such speculative flows are volatile by nature, they can impair the orderly functioning of the financial markets. when investors exit from securities markets abruptly in a herd, stock and bond prices get affected, and when investors take the redemption proceeds out of the country, the exchange rate gets affected. should the central bank intervene to stabilize the forex market, the resultant tightened liquidity can affect the money markets. thus, speculative flows affect all financial markets – the securities markets, the forex market, the money market and the credit market, with contagion spreading from one market to another rapidly. if not contained, these swift developments can threaten financial stability and lead to output and employment losses. managing capital flows 5. surely, capital flows are important to meet the investment needs of emes. problems arise when the flows are largely in excess of the economy ’ s absorptive capacity and also when they are highly speculative in nature. emes have responded to managing the adverse macro impact of volatile capital flows through a variety of policy actions. stylistically, these can be categorized into three options. the first option is to do nothing ( exchange rate option ) in which case the exchange rate will appreciate. the second is to allow the flows to come in but intervene in the forex market ( reserve accumulation option ). the third option is to deploy capital controls. typically, emes have adopted a mix of all the options. let me briefly discuss the implication of these options. the option of exchange rate adjustment 6. the most straight forward option for the central bank is to allow flows to come in without any intervention. however, when capital inflows are large, this can lead to currency appreciation unrelated to fundamentals and trigger a “ dutch disease ” syndrome. experience has shown that a flexible exchange rate system is prone to overshooting, and this has engendered the “ fear of floating ” among many countries. the option of reserve accumulation 7. the second option for a central bank, confronted with a surge of capital flows, is to intervene in the foreign exchange market to dampen disorderly movements of the exchange rate. this will result in accumulation of foreign exchange reserves and release of additional liquidity into the system. if left unsterilized, the additional liquidity so generated in the system will have potential inflationary implications. typically central banks have sterilized the flows, either partly or fully, using a variety of tools including open market operations, tightening the access of banks to the discount window,

. obstfeld has largely been in coastal schools, and it will be interesting to find out if his academic persuasion fits in with this salt water – fresh water dichotomy. 10. prof. obstfeld ’ s earliest research was focused on portfolio models of exchange rate and capital flows, and the effects of sterilization policies, including foreign exchange intervention. later, he turned to models of monetary and real international adjustment based on dynamic optimization, an approach that has since become standard in international economics. in the mid - 1980s, prof. obstfeld began to pursue the insight that speculative attacks on exchange - rate regimes could be self - fulfilling. subsequent developments, notably the asian crisis of the late 90s, validated this theory. 11. prof. obstfeld will be speaking today on “ gross financial flows, global imbalances and crises ”, unexceptionably a topic of great relevance in the current context. global imbalances need to be redressed for the sake of global stability 12. no crisis as complex as the one we are going through has a simple or a single cause. in popular perception, the collapse of lehman brothers in mid - september 2008 will remain marked as the trigger of the crisis. at one level that may well be true. indeed, i can visualize future text books in finance dividing the world into “ before lehman ” and “ after lehman ”. but if we probe deeper, we will learn that at the heart of the crisis were two root causes – the build up of global imbalances and developments in the financial markets over the last two decades. and received wisdom today is that these two root causes are interconnected, and that financial market developments were in a sense driven by the global imbalances. 13. global macro imbalances got built up because of the large savings and current account surpluses in china and much of asia in the wake of the asian crisis in the 1990s. these were mirrored by large increases in leveraged consumption and current account deficits in the us. in short, asia produced and america consumed. 14. and why did these imbalances get built up? the answer lies in globalization – globalization of trade, of labour and of finance. the world witnessed a phenomenal expansion in global trade over the last three decades ; global trade as a proportion of global gdp increased from 37 per cent in 1980 to 53 per cent in 2008, just before the crisis hit us. 1 globalization of finance was even more