In this episode of How India’s Economy Works, Puja Mehra speaks with Ananth Narayan, Economist and Former Whole Time Member, SEBI about the growing interconnections between India’s interest-rate, equity and currency markets—and the unintended consequences of intervening in each of them separately.

Narayan argues that the RBI’s aggressive intervention in the bond market, including record purchases of government bonds, has kept interest rates artificially low and weakened the appeal of fixed-income assets for domestic savers. This, he says, has pushed more savings into equities and overseas assets, contributed to stretched equity valuations, and made it harder for foreign capital to flow into India. At the same time, lower interest-rate differentials have created incentives for hedgers and speculators to buy dollars, adding pressure on the rupee.

The conversation explores the idea of an “impossible trinity” in a more interconnected financial system, why RBI intervention in one market can create problems in another, and whether India needs to allow markets to function more freely. Narayan also discusses tax reforms for fixed income, greater freedom for Indians to invest overseas, and why policymakers need to take a holistic view of financial markets.

Tune in for insights on RBI intervention, interest rates, the rupee, capital flows, equity valuations and what India needs for more sustainable capital formation.

CHAPTERS

(00:00) Introduction to the Impossible Trilemma

(01:19) Interconnected Markets and Bond Interventions

(04:57) Low Rates Distort Credit Markets

(12:15) Discretionary Savings Flood Equity Markets

(15:47) Domestic Overvaluation Deters Foreign Capital

(24:49) Interest Differentials Drive Dollar Outflows

(28:51) Subsidized Swaps and Forex Interventions

(31:54) Reforming Fixed Income Tax Parity

(36:18) Allowing Freer Overseas Investment Limits

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TRANSCRIPT

NOTE: This transcript is done by a machine. Human eyes have gone through the script but there might still be errors in some of the text, so please refer to the audio in case you need to clarify any part. If you want to get in touch regarding any feedback, you can drop us a message on feedback@thecore.in.

Puja Mehra: Professor Anand, thank you so much for coming to the show.

Ananth Narayan: Thank you so much for having me, Puja. My pleasure.

Puja Mehra: Today I'd like you to help my listeners understand something which is extremely technical but is very important. I'm sure they read and hear about it a lot. And this is that you've suggested that the RBI may be having to intervene a lot more in the forex market than it otherwise would have, mainly because it is intervening very heavily in the bond market.

And those of us who have studied economics know that the RBI does in fact try to chase many policy objectives and it cannot at the same time, it is established that no central bank at the same time can achieve all of its policy goals, which is something that is called the impossible trilemma. And you've suggested that perhaps it's time now for the RBI to define what it is going to do when there are trade-offs between different policy objectives and when there is incoherence across different policy tools that it uses. This is very technical but who better than you to help my listeners understand.

Ananth Narayan: Thanks again, Puja, for having me. And I can't think of a better person, more erudite than you, to conduct this conversation because you understand all of this very, very well. In essence, Puja, the broad proposition is as follows, that markets are interconnected.

Your interest rate market, your currency markets, and as a spillover, other asset markets, including equity markets, are all interconnected. Now, we might have some objectives for certain markets, but in pursuing those objectives, we have to be very mindful of what the unintended consequences for other markets might be and how these interactions play out. Unfortunately, some of the interventions that our policymakers undertake sometimes ignores these intersections and then we sometimes get surprised that there are unintended consequences as a result of our actions.

So as you rightly put it, I would start with interest rate markets. You know, for long, during various regimes, we've tried to ensure that interest rates remain low, so that growth is given a chance, credit offtake can happen, capital formation can happen with borrowers coming in, raising money and creating fresh capital. That is seen as one way of getting a virtuous cycle of growth and employment and savings, etc., to go through. The problem, of course, is that once intervention takes hold and you determine interest rates not by a free market of willing savers and willing borrowers agreeing on a price, but because somebody, some other agency comes in and tries to set a particular price, then that has implications for other markets amongst many other things. So, as an example, during the fiscal year FY26, that's a great example, during that time, we actually saw inflation coming down quite dramatically. In fact, inflation averaged about 2% during that time.

