Friends,

I welcome this opportunity to be with you and benefit from the deliberations. There is an increasing awareness of the importance of domestic-debt markets, particularly in our region. Recent events in the Asian region have bought to light the importance of avoiding excessive reliance on the banking system for financial intermediation even as the health of the banking systems is being improved. Diversification of means of intermediation and competition therein within a country adds to both efficiency and stability of the domestic financial system and avoids shift of financial intermediation outside the country. Central bankers have a special interest in fixed income markets because they are to be addressed for ensuring a transmission channel of monetary policy. In many countries government securities market is critical in view of its role in creating the risk free yield curve as a benchmark for pricing other securities. Of course, the investors and intermediaries do look for efficient, reasonably stable and transparent fixed income market, and the regulators do strive to ensure these. In brief, the current challenge before us appears to be the mechanisms by which we encourage development of debt markets, as also carefully craft appropriate roles for manager of public-debt and regulator of debt markets as a whole.

Perhaps, India has been reasonably successful in meeting this challenge so far. No doubt, the progress in equity markets has been impressive in India, as it has been in most of the Asian region. But, the recent compulsions of a larger access to market borrowings by government as a source of financing fiscal deficit, and greater opportunities for corporates to access capital markets for their debt needs in addition to Development Financial Institutions, have provided challenges and opportunities for the policy makers in managing public debt and promoting debt markets in India. The organisers suggested that we should share with you our approaches, processes and strategies for our mutual benefit.

Before narrating our experience, it is essential to recognise that country context is very very critical, and generalisations would be inadvisable. Apart from the size and structure of the economy, state of fiscal and financial sectors, pattern of corporate structures and cultures, degree of openness of the economy, the foreign currency component of public debt which is low in India, and the maturity pattern of such external obligations which is generally of longer duration in India needs to be emphasised. In brief, the domestic dimension of debt in general and public debt in particular is dominant in India’s debt markets and this address today would naturally reflect such an orientation.

In fact, I was happy to read in BIS review, a speech by Governor, Chatu Mongol Sonakul on development of bond markets in Thailand, where he made a lucid presentation of the benefits of bond market, necessary conditions for development of bond markets and the criticality of a deep and liquid government bond market.

Similarly Mr. Joseph Yam, Chief Executive of the Hong Kong Monetary Authority said recently in May at Chang Mai : "there has been notably little disagreement about the desirability of developing domestic and regional bond markets. But there has also been little progress. And there has been no lack of explanation of why this is the case".

Recent years have seen significant transformation in the debt market in India with far reaching implications. As the process of reform continues, the role of financial markets in the economy gets significantly enhanced. While this process essentially involves domestic liberalisation, the decision to open up the economy adds urgency and complexity to the process of developing financial markets in India. The Reserve Bank of India has been taking special efforts to develop the various segments of financial markets, in particular, money, Government securities and forex markets. Government securities market constitutes a predominant portion of debt markets in India. The relative share of non-Government bonds has also picked up in recent years, as a logical extension of reforms in the Government securities markets and opening up of the financial sector. Even so, given the size of the sovereign debt, central to the development of debt market is the development of the Government securities market.

The primary interest of the Reserve Bank of India (RBI), in financial markets is because of its criticality in acting as the transmission channel of monetary policy especially while moving towards reliance on indirect instruments of policy. Currently, the Government securities market is the overwhelming part of the overall debt market. Interest rates in this market provide benchmarks for the system as a whole. In the recent past, several initiatives have launched the market into a high growth trajectory, in terms of depth, liquidity and turnover, participants, etc. Several initiatives for development of this market have helped the success of a large borrowing programme in recent years. This is critical not only from the point of view of the Reserve Bank, which is both the debt manager and regulator, but also from the point of view of investors who are concerned about the monetary and fiscal management in the country.

The Reserve Bank's strategy takes into account the considerations of both policy makers and investors. Reform has encompassed market practices in both primary and secondary markets, strengthening the institutional structure, developing new and innovative instruments, widening the participant base, rationalising tax measures, establishing a regulatory framework, initiating changes in legal framework, and imparting transparency in operations.

