Ladies and gentlemen, I'm Lawrence Cram, I'm the Acting Vice-Chancellor and on behalf of the Vice-Chancellor Ian Young who's currently overseas and the ANU, I'm delighted to welcome you all to the 2011 Nuran and Aurasian, the 15th in the series. The annual lecture is organised by the Australia South Asia Research Centre in the College of Asia in the Pacific and is part of the ANU public lecture series. In introducing the lecture, I would like to acknowledge the first Australians on whose traditional lands we meet and whose culture is among the oldest continuing cultures in human history. The lecture honours his excellency Dr K. R. Narayanan, past President of India. Dr Narayanan inaugurated ASARC in 1994 and maintained an active interest in its work. Unfortunately he passed away on the 9th November 2005 after the 2005 aurasian was delivered. Hence our present aurasian adds significance as it represents our homage to Dr Narayanan. I'm particularly pleased to welcome a number of dignitaries to the aurasian. These include the former Governor-General of Australia, Major-General Michael Geoffrey and Mrs Geoffrey and her Excellency, Mrs Surya Singh, Chief Commissioner of India. Our speaker today is Dr D. Sabarow, Governor of the Reserve Bank of India. Prior to his appointment, Dr Sabarow was the finance... Oops, wait a minute. Got to do this right. Dr Sabarow was the Finance Secretary to the Minister of Finance, Government of India. He had earlier been Secretary to the Prime Minister's Economic Advisory Council, Lead Economist in the World Bank, Finance Secretary to the Government of Andhra Pradesh and Joint Secretary in the Department of Economic Affairs, Ministry of Finance of the Government of India. Dr Sabarow has wide experience in public finance. In the World Bank he worked on issues of public finance in countries of Africa and East Asia. He managed a flagship study of decentralisation across major countries of East Asia including China, Indonesia, Vietnam, Philippines and Cambodia. Dr Sabarow was also involved in the initiation of financial reforms at the state level. He has written extensively on issues of public finance, decentralisation and a political economy reforms. He holds a BSc Honours in Physics from the Indian Institute of Technology in Karangpur and an MSc in Physics from the Indian Institute of Technology in Kanpur. Dr Sabarow also holds an MSc Degree in Economics from Ohio State University. He was the Humphrey Fellow at MIT during 1982-83. He has a PhD in Economics with a thesis in fiscal reforms at the sub-national level. He was a topper, I think that must be a very good thing to be, in the All Indian Civil Service examination for entry into the Indian Administrative Services and I guess as a physicist I could understand why that happens. He was one of the first students from the prestigious Indian Institute of Technology to join the Indian Civil Service. We would like to thank the India-Australia Council for supporting this lecture and I welcome all members of the Council who are attending the aeration today. Before introducing our lecturer I would like to request her Excellency, Method Surja Singh, High Commissioner of India to read out a message from the President of India. Mrs Singh. It's a privilege to read out the President's message on this occasion. I am happy to learn that the Australia South Asia Research Centre at the Australian National University is organising the 15th KR Narayanan aeration on the theme India and the Global Financial Crisis. What have we learnt? By Dr. Duhuri Subaral, Governor Reserve Bank of India at the University in Canberra on June 23rd. The Indian economy has posted robust growth in recent years. While several other economies of the world have contracted, India has continued to fare better than other countries because of its domestic demand and investor friendly policies. There is growing interest the world over in the Indian economy and our developmental model. I have no doubt that the aeration will go a long way towards addressing this interest, focusing on the lessons learnt while tackling the challenges faced by the Indian economy and the opportunities, shape its growth and development in the years to come. I wish the event all success. Pratipa Devi Singh, Party. Thank you. Thank you very much, High Commissioner. May I now request Governor Subaral to deliver the 2011 KR Narayanan aeration. Good evening. First of all, my thanks to Australian National University and to the South Asian Research Centre for inviting me to deliver the KR Narayanan aeration. I know that very distinguished people have delivered this aeration in the past, so I'm very pleased and honoured to add my name to that list. Late President Narayanan was a distinguished diplomat, a reputed parliamentarian, a capable minister, and above all an erudite scholar. He was born at the very bottom of India's social pyramid and rose on to occupy the highest office in the country with assets, no other assets than artwork, humility and integrity. President Narayanan was in office from 1997 to 2002 when globalization, the current wave of globalization, as we understand it, now was in full swing. When President Clinton visited India in March 2000, when he hosted a banquet for him, this is what he said, Mr. President, we do recognize and welcome the fact that the world has been moving inevitably towards a one world. But for us, globalization does not mean the end of history and geography, one of the lively and exciting diversities of the world. In hindsight, I think that was a very thoughtful remark because if you look at 2000, that was a time when this idea of Francis Fukuyama end of history had a profound influence all around the world. But as much as globalization might be inevitable, history and geography need not be destiny if we learn lessons of history and do not repeat the same mistakes. This indeed is the topic of my aeration and my tribute to President Narayanan to seek the lessons of the crisis that we've just gone through so that they can make this a better world for all of us. A lot of people ask this question is this time different. In other words, has this crisis been different from past crisis? I know in Australia you refer to that at the GFC. So is this GFC different from the past ones? If you look at it in a fundamental sense, the causes of all financial crisis are the same. They are global imbalances, loose monetary policy, high levels of leverage driven by irrational exuberance. In that respect, this crisis has been no different from past crisis. However, this crisis has been different from past crisis in terms of its manifestation. First, this crisis, all past crisis, if you look back on them, they all happened in individual emerging economies or in regions. You look at Russia, Argentina, Turkey, Mexico or East Asia as a region, they all happened in specific countries or specific regions. All those crisis happened because of retail banking problems. And in all the past crisis, because it affected one country or one region, there was the rest of the world to fall back on. There was the multilateral institutions to