So during that time, following the monetary policy framework that has been set now in the RBI Act, the MPC, the Monetary Policy Committee, actually cut interest rates by 1.25%, from 6.5% to 5.25%. So far, so good. That was well justified, at least the way the MPC framed it, given that inflation had come down dramatically, right? Now, it didn't stop there, however.

Beyond what the MPC did with respect to policy rates, the RBI intervened aggressively in the bond markets and in the banking liquidity markets to ensure that this monetary policy framework was transmitted into the larger interest rates of the economy, and that therefore there was a chance to transmit these policy changes onto the larger borrowing market as well. So, specifically, the RBI bought about 8.8 lakh crores of bonds, and this is 5-year, 10-year, 15-year, 20-year bonds, during the course of April 25 to March 26. This is a record intervention, Puja, and you know that.

This is more than 80% of the gross borrowing programme of the central government alone. So a big chunk of the borrowing programme of the government was actually effectively purchased by the RBI, of course, through the secondary market than through the primary markets. So what that did was that accounted for such a large amount of demand for bonds that interest rates came down.

Now, it didn't come down because you and I were saving money at those lower interest rates. It came down because RBI was pushing those rates down, right, by buying bonds very aggressively.

Puja Mehra: And the RBI can do this because it is such a dominant player in that market.

Ananth Narayan: Right. Now, that's a great topic to have a separate discussion on, on whether the RBI should do this or not. But you're absolutely right.

The RBI, if it chooses to intervene, and by the way, central banks around the world are intervening in bond markets. So it's not as if the RBI is alone in that sense. But when it chooses to intervene in such a strong manner and with such a huge amount of force, obviously, it has implications for interest rates.

10-year bond yields during the course of FY26 came down to as low as 6.1%. Clearly, this was brought down because of RBI's aggressive buying. Otherwise, you didn't have discretionary savings coming and saying, you know what, I want 6.1% interest rates. In fact, discretionary savings completely stayed away.

That's the other interesting part of our bond markets, Puja. There's a lot of buying of bonds that is done by captive sources, you know, banks, insurance companies, pension funds, the EPFO. Frankly, they have no choice but to buy bonds issued by the Government of India, simply because their mandate or the regulatory requirements require them to buy these bonds.

But even so, that buying by all these partly captive or entirely captive buyers was not enough to meet the entire supply of paper, which was being put in by both the central government as well as the state governments. In fact, through FY26, the centre and the states put together, they're borrowing as much as 27 lakh crores of gross borrowing. There were repayments as well.

So 27 lakh crores was a gross borrowing, which is a record high of all time. So the amount of paper they were supplying was huge, and the captive buyers was not enough to buy all of this. Now, what then needs to happen is discretionary buyers need to come, which means you and I need to decide and say, you know what, I'm okay to get this particular interest rate, so let me buy this bond.

But the reality is discretionary savings find that on a post-tax basis, the returns you get by investing in bonds or any fixed income for that matter is just ridiculously low. So a discretionary saver who's at the highest tax bracket has to pay 39%, let's call it 40%, inclusive of all surcharges, on every cent she makes on interest income or on fixed income investments. So if you're earning 7% and you're at the highest tax bracket, and remember, a lot of the discretionary savings are at the highest tax bracket, you're losing 2.8% to tax. So your net interest that after tax you get is 4.2%, which is simply not enough for a person who sees inflation, especially inflation, at a much higher level. So what therefore happens is your 6.1% or currently 10-year bond deal is 6.85%. That's not being determined by you and I saying that, you know what, this interest makes sense to me on a post-tax basis. And this is a good return for my inflation risk and my duration risk.

It's being determined by factors outside of us. And it's being set at a rate which is not where the free market is being determined by discretionary savers. Now, as you said, the RBI can do this, central banks around the world do this.

But there are consequences. There are multiple consequences that result when you decide to set aggressively rates at such a low level. First, your fixed income market does not develop because it's no longer a free market, which is being decided by free savers and free borrowers.

The rates are being set artificially low. And you know economics better than I do, Puja. So moment you set price controls on a particular product, you're effectively killing the development of that market.