The approach to reform in the Government Securities market has several features which may interest the observers. First, the reform process is characterised by the caution with a tilt towards preserving stability, by the careful sequencing, by the mutually reinforcing monetary measures and by the complementarity with other policies. Creating a conducive policy environment as will be explained later has been a priority. Further, the reform in this market has always been undertaken within the overall monetary policy framework and is coordinated with reform in money and forex markets. Second, it progressed on the basis of a clear-cut agenda, which has aided the sequencing process. Third, major reforms were implemented in phases, allowing for transition so as not to detabilise market participants. Fourth, the entire process has been facilitated through collaborative approach imparting transparency in intentions. The Reserve Bank and Government have been working in close coordination on all issues. At a policy level, this involves legislative changes and many other parameters. At an operating level, there is a Working Group consisting of senior officials from Reserve Bank of India and Government of India on cash and debt management, which helps the process of consultation on management of government debt. In fact, RBI has initiated a process of periodical meetings with Finance Secretaries at State level (India is a federation of States) which has helped treasury management as well as debt management operations at State level. Fifth, a formal consultative mechanism with market participants was established by the Reserve Bank through a Technical Advisory Committee on Money and Government Securities Markets where important policy and operational changes proposed to be implemented are discussed. The Technical Advisory Committee has appointed working groups to more closely look into the technical details of policy proposals. This Committee has representation from banks - public sector, private and foreign, mutual funds, financial institutions, credit rating agencies, Primary Dealers Association and Fixed Income, Money Market and Derivatives Association (a self-regulatory organisation) and independent economists, apart from representation from Government. The Reserve Bank also holds separate consultations with Primary Dealers Association on important issues concerning public debt. Sixth, before finalising important policy changes especially on operational aspects, draft guidelines on issues are circulated as consultative papers to market participants and their comments are given serious consideration before issuing final guidelines. Seventh, coordination with Securities and Exchange Board of India, the regulator of stock exchanges and corporate debt except those with initial maturities upto one year is ensured both at a policy level and at operational level. In particular, at a policy level, coordination is ensured through a High Level Committee on Capital Markets presided by Governor, and at an operational level through a technical group of officials, both of which include nominees of Ministry of Finance. Eighth, international best practices are constantly reviewed in inter-departmental Working Groups within RBI before designing and opertionalising changes. Ninth, public debate is generated on the changes contemplated by announcing the intentions and proposals for structural reform through Monetary and Credit Policy statements and speeches of senior officials. Consultation and transparency are at the core of the reform process. Finally, in all these processes, the interests of investors and intermediaries are kept in view and these include a liquid market to facilitate easy entry and exit, tools for hedging, transparency in operations, an efficient settlement system, an enabling legal environment, and a clear and simple, but robust regulatory framework. Of course, development of technological infrastructure overrides all these objectives in the sense that it facilitates these objectives.

There are three main segments in the debt markets in India, viz., Government Securities, Public Sector Units (PSU) bonds and corporate securities. The market for Government Securities comprises the Centre, State and State-Sponsored securities. The PSU bonds are generally treated as surrogates of sovereign paper, sometimes due to explicit guarantee and often due to the comfort of public ownership. Some of the PSU bonds are tax free while most bonds, including government securities are not tax free. The Government Securities segment is the most dominant among these three segments. Many of the reforms in pre-1997 period were fundamental, like introduction of auction systems and PDs. The reform in the Government Securities market which began in 1992, with Reserve Bank playing a lead role, entered into a very active phase since April 1997, with particular emphasis on development of secondary and retail markets.

Since the sixties and until the nineties, the Government Securities market remained dormant since the government was borrowing at preannounced coupon rates from basically a captive group of investors, such as banks. In a way, we had a passive internal debt management policy. This, coupled with automatic monetisation of budget deficit prevented development of a deep and vibrant Government Securities market. As long as automatic monetisation existed, it was difficult to assure a framework for Government securities market in terms of matching demand and supply through a price discovery mechanism. Hence, a most significant development has been the elimination of the practice of automatic monetisation of the Central Government budget deficit through Ad hoc Treasury Bills with effect from April 1, 1997 and the introduction of a new scheme of Ways and Means Advances (WMA). In the nineties, several other measures were taken for creating an enabling environment for efficient market conditions. For instance, the total effective statutory pre-emptions of the banking system has been progressively brought down, the administrative structure of interest rates has almost been dismantled, prudential norms have been introduced gradually in line with international best practices, banking supervision has been strengthened, transparency and disclosure standards were enhanced to be on par with international standards, and risk management practices have been prescribed.

There are several ways of analysing market development, and perhaps a convenient way is to track measures in regard to instruments, institutions and participants.