provide support and other countries to provide support and get back it up. This crisis was different because, number one, it originated in the United States, the richest country in the world. It hit at the very core of the global financial system. As opposed to past crisis which originated from the retail side, this crisis originated from the wholesale banking side. And of course, when the US went into a crisis and pulled down advanced economies and the rest of the world, there was no buffer to fall back on. All of us went down together. So all emerging economies went down and India was no exception. What I propose to do during my oration is to answer these questions. How was India hit by the crisis? Why was India hit by the crisis? And based on those two answers, how did we respond to the crisis? And then go on to look at eight big lessons of the crisis from the Indian perspective. Let me add a personal note here, which is that I took office as the governor of the Reserve Bank of India on the 5th of September, 2008, nearly three years ago. Fannie and Freddie happened on the 6th of September. Lehman Brothers collapsed on the 15th of September. And World Financial Markets came to the brink of collapse on the 16th of September. So in India, very rightly, people think I brought on the crisis. And they ask me, when is the crisis going to be over? So I tell them, when my term is going to end, they have the answer. So let me get on with the first question. How was India hit by the crisis? What, indeed, was the impact of the crisis? In terms of GDP growth rate, in the three years before the crisis, 2005 to 2008, we were clocking 9.5% on the average. In the crisis year, 2008, 9, growth went down to 6.8%. In the three years before the crisis, 2005 to 2008, exports were growing at 25%. In the crisis year, they came down to 12%. In the year after that, exports actually declined by 2%. In the years before the crisis, we were having a lot of capital flows coming in far excess of the current account deficit. In the crisis year, capital flows fell short of current account deficit. In the years before the crisis, the rupee was appreciating. And during the crisis, it depreciated. Actually, between January 2008 and March 2009, the rupee depreciated by 30%. So that's how we were hit by the crisis. However we hit by the crisis, we were hit through all these channels that you're not familiar with the finance channel, the confidence channel, and the real channel. The finance channel is a bit complex. So let me explain that to you in a minute. There was a lot of foreign investment into Indian equity markets and debt markets before the crisis. And when there was uncertainty, there was flight to safety. People really have reached. They've got out of India. In the process, it put pressure on the exchange rate. It put pressure on the equity markets. Again, Indian corporates, they were borrowing vigorously outside the country from external sources. Suddenly they found that their external sources of credit had dried up, so they brought the credit demand home. That put pressure on the credit markets. Again, Indian corporates were putting their excess money into the mutual funds, into the money markets. When they ran short of money, they suddenly started withdrawing money from the mutual funds and that put pressure on the money markets. So all the financial markets, our equity market, our foreign exchange market, our debt market, our money market, all of them came under pressure. The confidence channel, again, if you go back to around mid-September 2008, what do you see? Every day, one storied institution falling. You had Lehman, then followed by AIG, Merrill Lynch, Wells Fargo, UBS, they've all gone into history now. So every day, one institution that we had grown to admire had started falling and there was lack of confidence all around. Nothing really happened in the Indian financial markets, but it was just the contagion of confidence from outside that sort of sent a hiccup. Banks started hoarding money and there was some sort, I wouldn't say seizure, certainly a liquidity market sort of curled up and for a few days there was problem there. The transmission through the real channel, of course, is quite straightforward. You understand that there was recession, there was slump in demand for exports and so we were hit too. Now the second question, which is perhaps more intriguing, which is why was India hit by the crisis? Actually, there was this may in India that we too could be hit by the crisis. And that this may arose from mainly two strands. First people said, look, you say that you had regulated your financial sector quite well, much like Australia has. Our banks did not have exposure to the toxic assets. Our banks did not have exposure to the subprime assets. They were quite prudently regulated. So if you're shouting from the rooftops that your financial sector is safe, how can India be affected by a crisis that had its roots in the financial sector? That was the first cause of this may. The second cause of this may was that, look, you say that your drivers of growth are domestic. You do not depend on exports so much. So we having a global recession, countries like Germany, countries like China, Japan, who depend on exports, we can understand they're hurt, but why should you be hurt? The answer to both those questions is globalization. That India in a 10 year period had integrated with the rest of the country much more than we realized and much more than we cared to acknowledge. Our perceptions in India were shaped by what happened in the Asian crisis. Asian crisis, we were not affected because among other things and importantly, we were not integrated into the world, but in the 10 year period, we had become more globalized than we realized. So let me give you some numbers just to illustrate that. The way we measure integration is to take the two-way trade flow as a proportion of GDP in the 10 year period of the Asian crisis, 98th and 2008, that ratio doubled from 19.6 to 40.7. So trade integration got deeper, but what is even more important is that our financial integration got even more deeper as illustrated by two-way trade and finance flows. That had multiplied two and a half times from 44 to 112% with a proportional GDP. So how did we respond to the crisis? The government came out of the fiscal stimulus in the Reserve Bank, we came out with monetary accommodation. But in the Reserve Bank, we were guided by two factors in our response. First, we said that our financial markets must continue to function normally. That when around the world financial markets were seizing, our market should function every day normally. Second, we must see that credit continues to flow to productive sectors. So what did we do? We ensured that there was ample rupee liquidity, we ensured that there was comfortable foreign exchange liquidity, and we made sure that credit continued to flow. We took conventional and unconventional measures. I don't want to go into details of them. That's not very relevant three years after the crisis. But I do want to say that credit continues to flow to productive sectors. So what did we do? But I do want to say that there was criticism against the Reserve Bank, which is understandable. People said that we were timid rather than being bold. They said we were hesitant rather than being confident. They said we were behind the curve rather than being ahead of the curve. All sorts of expected, predictable criticism. I did not defend the Reserve Bank at that time, but I do want to offer a defense now.  