Because why should supply come in? Why should that market develop at all? There might be a lot of demand for money at 6.85%. But guess what, nobody's willing to save money, especially when you have to work a counter or a huge amount of tax as well at that particular rate. So which means that the market doesn't develop automatically. Therefore, your fixed income markets tend to become suppressed and repressed in relation to other fear markets. Our equity markets are a lot more freer.

Because while we have a lot of regulations surrounding our equity markets, at least no government agency or regulator stands and says this is a free price at which you should dip. Prices are effectively dealt and agreed upon by willing buyers and willing sellers. That's not the case with our fixed income markets.

One statistic I track, Puja, is what is the size of the non-government credit in an economy as a percentage of the total equity market capitalisation of that economy? So how big is the credit market in relation to the equity market? India, the size of the non-governmental credit market, including loans, including corporate bonds, including NBFC lending to non-government corporates, all that put together, is 65% of our equity market capitalisation.

It's the lowest, Puja, anywhere in the world. In the US, which has a far bigger equity culture, the non-government credit market is 95% of market cap. In Italy, in France, in Germany, in South Korea, in Japan, middle-income or high-income countries with a large industrial base, credit markets are 125% to 195% of the market capitalisation, equity market capitalisation.

China, and let's not go there, is 310% of market capitalisation, the credit markets. But in India, we've managed to keep this credit market suppressed simply because we set rates at a very, very low level and then expect free markets to develop around it when you know that there are no real true savers coming at those particular rates. So that's one consequence, your credit markets tend to be underdeveloped.

The second consequence, which flows as a result of this, especially in a country where you have a K-shaped recovery and you have a lot of savings at the top portion of the K, where you have people who have discretionary savings, that savings will not go to fixed income, it will instead go to gold, it will go to overseas assets, it will go to real estate, and it will go to equity markets. And in fact, over the last 6-7 years, we've seen this bludgeoning of savings going into our equity markets. I would argue that a big reason for this flood to go into equity markets, there are plenty of reasons, including the success of this Mutual Fund Sahiya campaign.

But along with that, the fact is, discretionary savings simply does not see fixed income as a viable alternative. Because on a post-tax basis, and you remember, there were changes done to the taxation in 2023, where some SOPs that were available to fixed income debt funds, even those were removed, indexation was removed, right? So which means that there was simply no way you would put money into fixed income for your discretionary savings.

Instead, you have to chase other assets. And the one asset which seemed to make the most sense was equity markets. And you know, when I was in SEBI, Puja, we saw this regularly going through year after year, where the amount of money flowing into our equity markets from people like retail savers, through mutual funds, through pension funds, through insurance companies, or even directly, people going into the equity markets was just growing year after year after year.

Puja Mehra: In fact, SEBI issued warnings saying that there was fraud in the market.

Ananth Narayan: Yes, the then chairperson did make statements about the, especially in the mid cap and small cap indices, etc. But some of the numbers that we saw were really stark, Puja. So FY25, and I was still in SEBI, I remember the numbers very distinctly.

The flow from mutual funds, both through primary market and secondary markets seeking equity risk was 6.1 lakh crores. This was a record, it was almost twice as high as the previous record that we had seen. Okay.

Alongside that, you add insurance companies, pension funds, remember, EPFO and pension funds have also been increasing their exposure to equity markets and individuals are also putting in money. So pension funds, insurance companies, EPFO individuals was another 2.7 lakh crores of demand for equities, both through primary markets and secondary markets. So domestic demand for equity during FY25 was 8.8 lakh crores, a record high. This was again, twice as high as the previous high that we've seen. Against this, we saw 1.3 lakh crores of outflows from FBIs. That still left us with 7.5 lakh crores of demand for equity, both primary and secondary. This was a record 60% higher than the net demand we've seen in the past. Against that, we also had a record fresh supply of paper. So if I count all IPOs, FPOs, QIPs, rights issues, offer for sale, everything put together, that was 4.6 lakh crores. That was also a record. So, you know, record demand for paper, record supply of paper, that sounds like great for capital formation. It is.