From the investor point of view, a range of Treasury Bills give a variety of options for managing cash surpluses. At the same time, for Government spending long-term funds are needed to be raised in a cost-effective manner. Keeping these in view, over the reform period, a variety of Treasury Bills of 14-day, 91-day, 182-day and 364-day maturity have been introduced. In the long-term segment, the vanilla or the fixed coupon bonds are the most commonly issued instruments. However, over the years, given the large market borrowing programme of the Government and a large variety of investors, we have tried to innovate and issued zero coupon bonds, floating rate bonds, and capital indexed bonds. Government dated securities have been issued in a maturity range of 2 to 20 years depending on prevailing conditions in the market. Currently, the weighted average maturity of outstanding marketable debt is 7.75 years.

The non-Government debt market has a wider variety of bonds from very short-term to long-term maturity. These bonds have many innovative features like step-up, call and put options, and include structured obligations, etc. Much of the PSU bonds and corporate securities are privately placed.

Repos are permitted in Government securities. It has also been decided to extend repos in PSU bonds and private corporate debt securities, provided they are held in dematerialised form in a depository and the transactions are done in recognised stock exchanges. The system is yet to be fully operationalised.

Early during the reform process, the Reserve Bank promoted the Discount and Finance House of India and Securities Trading Corporation of India to promote the development of the money market and secondary market for government securities. The Reserve Bank has subsequently sold its majority shares to market participants and these institutions have since obtained Primary Dealership in Government Securities.

Since the inception in 1995, the number of Primary Dealers (PDs) in Government Securities has progressively increased from 6 to 15. The obligations cast upon PDs include an annual minimum bidding commitment for dated securities and Treasury Bills with a minimum success ratio and commitment to underwrite the gap between the subscribed/accepted amount in respect of dated securities and the notified amount, where there is a short-fall. The PDs are allowed access to call money as well as repos/reverse repo markets and to trade in all money market instruments. They have access to Subsidiary General Ledger (SGL) and current account facility with the Reserve Bank. The Reserve Bank also conducts exclusive Open Market Operations (OMO) in T-Bills through PDs. A second level satellite dealer system exits, with the main objective of retailing Government Securities. These satellite dealers are also given some liquidity support by the Reserve Bank. A few of these SDs have graduated as PDs.

It may be of interest to some of you to note that among the Primary Dealers, the newly licensed are, J.P. Morgan, ABN Amro, Deutsche Bank, and DSP-Merrill Lynch.

The Reserve Bank has also encouraged the setting up of mutual funds dealing exclusively in gilts, called gilt funds. Like PDs and SDs, these gilt funds are also provided with liquidity support, among other facilities.

Significant reforms in the non-Government debt market should also be recognised. National and local stock exchanges have been set up with facility for trading in corporate debt, and for that matter, even Government debt, through screen based systems. The securities and Exchange Board of India regulates the primary issuances in capital and non-Government debt markets and ensures sound trading practices through stock exchanges. Depositories have been set up to facilitate dematerialisation and quicker transfer mechanisms.

As is well known, a large participant base would result in lower cost of borrowing for the Government. In fact, retailing of Government Securities is high on the agenda of further reforms.

Banks are the major investors in the Government Securities markets. Traditionally, banks are required to maintain a part of their net demand and time liabilities in the form of liquid assets of which Government Securities have always formed the predominant share. Despite lowering the Statutory Liquidity Ratio (SLR) to the minimum of 25 per cent, banks are holding a much larger share of Government Stock as a portfolio choice. Other major investors in Government Stock are financial institutions, insurance companies, mutual funds, corporates, individuals, non-resident Indians and overseas corporate bodies. Foreign institutional investors are permitted to invest in Treasury Bills and dated Government Securities in both primary and secondary markets.

Often, the same participants are present in the non-Government debt market also, either as issuers or investors. For example, banks are issuers in the debt market for their Tier-II capital. On the other hand, they are investors in PSU bonds and corporate securities. Foreign Institutional Investors are relatively more active in non-Government debt segment as compared to the Government debt segment.

It will be useful to identify the progress in primary and secondary market. Credible systems have been established ensuring transparent mechanisms of issuance in the primary market and creating efficient mechanisms for trading and settlement in the secondary market for Government Securities.