I mean, nobody knew what was going to happen, not just us in India or in Australia or in East Asia, but even advanced economy governments and central banks didn't know what was going to happen. Forget the next day, they didn't know what was going to happen the next hour. So with so much uncertainty around, it was unrealistic to expect that a central bank that is at the periphery of the crisis could react or respond in a proactive sense. The second thing is you must realize that, unlike in advanced economies, where the crisis transmitted from the financial sector to the real sector in countries of emerging economies, I believe that's true of Australia as well, the crisis transmitted from the real sector to the financial sector in the reverse direction. So our policy response had to be different. I want to give you an example. Yesterday we were talking about it actually at the lunch meeting I had with Australian bankers in Sydney, which is that, you know, at that time, England, UK, they had taken that step to be this. All regulators, all governments, insured deposits in the bank to some extent, to varying extents. In the UK, they said we're going to insure all deposits, just to give confidence to depositors not to withdraw money. They had done that in the UK, that's fine, but they needed to do that. But in India, there was clamour that we should do that too. And we were agonizing over that. What happens if we had insured deposits? People would not have felt safer actually. People would have got panicky that after all, why is India, which is not having any problem at all, why are you insuring deposits of people? So we decided after a lot of discussion that no, we will not insure deposits, we will let it remain like this. The cost was a consideration, but more importantly than the cost, was what we were going to do to the confidence of ordinary people if we made them believe that our banks were less safe than they actually were. So I want you to understand that reacting to a situation in a crisis like this by doing, copying what others are doing is not such a straightforward response. This is my final slide on the India situation, which is what is the outlook now, what is the post-crisis situation. We recovered out of the crisis sooner than most other countries. That is because, as I said, our financial sector has been relatively unexposed to the toxic assets, also because our export sector was small. But inflation too caught up with us. First it started as inflation triggered by supply shocks, a food shortage for deficient monsoon two years ago, but over the last two years it's become generalized, more broad-based inflation, both supply factors and demand pressures. So it's quite an explosive cocktail of factors which are driving inflation in India at this time. We raised rates 10 times in the last 15 months. But one thing I want to say before I move away from this slide, which is that managing recovery is incredibly more complex than managing the crisis. Because during the crisis what needed to be done was quite clear, and indeed what the precise thing that you did was less important than the fact that you did something.  So I realized that it doesn't matter what you did, how insignificant it was that you kept doing something. On the other hand, in managing the recovery we have to be, we have to finish it very well. You've got to be quite precise in calibrating this because of all sorts of domestic and international implications of being out of phase with the rest of the world. To give you a simple example, if our interest rates are very high and advanced economy interest rates are low, as is the case now, a lot of capital will flow into our countries. More capital than we need, and that creates its own problem. That's something that I'll talk about later. So we have to manage and calibrate the exit much more carefully than we calibrated the entry into the accommodative phase. So let me move on to the lessons of the crisis, which is the second part of my oration. A lot's being written about the crisis, about the lessons of the crisis. Somebody very famously and notoriously said that this crisis is too valuable to waste. We must learn the lessons of the crisis. That there is creative destruction. We must destroy old ideas and create new ideas. But not everybody agrees with that. Some people think that it's too early to draw the lessons of the crisis. We must wait back, let the crisis settle, and then get the lessons out more carefully, more studiously. Things are when light was who was asked sometimes, what do you think of the French Revolution? And he said, it's too early to say. So perhaps it's too early to draw the lessons of this crisis. But practical policymakers do not have the luxury of setting back and saying that we will wait till we get all the lessons of the crisis. So I'll get on to them. I've listed eight, but depending on the time, we will get through as many as possible. Maybe I'll cut down as we go along. The first crisis, per first lesson, I want to say is that in a globalizing world, decoupling does not work. Actually, when historians take a long view of what happened in the first decade of the century, I try to make a list of the things that will catch history. They'll probably talk about the rise of worldwide terrorism. They'll talk about maybe the deepening of the internet culture. They'll probably talk about the rise and fall of the global financial sector. The question is, will the emergence of emerging economies be one of the defining features of the first decade of the 21st century? That I think will depend not only on what emerging economies accomplished in the last decade, but how they consolidate on those gains going forward. Anyway, before the crisis, there was this intellectually fashionable idea that emerging economies have decoupled. What that meant to say was that even if advanced economies went into a downturn, emerging economies will escape that downturn because of their improved macroeconomic management, their resilient financial sectors, their robust external reserves. The crisis invalidated that theory because all emerging economies got pulled into the whirlpool. It's actually quite intriguing if you think about it. I expect many of your students of economics. You're taught in economics that a problem that arises in a non-tradable sector is confined to the economic boundaries. It cannot transfer across economic boundaries. For good measure, textbooks of economics give housing as a quintessential example of a non-tradable sector. It's intriguing that a crisis that started in a non-tradable housing sector in the US has snowballed into a global housing