing that problems stem fromindividualethicsratherthanthesystemwehave.InaspeechImadebeforetheBombay Chamber of Commerce in 2008, I argued that the tolerance for the

venal politician is because he is the crutch that helps the poor andunderprivilegednavigateasystemthatgivesthemsolittleaccess(thisideawasinspiredbyRichardHofstadter’sseminalbookTheAgeofReform).

Letmeexplain.Ourprovisionofpublicgoodsisunfortunatelybiasedagainstaccessbythepoor.Inanumberofstates,rationshopsdonotsupplywhatisdue,even ifonehasa rationcard–and toomanyamongst thepoordonothavearationcardoraBelowPovertyLinecard;teachersdonotshowupatschoolstoteach; the police do not register crimes, or encroachments, especially ifcommittedbytherichandpowerful;publichospitalsarenotadequatelystaffedandostensiblyfreemedicinesarenotavailableatthedispensary;…Icangoon,butyouknowtheall-too-familiarpicture.

Thisiswherethecrookedbutsavvypoliticianfitsin.Whilethepoordonothavethemoneyto‘purchase’publicservicesthataretheirright,theyhaveavotethatthepoliticianwants.Thepoliticiandoesalittlebittomakelifealittlemoretolerable for his poor constituents – a government job here, an FIR registeredthere,alandrighthonouredsomewhereelse.Forthis,hegetsthegratitudeofhisvoters,andmoreimportant,theirvote.

Ofcourse,therearemanypoliticianswhoarehonestandgenuinelywanttoimprove the lot of their voters. But perhaps the system tolerates corruptionbecause the street-smart politician is better at making the wheels of thebureaucracy creak, however slowly, in favour of his constituents. And such asystemisself-sustaining.Anidealistwhoisunwillingto‘work’thesystemcanpromise to reform it, but the voters know there is little one person can do.Moreover, who will provide the patronage while the idealist is fighting thesystem?Sowhynotstaywiththefixeryouknowevenifitmeansthereformistloseshisdeposit?

So the circle is complete. The poor and the underprivileged need thepoliticiantohelpthemgetjobsandpublicservices.Thecrookedpoliticianneedsthebusinessmantoprovidethefundsthatallowhimtosupplypatronagetothepoorandfightelections.Thecorruptbusinessmanneeds thecrookedpoliticiantogetpublicresourcesandcontractscheaply.Andthepoliticianneedsthevotesofthepoorandtheunderprivileged.Everyconstituencyistiedtotheotherina

cycleofdependence,whichensuresthatthestatusquoprevails.Well-meaningpoliticalleadersandgovernmentshavetried,andaretrying,to

breakthisviciouscycle.Howdowegetmorepoliticianstomovefrom‘fixing’thesystemtoreformingthesystem?Theobviousansweristoeitherimprovethequality of public services or reduce the public’s dependence on them. Bothapproachesarenecessary.

But thenhowdoesone improve thequalityofpublic services?The typicalanswerhasbeentoincreasetheresourcesdevotedtotheservice,andtochangehowitismanaged.Anumberofworthwhileeffortsareunderwaytoimprovethequality of public education and health care. But if resources leak or publicservants are notmotivated,which is likely in theworst-governed states, theseinterventionsarenotveryeffective.

Somehavearguedthatmakingapublicservicearightcanchangedelivery.Itishardtoimaginethatsimplylegislatingrightsandcreatingapublicexpectationofdeliverywill,infact,ensuredelivery.Afterall,istherenotanexpectationthata ration card holderwill get decent grain from the fair price shop, yet all toofrequentlygrainisnotavailableorisofpoorquality.

Information decentralization can help. Knowing how many medicines thelocalpublicdispensaryreceived,orhowmuchmoneythelocalschoolisgettingfor mid-day meals, can help the public monitor delivery and alert higher-upswhen the benefits are not delivered.But the public delivery system is usuallymost apathetic where the public is poorly educated, of low social status, anddisorganized,somonitoringbythepoorisalsounlikelytobeeffective.

Some argue that this iswhy themiddle class should enjoy public benefitsalongwiththepoor,sothattheformercanprotestagainstpoordelivery,whichwillensurehighqualityforall.Butmakingbenefitsuniversaliscostly,andmaystill lead to indifferent delivery for the poor. The middle class may live indifferentareas from thepoor. Indeed,evenwhen located in the samearea, thepoormay not even patronize facilities frequented by themiddle class becausetheyfeeloutofplace.Andevenwhenallpatronizethesamefacility,providersmay still be able to discriminate between the voluble middle class and theuncomplainingpoor.

So if more resources or better management are inadequate answers, whatmightwork?Theanswermaypartlylieinreducingthepublic’sdependenceongovernment-provided jobs or public services. A good private sector job, forexample,maygiveahouseholdthemoneytogetprivatehealthcare,education,andsupplies,andreducetheirneedforpublicservices.Incomecouldincreaseanindividual’sstatusandincreasetherespecttheyareaccordedbytheteacher,thepolicemanorthebureaucrat.

Buthowdoesapoormangetagoodjobifhehasnotbenefitedfromgoodhealthcareandeducation in the firstplace? In thismodernworldwheregoodskills arecritical toagood job, theunskilledhave little recoursebut to takeapoorlypayingjobortolookforthepatronagethatwillgetthemagoodjob.Sodo we not arrive at a contradiction: the good delivery of public services isessentialtoescapethedependenceonbadpublicservices?

MONEYLIBERATESANDEMPOWERS…

We need to go back to the drawing board. There is a way out of thiscontradiction,developingtheideathatmoneyliberates.Couldwenotgivepoorhouseholds cash insteadofpromising thempublic services?Apoorhouseholdwith cash can patronize whomsoever it wants, and not just the monopolisticgovernmentprovider.Becausethepoorcanpayfortheirmedicinesortheirfood,theywillcommandrespectfromtheprivateprovider.Notonlywillacorruptfairpriceshopownernotbeable todivert thegrainhegets sincehehas tosellatmarketprice,butbecausehehastocompetewiththeshopacrossthestreet,hecannot afford to be surly or lazy. The government can add to the effects ofempowering thepoorby instilling agenuine cost tobeinguncompetitive–byshuttingdownpartsofthepublicdeliverysystemsthatdonotgenerateenoughcustom.

Muchofwhatweneedtodoisalreadypossible.ThegovernmentintendstoannounceaschemeforfullfinancialinclusiononIndependenceDay.Itincludesidentifying the poor, creating unique biometric identifiers for them, openinglinked bank accounts, and making government transfers into those accounts.Whenfully rolledout, Ibelieve itwillgive thepoor thechoiceandrespectas

wellastheservicestheyhadtobegforinthepast.Itcanbreakalinkbetweenpoorpublicservice,patronage,andcorruptionthat isgrowingmoreworrisomeovertime.

Undoubtedly, cash transfers will not resolve every problem, nor are theyuncontroversial.Aconstant refrain frompaternalistic socialworkers is that thepoorwill simply drink away any transfers. In fact, studies byNGOs like SelfEmployedWomen’sAssociation indicate this is not true.Moreover, one couldexperimentwithsendingtransferstowomen,whomaybebetterspenders.Somearguethatattachingconditionstocashtransfers–forexample,theywillbemadeprovided the recipient’s children attend school regularly – may improve theusageofthecash.Thedangerofattachingconditionalityisthatifthemonitoriscorrupt or inefficient, the whole process of direct benefits transfers can bevitiated. Nevertheless, it will be useful to monitor usage carefully whereautomation ispossible, andautomatically attach furtherbenefits to responsibleusage.

Arelatedconcerniswhethercashtransferswillbecomeaddictive–whethertheybecomemillstoneskeepingthepoorinpovertyratherthansteppingstonesoutofit.Thisisanimportantconcern.Cashtransfersworkbestwhentheybuildcapabilities through education and health care, thus expanding opportunity,rather than when they are used solely for inessential consumption. The vastmajorityamongstthepoorwillseizeopportunities,especiallyfortheirchildren,withbothhands.Nevertheless,ifthereisevidencethatcashtransfersarebeingmisspent–andweshouldletdataratherthanpreconceivednotionsdrivepolicy– some portion could be given in the form of electronic coupons that can bespent by the specified recipient only on food, education or health care.Eventually, we will have to find a way to wean those who start earningsignificant amounts from receiving such transfers. How to do this withoutproviding disincentives to working and earning is a future problem born ofsuccesswhichisbestleftforanotherday.TheUnitedStateshasdealtwiththedisincentive effects of getting off welfare with programmes like the earnedincometaxcredit.

Anothersetofconcernshastodowithwhetherprivateproviderswillbother

toprovideservices inremoteareas.Clearly, ifpeople inremoteareashavethecash to buy, private providerswill find theirway there. Indeed, a particularlydesirableoutcomewillbeifsomeofthepoorfindworkprovidingservicesthathitherto used to beprovidedbypublic servants.Moreover, implementing cashtransfersdoesnotmeandismantlingthesystemofpublicdeliverywhereveritiseffective–itonlymeansthatthepoorwillpaywhentheyusethepublicservice.

Thebroader takeawayis thatfinancial inclusionanddirectbenefits transfercanbeawayofliberatingthepoorfromdependencyonindifferentlydeliveredpublicservices,and thus indirectly fromthevenalbuteffectivepolitician. It isnot a cure-all butwill help the poor out of poverty and towards true politicalindependence.But financial inclusion candomore; by liberating thepoor andthemarginalizedfromtheclutchesofthemoneylender,byprovidingcreditandadvice to the entrepreneurial amongst the poor, and by giving households theability to save and insure against accidents, it can set them on the road toeconomic independence, thus strengthening the political freedom that goodpublicserviceswillbring.Thisiswhyfinancialinclusionissoimportant.

FIVEPsOFFINANCIALINCLUSION

Letmeendwithavisionofhow theRBIcan speedupandenhance financialinclusionofthekindIhavejustoutlined.Financialinclusioninmyviewisaboutgettingfivethingsright:Product,Place,Price,Protection,andProfit.

Ifweare todraw in thepoor,weneedProducts thataddress theirneeds;asafe place to save, a reliableway to send and receivemoney, a quickway toborrowin timesofneedor toescapetheclutchesof themoneylender,easy-to-understandaccident,lifeandhealthinsurance,andanavenuetoengageinsavingforoldage.Simplicityandreliabilityarekey–whatonethinksoneispayingforiswhatone shouldget,withouthiddenclausesoropt-outs to triponeup.TheRBI is going to nudge banks to offer a basic suite of Products to addressfinancialneeds.

TwootherattributesofProductsareveryimportant.Theyshouldbeeasytoaccessatlowtransactionscost.Inthepast,thismeantthatthePlaceofdelivery,thatisthebankbranch,hadtobeclosetothecustomer.Soakeyelementofthe

inclusionprogrammeswastoexpandbankbranchinginunbankedareas.Today,withvariousothermeansofreachingthecustomersuchasthemobilephoneorthebusinesscorrespondent,wecanbemoreagnosticaboutthemeansbywhichthecustomer is reached. Inotherwords, ‘Place’ todayneednotmeanphysicalproximity, it can mean electronic proximity, or proximity via correspondents.Towards this end, we have liberalized the regulations on bank businesscorrespondents,encouragedbanksandmobilecompaniestoformalliances,andstartedtheprocessoflicensingpaymentbanks.

The transactions costs of obtaining the Product, including the Price theintermediary charges, should be low. Since every unbanked individual likelyconsumes lowvolumesoffinancialservices tobeginwith, theprovidershouldautomatetransactionsasfaraspossibletoreducecosts,anduseemployeesthatare local and are commensurately paid. Furthermore, any regulatory burdenshould be minimal. With these objectives in mind, the RBI has started theprocessof licensingsmall localbanks,andisre-examiningKYCnormswithaviewtosimplifyingthem.Lastmonth,weremovedamajorhurdleinthewayofmigrant workers and people living in makeshift structures obtaining a bankaccount,thatofprovidingproofofcurrentaddress.

New and inexperienced customers will require Protection. The RBI isbeefing up the Consumer Protection Code, emphasizing the need for suitableproducts thataresimpleandeasy tounderstand.Wearealsoworkingwith thegovernmentonexpandingfinancialliteracy.Teachingthepoortheintricaciesoffinancehastomovebeyondliteracycampsandintoschools.Banksthatlendtothe entrepreneurial poor should find ways to advise them on businessmanagement too, or find ways to engage NGOs and organizations likeNABARD in the process. We are also strengthening the customer grievance-redressalmechanism,whilelookingtoexpandsupervision,marketintelligence,andcoordinationwith lawandorder to reduce theproliferationof fly-by-nightoperators.

Finally, while mandated targets are useful in indicating ambition (andallowing banks to anticipate a large enough scale so as tomake investments),financialinclusioncannotbeachievedwithoutitbeingProfitable.SothelastPis

that there should be profits at the bottom of the pyramid. For instance, thegovernment should be willing to pay reasonable commissions punctually forbenefits transfers, and bankers should be able to charge reasonable andtransparentfeesorinterestratesforofferingservicestothepoor.

Letme conclude.One of the greatest dangers to the growth of developingcountries is themiddleincometrap,wherecronycapitalismcreatesoligarchiesthatslowdowngrowth.Ifthedebateduringtheelectionsisanypointer,thisisavery real concern of the public in India today. To avoid this trap, and tostrengthentheindependentdemocracyourleaderswonforussixty-sevenyearsago,wehavetoimprovepublicservices,especiallythosetargetedatthepoor.Akeymechanismtoimprovetheseservicesisthroughfinancialinclusion,whichisgoing to be an important part of the government and the RBI’s plans in thecomingyears.Ihopemanyofyouinthisaudiencewilljoininensuringwearesuccessful.Thankyou.

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IV

IwasinvitedbytheChiefMinisterofGoatospeakattheD.D.KosambiIdeasFestivalinGoaon20February2015.Sincethiswasan‘Ideas’festivalinhonourofthegreatpolymath,Ireachedintomyresearch interests and a broader analysis of political economy to, once again, make the case forfinancialinclusion.

Democracy,Inclusion,andProsperity

hankyouforinvitingmetothisFestivalofIdeas.Sincethisfestivalisaboutideas,IamnotgoingtotaxyouwiththeReserveBank’sviewsonmonetary

policy,whichare,bynow,wellknown.Instead,IwanttotalkaboutsomethingIhave been studying for many years, the development of a liberal marketdemocracy.Indoingthis,Iwillwearmyhatasaprofessorinthefieldknownaspoliticaleconomy,anddiscardmyRBIhatforthetimebeing.Ifyoucamehereexpectingmore insights on thepathof interest rates, as I expectmanyof youdid,letmeapologizefordisappointingyou.

Mystartingpointisthetruismthatpeoplewanttoliveinasafeprosperouscountrywhere they enjoy freedom of thought and action, andwhere they canexercise their democratic rights to choose their government. But how docountries ensure political freedom and economic prosperity?Why do the twoseem to go together? And what more, if anything, does India have to do toensure it has these necessary underpinnings for prosperity and continuedpolitical freedom? These are enormously important questions, but given theirnature,theywillnotbesettledinonespeech.Thinkofmytalktoday,therefore,asacontributiontothedebate.

FUKUYAMA’STHREEPILLARSOFALIBERALDEMOCRATICSTATE

In his magisterial two-volume analysis of the emergence of political systemsaroundtheworld(TheOriginsofPoliticalOrder:FromPre-HumanTimestotheFrench Revolution, 2011; and Political Order and Political Decay: From theIndustrial Revolution to the Globalization of Democracy, 2014), political

scientistFrancisFukuyamabuildsontheworkofhismentor,SamuelHuntington(PoliticalOrderinChangingSocieties,1968),toarguethatliberaldemocracies,whichseemtobebestatfosteringpoliticalfreedomsandeconomicsuccess,tendtohavethreeimportantpillars:astronggovernment,ruleoflaw,anddemocraticaccountability. I propose in this talk to start by summarizing my (necessarilyimprecise) reading of Fukuyama’s ideas to you. Iwould urge you to read thebooks toget their full richness. Iwill thengoon toargue thathe leavesoutafourth pillar, freemarkets, which are essential tomake the liberal democracyprosperous. Iwillwarn that these pillars areweakening in industrial countriesbecauseofrisinginequalityofopportunity,andendwithlessonsforIndia.

ConsiderFukuyama’sthreepillarsingreaterdetail.Stronggovernmentdoesnotmeanonethatisonlymilitarilypowerfulorusesitsintelligenceapparatustosniff out enemies of the state. Instead, a strong government is also one thatprovides an effective and fair administration through clean, motivated, andcompetentadministratorswhocandelivergoodgovernance.

Rule of lawmeans that government’s actions are constrained by what weIndians would term dharma – by a historical and widely understood code ofmoral and righteous behaviour, enforced by religious, cultural, or judicialauthority.

And democratic accountability means that the government has to bepopularlyaccepted,withthepeoplehavingtherighttothrowunpopular,corrupt,orincompetentrulersout.

Fukuyamamakesamoreinsightfulpointthansimplythatallthreetraditionalaspectsofthestate–executive,judiciary,andlegislature–areneededtobalanceone another. In sharp contrast to the radical libertarian view that the bestgovernmentistheminimal‘nightwatchman’,whichprimarilyprotectslifeandproperty rightswhile enforcing contracts, or the radicalMarxist view that theneed for the government disappears as class conflict ends, Fukuyama, as didHuntington, emphasizes the importance of a strong government in even adevelopedcountry.

Nomatterhowthuggishorarbitrarythegovernmentinatin-potdictatorship,these are weak governments, not strong ones. Their military or police can

terrorizetheunarmedcitizenrybutcannotprovidedecentlawandorderorstandup to a determined armed opposition. Their administration cannot providesensible economic policy, good schools or clean drinking water. Stronggovernmentsneedtobepeopledbythosewhocanprovideneededpublicgoods– they requireexpertise,motivation,and integrity.Realizing the importanceofstrong government, developing countries constantly request multilateralinstitutionsforhelpinenhancingtheirgovernancecapacity.

Strong governmentsmay not, however, move in the right direction. HitlerprovidedGermanywith extremely effective administration – the trains ran ontime,asdidthetrainsduringourownEmergencyin1975-77.Hiswasastronggovernment,butHitlertookGermanyefficientlyanddeterminedlyonapathtoruin,overridingtheruleoflawanddispensingwithelections.Itisnotsufficientthat the trainsrunontime, theyhavetogoin therightdirectionat thedesiredtime. The physical rail network guiding the trains could be thought of asanalogoustoruleoflaw,whiletheprocessbywhichconsensusisbuiltaroundthetrainschedulecouldbethoughtofasdemocraticaccountability.

Butwhydoweneedbothruleoflawanddemocraticaccountabilitytokeepstrong government on the right path?Would democratic accountability not beenoughtoconstrainadictatorialgovernment?Perhapsnot!Hitlerwaselectedtopower,anduntilGermanystartedsufferingshortagesandreversalsinWorldWarII,enjoyedthesupportofthemajorityofthepeople.Theruleoflawisneededtopreventthetyrannyofthemajoritythatcanariseinademocracy,aswellastoensure that basic ‘rules of the game’ are preserved over time so that theenvironment is predictable, nomatter which government comes to power. Byensuringthatallcitizenshaveinalienablerightsandprotections,theruleoflawconstrainsthemajority’sbehaviourtowardstheminorities.Andbymaintainingapredictableeconomicenvironmentagainstpopulistdemocraticinstincts,theruleoflawensuresthatbusinessescaninvestsecurelytodayforthefuture.

What about asking the question the other way?Would rule of law not beenough?Probably not, especially in a vibrant developing society!Rule of lawprovidesabasicslow-changingcodeofconductthatcannotbeviolatedbyeithergovernment or the citizenry. But that, by itself, may not be sufficient to

accommodate the aspirations of new emerging groups or the consequences ofnew technologies or ideas. Democratic accountability ensures the governmentrespondstothewishesofthemassofthecitizenry,allowingemerginggroupstogaininfluencethroughpoliticalnegotiationandcompetitionwithothers.Evenifgroups cannot see their programmes translated into policy, democracy allowsthem to blow off steam non-violently. So both rule of law and democraticaccountabilitycheckandbalancestronggovernmentincomplementaryways.

WHEREDOTHESETHREEPILLARSCOMEFROM?

MuchofFukuyama’sworkisfocusedontracingthedevelopmentofeachpillarindifferentsocieties.Hesuggeststhatthenatureofstatesweseetodayislargelyexplainedbytheirhistoricalexperience.Forinstance,Chinahadlongperiodsofchaos,mostrecentlybeforetheCommunistscametopower;groupsengagedintotalwaragainstoneanother.Suchunbridledmilitarycompetitionmeantgroupshad to organize themselves as hierarchical military units, with rulers havingunlimited powers.When eventually a groupwas victorious over the others, itwasnaturalfor it to imposecentralizedautocraticrule toensure thatchaosdidnot re-emerge. To rule over the large geographic area of the country, Chinaneeded a well-developed elite bureaucracy – hence the mandarins, chosen byexam based on their learning. So China had strong unconstrained effectivegovernment whenever it was united, and Fukuyama argues, unlike WesternEurope or India, did not have strong alternative sources of power founded inreligionorculturetoimposeruleoflaw.

InWesternEurope,bycontrast,theChristianchurchimposedconstraintsonwhattherulercoulddo.Somilitarycompetition,coupledwithconstraintsontherulerimposedbycanonlaw,ledtotheemergenceofbothstronggovernmentandruleoflaw.

InIndia,heargues,thecastesystemledtodivisionoflabour,whichensuredthat entire populations could never be devoted totally to the war effort. Sothrough much of history, war was never as harsh, or military competitionbetween states as fierce, as in China. As a result, the historical pressure forIndian states to develop strong governments that intruded into every facet of

societywasmuted.At thesametime,however, thecodesof justbehaviourforrulersemanatingfromancientIndianscripturesservedtoconstrainanyarbitraryexercise of power by Indian rulers. India, therefore, had weaker government,constrainedfurtherbyruleoflaw.And,accordingtoFukuyama,thesedifferinghistories explain why government in China today is seen as effective butunrestrained, while government capacity in India is seen as weak, but Indiangovernmentsarerarelyautocratic.

Anyof thesegrandgeneralizationscan,andshould,bedebated.Fukuyamadoesnot claimhistory isdestiny,butdoes suggest avery strong influence.Ofcourse, the long influence of history and culture is less perceptible when itcomestodemocracywheresomecountrieslikeIndiahavetakentoitlikeaducktowater.Avibrant,accountabledemocracydoesnotonlyimplythatpeoplecasttheir vote freely every five years. It requires the full mix of a raucousinvestigative press, public debate uninhibited by political correctness, manypolitical parties representing varied constituencies, and a variety of non-governmental organizations organizing and representing interests. It willcontinuetobeasourceofacademicdebatewhyacountrylikeIndiahastakentodemocracy, while some of its neighbours with similar historical and culturalpastshavenot.

Iwillnotdwellonthis.Instead,IturntoadifferentquestionthatFukuyamadoesnotaddress.Clearly,stronggovernmentsareneededforcountries tohavethegovernancetoprosper.Equally,freemarketsunderpinprosperity.Butwhyisitthateveryrichcountryisalsoaliberaldemocracysubjecttoruleoflaw?

Iwillmaketwopointsinwhatfollows:First,freeenterpriseandthepoliticalfreedom emanating from democratic accountability and rule of law can bemutually reinforcing so a free enterprise system should be thought of as thefourth pillar underpinning liberalmarket democracies. Second, the bedrockonwhich all four pillars stand is a broadly equitable distribution of economiccapabilitiesamongthecitizenry.Thatbedrockisfissuringinindustrialcountries,whileithastobestrengthenedinemergingmarketslikeIndia.

FREEENTERPRISEANDPOLITICALFREEDOM

Whyarepoliticalfreedomsinacountry,ofwhichrepresentativedemocracyisacentralcomponent,andfreeenterprisemutuallysupportive?

There is, of course, one key similarity: both a vibrant democracy and avibrantfreeenterprisesystemseektocreatealevelplayingfieldwhichenhancescompetition. In the democratic arena, the political entrepreneur competeswithotherpoliticiansforthecitizen’svote,basedonhispastrecordandfuturepolicyagenda.Intheeconomicsphere,thepromotercompeteswithotherentrepreneursfortheconsumer’srupee,basedonthequalityoftheproducthesells.

But there is also at least one key difference.Democracy treats individualsequally, with every adult getting one vote. The free enterprise system, bycontrast,empowersconsumersbasedonhowmuchincometheygetandpropertytheyown.Whatthenpreventsthemedianvoter inademocracyfromvotingtodispossesstherichandsuccessful?Andwhydothelatternoterodethepoliticalrightsof theordinaryvoter.This fundamental tensionbetweendemocracyandfree enterprise appeared to be accentuated in the recent U.S. presidentialelections as PresidentBarackObama appealed tomiddle-class anger about itsstagnant economic prospects, while former Massachusetts governor MittRomney appealed to business people, disgruntled about higher taxes andexpandinghealthcaresubsidies.

Onereasonthatthemedianvoterrationallyagreestoprotectthepropertyofthe rich and to tax them moderately may be that she sees the rich as moreefficient managers of that property, and therefore as creators of jobs andprosperitythateveryonewillbenefitfrom.So,totheextentthattherichareself-made,andhavecomeoutwinnersinacompetitive,fair,andtransparentmarket,societymaybebetteroffallowingthemtoownandmanagetheirwealth,settlingin return for a reasonable shareof theirproduce as taxes.Themore,however,thattherichareseenasidleorcrooked–ashavingsimplyinheritedor,worse,gainedtheirwealthnefariously–themorethemedianvotershouldbewillingtovotefortoughregulationsandpunitivetaxesonthem.

Insomeemergingmarketstoday,forexample,propertyrightsoftherichdonotenjoywidespreadpopularsupportbecausesomanyofacountry’sfabulouslywealthy oligarchs are seen as having acquired their wealth through dubious

means. They grew rich because they managed the system, not because theymanaged their businesseswell.When the government goes after rich tycoons,fewvoices are raised in protest.And, as the richkowtow to the authorities toprotect their wealth, a strong check on official arbitrariness disappears. Thegovernmentisfreetobecomemoreautocratic.

Consider, in contrast, a competitive free-enterprise system with a levelplayingfieldforall.Suchasystemgenerallytendstopermitthemostefficienttoacquire wealth. The fairness of the competition improves perceptions oflegitimacy. Moreover, under conditions of fair competition, the process ofcreative destruction tends to pull down badly managed inherited wealth,replacing it with new and dynamic wealth. Great inequality, built up overgenerations,doesnotbecomeasourceofgreatpopularresentment.

Onthecontrary,everyonecandreamthatthey,too,willbecomeaBillGatesor a Nandan Nilekani. When such universal aspirations seem plausible, thesystem gains added democratic support. The rich, confident of popularlegitimacy, can then use the independence that accompanies wealth to limitarbitrary government, support rule of law, and protect democratic rights. Freeenterpriseanddemocracysustaineachother.

There are, therefore, deeper reasons for why democratic systems supportproperty rights and free enterprise than the cynical argument that votes andlegislators can be bought, and the capitalists have themoney. The cynics canonlyberightforawhile.Withoutpopularsupport,wealthisprotectedonlybyincreasinglycoercivemeasures.Ultimately, sucha system losesanyvestigeofeitherdemocracyorfreeenterprise.

THEBEDROCK:EQUITABLEDISTRIBUTIONOFECONOMICCAPABILITIES

There is, however, a growing concern across the industrial world. The freeenterprisesystemworkswellwhenparticipantsenterthecompetitivearenawithfundamentally equal chances of success. Given the subsequent level playingfield, the winner’s road to riches depends on greater effort, innovation, andoccasionally luck. But success is not pre-determined because no class ofparticipants has had a fundamentally different and superior preparation for the

competition. If, however, some group’s economic capabilities are sufficientlydifferentiated by preparation, the level playing field is no longer sufficient toequalizeapriorichancesofsuccess.Instead, thefreeenterprisesystemwillbeseenasdisproportionatelyfavouringthebetterprepared.Democracyisunlikelytosupportit,noraretherichandsuccessfulaslikelytosupportdemocracy.

Such a scenario is no longer unthinkable in a number of Westerndemocracies. Prosperity seems increasingly unreachable for many, because agoodeducation,whichseemstobetoday’spassporttoriches,isunaffordableformanyinthemiddleclass.Qualityhighereducationalinstitutionsaredominatedbythechildrenoftherich,notbecausetheyhaveunfairlyboughttheirwayin,but because they simply have been taught and supported better by expensiveschoolsandprivatetutors.Becausemiddleclassparentsdonothavetheabilityto give their children similar capabilities, they do not see the system as fair.Supportforthefreeenterprisesystemiseroding,aswitnessedbythepopularityofbookslikeThomasPikkety’sCapitalinthe21stCenturywhiletheinfluenceof illiberal parties on both the Left and Right who promise to suppresscompetition, finance,and trade is increasing.Themutual supportbetween freeenterpriseanddemocracyisgivingwaytoantagonism.

Moreover, as class differences create differentiated capabilities among thepublic, governments can either continue choosing themost capable applicantsfor positions but risk becoming unrepresentative of the classes, or they canchoose representativeness over ability, and risk eroding effectiveness. Neitherbiasednorineffectivegovernmentcanadministerwell.Sogovernmentcapacitymayalsobethreatened.

Thus, as the bedrock of equitable distribution of capabilities has starteddeveloping cracks in industrial countries, all four pillars supporting the liberalfree market democracy have also started swaying. This is, to my mind, anenormously important concern that will occupy states across theworld in theyearstocome.

LESSONSFORINDIA

Let me conclude with lessons for India. India inherited a kind of democracy

duringBritish rule and hasmade it thoroughly and vibrantly her own.Of thethree pillars that Fukuyama emphasizes, the strongest in India is thereforedemocraticaccountability.Indiaalsoadheresbroadlytotheruleof law.Wherearguablywemayhavealongwaytogo,asFukuyamahasemphasized,isinthecapacityofthegovernment(andbythisImeanregulatorsliketheRBIalso)todelivergovernanceandpublicservices.

Thisisnottosaythatwedonothaveareasofexcellencestrewnthroughoutcentral and state governments – whether it is the building of the New DelhiMetro,thereachofthepublicdistributionsysteminTamilNadu,orthespeedoftheroll-outofthePradhanMantriJanDhanYojana–butthatsuchcapabilitieshave to permeate every tehsil in every state. Moreover, in many areas ofgovernmentandregulation,astheeconomydevelops,weneedmorespecialists,with the domain knowledge and experience. For instance, well-trainedeconomistsareatapremium throughout thegovernment,and thereare far toofewIndianEconomicServiceofficerstogoaround.

An importantdifferencefromthehistoricalexperienceofothercountries isthatelsewherestronggovernmenthastypicallyemergedtherefirst,anditisthenrestrained by rule of law anddemocratic accountability. In India,wehave theopposite situation today, with strong institutions like the judiciary, oppositionparties, the free press, andNGOs,whose aim is to check government excess.However,necessarygovernmentfunctionissometimeshardtodistinguishfromexcess. We will have to strengthen government (and regulatory) capabilityresistingthetemptationtoimplantlayersandlayersofchecksandbalancesevenbeforecapacityhastakenroot.Wemustchooseahappymediumbetweengivingthe administration unchecked power and creating complete paralysis,recognizingthatourtaskisdifferentfromtheonethatconfrontedtheWestwhenitdeveloped,oreventhetaskfacedbyotherAsianeconomies.

For instance, a business-approval process that mandates numerousgovernment surveys in remote areas should also consider our administrativecapacity to do those surveyswell and on time. If it does not provide for thatcapacity,itensurestherewillbenomovementforward.Similarly,ifwecreateamultipleappellateprocessagainstgovernmentor regulatoryaction that isslow

and undiscriminating, we contain government excess but also risk haltingnecessarygovernmentactions.Ifthegovernmentorregulatorislesseffectiveinpreparing its case than private parties, we ensure that the appellate processlargelybiasesjusticetowardsthosewhohavetheresourcestouseit,ratherthanrectifyingamiscarriageofjustice.Sointhinkingthroughreforms,wemaywanttomovefromthetheoreticalidealofhowasystemmightworkinacountrywithenormous administrative capacity, to how it would work in the actual Indiansituation. Let me emphasize, we need ‘checks and balance’, but we shouldensure a balance of checks.We cannot have escaped from theLicencePermitRajonlytoendupintheAppellateRaj!

Finally, a heartening recent development is that more people across thecountryarebecomingwell-educatedandequippedtocompete.Oneofthemostenjoyable experiences at the RBI is meeting the children of our Class IVemployees, many of whom hold jobs as business executives in private sectorfirms. As, across the country, education makes our youth upwardly mobile,public support for free enterprise has expanded. Increasingly, therefore, thepoliticaldialoguehasalsomoved,fromgivinghandoutstocreatingjobs.Solongas we modulate the pace of liberalization to the pace at which we broadeneconomic capabilities, it is likely that the publicwill be supportive of reform.This alsomeans that ifwe are to embed the four pillars supportingprosperityandpolitical freedomfirmly inour society,wehave tocontinue tonurture thebroadly equitable distribution of economic capabilities among our people.Economic inclusion, by which I mean easing access to quality education,nutrition, health care, finance, and markets to all our citizens, is therefore anecessityforsustainablegrowth.Itisalso,obviously,amoralimperative.

Postscript: One name in this entire speech proved controversial: ‘Hitler’. If I had known theconnectionsthatwouldbemadeonsocialmedia,Iwouldnothaveusedit.Thespeechwasabouttheneed to remedy the weakness of government capacity in general in India – with no specificadministrationinmind.Itwasinsteadconstruedasawarningagainststronggovernment,specificallythecurrentadministration.Icouldnot,however,bulletproofmyspeechesagainstanyandallimaginedinterpretations.

T

V

PerhapsthemostimportantproposalforthereshapingofIndia’sfuturepathduringmytenurewastheNDAgovernment’sproposalto‘MakeinIndia’.Ithoughtthiswasanexcellentidea,foritwouldmeanthegovernmentwouldfocusonimprovingIndia’scapacitytoproduce,whetheritbegoodsorservices,either for the domestic economy through import substitution, or for the global economy throughexports.IthoughtitimportanttoclarifythatmakinginIndiadidnotnecessarilymeansellingprimarilytotheexportmarkets.Givenbothslowglobalgrowth,aswellasincreasingprotectionism,weshouldnotruleoutmakingforthelargeandvibrantIndianmarket.Indeed,forawhile,thiscouldwellbetheprimarygrowthmarketforIndianproducts.Intheshortrun,wewouldprobablymakeinIndia,largelyforIndia.Thelongerruncouldbedifferent,dependingonhowcircumstancesdeveloped.ThisiswhatIlaidoutinmyDrBharatRamLecture,deliveredinDelhiinDecember2014,whichwasprimarilyaspeechabouthowweshouldmanagerisksifwecateredprimarilytodomesticdemand.

MakeinIndia,LargelyforIndia

he global economy is still weak, despite a strengthening recovery in theUnitedStates.TheEuroareaisveeringclosetorecession,Japanhasalready

experiencedtwoquartersofnegativegrowthafterataxhike,andmanyemergingmarkets are rethinking their export-led growthmodels as the industrial worldstagnates.Inthelastcoupleofyears,theIMFhasrepeatedlyreduceditsgrowthforecasts.Aftersixyearsofatepidpost-crisisrecovery,theIMFtitleditsmostrecentWorldEconomicOutlook‘Legacies,Clouds,Uncertainties’.

WHATABOUTEMERGINGMARKETS?

Slow industrial country growth has made more difficult a traditionaldevelopmentpathforemergingmarkets–export-ledgrowth.Indeed,inthelastdecade, even as China developed on the back of its exports to industrialcountries, other emerging markets flourished as they exported to China.Emergingmarketsnowhave torelyonceagainondomesticdemand,alwaysadifficult taskbecauseof the temptation tooverstimulate.That taskhasbecomemoredifficultbecauseoftheabundanceofliquiditysloshingaroundtheworldasa result of ultra-accommodativemonetary policies in industrial countries.Anysignsofgrowth can attract foreign capital, and if notproperlymanaged, these

flows can precipitate a credit and asset price boom and exchange rateovervaluation. When industrial country monetary policies are eventuallytightened, some of the capital is likely to depart emerging market shores.Emergingmarketshavetotakeextremecaretoensuretheyarenotvulnerableatthatpoint.

What implications should an emerging economy like India, which hasweatheredtheinitialsquallsofthe‘TaperTantrums’ofthesummerof2013,takeawayforitspoliciesoverthemediumterm?Iwouldfocusonfour:1)MakeinIndia;2)MakeforIndia;3)Ensuretransparencyandstabilityoftheeconomy;4)Worktowardsamoreopenandfairglobalsystem.

LESSONSFORINDIA

1.MAKEININDIA

ThegovernmenthasthecommendableaimofmakingmoreinIndia.Thismeansimproving the efficiency of producing in India, whether of agriculturalcommodities,mining,manufacturing,orservices.

Toachievethisgoal,ithastoimplementitsambitiousplansforbuildingoutinfrastructure.Thisincludes

Physically linking every corner of the country to domestic andinternational markets through roads, railways, ports and airports. Thekind of economic activity that is generated when a pukka all-weatherroad is built into a village – the explosion of horticulture, poultry, anddairy farming, the opening of clothing and assorted goods shops, theincreasinguseofpoweredvehicles– is extraordinary, as is thekindofactivitythatemergesaroundnationalhighways.Ensuringtheavailabilityofinputssuchaspower,minerals,andwateratcompetitiveprices.Linking everyone electronically and financially to the broader systemthrough mobiles, broadband, and intermediaries such as businesscorrespondents.Encouraging the development of public institutions such as markets,

warehouses,regulators,informationaggregatorsanddisseminators,etc.Makingpossibleaffordableandsafehomesandworkplaces.

A second necessity for increasing productivity in India is to improve humancapital.Thisrequiresenhancingthequalityandspreadofhealthcare,nutrition,andsanitationtostartwithsothatpeoplearehealthyandable.Peoplealsoneedbetter and more appropriate education, skills that are valued in the labourmarkets,andjobswherefirmshavetheincentivetoinvestmoreintheirlearning.

ThegovernmentisexaminingthecostofdoingbusinessinIndiawithaviewtobringitdown.Thewoesofthesmallentrepreneur,assheconfrontsthemyriadmysterious regulations thatgovernher, and thenumerous inspectorswhohavethe power of closing her down, are well known. The petty bureaucrat,empoweredbytheseregulations,canbecomeatyrant.It isappropriatethatthegovernment intends to make him help business rather than hinder it. Asregulators,we too have to continuously examine the costs and benefits of theregulationsweimpose.

Finally,weneedmakeaccess tofinanceeasier. Ihavespokenabout that inothercontexts,andwillnotdwellonithere.BeforeImoveon,letmeaddsomecaveats.

There isadangerwhenwediscuss‘MakeinIndia’ofassumingitmeansafocus onmanufacturing, an attempt to follow the export-led growth path thatChinafollowed.Idon’tthinksuchaspecificfocusisintended.

First,as Ihave justargued,slow-growing industrialcountrieswillbemuchlesslikelytobeabletoabsorbasubstantialadditionalamountofimportsintheforeseeable future.Otheremergingmarketscertainlycouldabsorbmore,andaregionalfocusforexportswillpayoff.Buttheworldasawholeisunlikelytobeabletoaccommodateanotherexport-ledChina.