Since 1992, after the market orientation of Government borrowing programme, and later after the abolition of automatic monetisation of fiscal deficit, the Reserve Bank has been resorting to primary market issues at greater frequency. Efforts are made to raise all issues directly from the market. Dated Securities are generally issued through auctions or tap sale. Primary Dealers are permitted to underwrite the entire notified amount of the auctions. Depending on prevailing market conditions, dated securities are sometimes privately placed with the RBI, and subsequently offloaded in the secondary market when conditions turn conducive. Issues have occasionally devolved on the RBI.

Until recently, Government dated securities were issued through yield based auctions. A beginning has been made during the current year with regard to consolidation of Government debt with a view to developing benchmark securities and development of a market for STRIPS. Most of the current primary issues are, therefore, reissuances of existing stock through reopening, and this has helped in consolidation of Government debt to some extent as also in creating a critical fungible mass for active trading and enhanced liquidity in the secondary market.

Treasury Bills are issued through auctions. The notified amounts with respect to T-Bills have been rationalised in the recent period. A calendar of T-Bills is announced in advance. Non-competitive bids from select participants are accepted outside the notified amount. Both discriminatory and uniform price auction methods are used, as appropriate to each of the T-Bills.

A large part of the issuance in the non-Government debt market is currently on private placement basis. Stringent entry and disclosure norms for public issues coupled with low cost of issuance, ease of structuring instruments and saving of time lag in issuance has led to the rapid growth of the private placement market in recent years. Total resource mobilisation from the private placement market has increased sharply over 4-fold between 1995-96 and 1999-00, The share of private placement issues in total mobilisation from the primary capital market (public issues and private placements) thus increased from about 40 per cent in 1995-96 to around 85 per cent by 1999-2000.

Banks and Primary Dealers are the major players in the secondary market for Government Securities. Most of Government Securities transactions in the secondary market are through over-the-counter (OTC) negotiated deals. However, banks are allowed to transact through brokers who are members of the National Stock Exchange and over-the-counter-Exchange of India, which facilitated screen based trading. Since 1994, the National Stock Exchange (NSE) launched the Wholesale Debt Market (WDM) segment, which provides the only formal platform for trading in a wide range of debt securities, including Government Securities. The trading system known as National Exchange for Automated Trading (NEAT) is a fully automated screen based trading system that enables members across the country to trade simultaneously. The trading system is an order driven system which matches best buy and sell orders on a price-time priority. However, in actual practice, most of the trades in Government and non-Government debt are usually concluded over-the-counter and later reported on screen. Thus, data regarding OTC deals are available on a near real time basis on the NSE screen. Similarly, the dissemination of daily data by the RBI on price and volume of Gilts traded in the secondary markets has greatly aided the price discovery process.

Currently the Reserve Bank operates the Government Securities Settlement system for those having Subsidiary General Ledger Accounts in its Public Debt offices through Delivery Versus payments System. Setting up of a Clearing Corporation for money and debt securities is in advanced stage of implementation. This will pave the way for further opening up of the repo market to PSU bonds and bonds of financial institutions held in demat form in depositories and traded in recognised stock exchanges with essential safeguards.

The aggregate volumes of trading in Government and non-Government debt in the secondary market have increased substantially over the years. However, Treasury Bills and Government dated securities accounted for the bulk of the trading volume at over 96 per cent of the total trades. The average annual growth in secondary market transactions since 1994-95 was over 55 per cent, reflecting the increasing depth attained by secondary market in Government Securities. For instance, the average annual transactions increased over 10-fold between 1994-95 and 1999-2000.

The turnover in Government securities (calculated by counting twice the volume of transactions in the case of outright transactions and counting four times the volume of transactions in the case of repos) fiscal 1999-2000 amounted to Rs.12,370 billion of which the outright turnover aggregated Rs. 9,060 billion. Thus, the average monthly turnover in Central Government securities aggregated Rs. 1,030 billion in 1999-2000 of which the average monthly turnover of outright transactions amounted to Rs.755 billion. The daily turnover has also witnessed a significant increase and is about Rs. 34 billion. Reflecting this, the turnover ratio in dated securities (defined as the ratio of total turnover to total outstanding securities) increased to 3.2 as on March 31, 2000 from 1.7 as on March 31, 1999.