crisis, then into a global financial crisis, then into a global economic crisis. That's because housing like every other thing had become financialized. This is financialization or globalization which has caused the crisis. After the crisis, many people have studied decoupling and said that the IMF, for example, said if you look at the crisis period, 15 months, there was an initial period of decoupling when advanced economies started going down but emerging economies remained afloat. Then in the thick of the crisis, there was coupling because they went down and we went down too. But as we are emerging out of the crisis, again we are seeing some decoupling because they are still yet to recover whereas our recovery is well on its way. So the answer to the question is have we decoupled? I think it has to be more nuanced than it was before the crisis. Now I would say that we need to distinguish between trend decoupling and cyclical decoupling. Trend decoupling is that there is a differential between the growth rates of advanced economies and emerging economies and that will continue. To that extent we are decoupled. But around that trend in a cyclical sense, our fortunes are tied to the fortunes of advanced economies so cyclical coupling will continue to be there. So we got to be more nuanced. I think part of this was hubris, that you decouple, you will say long regardless of what happens to the rest of the world, that's no longer true. Let me go on to the second lesson which is that global imbalances need to be addressed for the sake of global stability. If you think about the causes of this crisis, you know that a crisis is complex as this one could not have been caused by a simple or a single cause. But in all our perceptions is the collapse of Lehman Brothers on 15 September 2008 that will remain as the cause of the crisis. In fact future textbooks will write about before Lehman and after Lehman. But regardless of that, if you think deeper, there were two fundamental causes of the crisis. The first was global imbalances. Second was financial sector developments. And early on people used to think of them as two independent causes that came together by coincidence and caused the crisis. But now if you think deeper you will find that actually one is, they're correlated, they're in a way interrelated. First let's talk about imbalances. Global imbalances got built up because of large savings and current account surpluses in China and other Asian economies. And they were mirrored by large deficits and leveraged consumption in the U.S. In short, Asia produced and America consumed. But how did these imbalances get built up? If you look at the wave of globalization in the 80s, 90s and early 2000s, there were three distinct factors driving globalization. There was trade, there was finance, and there was labor. So globalization of trade, we know if you take trade as a proportion of global GDP that had gone up so much in the 25 year period between 1980 and 2005. Globalization of finance was even more vigorous. The increase between 1980 and 2005-25 year period was even stronger. But by far the most influential I think was globalization of labor. Imagine India and China joining the global economic system. That's adding three billion people to the world economy. And enormous and almost abrupt increase in productivity. That in fact is the main cause or the main factor responsible for the great moderation that the world saw in the first decade. All of us had good growth, low inflation. So that was caused by global agitation of labor. So the chain of causation from these imbalances to financial crisis is interesting but not obvious. What really happened was as China and other Asian economies started having current account surpluses and having savings and also tried to maintain a competitive exchange rate, these savings turned into central bank reserves. And what the central banks do, they did not invest them in a diversified portfolio. They invested them in U.S. Treasuries and the other advanced economy, government securities. So what really happened was risk-free real interest rates around the world went down. So rich country investors started searching for yield that dropped credit standards, erosion of credit quality and we had this crisis growing. So in a way, the subprime move was caused by global imbalances. During the crisis, global imbalances came down somewhat. But what is worrying is that as we're getting out of the crisis, they're building up once again. In fact, many people ask whether we are sowing the seeds of the next crisis and trying to solve this one. So in the G20, there is this move about strong, sustainable, stable growth and they're talking about a mutual assessment process which is peer reviews of important countries, systemic countries. I don't want to get into details of all that. But what is important is that at the global level, if we decide on certain indicators to measure imbalances at the country level, which must then be put back to the country and ask the country to adjust, we should not be woodenheaded about it. It is not that your savings rate is so much, therefore you must adjust or your current account deficit is so much so you're causing global imbalances, you must adjust, but you must say in what circumstance the current account deficit is high. India's current account deficit is relatively high but we do not cause global imbalances because we get a lot of inflows and we try to manage that. So at the global level as much as we are concerned about ensuring that there is no recurrence of these imbalances, we are insured about making sure that there is a code of conduct for countries, we must also make sure that the code of conduct is applied judiciously, not in a woodenheaded sense. Let me move on to the third lesson which is that global problems require global coordination as a message that's relatively simple. Actually the crisis demonstrated as I said earlier how interconnected we are all through the trade, finance and confidence channels. The crisis originated in the US as we all know and it radiated in two ways. First it's spread from the US to other advanced economies then then to the rest of the world, that is geographically. Then sectorally it's spread from housing to other productive sectors. All countries tried to douse their fires domestically by themselves and they found that they were not being effective and very soon we realized that this is a global problem that requires global coordination. When historians look back on this crisis I'm pretty certain that the London G20 summit in April 2009 we looked upon as a turning point in the management of this crisis when global leaders showed extraordinary determination, unity in coming with a package that all countries must accept and implement. There were differences but those differences were sorted out, compromises were made with the ultimate objective of resolving the crisis. Today people are asking this question, that famous unity that G20 had shown during the crisis is that weathering away, are you breaking down under the pressure of peacetime problems? There are