But this gap that we saw between demand and supply of 2.9 lakh crores was also a record high. That gap was close to zero in FY20. It is steadily growing every year to reach a high of 2.9 lakh crores in FY25. Now, the question is, where is that gap being met from? Every demand has to have a supply. So what was happening was owners and promoters and strategic owners and companies were selling to meet this demand in the secondary market.

So effectively, you had owners reducing their stake and giving in to this demand for paper coming in from all of us put together. Now, to me, this was in part or at least in a large part being impacted by the fact that you and I did not see fixed income as a viable alternative to put money into. So therefore, we had to search for what looked like the best bet to beat inflation on a post-tax basis.

Therefore, you put money into equity markets. And that in turn creates pockets of overvaluation in equities. We shouldn't be surprised by this.

If you have too much of demand for paper, of course, supply does come in eventually. And today, we are seeing a lot of supply coming in, new IPOs coming in, etc. But a couple of things happen.

One is, a lot of the supply is not creation of greenfield new projects. It is essentially owners encashing out and saying, you know what, these valuations make a lot of sense to me. Let me cash in and take my money.

We also saw foreign owners, Korean large auto manufacturers, for instance, doing IPOs of their subsidiaries in India, because they were getting seven to eight times the valuation they would get in Korea for the stake in India. So you ended up after the IPO of their Indian stock being worth 40% of their market cap, whereas their Indian sales are only accounting for 5% of their global sales.

Puja Mehra: As trains for a capital short country, we don't have so much capital.

Ananth Narayan: To me, Puja, you're right. It's a sign that we were sort of breeding inefficiencies into our equity capital market. Now, I won't beat ourselves too much about it.

Because you know, you never get perfection of demand and supply meeting itself at every point in time. There are always needs and lags, you can't expect perfection. And we are a growing economy.

And frankly, this growing capital markets is a great sign. But a few things are going wrong. One, you are seeing a lot of money going in not because people were discerning value and there was a, you know, risk based allocation happening to equities, or there was a valuation based asset allocation happening to equities.

It was going there because tax was deciding where do I put my money. If there was a level playing field where the same taxation applied to interest income versus in bits and reads versus real estate versus equity, then you could argue that collectively we decide which is an asset class which deserves our money at what price. That was not determining in this particular case.

Here we had no choice but to pour money into equities because that seemed like the only bet to beat inflation on a post tax basis. Second, remember, there are lots of restrictions on us investing overseas. Yes, we have LRS, but the normal human being cannot take advantage of LRS because you know, you need to be a certain HNI to be able to open an account globally and take out money and invest there.

Not every bank in Singapore is going to open an account for you if you're not of a particular size. And secondly, there are restrictions on how much mutual funds in India can invest overseas. There's a $7 billion limit, which has not been increased for many, many years.

So if people are looking to invest in overseas assets, including in NASDAQ, including in FTSE, including in global, you know, MSCI global, you simply couldn't. So you are forcing the money to go into equity capital markets in India. And, you know, this is a analogy I like to draw with our own trade ecosystem.

So for instance, if you have a large trade imbalance, and if you have a large trade deficit, one way to say I'll address this is by saying ban imports. So make yourself atma nirbhara or whatever and make everything in India, right? Now, when you do that, that sounds like a great idea, except you end up with a very inefficient domestic industry, you will end up with ambassador cars and fiat cars and premium but because the global cars can't be made in India, which is, you know, it's a captive market for domestic producers.

But you can't export because your quality simply is not there for you to export, which means in a bid to stop yourself and protect yourself from imports, you end up with a situation where you can't export anything because your markets are not efficient enough, right? I'm saying there's an analogy with that with our domestic capital markets as well. If you protect your capital markets, and you say, you know what, you have to pour money only here, and I'm going to make sure that you can't take the money and put it somewhere else.

You end up making these markets part of it at least inefficient. And you end up therefore making it difficult for others to bring in money into the country. You know, Puja, I have seen several global investors, I've been in foreign banks myself many years ago, I still have friends in the investing community globally.