Development of technology is an integral part of reforming the debt market, especially in the context of providing a technologically superior dealing and settlement system. Hence, the RBI has embarked upon the technological upgradation of debt market. The RBI has just commenced a project for complete automation of the operations of its Public Debt Office (PDO) where the settlement for all Government Securities Transactions takes place. It will provide for connectivity between different PDOs, and facilitate on-line screen based execution for trade and settlement in Government Securities transactions. The project will be implemented in phases. The first phase will cover the PDO computeristion at Mumbai and facilitate screen based negotiated dealings in Government securities and money market instruments, tendering of screen based applications in auctions, full-fledged audit trail, debt servicing, information dissemination, price list for open market operations, central information system for access by monitoring and regulatory authorities, etc. It is expected that the first phase will be operationalised well within a year. In the second phase, other regional PDOs would be linked with the central PDO system. This phase will facilitate active open market operations of RBI through all regional PDOs. The entire project is expected to be operationalised in about a year. The RBI is also separately putting in place real time gross settlement system, which is scheduled to be operational within the same time frame.

In order to curb certain unhealthy trends that had developed in the securities market and to prevent undesirable speculation, the Government had prohibited forward trading in securities in June 1969 through a Notification. Recognising that rescinding the 1969 Notification is necessary for developing the debt markets, at the recommendation of the Reserve Bank, the Government recently brought about amendments to Securities Contracts (Regulation) Act 1956 which made it possible for Government to delegate some responsibilities to the RBI. Currently the regulatory jurisdiction over the Government and non-Government debt markets have been delegated to the Reserve Bank and Securities and Exchange Board of India by the Government. The Reserve Bank will regulate in relation to any contracts in Government securities, money market securities, gold related securities and in securities derived from these securities and in relation to ready forward contracts in bonds, debentures, debenture stock, securitised and other debt securities.

These amendments help RBI to put in place, from time to time, appropriate regulatory framework, keeping in view rapid changes in financial institutions, instruments and practices governing money, Government Securities and forex markets, apart from gold-related financial products. With the delegation of powers by Government to RBI in these matters, the procedural delays and constraints can be eliminated.

Transparency in operations and data dissemination is the hallmark of our Government Securities market. The process of policy making and implementation of reform are through consultative mechanisms. The entire market borrowing programme is announced at the beginning of the year. Based on this, a calendar of Treasury Bills is pre-announced to the market. Similarly, near real-time data is available with regard to auctions of Treasury Bills and dated Government Securities. The Reserve Bank also publishes all relevant data pertaining to Government securities market on daily, weekly, monthly and annual basis.

The Government Securities and their management by the Reserve Bank of India is governed by the Public Debt Act, 1944. The procedures prescribed are archaic and some of the provisions have ceased to be of relevance in the present context. A new legislation titled the Government Securities Act proposes to repeal and replace the Public Debt Act. The Government Securities Bill has already been approved by the Cabinet and is awaiting Parliament clearance. However, since the Public Debt Act, 1944, is applicable for marketable loans raised by the RBI on behalf of both the Central and State Governments, the proposal requires consent of all State Governments. The State Governments have to pass a Resolution for the purpose either prior to enactment by the Centre or subsequently adopt the same by passing a Resolution. Once the new Act is enacted, the RBI will have substantive powers to design and introduce an instrument of transfer suited to computer environment.

Before concluding with the outlook, I must confess that there are several areas which are important but have not been presented in this address. These include the dilemmas in the separation of debt and monetary management; aspects of risk management arising on account of issuance of long-term debt which may create asset-liability mismatches for banks, and short term debt which creates recycling problems; determining the extent of transparency without preempting actions of the Reserve Bank; ensuring removal of impediments on account of taxation, etc. These issues are significant and are being continuously reviewed by us.

Encouraged by the results of our efforts so far, we are now embarking on an active programme of consolidation of the reform of debt markets on all fronts, consistent with the interests of investors, intermediaries, the market borrowing programme of Government and within the broad framework of monetary policy.

The outlook for debt markets cannot be divorced from outlook for the economy as a whole. The GDP growth has averaged close to 6 per cent in eighties and nineties and the market-analysts’ consensus for this year that it would be around 7 per cent while we in RBI place it around 6.5 to 7 per cent. Inflation has been on down trend and moderate in the range of 4 to 6 percent in the last five years and most analysts expect inflation in the current year to be in the range of 5 to 5.5, close to about 4.5 percent mentioned in RBI’s latest monetary policy. The interest rates have been generally on the down turn in the last few years, and currently prime lending rates are around 12 percent – close to market expectations. By and large, the interest rates have been stable with general inclination towards south, till recently.