Second, industrial countries themselves have been improving capital-intensiveflexiblemanufacturing,somuchsothatsomemanufacturingactivityisbeing‘re-shored’.Anyemergingmarketwantingtoexportmanufacturinggoodswillhavetocontendwiththisnewphenomenon.Third,whenIndiapushesintomanufacturing exports, it will have China, which still has some surplus

agriculturallabourtodrawon,tocontendwith.Export-ledgrowthwillnotbeaseasyasitwasfortheAsianeconomieswhotookthatpathbeforeus.

I am not advocating export pessimism here – India has been extremelysuccessful at carving out its own areas of comparative advantage, and willcontinue todoso. Instead, Iamcounsellingagainstanexport-ledstrategy thatinvolves subsidizing exporters with cheap inputs as well as an undervaluedexchangerate,simplybecauseitisunlikelytobeaseffectiveatthisjuncture.Iamalsocautioningagainstpickingaparticularsectorsuchasmanufacturingforencouragement,simplybecauseithasworkedwellforChina.Indiaisdifferent,anddevelopingat adifferent time,andweshouldbeagnosticaboutwhatwillwork.

More broadly, such agnosticism means creating an environment where allsorts of enterprise can flourish, and then leaving entrepreneurs, of whom wehave plenty, to choosewhat theywant to do. Instead of subsidizing inputs tospecific industries because they are deemed important or labour intensive, astrategy thathasnot reallypaidoff forusover theyears, letus figureout thepublicgoodseachsectorneeds,andstrivetoprovidethem.Forinstance,SMEsmightbenefitmuchmore fromanagency thatcancertifyproductquality,oraplatformtohelpthemsellreceivables,orastateportalthatwillcreatemarketingwebsites for them, than from subsidized credit. The tourist industry willprobablybenefitmorefromvisaonarrivalandastrongtransportationnetworkthanfromthetaxsopstheyusuallydemand.

Asecondpossiblemisunderstandingistosee‘MakeinIndia’asastrategyofimportsubstitutionthroughtariffbarriers.Thisstrategyhasbeentriedandithasnot worked because it ended up reducing domestic competition, makingproducersinefficient,andincreasingcoststoconsumers.Instead,‘MakeinIndia’willtypicallymeanmoreopenness,aswecreateanenvironmentthatmakesourfirms able to compete with the rest of the world, and encourages foreignproducerstocometakeadvantageofourenvironmenttocreatejobsinIndia.

2.MAKEFORINDIA

If external demand growth is likely to bemuted, we have to produce for the

internal market. This means we have to work on creating the strongestsustainableunifiedmarketwecan,whichrequiresareductioninthetransactionscostsofbuyingandsellingthroughoutthecountry.ImprovementsinthephysicaltransportationnetworkIdiscussedearlierwillhelp,butsowillfewerbutmoreefficientandcompetitiveintermediariesinthesupplychainfromproducertotheconsumer.Awell-designedGSTbill,by reducing stateborder taxes,willhavethe important consequence of creating a truly national market for goods andservices,whichwillbecriticalforourgrowthinyearstocome.

Domesticdemandhastobefinancedresponsibly,asfaraspossiblethroughdomestic savings. Our banking system is undergoing some stress. Our bankshave to learn from pastmistakes in project evaluation and structuring as theyfinancetheimmenseneedsoftheeconomy.Theywillalsohavetoimprovetheirefficiency as they compete with new players such as the recently licenceduniversal banks as well as the soon-to-be licensed payment banks and smallfinance banks. At the same time, we should not make their task harder bycreating impediments in the process of turning around, or recovering, stressedassets.TheRBI,thegovernment,aswellasthecourtshaveconsiderableworktodohere.

We also have towork on spreading financial services to the excluded, foronce they learn how to manage finances and save they can be relied on toborrow responsibly. New institutions and new products to seek out financialsavings in every corner of the country will also help halt the erosion inhouseholdsavingsrates,aswillalowandstableinflationrate.Theincometaxbenefits foran individual to savehavebeen largely fixed innominal terms tilltherecentbudget,whichmeanstherealvalueofthebenefitshaveeroded.Somebudgetaryincentivesforhouseholdsavingscouldhelpensurethatthecountry’sinvestmentislargelyfinancedfromdomesticsavings.

3.ENSURETRANSPARENCYANDSTABILITYOFTHEECONOMY

As I argued earlier in the speech, even developed countries like Portugal andSpainhavebeensingularlyunabletomanagedomesticdemand.Countriestendto overstimulate,with large fiscal deficits, large current account deficits, high

creditandassetpricegrowth,only toseegrowthcollapseasmoneygets tight.Thefewcountriesthathaveavoidedsuchboomsandbuststypicallyhavedonesowithsoundpolicyframeworks.

Asacountrythatdoesnotbelongtoanypowerblocs,wedonoteverwanttobe in a position where we need multilateral support. It will be all the moreimportanttogetourpolicyframeworksright.

Clearly,asoundfiscalframeworkaroundaclearfiscalconsolidationpathiscritical.TheDrBimalJalanCommittee’sreportwillprovideagameplanfortheformer,whilethegovernmenthasclearlyindicateditsintenttosticktothefiscalconsolidationpaththathasbeenlaidout.Whetherweneedmoreinstitutionstoensure deficits stay within control and the quality of budgets is high, issomething worth debating. A number of countries have independent budgetoffices/committeesthatopineonbudgets.Theseofficesareespeciallyimportantinscoringbudgetaryestimates,includingunfundedlong-termliabilitiesthattheindustrialcountrieshaveshownaresoeasytocontractintimesofgrowthandsohardtoactuallydeliver.

Onthemonetaryside,acentralbankfocusedprimarilyonkeepinginflationlow and stable will ensure the best conditions for growth. In reacting todevelopments,however,thecentralbankhastorecognizethatemergingmarketsarenotasresilientasindustrialeconomies.Sothepathofdisinflationcannotbeassteepasinanindustrialeconomybecauseanemergingmarketismorefragile,andpeople’sbuffersandsafetynetsarethinner.A‘Volcker’likedisinflationwasnever on the cards in India, but an Urjit Patel glide path fits us very well,ensuring moderate growth even while we disinflate. Going forward, we willdiscuss an appropriate timeline with the government in which the economyshouldmovetothecentreofthemedium-terminflationbandof2to6percent.

In addition to inflation, however, a central bank has to pay attention tofinancialstability.Thisisasecondaryobjective,butitmaybecomecentraliftheeconomyenters a low-inflationcredit andassetpriceboom.Financial stabilitysometimes means regulators, including the central bank, have to go againstpopularsentiment.TheroleofregulatorsisnottoboosttheSensexbuttoensurethat the underlying fundamentals of the economy and its financial system are

soundenoughforsustainablegrowth.AnypositiveconsequencestotheSensexarewelcomebutareonlyacollateralbenefit,nottheobjective.

Finally, Indiawill, for the foreseeable future, run a current account deficit,whichmeanswewillneednetforeignfinancing.Thebestformoffinancingislong-term equity, that is, Foreign Direct Investment (FDI), which has theadditional benefit of bringing in new technologies and methods. While weshouldnotberailroadedintocompromisingIndia’sinteresttoattractFDI–forexample,therequirementstopatentamedicineinIndiaareperfectlyreasonable,nomatterwhattheinternationaldrugcompaniessay–weshouldensurepoliciesare transparent and redress quick. If we make it easier for young Indiancompaniestodobusiness,wewillalsomakeiteasierforforeigncompaniestoinvest,forafterallbothareoutsiderstothesystem.Thismeansatransparentandquick legal process to deal with contractual disputes, and a proper system ofbankruptcytodealwithdistress.Bothareissuesthegovernmenthastakenon.

Letmeturnfinallytotheinternationalframework.

4.WORKTOWARDSAMOREOPENANDFAIRGLOBALSYSTEM

Asacountry thatdoesnotbelong toanypowerbloc,and thatdoesnotexportvitalnaturalresourcesbutisdependentonsubstantialcommodityimports,Indianeedsanopen,competitiveandvibrantsystemofinternationaltradeandfinance.Ourenergysecurity,forexample,liesnotinowningoilassetsinremotefragilecountriesbutinensuringtheglobaloilmarketworkswellandisnotdisrupted.We need strong independent multilateral institutions that can play the role ofimpartialarbiterinfacilitatinginternationaleconomictransactions.

Unfortunately, the international monetary system is still dominated by theframeworksputinplaceinthepastbyindustrialcountries,anditsgovernanceisstill dominated by their citizens. To be fair, it is changing, albeit slowly. Butthereisamoreimmediatereasonforfasterchange.Withslowgrowth,aswellastheneedtofinancelargedebtloads,theinterestofindustrialcountriesinanopenglobalsystemcannotbetakenforgranted.Forinstance,regulationsthathavetheappearance of shoring up the safety and soundness of the industrial countryfinancial systemmay have the collateral effect of discouraging investment in

emerging market assets. We have to recognize that slow growth may directindustrial economypolicymakers’ attention inwards, evenwhile politics turnsprotectionist.Themultilateralgovernance system, still dominatedby industrialcountries,maynotprovideasufficientdefenceofopenness.

Emerging markets may therefore have the responsibility of keeping theglobaleconomyopen.Forthis,notonlydoemergingmarketshavetoworkonquotaandmanagementreformsinthemultilateralinstitutions,buttheyalsohavetoworkoninjectingnewagendas,newideas,andnewthinkingintotheglobalarena.No longerwill it suffice for India to simplyobject to industrial countryproposals,itwillhavetoputsomeofitsownonthetable.Andthismeansthatourresearchdepartments,universities,andthinktankshavetodevelopideasthattheycanfeedtoIndia’srepresentativesininternationalmeetings.

CONCLUSION

Letmeconclude.Wearemoredependentontheglobaleconomythanwethink.That it is growingmore slowly, and ismore inward looking, than in the pastmeansthatwehavetolooktoregionalanddomesticdemandforourgrowth–tomake in Indiaprimarily for India.Domestic-demand-ledgrowth is notoriouslydifficult to manage, and typically leads to excess. This is why we need tostrengthen domestic macroeconomic institutions, so that we can fostersustainableandstablegrowth.Atthesametime,wecannotletforeignmarketsshrinkfurther,andwehavetotakeupthefightforanopenglobalsystem.Ratherthan being reactive,we have to be active in setting the agenda. That requiresinvestmentinouridea-producinginstitutions–researchdepartmentsofofficialbodies,thinktanks,aswellasuniversities.Insum,thediminishedexpectationsintheworldatlargeshouldnotbeareasonforustoloweroursights.

Postscript:Thisspeechwasultimatelyoneonnationalriskmanagement–whatweneededtodointheenvironmentoffallingtradeandrisingprotectionismthatfacedus.Itbecamemildlycontroversial,Ibelieve, because itwasmisunderstood.Critics said itwas an attack on ‘Make in India’, and Iwasproposing an alternative, ‘Make for India’. This was completely incorrect. No sensible economistcouldbeagainstmakinginIndiaifthatcamefromanimprovementinthebusinessandinfrastructureenvironment rather than our old, discredited policy of raising import barriers to encourage importsubstitution.Equally clearly,mycriticshadnot read the title ‘Make in India,Largely for India’, letalonethecontentofthespeech,whichelaboratedon,andextended,thegovernmentproposal.Ididnot

disagreewithwhereoneshouldencourageproduction–weshould‘MakeinIndia’.WhereIfeltsomeofthenarrowvotarieswerebeingoverlyoptimisticisinexpectingstrongglobaldemandatthistime,given global weakness. I was not advocating export pessimism, but realism, borne out by thesubsequent significantweakness inexports thatwehaveexperienced.Wehad tomake in India,butinitiallylargelyforIndia,andsowehavedoneatthetimeofwriting.

T

VI

Iwas invited togive theconvocationaddress atmyalmamater, the Indian InstituteofTechnology,Delhi.AsIponderedoverwhatIwouldsay,Irealizedthatthegraduatingstudentswereyoungenoughto be my children. What message would I give my children at this time, a message that wouldchallengeaswellas inspire them,asconvocationspeechesaremeant todo?Itcouldnotbeanotherspeechoneconomics–thatmighteducatebutnotinspire.Themomentmadethechoiceoftopicclear.TherewasaragingdebateinIndiainlate2015ontheissueoftolerance,andthisiswhatIdecidedtospeakon.IexplainedtotheyounggraduatingscholarsthatIndia’sstrengthisherenduringtraditionoftoleranceanddebate,andthatitwillbeoursourceofcomparativeeconomicadvantageasweapproachthefrontiersofinnovation.ThisisthespeechIdeliveredon31October2015.

ToleranceandRespect:EssentialsforEconomicProgress

hank you very much for inviting me back to the Institute to deliver theconvocation address. I graduated with a degree in Electrical Engineering

thirtyyearsago. Iwasoverlyanxious thenaboutwhat the futureheld forme,becauseIdidnotrealizethattheInstitutehadpreparedmesowellforwhatlayahead.Our professors – and Iwill not single out any to avoid a disservice tothose I do not name – were dedicated professionals. They asked a lot of us,knowingthat inchallengingus theyallowedus to learnwhatwewerecapableof. Equally important, our Electrical Engineering class – in those days,ComputerSciencewaspartofElectricalEngineeringinIITDelhi–hadsomeofthesmartestpeopleithasbeenmyprivilegetoknow.Afterworkingwiththemas colleagues, and competing with them for grades, I learned what it took tosucceedinthefiercestenvironments;veryhardwork,friendship,andboatloadsofluck.Thoselessonshavestayedwithmesince.

IITDelhi then, as I amsure it isnow,wasnotonlyabout studies– itwasaboutgrowingup.Wewere,withafewnotableexceptions,theproverbialschoolnerdswhohadbeenexcludedfromallschoolsportsbythemachosportscases.WithalmosteveryoneinthesameboatatIIT,forthefirsttimeinourliveswegotachancetobatandbowlatthenets,insteadofbeingpostedatdeeplongon

to retrieve the odd six by the stars. Everyone did something, ranging fromphotography to publishing.Of course,we all aspired to join dramatics,whereyougottospendlonghourswithmembersoftheoppositesex.Unfortunately,Iwasnogoodatacting,soIhadtolookforself-actualizationelsewhere.Buttherewereenoughplacestolook.

Studentpoliticswasvibrant,withplentyofscheming,strategizing,andback-stabbing. It was an intellectual pastime, however, without the violence andcorruption that plagues student politics elsewhere in our country. You had toconvincethesmallintelligentelectoratetovoteforyou,andinfiguringouthowtogetthatvote,wealllearnttheartofpersuasion.

Sowe grewup in the classrooms, in the squash courts at theRCA, in thecivilizing SPIC-Macay overnight classical music concerts and in theovercrowded rock concerts at the OAT. Some of us spent long hours waitinghopefullyoutsideKailashHostel,andwhenoccasionallyourwaitwasrewarded,beautifulautumnnightswithourfriends,chattingandgazingatthestarswhilesittingontheroofofConvocationHall.TheInstitutereplacedournaivetywithamoreconfidentmaturity.Wecame inassmartboysandgirlsand leftaswiseryoungmenandwomen.IamconfidentthattheInstitutehasdonetoyouwhatitdidtous.Youwillthankitintheyearstocomeforthat.

Inspeakingheretoday,Iamawarethatmostconvocationaddressesaresoonforgotten. That creates a form ofmoral hazard for the speaker. If you are notgoingtorememberwhatIsay,Idon’thavetheincentivetoworkhardatcraftingmywords.Theneteffect iswhateconomistsrefer toasabadequilibrium;myspeech is forgettable, and you therefore forget it soon. If so,we are probablybetteroffwithmeskippingtherestofthespeech,andallofusgoingontootherpressingduties.

Nevertheless, I amgoing to look beyondmypersonal incentives and fulfilmydharmaaschiefguest.IwillspeakonwhyIndia’straditionofdebateandanopenspiritofenquiryiscriticalforitseconomicprogress.Letmeexplain.

RobertSolowwontheNobelPrizeinEconomicsforworkthatshowedthatthe bulk of economic growth did not come from putting more factors ofproduction such as labour and capital to work. Instead, it came from putting

thosefactorsofproductiontogethermorecleverly, that is, fromwhathecalledtotal factor productivity growth. Put differently, new ideas, new methods ofproduction,betterlogistics–thesearewhatleadtosustainedeconomicgrowth.Of course, a poor country like ours can grow for some time by puttingmorepeople to work, by moving them from low productivity agriculture to highervalue-addedindustryorservices,andbygivingthembettertoolstodotheirjobs.As many of you who have taken economics will recognize, we in India areusually far from theproductionpossibility frontier, sowecangrow for a longwhilejustbycatchingupwiththemethodsofindustrialcountries.

Butmoreintelligentwaysofworkingwillenableustoleapfrogoldmethodsandcomemorequickly to theproductionpossibility frontier–as forexample,wehavedoneinpartsofthesoftwareindustry.And,ofcourse,onceyouareatthefrontierandusingthebestmethodsintheworld,theonlywaytogrowistoinnovateandbeevenbetterthanothersintheworld.Thisiswhatoursoftwarefirmsarenowtryingtodo.

Ouralums,whomyoustudentswillshortlyjoin,areleadingIndia’schargetothefrontierandbeyond.Takethefantasticdevelopmentsine-commerce,rangingfrom the creation of electronic marketplaces to new logistics networks andpaymentssystems.Today,aconsumerinasmalltowncanhavethesamechoiceof clothing fashions that anyone from the largemetros enjoys, simplybecausethe Internet has brought all the shops in India to her doorstep.Andwhile herlocal shopno longercansell shoddyapparel, itnowfocuseson theperishableitemssheneedsinahurry,evenwhilesub-contractingtoprovidethelastlegofthe logisticnetwork that reachesher.Economicgrowth throughnew ideasandproductionmethodsiswhatourprofessorsandalumscontributetothenation.

Sowhat does an educational institution or a nation need to do to keep theideafactoryopen?Thefirstessentialistofostercompetitioninthemarketplaceforideas.Thismeansencouragingchallengetoallauthorityandtradition,evenwhile acknowledging that the only way of dismissing any view is throughempirical tests. What this rules out is anyone imposing a particular view orideology because of their power. Instead, all ideas should be scrutinizedcritically,nomatterwhethertheyoriginatedomesticallyorabroad,whetherthey

havematuredoverthousandsofyearsorafewminutes,whethertheycomefromanuntutoredstudentoraworld-famousprofessor.

I am suremany of you have come across Richard Feynman’sLectures onPhysics, amust-readwhenwewere at IIT.TheNobel prize-winningphysicistwasoneofthegiantsofthetwentiethcentury.Inhisautobiography,though,hewrites how he found the atmosphere at the Institute of Advanced Studies atPrinceton stultifying. Now, as you know, the Institute of Advanced Studiesbringstogethersomeofthefinestscholarsintheworldtoponderproblemsinamulti-disciplinary environment. But he found the atmosphere sterile becausetherewerenostudentstoaskhimquestions,questionsthatwouldforcehimtorethink his beliefs and perhaps discover new theories. Ideas start withquestioning and alternative viewpoints, sometimes seemingly silly ones.Afterall, Einstein built his Theory of Relativity pondering the somewhat wackyquestion of what someone travelling in a train at the speed of light wouldexperience.Sonothingshouldbeexcludedbuteverythingshouldbesubject todebate and constant testing. No one should be allowed to offer unquestionedpronouncements.Withoutthiscompetitionforideas,wehavestagnation.

This then leads to a second essential:protection, not of specific ideas andtraditions,buttherighttoquestionandchallenge,therighttobehavedifferentlyso longas itdoesnothurtothersseriously. In thisprotection liessocietalself-interest, for it isbyencouraging thechallengeof innovativerebels thatsocietydevelops, that it gets the ideas that propel Solow’s total factor productivitygrowth. Fortunately, India has always protected debate and the right to havedifferentviews.Somehaveevenembeddedtheseviewsinpermanentstructures.RajaRajaChola, inbuildingthemagnificentBrihadeeswaraShaivite templeatThanjavur, also incorporated sculptures of Vishnu as well as the meditatingBuddha,thusadmittingtoalternativeviewpoints.WhenShahenshahJalaluddinMuhammadAkbar invited scholars of all manner of persuasion to debate theeternalveritiesathiscourt,hewasonlyfollowingoldertraditionsofourHinduandBuddhistkings,whoencouragedandprotectedthespiritofenquiry.

What then of group sentiment? Should ideas or behaviour that hurt aparticular intellectual position or group not be banned? Possibly, but a quick

resort tobanswillchillalldebateaseveryonewillbeanguishedby ideas theydislike. It is far better to improve the environment for ideas through toleranceandmutualrespect.

Let me explain. Actions that physically harm anyone, or show verbalcontemptforaparticulargroupsothattheydamagethegroup’sparticipationinthemarketplaceforideas,shouldcertainlynotbeallowed.Forexample,sexualharassment, whether physical or verbal, has no place in society. At the sametime,groupsshouldnotbe lookingforslightsanyandeverywhere,so that toomuch is seen as offensive; the theory of confirmation bias in psychologysuggeststhatonceonestartslookingforinsults,onecanfindthemeverywhere,even in themost innocuousstatements. Indeed, ifwhatyoudooffendsmebutdoesnotharmmeotherwise,thereshouldbeaveryhighbarforprohibitingyouract.Afterall,anyban,andcertainlyanyvigilanteactstoenforceit,mayoffendyou asmuch, ormore, than the offence tome.Excessive political correctnessstiflesprogressasmuchasexcessivelicenceanddisrespect.

Putdifferently,whileyoushouldavoidpressingthebuttonsthatupsetmetotheextentpossible,whenyoudopush themyoushouldexplaincarefullywhythat is necessary so as tomove the debate forward, and how it should not beinterpretedasapersonalattackonme.Youhave to treadrespectfully,assuringme that a challenge to the ideas I hold is necessary for progress.At the sametime, I should endeavour to hold few ideas so closely intertwined with mypersonality that any attack on them is deemed an intolerable personal affront.Tolerancemeansnotbeingsoinsecureaboutone’sideasthatonecannotsubjectthem to challenge – it implies a degree of detachment that is absolutelynecessaryformaturedebate.Finally,respectrequiresthatintherarecasewhenanideaistightlyassociatedwithagroup’scorepersonality,weareextracarefulaboutchallengingit.

Tolerancecantaketheoffenceoutofdebate,andindeedinstilrespect.IfIgoberserkeverytimeaparticularbuttonispressed,rebelsaretemptedtopressthebutton,whilemischief-makersindeeddoso.ButifIdonotreactpredictably,andinsteadaskbuttonpresserstoexplaintheirconcerns,rebelsareforcedtodothehard work of marshalling arguments. So, rebels do not press the button

frivolously,whilethethuggishmischief-makerswhoaboundineverygroupareleft without an easy trigger. Tolerance and respect then lead to a goodequilibriumwheretheyreinforceeachother.

Forexample,rebelliousyouthintheUnitedStatesusedtoburntheAmericanflag.ItwascalculatedtoupsettheoldergenerationthathadfoughtinAmerica’swars,fortheflagwasasymbolofalltheyhadfoughtfor.Andthepolice,manyofwhomwere veterans, used to react with violence, whichwas precisely thereactiontherebelssoughttofurthertheircause.Overtime,though,U.S.societyhas become more tolerant of flag-burning. Because it no longer triggers areaction, it is no longer used as an instrument to shock. In sum, if groupsentimentbecomesmoretolerantandlesseasilyhurt,theactionsthattrytohurtitwilldiminish.AsMahatmaGandhisaid,‘Thegoldenruleofconductismutualtoleration,seeingthatwewillneverallthinkalikeandweshallalwaysseeTruthinfragmentsandfromdifferentpointsofvision.’

Letmeconclude.IITanslikeyouwill leadIndia’sracefor ideas.TheIndiathat youwill graduate into ismuchmore capable of using your technologicalprowess than the Indiawegraduated into. Iwishyouunlimited ambition, andforecastgreatsuccess for thoseofyouwhocontinue thinkingandchallenging.But as you go out in the world, remember our tradition of debate in anenvironment of respect and tolerance. By upholding it, by fighting for it, youwill be repaying your teachers in this great institution, and your parents whoworked so hard to send you here.And youwill be doing our country a greatpatrioticservice.Thankyouandgoodluck.

Postscript:Iknewthisspeechwouldbemisinterpretedbytheusualcritics,butIhaddecidedtolookbeyondthem.Onceagain,manywhodidnotread,criticizednevertheless.TheyfeltIwascomplainingaboutIndia’sintolerancewheninfactthespeechisaboutmaintainingourtraditionfortolerance.Someofthecommentaryborderedonthehilarious,essentiallysaying‘weareatolerantnation,heaccusesusofintolerance,sofirehim’orwordstothateffect.Whatmatteredmosttome,however,wasaone-linerfromoneofmystaunchestyoungcritics,myteenageson.Fromfaraway,hereadmyspeechclosely,andsatisfieditmethisexactingstandards,hewrote,‘Iamproudofyou.’

VII

Socialmediadoestakealifeofitsown.Initsworldofalternativetruths, therealitycangetgrosslydistorted.Occasionally, inagame resemblingChineseWhispers, eachcommentatoropinedonwhattheythoughtIhadsaid,basedonapreviouscommentator’sgarbledversion,withoutmanybotheringtofindoutwhatIactuallysaid.

Speakingofbeingmisunderstood,perhapsthegreatestflakIgotwasforsomecommentsImadeattheendofatiringdayattheIMFmeetings.IwasbeinginterviewedforMarketWatchbyGregRobb,whomIknewwell.Inthemiddleofalonginterview,thequestionIwasposedwas:

MarketWatch:TheIndianeconomyisthebrightspotintheglobaleconomy.Whenothercentralbankersandfinanceministersaskyouforyoursecretsauce,whatdoyoutellthem?

MynaturalcautionasacentralbankeraswellasmyconcernthatourrecoverywasworkinprogresssuggestedIshouldnotboast.SohereiswhatIsaid.

Rajan:Well,Ithinkwe’vestilltogettoaplacewherewefeelsatisfied.Wehavethissaying,‘inthe landof theblind, theone-eyedman isking.’We’rea littlebit thatway.We feel thingsareturningtothepointwherewecouldachievewhatwebelieveisourmedium-rungrowthpotential.Because thingsare falling intoplace. Investment is starting topickupstrongly.Wehavea fairdegreeofmacro-stability.Ofcourse,notimmunetoeveryshock,butimmunetoafairnumberofshocks.Thecurrentaccountdeficit isaround1percent.The fiscaldeficithascomedownandcontinuestocomedownandthegovernmentisfirmonaconsolidationpath.Inflationhascomedown from11per cent to less than5per centnow.And interest rates thereforecanalsocomedown. We have an inflation targeting framework in place. So a bunch of good things havehappened.

Therearestillsomethingstodo.Ofcourse,structuralreformsareongoing.Thegovernmentisengagedinbringingoutanewbankruptcycode.Thereisgoodsandservicestaxontheanvil.Butthereisalotofexcitingstuffwhichisalreadyhappening.Forexample,justlastweek,Iwasfortunate to inaugurate a platform which allows mobile-to-mobile transfers from any bankaccount to any other bank account in the country. It is a public platform, so anybody canparticipate.Itisnotownedbyanyonecompany,unlikeApplePayorAndroidPayorwhatever.Ithink it is the first of its kind.So technological developments are happening andmaking for amore,hopefully,reasonablelifeforalotofpeople.Let’sseehowitgoes.

On any fair read of my entire answer, one would conclude that I was optimistic about India, notdownplayingwhatwasgoingon,evenwhilerecognizingwehadworktodo.Butsocialmediawenttotownafterpluckingjustthefollowingwordsoutoftheanswer:‘Wehavethissaying,“inthelandof

A

theblind,theone-eyedmanisking.”We’realittlebitthatway.’Acoupleofministers,fedthisquote,commented adversely on what I said. I was finally fed up of the perhaps motivated search forcontroversy.SoIpickedtheNationalInstituteofBankManagementConvocationon20April2016tosaythefollowing,cautioningoneuphoriaandendingbyemphasizingonceagaintheneedformutualrespectandtolerance.

WordsMatterbutSoDoesIntent

sIreflectedonwhatIshouldspeakon,IthoughtIwouldspeakonarecentexperience that offerswhat theAmericans call ‘a teachablemoment’. To

gettotheexperience,startfirstwithwhereIndiais.Indiaisthefastestgrowinglargecountryintheworld,thoughwithmanufacturingcapacityutilizationlowat70 per cent and agricultural growth slow following two bad monsoons, ourpotentialisundoubtedlyhigher.

Growth,however,isjustonemeasureofperformance.ThelevelofpercapitaGDP is also important.We are still one of the poorest large countries in theworld on a per capita basis, and have a longway to go beforewe reasonablyaddress the concernsof eachoneof our citizens.Weareoften comparedwithChina.ButtheChineseeconomy,whichwassmaller thanoursinthe1960s, isnowfivetimesoursizeatmarketexchangerates.TheaverageChinesecitizenisoverfourtimesricherthantheaverageIndian.Thesoberingthoughtiswehavealongwaytogobeforewecanclaimwehavearrived.

Asacentralbankerwhohastobepragmatic,IcannotgeteuphoricifIndiaisthefastestgrowinglargeeconomy.Ourcurrentgrowthcertainlyreflectsthehardworkofthegovernmentandthepeopleofthecountry,butwehavetorepeatthisperformanceforthenexttwentyyearsbeforewecangiveeveryIndianadecentlivelihood.Thisisnottodisparagewhathasbeenandisbeingdone.Thecentralandstategovernmentshavebeencreatingaplatformforstrongandsustainablegrowth,andIamconfidentthepayoffsareontheirway,butuntilwehavestayedonthispathforsometime,Iremaincautious.

Wemustrememberthatourinternationalreputationisofacountrywithgreatpromise, which has under-delivered in the past. This is why we are still thepoorest country on a per capita basis among the BRICS.We need to change

perceptions by delivering steadily on our promise for a long time – byimplementing,implementing,andimplementing.Wecannotgetcarriedawaybyour current superiority in growth, for as soon as we believe in our ownsuperiorityandstartdistributingfuturewealthasifwealreadyhaveit,westopdoingallthatisrequiredtocontinuegrowing.ThismoviehasplayedtoomanytimesinIndia’spastforustonotknowhowitends.

So in speaking toa foreign journalist theotherday,whoaskedwhat it feltliketobethebrightspotintheworldeconomy,Iusedthephrase‘Andhonmeinkanaraja’or‘Inthelandoftheblind,theone-eyedmanisking’.Theproverbhas a long multinational history. The Dutch philosopher, Erasmus, used it inLatinwhenhewrote‘Inregionecaecorumrexestluscus’,butheprobablywasinspiredbyearlierwork.

My intent was to signal that our outperformancewas accentuated becauseworldgrowthwasweak,butwe in Indiawere still hungry formoregrowth. Ithenexplainedthatwewerenotyetatourpotential,thoughwewereatacuspofasubstantialpick-upingrowthgivenallthereformsthatwereunderway.

In our news-hungry country, however, our domestic papers headlined thephraseIused.Tobefair,theyalsoofferedthesurroundingcontext,butfewreadbeyondtheheadline.Sotheinterviewbecamemoderatelycontroversial,withtheimplicationthatIwasdenigratingoursuccessratherthanemphasizingtheneedtodomore.

More generally, every word or phrase a public figure speaks is intenselywrung for meaning. When words are hung to dry out of context, as in anewspaperheadline, it thenbecomesfairgameforanyonewhowantstofill inmeaning to createmischief.Worst, of course, arewordsor proverbs that havecommon usage elsewhere, because those can be most easily and deliberatelymisinterpreted.Ifwearetohaveareasonablepublicdialogue,everyoneshouldreadwordsintheircontext,notstrippedofit.Thatmaybeaforlornhope!

Ido,however,wanttoapologizetoasectionofthepopulationthatIdidhurt,the blind.After all, the proverb suggests that a one-eyedman is better than ablind one. A moment’s thought suggests this is not true. For the blind candevelopcapabilitiesthatmorethanmakeupfortheirdisability.Indeed,thesheer

willpower andhunger to succeedof the disabled can help thembecomeover-achieversinaseeingman’sworld.Moreover,becausetheirotherfaculties,suchas touch, smell, and hearing, are more finely honed, the blind may add newperspectivesandnewvarietytoourworld,makingitricherandmorevibrant.SoIamindeedsorryforimplyingtheblindwereotherwisethancapable.

Butthisleadstoanimportantquestion.Howmuchofourlanguageistingedwithmeaningthatisliabletomisinterpretation?Howforgivingshouldwebeofabadchoiceofwordswhentheintentisclearlydifferent?

Letmegiveyoutwoexamples.Gandhijiusedtosay,‘Aneyeforaneyewillonlymakethewholeworldgoblind’.Clearly,whatisimpliedisthatthewholeworld going blind is not a desirable state of affairs. Onemight take umbragesinceitsuggestsblindnessisaninferiorstatetothatofbeingabletosee,andthesaying could be seen as discriminatory. Yet Gandhiji’s focus was on theabsurdity of a policy of revenge, not on blindness, and his intent was not todisparagetheblind.

MysecondexamplecomesfromafacultymeetingIonceattendedwhereamaleprofessorusedthephrase‘Asaruleofthumb’tomakehispoint.Afemalehistoryprofessorbecamevisiblyagitatedandangry.Sheexplainedthat‘theruleofthumb’referredhistoricallytothemaximumwidthofthestickwithwhichaman could beat his wife without breaking the law. She was angry the maleprofessor used the phrase so lightly, seemingly condoning domestic violence.He,ofcourse,hadnoclueofthehistoricaloriginsofthephrase,andapologizedprofusely.Clearly, his ignorance suggested he had no intent to offend, yet thefemaleprofessorwasoffended.

Therearetwoimportantissueshere.First,ifwespendallourtimewatchingourwords andusing inoffensive languageorhedgingeverythingwith caveats,wewillbedullandwillnotbeabletocommunicatebecausenoonewilllisten.

Forinstance,‘Aneyeforaneyewillonlymaketheworldgoblind’couldbereplacedby‘Revengereducescollectivewelfare’.Thelatterisshort,inoffensive,andpithy,butmeaninglessformost listeners.Alternatively,wecouldsay‘Thetaking of any body part for another will temporarily reduce the collectivecapabilitiesofthepopulationthusaffected,untiltheydevelopthefacultiesthat

willallowthemtocompensate for themissingbodyparts.’This restatement ismore correct than the original, but lacks zing and therefore the ability topersuade.

Atthesametime,notpayingattentiontowordsorphrasesthatgiveoffencerisks perpetuating debilitating stereotypes that prevent advancement. Whenreferring tobankers, scientists,engineers,orsurgeons in theabstract,weoftenrefertothemas‘he’,thusperpetuatingtheunfortunatestereotypethatthesearenotjobsforwomen.Clearly,indoingsoweignoretheincreasingpresence,andeven dominance, of women in these fields. What should we do to remedymatters?

Ithinkweallhaveworktodotoimprovepublicdialogue.Speakershavetobemorecarefulwithwordsandnotbegratuitouslyoffensive.Atthesametime,listeners should not look for insults everywhere, and should place words incontextsoastounderstandintent.Inotherwords,foreffectivecommunicationanddebate,ratherthantheangryexchangesthatweseeonsomeTVshows,weneed both respect and tolerance. The greatest danger of all is that we do notcommunicateordebate,forthenwewillallowdistortedstereotypestoflourishunchallenged,anddivisivenesstoincrease.Inacountrylikeours,conceivedandflourishingindiversity,thatwilltrulybeadisaster.

Interestingly,someofthereportsofthisspeechwerealsoconfused.WasIcontriteandapologizingformywords,was I apologizing to the blind, orwas I defiant. I thought therewas no need to clarifyfurther.Thosewhodidnotwishtounderstandcouldnotbeforcedtodoso.

A

CHAPTER8

INTERNATIONALISSUES

I

Throughmuchofmy term, Iworriedabout the floodof liquidityunleashedby thecentralbanksofindustrialcountries.InmypreviousroleasChiefEconomicAdvisor,andco-chairoftheFrameworkWorkingGroupof theG-20,I, togetherwithmyverycapableadvisors, includingDrPrachiMishra,hadpushedtheG-20tofinallyrecognizethepossibleadversespillovereffects(throughcapitalflows)caused by industrial country monetary policies. When the U.S. Federal Reserve embarked on itsprocessoftightening,Ispokepubliclyoftheneedforittotaketheconsequencesofitsactionsaroundtheworldintoaccount–Iwascommittingthecardinalcentralbankersinofcommentingonanothercentralbank’spolicy,butIthoughtitwasimportantforIndia.WhileIwasnotnaïveenoughtobelievethis would alter Fed policy, it contributed to an attitudinal change. Perhaps as a result of suchcommentaryfromavarietyofsources,theFeddidsayinanumberofitssubsequentstatementsthatitwas sensitive to conditionsoutside theUnitedStates, and inonepolicymeeting,mayhaveheld itshand because of unsettled conditions abroad. At any rate, I was invited to give a speech at theBrookings Institution on 10 April 2014 on my concerns.* Ben Bernanke, the recently retired FedChairman,wasintheaudience.

CompetitiveMonetaryEasing:IsItYesterdayOnceMore?

stheworldseemstobestrugglingbacktoitsfeetafterthegreatfinancialcrisis, Iwant todrawattentiontoanareaweneedtobeconcernedabout:

theconductofmonetarypolicyinthisintegratedworld.Agoodwaytodescribethe current environment is one of extreme monetary easing throughunconventional policies. In a world where debt overhangs and the need forstructuralchangeconstraindomesticdemand,asizeableportionoftheeffectsofsuch policies spill over across borders, sometimes through aweaker exchange

rate. More worryingly, it prompts a reaction. Such competitive easing occursboth simultaneously and sequentially, as I will argue, and both advancedeconomiesandemergingeconomiesengageinit.Aggregateworlddemandmaybeweaker andmoredistorted than it shouldbe, and financial risks higher.Toensurestableandsustainablegrowth,theinternationalrulesofthegameneedtoberevisited.Bothadvancedeconomiesandemergingeconomiesneedtoadapt,elseIfearweareabouttoembarkonthenextlegofawearisomecycle.

Central bankers are usually reluctant to air their concerns in public. Butbecause the needed change has political elements to it, I take my cue fromspeeches by two central bankerswhom I respect greatly,BenBernanke in his2005 ‘Global SavingsGlut’ speech, and JaimeCaruana in his 2012 speech atJackson Hole, both of whom have raised similar concerns to mine, althoughfromdifferentperspectives.

Beforestarting,Ishoulddisclosemyinterestsinthiseraoftransparency.ForthelastfewmonthsIndiahasexperiencedlargeinflowsofcapital,notoutflows,andisseenbythemarketsasanemergingeconomythathasmadesomeofthenecessary policy adjustments.We are well buffered with substantial reserves,thoughnocountrycanbede-coupledfromtheinternationalsystem.Myremarksaremotivatedbythedesireforamorestableinternationalsystem,asystemthatworks equally for rich and poor, large and small, and not the specifics of oursituation.

UNCONVENTIONALPOLICY

Iwant to focusonunconventionalmonetarypolicies (UMP),bywhichImeanboth policies that hold interest rates at near zero for long, as well as balancesheetpoliciessuchasquantitativeeasingorexchangeintervention that involvealteringcentralbankbalancesheetsinordertoaffectcertainmarketprices.Thekey point that Iwill emphasize throughout this talk is that quantitative easingand sustained exchange intervention are in an economic equivalence class,thoughthechannelstheyworkthroughmaybesomewhatdifferent.Ourattitudestowardsthemshouldbeconditionedbythesizeoftheirspillovereffectsratherthanbyanyinnatelegitimacyofeitherformofintervention.