Many of them and most of them like India, they like the fire in the belly in India, they know that there is a lot of willingness and ambition to do things in India. They like companies as well. Except when they see the valuations of some of these companies, they say, you know what, I can't put money at these valuations.

So the companies they like, if they're quoting at price earnings of 60 and 70 and 80, they've got to think really hard before they bring in money into these markets. On the contrary, many of these guys, even if they like these companies, they say it's a great time for me to exit. Because the valuations are offering me such huge premiums over what I expect, right?

So people who brought in money as private equity 15 years ago, if you're getting fantastic exits, even though you left the company, your primary markets are giving you fantastic exits, even your private markets. Now that the AIF, the alternate investment funding ecosystem is growing a lot, there is a lot of domestic money searching for unlisted paper as well. So you suddenly have a situation where I'm getting very good valuations to exit.

So therefore, it should not come as a surprise that FDI and FPI struggle to come in and net FDI, FPI actually go out rather than come in. And here is the beauty Puja, you're suppressing interest rates, and keeping rates very, very low has pushed money into equity markets, made the valuation so expensive there, that net capital flows struggle to come in. Because your bond markets are overvalued, thanks to RBI, your equity markets are overvalued, thanks to retail money pouring in there.

Where do you expect foreigners to come in? So my broader point is, the unintended consequences, for the best of reason saying, let me keep interest rates low and give growth a chance, you end up with a very distorted capital market ecosystem, where foreign investment struggles to come into the country. And therefore, that causes problems on the external front for you.

Last year, FY26, as you well know, our current account deficit was just 0.6% of GDP. That's a tiny number compared to the 2% average that we've seen over the last 25 years. Yet we even struggled to meet that through our capital flows, which you know, it just boggles the mind that we couldn't even get 0.6% of net FDI and net FDI put together, as capital inflows into the country. I'm saying, there is a deep nexus between the fact that you have sat on interest rates and kept the interest rates repressed, and therefore pushed money into equity markets and kept valuations outsized out there, making it very difficult for flows to come in. It doesn't stop there, Puja. This is only one way in which the FX market is impacted through lower interest rates.

There are other ways as well. Think of HNI sitting in India, and look at the current context. Your 10-year US treasury is 4.7%. Your 10-year Indian government bond is 6.85%. Both are risk-free, correct? Many HNIs will say, you know what, a 2.1% differential or 2.1-2.2% differential, I'd rather hold a hard currency and earn that 4.7% than hold rupee and earn 6.85%. So do not be surprised if even today, a lot of people decide to take out money through LRS, through GiftCity, through ODI, through that is overseas direct investments, and invest overseas rather than investing in India, simply because your differentials are so low.

So once you've kept your interest rates in India very low at a time when global interest rates are going up, you're purely asking domestic investors to seriously think about taking money and investing it overseas. And money, with all the restrictions you put in, money still finds its own level, which means ODI, outward direct investments, can remain on the higher side, again making net FDI a problem. That's the second way in which these flows can again be a problem.

Third, when you keep interest rates low in India, and therefore your differentials between global interest rates and Indian rates are very, very low, you're making it cheaper in the currency market for anybody to buy forward dollars as opposed to sell forward dollars. Because as you well know, the price of forward dollars, so one-year forward dollars, if I need to buy dollars one year from now, that's a function of where the spot rate is, where the current spot dollar rupee is, and it's a function of the differential between the interest rate and the dollar interest rates. Of course, you can argue that interest rate parity does not work perfectly in India.

That's true. But nevertheless, it's guided by the interest rate parity. So which means, if my interest rate differential is only 2.5%, 3% as it is today, and therefore I can buy dollars one year forward by just paying a 3% premium over the current spot rate. Remember, at the time in FY26, rupee was weakening by 1-2% every month. So if I could buy one-year forward dollars for a 2% or 2.5% premium, it seemed like a great bet. Now, it's not just speculators who end up buying dollars, therefore.

People who have taken ECBs, external commercial borrowings, and have liabilities in dollars. Hedging that makes a lot of sense if you can buy forward dollars at just 2% per annum. Similarly, for a foreigner who is invested in India and is holding rupee assets, buying dollars as a hedge against your rupee assets seems like a great idea.