The exchange rate has been among the most stable and the exchange market continues to be characterised by non-volatile conditions by global standards.

The current account deficit is universally expected to continue to be below 2 percent of GDP. Foreign currency reserves are high at $ 35 billion and have been rising every year in the last three years. The trend may continue this year also. The growth with stability was possible inspite of the well-known domestic and international uncertainties.

I wish to add that while taking all measures to develop the Government Securities market and ensure appropriate regulatory framework from time to time, continuous monitoring of developments on a day-to-day basis in the market is necessary to avoid excess volatility and maintain orderliness.

In all these efforts in managing policy and Government Securities market, we had unstinted support from several sources, including multinational banks and investment firms. Some of them, either directly or through joint ventures with local firms are playing a very active role in our debt markets, particularly as Primary Dealers in government markets, duly licensed by Reserve Bank of India. I am sure they will share their assessment of what we in RBI intend doing. Let me advice you that exploring with them for a view on India’s debt markets will be a worthwhile effort for all of you.

Let me wish you very fruitful deliberations and success in your efforts.

The RBI closely monitors the foreign currency mismatch and open foreign currency and gold positions of banks. The foreign currency/gold maturity mismatch limits and open foreign currency positions are vetted by RBI. The open foreign currency position is applicable for all currencies put together using shorthand method, i.e. the higher of the total short or long positions. No limits have been placed for individual currencies. While vetting these limits, RBI ensures that these have a reasonable relation not exceeding an internally laid down limit to Tier I capital funds of the bank.

Besides vetting limits on open foreign currency and gold positions and maturity mismatches, RBI had prescribed capital requirements for market risk on open foreign currency positions. Banks are required to add the open position limit to total risk weighted assets and maintain the required capital adequacy ratio.

India is one of the earliest subscribers to the SDDS of the International Monetary Fund. In this section the focus is on state of transparency in regard to the external sector statistics. The RBI publishes detailed data on external sector in its Annual Report and the Report on Currency and Finance, annually.

The Balance of Payments data is published in the monthly bulletin on a quarterly basis with a three-month lag.

The Weekly Statistical Supplement to the RBI Bulletin contains data on monetary and financial aspects as well as the external sector. In the external sector, the daily exchange rates, spot and forwards and the weekly forex reserves position are given.

The total external debt of India is compiled and published by the Ministry of Finance and the RBI at different frequencies. The Ministry of Finance publishes data annually in the form of "Status Report" and in the Economic Survey, which are public documents. These Reports provide information on multilateral, bilateral and commercial debt and identifies Government debt separately. The data includes debt for defence purposes, rupee-denominated debt and NRI deposits. Sources of data are reporting by Government, corporates concerned and banks, compiled by Ministry of Finance and the Reserve Bank of India (RBI). Since all external borrowings need approvals, the quality of data is reasonably sound. Currently, the data is reported on original maturity basis.

The data on foreign investments, both direct and portfolio, as well as data on outstanding balances under various non-resident deposit schemes are published on a monthly basis in the RBI Bulletin. This is in addition to trade data. The Reserve Bank of India disseminates data on forex reserves on a weekly frequency with a lag of one week. Data is given separately with regard to foreign currency assets and SDR and gold holdings. Information on sale and purchase of foreign currency by RBI as also information on forward liabilities of the central bank are disseminated to the public on a monthly basis, with a lag of one month. The dissemination of data on forex reserves is through the Weekly Statistical Supplement and the monthly RBI Bulletin, which are also available on the RBI website.

The RBI also publishes the 5-country and 36-country NEER and REER on a monthly basis with a lag of one month.

Recently, the Government of India has set up a National Statistical commission to examine the deficiencies of the present statistical system in the country with a view to recommending measures for a systematic revamping of the system. One of the subgroups is looking into financial and external sector statistics. The subgroup has already identified aspects of external sector data that require further refinements, and initiated follow-up action to bridge the data gaps.

The Foreign Exchange Regulation Act (FERA) by Foreign Exchange Management Act (FEMA) with effect from the beginning of this month, i.e., June 2000. The philosophy of foreign exchange management has shifted from that of conservation of foreign exchange to one of facilitating trade and payments as well as developing financial markets. This definitive shift in the objectives of foreign exchange management will automatically get reflected in the operations of the Reserve Bank. There is a clear distinction between the current and capital account. Under the new system, all current account payments except those notified by the Government are eligible for appropriate foreign currency in respect of genuine transactions from the Authorised Dealers without any restrictions. The surrender requirements in respect of exports of goods and services continue to operate. The Reserve Bank however, would have the necessary regulatory jurisdiction over capital account transactions. To this extent, further action in regard to capital account liberalisation appears to have been put by Government squarely in the court of the Reserve Bank of India.