Letmealsoadd there isa role forunconventionalpolicies–whenmarketsare broken or grossly dysfunctional, central bankers do have to thinkinnovatively.Fortunatelyfortheworld,muchofwhattheydidimmediatelyafterthefallofLehmanwasexactlyright,thoughtheyweremakingitupastheywentin the face of extreme uncertainty. They eased access to liquidity throughinnovative programmes such as Term Asset-Backed Securities Loan Facility(TALF), Term Auction Facility (TAF), Troubled Asset Relief Programme(TARP), Securities Market Programme (SMP), and Long-Term RefinancingOperation(LTRO).Bylendinglongtermwithoutaskingtoomanyquestionsofthe collateral they received, by buying assets beyond usual limits, and byfocusingonrepairingmarkets,theyrestoredliquiditytoaworldfinancialsystemthat would otherwise have been insolvent based on prevailing market assetprices.Inthismatter,centralbankersaredeservedlyheroes.(Iwasnotamemberofthefraternityatthattime,soIdonotfeelaconflictindolingoutpraise!)

The key question iswhat happenswhen these policies are prolonged longbeyondrepairingmarkets–andtherethebenefitsaremuchlessclear.Letmelistfourconcerns:

1) Isunconventionalmonetarypolicytherighttooloncetheimmediatecrisisisover?Doesitdistortbehaviourandactivitysoastostandinthewayofrecovery?Isaccommodativemonetarypolicythewaytofixacrisisthatwaspartlycausedbyexcessivelylaxpolicy?

2) Dosuchpoliciesbuytimeordoesthebeliefthatthecentralbankistakingresponsibilitypreventother,moreappropriate,policiesfrombeingimplemented?Putdifferently,whencentralbankerssay,howeverreluctantly,thattheyaretheonlygameintown,dotheybecometheonlygameintown?

3) Willexitfromunconventionalpoliciesbeeasy?

4) Whatarethespilloversfromsuchpoliciestoothercountries?

SinceIhavedweltatlengthonthefirsttwoconcernsinanearlierspeech,letmefocusonthelasttwo.

EXIT

Themacroeconomicargumentforprolongedunconventionalpolicyinindustrialcountriesisthatithaslowcosts,providedinflationstaysquiescent.Henceitisworthpursuing,evenifthebenefitsareuncertain.Anumberofeconomistshave,however, raised concerns about financial sector risks that may build withprolonged use of unconventional policy. Asset prices may not just revert toearlier levels on exit, but they may overshoot on the downside, and exit cancausesignificantcollateraldamage.

One reason is that leverage may increase both in the financial sector andamongst borrowers as policy stays accommodative. One channel seems to bethat a boost to asset liquidity leads lenders to believe that asset sales willbackstop loan recovery, leading them to increase loan to value ratios. Whenliquidity tightens, though, toomany lenders rely on asset sales, causing assetprices and loan recovery to plummet. Because lenders do not account for theeffectsof their lendingon the‘firesale’price,andsubsequentlyon lendingbyothers,theymayhaveanexcessiveincentivetobuildleverage.Theseeffectsareexacerbated if, over time, lenders become reliant on asset sales for recovery,rather than on upfront project evaluation and due diligence. Another possiblechannelisthatbanksthemselvesbecomemorelevered,orequivalently,acquiremore illiquid balance sheets, if the central bank signals it will intervene in asustainedwaywhentimesaretoughbecauseunemploymentishigh.

Leverage need not be the sole reason why exit may be volatile afterprolonged unconventional policy. Investment managers may fearunderperformingrelativetoothers.Thismeanstheywillholdariskyassetonlyifitpromisesariskpremium(oversafeassets)thatmakesthemconfidenttheywillnotunderperformholding it.A lowerpathofexpected returnson thesafeassetmakesiteasierfortheriskyassettomeettherequiredriskpremium,andindeed draws more investment managers to buy it – the more credible theforward guidance on ‘low for long’, the more the risk taking. However, asinvestmentmanagers crowd into the risky asset, the risky asset ismore finelypriced so that the likelihood of possible fire sales increases if the interest rateenvironmentturns.Everymanagerdumpstheriskyassetatthatpointinorderto

avoidbeingthelastoneholdingit.Leverageandinvestorcrowdingmaythereforeexacerbatetheconsequences

of exit.When monetary policy is ultra-accommodative, prudential regulation,eitherof themacroormicrokind, isprobablynotasufficientdefence.Inpart,thisisbecause,asFedGovernorSteinsosuccinctlyputit,monetarypolicy‘getsintoeverycrack’,includingtheunregulatedpartofthefinancialsystem.Inpart,ultra accommodative monetary policy creates enormously powerful incentivedistortionswhoseconsequencesaretypicallyunderstoodonlyafterthefact.Theconsequences of exit, however, are not just felt domestically, they could beexperiencedinternationally.

SPILLOVERS

Perhapsmostvulnerabletotheincreasedrisktakinginthisintegratedworldarecountries across the border. When monetary policy in large countries isextremely and unconventionally accommodative, capital flows into recipientcountriestendtoincreaselocalleverage;thisisnotjustduetothedirecteffectofcross-border banking flows but also the indirect effect, as the appreciatingexchangerateandrisingassetprices,especiallyofrealestate,makeitseemthatborrowershavemoreequitythantheyreallyhave.

Exchange rate flexibility in recipient countries in these circumstancessometimes exacerbates booms rather than equilibrates. Indeed, in the recentepisode of emergingmarket volatility after the Fed started discussing taper inMay2013,countriesthatallowedtherealexchangeratetoappreciatethemostduring the prior period of quantitative easing suffered the greatest adverseimpact to financial conditions. Countries that undertake textbook policies offinancial sector liberalization are not immune to the inflows – indeed, theirdeepermarketsmaydrawmoreflowsin,andtheseliquidmarketsmaybewheresellingtakesplacewhenconditionsinadvancedeconomiesturn.

Macro-prudentialmeasureshavelittletractionagainstthedelugeofinflows–Spain had a housing boom despite its countercyclical provisioning. Recipientcountriesshouldadjust,ofcourse,butcreditandflowsmaskthemagnitudeandtiming of needed adjustment. For instance, higher collections from property

taxesonnewhouses, sales taxesonnewsales,capitalgains taxeson financialasset sales, and income taxes on a more prosperous financial sector maymisleadingly suggest a country’s fiscal house is in order, evenwhile low-riskpremia on sovereign debt add to the sense of calm. At the same time, anappreciatingnominalexchangeratemayalsokeepdowninflation.

Thedifficultyofdistinguishingthecyclicalfromthestructuralisexacerbatedin some emerging markets where policy commitment is weaker, and thewillingnesstosuccumbtothesirencallsofpopulistpolicygreater.Butitwouldbe amistake to think that pro-cyclical policy in the face of capital inflows isprimarily a disease of the poor; Even rich recipient countries with stronginstitutions, suchas IrelandandSpain,havenotbeen immune to capital-flow-inducedfragility.

Ideally, recipient countries would wish for stable capital inflows, and notflowspushedinbyunconventionalpolicy.Onceunconventionalpoliciesareinplace,however,theydorecognizetheproblemsstemmingfromprolongedeasymoney,andthustheneedforsourcecountriestoexit.Butwhensourcecountriesmove to exit unconventional policies, some recipient countries are leveraged,imbalanced,andvulnerabletocapitaloutflows.Giventhatinvestmentmanagersanticipate theconsequencesof thefuturepolicypath,evenameasuredpaceofexit may cause severe market turbulence and collateral damage. Indeed, themoretransparentandwell-communicatedtheexitis,themorecertaintheforeigninvestmentmanagersmay be of changed conditions, and themore rapid theirexitfromriskypositions.

Recipient countries are not being irrational when they protest both theinitiationofunconventionalpolicyaswellasanexitwhosepaceisdrivensolelybyconditionsinthesourcecountry.Havingbecomemorevulnerablebecauseofleverageandcrowding,recipientcountriesmaycallforanexitwhosepaceandtimingisresponsive,atleastinpart,toconditionstheyface.

THECASEFORINTERNATIONALMONETARYPOLICYCOORDINATION

Hence,mycall is formore coordination inmonetarypolicybecause I think itwould be an immense improvement over the current international non-system.

International monetary policy coordination, of course, is unpopular amongcentralbankers,andI thereforehave tosaywhyI reiterate thecallandwhat Imeanbyit.

I do not mean that central bankers sit around a table and make policycollectively, nor do I mean that they call each other regularly and coordinateactions. In its strong form, I propose that large country central banks, both inadvanced countries and emerging markets, internalize more of the spilloversfromtheirpoliciesintheirmandate,andareforcedbynewconventionsonthe‘rulesofthegame’toavoidunconventionalpolicieswithlargeadversespilloversandquestionabledomesticbenefits.Giventhedifficultiesofoperationalizingthestrong form, I suggest that, at the very least, central banks reinterpret theirdomesticmandatetotakeintoaccountothercountryreactionsovertime(andnotjust the immediate feedback effects), and thus become more sensitive tospillovers. This weak ‘coordination’ could be supplemented with a re-examinationofglobalsafetynets.

THEGAINSFROMCOORDINATION

Economists generally converged on the view that the gains to policycoordination were small provided each country optimized its own policieskeepinginmindthepoliciesofothers.The‘Nashequilibrium’wasnotthatfarfromtheglobaloptimum,hencethe‘ownhouseinorder’doctrinewasdominantin the internationalmonetary field.Nationalmacroeconomicstabilitywasseenas sufficient for international macroeconomic stability. The domestic andinternationalaspectswereessentiallyregardedastwosidesofthesamecoin.

Two factors have led to a rethinking of the doctrine. First, domesticconstraintsincludingpoliticalimperativesofbringingunemploymentdownandtheeconomicconstraintofthezerolowerboundmayleadmonetarypolicytobeset at levels different from the unconstrained domestic optimal.Dysfunctionaldomesticpoliticscouldalsocontributeinmovingmonetarypolicyfurtherfromthe unconstrained optimal. In other words, the central bank, responding to avariety of political pressures and weaknesses, may stray away from even theconstrainedoptimal–towardsthirdbestpoliciesratherthansecondbestpolicies.

Second,cross-bordercapitalflowscanleadtoamoredramatictransmissionofpolicies, driven by agency (and other) considerations that do not necessarilyrelatetoeconomicconditionsintherecipientcountries.

One argument along these lines is that if some large country adoptsunconventionalandhighlyaccommodativesub-optimalpolicies,othercountriesmay follow suit to avoid exchange rate appreciation in a world with weakdemand.As a result, thepolicy equilibriummayestablish at rates that are toolowcomparedtothatwarrantedbytheglobaloptimal.Anotherargumentisthatwhenthesendingcountryisatthezerolowerbound,andthereceivingcountryresponds tocapital inflowswithaggressivereserveaccumulation,bothmaybebetteroffwithmoremoderatepolicies.Indeed,itmaywellbethatcoordinationmay allow policy makers political room to move away from sub-optimalpolicies. If political paralysis and consequent fiscal tightening forces a sourcecountrytoasub-optimalrelianceonmonetarystimulus,policycoordinationthatallows for expanded demand elsewhere could allow the source country to cutbackonitsdependenceonmonetarystimulus.

DOMESTICOPTIMALISCLOSETOTHEGLOBALOPTIMAL

Despite thesearguments,officialstatementsbymultilateral institutionssuchasthe IMF continue to endorse unconventional monetary policies whiledownplaying the adverse spillover effects to other countries. Indeed, in anexcellentanalysisoftheobstaclestointernationalpolicycoordination,theIMF’sownJonathanOstryandAtishGhosharguethat‘impartial’internationalpolicyassessmentsbymultilateralentitiescouldbesuspectedofbias

‘…if therewere a systematic tendency of the assessor to identify a change in policy (tighter fiscalpolicy;loosermonetarypolicy;structuralreform)asalwaysyieldingwelfaregainsatthenationalandgloballevels.Thiswouldbreedsuspicionbecausethebasecaseshouldbethatcountriesdonotfailtoexploitavailablewelfaregains…it is implausible thatwelfaregainsat thenationalandglobal levelsshouldalwaysbepositivelycorrelated…’

By downplaying the adverse effects of cross-bordermonetary transmission ofunconventionalpolicies,weareoverlookingtheelephantinthepost-crisisroom.

Iseetwodangershere.Oneisthatanyremainingrulesofthegamearebreakingdown. Our collective endorsement of unconventional monetary policiesessentially says it is okay to distort asset prices if there are other domesticconstraintstorevivinggrowth,suchasthezerolowerbound.Butnetspillovers,ratherthanfancyacronyms,shoulddetermineinternationallyacceptablepolicy.

Otherwise, countries could legitimately practice what they might callquantitative external easing or QEE, whereby they intervene to keep theirexchangeratedownandbuildhugereserves.ThereasonwefrownedonQEEinthepast isbecausewebelieved theadversespillovereffects for the restof theworld were significant. If we are unwilling, however, to evaluate all policiesbased on their spillover effects, there is no legitimate way multilateralinstitutions can declare that QEE contravenes the rules of the game. Indeed,someadvancedeconomycentralbankershaveprivatelyexpressedtheirworrytome that QE ‘works’ primarily by altering exchange rates, which makes itdifferentfromQEEonlyindegreeratherthaninkind.

The second danger is a mismanaged exit will prompt fresh distortionarybehaviour. Even as source country central banks go to great pains tocommunicate how their removal of accommodation will be contingent ondomestic activity, they have been silent on how they will respond to foreignturmoil.Market participants conclude that recipient countries, especially thosethatdonotbelongtolargereservecurrencyblocks,areontheirown,andcrowddevastatinglythroughtheexit.

Indeed, the lesson some emergingmarketswill take away from the recentepisodeofturmoilis(i)don’texpanddomesticdemandandrunlargedeficits(ii)maintain a competitive exchange rate (iii) build large reserves, because whentrouble comes, you are on your own. In a world with deficient aggregatedemand,isthisthemessagetheinternationalcommunitywantstosend?

Forthisisnotthefirstepisodeinwhichcapitalhasbeenpushedfirstinonedirection and then in another, each time with devastating effect. In the early1990s,rateswereheldlowintheUnitedStates,andcapitalflowedtoemergingmarkets.ThewaveofemergingmarketcrisesstartingwithMexicoin1994andending with Argentina in 2001, sweeping through East Asia and Russia in

between,waspartiallycausedbyareversaloftheseflowsasinterestratesrosein industrial countries. The subsequent reserve build-up in emerging markets,including China, contributed to weak global demand and excess spending bysomeindustrialcountries,culminatingintheglobalfinancialcrisisof2007-09.Once again, though, post-crisis unconventional monetary policy has pushedcapital to emergingmarkets, with the associated build-up in fragility. Are wesetting the stage for a resumption of the ‘global savings glut’ as emergingmarketsbuildreservesonceagain?

Two obvious remedies suggest themselves; less extrememonetary policieson all sideswith some thought given to adverse spillover effectswhen settingpolicy, and better global safety nets tomitigate the need for countries to self-insurethroughreservebuffers.

MOREMODERATEPOLICY

Even thoughwe live inaworldwheremonetary transmission isglobal,policyfocusislocal.Centralbanksmountanumberofdefencesastowhytheyshouldnot take full accountof spillovers.Oneway todemonstrate theweaknesses intheusualargumentsthatareputforwardtodefendthestatusquoistoseehowthey would sound if they were used to defend QEE, that is, sustainedinterventionintheexchangemarkettokeeptheexchangeratecompetitive.

Defence1:Weareadevelopingcountryandwearemandatedtosupportgrowth.Institutional constraints in enhancing productivity, and our vulnerability tosuddenstops,meansthatacompetitiveexchangerate,andthusQEE,isessentialtofulfillingourmandate.

Defence 2: Would the world not be better off if we grew strongly? QEE isessentialtoourgrowth.

Defence3:Wetakeintoaccountfeedbackeffectstooureconomyfromtherestof the world while setting policy. Therefore, we are not oblivious to theconsequencesofQEEonothercountries.

Defence4:Monetarypolicywithadomesticfocusisalreadyverycomplicatedand hard to communicate. It would be impossibly complex if we wereadditionally burdenedwith having to think about the effects ofQEE on othercountries.

There are many problems with these defences that those who havecomplainedaboutcurrencymanipulationwillrecognize.Currencymanipulationmayhelp growth in the short run (even this is debatable) but creates long-rundistortions thathurt themanipulatingcountry.Therearemoresensiblepoliciestofostergrowth.Andevenifacentralbankhasapurelydomesticmandate,thecountry’sinternationalresponsibilitiesdonotallowittoarbitrarilyimposecostson the rest of theworld.Thenet spillover effectsneed tobe estimated, and itcannot be taken for granted that the positive spillovers from the initiatingcountry’s growth (say through greater trade) more than offset the adversespillovers to other countries. Feedback effects to the source country representonlyasmallpartofthespillovereffectsexperiencedbytheworld,andacentralbankwill be far from implementing the globally optimal policy if it is solelydomestically oriented, even if it takes these feedback effects into account.Countriesarerequiredtopayattentiontotheeffectsoftheirpoliciesonothers,nomatterhowmuchtheaddedcomplication,becauseweallhaveinternationalresponsibilities.

Of course, the readerwill recognize that each one of these arguments hasbeen made defending unconventional monetary policy. Yet multilateralinstitutions treat sustained currency intervention with great opprobrium whilegiving unconventionalmonetary policy a clean chit. Should the cleanliness ofthechitnotdependonthesizeofthenetspilloversandthecompetitiveresponseitengenders?Withoutestimatingthemcarefully,howcanwetell?

OPERATIONALIZINGCOORDINATION:SOMESUGGESTIONS

We need to break away from this cycle of unconventional policies andcompetitivemonetaryeasing.Already,theeventsofrecentmonthshavesetthestageforrenewedreserveaccumulationbytheemergingmarkets.Andthistime,itwillbeharderforadvancedeconomiestocomplainiftheydownplaytheirown

spillovereffectswhiletheyarepushingforrecovery.

ANINDEPENDENTASSESSOR

Inanidealworld,unconventionalmonetarypoliciessuchasQEorQEEshouldbevettedbyanindependentassessorfortheirspillovereffects.Theassessmentprocedure is easy to visualize; Perhaps following a complaint by an impactedcountry(as in theWTO), theindependentassessorcouldanalysetheeffectsofsuchpolicies andcome to a judgmentonwhether they follow the rulesof thegame. Policies where the benefits are largely domestic, while the costs falllargely abroad, would be especially carefully scrutinized. And if the assessordeems the policy reduces global welfare, international pressure should beappliedtostopsuchpolicies.

Theproblemswithsuchanidealisticprocessareeasytosee.Whereissuchan impartial assessor to be found? The staff at multilateral institutions isexcellent, and well capable of independent judgment. But political pressuresubsequent to the initial assessment operates unevenly. Initial assessmentstypically remain unaltered when a small country complains (no country likesindependent assessments), but are often toned down when a large economyprotests.There aremany exceptions to this, butmorework is needed to buildtrustintheimpartialityofassessmentsofmultilateralinstitutions.

Evenifmultilateralorganizationsbecomeimmunetopowerpolitics,theyarenot immune to cognitive capture. Their staff has been persuaded by the samemodelsandframeworksasthestaffofindustrialcountrycentralbanks–modelswhere monetary policy is an extremely powerful tool to elevate activity, andexchange rate flexibility does wonders in insulating countries from the mostdebilitating spillovers. ‘Decoupling’ is always possible in such models, eventhough the evidence is that the models typically underestimate the extent of‘coupling’.Indeed,manyofthesemodelsdonothaverealisticmodelsofcredit,orofmonetarytransmissioninaneconomywithdebtoverhang,whichreducestheirvalueconsiderably.Progressisbeingmadebutitwilltaketime.

And, of course, even if a truly independent assessment came to theconclusionthatcertainpolicieswereinviolation,howwouldsuchajudgmentbe

enforced?Therealityisthattherulesofthegamewereframedinadifferenteratodeter

competitive devaluations and currency manipulation. They have not beenupdated for today’sworldofmorevariedcompetitiveeasing.But it isunclearthat even if they were updated, they could be assessed and enforced in thecurrentenvironment.

AMOREMODESTPROPOSAL

Perhaps, then, itwouldbebetter to settle for amoremodestproposal.Centralbanksshouldassessspillovereffectsfromtheirownactions,notjustintermsofimmediate feedback, but also in terms of medium-term feedback as othercountriesaltertheirpolicies.Inotherwords,thesourcecountryshouldnotjustworryabouttheimmediateflowsofcapitaltoothercountriesfromitspolicies,but the longer run reaction such as sustained exchange intervention that thiswould bring about. This would allow central banks to pay more attention tospilloversevenwhilestayingwithintheirdomesticmandate.

For example, this would mean that while exiting from unconventionalpolicies, central bankswould pay attention to conditions in emergingmarketsalsowhiledecidingthetimingofmoves,whilekeepingtheoveralldirectionofmovestiedtodomesticconditions.Theirpolicystatementsshouldacknowledgesuchconcerns.Tobeconcreteinaspecificcase,theFedpostponingtaperinginSeptember 2013 allowed emerging economies more time to adjust after theinitial warning in May 2013. Whatever the underlying rationale forpostponement, it helped set the stage for tapering start smoothly inDecember2013, without disruptingmarkets. In contrast, with volatility hitting emergingmarkets after the Argentinian problems in January 2014, the Fed policystatement in January 2014, with no mention of concern about the emergingmarket situation, and with no indication Fed policy would be sensitive toconditionsinthosemarketsinthefuture,senttheprobablyunintendedmessagethat those markets were on their own. Speeches by regional Fed presidentsemphasizing the Fed’s domestic mandate did not help. Since then, Fedcommunication has been more nuanced, though the real challenge in

communicationliesaheadwhenpolicyrateshavetomoveup.

INTERNATIONALSAFETYNETS

Emergingeconomieshavetoworktoreducevulnerabilitiesintheireconomies,togettothepointwhere,likeAustralia,theycanallowexchangerateflexibilityto do much of the adjustment for them to capital inflows. But the neededinstitutions take time to develop. In themeantime, the difficulty for emergingmarketsinabsorbinglargeamountsofcapitalquicklyandinastablewayshouldbeseenasaconstraint,muchlikethezerolowerbound,ratherthansomethingthat can be altered quickly. Even while resisting the temptation of absorbingflows,theywilllooktosafetynets.

Soanotherwaytopreventarepeatofsubstantialreserveaccumulationistobuildstrongerinternationalsafetynets.Asthefinancialcrisissuggested,thisisnotjustanemergingeconomyconcern.Inaworldwhereinternationalliquiditycan dry up quickly, the world needs bilateral, regional, and multilateralarrangementsforliquidity.Multilateralarrangementsaretriedandtested,andareavailablemorewidely,andwithoutsomeofthepossiblepoliticalpressuresthatcouldarisefrombilateralandregionalarrangements.IndeedswaparrangementscanbechannelledthroughmultilateralinstitutionsliketheIMFinsteadofbeingconducted on a bilateral basis, so that the multilateral institution bears any(small) credit risk, and the source central bank does not have to justify thearrangementstoitspoliticalauthorities.

Perhaps equally valuable would be a liquidity line from the IMF, wherecountriesarepre-qualifiedbytheIMFandtold(perhapsprivately)howmuchofalinetheywouldqualifyforundercurrentpolicy–withthesizeoftheavailablelinerevisedannuallyaftertheIMF’sassessmentandanycurtailmentbecomingeffectivesixmonthslatersoastogiveacountrytimetoadjustpoliciestoqualifyforhigher limits,or to findalternativearrangements.Access to the linewouldgetactivatedby the IMFBoard ina situationofgeneralized liquidity shortage(as, for example,whenpolicy tightening in source countries after an extendedperiodoflowratescausesinvestmentmanagerstobecomeriskaverse).TheIMFhas suggested such arrangements in a discussion paper, and they should be

exploredbecausetheyallowcountriesaccesstoliquiditywithoutthestigmaofapproaching the Fund, and without the conditionality that accompanies mostFundarrangements.

Clearly, the Fund’s resources will be safe only if the situation is one ofgenuine temporary illiquidity rather than onewhere countries need significantreforms to regain market access. Equally clearly, access will vary acrosscountries,andprolongeduseaftertheliquidityemergencyisdeclaredoverwillnecessitatean IMFprogramme.Nevertheless, the twinproposalsof theGlobalStability Mechanism and Short-term Liquidity Line that the IMF Board hasexamined in the past deserve close examination for they come closest togenuinelyhelpingoffsetreservebuild-up.

Finally, itwouldbe a useful exercise for theFund, in a periodof growingvulnerability to capital flow reversals, to identify those countries that do nothaveown,bilateral,regional,ormultilateralliquidityarrangementstofallbackon,andtoworkto improvetheiraccess tosomesafetynet.Theroleofhonestex-antemarriagebrokermaybeonethatcouldprovetobeimmenselyimportantwhentheinterestrateenvironmentchanges.

CONCLUSION

Thecurrentnon-systemininternationalmonetarypolicyis,inmyview,asourceofsubstantialrisk,bothtosustainablegrowthaswellastothefinancialsector.Itis not an industrial country problem, nor an emergingmarket problem, it is aproblemofcollectiveaction.Wearebeingpushedtowardscompetitivemonetaryeasing.

If I use terminology reminiscent of the Depression era non-system, it isbecauseIfearthatinaworldwithweakaggregatedemand,wemaybeengagedinafutilecompetitionforagreatershareofit.Intheprocess,unlikeDepression-era policies, we are also creating financial sector and cross-border risks thatexhibit themselveswhen unconventional policies come to an end.There is nouse saying that everyone should have anticipated the consequences. As theformer Bank of International Settlements (BIS) General Manager AndrewCrockettputit,‘financialintermediariesarebetteratassessingrelativerisksata

pointintime,thanprojectingtheevolutionofriskoverthefinancialcycle.’Afirststeptoprescribingtherightmedicineistorecognizethecauseofthe

sickness.Extrememonetary easing, inmyview, ismore cause thanmedicine.Thesoonerwerecognizethat,themoresustainableworldgrowthwewillhave.

T

CHAPTER9

RBIMATTERS

I

PerhapsthemostenergizingaspectofmytermattheReserveBankwastheopportunitytoworkwithsomeof themostdedicatedprofessionals Ihavemet inmy life, the staffof theReserveBank.Theaveragequalityofpeoplewashighbyeveninternationalstandards,letalonepublicsectorstandards,theorganizationtookprideinitswork,andithadagreattraditionofcomraderyandcommunity.TheyoungerstaffoftheRBIwerefromabroadvarietyofschoolsandbackgrounds,trulyrepresentativeofIndiandiversity.Theywereenthusiastic,andeagertoworkandlearn.IsoonrealizedthatwhenIsetagroup a task, theywould invariably rise to the occasion and produce high qualitywork.On the 80anniversaryoftheRBIon1April2015,thisisthemessageIsentmycolleagues.

RemarksonRBI’s80thAnniversary

heReserveBankof India iseightyyearsold today.Eightyyears isa longtimeinthelifeofahuman,onewhichpeopleinthesouthcelebratewitha

Sathabhishekham, but it is not a long time in the life of an institution.Neverthelessmuch has happened since the year 1935when theReserveBankwassetupto‘regulatetheissueofBanknotesandthekeepingofreserveswiththe view to securing monetary stability in India and generally to operate thecurrencyandcreditsystemofthecountrytoitsadvantage’.

IndiawasthenunderBritishrule,andthefirstGovernor,SirOsborneSmith,wasanAustralian.But theRBIwascertainlynotaBritish institution,andhasbeen working right from the outset for Indian economic interests. It has alsonurturedIndian talent. In1943,ChintamanDwarkanathDeshmukh,oneofourfinestfinancialminds,wasappointedasthefirstIndiangovernoroftheReserveBank.NotonlydidherepresentIndiaattheBrettonWoodsconference,healso

went on to become one of its longest serving financeministers. Amongst theproblems he had to confrontwas how to deal respectfully but firmlywith thedebtsthecolonialpowerhadaccumulatedtoIndiaduringWorldWarII.

Over theyears, theReserveBankhasbeenblessedwith anumberof suchfineleaders,areflectionalsooftheimportancethegovernmentplacesinhavingastrongcentralbank.Thelistofpastgovernorsanddeputygovernorsreadslikeawho’swhooftheIndianeconomicestablishment,withgovernorslikeBenegalRama Rau, M. Narasimham, Dr I.G. Patel, Dr Manmohan Singh, Dr C.Rangarajan,DrBimalJalan,DrY.V.Reddy,andDrD.Subbarao,ablyassistedbyDeputyGovernorssuchasS.S.Tarapore,VepaKamesan,DrRakeshMohan,ShyamalaGopinath,UshaThorat, andDrSubirGokarn.TheRBI’s board hasalso been superb, with people like Sir Purshottamdas Thakurdas and YezdiMalegamguidingit.

Interestingly,manyof thegovernorswere from theadministrative services,withonlyone,M.Narasimham,fromtheRBIitself.Nevertheless,allunderstoodthattheReserveBank’sroleistosafeguardthemonetaryandfinancialstabilityofthecountryevenwhileworkingtowardsitsfinancialdevelopment.TherehasalwaysbeenahealthydialoguebetweenthegovernmentandtheBank,informedby their respective timehorizonsandattitudes towardsrisk.And invariably,ashistory records, successive governments have appreciated the wisdom of theReserveBank’scounsel.

Noinstitutionisbiggerthanthepeoplewhoworkforit.IftheReserveBankis respected today, it isbecauseof themany thousandswhohaveworkedovertheyearsfortheBank,withcapabilityanddedication.Letmerecognizetwoasrepresentativeofthemany.RaniDurve,aDGMintheBhopaloffice,hascreatednumerousfilms,books,andstreetplaysonthemessuchasfictitiousemailsandexcessiveinterestratessoastoeducateandalert thepublic.NirmalPattnayak,anAGM in theDepartment of InformationTechnology, enabled the pan-Indiaelectronic transfer of funds for government departments through the nationalelectronicpaymentsystems,thusovernightmakingthegovernmentasignificantuserofthesesystems.Bothhavegonebeyondtheordinarycallofduty,butsodomanyothersintheBank.

Equally commendable is the general integrity of the staff. It is amatter ofgreatprideformetodaythatwhensomeoneentersourbuildingtopersuadeustochangearegulation,theycomearmednotwithmoneybutwithargumentsaboutwhatisright.

Strong national institutions are difficult to build. Therefore existing onesshouldbenurturedfromtheoutside,andconstantlyrejuvenatedfromtheinside,for there are precious few of them. Rejuvenation means constantly thinkingabouthowwecandobetter in serving thepeopleof thiscountry.Whetherwecontribute by speeding up files we are sitting on, curtailing expenses,simplifying paperwork and regulations, doing innovative research, orworkingcooperativelywithcolleagues,therearemanywaysweallcandoourbit.Iaskyoutojoinmeinrededicatingourselvesinthe81styearofthisgreatinstitutionto ensure that the Reserve Bank of India continues to help the nation secureprosperityandeconomicopportunityforall.

D

II

While Iwas very proud of theBank, therewas room for improvement.We embarked on a seriousinternal reorganization, intended to streamline theorganization.Wealso revamped theperformance-evaluationsystem,andworkedtoimprovetheskill-assessmentandskill-buildingprocesses.Allthesechangesweredesignedbyseniormanagement,withouttheinvolvementofoutsideconsultants,sothattheorganizationwouldownthechanges.Therewerenopublicspeechesonallthis,butsomeofthisdidbecomepublic:Everyyear-end,Iwrotealettertoourstaff.Whilethiswasmeanttobeaninternalcommunication, the following letter was leaked piece-meal to the press (reflecting the adage thatnothingtheRBIGovernorsaysorwritesissecret).Unfortunately,whatleakedoutwereprimarilymyreflectionsonthescopeforimprovement(suggestingthatwasnewsworthy)andnotmysenseofwhatwasworkingwell.Ireproduceitinitsentiretybecauseitisalreadyinthepublicdomain.

Year-endLettertoRBIStaff,31December2015

earColleagues:I wish all of you and your loved ones a very happy, healthy, and

fulfillingNewYear.Ihopeyouspentsometimewithyourfamiliesandfriendsinthelastweekoftheyear.

The last year has been full of actions and accomplishments by ourcolleagues. I will not catalogue them here – I trust you have followed thedevelopments in thenewspapers, andwill readanoveralldetailedview inourannual report. I am confident that based on the compliments I hear from thepublic about our staff’s professionalism and integrity, our ability to continuerecruitingthehighestqualitytalentintoourstaffwillbemaintained.Icontinuetobe impressedby thededicationandcapabilitiesofmanyofourstaff–mostrecently,ateamofregulatorsandsupervisorsthathasworkedtirelesslyoverthelast fewmonths, foregoing numerous holidays, on the very important task ofcleaningupbankbalancesheets.

Nevertheless,astrongorganizationreliesoncontinuousself-examinationinordertostayathighlevelsofexcellence.Inthecomingmonths,wewillhavetheoccasiontohaveadialoguethroughtownhallmeetings.Letme,however,flagsomeareasofstrengthaswellasthoseofconcern.

EFFECTIVESERVICE

We are a service organization. We have customers, whether they are theregulatedorganizations, thepublic,or thegovernment.Weneed to serve themeffectivelyandefficiently.Byandlarge,ourstaffmembersperformwell,withafew committed extraordinary individuals going way beyond the call of duty.Nevertheless, if I press the stakeholders I meet, I do hear criticisms. Ourregulations are not always very clear, our staff sometimes is neither wellinformed about our own regulations nor willing to help the customer, ourresponsesareoccasionallyextraordinarilyslowandbureaucratic(inthesenseofhidingbehindopaquerulesoravoidingadecisionratherthantakingasensiblecourseofaction).Theimagerythatcomestomindforcriticsisofatraditional,unimaginativeorganizationratherthanadynamic,intelligentone.

We are working on streamlining our regulations in the new masterdocuments,and trying toweedoutoldhistoricalones.Weneed tocontinue toimprove the language in them so that every concerned person can understandwithout much effort the letter and spirit of what we want to say. Simple-to-understand regulationswillbeabenefit toour staff also, especially thosewhoarenew toadepartment,because theycancomeup to speedquickly.Wealsoneed to build a library of cases that will help us understand how similarquestions were dealt with in the past, that is, we need to build institutionalmemory rather than let crucial experiencesget carried away into retirement inindividual memories. This requires experts in departments to document theirknowledge,especiallyas theygetreadyto leave.Indeed,onecouldvisualizeaprocess of documentation and debriefing as an essential part of the transferprocess. We also need to streamline all our forms and put the bulk of filingonline,withuniquecustomer idsso that repetitivefillingofcommondetails iseliminated. Finally, we need to adhere to timelines.We are in the process oftracking response times.Wehope to see concretemeasuresduring the comingyearonbringingthemdownwherenecessary.

CULTUREOFCOMPLIANCE

IthasoftenbeensaidthatIndiaisaweakstate.Notonlyareweaccusedofnot

havingtheadministrativecapacityofferretingoutwrongdoing,wedonotpunishthewrongdoer–unlessheissmallandweak.Thisbelieffeedsonitself.Noonewantstogoaftertherichandwell-connectedwrongdoer,whichmeanstheygetawaywithevenmore.Ifwearetohavestrongsustainablegrowth,thiscultureofimpunity should stop. Importantly, this does notmean being against riches orbusiness,assomewouldliketoportray,butbeingagainstwrongdoing.

Asthepremierandmostrespectedregulator in thecountry,weshould takethe lead.Wehavemotivatedstaffwith thehighest integrityatevery level.Yetthere isasense thatwedonotenforcecompliance.Areweallowingregulatedentities to get away year after yearwith poor practices even though these arenoted during inspections/scrutinies? Should we become more intolerant ofsloppypracticesatregulatedentities,sothatthesedonotresultinmassivescamsyearslater?Shouldwehaulupaccountantswhodonotflagissuestheyshoulddetect?Mysenseisthatweneedacontinuingconversationabouttighteningbothdetectionaswellaspenaltiesfornon-compliancethroughout thehierarchy.Wecannot be seen as a paper tiger. We are changing our attitude towardscompliance,butthisisworkinprogress.

SELF-EXAMINATIONANDMUTUALSUPPORT

Ifwedemandmoreoftheregulated,weshouldnotbefoundwantingourselves.As with all organizations, we are reliant on a few stalwarts who carry theorganizationontheirbroadshoulders.Thesearethebestperformers.Thereisasecond tier that exceeds the needs of the job through their effort or theircapabilities, but they fall a little short of being truly excellent. A third tierconsistsoftime-servers,forwhomthejobisasourceoflivelihoodbutwhohavelost thedesire toexcel.Theyput inareasonableday’swork,butnotanouncemore than what is demanded of them. And then there are those who areoverwhelmed by the work or who have lost any desire to perform. I haveencounteredallthesetypesattheBank.

Unfortunately, our performance-evaluation system did not help us identifywhoneededmotivationandimprovement,andhowtheycouldbehelpedtodoso.Almosteveryonewasdeemedexcellent,rangingfromthosewhogavetheir

heartandsoulfortheBanktothosewhoshirkedallresponsibilityorduty.Weneedtochangethis,torewardthosewhoperformandtohelpthosewho

donot.Thenewperformance-evaluationsystemismeant toaid in this.Wedorealizetherewereshortcomingsintheinitialround,astherewillbewitheverynewsystem.Weareworkingtofixthem.Butpleasedonotattributealowerthannormal rating for yourself to a shortcoming in the process. There may beinformationintheratingthatyoushouldtakeseriously.Asanorganization,ifwedo not subject ourselves to serious self-examination and continue to pretendeveryoneisworkingfine,letmeassureyouthattheorganizationcannotbecomebetterthanwhatitisnow.Weneedtocontinuouslyreviewandrenewourselvesifwehavetocompetewiththebestintheworld.

Inthecomingyear,muchwillbedemandedofreportingofficers.Theyneedtolettheirsubordinatesknow,perhapsevenasfrequentlyaseveryquarter,howtheirperformancehasbeen,andeveninformallydocumentthisdiscussion.Thefinalperformanceappraisalshoulddifferentiategoodfrombadperformance,andshouldnotcomeasasurprisetothepersonbeingevaluated–theyshouldhavepicked up cues during the year. Subordinates who are not getting regularfeedbackshouldasktheirreportingofficers.Thismeansmoreworkforall,butitwillbecriticalinhelpingusimprove.

Let me highlight an issue that especially concerns me. As I sit throughpromotioninterviews,Iamworriedthatpeoplearelosingcuriosity,thedesiretolearn and improve themselves. I am concerned that some people do not readoutside thepapers thatcomeacross theirdesk, that theyhaveno ideaofotherbranchesoftheBankandtheirwork, letalonethewiderworld.Weemphasizespecialization,butthatdoesnotmeanthereisnoneedtoreadthenewspapers,letalonemagazinesandbooks.Thishastochangeiftheorganizationistoremainvibrant.Incomplacencyandself-satisfactionliesaslowdescentintomediocrity.

Wedowant to revampthesupportwegiveourstaff to learn.Weintend toinvest in our staff on a continuing basis, as evidenced by the expansion inGoldenJubileefellowships.ThecomingyearwillbefocusedonrevampingtheHuman Resource Department’s efforts to assess individual needs and careerplansandprovidethenecessaryskillbuilding.Wewantmoreofone’scareerin

theBanktobeself-drivenratherthandrivenbytheneedsoftheBank–thoughamixofthetwowillalwaysbeinevitable,itisbestwhenthetwocoincide.Seniormanagementwouldappreciateanysuggestionsandideasthatyoumayhaveinthisregard.