actually two problems with the G20. One is the tyranny of the present, that you're not able to, the weight of current problems is so high that you're not able to see beyond today. And the second is the tyranny of self-interest, that you've got your self-interest so much that you're not able to see beyond that. Regardless, I would think that to some extent we cannot expect the same type of unity that was shown during the crisis to be shown during normal times. Some differences of opinion are bound to be there. In fact I would go a little beyond and say that the difference of opinion might actually be value-added because it would get a good compromise out of that. I had actually seen G20 meetings before the crisis, during the crisis, and after the crisis. There is a distinct realization that in order to resolve global problems you need global solutions and second that no global solution is worth its name if it does not take into account the interest and the voice of emerging and developing economies. So what do we have on the global agenda today? We have currency wars that we were talking about until a month ago, global imbalances, US dollar as a world reserve currency, protectionism, financial sector regulation, all these issues. I think some wisdom is arising out of that but what is important is that we continue to remember that we need to be together because in a world divided by nation states there is no constituency for the global situation. We need to remember that even as we speak for our countries we also need to remember that we are part of a more integrating global system. Let me move on to lesson four which is that price stability and macroeconomic stability do not guarantee financial stability. Now what is financial stability? That's very difficult, not totally difficult to define if I was in a smaller gathering I would have told you it's a joke but I would not tell you now. But what is financial stability is that any sharp, disruptive, abrupt movement in economic fundamentals, in the interest rate, in inflation rate, in exchange rate and that disruption in the financial markets would be financial instability. Before the crisis, governments and central banks thought very good we will take care of price stability, we will make sure that there is no inflation, we will make sure that there is macroeconomic stability, in other words we will make sure that interest rates are stable, exchange rates are stable, are predictable and we will have financial stability and a dramatic derivative of price stability and macroeconomic stability. But the crisis taught us that you can have these two but you can still not have financial stability. For example, we saw the great moderation right in the period between 2001 and 2007 when the entire world had extraordinary growth developed countries, developing countries. We had low inflation, we had relative financial stability but in the midst of that extraordinary stability we had one of the most extraordinary financial instabilities coming across. So that lesson was very clear. In fact some people may give a stronger assertion which is that if you have price stability and macroeconomic stability for long enough that itself would cause financial instability. Why? Which is that you are lulled into complacency and you tend to underestimate, I was going to say miss underestimate, underestimate the cancer of financial instability brewing underneath. It's like having a normal child. If your child is doing well in school you tend to neglect the child and in the process you tend to neglect other problems. The child may be okay in academics but the child may be having personality problems but you tend to neglect them because you've neglected the child. It's like that. So as much as you take care of price stability you take care of macroeconomic stability you've got to take care of financial stability. Lesson five which is that microprudential supervision is necessary but not sufficient. Needs to be supplemented by microprudential oversight somewhat technical but it's important. Which is that before the crisis what were we doing as central bankers, as governments? We took care of individual institutions. You take care of Commonwealth Bank. It's a good institution. You take care of A&G Bank, good institution. You take care of West Bank, good institution. So you've got four banks in Australia. You take care of them so you're okay. You're not okay. Even if you have four healthy institutions four healthy institutions can together make you an unhealthy system. So the lesson is that a collection of healthy institutions does not necessarily make a healthy system. Why is that so? That is so because there is pro-cyclicality. Every bank behaves the same way. A&G behaves the same way. West Bank behaves the same way as Commonwealth Bank. People ask me this question. Why is so worried after all? What's the difference between Commonwealth Bank and Rio Tinto? Would I be worried if Rio Tinto fails? I would be worried as it's a big corporation but I would be more worried if Commonwealth Bank is failing. Why? Because a financial institution is not just a corporate. Financial institutions are interconnected not only within the country but around the world increasingly. So if one institution anywhere in the world fails it can spread around the world very easily and that's indeed the reason why all of us are concerned about the Greek crisis. After all, what is Greece? It's a small country in a distant part of the world for all of us but the reason we are focused on what's happening in Greece and how Europe is trying to resolve the problem is because there is interconnectedness in the financial system. So somebody said, one famous economist got a lot of my list for saying this. I wish I had said this. He said that if something cannot go on forever it will eventually stop. So that's what happened to the subprime. You just cannot keep that happening and the system failed. But before I move on from this lesson I want to give a counter lesson which is that we should not get carried away by this macro prudential because you can make a mistake. It's nice to be cautious. As governor of the Reserve Bank if I'm cautious I will protect Indian economic system from a crisis but I might also be paying a very high price for that. So you've got to constantly weigh the costs and benefits and you've got to keep track of what's the counterfactual because in real world nobody would be able to say if you did not raise interest rates what would have happened? That's a matter of conjecture. But in economic management as policy managers we have to be very conscious of managing the balance between caution and the cost we pay for caution. So you can make, for example, let's say I increase the provisioning for Indian banks. If I do it too early I can choke growth. If I do it too late I can let an acid bubble build up. So you've got to do it at the right time. Timing is very important. So let me move on to the next lesson. Let me also tell you that lessons get relatively short as we move on. Lesson six which is that this is actually quite high profile and