raghuram rajan : strengthening our debt markets annual day address by dr raghuram rajan, governor of the reserve bank of india, to the foreign exchange dealers association of india, mumbai, 26 august 2016. * * * thank you for inviting me to speak to fedai. in the last few weeks, in successive speeches, i have outlined the rbi ’ s approach to inflation, distressed debt, financial inclusion, and banking sector reform. i want to speak today about debt markets and associated derivatives ; why we need them to be deep and liquid, why, in addition to central and state governments, we need riskier firms and projects to be able to access the bond markets for funds, why we need to encourage product innovation, and finally the dilemmas that regulators like the rbi face. in the process, i hope to touch on some of our recent successes, as well as failures, and our ambitions for the future. there are three important reasons why debt markets have become a lot more attractive in recent months. first, we finally have a framework that commits us to low and stable inflation. yes, july ’ s inflation reading was a high 6. 07 %, but i have no doubt that inflation will fall in the months ahead. the key point is that market participants know that the monetary policy committee has to maintain low and stable inflation, certainly over the next five years for which its remit has been set, and it will do what it takes. this lowers the inflation risk premium, and thus reduces the nominal fixed interest rate for everyone, from the government to the riskiest borrower. in this regard, i am confident that dr. urjit patel, who has worked closely with me on monetary policy for the last three years, will ably guide the monetary policy committee going forward in achieving our inflation objectives. a second development has been the reluctance of public sector banks ( psbs ) to lend, and together with private sector banks, the reluctance to fully pass through past policy rate cuts into bank lending rates. short term market rates, however, have seen full pass - through. no wonder highly rated firms are bypassing banks to borrow from the commercial paper ( cp ) markets, with outstanding commercial paper having more than doubled in the last two years to over 3 lakh crores ( see chart below on cp outstanding juxtaposed against incremental bank lending ). but what of lower rated firms? unfortunately, the difficulty of debt recovery in india has meant that credit

the highest rating, it is important that there be no explicit or implicit default or restructuring of such obligations. while a restructuring may seem like a way to postpone obligations, its ramifications, not just for the yield the market will demand of the particular state government issuer in the future but also for the yields on obligations of other state governments, are large enough that such actions should continue to remain “ unthinkable ”. bis central bankers ’ speeches regulations we are conscious of the limitations placed on netting of derivative contracts, and thus the higher associated capital requirements on banks. the issue has been taken up with the government, and we hope to amend the rbi act to make such netting possible. as with the tax issues associated with securitization, which have recently been addressed by the government, resolving this issue should hopefully lead to substantial market activity. finally, while the rbi is a liberalizer, we have to be careful not to relax prudential regulations simply because an entity or activity is deemed of national importance. dispensation on prudential regulation is the wrong instrument to favor such activities. a nationally important activity such as infrastructure may be very risky. to require lower provisions, or to allow higher leverage or ecbs against such activities, may increase systemic risk. in the long run, the activity may be damaged by the regulatory dispensation ( too many infrastructure projects that do not have dollar earnings will be financed with dollar or yen loans and cannot repay ) and stability may also be compromised. it is far better for the government to directly subsidize such activities if it deems them important than for rbi to sacrifice systemic stability on the altar of national importance. conclusion let me conclude. while the rbi has been cautious in reforming during the recent period of global market turmoil, it has not stood still. market reforms have proceeded at a steady measured pace. observers may be impatient, but my belief is that steady and irreversible reform and “ mini bangs ” like yesterday ’ s rather than “ big bang ” is the need of the hour. as global conditions become less uncertain, the pace of reform can pick up. the lessons we have learnt during this period on what works will be invaluable then. thank you. bis central bankers ’ speeches