COMMUNICATIONANDCOOPERATION

I have made this point before, and will make it again. We need to improvechannels of communication within the Bank, both horizontally and vertically.TheBank cannot afford to be divided into silos – toomuch of ourwork cutsacross departmental boundaries. For managers, better communication meansmorewillingnesstomeetinpersonorbyvideoconference/phone/emailthanbyinterdepartmentalmemosandfilepushing.Itmeansfastresponsestothequeriesthat come to your desk, recognizing that cooperationwill be amply repaid. Itmeansregularmeetingswithstafftoaddresstheirquestions.

Forstaff,itmeansbeingwillingtoaskquestionsandresolveanxietieswhenyouhaveface-to-facemeetingswithmanagers,ratherthanbesilentatthattimeandthensuccumbingtounfoundedrumoursfloatedbyvestedinterestswhowanttopreyonyouranxieties.Itisalwaysfuntoconcoctconspiracytheories,andweIndiansoftenpreferthemtomoremundaneexplanations.However,managementintheBankisopen,andoneonlyneedstoasktogetthefacts.

We also need to communicate betterwith the outside. Thismeans thatweshould get ahead of the press, rather than be reactive. Ifwewant to highlightachievementsorregulations,weshouldprepareapressreleasetofocusthepressonwhat is important–with thereleasegetting to thepointquicklyrather thanstartingwithpagesofirrelevanthistory.Pressreleasesarebestdoneatorbefore5.30pmifyouwantit toshowupinthepapers.Beyondthat,reportersdonothavethetimetowritecopyforthenextday,andthenewsistoooldforthedayafter.

Some in theBank disdain communication. ‘Why not let our achievementsspeak for themselves?’ theymight say.Unfortunately, in thisworldwhere thepress ismoreattentiveand thepublicmorehungry fornews,weeither shouldshapenewsorwewillbeshapedbyit.Thelatterisinfinitelymoreunpleasant–

somemayrecall thewayweweretermedanti-technologyforsomeactionswetookagainstataxicompany.

FLEXIBILITY

Successful organizations are usually vibrant and flexible. They adapt tocircumstances.Asweconfrontthechallengesahead,weneedtobeflexible.Atonelevel,thismeansseizingopportunitiesthatarethrownupbytheexpandingIndianeconomy.Forexample,thenewfunctionofgatheringmarketintelligence,whichfeedsintoState-levelCoordinationCommittees,wasadynamicresponsetoourinabilitytoregulatealltheoperatorswhoattemptedtotakeadvantageofregulatory vacuums. Going forward, we need to create regulatory capacity tomonitor new entities like the internet market places that are also getting intolending.

Whilewe shouldbewaryof regulatoryoverreach,wemust also recognizethat ifwedonot expandour responsibilities, otherswill fill them.That is notalwaysabad thing,but ifnewregulators lead toaBalkanizationof regulationandmanyregulatorygaps,thesystemwillbeworseoff.Soletusbepreparedtostepupwherenecessaryinsteadofassumingotherswilltakeresponsibility.

But thisalsomeansweshouldbepreparedtohirenewcapabilities into theorganization.Whilewewilllookforhomegrowntalentwherepossible,weneedlateralentryinsomeareas.Wewillminimizetheseareas,butifweareasgoodaswe thinkweare,we shouldbeprepared to see some lateral entrywherevernecessary–providedinternalpeoplehaveafairchancetocompeteforthejobs.ThisisoneareawhereIfeelprotectionistattitudesintheorganizationarestrongandrequiretobedebated.

EMBEDDEDINTHECOMMUNITY

Finally,weareembeddedinachangingcommunity.Whatwasokayinthepastis no longer all right when the public demands transparency and bettergovernance frompublic organizations. I am glad to report that henceforth ourbudgetwillbeapprovedbyourCentralBoard.Ourdividendpolicyiscurrentlybeingdebatedwith thegovernment,butwe intend tomake it rule-basedusingcuttingedgeprinciples,sothatthestabilityoftheBankisprotected,evenwhile

the government gets all possible dividends fromownership.We also intend toimprovetheBoard’soversightofwageandperquisitenegotiations.Transparencyand good governance are ways to protect ourselves from roving enquiries –everyone should recognize that an effective regulator has enemies, and likeCaesar’swife,shouldbeaboveallsuspicion.

We also need to pay attention to the demands of the community.While itwouldbehardtoarguethatourprofitsnetofreservesbelongtoanybodyotherthanthegovernment,whichisalreadyinthebusinessofpublicandcommunityservice,wecanconductCSRoutofourownpersonalfunds.Iamproudthatouremployees have agreed to donate significant amounts to the various tragediesthathavehit thecountry,mostrecently inChennai,bygivingupaday’s leaveencashment. I am even prouder of our regional offices that have risen to theoccasion when faced with calamity, and ensured banking services keepfunctioning,evenwhiletheirownfamilieswerefacingdifficulties.Iamtoldthatourmedicalofficers inChennaiprovidedvitalpublicservices in thedaysafterthefloods.Thisis trulycommendable,butonlyconsistentwiththecommunityspiritthatcoursesthroughourorganization.

We have also committed to working for a cleaner India. Let us set anexample by cleaning up our environment,whether it is at the office or in ourcolonies,orevenoutside,inourcommunities.WeneedtorevitalizeourSwachhBharateffortsintheBanktomeetthechallengesetoutbyourPrimeMinister.

Letme end by sayingwe are all privileged to beworking for such a fineinstitution, an institution that compensateswell andgivesus challengingworkevenwhilegivingusthefulfilmentofdoingpublicservice.IfIhavepointedoutareaswherewecanimprove,itisbecauseIbelievetodootherwisewouldbetodo this great organization a disservice. In a similar vein, I would like you topointoutwhereweinseniormanagementcanimprove.Ideasandsuggestions,aswellasconstructivecriticism,shouldflowbothupanddownifwearetostaydynamic.

LetmewisheveryoneaHappyNewYearonceagain.

T

III

The quality and integrity of the RBI’s staff is a national treasure that we should do everything topreserve.Ontheinternalfront,mybiggestregretisthatIcouldnotsolvealong-pendingmatterthatIinherited from my predecessors: securing for retired RBI staff the same pension benefits thatgovernmentemployeesenjoy,despiterepeatedassurancesfromthegovernmentthatthematterwouldbeaddressed.Ihopethegovernmentwilldotherightthinghere.

TheReserveBank, perhaps because of its competence and integrity, is called upon to do a lot.Moreover,becauseitistheprimaryinstitutionsafeguardingourmonetaryandfinancialsecurity,ithasto say no to a lot of powerful people with significant interests. All this means there are perpetualbattleswiththosewhodisagreewithRBIpolicy,andwhobelievetheeasiestwaytochangepolicyisnottopersuadetheRBIbuttotakeawayitspowers.IdidnotthinktheRBIneededallthepowersithad,nordidithaveallthepowersitneeded,butIwaswaryofsuggestionsforchangethatwerenotaccompanied by sound rationale. I feared that without such rationales, we might be giving in tomotivatedinterests(whowantedalesscompetentregulator)orpowergrabs(fromthoseingovernmentwhowantedtoexpandturf)ortheRBImightbecomeascapegoat(aswewereentrustedwithtasksthatcouldnotpossiblybeaccomplished).

I mentioned earlier that committee reports are the way to initiate change in government. Thelegitimacyofcommitteereports,ofcourse,varies,especiallyiftheyaredrivenbyaspecificagendaorby interested parties. A vast quantity of underlying research can mask the fact that many policyrecommendations are ultimately just opinions, unsupported by research. The Financial SectorLegislativeReformsCommittee (FSLRC) report, commissionedby the financeministry in theUPAgovernment, recommendedenormouschanges to the financial system.Some recommendationswerevery useful and well-thought-out, but my fellow regulators and I had serious concerns about thepracticalityof,andrationale for,other recommendations,andwhether theywere reallyconnected totheresearchthatunderlaythereport.Here,thebiasesofsomeofthosewhocommissionedthereportorthedrafters,ratherthanareasonedconsensusamongallmembers,seemedtobecomingthrough.Fewrealizedthatthereportwassubmittedwithalargenumberofrecordeddissentstoitsfinaldraft.Withpressurebuildingtoimplementitwithoutaconsensusbeingreachedwithregulators–asifitwasthelaw of the land rather than simply another report – I thought it was important to air some of ourconcerns and I did so in a speech in June 2014. I had to be diplomatic, but also raise the rightquestions.

FinancialSectorLegislativeReformsCommitteeReport(FSLRC):WhattoDoandWhen?

heFinancialSectorLegislativeReformsCommittee(FSLRC)Reportisoneofthemostimportant,well-researched,aswellaswell-publicizedreportsin

Indianfinancialhistory.Itnotonlylaysoutthefunctionsofthefinancialsectorand how it should be structured, but also how legislation and regulationgoverning it ought to look like. The authors of this report truly have to becommendedfortheirnationalservice.

Thereismuchtolikeandagreewithinthereport.Inlayingouttheneedforconsumerprotection,raisingtheissueofwhetherproductssoldaresuitableforthetargetcustomer,andputtingtheonusonthefinancialinstitutiontodeterminesuitability, the reporthas forced regulators to review theirconsumerprotectionframeworks.WeattheRBIareindeedengagedinsuchanexercise,informedbythevaluableguidelinesintheFSLRCreport.

There ismore of great value. The FSLRCwants law not tomicromanage,andpreferstogiveregulatorsmoreleeway.Thisisindeedimportantastheworldwe regulate changes faster than the pace atwhich legislation can change.TheFSLRC’semphasison theneed fora clearmonetary frameworkculminated intheDrUrjitPatelCommitteereport,whichwillguideourthinkingintheyearsto come. Similarly, its focus on creating new institutions like the FinancialResolutionAuthoritytofillgapsinourinstitutionalstructureismuchneeded.

Icouldgoon.ButIcomeherenottopraisetheFSLRCReport,buttoarguethatitwouldbeamistaketoimplementsomeproposalsinthereporttoday.Forsomeproposals,theunderlyinglogicisquestionable,andseemstogoagainsttheveryrationaleofregulation.Inothercases,theproposalsmakemoresenseforaneconomywhere the regulatory framework ismoredevelopedand the judiciarymoreseasonedinmattersfinancial.Toimplementtheproposalsnowwouldbetotiethesystemupinknots.Letmeexplain.

THELOGICFORREGULATION

Thelogicforregulationaccordingto theFSLRCis todealwithmarketfailureor, more colloquially, bad behaviour. The committee talks about incompleteinformationorpoorincentivesasareasonforbadbehaviour,butoneofthemostimportantreasonsforbadbehaviournecessitatingregulationiswhateconomistscall incomplete contracts; that the behaviour of the regulated entity (vis-à-viscustomers,thepublicatlarge,thetaxpayer,orthemarket)cannotbecompletely

specifiedincontractsbecauseitistoodifficulttoobserveorverifyinrealtime,oritcanonlybegaugedacrossmanycontracts.

Whilecourtscanenforcespecificcontracts, theregulatorcansometimesdobetter.For instance,abankmayattracta lotofcomplaints fromitscreditcardcustomers.Whilenosinglecustomermaythinkthecaseworthtakingtocourt,andwhilenocustomermaybeabletoprovethebankwasinthewrong,thelargenumberofcomplaintswillsuggesttotheregulatorthatthebankneedstoshapeup.Bycomparingthenatureofthecomplaintsitgetsfromthisbank’scustomerswith the complaints it gets from other banks, the regulator can gaugewhat iswrongandact.Similarly, if aparticularproduct attracts a lotmorecomplaintsthan other products, the regulator can ask the industry to modify the productappropriately,orevenbanit.

Aregulatormayalsohavetopreventcertainformsofcontracting–suchasthe exotic securities that emerged before the financial crisis. If the regulatorthinksacertainkindofsecuritywillimposeunduesystemicrisksonthesystem,hecanban it,even though thesecuritywouldhave tradedamongstconsentingadults.Whilehehasnoproofthatthesecuritywillbehaveashethinksitwill,hecannotwaittilltherisksoccur,foritmaybetoolate.

Thebroaderpointisthatalotofregulatoryactionisaboutthesoundexerciseofjudgmentbytheregulatorbasedonyearsofexperience.Indoingso,hefillsinthegapsinlaws,contracts,andevenregulations.Noteverythingtheregulatordoes can be proven in a court of law. Courts do not interfere in the specificdecisionsofacorporateboard–using thebusiness judgment rule, theydonotsecond guess business decisions, and only pull up boards when there is aviolationofthelegalprocessofarrivingatadecision.Inthesameway,therearearangeofregulatorydecisionswhereregulatoryjudgmentshouldnotbesecondguessed.

THEDANGEROFEXCESSIVELEGALOVERSIGHT

YettheFSLRCwantsalmosteverythingtheregulatordoes,notjusttheframingofregulationbutalsotheexerciseofregulatoryjudgment,tobesubjecttolegalappeal. For that, itwants to create a Financial SectorAppellateTribunal.The

intentistoplacemorechecksandbalancesonregulatoryactions(notethatmostregulatory actions can already be appealed in high court). But how muchcheckingandbalancingisenough,andcanlegaloversightbecomeexcessive?

Therearethreedangerswehavetoguardagainst.Thefirstistoaskcourtstomake judgments that they simply do not have the capability, experience, orinformationtomake,andwherepreciseevidencemaybelacking.Ifweattemptto do this,wewill undermine the very purpose of a regulator.Of course, onecouldtrustthegoodsenseofthetribunaltofollowa‘regulatoryjudgment’ruleandnot interveneinabroadarrayofmatters,butdoes thisnot implyadoublestandard –we trust the tribunal’s judgment but not the regulator.More likely,though,pastexperiencesuggeststhatentitiesliketojustifytheirexistence,andifsetup,atribunalwillintervenemorethannecessary.

Aseconddangeris thateasingtheappellateprocesswill inviteappeal.Inadeveloped country with well-established regulations, a case history ofjudgments,andspeedycourts,thiswouldnotbeaproblem.InIndia,wherethefinancial system is developing and many new regulations have to be framed(more so ifwemove to aprinciples-basedapproach for legislation),while thejudiciarywill have a significant amount of learning to do evenwhile judicialprocesses have been slow, the encouragement to appeal could paralyse thesystemandcreatedistortions,asneededregulationsareheldupandparticipantsexploitloopholes.

Finally, in every country, ahealthy respect for the regulator serves tokeepparticipantson thestraightandnarrow. Inadevelopingcountry,whereprivatebehaviour is less constrained by norms or institutions, this is especiallyimportant.But to the extent that private partieswith their high-priced lawyerscanchecktheregulator,thathealthyrespectdissipates.Sothefinaldangeristhattheregulatorcouldbecomeapapertiger,andlosehispowerofinfluencinggoodbehaviour,eveninareasthatarenotsubjecttojudicialreview.

Am I arguing that no checks and balances are needed? Certainly not! Buttherearealreadychecksandbalancesinplace,includingthefactthathighcourtscanreviewregulatorydecisionsand that theregulator isappointed,andcanberemoved, by democratically elected representatives of the people.TheFSLRC

recommendsanannualreporttoparliament,aswellasregulardiscussionswithparliamentarians. These are good suggestions, which would add to oversight.But I would strongly urge the government not to draw parallels to otherregulated sectors and tie the financial regulatorwith further judicial oversightunderamisplacedsensethatthisisthepathtofinancialdevelopment.

REGULATORYARCHITECTURE

Anotherareawhere theFSLRChasstrongviews ison regulatoryarchitecture.As I said earlier, someof its suggestionshere aremuchneeded, including theFinancialResolutionAuthority.Butthelogicforsomeofthesuggestedchangesisweak,andsometimesinconsistent.

Let us take the suggestion tomerge all regulation of trading under a newUnifiedFinancialAgency.SotheForwardMarketsCommissionaswellas thebond regulation activities currently undertaken by the RBI would move, aswouldSEBI.Butthisassumesthatthecentralregulatorysynergyisthefactthattheinstrumentistraded.Butcouldothersynergiesexist?Andhowimportantarethey?

For instance, in forward trading where a real commodity is delivered,regulatory oversight over real markets for the commodity where price isdiscovered,aswellasoverwarehouseswherethecommodityisdelivered,maybe an important source of regulatory synergy. Should the FMC be subsumedundertheUnifiedFinancialAgencyorbebetteroffhavingstrongerlinkstotheministries overseeing the real commodities? I think the answer needs moreinvestigation.

Similarly, is the regulation of bond trading more synergistic with theregulationofotherdebtproductssuchasbank loansandwith theoperationofmonetarypolicy(wherebondsaretraded)orwithotherformsoftrading?Onceagain, I am not surewe have a compelling answer in the FSLRC report.Mypersonalviewis thatmoving theregulationofbond tradingat this timewouldseverelyhamperthedevelopmentofthegovernmentbondmarket,includingtheprocessofmakingbondsmore liquidacross thespectrum,aprocesswhich theRBIisengagedin.

TheFSLRCalsoseems tobe inconsistent in itsemphasisonsynergiesandregulatoryuniformity.Allregulationoftradingshouldmoveunderoneroof,allregulation of consumer protection should move under another roof, but theregulationofcreditshouldbebalkanized–banksshouldcontinuetoberegulatedby the RBI but the regulation of the quasi-bank NBFCs should move to theUnified Financial Agency, a regulatory behemoth that would combinesupervisionoftradingaswellascredit.Thisbalkanizationmakeslittlesenseandwouldhamper regulatoryuniformity, the supervisionof credit growth, and theconductofmonetarypolicy.

Morebroadly,theFSLRCseemstohaveanidealisticviewofthebenefitsofreorganization. It seems to believe that once activities are combined in anorganization, synergies can be fully exploited, while if they exist in separateorganizations, synergieswill not be exploited. I too shared such a view, but Inowbelieve it is too extreme. Siloswithin a large bureaucratic regulatormaypreventsynergiesfrombeingexploited,whilefrequentinter-regulatorymeetingscan allow regulators to capture many of available synergies between theiractivities. Indeed, oneparticularly useful proposal by theFSLRC is to put theFinancialSectorDevelopmentCouncilonafirmerfooting.Itisagoodvenueforinter-regulatorycooperation,anditsbenefitsarefurtheraugmentedbypersonalinteractions.For instance,ChairmanSEBIand I try toget togetheronceeverymonthtonoteandresolveissues.

Atthesametime,whilenegotiationsandcooperationbetweenregulatorscanovercome organizational barriers, it is not wise to give a regulator aresponsibility and leave the tools for exercising that responsibility in otherhands.TheRBIhasresponsibilityformanagingtheinternalandexternalvalueoftherupee,andmorebroadly,workingtowardsmacroeconomicstability.Asanumber ofmultilateral agencies and academics have recognized, the ability toshapecapitalinflowsisnowarecognizedpartofthemacro-prudentialtoolkit.ButbytakingawaycontroloverinternalcapitalinflowsfromtheRBI,isn’ttheFSLRCtakingawayanimportanttoolfromtheRBI?

IFITAIN’TBROKE…

Lestallthissoundlikeanunthinkingdefenceofregulatoryturf,letmeaddthatthere are places where the RBI could give up powers. For instance, if thegovernment wants tomanage its own debt, there is no reason for the RBI tostandintheway.Idon’tbelievethegovernmentsuffersanylessfromconflictsof interest indebtmanagement (unlike theviewsof theFSLRC), but theRBIcouldwellcarryoutthegovernment’sinstructionswithoutanylossinwelfare.Iimagine,however,thatthegovernmentwilldependondeputationsfromtheRBIforawhiletohelpitmanageitsdebt.

Instead, thinkofmyremarksasanattempt todistilwhat isusefulfromtheFSLRCreport,whileeschewinggrandschemeswithdubiouschancesofsuccess.Undoubtedly our laws need reform, but that is no reason to try entirely newapproachestolegislation,overlaidonentirelynewregulatorystructures,overlaidonentirelynewoversightoverregulation.Undoubtedly,wehavehad,andwillhave,periodswhenregulatorshavenotgottenalongwitheachother.Butisthata reason to merge some organizations and break up others, perhaps ensuringdysfunctionality along many other dimensions. After all, there is no singleregulatoryarchitecturethathasemergedwithdistinctionfromthecrisis.Instead,different regulatory architectures have succeeded or failed based on thecircumstancesofthecountryfailedandthequalityoftheregulator.

Undoubtedly, we have also had occasions when regulators have exceededtheirremitorbeenhigh-handed.Butisthatareasontosubjecttheireveryactionto judicial second-guessing? Is there a reason we need more checks andbalances,orarewetryingtosolveaproblemthatdoesnotexist.AstheChinesewouldsay,letusrecognizethevalueofcrossingtheriverbyfeelingeachstonebeforeweputourweightonit.Letusnottakeablindjumphopingthatastonewillbetheretosupportuswhenweland.

G

IV

AsIenteredmylastfewdaysinoffice,IwantedtoleaveexplainingwhyanindependentcentralbankwasnecessaryinIndia.AninvitationfromStStephen’sCollege,whichhasproducedsomanygoodeconomists in India,was the idealvenue.Therewasone specific issue Iwanted to clarify, theRBIdividend.Despite paying the largest amounts theRBIhad ever paid to the government as dividendduringmy termasGovernor, therewas still constant suggestions thatwecouldpaymore.Someofthesesuggestionsreflectedaninadequateunderstandingoftheeconomicsatworkinacentralbank’sbalancesheet.Onmylastdayinoffice,3September2016,Iaddressedbothissues.

TheIndependenceoftheCentralBank

oodmorning. It isgreat tobe invited tospeakatStStephen’sCollege. In1980, I toyed with the idea of joining my best friends in applying for

admissiontotheBAinEconomicshere.BecauseIhadworkedsohardfor theIITexam,however,IsuccumbedtothesunkcostfallacyandstudiedElectricalEngineering.Idon’tregretamomentofthatmisspentyouthbutIhopeyouwillgrantmetemporarymembershipofyourclubtoday!

Over the last few weeks, I have outlined the RBI’s approach to inflation,distresseddebt, financial inclusion, banking sector reform, andmarket reform.Today,IwanttoexplainwhyallthismeansIndianeedsastrongandindependentRBI to ensure macroeconomic stability. Then I will discuss what I think isneededtoensuresuchindependencegoingforward.

THENEEDFORMACROECONOMICSTABILITY

Growthisgood,butgrowthwithstabilityisbetter,especiallyinapoorcountrywheresomanypeopleliveatthemargin.FortheRBI,itmeansensuringgrowthdoesnotexceedourpotential,adoptingprudentialpoliciesthatreduceourrisk,andbuildingsufficientbuffersthatthecountryisprotectedagainstshocks.

HAVINGYOURCAKEANDEATINGITTOO:INTERESTRATESANDTHEEXCHANGERATE

Thismission,however,exposesthecentralbanktocriticism.Ifwetryandbringdown inflation, interest rates will remain higher than borrowers desire. If

inflation comes down, the currency will depreciate less than some exportersdesire. If we push the banks to clean up, banksmay be less tolerant towardshabitual non-payers. Whatever we do, someone will object. The RBI thenbecomes the favourite scapegoat for underperformance – if exports are notpickingup,itisbecauseinterestratesaretoohighandbecausetheexchangerateistoostrong.

Unlike the complainants, the RBI does not have the luxury of economicinconsistency.Ifwestartbuyingdollarsinabigwaytodepreciatetheexchangerate, we will be able to buy fewer government bonds if we are to maintaincontroloverliquidity.Theconsequencewillbehigherinterestratesinthebondmarket. Moreover, the depreciated exchange rate will mean higher inflation,whichinturnwillmeanhigherpolicyinterestratesgiventheinflationobjectivethegovernmenthassetforus.Onceagain,thismeanshigherinterestrates.Justlook at Brazil or Russia to understand you cannot have a significantlydepreciatedexchangerateandlowerinterestratesatthesametimeifyouwantstablegrowth!

FIRSTYEARECONOMICS:THEREISNOFREELUNCH.RBIDIVIDENDPOLICY

Afundamentallessonineconomicsisthereisnofreelunch.ThiscanbeseeninthematteroftheRBIdividend:Somecommentatorsseemtosuggestthatpublicsector banks could be recapitalized entirely if only the RBI paid a largerdividend to thegovernment.Letme explainwhymatters arenot so simple. Ifwhat follows is complicated, trust me, it is. But pay attention, students,especiallybecauseitisaboutyourmoney.Iamsureyouwillunderstand.

HowdoestheRBIgeneratesurplusprofits?We,ofcourse,printthecurrencyheld by the public, aswell as issue deposits (that is, reserves) to commercialbanks. Those are our fixed liabilities. As we issue these liabilities, we buyfinancial assets from the market. We do not pay interest on our liabilities.However, the financial assets we hold, typically domestic and foreigngovernmentbonds,dopay interest.Sowegeneratea largenet interest incomesimplybecausewepaynothingonvirtuallyallourliabilities.

Our total costs, largely for currency printing and banker commissions,

amounttoonlyabout1/7thofourtotalnetinterestincome.Soweearnalargesurplusprofit,morethanalmosttheentirepublicsectorputtogether,becauseoftheRBI’sroleasthemanagerofthecountry’scurrency.Thisbelongsentirelytothecountry’scitizens.Therefore,aftersettingasidewhatisneededtoberetainedasequitycapitaltomaintainthecreditworthinessoftheRBI,theRBIBoardpaysouttheremainingsurplustotheRBI’sowner,thegovernment.

TheRBIBoardhasdecideditwantstheRBItohaveaninternationalAAAratingsothatRBIcanundertakeinternationaltransactionseasily,evenwhentheGovernment is inperceiveddifficulty– in themidstof theTaperTantrum,nobankquestionedourabilitytodeliverontheFCNR(B)swaps,eventhoughtheliabilitycouldhavebeentensofthousandsofcrores.BasedonsophisticatedriskanalysisbytheRBI’sstaff,theBoardhasdecidedinthelastthreeyearsthattheRBI’s equity position, currently around 10 lakh crores, is enough for thepurpose.Itthereforehaspaidouttheentiresurplusgeneratedtothegovernment,amountingtoaboutRs66,000croreseachinthelasttwoyears,withoutholdinganythingback.This is of the order ofmagnitude of the dividends paid by theentirepublic sector to thegovernment. Inmy threeyears at theRBI,wehavepaid almost as much dividend to the government as in the entire previousdecade. Yet some suggest we should pay more, a special dividend over andabovethesurpluswegenerate.

Evenifitwerelegallypossibletopayunrealizedsurplus(itisnot),andevenif the Board were convinced a higher dividend would not compromise thecreditworthinessoftheRBI,thereisamorefundamentaleconomicreasonwhyaspecialdividendwouldnothelpthegovernmentwithitsbudgetaryconstraints.

Here’swhy:Muchofthesurpluswemakecomesfromtheinterestwegetongovernment assets or from the capital gains we make off other marketparticipants.Whenwepaythis to thegovernmentasdividends,weareputtingbackintothesystemthemoneywemadefromit–thereisnoadditionalmoneyprintingorreservecreationinvolved.(Thisisnotstrictlytrue.Ourearningsonforeignexchangeassetscomefromoutsidethesystem,sowhenwepaythistothegovernment asdividend,weareprintingadditionalmoney.Wedoaccountfor this.) Butwhenwe pay a special dividend to the government,we have to

create additionalpermanent reserves,ormorecolloquially,printmoney.Everyyear,wehave inmindagrowthrateofpermanent reservesconsistentwith theeconomy’scashneedsandourinflationgoals.Giventhatbudgetedgrowthrate,to accommodate the special dividendwewill have towithdraw an equivalentamountofmoneyfromthepublicbysellinggovernmentbondsinourportfolio(oralternatively,doingfeweropenmarketpurchasesthanwebudgeted).

Ofcourse,thegovernmentcanusethespecialdividendtospend,reducingitspublicborrowingbythatamount.ButtheRBIwillhavetosellbondsofexactlythatamounttothepublicinordertosticktoits targetformoneycreation.TheoverallnetsaleofgovernmentbondsbythegovernmentandtheRBIcombinedtothepublic(thatis,theeffectivepublicsectorborrowingrequirement)willnotchange.ButtheentireobjectiveoffinancinggovernmentspendingwithaspecialRBI dividend is to reduce overall government bond sales to the public. Thatobjectiveisnotachieved!

ThebottomlineisthattheRBIshouldtransfertothegovernmenttheentiresurplus,retainingjustenoughbuffersthatareconsistentwithgoodcentralbankriskmanagementpractice. Indeed, this year theBoardpaidout an extra8,000croresthanwaspromisedtothegovernmentaroundbudgettime.Separately,thegovernment can infuse capital into the banks. The two decisions need not belinked. There are no creativeways of extractingmoremoney from theRBI –there is no free lunch! Instead, the government should acknowledge itssubstantial equityposition in theRBIand subtract it from itsoutstandingdebtwhenitannouncesitsnetdebtposition.Thatwouldsatisfyallconcernedwithoutmonetarydamage.

IfwhatIhavesaidjustnowseemscomplicated,itis,butitisalsothecorrecteconomicreasoning.Similardetailedrationalesleadustoturndowndemandstocut interest rates in the face of high inflation, to depreciate or appreciate theexchangeratedependingon thewhimof themoment, touseforeignexchangereserves to fund projects, to display forbearance in classifying bad loans orwaivedfarmerloansasNPAs,andsoon…

Wehavebeentaskedwithajobofmaintainingmacroeconomicstability,andoftenthattaskrequiresustorefuseseeminglyobviousandattractiveproposals.

Thereasonwhywehave todowhatwehave todomaynotbeeasyforeveryunspecialized person, even ones with substantial economics training, to graspquickly.Ofcourse,we stillmust explain to thebestofourabilitybutwealsoneedtocreateastructurewherethepublictruststhecentralbanktodotherightthing.Thistheniswhyweneedatrustedindependentcentralbank.

CENTRALBANKINDEPENDENCE

In this environment, where the central bank has to occasionally stand firmagainstthehighestechelonsofcentralandstategovernment,recallthewordsofmypredecessor,DrSubbarao,whenhesaid‘IdohopetheFinanceMinisterwillonedaysay,“IamoftenfrustratedbytheReserveBank,sofrustratedthatIwanttogoforawalk,evenifIhavetowalkalone.ButthankGod,theReserveBankexists.”’Iwouldgoalittlefurther.TheReserveBankcannotjustexist,itsabilityto say ‘No!’ has to be protected. At the same time, the central bank cannotbecome free of all constraints, it has to work under a framework set by thegovernment.Thisrequiresanumberofactions.

OUTLINERESPONSIBILITIESOFTHERBI

Whentheresponsibilitiesof theRBIare fuzzy, itsactionscancontinuouslybequestioned.Instead,iftheconstitutionalauthoritiesoutlineaframeworkfortheresponsibilities of the RBI, it can take actions consistent with thoseresponsibilitiesandbeheldtooutcomes.Theinflationobjectivesrecentlysetforthe RBI by the government are an example of what is needed. Critics canlambasttheRBIifitfailscontinuouslytomeettheobjectives,butiftheywantitto lower interest rates even when the RBI barely meets its objectives, theyshouldinsteadpetitionthegovernmenttochangetheobjectives.

Similarly, theRBIBoardhasadopteda risk-management frameworkwhichindicatesthelevelofequitytheRBIneeds,giventherisksitfaces.ThedividendpolicyoftheRBIthenbecomesatechnicalmatterofhowmuchresidualsurplusisavailableeachyearafterbolsteringequity.Frameworksthusreducethespacefordifferences.

The RBI’s role in macroeconomic stability is, however, still fuzzy.WhileRBIclearlyhasresponsibilityforthesafetyandsoundnessofcreditinstitutions

andthestabilityoftheexternalaccount,therearesomeareasthatarehazier.Forexample, with an inflation-focused framework, the RBI’s ability to beaccommodative depends on fiscal prudence from the centre and states. Howmuch should the RBI warn on fiscal profligacy, including the building up ofcontingentliabilities,andwhenshouldsuchwarningbeseenasinterferinginthelegitimatedecisionsoftheelectedrepresentativesofthepeople?Thisisanareawhereclaritywouldbeuseful.

STRENGTHENOVERSIGHT

The freedom theRBIhas to take operational decisions such as theFCNR (B)swaparrangement,albeitinvariablyinconsultationwiththefinanceministry,isimportant. However, there are always government entities that are seekingoversightovervariousaspectsoftheRBI’sactivities.Multiplelayersofscrutiny,especially by entities that do not have the technical understanding, will onlyhamperdecisionmaking.Instead, thegovernment-appointedRBIBoard,whichincludes ex-officio government officials as well as government appointees,shouldcontinuetoplayitskeyoversightrole.Inthisregard,all importantRBIdecisionsincludingbudgets,licences,regulation,andsupervisionarenoweitherapproved by the Board or one of its sub-committees. Vacancies in the RBIBoard, which have remained unfilled for manymonths now, should be filledquicklysothatthefullexpertiseandoversightoftheBoardcanbeutilized.

ItisalsoimportantthatParliamentunderstandwhatthecentralbankisdoing.The Governor and deputy governors interact regularly with variousparliamentarycommittees,butwehavealso initiateda six-monthly interactionwith the Parliamentary Standing Committee on Finance, where the Governorreports on the activities of the Bank, and the Committee offers its views andconcerns.

RANKOFRBIGOVERNOR

There is a reason why central bank governors sit at the table along with thefinanceministersinG-20meetings.It isthatthecentralbankGovernor,unlikeotherregulatorsorgovernmentsecretaries,hascommandoversignificantpolicylevers and has to occasionally disagree with themost powerful people in the

country.Itisdangeroustohaveadefactopowerfulpositionwithlowdejure status.

Today, theRBIGovernorhas the salaryof theCabinetSecretary.Heor she isappointedbythePrimeMinisterinconsultationwiththeFinanceMinister.TheGovernor’s rank in thegovernmenthierarchy isnot definedbut it is generallyagreed that decisions will be explained only to the Prime Minister and theFinanceMinister.ThereisaninformalunderstandinginIndiathattheGovernorhas the room to make needed decisions. In the interests of macroeconomicstability, none of this should be changed, though if these issues are everrevisited, there may be some virtue in explicitly setting the Governor’s rankcommensuratewithherpositionas themost important technocrat in chargeofeconomicpolicyinthecountry.

COMMUNICATION

I do not fool myself into thinking that reporters and TV cameras follow mearound everywhere because I am a magnetic speaker. They follow RBIgovernorsaroundbecausetheymayoffermarket-movinginformationonpolicy.Fortunately,Ihaveescapedunintentionallysayinganythingthatmovesmarkets.

Atthesametime,whiledifferentRBIgovernorshavedifferentapproachestocommunication,noonecandispensewithit.Unlikeadevelopedcountry,wherethecentralbankchairmancanofferperiodicDelphicpronouncementsaboutthecourseofmonetarypolicy,andoccasionallyremonstratewithParliamentorthegovernmentabout thecourseoffiscalpolicy, inourdevelopingdemocracy theRBIGovernorhastocontinuouslymakethecasefortheactionsthecentralbankistaking,includingthemanystructuralreformsthatareunderway.

Indeed,communicationisasmuchabouteducatingasitisaboutinforming.For instance, even as I explained to entrepreneurs and retail borrowers whyinterestrateswerenotfallingfaster,Ihadtousethepriceofdosastoexplaintopensionerswhy theywereactuallybetteroffearning lowernominalbuthigherreal interest rates. Public understanding can help ease theway for reforms, aswellasincreasesupportforpolicies.TheRBIGovernorthereforehastoexplainagainandagain.

Occasionally, of course, the Governor has to warn about the dangers ofcertain courses of action or certain tendencies in the economy for growth andmacroeconomicstability.Finally,theGovernorisalsoarolemodelfortheyouthinthiscountry,andshouldthereforenotducktheresponsibilitytourgethemtofollow the highest standards of citizenshipwhen he or she is invited to speakdirectlytothem.

CONCLUSION

ThisisthelastpublicspeechIwillgiveinIndiaforawhile–mysuccessorhasto takeover theRBI’scommunicationand Iwant togetoutofhisway. Ithasbeenanhonourtoworkforthecountryandespeciallytotalktopeoplelikeyou,itsfuture.Thanksforlisteningtome.

Postscript:IamnottheRBIGovernoranymore.Butthepointinmyspeechisworthreiterating:thereis a danger in keeping the position ill-defined, because the constant effort of the bureaucracy is towhittledownitspower.Thisisnotarecentphenomenon,asobserverslikeT.C.A.Srinivasa-Raghavanhavenoted,buttheRBIrisksbecomingdangerouslyweakenedassuccessivegovernmentsandfinanceministers misunderstand its role. The RBI Governor, as the technocrat with responsibility for thenation’s economic risk management, is not simply another bureaucrat or regulator, and efforts tobelittlethepositionbybringingitintothebureaucratichierarchyaremisguidedanddonotservethenationalinterest.MoreclarityabouttheRBI’srole,andaclearerassertionofitsindependence,wouldbeinthenation’sinterest.

D

V

PerhapsthehardestlettertowritetomycolleaguesattheRBIwasaletterinformingthemthatIwouldbeleavingattheendofmyterm.ItisprobablyfittingtoendthepiecesonmytermattheRBIwiththatletter,writtenon18June2016.Iwantedtoreflectonhowmuchwehadaccomplishedtogether,evenwhilepromisingaflurryofactivitytotieuplooseendsinthefewmonthsIhadleft.

MessagetoRBIStaff

earColleagues,I took office in September 2013 as the 23rdGovernor of theReserve

BankofIndia.Atthattime,thecurrencywasplungingdaily,inflationwashigh,andgrowthwasweak.Indiawasthendeemedoneofthe‘FragileFive’.Inmyopening statement as Governor, I laid out an agenda for action that I haddiscussedwithyou.Byimplementingthesemeasures,Isaidwewould‘buildabridge to the future, over the stormy waves produced by global financialmarkets’.

Today,IfeelproudthatweattheReserveBankhavedeliveredonalltheseproposals.Anewinflation-focusedframeworkisinplacethathashelpedhalveinflationandallowedsaverstoearnpositiverealinterestratesondepositsafteralongtime.Wehavealsobeenabletocutinterestratesby150basispointsafterraisingtheminitially.Thishasreducedthenominalinterestratethegovernmenthastopayevenwhilelengtheningmaturitiesitcanissue–thegovernmenthasbeen able to issue a forty-year bond for the first time. Finally, the currencystabilized after our actions, and our foreign exchange reserves are at a recordhigh, even after we have fully provided for the outflow of foreign currencydepositswesecuredin2013.Today,wearethefastestgrowinglargeeconomyintheworld,havinglongexitedtheranksoftheFragileFive.

Wehavedonefarmorethanwaslaidoutinthatinitialstatement,includinghelping the government reform the process of appointing public sector bankmanagement through the creation of the Bank Board Bureau (based on therecommendationoftheRBI-appointedNayakCommittee),creatingawholeset

ofnewstructurestoallowbankstorecoverpaymentsfromfailingprojects,andforcing timely bank recognition of their unacknowledged bad debts andprovisioning under theAsset Quality Review (AQR).We haveworked on anenablingframeworkforNationalPaymentsCorporationofIndiatorollout theUniversal Payment Interface, which will soon revolutionize mobile-to-mobilepaymentsinthecountry.Internally,theRBIhasgonethrougharestructuringandstreamlining,designedanddrivenbyourownseniorstaff.Wearestrengtheningthespecializationandskillsofouremployeessothattheyaresecondtononeintheworld. In everythingwe have done,we have been guided by the eminentpublic citizens on our Board such as Padma Vibhushan Dr Anil Kakodkar,formerChairmanof theAtomicEnergyCommission andPadmaBhushan andMagsaysayawardwinnerElaBhattoftheSelfEmployedWomen’sAssociation.Theintegrityandcapabilityofourpeople,andthetransparencyofouractions,isunparalleled,andIamproudtobeapartofsuchafineorganization.