a lot of people including in Australia in my meetings over the last two days this had come up almost invariably in every meeting which is that we're having capital flows in the emerging economies because as I said earlier we've had to raise interest rates because of our inflation management. Advanced economies have kept their interest rates still low because they're still recovering. And because of this interest rate differential and because of this quantitative easing and credit easing and whatever name you call it by that causes capital flows coming into the emerging economy. We do need capital flows. It's not that we don't need them. We need foreign savings but we need them just enough to meet our current account deficit. So in my investigation into this issue I have not come up with a law of capital flows which is that no country ever gets capital flows in the exact quantity or at the exact time it wants. You always have too much or too little or always at the wrong time. It's a very difficult problem to address because if flows are coming in much more than you need and you don't do anything, your currency will appreciate. That appreciation is unrelated to fundamentals. So your export competitiveness gets hurt. If you intervene in the foreign exchange market you will pump liquidity into the domestic market and that causes inflation. If we intervene and then sterilize the result and liquidity through combat inflationary pressures that raises interest rates. So no solution is totally benign and whatever you do, you will be criticized but more important than criticism, whatever you do you've got to be very careful about both the short term and the medium term consequences. This debate on capital flows has been a very heated debate that's actually frowned on moderation. There's people who say that you can actually you should not put any controls on capital because they're always distortionary, they're ineffective, they're difficult to implement, they're easy to evade and tail negative externalities. On the other hand, there are supporters of capital flows who say that if you control capital flows your monetary policy will be more effective, you will be able to determine what type of flows you can attract, I want long term flows, I can get them in and you will ensure macroeconomic stability. This debate has festered for several decades but it resurfaced during the crisis. What is significant about this debate and this crisis is that for the first time, the orthodoxy about capital controls has changed, one of the most orthodox institutions in the world, the IMF, which for a long time said that emerging economy should not control capital has had a change of heart and a change of mind I've said now, said that in certain circumstances it will not only be advisable but also inevitable for emerging economies to control capital coming in. So, even after that, what type of capital controls we must institute, how and when remains a very contentious issue. I think about it in this way, that you can have strategic capital controls and tactical capital controls. Strategic controls are the type that we have in India which is that you have a playing field you have the rules of the game, you tell market players what type of flows you will attract, what type of flows you want you want equity flows over debt flows, you want long term flows over short term flows, you want stable flows over volatile flows, you have the levers for that let the world know what you want. Use those rules transparently, predictably predictably in a fair way, strategic control. Then you can have tactical controls which is that you've flooded with capital and then you institute in a manner of firefighting which is actually the problem of Latin American country which is fighting capital flows now because they had opened up their capital accounts they've had to institute tactical controls which causes uncertainty. So one of the lessons of the crisis is that capital controls are not only unavoidable but advisable and if you have strategic controls your need for tactical controls is that much less. Let me move on. This is actually interesting from the student perspective that economics is not physics because many of you may have heard about this a few months into the crisis Queen went to the London School of Economics and all the economists lined up to welcome her and she said how come none of you saw the crisis coming and all these people just went very embarrassed went right in the face. Actually the Queen's question resonated with ordinary people around the world because ordinary people felt let down by economists and economics. What went wrong with economics many things went wrong but one of the things is that people say economists suffered from physics envy that they wanted economics to be like physics that you come up with very sophisticated models very fancy math and exact numbers. Remember these books which talked about questions like why do drug dealers live with their mothers or why do sumo wrestlers, what's common between sumo wrestlers and school teachers? I mean did we ever think of those questions in normal times? But economists thought of those obscure questions and answered them and everybody was impressed and economists opinions were sought not only on questions of economics but on everything around the world including how to cure AIDS and how to get whatever. So economics is a social science unlike physics which is an exact science. Just think about it you know I cannot change the mass of an electron no matter how I behave but I can change the price of a derivative by my behavior that's the important difference between physics and economics. So to give you another example the mass of an electron does not change that I am in the world of Newton in the world of Einstein but I can in the real world how firms households governments behave is altered by the reigning economic ideology. Just say that you know we all know that supply equal to demand but that's not necessarily true. That's economics you know supply need not be equal to demand but in physics energy loss is equal to energy gain that has necessarily to be true that is one of the most fundamental loss of the universe. So physics can excuse me economics cannot be like physics so but I also want to say respond to this question by the queen I'm finishing in two to five minutes professor the question that queen asked I have a response for that which is that it's not as if economists did not see the crisis coming they did. If you go back to the pre-crisis times people predicted that there would be a currency crisis in the event it imploded as a financial crisis which is to say that when a system is building up you do not know where it will implode but you do know that it will implode. Same thing about the Greek crisis which is that you know if you go back about shortly after we recovered from the crisis a lot of people said we might have a fiscal crisis they said we might have a fiscal crisis not because they knew that Greek was Greece was on a prodigal path but because they said governments are going to finance their