It must be noted that the new legal framework keeps the option of reimposing controls, capital or current account if it becomes necessary. Thus, the Central Government is vested with the power to suspend and revoke any permission granted if the Government is satisfied that circumstances warrant such actions, in public interest.

The committee on Capital Account Convertibility (CAC), with Dr.S.S.Tarapore as Chairman, which submitted its Report in May 1997, observed that although there were benefits of a more open capital account, international experience showed that a more open capital account could also impose tremendous pressures on the financial system. Hence, the committee indicated certain signposts or preconditions for capital account convertibility in India.

The three crucial preconditions were fiscal consolidation, a mandated inflation target and above all, strengthening of the financial system. The committee recommended a reduction in Gross Fiscal Deficit / Gross Domestic Product ratio from 4.5 per cent to 3.5 per cent in 1999-2000 and a mandated rate of inflation for the period 1997-98 to 1999-2000 at an average of 3 to 5 per cent. In the financial sector, the time frame for signposts that were recommended was in terms of cash reserve ratio (CRR) and non-performing assets (NPAs). The recommendations were to reduce gross NPAs of banks as a percentage of total advances from 13.7 per cent in 1996-97 to 9 per cent by 1998-99 and to 5 per cent by 1999-2000, and the average effective CRR from 9.3 as of April 1997 to 3 per cent by 1999-2000.

The process of convertibility on the capital account has been gradual and as the experience shows there is a hierarchy to it. There is a differentiation between inflows and outflows and within this between corporates, individuals and banks. Currently, the priority is to liberalise inflows, and in particular on corporate account. The recent freedom given to corporates to raise funds through ADRs/GDRs is a signal to this effect. With regard to liberalisation of outflows the hierarchy is corporates, financial intermediaries and individuals, although Tarapore Committee preferred liberalisation of flows on individual account earlier in the hierarchy. It would, therefore, be reasonable to expect some liberalisation on outflows with regard to corporates in the near term, and in regard to banks and other financial intermediaries after some progress in financial sector reforms.

On the path towards capital account convertibility, there is now a lot more stronger public opinion and the issue is more of a technical judgement on sequencing rather than whether to open up or not. Between the preconditions and the time frame for CAC recommended by the committee, it is clear that the achievement of preconditions has emerged, as perhaps intended, the more important criterion for liberalizing the capital account, while the timetable itself has lesser significance. Thus, the pace of liberalisation of capital account would now depend on domestic factors, especially the progress in financial sector reform and the evolving international financial architecture.

The introductory part of the paper dealt with the importance of country context and hence, any inferences based on the country experience described should be either totally eschewed or viewed with great circumspection. With this cautionary note, some broad generalisations are attempted here. The generalisations are somewhat narrowly focussed on the external sector and not the broader macro-policy issues such as implications for monetary management and exchange rate policy.

First, the current account deficit represents the use of external resources in a country. Capital inflows to finance such deficits are welcome for their role in financing investment, and thereby sustaining long-term development. At the same time, it should be apparent that a large current account deficit implies correspondingly a large dependence on such capital inflows. The developing countries are vulnerable in many spheres and hence such large dependence has a potential for destability. The issue is not whether there are inflows or outflows at a point of time, since a fall in inflows is enough to cause a crisis when there is large dependence. It is precisely with this view that India resisted the urge to allow current account deficit to exceed around 2 per cent of GDP in India. No doubt, the level of normal capital flows or sustainable current account deficit is contextual – to the country concerned, level of development, extent of external sector and even geo-political considerations. Briefly stated, for developing countries, non-volatile flows are ensured only if current account deficit is sustainable and policy makers need to constantly review the sustainability.

Second, there is a trade-off in the short run between financial stability and efficiency which all policy makers are aware of. More the prudential regulations, greater is the cost of intermediation, though in the long-term it is the stability that imparts efficiency. In search of higher efficiency gains in one stage of development, a country may accept the risk of greater volatility. But, the trade-off has to be viewed in a contextual sense in relation to both domestic policy stance and the international environment. There is an impression that in the light of the Asian experience, policy choice should in future tilt totally in favour of stability at the cost of efficiency. While the crisis has drawn attention to the risks, and inadequacies in international financial systems, there is a greater global awareness of the issues now. In other words, the relative weights to efficiency and stability needs to be constantly reviewed with reference to both domestic and international developments.