IamanacademicandIhavealwaysmadeitclearthatmyultimatehomeisintherealmofideas.Theapproachingendofmythree-yearterm,andofmyleaveattheUniversityofChicago,wasthereforeagoodtimetoreflectonhowmuchwehadaccomplished.Whileallofwhatwelaidoutonthatfirstdayisdone,twosubsequentdevelopmentsareyettobecompleted.Inflationisinthetargetzone,but themonetary policy committee that will set policy has yet to be formed.Moreover, thebank clean-up initiatedunder theAssetQualityReview, havingalready brought more credibility to bank balance sheets, is still ongoing.Internationaldevelopmentsalsoposesomerisksintheshortterm.

While Iwasopen to seeing thesedevelopments through,ondue reflection,andafterconsultationwiththegovernment,IwanttosharewithyouthatIwillbereturningtoacademiawhenmytermasGovernorendson4September2016.Iwill,ofcourse,alwaysbeavailabletoservemycountrywhenneeded.

Colleagues,wehaveworkedwiththegovernmentoverthelastthreeyearstocreate a platform of macroeconomic and institutional stability. I am sure thework we have done will enable us to ride out imminent sources of marketvolatilitylikethethreatofBrexit.Wehavemadeadequatepreparationsfortherepayment of Foreign Currency Non-Resident (B) deposits and their outflow,

managed properly, should largely be a non-event.Morale at the Bank is highbecause of your accomplishments. I am sure the reforms the government isundertaking, togetherwithwhatwillbedonebyyouandother regulators,willbuild on this platformand reflect in greater jobgrowth andprosperity for ourpeople in theyears to come. I amconfidentmy successorwill takeus tonewheightswithyourhelp. Iwill stillbeworkingwithyou for thenext coupleofmonths, but let me thank all of you in the RBI family in advance for yourdedicatedworkandunflinchingsupport.Ithasbeenafantasticjourneytogether!

Withgratitude

YourssincerelyRaghuramG.Rajan

SectionII

THEGLOBALFINANCIALCRISIS

I

I

The 2005 Jackson Hole Conference was to be the then Federal Reserve Board Chairman AlanGreenspan’s last, and the theme, therefore, was the legacy of the Greenspan Era. I was the ChiefEconomistoftheInternationalMonetaryFundatthattime,onleavefromtheUniversityofChicago.Iwasaskedtopresentapapertotheworld’scentralbankingfraternityonhowthefinancialsectorhadevolvedduringGreenspan’stermatthehelm.Istartedtowriteapaperextollingthedevelopmentsinfinance,butasIanalysedthedata,Ibecameworriedaboutwhatwasgoingon.Ishiftedtackandwrotethepaperontherisksposedbythefinancialsystem.

IremembertellingmywifeasIlefthomefortheconferencethatthisspeech,sofaroutoflinewithwhatIknewwouldbecongratulatoryspeechesat theconference,wouldeitherbeseenassingularlyprescient, or unwarranted scaremongering. The global financial crisis in 2007-08 ensured opinionlargely switched from the latter to the former.The followingpiece is based on that paper, andwaspublishedintheIMF’smonthlyStraightTalkinSeptember2005.

RiskyBusiness:SkewedIncentivesforInvestmentManagersMayBeAddingtoGlobalFinancialRisk

n the past thirty years, financial systems around the world have undergonerevolutionary change. People can borrow greater amounts at cheaper rates,

investinamultitudeofinstrumentscateringtoeverypossibleprofileofriskandreturn, and share riskswith strangers across theglobe.Financialmarketshaveexpandedanddeepened,andthetypicaltransactioninvolvesmoreplayersandiscarriedoutatgreaterarm’slength.

Atleastthreeforcesarebehindthesechanges.Technicalchangehasreducedthe cost of communication and computation, aswell as the cost of acquiring,processing, and storing information. For example, techniques ranging fromfinancialengineeringtoportfoliooptimization,andfromsecuritizationtocreditscoring, are now widely used. Deregulation has removed artificial barrierspreventing entry of new firms, and has encouraged competition betweenproducts, institutions, markets, and jurisdictions. And institutional change hascreatednewentitieswithinthefinancialsector–suchasprivateequityfirmsandhedgefunds–aswellasnewpolitical, legal,andregulatoryarrangements(for

example, the emergence over the past two decades of the entire institutionalapparatus behind the practice of inflation targeting, ranging from central bankindependencetothepublicationofregularinflationreports).

While these changes in the financial landscape have been termed‘disintermediation’ because they involve moving away from traditional bank-centred ties, the term is a misnomer. Although in a number of industrializedcountries,individualsdon’tdepositasignificantportionoftheirsavingsdirectlyin banks any more, they invest indirectly in the market via mutual funds,insurancecompanies,andpensionfunds,andinfirmsviaventurecapitalfunds,hedgefunds,andotherformsofprivateequity.Themanagersofthesefinancialinstitutions,whomIshallcall‘investmentmanagers’,havedisplacedbanksand‘reintermediated’themselvesbetweenindividualsandmarkets.

What aboutbanks themselves?Whilebanks cannowsellmuchof the riskassociatedwiththe‘commodity’transactionstheyoriginate,suchasmortgages,bypackagingthemandgettingthemofftheirbalancesheets,theyhavetoretaina portion. This is typically the first loss, that is, the loss from the first fewmortgagesinthepackagethatstoppaying.Moreover,theynowfocusfarmoreontransactionswheretheyhaveacomparativeadvantage,typicallytransactionswhereexplicitcontractsarehardtospecifyorwheretheconsequencesneedtobehedgedby trading in themarket.Forexample,banksofferback-up linesofcredittocommercialpaperissuancesbycorporations.Thismeansthatwhenthecorporation is in trouble and commercial papermarkets dry up, the bankwillstep in and lend.Clearly, these are riskyand illiquid loans.And they reflect alarger pattern: as traditional transactions becomemore liquid and amenable tobeing transacted in the market, banks are moving on to more illiquidtransactions. Competition forces them to flirt continuously with the limits ofilliquidity.

No doubt, the expansion in the variety of intermediaries and financialtransactions has major benefits, including reducing the transaction costs ofinvesting, expanding access to capital, allowing more diverse opinions to beexpressedinthemarketplace,andpermittingbetterrisksharing.Butitalsohaspotential downsides, raising the question of whether we have unwittingly

acceptedaFaustianbargain,tradinggreaterwelfaremostofthetimeforasmallprobabilityofacatastrophicmeltdown.Myviewisthattheworldmayberiskierbecause of skewed incentives among investment managers, which I will nowdescribe,butit’sunlikelywewillknowforsure.Thus,themessageforcentralbankersandfinancialsystemregulatorsissimple:besttobeprepared.

GETTINGTHEINCENTIVESRIGHT

Inthepast,bankmanagerswerepaidalargelyfixedsalary.Giventhatregulationkept competitionmuted, therewasnoneed for shareholders tooffermanagersstrong performance incentives (such incentives might even have beendetrimentalasitwouldhavetemptedbankmanagerstoreachoutforrisk).Themaincheckonbankmanagersmakingbadinvestmentdecisionswasthebank’sfragilecapitalstructure(andpossiblyregulators).Ifbankmanagementdisplayedincompetence or knavery, depositors would get jittery and possibly run. Thethreatofthisextremepenalty,coupledwiththelimitedupsidefromsalariesthatwerenotbuoyedbystockoroptionscompensation,combinedtomakebankersextremelyconservative.Thisserveddepositorswellsincetheircapitalwassafe.Shareholders, who enjoyed a steady rent because of the limited competition,werealsohappy.

Inthenew,deregulated,competitiveenvironment,investmentmanagerscan’tbeprovided thesamestaid incentivesasbankmanagersofyore.Because theyneedtheincentivetosearchforgoodinvestments,theircompensationhastobesensitive to investment returns, especially returns relative to their competitors.Furthermore,newinvestorsareattractedbyhighreturns.Andcurrentinvestors,if dissatisfied,do take theirmoneyelsewhere (although theyoften suffer frominertia in doing so). Since compensation also varies with assets undermanagement, overall, investmentmanagers face a compensation structure thatmoves up very stronglywith good performance, and falls, albeitmoremildly,withpoorperformance.

Therefore,theincentivestructureforinvestmentmanagerstodaydiffersfromthe incentive structure for bankmanagers of the past in two important ways.First, there is typically less downside and more upside from generating

investmentreturns,implyingthatthesemanagershavetheincentivetotakemorerisk. Second, their performance relative to other peermanagersmatters, eitherbecauseit’sdirectlyembeddedintheircompensation,orbecauseinvestorsexitorenterfundson thatbasis.Theknowledge thatmanagersarebeingevaluatedagainstotherscaninducesuperiorperformance,butalsoperversebehaviourofvariouskinds.

PERVERSEBEHAVIOURS

Performance-basedpaycaninduceriskybehaviouramonginvestmentmanagers.Onetypeistotakeriskthatisconcealedfrominvestors.Sinceriskandreturnarerelated, the manager then looks as if he outperforms peers given the risk hetakes.Typically,thekindsofrisksthatcanmosteasilybeconcealed,giventherequirementofperiodicreporting,are‘tail’risks–thatis,risksthathaveasmallprobability of generating severe adverse consequences and offer generouscompensationtherestofthetime.Asecondtypeistoherdwithotherinvestmentmanagers on investment choices, because herding provides insurance themanagerwill not underperform his peers.However, herd behaviour canmoveassetpricesawayfromfundamentals.

Bothbehaviourscanreinforceeachotherduringanassetpriceboom,wheninvestmentmanagersarewillingtobearthelowprobability‘tail’riskthatassetpriceswillreverttofundamentalsabruptly,andtheknowledgethatmanyoftheirpeersareherdingonthisriskgivesthemcomfortthattheywillnotunderperformsignificantlyifboomturnstobust.Thesebehaviourscanbecompoundedinanenvironmentof low interest rates,where the incentivesofsomeparticipants to‘searchforyield’notonlyincrease,butwhereassetpricesalsospiralupwards,creatingtheconditionsforasharpandmessyrealignment.

Do banks add to this behaviour or restrain it? The compensation of bankmanagers, while not so tightly tied to returns, has not been left completelyuntouched by competitive pressures. Banks make returns both by originatingrisksandbybearingthem.Astraditionalriskssuchasmortgagesorloanscanbemovedoffbankbalancesheetsintothebalancesheetsofinvestmentmanagers,bankshaveanincentivetooriginatemoreofthem.Thustheywill tendtofeed

rather than restrain the appetite for risk. As I argued earlier, however, bankscannot sell all risk. In fact, they often have to bear themost complicated andvolatileportionof the risks theyoriginate, soeven though some riskhasbeenmoved off their balance sheets, balance sheets are being reloaded with fresh,morecomplicatedrisks.Thedatasupportthisassessment–despiteadeepeningof financial markets, banksmay not be any safer than in the past.Moreover,eventhoughtherisksbanksnowbearareseeminglysmaller,suchrisksareonlythetipofaniceberg.

But perhaps the most important concern is whether banks will be able toprovide liquidity to financialmarkets so that if the ‘tail’ riskdoesmaterialize,financialpositionscanbeunwoundand losses allocated soas tominimize theconsequencestotherealeconomy.Pastepisodesindicatethatbankshaveplayedthis role successfully.However, there is no assurance theywill continue to beable to do so. Banks have in the past been able to provide liquidity in partbecause their sound balance sheets allowed them to attract available spareliquidity in themarket. However, banks today requiremore liquidmarkets tohedge some of the risks associated with the complicated products they havecreated or guarantees they have offered. Their greater reliance on marketliquiditycanmaketheirbalancesheetsmoresuspect in timesofcrisis,makingthemlessabletoprovidetheliquidityassurancethattheyhaveprovidedinthepast.

Taken together, these trends suggest that even though there are far moreparticipantswhoareabletoabsorbrisktoday,thefinancialrisksthatarebeingcreated by the system are indeed greater. And even though there shouldtheoreticallybeadiversityofopinionandactionsbymarketparticipants,andagreatercapacitytoabsorbrisk,competitionandcompensationmayinducemorecorrelationinbehaviourthanisdesirable.Whileitishardtobecategoricalaboutanything as complex as the modern financial system, it’s possible that thesedevelopments are creatingmore financial-sector-induced procyclicality than inthe past. They may also create a greater (albeit still small) probability of acatastrophicmeltdown.

Unfortunately, we won’t know whether these are, in fact, serious worries

untilthesystemhasbeentested.Thebesthopeisthatthesystemfacesshocksofincreasing size, figures out what is lacking each time, and becomes moreresilient.ToparaphraseStAugustine,weshould thereforepray:‘Lord, if therebeshocks,letthemfirstbesmallones.’Thedangeristhattheeconomywillbehitunexpectedlybyaperfectstormbeforeithasbeenstress-tested.

If indeed risk taking is excessive,whydon’t investorsoffer theirmanagerscompensation contracts that restrain the short-term emphasis on returns andassociated risk taking? The answer is that there may be too little privateincentive to do so. For one, there is very little systematic evidence that pastperformance in financial investment is an indicator of future performance,Warren Buffet or Peter Lynch notwithstanding. This implies that the constantmovementbyinvestorsbetweenfundshaslittlesocialvalue.Butinvestorsinanindividual fund benefit when new investments pour in because the fund’saverage costsgodown.As a result, theprivategains fromattracting investorsthrough a fund’s superior short-termperformance exceed the social value, andinvestorshavetoolittleincentivetorestrainmanagersfromfocusingontheshortterm.

Ofcourse,ifinadditioninvestorsdon’thavecompletecontrolovermanagers–becauseofweaknessesincorporategovernance,forexample–andmanagershave private incentives to generate returns in the short term (to preserve theirjobsorforthepublicadulationthatsuccessbrings),theprivateequilibriummayagain generate excessive risk taking. It’s also hard for a private actor to fullycapturethebenefitsofprovidingliquidity–ifpricesarehigherandmorecloselyreflect fundamentals, all those who trade will benefit, not just the actor whoinjected liquidity into the market. Therefore, the private sector has too littleincentivetoprovisionforitalso.

LIMITINGTHEFALLOUT

So what can policy makers do? While too much regulation can stifle thecompetition that drives financial sector innovation, not doing anything at alldoesn’t seem like a good option either. While we still know little about thecomplexworkingsoffinancialmarkets,twomaintoolscometomind.

Monetary policy. Monetary policy must be informed by its effects onincentives.Asalreadypointedout,bothalowlevelaswellasanunanticipatedsharpfall ininterestratescanhaveperverseeffectsonincentives.Thisimpliesthat rapid, large,changes inmonetarypolicyhavesignificantcosts,not just inthedomesticeconomybutinallinterconnectedmarkets.Oneimplicationisthatpolicy changes ought to happen at a measured (though not necessarilypredictable)paceratherthanabruptly.Second,whiledeflationcanbeimmenselyharmful for the real economy, an unanticipated but persistent low interest ratecanbeasourceofsignificantdistortionsforthefinancialsector,andthenceforassetprices.Notonlydoesthismeanstayingfurtherawayfromdeflationsothatextremely low policy rates don’t have to be used as a tool, it also impliesexercisinggreatersupervisoryvigilancewhenthoseratesareinplacetocontainasset price bubbles. Third, and somewhat obviously, one can no longer justexamine the state of the banking system and its exposure to credit to reachconclusionsaboutaggregatecreditcreation,letalonethestabilityofthefinancialsystem. Finally, the financial sector may experience greater liquidity andsolvencyproblems in some situations, so central bankshave tobevigilant foranypossibleshortfallsinaggregateliquidity.

PRUDENTIALSUPERVISION

Theprudentialnetmayhavetobecastwiderthansimplyaroundcommercialorinvestmentbankstoincludeinstitutionssuchashedgefunds.Whatinstrumentsmightbeused?Certainly,greatertransparencyanddisclosure,alongwithcapitalregulation, have a role to play. But policymakersmight also need to considerusingthemanagerialcompensationsystemtoalignthebehaviourofinvestmentmanagers with the public interest. Rather than limiting or constrainingcompensation, compensation regulation might simply require long-terminvestmentofaportionoftopinvestmentmanagers’compensationintheclaimsissued by the investment that is being managed. Given that some investorsalreadyrequirethisoftheirinvestmentmanagers,sucharequirementmaynotbeexcessivelyintrusive.Ofcourse,onehastobecarefulaboutmakinginvestmentmanagers overly conservative, and thus losing the benefits their risk-taking

behaviour brings to the economy. This is why the optimal probability of afinancialsectormeltdownwillneverbezero.

Postscript:AstheWallStreetJournalreportedon2January2009inanarticlebyJustinLahartonmyJacksonHolepresentation:

‘Incentives were horribly skewed in the financial sector with workers reaping rich rewards formakingmoneybutbeingonlylightlypenalizedforlosses,MrRajanargued.Thatencouragedfinancialfirms to invest in complex products, with potentially big payoffs, which could on occasion failspectacularly.

Hepointedto“creditdefaultswaps”whichactasinsuranceagainstbonddefaults.Hesaidinsurersandothersweregeneratingbigreturnssellingtheseswapswiththeappearanceoftakingonlittlerisk,eventhoughthepaincouldbeimmenseifdefaultsactuallyoccurred.

Mr Rajan also argued that because banks were holding a portion of the credit securities theycreatedontheirbooks,ifthosesecuritiesranintotrouble,thebankingsystemitselfwouldbeatrisk.Bankswouldloseconfidenceinoneanother,hesaid.“Theinterbankmarketcouldfreezeup,andonecouldwellhaveafull-blownfinancialcrisis.”

Twoyearslater,that’sessentiallywhathappened.’

D

II

IreturnedtoacademiainJanuary2007afterathreeandahalfyearstintattheIMF.Whatfollowsareasampling of the pieces, including public speeches. The following elaborates on the risk-takingincentivesinthesystem,andwasdeliveredinFebruary2007,justbeforethecrisis.

FinancialConditions,AssetManagement,andPoliticalRisks:TryingtoMakeSenseofOurTimes

espite widespread strong productivity growth, nominal investment,especiallycorporateinvestment,hasremainedrelativelyweakfortheworld

as a whole, while desired savings is strong. Call this a ‘savings glut’ as didChairmanBernankeor‘investmentrestraint’asdidtheIMF,theneteffectisanimbalancebetweendesiredsavingsandrealizedinvestment.Consequently, reallong-terminterestrateshavebeenlowforsometime.Interestingly,evenastheFederal Reserve raised policy rates during 2006, long-term interest rates fellfurther–inslowingdomesticdemandintheUnitedStates,marketsmaybelievethe Fed is aggravating the worldwide excess of desired savings over realizedinvestmentfurther.

Currentconditionsareunlikelytobepermanent.Givenagingpopulationsindeveloped countries though, one would presume that the rebalancing ofworldwide investment to desired savings will have to take place primarily innon-industrial countries. Investmentwill increase partly through foreign directinvestment, but partlymediatedby the financial systems in emergingmarkets,which will have to develop further. Increases in consumption as safety netsimprove and retail finance becomes widely available will also help reducedesired savings.Certainly, the seeminglyperverse patternof net capital flows,frompoor torichcountries,willhave tochange, if fornootherreason than toaccommodatedemographics.

Inowwant to turn to the increasing institutionalizationof,andcompetitionwithin, advanced financial markets. The link between the issues will soon be

clear. The break-up of oligopolistic banking systems and the rise of financialmarkets has expanded individual financial investment choices tremendously.Whileindividualsdon’tdepositasignificantportionoftheirsavingsdirectlyinbanks any more, they don’t invest directly in the market either. They investindirectlyviamutualfunds,insurancecompanies,pensionfunds,venturecapitalfunds, hedge funds, and other forms of private equity. Themanagers of thesefinancial institutions, whom I shall call ‘investment managers,’ have largelydisplaced banks and ‘reintermediated’ themselves between individuals andmarkets.

As competition between these various institutional forms for the public’sinvestmentdollarincreases,eachoneattemptstoassurethepublicthattheywilloffersuperiorperformance.Butwhatdoessuperiorperformancemean?

PERFORMANCEMANAGEMENT

Thetypicalmanageroffinancialassetsgeneratesreturnsbasedonthesystematicriskhetakes–theso-calledbetarisk–andthevaluehisabilitiescontributetothe investment process – his so-called alpha. Shareholders in any assetmanagement firmare unlikely to pay themanagermuch for returns frombetarisk–forexample,iftheshareholderwantsexposuretolargetradedU.S.stocks,she can get the returns associated with that risk simply by investing in theVanguardS&P500 index fund, forwhich she pays a fractionof a per cent infees.What the shareholderwill reallypay for is if themanagerbeats theS&P500indexregularly,thatis,generatesexcessreturnswhilenottakingmorerisk.Indeed, hedge fund managers often claim to produce returns that areuncorrelatedwiththetraditionalmarket(theso-calledmarketneutralstrategies)sothatallthereturnstheygenerateareexcessreturnsoralpha,whichdeservetobewellcompensated.

Inreality,thereareonlyafewsourcesofalphaforinvestmentmanagers.Onecomes from having truly special abilities in identifying undervalued financialassets – Warren Buffet, the U.S. billionaire investor, certainly has these, butstudy after academic study shows that very few investmentmanagers do, andcertainlynotinawaythatcanbepredictedbeforethefactbyordinaryinvestors.

Asecondsourceofalphaisfromwhatonemightcallactivism.Thismeansusingfinancialresourcestocreate,orobtaincontrolover,realassetsandtousethatcontroltochangethepayoutobtainedonthefinancialinvestment.Aventurecapitalistwho transformsan inventor,agarage,andan idea intoa full-fledgedprofitable and professionallymanaged corporation is creating alpha.A privateequity fund that undertakes a hostile corporate takeover, cuts inefficiency, andimproves profits is also creating alpha. So is a vulture investor who buys updefaulted emerging market debt and presses authorities through various legaldevicestopressthecountrytopaymore.

A third source of alpha is financial entrepreneurship or engineering –investinginexoticfinancialsecuritiesthatarenoteasilyavailabletotheordinaryinvestor, or creating securities or cash flow streams that appeal to particularinvestors or tastes. Of course, if enough of these securities or streams arecreated,theyceasetohavescarcityordiversificationvalue,andarevaluedlikeeverything else. Thus this source of alpha depends on themanager constantlyinnovatingandstayingaheadofthecompetition.

Finally, alpha can also stem from liquidity provision. For instance,investmentmanagers,havingrelativelyeasyaccesstofinance,canholdilliquidorarbitragepositionstomaturity:ifaclosedendfundistradingatasignificantpremium to the underlying market, the manager can short the fund, buy theunderlyingmarket,andholdthepositiontillthepremiumeventuallydissipates.Whatisimportanthereisthattheinvestmentmanagershavetheliquiditytoholdtillthearbitragecloses.

ILLIQUIDITYSEEKING

This discussion should suggest that alpha is quite hard to generate sincemostwaysofdoingsodependontheinvestmentmanagerpossessinguniqueabilities– to pick stock, identify weaknesses in management and remedy them, orundertakefinancialinnovation.Uniqueabilityisrare.Howthendothemassesofinvestment managers justify the faith reposed in them by masses of ordinaryinvestors?Theanswerisprobablyliquidityprovision,whichistheactivitythatdepends least on special managerial ability and could be termed the poor

manager’ssourceofalpha.The problem when the world has excess desired savings relative to

investment, andwhen central banks are accommodative, is that it is awash inliquidity. Many investment managers can enter the business of liquidityprovision,andevenastheytakeevermoreilliquidpositions,theycompeteawaythereturnsfromdoingso.Thepointisthatcurrentbenignconditionsengender‘illiquidity-seeking’behaviour.Buttheycouldhaveworseeffects.

TAILRISKANDHERDING

Forwhatisthemanagerwithrelativelylimitedabilitytodowhencentralbanksflood the market with liquidity and the rents from liquidity provision arecompetedaway?Hecouldhiderisk–thatis,passoffreturnsgeneratedthroughtakingonbeta risk as alphabyhiding the extentofbeta risk.Sinceadditionalrisks will generally imply higher returns, managers may take risks that aretypicallynotintheircomparisonbenchmark(andhiddenfrominvestors)soastogeneratethehigherreturnstodistinguishthemselves.

For example, a number of hedge funds, insurance companies, and pensionfunds have entered the credit-derivative market to sell guarantees against acompany defaulting. Essentially, these investment managers collect premia inordinarytimesfrompeoplebuyingtheguarantees.Withverysmallprobability,however, the company will default, forcing the guarantor to pay out a largeamount. The investment managers are thus selling disaster insurance or,equivalently,takingon‘peso’or‘tail’risks,whichproduceapositivereturnmostofthetimeascompensationforarareverynegativereturn.Thesestrategieshavethe appearance of producing very high alphas (high returns for low risk), somanagershaveanincentivetoloaduponthem,especiallywhentimesaregoodanddisaster looks remote.Everyonce inawhile,however, theywillblowup.Sincetrueperformancecanonlybeestimatedoveralongperiod,farexceedingthe horizon set by the averagemanager’s incentives,managerswill take theserisksiftheycan.

One example of this behaviour was observed in 1994, when a number ofmoneymarketmutual funds in theUnited States came close to ‘breaking the

buck’ (going below a net asset value of $1 per share, which is virtuallyunthinkableforanostensiblyrisklessfund).Somemoneymarketfundshadtobebailedoutbytheirparentcompanies.Thereasontheycamesoclosetodisasterwas because they had been employing risky derivatives strategies in order togooseupreturns,andthesestrategiescameunstuckin the taileventcausedbytheFederalReserve’sabruptratehike.

Whilesomemanagersmayloaduponhidden‘tail’risktolookasiftheyaregenerating alpha, others know that for the more observable investments orstrategies for their portfolio, there is safety in mimicking the investmentstrategies of competitors – after all, who can be fired when everybodyunderperforms? In other words, even if they suspect financial assets areovervalued, they know their likely underperformance will be excused if theyherdwitheveryoneelse.

Suchherdbehaviour–adesiretonotunderperformtheobservablestrategiesofpeers–mayhavemotivatedanumberofEuropeaninsurers,whomovedintoequitiesinthelate1990sjustbeforethecrash.Itcouldbemotivatingthemovebypensionfundsandinsurancecompaniestodayintoinvestingincommoditiesorhedgefunds.

Both the phenomenon of taking on ‘tail’ risk and that of herding canreinforceeachotherduringanasset-priceboom,wheninvestmentmanagersarewilling to bear the low probability ‘tail’ risk that asset prices will revert tofundamentalsabruptly,andtheknowledgethatmanyof theirpeersareherdingonthisriskgives themcomfort that theywillnotunderperformsignificantly ifboomturnstobust.

RISKSEEKING

Times of plentiful liquidity not only induce investment managers to seekilliquidity, ‘tail’ risk, aswell as herd, since they are also times of low interestrates,theymayinducemorefamiliarrisk-seekingbehaviour.Forexample,whenan insurance company has promised premium holders returns of 6 per cent,whilethetypicalmatchinglong-termbondrateis4percent,ithasnooptionifitthinks low interest rates are likely to persist, or if it worries about quarterly

earnings,buttotakeonrisk,eitherdirectlyorthroughinvestmentsinalternativeassets like hedge funds. Similarly, a pension fund that has well-defined long-datedobligationswillhaveagreaterincentivetoboostreturnsthroughextrariskwhen risk-free returns are low.Allmannerof riskpremia aredrivendownbythissearchforyieldandthusrisk.

So let me summarize. We are experiencing a widespread phenomenon ofhighproductivitygrowth,butlowinvestmentrelativetodesiredsavings,whichhas pushed down interest rates and pushed up asset prices. With plentifulliquidity, investmentmanagershavereduced thepremiafor riskas theysearchforyield.Inanattempttogeneratealpha,manymanagersmaybetakingonbetarisk,andevenunderpricingit.Ofcourse,lowinterestratesandplentifulaccesstocreditwill,foratime,resultinlowdefaultrates,whichwillappeartojustifythelowriskpremia.Thesearchforyieldandforilliquidityknowsnobordersasoceansofcapitalspreadacross theglobe,andassetpricesacross theglobearebeingpumpedup.AstheFrenchsay,‘Pourvuqueçadure!’

CONSEQUENCES

Whatcouldgowrong?Thehopeisofa‘soft’landingintherealsectorwherethefactorsthatledtothecurrentrealsectorimbalancesreversegently–forinstance,domesticdemandpicksup in thenon-industrialworld,andgrowth recovers inEuropeandJapan,evenwhile tighterfinancialconditionsslowconsumptionintheUnitedStates.Asabetterbalancebetweendesiredsavingsandinvestmentisachieved, interest rates move up slowly, credit becomes less easy (aided bycentralbanktightening),andilliquidityseekingandriskseekingreversegentlywithoutmajorblow-ups.

Ofcourse, ifanyof thishappensmoreabruptly, theconsequencescouldbeuglier. The problems would be most acute if the banking sector is infected.Banksmakereturnsbothbyoriginatingrisksandbybearing them.Sincerisksthatdonotneedmanagementorarerelativelyeasytoassesscanbemovedoffbankbalancesheetsintothebalancesheetsofinvestmentmanagers,bankshavean incentive tooriginatemoreof them.Thus theywill tend tofeedrather thanrestrain the appetite for risk.Banks cannot, however, sell all risks.Theyoften

have tobear themostcomplicated,hard-to-manage,andvolatileportionof theriskstheyoriginate.Soeventhoughsomeriskhasbeenmovedoffbankbalancesheets,balancesheetshavebeenreloadedwithfresh,morecomplicated,risks.Infact, thedatasuggest thatdespiteadeepeningoffinancialmarkets,banksmaynot be any safer than in thepast.Moreover, the risk theynowbear is a small(thoughperhapsthemostvolatile)tipofanicebergofrisktheyhavecreated.

Perhapsamore importantconcern iswhetherbankswillbeable toprovideliquidity to financial markets so that if ‘tail’ risks do materialize, financialpositionscanbeunwoundand lossesallocatedso that theconsequences to therealeconomyareminimized.Pastepisodesindicatethatbankshaveplayedthisrolesuccessfully.However,thereisnoassurancetheywillcontinuetobeabletoplaytherole.Inparticular,bankshavebeenabletoprovideliquidityinthepast,in part because their sound balance sheets have allowed them to attract theavailable spare liquidity in the market. But banks today also require liquidmarkets to hedge some of the risks associated with the complicated productsthey have created, or guarantees they have offered. Their greater reliance onmarket liquiditycanmake theirbalancesheetsmoresuspect in timesofcrisis,makingthemlessabletoprovidetheliquidityassurancethattheyhaveprovidedinthepast.

Even if the banking system is safe, supervisors and regulators have to beconcernedabout the restof the financial system– in theUnitedStates,80percentofvalueisaddedbythefinancialsectorthatisoutsidethebankingsystem.Thenon-banksectorisincreasinglycentraltoeconomicactivityandisnotjustapassive holder of assets. Moreover, some non-banks such as insurancecompaniesandsomehedgefundsaresubjecttoruns.Butmostimportant,riskstofinancialstabilityareinvariablycompoundedbypoliticalrisk.

Letmeexplain this lastconcern.First, thegeneralpublic’smoney isbeinginvestedinsomeofthemoreriskyventures,afacthighlightedbytherevelationthatanumberofstatepensionfundsintheUnitedStateswereinvestedinariskyhedgefundlikeAmaranth.Diversificationintosuchalternativeinvestmentscanbe a valuable component of an overall investment strategy if it is carefullythoughtout.Theproblemisthatalltoooften,ittakesplaceasaformofherding

andlateinthegame–afterlaggingpensionmanagersseethewonderfulreturnsin energy or fromwriting credit derivativesmade by theirmore competent orluckycompetitors,thereispressureonthemtoenterthefield.Theydosolate,when thegoodhedgeorcommodity fundsareclosed to investment,andwhenthe cycle is nearer peak than trough. Myriad new unseasoned hedge orcommodityfundsarestartedprecisely toexploit thedistorted incentivesof thepensionorinsurancefundmanagerswhoqueuelikelemmingstodutifullyplacethe public’s money. Thus far losses from isolated failures have been washedaway in diversifiedportfolios and thepublic has not noticed.Will this alwayscontinue?

InEurope,wehavealreadyhadatasteofthepotentialfalloutaspensioners,whowere inappropriately advised to invest inArgentinianBondsorParmalat,justbeforetheseentitiesdefaulted,pressedforcompensation.Thedefaultswereisolated,sothefalloutwasmanageable.Couldamoregeneralizeddownturnleadto more widespread revulsion against financial markets? What of emergingmarkets where the investors who have been drawn into the financial marketsoverthelastfewyearshaveneverexperiencedadownturn?

Second, the fees charged by investment managers like hedge funds andprivateequitycannotbutarouseenvy.ItissurprisingthatdespitethefuroroverCEO pay, very little angst has been expressed over investment manager pay,eventhoughSteveKaplanandJoshuaRauhoftheUniversityofChicagosuggestina2006workingpapertitled‘WallStreetandMainStreet:WhatContributestothe Rise in the Highest Incomes?’ that investment manager pay growth hasprobablyexceededCEOpaygrowth.Mysenseisthatthereisabeliefamongstthe public that many investment managers are following sophisticatedinvestmentstrategies– inotherwords, that themanagersaregeneratingalphasandearningreturnsfortheirtalents–hencetheirpayisnotquestioned.

Yet investigationsofcollapsed fundssuchasLTCMdon’t seemto indicateterriblysophisticatedstrategies–indeedmorebetathanalpha.Whilethereisaselectionbiasinexaminingfailedfunds–theyarelikelytohavemorebeta–itisalso likely that large funds with unsophisticated strategies got to that sizethrougha seriesof luckybets thatpaidoff.So theirmanagerswillhave taken

homeenormoussumsofmoneybefore it is realized that theyhadsimplybeengamblingwith other people’smoney. Large losses, ‘greedy’managers, and anangrypublic–this isaperfectscenarioforamuck-rakingpoliticiantobuildacareeron.Theregulatoryimpedimentsthatcouldbeimposedontheinvestmentmanagers who add value, and on the financial sector as a whole, could bedebilitating.

Third,andaccentuating thepoliticalproblem, is thatwhile it isclear to thepublichowabankmakingaloanbenefitstherealeconomyor‘MainStreet’,itisless clear to it how an investment manager who spreads and allocates risk,improves governance, or reveals information through his trading, helps. Weeconomistsknowtheseareveryimportantfunctionsintheeconomybuttheyarenotsoeasilysoldpolitically.

And finally, since capital has spread across borders, any sudden futureretrenchmentcouldnotonlyinflictpainonrecipientcountriesbutalsogenerateforeignpoliticalpressureseekingtoimpedethefreeflowofcapital.

Letmeconclude.The last fewyearshavebeen, inmanyways, thebestoftimes for theworld economy.The financial sector has contributed immensely.However, the current conjuncture has led to some practices that deserveexamination. In particular, I worry whether compensation structures give toomuchincentive to takeriskand, relatedly,whetherpay issufficiently linked toperformance.Whileclaimsaremadethatthefinancialsectorisbecomingmoreandmoreefficient,andthatitisaddingmoreandmorevalue,theamountoftruevalue added by the sector is hard to observe. With high pay, questionablepractices, andhard-to-observe value addition, the financial sector is politicallyvulnerable. In a downturn, even if there are no systemic risks in the financialsystem–forinstance,ifallthelossesarerunbystablepassiveholdersofassetssuchaspensionfunds–thepoliticalsystemmayreactinawaythathassystemicconsequences. To avoid the risk of possibly excessive political reaction, it isimportantthattheissuesthatIhavejustalludedtobediscussedbythefinancialsectoritself,andwherenecessary,andpossible,adjustmentsmade.Itwouldbeashame if sparks from the red-hot financial sector set off a conflagration thatdestroyedtheveryrealgainsfinancehasmadeinthelastfewdecades.Indeed,

historysuggestsabundantcaution.

T

III

In2009,asregulatorsstartedfiguringoutwhatneededtobedonetomakesurethefinancialsystemwasmademoresecureafterthefinancialcrisis,IdeliveredtheHomerJonesLectureorganizedbytheFederalReserveBankofStLouisinStLouison15April.ThisiswhatIsaid.(IthankLuigiZingalesforveryusefuldiscussionincludingsomeoftheideasinthistalk.)

TheCreditCrisisandCycle-proofRegulation

here is some consensus that the proximate causes of the crisis are: (i) theU.S.financialsectormisallocatedresourcestorealestate,financedthrough

the issuance of exotic new financial instruments; (ii) a significant portion ofthese instruments found their way, directly or indirectly, into commercial andinvestment bank balance sheets; (iii) these investments were largely financedwithshort-termdebt;(iv)themixwaspotent,andimplodedstartingin2007.Onthese,thereisbroadagreement.Butletusdigalittledeeper.

Thisisacrisisborninsomewaysfrompreviousfinancialcrises.Awaveofcrises swept through the emerging markets in the late 1990s: East Asianeconomiescollapsed,Russiadefaulted,andArgentina,Brazil,andTurkeyfacedseverestress.Inresponsetotheseproblems,emergingmarketsbecamefarmorecircumspectaboutborrowingfromabroadtofinancedomesticdemand.Instead,their corporations, governments, and households cut back on investment andreducedconsumption.

Fromnetabsorbersoffinancialcapitalfromtherestoftheworld,anumberof these countries became net exporters of financial capital. When combinedwiththesavingsofhabitualexporterslikeGermanyandJapan,therewaswhatChairmanBernankereferredtoasaglobalsavingsglut.

Clearly,thenetfinancialsavingsgeneratedinonepartoftheworldhavetobe absorbed by deficits elsewhere. Industrial country corporations initiallyabsorbed these savings by expanding investment, especially in informationtechnology.Butthisprovedunsustainable,andinvestmentwascutbacksharplyfollowingthecollapseoftheInformationTechnologybubble.

Extremelyaccommodativemonetarypolicybytheworld’scentralbanks,ledby the Federal Reserve, ensured the world did not suffer a deep recession.Instead, the low interest rates in a number of countries ignited demand ininterest-sensitivesectorssuchasautomobilesandhousing.Housepricesstartedrisingasdidhousinginvestment.

TheUnitedStateswasnotbyanymeansthehighestintermsofpricegrowth.Housing prices reached higher values relative to rent or incomes in Ireland,Spain, the Netherlands, the UnitedKingdom, andNew Zealand, for example.Then, why did the crisis first manifest itself in the United States? Probablybecause the U.S. went further on financial innovation, thus drawing moremarginal-credit-qualitybuyersintothemarket!

A home mortgage loan is very hard for an international investor to holddirectly because it requires servicing, is of uncertain credit quality, and has ahighpropensity todefault.Securitizationdealtwith someof theseconcerns. Ifthe mortgage was packaged together with mortgages from other areas,diversificationwouldreducetherisk.Furthermore,theriskiestclaimsagainstthepackagecouldbesoldtothosewhohadthecapacitytoevaluatethemandhadanappetiteforbearingtherisk,whilethesafestAAA-ratedportionscouldbeheldbyinternationalinvestors.

Indeed,becauseof thedemandfrominternational investorsforAAApaper,securitization became focused on squeezing out themostAAApaper from anunderlyingpackageofmortgages;thelowerqualitysecuritiesissuedagainsttheinitial package of mortgages were packaged together once again with similarsecuritiesfromotherpackages,andanewrangeofsecurities,includingalargequantityratedAAA,issuedbythis‘CollateralizedDebtObligation’.