banks rescue their banks and they're going to borrow for doing that and therefore there will be a fiscal crisis but we are having a fiscal crisis in parts of the world but that's nothing to do with governments rescuing banks in fact governments are making money out of rescuing banks so as we move out of this one thing quite unconnected with this but let me say this which is that before the crisis we used to say for every real sector problem no matter how complex there is a financial sector solution now we say for every real sector problem no matter how complex there is a financial sector solution which is wrong this is my final lesson which is that having a sense of economic history is important to prevent and resolve financial crisis you know there is this book this time is different 800 years of folly financial folly by Kenneth Rogoff and Carmen Reynard which is by this title which is that this time is different which is to say that every time a crisis occurred ordinary people would ask economists why did this occur why did you not see it coming and economists would say no no no we know all this you know this time is different we learnt the lessons of all past crisis we could have prevented a crisis if it happened for the same reasons this crisis is happening for a different set of reasons and Reynard and Rogoff had gone into very impressive painstaking research over 800 years to show that all financial crisis the fundamental cost is the same which is people get exuberant so why is that important that is important because students of economics professors of economics is very important that even as you learn economics also learn economic history I am signing off on this because it has special relevance for India and emerging economists maybe for Australia too which is that there is a sense that look we've managed very well we've insulated ourselves from this crisis therefore we have insulated ourselves from every future crisis I think it's very important that we do not succumb to that sense of hubris because we've insulated ourselves by good management probably by fortunes, circumstances and context that does not mean that there will be no future crisis we will continue to have crisis and what is important is that we prevent crisis as much as possible but should one occur we have the policy and the management capacity to manage that crisis so thank you very much for this opportunity I really enjoyed talking to you indeed Governor, I am interested in how you can see monetary policy settings currently in Asia you've mentioned today that inflation in India is an explosive cocktail was there a use of private use are some of the problems related to private media good or bad policy settings elsewhere before I answer your question I request you not to use that phrase in whatever your report because that can be quite explosive in itself so I just wanted to make the point that there is a combination of supply and demand side pressures I was shortly before I set out for Australia I saw the world economic outlook of the IMF which some of you may have seen what the IMF had said is that growth in emerging economies will be as they had predicted before indeed even in advanced economies maybe it will drop point one percentage point or something like that but importantly they said inflation concerns have become more important both in advanced economies and in emerging economies that by to us as India that did not come as a surprise because we've been experiencing inflationary pressures for the last two years but the fact that other emerging economies too are having inflation is to be expected because of fast growth and demand pressures so I would see that I would see continuation of monetary tightening across emerging countries in India if you're looking for some guidance we said in our statement of 16th of June that the Reserve Bank will have to continue with its anti-inflationary stance and that's what I would like to repeat here does that answer your question yes thank you please India's prosperity enough prosperity has been managed due to investor friendly policies and I would like to know if the prosperity has been gained at the expense of the environment lower levels of India's social pyramid please lower levels of India's what I'm sorry I didn't get you social pyramid social pyramid okay okay okay thank you very much excuse me yes we've had investor friendly policies I'm glad you say that because a lot of people say that investor friendly enough but the constant effort has been to make them investor friendly it's a judgment call about where we drew the balance between environment protection and the need for investment and every country is having to decide on that difficult issue as a poor country we cannot say that we will no investment take place because we want to protect our environment nor can we say that we will sacrifice our environment altogether because we want investment and I will you perhaps know I mean because you're present here I assume that you're interested in India and you're familiar with India a lot of environmental damage also happens because of poverty so we're struggling with it and there is more news about India's environmental sensitivity coming out of because there is more media attention to that and more investment into activities that have an environment interface like mining for example so around the country in the policy makers in the civil society there is greater awareness about environmental sensitivity in a fewer number of people there is also an awareness of drawing the right balance about the social pyramid I'm trying to interpret your question which is that like president Narayanan was born at the bottom of the social pyramid in most prosperous countries the wet stage of the talk seven million the wealth stays at the top yes to some extent but there's been some you know when in a rising tide all boats rise right okay so the rich may be getting richer but what's important about India as I see is that the poor are not remaining poor or nor are they getting poorer as used to be the acquisition 15-20 years ago they're also getting better maybe not as fast as the rich people but the poor are certainly getting better and because of that in fact one of the reasons we weathered the crisis was because in the rural areas consumption held out and another thing I want to say is that among the mega trends in India is this terms of trade shift from modern urban sectors to rural sectors for about 50 years after independence we got our independence in 1947 for about 50 years we ran a very regimented economic regime with licenses, permits etc protected our modern sectors which by definition shifted the terms bias the terms of trade in favour of the modern sector, industry and services thus changed in the last 10 years and rural incomes are going up terms of trade are shifted in favour of the farm sector so I cannot give a precise number about whether the rich are getting richer faster than the poor are getting better but the poor are certainly getting better and a much faster pace than they used to here and there thank you we