Third, in the context of normal flows, one way of giving a greater weight to stability would be emphasising longer term flows. The issue would of course be how to distinguish between long-term and short-term. It is necessary to recognise the existence of a hierarchy, however, difficult to achieve. From a purist’s point of view, an efficient system of financial intermediation would require easy movements and transmission mechanisms. But, the cross border flows, with all the globalisation, are not subject to the same logic as domestic flows. True, the presumed differences between portfolio flows and FDI flows can be overdone as FDI flows can also be volatile. Longer maturity external liabilities may seem less vulnerable to volatility than short maturity ones but if there are active secondary markets, long maturities may be highly liquid. Similarly, there are also different points of view regarding the risks involved in debt and equity. Foreign owners of equity can choose to exit although a falling market or depreciating currency should provide a disincentive, but not if there is herding. Yet experience has shown that FDI has a tendency to be less volatile, because the original motivations for inflow is both financial and non-financial. Further, there is also a gestation period, i.e., project completion, which is built into the profit projection and thus imparting stability. Hence, there is merit in giving greater weight to FDI than portfolio in deciding what is relatively long-term.

Fourth, the treatment of trade related flows for defining short-term debt assumes importance. It is important to distinguish between trade credit, which provides a rather stable source of financing even though each individual loan has a short maturity and other types of short-term borrowing. It is also essential to capture the leads and lags in trade related payments that affect the level of short-term debt.

Fifth, while the size and maturity structure of debt are important, bunching of repayments is critical. In this context, the impression that all long-term debt is a panacea may not be totally correct. The approach should not be merely to contain certain debt under all circumstances, but to moderate the size and changes in debt flows. Keeping the external debt within limits has a role in avoidance of financial crisis, but bunching of repayments has a potential to create liquidity problems.

Sixth, it would do well for authorities to continuously monitor the level of private sector debt and the positions that are taken by them. Since large transactions have the potential to disrupt the market, it is better to keep a tab on such transactions. Financial institutions have to be sensitised for monitoring unhedged positions of corporates.

Seventh, there is need to be careful on dollarisation of the economy. It is now recognised that large scale dollar denominated assets within a country can disrupt the economy by creating a potential for destabilisation.

Eighth, the discipline of releasing timely data, compels the authorities to be lot more accountable and markets to be less prone to surprises. The data dissemination should be regular, relevant, timely and authentic though such transparency does not eliminate the risk of wrong inferences by market participants.

Ninth, skills of market participants as well as regulators have to be continuously upgraded in order to keep pace with developments in technology and innovations in market if both policy changes and responses are to be effective. There is in some senses a big dilemma here. Controls are imposed because markets are imperfect and participants’ skills are inadequate; but markets do not get less imperfect and participants’ skills do not improve as long as controls exist. The interactive process is critical here.

Tenth, the nature of relationship between different financial markets is important. It is now recognised that capital account liberalisation should not be undertaken without a strong financial sector since the strength of the financial sector has systemic implications. It is not appropriate to assume that since markets are developed they are integrated fully. There can be varying patterns of integration. Thus, opening of capital account should take into account specific country circumstances while establishing strong legal, regulatory and institutional framework. An added dimension, of course is the developing international financial architecture. Thus, the pace and sequencing have to be determined by both domestic and international developments.

Eleventh, whether the liberalisation of capital account should totally foreclose the option of imposing controls? It is perhaps wise for many developing countries to have the legal framework for reimposing controls in times necessity and keep the policy option open both for prudential and ad hoc controls. Such options for domestic actions are warranted as long as international financial system imposes unequal burdens between domestic economy and market participants in the event of volatility.

Finally, and an issue that is often raised relates to the speed with which a country should open up. As would be evident from the description in the paper, the issue of liberalisation of capital account cannot be approached in isolation. The degree of sustainable openness, in some ways, depends on productivity and prospects for improvements in productivity in the real sector. Even more important, it would depend on the size and structure of domestic economy, the political economy of the country concerned and the assurances of stability and support when needed, from international financial system. As of now, the burden of crises arising out of capital account appears to be predominantly on the residents. In sum, capital account liberalisation has both a national and international context - a truism indeed.

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