The ‘originate-to-securitize’ process had the unintended consequence ofreducing the due diligence undertaken by originators. Of course, originatorscouldnotcompletelyignorethetruequalityofborrowerssincetheywereheldresponsibleforinitialdefaults,butbecausehousepriceswererisingsteadilyoverthisperiod,eventhissourceofdisciplineweakened.Ifthebuyercouldnotmakeeventhenominalpaymentsinvolvedontheinitiallowmortgageteaserrates,thelendercould repossess thehouse, sell it quickly in thehotmarket, and recoup

anylossesthroughthepriceappreciation.Intheliquidhousingmarket,solongasthebuyercouldscrawlXonthedottedline,shecouldown.

Theslicinganddicingthroughrepeatedsecuritizationoftheoriginalpackageofmortgagescreatedverycomplicatedsecurities.Theproblemsinvaluingthesesecuritieswerenotobviouswhenhousepriceswererisinganddefaultswerefew.But as the house prices stopped rising and defaults started increasing, thevaluationofthesesecuritiesbecameverycomplicated.

It was not entirely surprising that bad investments would be made in thehousingboom.Whatwas surprisingwas that the originators of these complexsecurities, the financial institutions, who should have understood thedeteriorationoftheunderlyingqualityofmortgages,heldontosomanyofthemortgage-backedsecurities(MBS)intheirownportfolios.Whydidthesausage-makers,whoknewwhatwasinthesausage,keepsomanysausagesforpersonalconsumption?

The explanation has to be that at least one arm of the bank thought thesesecuritieswereworthwhile investments, despite their risk. Investment inMBSseemedtobepartofacultureofexcessiverisk-takingthathadovertakenbanks.Akeyfactorcontributingtothiscultureisthat,overshortperiodsoftime,itisvery hard, especially in the case of new products, to tell whether a financialmanager is generating true excess returns adjusting for risk, or whether thecurrentreturnsaresimplycompensationforariskthathasnotyetshownitselfbutthatwilleventuallymaterialize.Thiscouldengenderexcessrisktakingbothatthetopandwithinthefirm.

For instance, the performance of CEOs is evaluated based in part on theearnings they generate relative to their peers. To the extent that some leadingbankscangeneratelegitimatelyhighreturns,thisputspressureonotherbankstokeep up. Follower-bank bossesmay end up taking excessive risks in order toboostvariousobservablemeasuresofperformance.

Indeed, even if managers recognize that this type of strategy is not trulyvalue-creating, a desire to pump up their stock prices and their personalreputationsmayneverthelessmakeitthemostattractiveoptionforthem.Thereis anecdotal evidence of such pressure on top management – perhaps most

famously,CitigroupChairmanChuckPrince,describingwhyhisbankcontinuedfinancingbuyoutsdespitemountingrisks,said:‘Whenthemusicstops,intermsof liquidity, things will be complicated. But, as long as themusic is playing,you’ve got to get up and dance.We’re still dancing.’Financial Times, 9 July2007.

Even if topmanagementwants tomaximize long-term bank value, itmayfinditdifficulttocreateincentivesandcontrolsystemsthatsteersubordinatesinthis direction. Given the competition for talent, traders have to be paidgenerouslybasedonperformance.But,manyofthecompensationschemespaidforshort-termrisk-adjustedperformance.Thisgavetradersanincentivetotakerisksthatwerenotrecognizedbythesystem,sotheycouldgenerateincomethatappearedtostemfromtheirsuperiorabilities,eventhoughitwasinfactonlyamarket-riskpremium.

Theclassiccaseofsuchbehaviouristowriteinsuranceoninfrequenteventssuch as defaults, taking onwhat is termed ‘tail’ risk. If a trader is allowed toboostherbonusbytreatingtheentireinsurancepremiumasincome,insteadofsettingasideasignificantfractionasareserveforaneventualpayout,shewillhaveanexcessiveincentivetoengageinthissortoftrade.

Indeed,traderswhoboughtAAAMBSwereessentiallygettingtheadditionalspread on these instruments relative to corporate AAA securities (the spreadbeingtheinsurancepremium)whileignoringtheadditionaldefaultriskentailedintheseuntestedsecurities.

The traders in AIG’s Financial Products Division just took all this to anextremebywritingcreditdefaultswaps,pocketingthepremiumsasbonus,andnotbothering to set aside reserves in case thebonds thatwere coveredby theswapsactuallydefaulted.

Thisisnottosaythatriskmanagersinafinancialinstitutionareunawareofsuch incentives. However, theymay be unable to fully control them, because‘tail’risksarebytheirnaturerare,andthereforehardtoquantifywithprecisionbeforetheyoccur.Whiletheycouldtryandimposecrudelimitsontheactivitiesof the traders takingmaximum risk, these traders are likely tohavebeenveryprofitable(beforetheriskactuallyisrealized),andsuchactionsareunlikelyto

sitwellwithatopmanagementthatisbeingpressuredforprofits.Finally, all these shaky assets were financed with short-term debt. This is

becauseingoodtimes,short-termdebtseemsrelativelycheapcomparedtolong-termcapital,andthemarketiswillingtosupplyitbecausethecostsofilliquidityappearremote.Marketsseemtofavourabankcapitalstructurethatisheavyonshort-term leverage. In bad times, though, the costs of illiquidity seem to bemore salient, while risk-averse (and burnt) bankers are unlikely to take onexcessiverisk.Themarkets thenencourageacapitalstructure that isheavyoncapital.

Given the proximate causes of high bank holdings of mortgage-backedsecurities,aswellasotherriskyloans,suchasthosetoprivateequity,financedwithacapitalstructureheavyonshort-termdebt,thecrisishadacertaindegreeof inevitability. As house prices stopped rising, and indeed started falling,mortgage defaults started increasing.Mortgage-backed securities fell in value,became more difficult to price, and their prices became more volatile. Theybecame hard to borrow against, even short term. Banks became illiquid, andeventually insolvent. Only heavy intervention has kept the financial systemafloat,and though themarket seems tobelieve that theworst isover, its reliefmaybepremature.

Who is toblame for the financialcrisis?As theabovediscussionsuggests,there are many possible suspects – the exporting countries who still do notunderstandthattheirthriftisaburdenandnotablessingtotherestoftheworld,the U.S. household that has spent way beyond its means in recent years, themonetary and fiscal authorities who were excessively ready to intervene toprevent short-term pain, even though they only postponed problems into thefuture,thebankerswhotooktheupsideandleftthedownsidetothetaxpayer,thepoliticianwho tried to expand his vote bank by extending home-ownership toeventhosewhocouldnotaffordit,themarketsthattoleratedhighleverageintheboomonlytobecomeriskaverseinthebust…

Thereareplentyof suspects, andenoughblame to spread.But if all are toblame,though,shouldwealsonotadmittheyallhadawillingaccomplice–theeuphoriageneratedbytheboom.Afterall,whoistheretostandforstabilityand

againsttheprosperityandgrowthinaboom?Internal risk managers, having repeatedly pointed to risks that never

materializedduringanupswing,havelittlecredibilityandinfluence–that is iftheystillhavejobs.Itisalsoveryhardforcontrarianinvestorstobetagainsttheboom–asKeynessaid,themarketcanstayirrationallongerthaninvestorscanstay solvent. Politicians have an incentive to ride the boom, indeed to abet itthroughthederegulationsoughtbybankers.Afterall,bankersnotonlyhavethemoney to influence legislation but also have themoral authority conferred byprosperity.

Andwhatofregulators?Wheneveryoneisfortheboom,howcanregulatorsstandagainst it?Theyarereducedtorationalizingwhyitwouldbe technicallyimpossible for them to stop it. Everyone is therefore complicit in the crisisbecause,ultimately,theyareaidedandabettedbycyclicaleuphoria.Andunlesswerecognizethis,thenextcrisiswillbehardtoprevent.

Forwe typically regulate in themidst of a bustwhen righteous politiciansfeel the need to do something, when bankers’ frail balance sheets and vividmemoriesmakes them eschew any risk, and when regulators have backbonesstiffenedbypublicdisapprovalofpastlaxity.

Butwe reformunder the delusion that the regulated, and themarkets theyoperate in, are static andpassive, and that the regulatoryenvironmentwill notvarywith the cycle. Ironically, faith indraconian regulation is strongest at thebottomofthecycle,whenthereislittleneedforparticipantstoberegulated.Bycontrast, the misconception that markets will take care of themselves is mostwidespread at the top of the cycle, at the point of maximum danger to thesystem. We need to acknowledge these differences and enact cycle-proofregulation,foraregulationsetagainstthecyclewillnotstand.

Consider thedangersof ignoring thispoint.Recent reportshavearguedfor‘countercyclical’ capital requirements – raising bank capital requirementssignificantlyingoodtimes,whileallowingthemtofallsomewhatinbadtimes.While sensible prima facie, these proposals may be far less effective thanintended.

To see why, recognize that in boom times, the market demands very low

levelsof capital from financial intermediaries, inpart because euphoriamakeslosses seem remote. So when regulated financial intermediaries are forced toholdmorecostlycapitalthanthemarketrequires,theyhaveanincentivetoshiftactivity to unregulated intermediaries, as did banks in setting up SIVs andconduitsduring thecurrentcrisis.Even if regulatorsarestrengthened todetectand prevent this shift in activity, banks can subvert capital requirements bytaking on risk the regulators do not see, or do not penalize adequately withcapitalrequirements.

Attempts to reduce capital requirements in busts are equally fraught. Therisk-aversemarketwantsbankstoholdalotmorecapitalthanregulatorsrequire,anditswillnaturallyprevails.

Even the requirements themselvesmay not be immune to the cycle. Oncememoriesof thecurrentcrisis fade,andonce the ideologicalcycle turns, therewill be enormous political pressure to soften capital requirements or theirenforcement.

To have a better chance of creating stability through the cycle – of beingcycle-proof – new regulations should be comprehensive, contingent, and cost-effective. Regulations that apply comprehensively to all levered financialinstitutions are less likely to encourage the drift of activities from heavilyregulated to lightlyregulated institutionsover theboom,asourceof instabilitysince the damaging consequences of such drift come back to hit the heavilyregulatedinstitutionsinthebust,throughchannelsthatnooneforesees.

Regulationsshouldalsobecontingentsotheyhavemaximumforcewhentheprivatesectorismostlikelytodoitselfharmbutbindlesstherestofthetime.Thiswillmakeregulationsmorecost-effective,whichwillmakethemlesspronetoarbitrageordilution.

Consider some examples of such regulations. First, instead of askinginstitutions to raise permanent capital, ask them to arrange for capital to beinfused when the institution or the system is in trouble. Because these‘contingent capital‘ arrangements will be contracted in good times when thechancesofadownturnseemremote,theywillberelativelycheap(comparedtoraisingnewcapitalinthemidstofarecession)andthuseasiertoenforce.Also,

becausetheinfusionisseenasanunlikelypossibility,firmscannotgooutandincrease their risks, using the future capital as backing. Finally, because theinfusions come in bad times when capital is really needed, they protect thesystemandthetaxpayerintherightcontingencies.

One version of contingent capital is for banks to issue debt which wouldautomaticallyconverttoequitywhentwoconditionsaremet;first,thesystemisin crisis, either based on an assessment by regulators or based on objectiveindicators,andsecond, thebank’scapital ratio fallsbelowacertainvalue.Thefirst condition ensures that banks that do badly because of their ownidiosyncraticerrors,andnotwhenthesystemisintrouble,don’tgettoavoidthedisciplinaryeffectsofdebt.Thesecondconditionrewardswell-capitalizedbanksbyallowingthemtoavoidtheforcedconversion(thenumberofsharesthedebtconverts to will be set at a level so as dilute the value of old equitysubstantially),whilealsogivingbanksthatanticipatelossesanincentivetoraisenewequitywellintime.

Anotherversionofcontingentcapitalistorequirethatsystemicallyimportantlevered financial institutions buy fully collateralized insurance policies (fromunleveredinstitutions,foreigners,orthegovernment)thatwillinfusecapitalintotheseinstitutionswhenthesystemisintrouble.

Here is oneway it could operate.Megabankwould issue capital insurancebonds,say tosovereignwealthfunds. Itwould invest theproceeds inTreasurybonds,whichwouldthenbeplacedinacustodialaccountinStateStreetBank.Everyquarter,Megabankwouldpayapre-agreedinsurancepremium(contractedatthetimethecapitalinsurancebondisissued)which,togetherwiththeinterestaccumulatedontheTreasurybondsheldinthecustodialaccount,wouldbepaidtothesovereignfund.

Iftheaggregatelossesofthebankingsystemexceedacertainpre-specifiedamount,Megabankwould start getting a payout from the custodial account tobolster its capital. The sovereign wealth fund will now face losses on theprincipal ithas invested,butonaverage, itwillhavebeencompensatedby theinsurancepremium.

Considernextregulationsaimedat‘too-big-to-fail’ institutions.Regulations

tolimittheirsizeandactivitieswillbecomeveryonerouswhengrowthishigh,thusincreasingtheincentivetodilutethem.Perhaps,instead,amorecyclicallysustainableregulationwouldbetomaketheseinstitutionseasiertoclose.Whatif systemically important financial institutionswere required todevelopaplanthat would enable them to be resolved over a weekend? Such a ‘shelfbankruptcy’ planwould require banks to track, and document, their exposuresmuchmorecarefullyandinatimelymanner,probablythroughmuchbetteruseof technology.Theplanwillneed tobestress testedby regulatorsperiodicallyand supported by enabling legislation – such as one facilitating an orderlytransferoftheinstitution’sswapbookstopre-committedpartners.Notonlywillthe need to develop a plan give these institutions the incentive to reduceunnecessary complexity and improve management, it will not be much moreonerousintheboom,andmayindeedforcemanagementtothinktheunthinkableatsuchtimes.

Let me conclude. A crisis offers us a rare window of opportunity toimplement reforms – it is a terrible thing towaste. The temptationwill be toover-regulate, as we have done in the past. This creates its own perversedynamic.

For as we start eliminating senseless regulations once the recovery takeshold, we will find deregulation adds so much economic value that it furtherempowers the deregulatory camp. Eventually, though, the deregulatorymomentum causes us to eliminate regulatory muscle rather than fat. Perhapsrather than swingingmaniacally between toomuch and too little regulation, itwouldbebettertothinkofcycle-proofregulation.

Postscript:Theseideas(Icannotclaimoriginalitybecausethesewereintheair)madetheirwayintopost-crisisregulationascontingentconvertiblebonds(CoCos)andlivingwills.

A

IV

In2012,IwrotealongerpieceinForeignAffairssummarizingmyviewsonthereasonsforthebuild-upindebtbeforethecrisisandthepost-crisisrecoverymeasures.

TheTrueLessonsoftheGreatRecession

ccording to the conventional interpretation of the global economicrecession, growth has ground to a halt in theWest because demand has

collapsed, a casualty of the massive amount of debt accumulated before thecrisis.

Households and countries are not spending because they can’t borrow thefundstodoso,andthebestwaytorevivegrowth,theargumentgoes,istofindwaystogetthemoneyflowingagain.Governmentsthatstillcanshouldrunupeven largerdeficits,andcentralbanksshouldpush interest rateseven lower toencourage thrifty households to buy rather than save. Leaders should worryabouttheaccumulateddebtlater,oncetheireconomieshavepickedupagain.

Thisnarrative– thestandardKeynesianline,modifiedforadebtcrisis– isthe one to which most Western officials, central bankers, and Wall Streeteconomistssubscribe today.As theUnitedStateshasshownsignsof recovery,Keynesianpunditshavebeenquicktoclaimsuccessfortheirpolicies,pointingtoEurope’semergingrecessionasproofofthefollyofgovernmentausterity.Butitishardtotierecovery(orthelackofit)tospecificpolicyinterventions.Untilrecently,thesesamepunditswerecomplainingthatthestimuluspackagesintheUnitedStatesweretoosmall.SotheycouldhaveclaimedcreditforKeynesianstimuluseven if the recoveryhadnotmaterialized, saying, ‘We toldyou todomore.’AndthemassivefiscaldeficitsinEurope,aswellastheEuropeanCentralBank’stremendousincreaseinlendingtobanks,suggestthatitisnotforwantofgovernmentstimulusthatgrowthisstillfragilethere.

In fact, today’s economic troubles are not simply the result of inadequatedemandbuttheresult,equally,ofadistortedsupplyside.Fordecadesbeforethe

financialcrisisin2008,advancedeconomieswerelosingtheirabilitytogrowbymaking useful things. But they needed to somehow replace the jobs that hadbeenlosttotechnologyandforeigncompetitionandtopayforthepensionsandhealth care of their aging populations. So in an effort to pump up growth,governmentsspentmorethantheycouldaffordandpromotedeasycredittogethouseholdstodothesame.Thegrowththatthesecountriesengineered,withitsdependenceonborrowing,provedunsustainable.

Rather than attempting to return to their artificially inflatedGDP numbersfrombeforethecrisis,governmentsneedtoaddresstheunderlyingflawsintheireconomies.IntheUnitedStates,thatmeanseducatingorretrainingtheworkerswho are falling behind, encouraging entrepreneurship and innovation, andharnessingthepowerofthefinancialsectortodogoodwhilepreventingitfromgoing off track. In southern Europe, by contrast, it means removing theregulations that protect firms andworkers from competition and shrinking thegovernment’s presence in a number of areas, in the process eliminatingunnecessary,unproductivejobs.

THEENDOFEASYGROWTH

Tounderstandwhatwill,andwon’t,worktorestoresustainablegrowth,ithelpstoconsidera thumbnail sketchof theeconomichistoryof thepast sixtyyears.The1950sand1960swereatimeofrapideconomicexpansionintheWestandJapan.Severalfactorsunderpinnedthis longboom:postwarreconstruction, theresurgenceoftradeaftertheprotectionist1930s,moreeducatedworkforces,andthebroaderuseoftechnologiessuchaselectricityandtheinternalconsumptionengine.Butas theeconomistTylerCowenhasargued,oncetheselow-hangingfruithadbeenplucked,itbecamemuchhardertokeepeconomieshumming.Theera of fast growth came to a sudden end in the early 1970s,when theOPECcountries,realizingthevalueoftheircollectivebargainingpower,jackedupthepriceofoil.

Asgrowthfaltered,governmentspendingballooned.Duringthegoodyearsof the 1960s, democratic governments had been quick to expand the welfarestate. But this meant that when unemployment later rose, so did government

spendingonbenefits for the jobless,evenas tax revenuesshrank.Forawhile,centralbanksaccommodatedthatspendingwithexpansionarymonetarypolicy.That,however,ledtohighinflationinthe1970s,whichwasexacerbatedbytherise in oil prices. Such inflation, although it lowered the real value ofgovernments’ debt, did not induce growth. Instead, stagflation eroded mosteconomists’andpolicymakers’faithinKeynesianstimuluspolicies.

Central banks then changed course, making low and stable inflation theirprimaryobjective.Butgovernmentscontinuedtheirdeficitspending,andpublicdebtasashareofGDPinindustrialcountriesclimbedsteadilybeginninginthelate1970s–thistimewithoutinflationtoreduceitsrealvalue.Recognizingtheneed to find new sources of growth,Washington, toward the end of PresidentJimmyCarter’stermandthenunderPresidentRonaldReagan,deregulatedmanyindustries,suchasaviation,electricpower,trucking,andfinance.SodidPrimeMinister Margaret Thatcher in the United Kingdom. Eventually, productivitybegantopickup.

WhereastheUnitedStatesandtheUnitedKingdomrespondedtotheslumpofthe1970swithfreneticderegulation,continentalEuropemademorecosmeticreforms.TheEuropeanCommissionpushedderegulation in various industries,includingthefinancialsector,butthesemeasureswerelimited,especiallywhenitcametointroducingcompetitionanddismantlinggenerousworkerprotections.Perhapsasaresult,whileproductivitygrowthtookoffonceagainintheUnitedStates starting in the mid-1990s, it fell to a crawl in continental Europe,especially in its poorer and less reform-minded southern periphery. In 1999,when the euro was introduced, Italy’s unemployment rate was 11 per cent,Greece’swas12percent,andSpain’swas16percent.The resultingdrainongovernmentcoffersmade itdifficult tosavefor futurespendingonhealthcareandpensions,promisesmadeevenmoreonerousbyrapidlyagingpopulations.

Incountriesthatdidreform,deregulationwasnotanunmitigatedblessing.Itdid boost entrepreneurship and innovation, increase competition, and forceexistingfirmstofocusonefficiency,allofwhichgaveconsumerscheaperandbetterproducts.Butitalsohadtheunintendedconsequenceofincreasingincomeinequality – creating a gap that, by and large, governments dealt with not by

preparingtheirworkforcesforaknowledgeeconomybutbygivingthemaccesstocheapcredit.

DISRUPTINGTHESTATUSQUO

For the United States, the world’s largest economy, deregulation has been amixed bag. Over the past few decades, the competition it has induced haswidenedtheincomegapbetweentherichandthepoorandmadeitharderfortheaverageAmericantofindastable,well-payingjobwithgoodbenefits.Butthatcompetitionhasalsoledtoafloodofcheapconsumergoods,whichhasmeantthatanyincomeheorshegetsnowgoesfurtherthaneverbefore.

During the postwar era of heavy regulation and limited competition,establishedfirmsintheUnitedStateshadgrownfatandhappy,enjoyingmassivequasi-monopolisticprofits.Theysharedthesereturnswiththeirshareholdersandtheirworkers.Forbanks,thiswastheageofthe‘3-6-3’formula:borrowat3percent, lend at 6per cent, andheadoff to thegolf course at 3p.m.Bankswereprofitable, safe,andboring,and thepricewaspaidbydepositors,whogot theoccasionaltoasterinsteadofmarketinterestrates.Unionsfoughtforwell-payingjobswithgoodbenefits,andfirmswerehappytoaccommodatethemtosecureindustrialpeace–afterall,therewereplentyofprofitstobeshared.

Inthe1980sand1990s,thedismantlingofregulationsandtradebarriersputanendtothiscozylife.Newentrepreneurswithbetterproductschallengedtheirslower-moving competitors, and the variety and quality of consumer productsimproved radically, altering peoples’ lives largely for the better. Personalcomputers, connected through the Internet, have allowed users to entertain,inform,andshopforthemselves,andcellphoneshaveletpeoplestayinconstantcontact with friends (and bosses). The shipping container, meanwhile, hasenabled small foreign manufacturers to ship products speedily to farawayconsumers. Relative to incomes, cotton shirts and canned peaches have neverbeencheaper.

Atthesametimeasregularconsumers’purchasingpowergrew,sodidWallStreetpayouts.Becausecompanies’profitswereunderpressure, theybegan toinnovatemoreandtakegreaterrisks,anddoingsorequiredfinancierswhocould

understand those risks, price them accurately, and distribute them judiciously.Bankingwas no longer boring; indeed, it became the command centre of theeconomy, financing one company’s expansion here while putting another intobankruptcythere.

Meanwhile, the best companies became more meritocratic, and they paidmoretoattracttoptalent.Thetop1percentofhouseholdshadobtainedonly8.9percentofthetotalincomegeneratedintheUnitedStatesin1976,butby2007this had increased to nearly 25 per cent. Even as the salaries of uppermanagementgrew,however,itsranksdiversified.Comparedwithexecutivesin1980,corporateleadersintheUnitedStatesin2001wereyounger,morelikelyto be women, and less likely to have Ivy League degrees (although they hadmore advanced degrees). It was no longer as important to belong to the rightcountryclub toreach the top;whatmatteredwashavingagoodeducationandtherightskills.

It is tempting toblame theever-widening incomegaponskewedcorporateincentivesandmisguidedtaxpolicies,butneitherexplanationissufficient.Iftherise in executive salarieswere just the result of bad corporate governance, assomehaveclaimed, thendoctors, lawyers,andacademicswouldnothavealsoseentheirsalariesgrowasmuchastheyhaveinrecentyears.Andalthoughthetop tax rates were indeed lowered during the presidency of GeorgeW. Bush,thesecutsweren’ttheprimarysourceoftheinequality,either,sinceinequalityinbefore-taxincomesalsorose.Thisisnottosaythatalltopsalariesaredeserved–itisnothardtofindthepliantboardoverpayingtheunderperformingCEO–butmostaresimplyreflectionsofthevalueofskillsinacompetitiveworld.

Infact,sincethe1980s,theincomegaphaswidenednotjustbetweenCEOsand therestofsocietybutacross theeconomy, too,as routine taskshavebeenautomated or outsourced.With the aid of technology and capital, one skilledworker can displace many unskilled workers. Think of it this way: whenfactories used mechanical lathes, university-educated Joe and high-school-educated Moe were no different and earned similar paychecks. But whenfactoriesupgraded tocomputerized lathes,notonlywasJoemoreuseful;Moewasnolongerneeded.

Not all low-skilled jobshavedisappeared.Non-routine, low-paying servicejobsthatarehardtoautomateoroutsource,suchastaxidriving,hairdressing,orgardening, remain plentiful. So the U.S. workforce has bifurcated into low-paying professions that require few skills and high-paying ones that call forcreativityandcredentials.Comfortable,routinejobsthatrequiremoderateskillsandoffergoodbenefitshavedisappeared,andthelaid-offworkershavehadtoeitherupgradetheirskillsortakelower-payingservicejobs.

Unfortunately, for various reasons – inadequate early schooling,dysfunctionalfamiliesandcommunities,thehighcostofuniversityeducation–fartoomanyAmericanshavenotgottentheeducationorskillstheyneed.Othershave spent toomuch time in shrinking industries, suchas automanufacturing,insteadofacquiringskillsingrowingsectors,suchasmedicaltechnology.AstheeconomistsClaudiaGoldinandLawrenceKatzhaveputit,in‘theracebetweentechnologyandeducation’intheUnitedStatesinthelastfewdecades,educationhasfallenbehind.

As Americans’ skills have lagged, the gap between the wages of the welleducated and the wages of the moderately educated has grown even further.Sincetheearly1980s,thedifferencebetweentheincomesofthetop10percentofearners(whotypicallyholduniversitydegrees)andthoseofthemiddle(mostofwhomhaveonlyahighschooldiploma)hasgrownsteadily.Bycontrast,thedifferencebetweenmedianincomesandincomesofthebottom10percenthasbarely budged. The top is running away from the middle, and the middle ismergingwiththebottom.

Thestatisticsarealarming.IntheUnitedStates,35percentofthoseaged25to 54with no high school diplomahave no job, and high school dropouts arethree times as likely to beunemployed as university graduates.What ismore,Americansbetweentheagesof25and34arelesslikelytohaveadegreethanthosebetween45and54, even thoughdegreeshavebecomemorevaluable inthelabourmarket.Mosttroubling,however,isthatinrecentyears,thechildrenofrichparentshavebeenfarmorelikelytogetcollegedegreesthanweresimilarchildren in the past, whereas college completion rates for children in poorhouseholds have stayed consistently low. The income divide created by the

educationaldivideisbecomingentrenched.

THEPOLITICIANSRESPOND

In the years before the crisis, the everyday reality formiddle-classAmericanswas a paycheck that refused to grow and a job that became less secure everyyear, even while the upper-middle class and the very rich got richer. Well-paying,low-skilledjobswithgoodbenefitswerebecomingharderandhardertofind,exceptperhapsinthegovernment.

Rather than address the underlying reasons for this trend, Americanpoliticiansoptedforeasyanswers.Theirresponsemaybeunderstandable;afterall, it isnoteasytoupgradeworkers’skillsquickly.But theresultingfixesdidmoredamagethangood.Politicianssoughttoboostconsumption,hopingthatifmiddle-classvotersfeltliketheywerekeepingupwiththeirricherneighbours–iftheycouldaffordanewcareveryfewyearsandtheoccasionalexoticholiday– theymight pay less attention to the fact that their salariesweren’t growing.Oneeasywaytodothatwastoenhancethepublic’saccesstocredit.

Accordingly, starting in the early 1990s, U.S. leaders encouraged thefinancialsectortolendmoretohouseholds,especiallylower-middleclassones.In1992,CongresspassedtheFederalHousingEnterprisesFinancialSafetyandSoundnessAct,partlytogainmorecontroloverFannieMaeandFreddieMac,the giant private mortgage agencies, and partly to promote affordablehomeownershipforlow-incomegroups.

Such policies helped money flow to lower-middle-class households andraisedtheirspending–somuchsothatconsumptioninequalityrosemuchlessthan income inequality in the years before the crisis.These policieswere alsopoliticallypopular.Unlikewhenitcametoanexpansioningovernmentwelfaretransfers,fewgroupsopposedexpandingcredit tothelower-middleclass–notthepoliticianswhowantedmoregrowthandhappyconstituents,notthebankersandbrokerswhoprofitedfromthemortgagefees,nottheborrowerswhocouldnowbuytheirdreamhouseswithvirtuallynomoneydown,andnotthelaissez-fairebankregulatorswho thought theycouldpickup thepieces if thehousingmarketcollapsed.Cynicalasitmayseem,easycreditwasusedasapalliativeby

successive administrations unable or unwilling to directly address the deeperproblemswiththeeconomyortheanxietiesofthemiddleclass.

The Federal Reserve abetted these short-sighted policies. In 2001, inresponse to thedot-combust, theFedcutshort-term interest rates to thebone.Even though the overstretched corporations that were meant to be stimulatedwere not interested in investing, artificially low interest rates acted as atremendous subsidy to the parts of the economy that relied on debt, such ashousing and finance. This led to an expansion in housing construction (andrelated services, such as real estate brokerage and mortgage lending), whichcreatedjobs,especiallyfortheunskilled.Progressiveeconomistsapplaudedthisprocess, arguing that the housing boom would lift the economy out of thedoldrums. But the Fed-supported bubble proved unsustainable. Manyconstruction workers have lost their jobs and are now in deeper trouble thanbefore,havingalsoborrowedtobuyunaffordablehouses.

Bankersobviouslydeservealargeshareoftheblameforthecrisis.Someofthe financial sector’s activitieswere clearly predatory, if not outright criminal.But the role that the politically induced expansion of credit played cannot beignored; it is themain reason theusual checks andbalanceson financial risk-takingbrokedown.

Outside the United States, other governments responded differently toslowing growth in the 1990s. Some countries focused on making themselvesmore competitive. Fiscally conservative Germany, for example, reducedunemployment benefits even while reducing worker protections. Wages grewslowly even as productivity increased, andGermany became one of themostcompetitive manufacturers in the world. But some other European countries,such asGreece and Italy, had little incentive to reform, as the inflow of easycreditaftertheiraccessiontotheeurozonekeptgrowthgoingandhelpedbringdown unemployment. The Greek government borrowed to create high-payingbutunproductivegovernmentjobs,andunemploymentcamedownsharply.Buteventually,Greece could borrow nomore, and itsGDP is now shrinking fast.NotallEuropeancountriesintroublereliedonfederalborrowingandspending.In Spain, a combination of a construction boom and spending by local

governmentscreatedjobs.InIreland,itwasprimarilyahousingbubblethatdidthe trick. Regardless, the common thread was that debt-fuelled growth wasunsustainable.

WHATCANBEDONE?

Sincethegrowthbeforethecrisiswasdistortedinfundamentalways,itishardto imagine that governments could restore demand quickly – or that doing sowouldbeenoughtogettheglobaleconomybackontrack.Thestatusquoanteisnot agoodplace to return tobecausebloated finance, residential construction,and government sectors need to shrink, and workers need to move to moreproductivework.Thewayoutof thecrisiscannotbestillmoreborrowingandspending,especially if thespendingdoesnotbuild lastingassets thatwillhelpfuturegenerationspayoff thedebtsthat theywillbesaddledwith.Instead, thebestshort-termpolicyresponseistofocusonlong-termsustainablegrowth.

Countries that don’t have the option of running higher deficits, such asGreece, Italy, and Spain, should shrink the size of their governments andimprove their taxcollection.Theymustallowfreerentry intosuchprofessionsas accounting, law, and pharmaceuticals, while exposing sectors such astransportation to more competition, and they should reduce employmentprotections – moves that would create more private sector jobs for laid-offgovernmentworkersandunemployedyouth.Fiscalausterityisnotpainlessandwill probably subtract from growth in the short run. It would be far better tophasereformsinovertime,yetitispreciselybecausegovernmentsdidnotactingoodtimesthattheyareforcedtodoso,andquickly,inbadtimes.Indeed,thereisacasetobemadefordoingwhatisnecessaryquicklyandacrosstheboardsothateveryonefeelsthatthepainisshared,ratherthanspreadingitovertimeandrisking dissipating the political will. Governments should not, however,underestimate thepain that thesemeasureswillcause to theelderly, theyouth,and the poor, and where possible, they should enact targeted legislation toalleviatethemeasures’impact.

TheUnitedStates,foritspart,cantakesomecomfortinthepowerfulforcesthatshouldhelpcreatemoreproductivejobsinthefuture:betterinformationand

communicationstechnology,lower-costcleanenergy,andsharplyrisingdemandin emerging markets for higher-value-added goods. But it also needs to takedecisiveactionnowsothatitcanbereadytotakeadvantageoftheseforces.TheUnited States must improve the capabilities of its workforce, preserve anenvironmentforinnovation,andregulatefinancebettersoastopreventexcess.

Noneofthiswillbeeasy,ofcourse.Considerhowharditistoimprovethematchbetweenskillsandjobs.Sincethehousingandfinancialsectorswillnotemploy thenumbers theydidduring thepre-crisis creditboomany timesoon,people who worked in, or depended on, those sectors will have to changecareers. That takes time and is not always possible; the housing industry, inparticular, employed many low-skilled workers, who are hard to place.Governmentprogrammesaimedatskillbuildinghaveacheckeredhistory.Evengovernmentattempts tohelpstudents finance theireducationshavenotalwaysworked; some predatory private colleges have lured students with access togovernment financing into expensive degrees that have little value in the jobmarket.Instead,muchoftheinitiativehastocomefrompeoplethemselves.

That isnot tosaythatWashingtonshouldbepassive.Althougheducationalreform and universal health care are long overdue, it can do more on otherfronts.More informationon jobprospects in various career tracks, alongwithbettercounsellingabouteducationaland trainingprogrammes,canhelppeoplemakebetterdecisionsbeforetheyenrolinexpensivebutuselessprogrammes.Inareaswithhighyouthunemployment,subsidiesforfirmstohirefirst-timeyoungworkersmaygetyouth into the labour forceandhelp themunderstandwhat ittakes to hold a job.Thegovernment could support older unemployedworkersmore–payingforchildcareandtraining–sothat theycanretrainevenwhilelookingforwork.Someportionofemployedworkers’unemploymentinsurancefeescouldaccumulateintrainingandjob-searchaccountsthatcouldhelpthemacquireskillsorlookforworkiftheygetlaidoff.

At the same time, since new business ventures are what will create theinnovation that is necessary for growth, the United States has to preserve itsentrepreneurial environment. Although the political right is probably alarmistaboutthedownsidesofsomewhathigherincometaxes,significantlyhighertaxes

canreducethereturnsforentrepreneurshipandskillacquisitionconsiderably–fortherichandthepooralike.Farbettertoreformthetaxsystem,eliminatingtheloopholesandtaxsubsidiesthataccountantsaresofondoffindinginordertokeepmarginalincometaxratesfromrisingtoomuch.

Culture also matters. Although it is important to shine the spotlight onegregious unearned salaries, clubbing all high earners into an undifferentiatedmass–asthe‘1percent’ labeldoes–coulddenigratethewealthcreationthathas served thecountry sowell.Thedebateon inequality should focusonhowtheUnitedStatescanlevelupratherthanonhowitshouldleveldown.

Finally, even though the country should never forget that financial excesstipped the world over into crisis, politicians must not lobotomize bankingthroughregulationtomakeitboringagain.Financeneedstobevibranttomakepossibletheentrepreneurshipandinnovationthattheworldsorelyneeds.Atthesametime, legislationsuchas theDodd-FrankAct,whichoverhauledfinancialregulation,althoughmuchderidedfortheburdensitimposes,needstobegiventhechance todo its jobofchannelling theprivatesector’senergiesawayfromexcessrisktaking.Astheexperiencewiththesenewregulationsbuilds,theycanbealteredif theyare tooonerous.Americansshouldremainalert to therealitythat regulations are shaped by incumbents to benefit themselves. They shouldalsoremembertherolepoliticalmandatesandFederalReservepoliciesplayedinthecrisisandwatchoutforarepeat.

The industrialcountrieshaveachoice.Theycanactas ifall iswellexceptthat their consumers are in a funk and so what JohnMaynard Keynes called‘animalspirits’mustberevivedthroughstimulusmeasures.Ortheycantreatthecrisisasawake-upcallandmovetofixallthathasbeenpaperedoverinthelastfewdecades and thus put themselves in a better position to take advantage ofcoming opportunities. For better or worse, the narrative that persuades thesecountries’governmentsandpublicswilldeterminetheirfutures–andthatoftheglobaleconomy.

SectionIII

OCCASIONALPIECES

T

I

Thispiece,writtenwithLuigiZingales(alsoaUniversityofChicagoprofessorandmyco-authorforSavingCapitalism from theCapitalists), was published in the early days of the Iraq occupation in2003.ItisquitescepticalabouttheprospectsofbuildingdemocracyinIraq.

CapitalismDoesNotRhymewithColonialism

he end of the ColdWarmarked the triumph of market democracies oversocialismandtheascendanceoftheUnitedStatestothepositionofthesole

worldsuperpower.Whilethisoccurredmorethanadecadeago,onlynowwithOperationIraqiFreedomarethegeopoliticalimplicationsbecomingclearer.Themilitary power now enjoyed by the United States is similar to that WesternEurope had during the second half of the 19th century. Back then Europeanpowers went on a hunt for colonies, partly because of economic self-interest,partly in an attempt to ‘civilize’ the rest of theworld.While history is not soboringas torepeat itself,someinU.S.policycirclesgenuinelybelievethatbydeposing rogue regimes like Iraq and planting the seeds of democracy andcapitalism in those countries, the United States can also infect neighbouringcountriesandeventuallyremaketheworldinitsownimage.Whilethesepolicymakers would reject any parallels in motives with colonialism, they existnonetheless:amixofself-interest–theworldwillbecomesaferfortheUnitedStates–andidealism–itwillalsomaketheworldmoreprosperousandliberal.Butcanthesepolicieswork?

Thereasoningisnotwithoutmerit.DictatorslikeSaddamHusseinholdsuchagriponpowerthatinternalchangeisallbutimpossible.Insuchsituations,anoutside power that truly has the interests of the people at heart can effect achange that the people themselves cannot manage easily. Without foreignintervention, the Franco dictatorship in Spain lasted forty years. By contrast,militarydefeatbroughtMussolini’sandHitler’sregimestoaquickerend.IftheUnitedStatescanoverthrowabloodydictatorlikeSaddamHusseininthespace

of weeks and free his people, why not do it? This logic would favour anintervention in every dictatorial country, from Cuba to North Korea, fromVenezuelatoZaire,constrainedonlybycrassbudgetaryconstraints.

Overthrowing a dictator, however, is only the first and easiest step towardbuilding a democracy. If the United States simply left Iraq at this point afterholdingelections,orwithapuppetgovernmentinplace,therewouldbelittletosafeguardtheIraqipeoplefromtheemergenceofanewtyrant.Countriesdonotfallpreytodictatorialregimessimplybecauseofbadluck.Suchcountriesoftenhavepowerstructuresinplacethatfacilitatedictatorships:typically,dictatorsarethe face of a narrow elite, which has captured both political and economicpower.Change ispossibleonly if thepowerstructure ischangedandbecomesmorebroad-based.Withoutthat,anypoliticalrevolutionwillonlyreplacetheoldtyrantswithnewones.