were talking about Zubrin earlier and Australia is going into a rather in Zubrin mining boom I'm just interested in your thoughts whether we are putting too many about a non-basket it would be presumptuous for me to be able to comment on the Australian economy but I think from what I heard from my colleague governor yesterday and from your treasurer whom I met shortly before coming here it's not as if Australia is investing putting all its eggs in one basket they've said that service sector is doing well it's probably true that mining sector has become high profile and is attracting a lot of attention because of the terms of trade because of the exchange rate etc and Australia has quite a diversified economy I would imagine so I think you're far from putting all your all your engines of growth in one basket one more Dr Subrat Stephen House from the ANU thank you very much for a very interesting pleasure meeting you you mentioned was the global imbalances need to be regressed and you mentioned the build up of foreign exchange reserves among emerging economies to be impacted with the crisis and I just wondered where he is continuing those crisis in particular what India's stance is on I had that in my notes I did not go into it because I did not want to be very India specific but first about India what's the stance on foreign exchange reserve management on capital account management which is I don't know Latin but somebody said it's in Alente which is make haste slowly so that's our policy on capital account we will continue to open but we will make it gradual our roadmap will be calibrated as we go along in particular on foreign exchange management we work quite an outlier in terms of capital flows because after the crisis because of quantitative easing etc when flows have gone into emerging economies flows have come into India too but we were able to absorb them without the currency moving up very much because we had a current account deficit however I what a policy towards foreign exchange management exchange rate management is that we will intervene in the market to manage volatility we will intervene in the market to manage macroeconomic instability but we will not intervene in the market to target a specific exchange rate so we've not accumulated reserves any accumulation will happen in the normal cause but not as a result of deliberate policy about the rest of Asia you know this has become quite a contentious debate about how much of reserves you must build up I subscribe to the view that emerging economies should have some level of reserves but how much is your self insurance is a judgment call during the crisis some of you would follow it very closely would have remembered that the IMF was coming up with this what did I call it conditional fund unconditional fund facility or something like that which is that it's a line of credit that emerging economies could just draw when they need it without protracted negotiation in effect what they were saying is that you don't have to build up reserves you can wind down your reserves because the IMF facility is there I believe that we cannot wind down our reserves to zero we need a minimum amount of reserves for self insurance but building up reserves without an end and building up reserves as a consequence of intervening in the exchange rate market I think is inadvisable that's a long winner answer to your question very good Ben very much for a most illuminating talk and some very interesting questions I think I'd like to ask Professor Ja the Executive Director of the Centre for Proposals Thank you Good evening and thank you all very much for coming to the 2011 Narayanan Oration the 15th in the series this lecture along with the message from President of India Her Excellency Srimati Patil will soon be printed and copies will be available with ASARC and they'll also be available for free download from the ASARC website at this time it is my pleasant duty to bring this oration to a close by thanking the people and organizations who have contributed to making this year's oration such a success we have a 500 seating capacity here and it looks quite full to me, it's fantastic this oration is named after the now deceased Dr. K. R. Narayanan former President of India he inaugurated ASARC in 1994 and continued his support to ASARC throughout his life we have in the audience here senior public servants from the Commonwealth Government of Australia the Indian High Commissioner Her Excellency Mrs. Sujata Singh and other senior members of the Indian High Commission as well as a number of distinguished guests from the Australia India Council and the ANU in addition we have a very distinguished speaker who has a key role in India's recent transformation following from President Narayanan President APJ Abdul Kalam continued his support for the oration series we are indeed grateful that the current President of India has continued her support for this lecture series so that the Narayanan Lecture now forms part of the institutional links between the ANU and the Office of the President of India the High Commissioner of India and her staff have provided invaluable help in coordinating our contacts with the President's Office and the logistics for this oration for which I am very grateful we look forward to the continued support of the Indian High Commission to the Narayanan oration and other ASARC activities now I would like to thank the Australia India Council which has in the past supported this year's oration potentially and in many other ways I thank our Acting Vice Chancellor Professor Laurence Cram for chairing this session at the RBI Mr. S. Sinha who is with us today and a number of his colleagues in the Office of the Governor provided invaluable logistical support for this oration at ASARC Stephanie Hancock has as usual worked tirelessly and efficiently in organizing the details I would like to thank her most sincerely for her many efforts I would also like to thank Mr. Deepak Rajgupta chair of the ACT branch of the AIBC for his help in advertising this event finally it's my turn now to thank our speaker Dr. D. Subaraw ASARC is delighted and honored to be associated with him we are sincerely grateful to him for taking the time and the trouble and to undertake a long journey to be with us today ASARC's list of Narayanan speaker seats like a who's who of important Indian economists and public figures and Dr. Subaraw is a stellar addition to this list the Narayanan oration now ranks among the very best India lecture series anywhere in the world coming to the lecture proper Dr. Subaraw's speeches as you have no doubt found out of enthralling audiences of varied backgrounds and even conflicting intellectual persuasions his oration today has been encyclopedic, profound and provided a most erudite account of what we have learned from India's experience with dealing with the global financial crisis the raptor tension and admiration with which this august audience has deceived this oration are evidence both of the importance and the clarity and profound scholarship of Dr. Subaraw's exposition thank you very much