Japanisoftenmentionedasasuccessfulexampleofdemocracyimposedbyoutside forces. The origins of that success, however, have to be found in thesweeping reforms imposed by Douglas MacArthur. Before his reforms, landholdings in Japanwere concentrated and economic powerwas held by a fewlarge industrial and financial combines called the Zaibatsus. MacArthur sawthese agrarian and industrial elites gave backbone to the Japanese Nationalistgovernment, which had taken Japan to war. For this reason, he tried toundermine their power. The post-war land reforms did expand andwiden theland-owningclass, in theprocess fosteringanagricultural revival, andmakingJapanesedemocracymore stable.But even thoughMacArthur started tobreakuptheZaibatsus,hedidnothavethenecessarytimetocarryitout.TheneedforreliablesuppliersduringtheKoreanWarforcedthegovernmenttocompromisewith the Zaibatsus. This failure explains in part why the Japanese domesticmarketisstillsouncompetitiveeventhoughJapanesedemocracyisvibrant.

Nevertheless,MacArthuraccomplisheda lot. Inpart,hewashelpedby thecomplete collapse of Japan and the utter exhaustion of its people. There wasvirtuallynoarmedresistancetotheoccupyingauthority.TheJapaneseheldtheirdomesticelitesresponsibleforinitiatingandprolongingthedisastrouswar,andattemptstocutthemdowntosizewerenotresisted,andevenwelcomedbythe

citizenry.Theproblemwitha situation like Iraq’s is that theoccupying forces facea

people who are neither completely subdued nor completely convinced of thelegitimacyoftheoccupation.Withoutpopularlegitimacyanymajorreformmaynotstick.Worse,theexigenciesofanunpopularoccupationcanperpetuate(andevenstrengthen)thepowerofexistingelites.

Ifitdoesnotobtainthecitizenry’ssupport,theoccupyingauthoritywillhaveto seekallies to control the territory– else the costsof armedoccupationwillbecome prohibitive. These allies are typically found among powerful localbosses, who are often the very same ones who made possible the previousregime.Inreturn,thesebosseswillseekeconomicfavourssuchasgovernmentcontractsandlocalmonopolies.Inotherwords,iftheoccupyingauthoritydoesnot havewidespread popular support – and few foreign rulers, nomatter hownoble their intentions,will have such support – its natural tendencywill be toallow mutually dependent concentrations of power to build up. If this seemsmuchliketheconcentrationsofpowerthatsurroundedthepreviousdictatorship,it is because of natural parallels: the dictator was also an unpopular occupierwho ruled largely by distributing privileges to a supportive few. Under theseconditionsofconcentratedpower, it ishardforeitherdemocracyormarketstotakeroot.

All this is not idle theorizing. Studies show that colonies like the UnitedStates,Canada,andAustralia,whereEuropeans(typicallytheBritish)settledinlarge numbers, often displacing or driving out native populations, developedmany of the institutions necessary for a market democracy. Government wasrelativelybenign,andevendemocratic, in largepartbecauseitdidnothavetokeepanativepopulationundercontrol.Bycontrast,incolonieslikeIndiawherethere was too large a population to be displaced, or where disease preventedlarge-scaleEuropeanmigration,asmallbodyofEuropeanshadtokeepalargenative population under check. Typically, this was done by co-opting thedomesticelites,suchasthenativerajasandbiglandlords,andsupportingtheirpower so long as they repaid the compliment. Under these circumstances,democraticandmarketinstitutionsdidnotemerge.Studiesshowthatregionsin

Indiawherethesearrangementswereparticularlypredominanthave,eventoday,underdevelopedsocialandmarketinfrastructure.

Insum,theendoftheColdWargivestheUnitedStatesboththepowerandthe interest to spreaddemocracy and capitalismby force.But history suggeststhatdemocracyand freemarketsarehard to impose,nomatterhowbeneficialtheyare.Rarelydidanoccupyingoutsidepower,unconnectedby thebondsofethnicity,culture,andnationaloriginwith the ruledcitizenry, leavebehind theconditions that would foster both democracy and markets. Even in the 21stcentury,capitalismdoesnotrhymewithcolonialism!

K

II

This is another of the quarterly columns for StraightTalk, written while I was at the InternationalMonetary Fund in 2004. It reflectsmy general uneasewith ‘magic bullet’ or quick-fix solutions tocomplexproblems.Ifindthat‘magicbullets’oftenhaveoverlookedcollateraleffects.Theroleofthepragmaticeconomististopointthemout.

CleverSolution:ButWillItWork?

notty problems abound in economics: For example, how can the poorobtain access to credit? How can international economic and financial

policieshelptocutshortthedurationofkleptocratic,despoticregimes?Howcanweeliminatebankruns?Andcleversolutionskeepbubblingup.Givethepoorformaltitletotheirlandbecausethatwillgivethemcollateralagainstwhichtoborrow.Declare thedebt issuedbyterribleregimes‘odious’andunenforceableso that investorswillbeunwilling tofinancesuchregimes in thefuture.Forcebanks to hold only liquid, marketable instruments so that they can meet thedemandsofdepositors.Thesolutionsseemingenious,low-costresponsestotheproblemsposed.Yettheyarerarelyimplemented.

Often, this is not because there is a conspiracy to ignore the solutions, butbecauseboththeunderlyingcausesoftheproblemandtheramificationsoftheproposed solution are broader than have been allowed for. Not only can theclever proposal not solve the problem, but it also has the unintendedconsequenceofdetractingfromlessattractive,painfulreformthatisultimatelynecessary to solve it.This isnotnecessarily to say thatone shouldn’tproposeclever ideasor try to implement them,butoneshouldbeaware that tohaveahighprobability ofworking, solutions have to be robust, that is, allow for thepossibility that the underlying problem is not the obvious one. Many cleversolutionsarenotrobust.Considerthefollowingexample.

DOLLARIZATIONANDORIGINALSIN

Thedollarizationofliabilitieshasbecomewidespreadinrecentyears.Moreand

morecountries,banks,andfirmsinemergingmarketsissuedebtdenominatedinaforeigncurrency(typicallythedollar),eventhoughtheydon’thavelargedollarrevenues. When a country’s currency depreciates, the resulting currencymismatchbetweenrevenuesandobligationscanleadtoseriousconsequences–sovereign defaults, banking system meltdowns, and widespread corporatebankruptcy.

Given these risks, why do countries persist in borrowing in foreigncurrencies?Onereason–referredtoasthe‘originalsin’hypothesis–isthatnotonlydocountriesnothaveanychoicenowbutalsotheycan’tdoanythingaboutitinthefuture.Manyyearsago,thecountrycommittedahorrible‘originalsin’and ever since, investors have feared that country, refusing to accept paperdenominatedin itscurrency.Inotherwords,nomatterhowgoodthecountry’sfiscal and monetary situation becomes, it has little hope of escaping therejection, albeit irrational, of the market (I should note that there are morerationalexplanationsfor‘originalsin’now–itisamovingtarget).

But recent studies show the empirical basis for this argument is shaky. ItslogicisalsoparticularlyproblematicwhenweseeinvestorsreturningtolendtoLatinAmericaneconomies thathaddefaultedon themjusta fewyearsbefore.Suchhistoricalexperiencesuggeststhatinvestorshaveshortmemories,certainlynotonesextendingovercenturiesorevendecades.Nevertheless,theoriginalsinargument ispoliticallyattractivebecause itabsolvescountriesof responsibilityfortheircurrentcondition.

Arelatedbutmoreplausibleexplanationforthesteadyincreaseindollarizeddebtisthatcountriesareforcedintothispositionbecausetheirmonetarypolicieslackcredibility.Ifacountryissueddebtindomesticcurrency,theargumentgoes,itwouldhaveanincentivetoinflateitswayoutofdebtandwouldbeviewedaslikelytosuccumbtothattemptationeventhoughitspolicieshaverecentlybeenonthestraightandnarrow.Butwithdollarizeddebt,thecountrywouldn’thavethisincentive,andsoinvestorswouldbemorewillingtolendtoit.

Whatisthecleversolution?SomesuggestthattheWorldBankorIMFissuebonds in the country’s domestic currency and then lend the proceeds to thecountry with repayment also denominated in the domestic currency. These

international financial institutions (IFI) are presumably more sensible thanmarketinvestorsandaren’tfazedbyoriginalsinormisleadingreputations.Theycan also serve as guarantors that the country will not inflate its way out oftrouble,givinginvestorsreasonstoholddomesticcurrencydebt that theyhaveissued(alternatively,theIFIscanissuedebtindexedtoinflation).Suchproposalshavebeenfloated inanumberof formswithvaryingdegreesofsophisticationand varying objectives. Some of the most reasonable are those by BarryEichengreenandRicardoHausmann(‘Howtoeliminateoriginal financialsin’,FinancialTimes,22November2002)andbyEduardoLevyYeyati (‘Financialde-dollarizationandtheroleofIFIs:De-dollarizingmultilateralcredit’,mimeo,UniversidadTorcuatoDiTella).

Would the clever solution work? The key question is whether thephenomenonofdollarizationisdrivenpurelybybadreputationsfromthepast.History suggests that countries have graduated from issuing foreign currencydebttoissuingdebtdenominatedindomesticcurrency,andtheyhavetypicallydonesobyfixingfundamentalproblemslikeexcessivedeficitsoratendencytoinflate,ratherthanbyobtainingabsolutionforsinsfromahigherpower.

DOLLARIZATIONANDFEARPREMIUMS

To see whether this solution is robust, consider another explanation fordollarizationofliabilities.Typically,acountry’sdebtisn’tsoldonlytoforeignersbut also to locals. This is natural, especially given that locals aremore likelythan foreigners to believe they can enforce repayment.Themarginal domesticinvestor will care about the pattern of returns the debt offers. Finance theoryindicates thatheorshewillbeprepared topaymore for (accept lower returnsfrom) a security that is expected to retain its value or go up in bad economictimes relative to a security that is expected to plummet in value. The formersecurityprovidesmoreinsurance.

What do citizens in these investing countrieswant insurance against?Onemajor problem in an emerging market is that it’s prone to adverse economicshocks that cause foreign lenders to stop lending, forcing a real currencydepreciationaswellashighinflationinthecountry.Economicactivitytendsto

collapse, causing immense hardship for the people. Considerwhat happens tothe securities at this time. As long as the country doesn’t default, dollar-denominateddebtgoesupinvaluebecauseoftherealdepreciation,whiledebtdenominated in local currency falls because of inflation and depreciation.Domesticinvestorswhowantedprotectionagainstsuchcrisescausedbysuddenstops would prefer dollar-denominated debt because it provides valuableinsurance,andthusbewillingtoacceptalowerrateofinterestonit.(Ofcourse,such debt is valuable only under the reasonable belief that the governmentwouldn’t default on its debt or that, even if it defaulted, it would repay inproportiontoitsoutstandingobligations.)

This doesn’t immediately imply that domestic issuers would rush to issuesuchdebt,fortheywouldhavetopaymoreinbadtimes.Buteventhoughinaperfectworldissuerswouldbeindifferentbetweendollaranddomesticcurrencydebt,intherealworld,ministers,bankers,andindustrialmanagersmightnotbe.Givenanexpectedrevenuestreamwithwhichtorepay,thelower-interestdollardebtwillallowtheministermoreborrowingupfront. If thecountryfinds itselfgreatly constrained in its borrowing, dollar debtmight be attractive even if aminister isn’tmyopic.Ifoneaddstheveryrealpossibility thathedoesn’t lookbeyondhisshort termofoffice,aministermightbeextrawillingtoaccept theuncertainlonger-runriskforthecertainshort-runbudgetaryflexibility.Similarlyforbankersandchiefexecutiveofficersofindustrialfirms.

In these circumstances,will the clever solutionwork?Absolutely not. TheIMFandtheWorldBankwouldhavetopaythesameriskpremiumwhentheyissue domestic currency-denominated debt as does the country. If the countryborrowed in local currency through these institutions, it would simply add acostly layerof intermediation to itsborrowingcosts.That said, if internationalfinancial institutionswerewilling to step in to such an extent that the countrydidn’tneedtoborrowfromitsowncitizens–anextremelyunlikelyscenario–then the holders of the country’s debtwould all be foreigners and the countrywouldn’tneedtopayapremium.

One should also be careful about condemning dollarization out of hand:banningitmightseemanothercleversolution.Althoughacurrencymismatchis

asevereprobleminthemidstofacrisis,onecannotjudgethemeritofactionsthat led to it simply by looking at outcomes. Theremay be costs of banningdollarization–suchasalowerabilityforacountryorfirmtoborroworlowerhedgingpossibilities.Thesehavetobetradedoffagainstthepotentiallydistortedincentivesforissuerstoraiseexcessiveamountsofdollardebt.

Withoutaclearsenseofthecostsandbenefits,aprudentpolicymightbetowork on fixing the deep underlying causeswhile takingmeasures to limit theobvious risks.Thebig fixeswould includeboosting theprivate saving rate sothatacountrybecomeslessdependentonoutsidecapital,strengtheningrevenuecollectionandcuttingexpendituresingoodtimessoacountryaccumulatessparecapacityforbadtimesandreducestheneedtoinflate,andincreasingacountry’sabilitytoexportitswayoutofsuddencapitalinflowstoppages.Suchapolicyof‘livingwithdollarization’maybeneitherclevernorquickbut,inthelongrun,itismorelikelytowork.Ofcourse,suchapolicyisnotrobustif‘originalsin’isthetrueproblem.Fortunately,historysuggestsitworks.

I

III

Inthefollowingpiecein2004inStraightTalk,Iworriedaboutthestartingpointforeconomicmodels,andwhyitwasunrealistic.Modelsare,bytheirverynature,abstractionsfromreality,butwealwayshavetoaskwhetherintheprocessofabstractionwearethrowingimportantfeaturesoftherealworldaway.

AssumeAnarchy?

nstitutionsarealltherage.Theabsenceofinstitutions–suchasefficientandimpartial judiciaries, legal systems to protect intellectual property, tax

administrations that are efficient and free of corruption, and credible centralbanks – is offered as an explanation for some of the central puzzles indevelopment economics, including why so many countries do not grow fastenoughtovanquishpoverty.Butunfortunately,economictheoryoffersuslittleguidance on how strong institutions are created and nurtured.And, unlesswedevelop a better understanding, simply reciting themantra ‘institutions’ offerslittle in the way of constructive policy advice to less developed countries,leaving the policy arena open to other, more dubious, views. A tremendousamount of research is now being conducted on the provenance of institutions(includingwhethertheyareaproxyfordeeperforces)butmyfocushereisonwhymainstreameconomistshaveneglectedthisinthepast.Inparticular,Iwantto ask how much blame for this neglect should be attached to the canonicalmodelineconomics,thecompletemarketsmodel.

Inthistheoreticalmodel,whicheverygraduateeconomicsstudentencountersin some form or other, everyone is fully informed; every eventuality isanticipated in contracts; all contracts are enforcedbyomniscient, incorruptiblecourts; and governments automatically take care of all the public goods andinterfere in none of the private ones. Clearly this is an abstraction even inrelationtothedevelopedworld.Yetitisregardedasausefulstartingpointforanumber of reasons. First, it is argued, the model is in important respects areasonable approximation of reality. Second, it usefully serves as a common

pointofdeparture,deviationsfromwhich–andthefewerthebetter–havetobejustified. This disciplines research, preventing original but muddled thinkersfromgeneratingresultssimplybymakingunorthodoxassumptions.Thisenableseconomists to talk to each other rather than past each other, and to see theimplicationsoftheirfavouritedeviationbycomparingtheconclusionsfromthemodel incorporating it with the outcomes from the complete markets model.Thismethodicalone-stepdeviationapproachenhancesdebateandunderstanding(and makes refereeing for scholarly publications easier). Third, the model ismathematicallytractableandallowseleganttheoremsandproofs.

Thepointofbuildingmodelsistolearnabouttherealworldbyabstractingfromdetailsthatareirrelevanttotheissuebeingconsidered.Withoutmodels,wewould just have descriptions. But while some abstraction is important, grossabstractioncanmakeamodelirrelevant.Andformanysituations,atleastinthedevelopingworld,thecompletemarketsmodelistoofardistancedfromrealityto be useful. Take, for example, armed conflict, which plagues many poorcountries. It is usually viewed as wasting resources and therefore beingeconomicallyinefficient.Thereisnoroomforconflictinthecompletemarketsparadigm: with complete markets, we would simply anticipate all possiblesituationsofconflictandcontractthemaway.Butintruth,animportantreasonfor continued conflicts in some countries is that there is simply no crediblemechanismtoenforcecontracts.Warlordsmaysignpeacetreaties,butknowingtheywillnotbeenforced,exploittheensuingpeacetoprepareforthenextwar.

How to build commitment against predation and enforce contracts at thenationallevelarefirst-ordereconomicissues.Earlyeconomists,likeHobbesandLocke, reflected on them, but with a few notable exceptions, economistsneglectedthemformanydecades,inpart,perhaps,becausemanyweretrainedindevelopedcountrieswherethecompletemarketsmodelissomewhatlessabsurd.Onlyrecentlyhaveeconomistsreturnedtothesequestions.

Although the completemarketsmodel can be a useful abstraction in somecircumstances, it is an intellectual straitjacket when applied universally,particularly because it ignores the costs of contracting and enforcement.Requiringcard-carryingeconomists tostaywithinafewstandarddeviationsof

the model may greatly hinder their ability to focus on what is essential inenvironmentsdifferentfromtheonethatgavebirthtothemodel.Isaythiseventhough several importantbreakthroughs ineconomics in the last threedecadeshavecomefromone-stepdeviations,suchasassumingthatnoteveryonehasthesame information (known in the jargon as ‘asymmetric information’), or thateconomic activity is carried out by organizations where employees may notsharethegoalsoftheorganization(knowninthejargonas‘agency’).

One problem with relying on models that are within a few standarddeviationsofthecompletemarketmodeltoguidepolicyinapoorcountryisthatsolutions may seem far easier than they actually are. For example, in thesecountries some contracts are inflexible or do not exist. The facile policyprescription from the model is to advocate greater flexibility or to create themissing contract. Yet there may be far deeper deficiencies that need to beaddressedinordertorectifytheproblem.

Forexample,theinflexibilityoflabourcontracts–inparticularthedifficultyof firingemployees– isseenas inefficientbecause itdoesnotpermit firms toreact quickly to business conditions. Often, these prohibitions are ascribed tooverlystrongunionsthatholdtheeconomytoransom.Butifcourtsareslowandcorrupt, so that aworkerwho iswrongfully fired has no redress, perhaps theprohibitionoffiring–becauseviolationsaresoeasilyandpubliclyobservable–is theonlyway toprotectworkers fromarbitrarydecisionsby employers. Jobtenure may also act as a form of social security, necessary because thegovernmentdoesamiserable jobprovidinga safetynet, andprivate insurancemarkets do not exist. Admittedly, these explanations are speculative, and thetruthmay lieelsewhere.Butmypoint is thatcrude, inefficientprohibitionsonfiringmaybearobustresponsetoanumberofdeficienciesinthesystem,manyofwhichreinforceeachotherinsubtleways.Ifso,unionsmaycommandstrongpopularsupportbecauseofdeficienciesinthesystemratherthanbethecauseofthem.Thisisnottosaythatinflexiblecontractsarewithoutcost,butthatalteringthemmayrequiredeep-rootedreform.

Consideranotherexample.Smallentrepreneursindevelopedcountriesoftenhavetopledgepropertyascollateralforaloan.Thepoorindevelopingcountries

often lack clear title to their assets – such as the land they occupy. So, someanalystssuggest,awaytogivethemaccesstofinanceistogivethemcleartitle.In practice, however, this suggestion is hard to implementwhen somuch elsedoesnotwork.Foronething,howis thetenuousprotectionofexistingprivatepropertyaffectedwhensquattersobtainpropertyrights?Howwillinformalwaysof establishing ownership by determining the historical antecedents of aparticular piece of property be misused when local thugs and politicians cancoercethecitizenry?Insteadofanalysingtheeffectsofintroducingcontractsinaworldwhereeverythingelseworks,abetterapproachmightbetoinvestigatetheeffectsofintroducingalegitimatecontractinaworldwherenothingworks.Ouranalysiswouldbebetterinformedbyassuminganarchyasastartingpointratherthanapristineworldofcompletecontracts!

Iamnotsuggestingthatpolicymakersdoactuallyanalyseproblemswithacompletemarketsmodelinmind.Theydo,ofcourse,makeadjustmentsfortheworld they confront. But their world view is naturally influenced by theframeworks theywere taught.Andbecause thoseframeworksassumesomuchthat is unrealistic, how confident can policy makers be in theirrecommendations?

NoramIarguingforundisciplinedeconomicthinking,foran‘anything-goes’schooloftheory.Economicshascomealongwayinthepasthalfcentury,andmuchthatwehavelearntisofgreatrelevance.RespectableeconomistssuchasOliverHart and JackHirshleifer have escaped the straitjacket of the completemarketsmodelwithoutsacrificingsensibleeconomics.Butasizeablegroupofeconomists still thinks there is only one model, and complete markets is itsname. One cannot but help suspect that elegance rather than relevance is itsappeal.

Institutionbuildingisoneareawhereinternationalfinancialinstitutionsandpolicymakershavelearnedfromexperienceandusedcommonsensetodevisepracticalapproaches,withoutmuchguidancefromacademia.Andthereishope,supported by a growing body of research work, that more students ofdevelopment are realizing that abetter startingpoint for analysis than aworldwithonlyminorblemishesmaybeaworldwherenothingisenforceable,where

property and individual rights are totally insecure, and the enforcementapparatus for every contractmust be derived from first principles – theworldthatHobbes sovividlydepicted.Notonlywill thiskindofworkmorecloselyapproximate reality in the poorest, conflict-ridden countries, but it could alsoleadtomoresensiblepolicy.

S

IV

Another Straight Talk column, which appeared in December 2004, this time pointing out thedifficultieswithacleverproposaltodeclaredebttakenonbyunpleasantregimesunpayable.

OdiousorJustMalodorous?

omething terribly wrong happens when debt is incurred by a sovereigngovernmentthatdoesnothavegoodclaimtorepresentthewillofthepeople

of thecountry,and itsproceedsarenotusedfor theirbenefit.Take thecaseofSouthAfricaunder theapartheidregime,whichborrowed, inpart, tofinanceamilitarymachinethatwasusedtorepressthemajorityAfricanpopulation.Thedebt thus incurredwas doubly odious, for not onlywere the proceeds used tosuppress theAfricanmajority andkeep the apartheid regime in power but thesuppressedalsoeventuallyendedupbeing responsible for thedebt repayment.Thepost-apartheidgovernmentacceptedthatresponsibility.Yet,thecaseseemsto have all the hallmarks of a situationwhere ‘something ought to have beendone’toremovethe‘odiousdebt.’

Butwhat should be done in such a case?One suggestion is to institute aninternational commission (say under the United Nations) that will determinewhichregimeshaveneitherpopularlegitimacy,northeinterestsoftheirpeopleatheart.Oncethecommissiondeclarestheregimeanditsdebtodious,successorregimescouldbeabsolved,throughinternationalagreement,ofhavingtorepaythe debt incurred by the odious regime. Also, creditor country laws could bealteredsoastomakeitdifficultforcreditorsfromthatcountrytoenforcedebtpaymentfromanothercountryoncethatcountry’sdebtisdeclaredtobeodious.

The possibilities of such a mechanism are dramatic. If a commission haddeclaredMobutuSeseSekoodious earlyon inhis regime, hewouldnot havebeen able to build up Zaire’s debt to $12 billion, or to use $4 billion of it inbuildinghisownpersonalassets.Hemightnotevenhavelastedlonginpowerifhe had not been able to borrow to keep his regime afloat. Certainly, the

objectives of those advocating mechanisms to declare debt ‘odious’ arecompelling(seeKremerandJayachandraninF&D,June2002,p.36).

Unfortunately, themechanismwouldnotworkaspreciselyas thisexamplesuggests–itwouldbemoreofaneutronbombthanalaser-guidedmissile.Notonlywoulditmakeitmoredifficultforodiousregimestoborrow,butitwouldalsomake borrowingmore difficult for any legitimate regime that had even aremote possibility of being succeeded by an odious regime. A fledglingdemocraticregime,strugglingtoborrowtoavoidtheconsequencesofdrought,mightfindthegoingevenharder ifcreditorswerealsoattemptingto judgethepossibility that the regimemight collapse. If the regime gave way to a nastysuccessor, the debt would be declared odious, imposing huge losses on thecreditors.Anticipatingthis,thecreditorswouldnotlend,makingregimechangemore likely.How, then,doesoneprevent theodouroffutureodiousdebt frompollutingallpriordebtandmakingborrowingmoredifficultforallcountriesthathaveevenaremotepossibilityoffutureregimechange?

A clever proposal is simply to restrict odium to future debt (Kremer andJayachandran, 2003). In other words, successor regimes could legitimatelyescaperepaymentonlyofthedebtthatisissuedafterthecommissiondeclaresaregime’sdebtodious.Thebeautyof this idea is thatmarketswouldnotbe leftguessingaboutwhethertheirdebtwouldbelegitimate.Moreover, totheextentthattheregimecouldnotborrowtofinancetheftorbuildmonumentstoitsownglory, resourceswouldbepreserved to service theolddebt, thusenhancing itsvalue.

Butwoulditwork?Thetroubleisthatimplementationoftheproposalcouldhaveother,unintended,consequences.Thoughcreditorswouldnotbeforcedtoguesswhether the loan theymade toacountrywouldbeviewedas legitimate,theymightstillbeleftguessingwhetheritwouldbevaluable.Hereiswhy:fewdeveloping countries or expanding firms can repay all the debt they havecontractedorevengeneratesubstantialincomeunlesstheyhaveaccesstofurtherfinancing.Thisisbecausecountriesandfirmsrelyongrowth–asteadystreamof new projects and continuing old projects to provide both the cash flows toservicedebt incurredtosetupthoseprojectsaswellasaresidualamount– to

serviceolderdebt.Countriesandfirmstypicallygrowtheirwayoutofdebt.Butiffuturedebtweredeclaredodious,thecountrywouldnolongerbeable

to borrow to continue old projects, let alone finance new ones (assuming, ofcourse, that the odious regime was not bent on driving the country intoimmediateeconomiccollapse–ifitweresodestructive,fewwouldbewillingtolend in the first place, and therewould be no need for a special procedure todeclareitsdebtodious).Eveniftheodiousregimehadtheintentionofservicingitsdebt,thedeclarationthattheregime’sfuturedebtwasodiouswouldmakeitverydifficult for it todoso.Whencoupledwith thefact that the incentives torepaydebtcome,inpart,fromtheattractionofcontinuingtobeabletoborrow,itmightwellbethattheregimedefaultsonexistingdebtassoonasitisdeclaredodious, with adverse consequences for its valuation. The proposal to declareonlyfuturedebtodiousmightmitigatesomeoftheconcernsassociatedwiththeoriginalodiousdebtmechanisms,butitwouldnoteliminatethembyanymeans.

Anothervariantistosingleoutpastdebtthatwasusedfornefariouspurposessuchasrepressionortheftanddeclareonlythatodiousanduncollectible(seeforexample, ‘Iraq’s Odious Debts’ by Patricia Adams, Policy Analysis, 28September 2004, Cato Institute). Such a mechanism would make lendersresponsiblefortheenduseoftheirfunds.Butthissuggestionisalsonotwithoutproblems.Forone,itishardtoknowwhethersteelthatisbeingimportedwillbeused tomake cradles or cannons. Even guns and bulletsmay have legitimateusesifthepoliceusethemtocombatcrime.Iflenderswereheldresponsibleforend use, they would shy away from financing a large number of legitimateactivities.Moreover,thisproposalassumesthatmoneyisnotfungible.Whatistopreventthegovernmentfromfundingroadsandportswithforeignloanswhileusingtaxpayerfundstobuytanksandsubmarines?

If there are potential costs to such proposals, then a re-examination of thebenefits becomes important.Would dictators really be stopped in their tracks?Would the trulycorruptnot simplysell thecountry’sexistingassetsatbargainbasement prices for cash? Would we not see an increase in trafficking inantiques, endangeredanimals,wood,anddrugs? Is itpossible that thecountrycouldbeworseoffifthedictatorstolethroughunusualchannelsthanifhestole

bybuildingupdebt?The point is that while the odious debt proposal is well motivated, it is

unlikelytoprovideapanacea.Wehavetorecognizetherewillbetrade-offs–theupfrontcoststoanyfragiledemocracyfromtheodourofpossiblefutureodium,weighed against the possible benefits of curbing corrupt dictators financed byovereagerbankers.Iftherearemanyodiousregimestodaybutlittlechancethatcurrently democratic regimes will switch to being odious, the benefits of theproposal outweigh the costs. If there are fewodious regimes today, andmanypossibleswitches,thereverseistrue.

Insumthen,onedoesnotneedconspiracytheoriestoexplainwhytheodiousdebtproposalhasnotgoneanywhere,orwhynewlylegitimategovernmentslikethatofpost-apartheidSouthAfricahaveacceptedtheresponsibilityofservicingthepotentiallyodiousdebtstheyinherited.Theconcernthatdebtmarketsmightbedisrupted iswell-founded.But there are alsopotential benefits that deservefurther investigation. If researchers had their way, we would pick one pettydictator through a random draw, declare his debt odious, and watch whathappened. This suggestion is unlikely to find many takers – the notion ofexperimenting with countries seems repugnant to most. So in the absence ofresearch thatwill use existing data cleverly to informus, or fortuitous naturalexperiments,itisnotsurprisingnorevenunfairthattheodiousdebtproposalislikelytostayincoldstorage.

Manyofthefactsinthisarticlearedrawnfrom‘OdiousDebt,’aworkingpaperbyMichaelKremerandSeemaJayachandran,publishedbytheNationalBureauofEconomicResearchintheU.S.inMay2002.

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Oneofmyresearchforaysat theIMFwasintothecostsandbenefitsofforeignaid.ThiswasworkdonewithArvindSubramanian,theIndiangovernment’scurrentChiefEconomicAdvisor.Thisworkwascontroversialbecauseitwentagainst thereceivedwisdomindevelopmental institutions thataidwastremendouslybeneficial.This2005piecereportsonthatjointresearch.

AidandGrowth:ThePolicyChallenge

ow that developed countries and international financial institutions havecommitted themselves to writing off the debt of highly indebted poor

countries,thechallengewillbetoconverttheseresourcesintoactualgrowthandfaster progress toward theMillenniumDevelopmentGoals.While for some itmay seem that the war against poverty can be won simply by getting richcountries to providemore debt relief and aid, the viewof experts – includingthose behind recent reports by the UK Commission for Africa and theMillenniumProject – is that this is just one of the necessary ingredients. It isearlydaysyet in thecampaign tomakepovertyhistory. If it is to succeed,wehave to recognize the failuresof thepastaswellasbeopen-mindedabout thesolutionsforthefuture.Andthefirstthingtorecognizeisthecheckeredhistoryofaid.

AIDANDGROWTH

The best way to get the poor in low-income countries out of poverty is tostrengtheneconomicgrowth in thosecountries.Tothe layperson, thismayjustmean sending these countries more aid. Yet one point about which there isgeneralagreementamongsteconomistsisthatthereislittleevidenceofarobustunconditionaleffectofaidongrowth.

Beforegoingfurther,letmesaythattheword‘effect’impliescausality.Thisis different from correlation. It is possible to find in the data a negativecorrelationbetweenaidandeconomicgrowth,but thisdoesn’tmeanthatmoreaidcauseslessgrowth.Forinstance,ifaidtendstogotocountriesthataredoing

badly,youwouldgetaidandgrowthbeingnegativelycorrelatedeventhoughaiddoesnotcausepoorgrowth:thedirectionofcausationisthereverse.Thisiswhyeconomistsuseatechniquecalledinstrumentalvariablesanalysistotellcausalityfrom simple correlation. In recent papers that I have written with ArvindSubramanianof the IMF’sResearchDepartment,wedescribehowwefoundanegativecorrelationbetweenaidandgrowthwhenwedidnotuseinstrumentalvariables, but how this essentially disappeared once we used the technique(RajanandSubramanian2005aandb).Thismeansthataidscepticsmayhavebeenmistaken inviewingnegativecorrelationsfound in thepastassupportingtheir view. But unfortunately, we don’t find a robust, significant positivecorrelationeither.

Does this mean that aid cannot, in any circumstances, boost growth? Ofcourse not! The layperson’s thinking does, of course, have some significantbasis. Poor countries are short of resources and ought to be able to put aidinflowstogooduse.Therearecasestudiesofcountries thathavegrownusingaid, and specific aid projects that have helped the poor enormously.Whatweeconomists have not identified is a reliable set of economic circumstances inwhichwecansaythataidhashelpedcountriesgrow.Andthisisnotforwantoftrying.

Forexample,aninfluentialstudysuggestedthataidleadstogrowth,butonlyin countries that have good governance (Burnside and Dollar 2000). Thiscertainlyseemedaveryreasonableconclusion–anecessaryconditionforaidtohelpgrowthisobviouslythataidreceiptsshouldnotbespiritedawaytoSwissbank accounts. Unfortunately, however, it doesn’t seem to be a sufficientconditionforaidtohelpgrowth,asfollow-upstudiessuggestthefindingisnotrobust(Easterly,Levine,andRoodman2004).Itwouldappearthatotherleversareneededinadditiontoreasonablegovernanceforaidtobeeffective.

Arecentstudy(Clemens,RadeletandBhavnani2004)takesanothercrackatparsing the data, working from the assumption that not all aid is alike in itsimpactongrowth.Again,therationaleisplausible.Why,forinstance,shouldweexpect humanitarian aid to result in growth, or why should we expect aiddevotedtoeducation(childrenarealong-termprojectifevertherewasone)to

producegrowthintheshortrun?Thestudyindeedshowsthataidlikelytohavea short-termeconomic impact (for instance, aidused tobuild roadsor supportagriculturedirectly)ispositivelycorrelatedwithshort-termgrowth.Hereagain,however,I’mnotfullypersuaded.Theauthorsofthisstudyarguethatthereasontofocusonshort-impactaidisbecausetheliteraturefocusesoncountrygrowthratesoverfour-yearperiods.SoIpresumeit followsthat ifonewere todepartfromtheliteratureandlookatlong-rungrowth(saygrowthoverdecades,whichis what we really care about), economic aid (as contrasted with, say,humanitarianaid)cumulatedduring theperiodshouldhaveadiscernibleeffecton growth (and therewould be no need to separate out short-impact aid fromlong-impactaid).MyworkwithSubramaniansuggests thateconomicaiddoesnothavearobustpositivecorrelationwithlong-rungrowth.

Despitemyownconvictionsaboutwhatthepasttellsus,Iwillacknowledgethat the debate about aid effectiveness is one where little is settled.Unfortunately,furthercross-countryresearchalongexistinglinesmaynotyieldcredibleanswers.Wecancontinue trying to findsomevariable thatwillselectout those countries that have received aid and also grown (or attempt to findsome form of aid that is positively correlated with growth). But what do weconcludeoncewedothat?Putanotherway,whenthesamedataareporedovermany times, there is a dangerwewill findpatterns that are thereby accident.This iswhymanyeconomistshavebecomesceptical thatcross-countrystudiescantellusmuchmore.

Of course, the layperson would despair of econometrics long before theeconomist. It should, however, be of concern to the layperson that the bestexamplewehaveofaidworkingsystematically foragroupofcountries is theMarshallPlan,wherebytheravagedcountriesofpost-warWesternEuropewerereturned to the ranks of the rich. The reason it worked sowellmight be thatthese countries’ institutions, including the education of their people, wereprobablycapableofsustainingmuchhigherpercapitaGDPthantheirpost-warlow. Perhaps this is why one might see a country emerging from conflictexperienceasubstantialperiodofcatch-upgrowth,whereaidisveryeffective–MozambiqueorUgandamightbemorerecentexamples.Nevertheless,itshould

besoberingthatthecanonicalrecentexampleofacountryclawingitselfoutofpoverty into the ranks of the rich is South Korea. South Korea was indeedravaged by war, but its spectacular growth started approximately when aidinflowstaperedoff.

DODGING‘DUTCHDISEASE’

According to some, there is a betterway– to focusonwhatweknowworks.Specifically, funding should support micro-interventions or programmes,validated throughevaluations and experimentation, thatmight beveryhelpful,say,infurtheringeducationandhealthcare,whichundoubtedlyleadtogrowth.Here, we have learned a lot fromwork byAbhijit Banerjee ofMIT,MichaelKremer at Harvard, and their students, as well as from the World Bank,includingitsWorldDevelopmentReport2004.

Weknowthatprovidingservicestothepoorisn’tjustaboutmoney.Onecanbuild spanking new schools and pay teachers a goodwage, yet theymay notcomein to teach.Onecanprovidefreedrugs to thehospitals, intendedfor thepoor,butthedruggistmaysimplysellthemontheblackmarket.Thisisnottosay thatschoolsandhospitalsaren’tnecessary,butbricksandmortarareoftenthe easy part. Policy makers also need to create the right incentives for theserviceproviderandthepoorclient,aswellastherightallocationofpowerandinformation between them to ensure that reasonable quality services areprovided.Andwe know that the law of unintended consequences is always atwork.Thismeansthatfewprogrammeseveroperateasthedesignersintended,soweneedabundantexperimentation,frequentmonitoringandevaluation,andasharing of best practices so that these targeted interventions can have theirintendedeffect.

Unfortunately,Iamnotsurethatevenifeachmicro-interventionworkswellbyitself, theywillallworkwell together.Interventionscouldaffecteachotherand come in each other’sway or vie for the same resources. They could alsohaveadversespillovereffectsontherestoftheeconomy.

The last is not just a possibility. Suppose a lot of aid flows in to supportinterventions ineducation,healthcare, andother social services.The recipient

country quickly hires many educated workers as teachers, clerks, nurses,foremen (to build the schools), engineers, and government and aidadministrators. Because well-educated people will be in high demand, theirwageswilltendtoriseandmaywellgouprapidly.Inturn,factorieswillhavetoescalate the wages they pay to managers, engineers, and supervisors. Nowfactories that produce for the domesticmarket and don’t face competition canpasstheirhighercostson.Butfactoriesthatexportcannot,sotheywillcutdownon operations and even start shutting down. This is one example of aphenomenoncalledDutchDisease,whichmakesaidrecipientslesscompetitive.Subramanian and I show that in countries that receivedmore aid in the1980sand1990s, the export-oriented, labour-intensive industriesnotonlygrewmoreslowly than other industries – suggesting that aid did in fact create DutchDisease–butthemanufacturingsectorasawholealsogrewmoreslowly.Againit’s sobering to think that by constraining the growth of manufacturing, aidinflows may have prevented poor countries from taking the path to growthfollowedfirstbytheEastAsiantigersandnowbyChina.

That said, Dutch Disease is not a terminal condition. It can be mitigatedthroughsensiblepolicies.Buttodoso,onemustfirstacknowledgeitsexistenceanditsperniciouseffects.Similarlyforotherpossiblediseasescausedbyaid.

THEREISHOPE

Toignorethepast,ortoreadonlyrosylessonsfromit,istocondemnoneselftoreliveit.Whileitwouldbechurlishtodenythatmanypoorcountrieshavemadetremendousprogress increating theconditions for sustainedgrowth, itdoesn’tservethecitizensofpoorcountrieseitherifwesaythatalltheproblemsofthepast are well and truly in the past. While no one has the ‘magic bullet’ forgrowth, there are some things that do seem important. These include sensiblemacroeconomic management, with fiscal discipline, moderate inflation, and areasonably competitive exchange rate; laws and policies that create anenvironmentconducivetoprivatesectoractivitywithlowtransactioncosts;andaneconomyopenforinternationaltrade.Inaddition,investmentsinhealthandeducation,whichcreateapopulationthatnotonlylivesabetterlifebutalsosees

opportunitiesingrowthandcompetition,oughttobeencouraged.Onewayrichcountriesandinternationalfinancialinstitutionscanhelpisby

makingpoliciesthatbroadlymeettheserequirementsanessentialconditionforaid. They should, however, resist micromanaging and overlaying broadeconomicconditionalitywithtoomanydetailedeconomicprescriptions,orwithsocial and political conditionality. Once a country has the necessary broadenvironmentinplace,itshouldhavethefreedomtochartitsownpath.Afterall,the failureofpastgrand theoriesofgrowthshouldmakeuswaryofbecomingoverlyprescriptive.

Richcountriescanalsohelpbyreducingtheimpediments theyplacein thewayofpoorcountryexports,andbycoaxingthesecountriestolowertheirowntradebarriers,includingbarrierstootherpoorcountries.Theycanspendmoretofoster research on drugs and agricultural technologies that would benefit thepoorestcountries.Theycanbemoreactiveinensuringthattheircompaniesandofficials don’t grease thewheels of corruption in poor countries (seeBirdsall,Rodrik, and Subramanian 2005 for other suggestions).And they should neverhesitatetogivehumanitarianaidinthefaceofadisaster.

Letusdrawhopefromthewillingnessoftheoutsideworldtoprovidemore,andbetter,aid.Ultimately,though,poorcountriesholdtheirfutureintheirownhands. It isonly throughtheirownwillandactions that thegoodintentionsoftheoutsideworldcanbeusedtotrulymakepovertyhistory.

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AstheIMFembarkedondebtreliefin2005,thisarticletriedtolayoutthecircumstancesunderwhichthatmadesense.

DebtReliefandGrowth

nanumberofdevelopedcountries,debt relief for low-incomecountrieshasbecomeanimportantpoliticalissue.Rockstarsandpoliticiansrightlypointto

the overwhelming burden borne by poor countries who have to set aside asignificantfractionoftheirnationalincometorepaycreditors.Worsestill,theyargue, much of this debt is ‘odious,’ built up by past corrupt dictators whowhisked the money to Swiss bank accounts. Furthermore, evidence thatcountrieswithhighdebt tend tohave lowgrowthsuggests thatdebt reliefcanhelppoorcountriesgrow.

Several debt relief proposals are on the table, but there is little agreementamongdonorsonwhichonemakesthemostsense.Theproposalstypicallyhavea one-size-fits-all flavour, in part because uniform treatment would avoidpoliticking by potential recipients. But would poor countries benefit fromuniformtreatment?Thisarticletriestoclarifysomeofthebroadprinciplesthatcouldleadtoanoptimaldebtreliefproposal.

NETFLOWS,NOTDEBTRELIEF,MATTER

Considerapoorcountrythathastorepay$100milliontoofficialcreditorssuchas developed countries or international financial institutions in the currentperiod.Assumeitearns$50millioninforeignexchangeinthisperiodandhasno other resources. Clearly, it cannot repay the debt fully out of its ownresources.Nowconsider three alternativeproposals.First, the creditors donotforgivethedebt,butlend$120milliontothecountry.Second,creditorsforgivethedebtdownto$50million,butlendnothing.Third,creditorsforgivetheentiredebtandlendnothing.Whichalternativeisbestforthecountry?

Assuming thiscountryhasnoaccess toprivatecapitalmarkets, theanswer

seemsobvious:fulldebtforgiveness,whichwouldbetwiceasgoodashalfdebtforgiveness and surely better than a loan that is notmuchbigger than the fulldebtamount.Yetwhenviewedintermsofnetresourcesavailabletothecountryduring the period, under the first proposal thesewould amount to $70million(theloanof$120millionplusinflowsof$50million,lesstherepaymentof$100million),underthesecondtheywouldamounttonothing,whileunderthethirdthey would amount to $50 million. Of immediate importance to a resource-starvedpoorcountryistheamountofadditionalresourcesitgetsinthecurrentperiod(termed‘additionality’).Thebestproposalintermsofadditionalityisthefirst,whichoffersnodebtrelief.

The point is that if official creditors take with one hand (collecting debtservice)butgivemorewith theother (in theformofa loan), thepoorcountrymayhavemorefinancingintheshortrunthanwithdebtforgiveness.Anddebtforgiveness may actually be problematic if it exhausts donor aid budgets. Ofcourse,withoutforgiveness,inthelongrun,thecountrywillhavemoredebtonitsbooks,whichmaybecomeunsustainable.Inthethreeproposals,thecountrywillendtheperiodowing$120million,$50million,andnothing,respectively.However,highorunsustainabledebt isaproblemonly if ithurts thecountry’sgrowth.Letusturntothat.

Highdebtcanbedetrimentaltoacountry’sgrowth.Itcanincreasetheriskoffinancial distress or crisis,when foreign creditors rush to cash in their claims,resultinginthefailureofbanksandfirms.However,ifofficialcreditorsholdthebulkofthepoorcountry’sdebt,itisunlikelytheywillprecipitateacrisis,sothecountrywillnotexperienceameltdownnomatterwhatitslevelofdebt.

Asecond reasonwhyahigh levelofdebtmighthurt is that itcancreateadebtoverhangproblem.Forinstance,whenacountryhashighdebtoutstanding,privateinvestorsmaybereluctanttoinvestforfearthatthedebtwilleventuallyberepaidbylevyingextrataxesoncorporations.Similarly,thegovernmentmayhesitatetoinvestbecausethereturnswilllargelygotoservicedebt.Hence,highdebt can impair investment and thus growth, and reducing debt may benecessary to jump-start growth.Compelling as these argumentsmay be in thecase of emerging markets, I am not convinced they are important for poor

developing countries. Investors in poor countries face other, more significantimpedimentstoinvestment,suchasadiscouragingbusinessclimateandunevenregulation.Areductioninthelevelofgovernmentdebt,withoutanyadditionalresourcesorpolicychange,isunlikelytojump-startinvestment.

Some analysts have indeed found a negative correlation between debt andgrowthinpoorcountries,butthereareotherpossibleexplanations.Forinstance,thecausalitycouldrunfromlowgrowth tohighdebt,withcountries thathaveweakgrowth (whichmaybe due to poor policies) running larger deficits, andthusborrowingmore. If this is thedirectionofcausality, thendebt forgivenesswillnotspurmoregrowth,andIhaveyettoseecompellingevidenceagainstthispossibility.Thismeansthatforpoorcountriesborrowingprimarilyfromofficialcreditors, the extent of debt forgiveness matters only in that it increases netresources. Sometimesmore additionality – at least in the short term – can beobtainedwithnodebtrelief,especiallyifforgivenessimpairsdonoraidbudgets.And the ‘unsustainable’ outstanding debt can eventually be dealtwith throughsomemixofrepaymentandforgiveness(whendonorshavemorebudgetroom).

APOSSIBLEROLEFORDEBTRELIEF

This is not to say debt relief nevermakes sense.Debt relief could effectivelyprovide predictable additional resources directly to the budget (via therepayments that no longer have to be made) and could offer a way to forcecoordination on conditionality among donors. Equally important, debt reliefcould allow a poor country to obtain access to loans from private foreigninvestors. Private investors may be unwilling to lend to a highly indebtedcountry for fear that thecountrywillbeunable to repay,but ifofficialdebt iscompletely forgiven, theywill jump in to lend, because even theworst debtorcanbetrustedtoservicesmallamountsofdebt.Thus,officialcreditorsmaybeabletoexpandacountry’saccesstoprivateresourcesthroughdebtforgiveness.

Wouldsuchadditionalresourcesfromtheprivatesectorbebeneficial?Thatdepends on howmuch official debt is left on the books, on the nature of therecipient government, and on whether projects have a commercial or socialorientation.Clearly,ifmostoftheofficialdebtisforgiven,theprivatesectorhas

little need to be careful in its lending. Moreover, if the poor country’sgovernmentisirresponsibleitcanbuildupdebtagainbyspendingonworthlessprojects.Asa result, thecitizensof the recipientcountrywillnotbenefit fromthis reneweddebtbuild-up. Inaddition,donorcountrieswill likelysuffer from‘forgiveness fatigue’ the next time around. By contrast, moderate debtforgivenesscanleadtohigher-qualityinvestmentastheprivatesectorwillhavetoevaluatetheprofitabilityofprojectscarefully,whichinturncanhelpimprovethequalityofcommercialprojects.Ofcourse,ifprojectsproduceasocialreturnbutnocommercialone,theprivatesectorwilllikelynotprovideanyfunds,andofficialaidwillbenecessary.

DIFFERENTSITUATIONS,DIFFERENTAPPROACHES

Letusthensummarizewherelogicleadsus.Ifapoorcountryhasnoaccesstoprivatemarkets, and the investment climate is bleak, financial distress or debtoverhangareunlikelytoresultfromhighdebt.Afocusondebtforgiveness–asopposed to the net incremental resources available in the short run (that is,additionality)–ismisplaced.Debtforgivenessmakessenseifitgeneratesmoreresources from the private sector, but the country authorities must have theincentive to use resources well and the private sector to lend responsibly.Interestingly, this means that depending on the country’s situation, the statusquo, as well as any one of the three proposals I outlined, could be the bestapproachforthecountry.

If thecountry’sgovernment is thoroughlycorrupt, then thestatusquo–noforgivenessandnoadditionalaid–isbest,foritgivesthegovernmentnoofficialresourcestomisuseandlimitsitsabilitytoraiseprivatesectorfunds.Aidinthiscase should be distributed directly to nongovernmental organizations. If thecountryhasareasonablycommittedgovernment, lookat thecountry’sprimaryneed.Whensocialsectorprojectstopthelist,thenwhatmattersistheextentofofficial sectornet funding.Here, the firstalternative–debt isnot forgivenbutofficial creditors lend more – is best. But if most projects are commerciallyviable, the second alternative – some relief but leaving enough outstandingofficial debt that foreign private investors lend responsibly –may be optimal.

Finally, substantial debt forgiveness is prudent if the risk of financial distressreally is a serious problem – an unlikely eventuality. But there must be anassurancethatthecountrydoesnotborrowupagainfromprivatecreditorsandgamethesystemtoget furtherdebtrelief.Donor-imposedlimitsonborrowingmaybeneeded.

Political momentum in the developed world is building for offering someformofdebtrelief,andwhilenodevelopingcountrysituationwillfitneatlyintothese categories, debt-relief proposals can be better crafted. One-size-fits-allproposals, while politically more convenient, are unlikely to benefit recipientcountries as much as proposals that tie debt relief and additional aid to acountry’s specific situation.Of course, themore transparent the proposals andthemorequicklytheycanbeimplemented,thebetterofftherecipientswillbe.

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Countries, including India, have often tried to argue for buying stakes in commodity producers infarawaylandsasawayofensuringnationalsecurity.ThisarticleinStraightTalkinDecember2006explainswhythatismistaken.

TheGreatGameAgain?

ome commentators see the desperate search by countries to acquirecommodity-producing firms in other (typically poor, developing) countries

asarepeatoftheGreatGame–thetussleamongpowerslikeBritainandRussiaforinfluenceintheMiddleEastandCentralAsiaduringthe19thcentury.Inthisview,thosethatacquirethegreatestshareofcommodityproducersearlyonwillenjoythegreatesteconomicsecurityinthefuture,asgrowthinChina,India,andotherpopulousdevelopingcountriescreatesshortagesofcommodityresources.Economicsecurityisthenewjustificationforpurchases,suchasminoritystakesinopaquecompanies inpoorlygovernedcountries, thatwouldotherwisemakelittlebusinesssense.In thisreplayedGreatGame,will thosewhomovefastestand farthest acquire the most economic protection? Does the gain fromeconomicsecuritytrumpcommonbusinesssense?

AQUESTIONABLEBUYINGSPREE

I’ll leaveasidethequestionofwhetherwe’reinevitablyheadedforasustainedperiodofcommoditydemandoutstrippingsupply,eventhoughinthepastsuchpredictions have proved unfounded. Let me take as given that such aneventuality is possible.To simplify the argument, I’ll assume that state-ownedcompanies undertake the acquisitions and that all income and value obtainedflowdirectlytothecitizensoftheacquiringstate–aquestionableassumptionatbest.Evenunderthesestrongassumptions,shouldacountrygoonanacquisitionspreetoprotectitself?

Precisely how an incipient imbalance between demand and supply wouldplayoutmatters.Considerthemostlikelysituation,whereaworldmarketfora

commodity–let’susetheexampleofoilinwhatfollows–continuestooperate.If there’san incipient imbalanceandoil is infixedsupply in theshortrun, themarket price for oil will shoot up so that demand is brought down to equalsupply.

How does ownership of foreign oil assets help? One might think that acountrythatownsforeignoilcanusetheprofitsfromsalestokeepitsdomesticprice lowand thus insulate theeconomyfromhighoilprices.But thisdoesn’tmake economic sense. The market price of oil reflects its opportunity cost.Rather than subsidize the price in the domestic oil market (and thus givedomesticmanufacturersandconsumerstheincentivetousetoomuchoil,givenitstruecost),itwouldmakefarbettersensetoletthedomesticpricerisetotheinternational price and distribute the windfall profits from oil sales to thepopulation.

Putdifferently,supposethecountryexportedwidgetsthatitmanufacturedinanenergy-intensiveway.Itwouldbepoliticallyconvenienttoavoidlayoffsandcontinuecompetinginthewidgetmarketbysubsidizingtheoilprice,usingthefinancialleewayfromforeignoilassets.Butthiswouldeatuptheoilwindfallbysubsidizing both inefficientmanufacturing and foreignwidget buyers.Amoreeconomicaldecisionwouldbe toshrinkwidgetmanufacturing (orshift tonewtechnologies)andusethewindfalltomaketransferstocitizens,especiallythosemost affected by high prices. These citizens would thus receive additionalincomewhenthepriceofoilrose:theywouldbehedged.

Thekeypointisthatfundamentaleconomicdecisionsshouldn’tbeaffectedbytheownershipofadditionalforeignoilassets.However,becauseofpressureexertedbysmall,powerful,affected interestgroups,politicswill interveneandoil windfalls will inevitably be spent in unwise subsidies. As a result, theacquiring country will, if anything, make suboptimal economic decisionsbecauseofthefinancialwindfallavailablethroughhedging.

But let’s assume the country always makes the right economic decisions.Does hedging lead to more financial security? A hedge will always lookbeneficialifonelooksbackwardafterthepricehasrisen.Butifthepriceofoilhadfallen,citizenswouldhavesufferedalossofincomeandwealthfromhaving

bought foreign oil assets (relative to having instead invested the moneyelsewhere). Assuming the foreign oil assets were priced fairly at the time ofpurchase,thecountrybenefitsonlywhenthehedgehelpssmoothitsincomeandwealth.Thisisn’tobviouslytrueevenforacountrythatreliesheavilyonoil.

For instance, in a large country like the United States or China, whichaccountforasignificantportionofworlddemand,theworldpriceofoilislikelyto be high when the country is growing strongly and citizens have lots ofincome,whereasthepriceislikelytobelowwhenthecountryisdoingpoorly.Foreignoilassetsareabadhedgeinsuchacasefortheysubtractfromcitizens’incomewhenit’salreadylowandaddtoitwhenit’shigh.Indeed–andthismayseemheretical–thecountrymightbebetteroffsellingitsdomesticoilassetstoforeignersandinvestingtheproceedsinnon-oilassets.

Even if owning oil assets is a useful hedge (as in a small, oil-consumingcountry), it’s not clear that buying stakes in opaque companies in poorlygovernedforeigncountriesisthewaytogo.Astheoilpriceincreases,apoorlygoverned country is more tempted to expropriate foreign owners of its oilindustry through extortionary taxation or nationalization – especially if thedomesticpublicfeels,withthebenefitofhindsightandpopulistegging,thattheassets had been sold too cheaply in the past. The security of a country’sownership of oil assets in poorly governed foreign countries likely diminisheswhentheoilpricerises.

PLANNINGFORABLEAKWORLD

How then should a small country hedge oil price risk? Liquid, oil-linkedfinancialsecuritiesinwell-governedfinancialmarkets,suchasoilfuturestradedindevelopedmarkets,makethemostsense,butnotenoughisavailableveryfarout.Theredo,however,existliquid,long-dated,oil-linkedsecurities–theequityof large oil companies. So,without being facetious, perhaps the best advice Icouldoffercountriesseekingtohedgeoilpriceriskis‘BuyExxonshares!’

Ifeconomicsecurityisn’tthereason,whywouldacountrywanttobuylargeinterestsinpoorlymanagedoilcompaniesindangerouslocations?Itmightmakegood business sense – the target is poorlymanaged and can benefit from the

know-how and management the acquirer provides. But, then, this is a soundbusiness case for buying the asset untainted by specious claims of enhancingnational security. It’s important that the target’s price not fully discount thesefuture managerial improvements. For instance, targets in countries that areinternational pariahs may be attractive for acquiring countries that are stillwillingtodobusinesswiththembecausetheacquisitionpricemaybeextremelylow.Otherwise,it’shardtoseehowtheacquirerwillescapethecustomaryfateofacquisitions:theytypicallyoverpayandlosemoneyinthelongrun.

Other reasons are less good. One is that countries fear a total marketbreakdownanddescentintoanautarkic‘MadMax’worldinwhichoilisscarce,nocountryiswillingtoallowtradeinwhatithas,andthere’snoworldmarketclearing price. It’s not clear that, if such a situation were to come to pass,ownershipofoilassetsabroadwouldhelp.Mostlikely,thegovernmentswithinwhosebordersthoseassetslaywouldexpropriatetheassets.Eachcountrywouldhave only oil assets that are physicallywithin its political borders. Indeed, toprotect against such a bleak world, a country would do well to increaseexploration, theuseofalternativeenergysources,consumptionandproductionefficiency,andthestorageofreserveswithinitsownborders(regardlessofwhoowns the assets) while increasing the economy’s flexibility to respond to oilsupplydisruptions.

Eveninsuchableakworld, it’shard to imagine themarketbreakingdowntotally or for long. Indeed, one can imagine black marketers and smugglersbuyingwhere oil is cheap and transporting it to sell to countrieswhere oil iscostly.Unlessgovernmentsbuildleakproofbarriersaroundtheircountries–thecosts would likely be prohibitive – an implicit world price would be re-established.Wewouldthenbebacktothecasewe’vealreadyexamined.

Another bad motive might be that state-owned commodity companies areflushwithprofitsthatthey’dotherwisehavetoreturntothegovernment.Whatbetterwayformanagementtospendthoseprofitsthantobuildforeignempires,justifyingtheacquisitionswiththetime-honoured‘it’sinthenationalinterest’?Of course, sweetening any such rationale would be any ‘under the table’paymentstoacquiringmanagersifthetransactionisnon-transparent.

*Thebestway to secure the supplyof a commodity is to ensure that theworldmarket for that commodity is well informed and competitive and that thebusinessenvironmentistransparentandpredictable.Informationonreservesandinvestments helps market participants make sound business decisions.Competition keeps participants honest and prices informative, and allowsconsumers to reap the benefits. A predictable business environment allowsbusinesses to investfor thelongterm.Transparencynotonlyreducesthecostsassociatedwithcorruptionbutalsoprotectsbusinesses fromfutureaccusationsofhavingobtainedoverlysweetdeals.

Thebottom line is that the newmercantilism– I ownmore of others thantheyownofme–appealingasitmaybe,isnotgoingtoleadtomorenationalsecurity.Countriesarecollectivelymostsecureifthecontrolofproductiveassetsisinthehandsofthosewhocanmanagethembest.Indeed,anyonewhotakesorkeeps control of an asset that someone else canmanagemore productively iscontributing to both individual and collective insecurity. The Great Gameexacerbatedinsecurityevenaseachpowertriedtosecureitself.Let’shopethatbettersensewillprevailthistime.

NOTES

*http://www.hindustantimes.com/business-news/rajan-preferred-other-ways-over-demonetisation-to-tackle-black-money/story-vlTbd6oixy6M4DnH65dWxI.html*https://dbie.rbi.org.in/DBIE/dbie.rbi?site=home*A list of references I used for this piece can be found athttps://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=886.

INDEX

AAAratingsAadhaar,UniqueIdentityAadhaarEnabledPaymentSystemAcharya,Viraladjustednetbankcredit(ANBC)Aggarwal,Vivekagricultural:commodities,relativeprice;growth;inputcosts;labour,decline;loans;wagegrowthAgriculturalProduceMarketCommittee(APMC)Actsaidandgrowth,thepolicychallengeAmaranthAmericanInternationalGroup(AIG)AppointmentsCommitteeoftheCabinetArgentina;BondsAsianeconomiesassetmanagementAssetQualityReview(AQR)AssetReconstructionCompanies(ARCs)ATMs

baddebts,loansBanerjee,AbhijitBankBoardBureau(BBB)BankInvestmentCompany(BIC)bank(s),bankingsectorinIndia;interesting,profitableandchallenging;makingcompetitive;moralhazard;notesissue;oligopolistic;riskaversion;systemaudit

BankconConferencebankruptcycode,bankruptcysystemBernanke,BenBhatt,Elablackmoney,blackmarketBoothSchoolofBusiness,Chicago,USAborrowers,repaymentbehavior.SeerepaymentborrowingratesbranchexpansionBrazilBrexitBRICSBuffet,WarrenbureaucracyBush,GeorgeW.buyingspree

capacityutilization

capitalinsurancebondscapitalrequirementscapitalstructurecapitalismandcolonialismCarstens,AgustinCarter,JimmyCaruana,JaimeCashReserveRatio(CRR)castesystemanddivisionoflabourCentralVigilanceCommission(CVC)Chakrabarty,DrSukhamoyChaturvedi,VaibhavChidambaram,P.China;economy;exports;ChipandPINtechnologyclassconflicts,differencesColdWarcollectivebargainingCommissiononAgriculturalCostsandPrices(CACP)CommitteeoftheRBICentralBoardCommitteeonFinancialSectorReforms(MistryCommittee)comparativeadvantageCompetitionCommissionofIndiacompetition;inbankingsector;opportunitiesandchallenges;betweeninstitutionalforms;inmarket;topreventexploitation

competitive:intermediaries;monetaryeasingcompetitivenessComptrollerandAuditorGeneral(CAG)ConstitutionalCourtsConsumerPriceIndex(CPI);indexConsumerProtectionCodeconsumerprotectioncontingentcapitalcontingentconvertiblebonds(CoCos)contractingandenforcement,costofcontractualnormscorporatebondtradingcorporatedebtmarketscorporatedistresscorruptioncostdepositfinancingCowen,Tylercreditcardscreditcrisisandcycle-proofregulationcreditdefaultswapscreditderivativemarketcreditevaluationcreditgrowthCreditInformationBureauofIndiaLimit(CIBIL)creditinformationbureaus(CIBs)creditriskpremiumcreditscoring

creditworthinessCRILCdatabaseCrockett,Andrewcronycapitalism,persistenceofcrowdfundingcurrencyandcreditsystemcurrencymanipulationcurrentaccountdeficit(CAD)CurrentandSavingsAccounts(CASA)depositscustomergrievanceredressalmechanismcustomeridentificationcustomerloansCybersecurity

Dé,Shobhaadebt:contract;crisis;market,strengthening;odious;recovery;—roleofgovernment;reliefandgrowth;structure

DebtRecoveryAppellateTribunals(DRAT)DebtRecoveryTribunals(DRTs)decouplingdefault,defaultersdefaultriskpremiumdemandandsupply,balancedemocracy;inclusionandprosperitydemocraticaccountabilitydemonetizationdepositratesderegulationderivativecontractsDeshmukh,ChintamanDwarkanathdevelopmenteconomicsdisintermediationdiversificationdocumentationdollarization:andoriginalsin;andfearpremiumsdomesticcommercialbanks;branchingdomesticmarketsDurve,RaniDutchDiseaseEastAsianeconomies;crisis

e-commerceeconomicactivityeconomiccapabilities;equitabledistributioneconomicefficiencyeconomicgrowtheconomicsecurityeconomicstabilityeconomyandotherissueseducationaldivideEichengreen,BarryEinstein,AlbertElectronicBillFactoringExchanges

emergingmarketsEmployeeStockOwnershipPlans(ESOPs)entrepreneurshipequityinvestmentEuropeanCommissionexchangemarket;liquidityexchangerate:stability;volatilityexchangeriskexecutive,judiciaryandlegislatureexternalities

FannieMaefarmproductivityfemaleparticipationFeynman,RichardfinanceandopportunityinIndiaFinancialBenchmarksIndiaPvt.Ltdfinancialconditions,assetmanagement,andpoliticalrisksfinancialdistressinbankingsystem;resolving;sources,badfundamentals;sources,poormonitoringandcollection

financialengineeringfinancialinclusion;changingparadigmfor;democracy,inclusionandprosperity;fivePs;technology,institutionsandpolicies

financialinfrastructurefinancialinstitutionsfinancialliteracy;andconsumerprotection

financialmarketsfinancialreformsFinancialResolutionAuthorityfinancialrestructuringFinancialSectorDevelopmentCouncilFinancialSectorLegislativeReformsCommittee(FSLRC)financialsecuritiesfinancialstabilityfiscaldeficitfiscaldominanceFixedIncomeMoneyMarketandDerivativesAssociationofIndia(FIMMDA)fixedincomeproductsandderivativesflexibilityandforgivenessflexibilitynotforbearancefoodconsumption,percapitafoodprices;domestic;globalfoodproductionforbearanceinlabellingloansNPAsforbearanceforeigncapitalinflowsforeigncurrencydebtForeignCurrencyNon-Resident(FCNR)deposits;FCNR(B)swapForeignDirectInvestment(FDI)foreigndirectinvestmentForeignExchangeDealersAssociationofIndia(FEDAI)ForeignPortfolioInvestment(FPI)

ForwardMarketsCommissionFragileFivefraudsandwillfuldefaultsFreddieMacfreeenterpriseanddemocracyfreeenterprise;andpoliticalfreedomFukuyama’sthreepillarsofaliberaldemocraticstate

G-20Gandhi,M.K.Gandhi,R.;CommitteereportGates,BillgeographicalconcentrationrisksGermanyGhosh,Atishglobaleconomyglobalfinancialcrisis;GreatRecession,truelessonsofglobalfinancialmarketsglobalfoodpricesglobalsafetynetsglobalsavingsglutGokarn,SubirGoldMonetizationBondsGoldin,ClaudiaGopinath,ShyamalaGovernmentCapitalizationBondsgovernmentsecurities(G-Sec)/bondsmarketGreatGameGreenspan,AlanGST

Hart,OliverHausmann,RicardoHDFCBankHemchandra,MeenaHirshleifer,JackHobbes,ThomashouseholdconsumptionexpenditurehouseholdsavingsHuntington,Samuel

IDBIBankimportsubstitutionincentivesforrepaymentinclusivegrowthanddevelopmentIndianBanks’AssociationIndianInstituteofTechnology(IIT)industrialgrowthinequality;ofconsumption;ofincome;ofopportunityinflation;consumerpriceindex(CPI);costof;fightagainst;institutionalizationof;foodpriceinflation;global;management;andgrowth,correlation;politicaleconomyof;riskpremium;target;transitiontolowinflation;wholesalepriceindex(WPI)

InflationIndexedBonds(IIBs)

InformationCommunicationTechnology(ICT)informationsharinginformationtechnology;andfinancialengineeringInformation,Incentives,andTransactionCosts(IIT)infrastructure;financing;needs;projectsinnovationinstitutionbuildinginstitutional:constraints;infrastructure;investors;participation;stability;structureinstitutionalizationInterestRateFuturesinterestrates;realinterestrates,investments,andsavings;negativereal;positiverealintermediariesinternationalfinancialinstitutions(IFI)internationalmarketsInternationalMonetaryFund(IMF)internationalsafetynetsinternationalsysteminternationaltradeandfinanceinternationalizationinternetinvestmentmanagers;skewedincentivesfor,andglobalfinancialriskIreland

Jaitley,ArunJalan,Bimal;CommitteeReportJapan;negativegrowthJayachandran,SeemaJivikarurallivelihoodsprogrammeJointLendingForum(JLF)judicialprocess,judiciaryjuniordebtJunkbonds

Kakodkar,AnilKanungo,R.Kaplan,SteveKatz,LawrenceKeynes,JohnMaynardKeynesianeconomicsKhan,H.R.Killawala,AlpanaKipling,RudyardKnowYourCustomer(KYC)KoreanWarKosambi,D.D.Kremer,MichaelKurien,Verghese

labourforce,shifttoconstructionLalitDoshiMemorialLecturelandrecords,digitizationLaxman,R.K.liberalization;offixedincomeandderivativemarkets

licensingprocess;commercialbanklicencesliquidity;deficit;exchangemarket;illiquidity;—costof;international;ruralliquidityandcreditriskloanevaluation,monitoringandrepaymentloanrecoverysystemLocke,JohnLTCMLynch,Peter

MacArthur,Douglasmacroeconomic:advice;domesticinstitutions;management;policy;risk;stabilityMahalingam,G.Mahapatra,B.MahatmaGandhiNationalRuralEmploymentGuaranteeAct(MGNREGA)MakeinIndia,largelyforIndiaMalaysianCentralBankMalegam,YezdimandateandsubventionsManmohanSinghmanufacturingsectormarket:democracy;infrastructure;intelligence;participation;reforms;regulation,objectivesMarshallPlanMasalabondsmicro,smallandmediumfirms(MSMEs)microeconomicpolicymicrofinancefirmsMillenniumDevelopmentGoalsminimumsupportprice(MSP)Mishra,PrachimobilebankingModi,Narendramonetarypolicy;andbaddebt;committee;domestic;andfooddemand;andinflation;caseforinternationalcoordination

moneylendermonitoringandevaluationMor,Nachiket;Committeemortgage-backedsecurities(MBS)mortgagesMUDRAloansMukherjee,PranabmultilateralinstitutionsMundra,S.S.

Narasimham,M.NationalBankforAgriculturalandRuralDevelopment(NABARD)NationalInstituteofBankManagementNationalPaymentsCorporationofIndiaNayak,P.J.,CommitteeNDS-OMNetherlandsnetworkingNewDelhiMetroNewZealandNilekani,Nandan

NonPerformingAssets(NPAs)Non-BankFinanceCompanies(NBFCs)non-governmentalorganizations(NGOs)non-performingloansandrestructuredloans

Obama,BarackOccam’sRazoroilpricesoil-linkedfinancialsecuritiesone-timesettlements(OTS)on-lineinternetplatformOperationIraqiFreedomOrganizationofOilExportingCountries(OPEC)organizationalstructuresOstry,Jonathanover-invoicingover-performance

Padmanabhan,GPatel,I.G.Patel,Urjit;CommitteeReportPattanayak,Nirmalpayments:andremittances;andsettlementsystems;technologiesandinstitutionsPaymentBankspensionfundsperformance-basedpayperformanceevaluationsystemperformancemanagementperformancerecordofloansPikkety,Thomasplanningforableakworldpoliticalcorrectnesspoliticaleconomy;ofdevelopment;ofinflation;ofreformsandgrowthpoliticalriskspoliticaluncertaintyportfoliooptimizationpositivenetworkexternalitiesPostalPaymentBankpowersectorloansPradhanMantriJanDhanYojana(PMJDY)pricediscoveryandliquidityprices;assetpriceboom;food;housing;oil,domesticandglobalPrince,Chuckprioritysector;lendingcertificates;lendingrequirementsprivateinvestmentprivatesectorbanksprivatizationproductinnovationproduction;agricultural;costs;domestic;efficiency;offood;growth;andinvestmentproductivitygrowthprofessionalismprofitabilityproject:costoverruns;evaluation/monitoring;inputcosts;structuring

promoters;cost-overruns;andthedebtcontract;defaulters;equity;misusesthesystempropertyrightspublicdistributionsysteminTamilNadupublicinstitutionspublicinterestpublicsectorbanks(PSBs);badloans;capitalization;challenges;competition;customers’trust;depositgrowth;freeingtocompete;governance;andthegovernment;grandbargain;non-foodcreditgrowth;versusprivatesectorbanks;reluctancetolend

purchasingpower

quantitativeexternaleasing(QEE)

Rajan,Radhika(wife)Rajan,RaghuramG.:atFICCI-IBAAnnualBankingConference(2016);messagetoRBIstaff;remarksonRBI’s80thanniversary;year-endlettertoRBIstaff,31December,2015;atRBIonStatisticsDay,anexcerpt;atTataInstituteofFundamentalResearch(TFIR)

RakeshMohanRao,Rajeshwarratings,contingentsupport,andsupplyRauh,JoshuaReagan,RonaldRecoveryofDebtsDuetoBanksandFinancialInstitutions(RDDBFI)ActReddy,Y.V.regionalruralbanks(RRBs)regulationsregulator’sdilemmarepaymentofdebtReserveBankofIndia(RBI);Act;CharterofConsumerRights;communication;compensationpackage;dividendpolicy;financialsectorpolicies,fivepillars;fraudmonitoringcell;independence;rankofgovernor;outlineresponsibilities;SeniorManagementCommittee;State-levelCoordinationCommittees

restructuringprocessrighttoquestionandchallengerisk-adjustedperformanceriskmanagementriskmitigationrisktakingRobb,GregRomney,Mittruleoflawrupee:depreciation;internationalizationruralliquidityandcreditruralproductivityruralwagesRussia

SaddamHusseinSambamurthyCommitteeSavingsandLoanCrisisscandalspostSchemeforSustainableStructuringofStressedAssets(S4A)SecuritiesandExchangeBoardofIndia(SEBI)SecuritizationandReconstructionofFinancialAssetsandEnforcementofSecurityInterests(SARFAESI)Act

securitizationSeko,MobutuSeseSelf-EmployedWomen’sAssociation(SEWA)self-helpgroups(SHGs)Sen,SudarshansickcompaniesSinha,AnandSinha,ChandanSkillIndiaprogrammesmallandmediumenterprises(SMEs)Smith,OsborneSMS-basedfundtransfersocialmediaSolow,RobertSouthAfrica:apartheidregime;debtSpainspeculationspillovers,spillovereffectsstartupsStatutoryLiquidityRatio(SLR)Stein,JeremyC.StrategicDebtRestructuring(SDR)Subbarao,D.sub-contractingSubramanian,ArvindSubramanian,KrishnamurthisubsidiesSundar,Parvathysupplyconstraints

‘tail’risks;andherdingTaperTantrumTarapore,S.S.tariffbarriersTataInstituteofFundamentalResearch(TFIR)taxes;taxissuesassociatedwithsecuritizationtechnologytelecomsectortelecomserviceprovidersThatcher,MargaretThorat,UshatoleranceandrespectTrade-ReceivablesDiscountingSystems(TReDS)transactions;ATM;commodity;costs;e-commerce;illiquid;internationaleconomic;non-transparent;suspicious

transparencyTurkey

UdyogAadhaarunderperformanceunemploymentUnifiedFinancialAgencyUnifiedPaymentInterface(UPI)

UnionofIndiavs.theDRTBarAssociationUniqueIdentity.SeeAadhaarUnitedKingdom;CommissionforAfricaUnitedProgressiveAlliance(UPA)UnitedStates;bankingsystem;consumptioninequality;deregulation;domesticdemand;FederalHousingEnterprisesFinancialSafetyandSoundnessAct;FederalReserve;housingprices;lessonsofGreatRecession;mutualfunds;politiciansrespond;recoveryfromrecession;savingsandinvestment,balance

universaldepositinsuranceurbanco-operativebanksurbaneconomy

VanguardS&P500indexfundvettingprocessVishwanathan,N.S.Volcker,Paul

wholesalepriceindex(WPI)WorldBank

Yeyati,EduardoLevy

ZaibatsusZingales,Luigi

ABOUTTHEBOOK

WhenRaghuramG.RajantookchargeasGovernoroftheReserveBankofIndiainSeptember2013,therupeewasinfreefall,inflationwashigh,Indiahada large current account deficit, and India’s exchange reserveswere falling.Asmeasure after measure failed to stabilize markets, speculators sensed a full-blowncrisisandlabelledIndiaoneoftheFragileFiveeconomies.

Rajan’sresponsewastogoallout,notjusttotacklethecrisisofconfidence,butalso tosendastrongmessageabout thestrengthof India’s institutionsand thecountry’songoingprogrammeofreform.Heoutlinedavisionthatwentbeyondthe immediate crisis to focus on long-termgrowth and stability, thus restoringinvestorconfidence.Boldnessandfarsightednesswouldbecharacteristicofthedecisionshetookintheensuingthreeyears.

Rajan’scommentaryandspeechesinIDoWhatIDoconveywhatitwasliketobeatthehelmofthecentralbankinthoseturbulentbutexcitingtimes.Whetherondosanomicsorondebtrelief,Rajanexplainseconomicconceptsinareadilyaccessible way. Equally, he addresses key issues that are not in any bankingmanual but essential to growth: the need for tolerance and respect to assureIndia’s economic progress, for instance, or the connection between politicalfreedomandprosperity.

IDoWhatIDooffersafront-rowviewintothethinkingofoneoftheworld’smost respected economists, onewhose commitment to India’s progress shinesthrough in the essays and speeches here. It also brings homewhat everyRBIGovernordiscoversforhimselfwhenhesitsdownathisdeskonthe18thfloor:therupeestopshere.Righthere!

ABOUTTHEAUTHOR

RAGHURAM G. RAJAN is the Katherine Dusak Miller Distinguished ServiceProfessor of Finance at the Booth School of Business at the University ofChicago.HewastheGovernoroftheReserveBankofIndiabetween2013and2016, and also served as Vice-Chairman of the Board of the Bank forInternational Settlements between 2015 and 2016. Dr Rajan was the ChiefEconomist andDirector of Research at the InternationalMonetary Fund from2003to2006.

DrRajan’sresearchinterestsareinbanking,corporatefinance,andeconomicdevelopment, especially the role finance plays in it. He co-authored SavingCapitalism from the Capitalists with Luigi Zingales in 2003. He then wroteFault Lines: How Hidden Fractures Still Threaten the World Economy, forwhich he was awarded the Financial Times-Goldman Sachs prize for bestbusinessbookin2010.

DrRajanwasthePresidentoftheAmericanFinanceAssociationin2011andisamemberoftheAmericanAcademyofArtsandSciencesandtheGroupofThirty. In 2003, the American Finance Association awarded Dr Rajan theinaugural FischerBlackPrize for the best finance researcher under the age offorty. The other awards he has received include the Deutsche Bank Prize forFinancialEconomicsin2013,Euromoneymagazine’sCentralBankeroftheYearAward 2014 and The Banker magazine’s Global Central Banker of the Yearawardin2016.

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ThefollowingpiecehasbeenreproducedherewithpermissionfromForeignAffairs:‘TheTrueLessonsoftheGreatRecession’.ThefollowingpieceshavebeenreproducedherewithpermissionfromStraightTalk:‘RiskyBusiness:SkewedIncentivesforInvestmentManagersMayBeAddingtoGlobalFinancialRisk’;‘CleverSolution:ButWillItWork?’;‘AssumeAnarchy?’;‘OdiousorJustMalodorous?’;‘TheGreatGame

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