And of course, speculators as well. If you think that, you know what, I can buy forward dollars at 2% premium over the current spot market, and here is rupee going from 83 to 85 to 87 to 89 practically every month, this sounds like a great bet again. And we saw all of that happening.

In fact, you know, one metric I am fond of quoting, Puja, during FY25 and FY26 two years, the RBI sold $192 billion in the spot and forward markets put together. This is data available from the RBI own monthly bulletins on they give exactly how much have they intervened in the spot market, how much is the forward book changing by. So if you put the two together, you can figure out how much they've intervened across spot and forward markets.

So $192 billion is what RBI sold to protect the rupee between FY25 and FY26. If I take all the outflows that you can explain through the current account deficit, which was remember only 0.6% of GDP last year, and the net FDI and the net FDI, all of that put together was only $75 billion. So who was buying the remaining $117 billion?

I would argue that that $117 billion, which is higher than the 75 of FDI plus FDI plus current account deficit was either hedging demand for dollars or speculative demand for dollars. And I'm saying that was instigated by the fact that your interest rate differentials were so low that it was so cheap to buy forward dollars. So therefore, you saw this tremendous buying of dollars coming through not because you were only facing a current account deficit and FDI was taking out money, but it went far beyond that because speculators and hedgers came in and drove, taking advantage of the fact that you've kept rupee interest rates low to buy cheap forward dollars.

So long story short, when you sit on interest rates and keep interest rates low, multiple things happen. One, you overvalue your equity markets because you've made the fixed income a complete stepchild for asset allocation. Once you overvalue your equity markets, money struggles to come in.

Even willing investors suddenly say that these valuations do not make sense for me. Second, sitting inside India, domestic investors start thinking about should I take some money and invest overseas? If my differential between the US treasuries and Indian rupee rates is only 2%, am I better off earning 2% less in a hard currency than worrying about earning money in rupees?

Third, if the differential is so low for hedgers and speculators as well, it's far easier to buy dollars in the forward market than for exporters to sell in the forward market. It's a lot more lucrative for importers, for hedgers, and for speculators against the rupee. And we've seen all of this playing out.

So because you sat on interest rates amongst other things, of course there are other reasons as well, because you sat on interest rates, you suddenly saw yourself facing a flood of dollars going out of the system. And then we seem to be very surprised saying, oh my god, what's happening in the currency markets? And then you would continue to say that, you know what, I have to treat my interest rate markets as a separate compartment.

I have to treat my FX market as a separate compartment. So because you sat and you bought 8.8 lakh crores of bonds in FY26 and 12 lakh crores across FY25 and FY26, you suddenly had outflows on the dollar side. And therefore, you had to sell $192 billion on the currency market to try and protect the rupee.

So you are causing rupee weakness on one side through your interest rate action. And then you are forced to sell lots of dollars to try and protect the rupee. And you're pouring dollars into this leaky bucket and then wondering why is there so many leaks in the bucket.

Puja Mehra: And the best is that you also go after speculators in ways which are so crude and off-market that you have to eventually take steps back, retreat from all of those kinds of measures. So do you think it's a reluctance to just accept that this is how markets work or what's really at play? Because these are new features, markets always behave like this.

Why have things become so exaggerated in recent times?

Ananth Narayan: So Puja, it doesn't stop there, the horror story. You mentioned one part of the horror story which is the fact that you went after speculators etc. I don't have such a big problem with that to be honest.

But let's keep that aside. The horror story is as follows. You found yourself keeping interest rates low and then you suddenly found yourself having this leaky bucket on the currency front.

And this was before the Iran war broke out. Remember dollar rupee had crossed 92 well before Feb 28, right? So you were already having this problem and then the Iran war broke out which meant all hell broke loose all over again and oil prices were suddenly up etc.

Then what do you end up doing? You announce this huge subsidised FX swap to bring in foreign currency into the country by offering this massive subsidy of 3% per annum for three years to five years which comes at a tremendous cost which means you are actually cutting checks and incentivising foreign investors, foreign NRI savers and foreign banks to bring in dollars into the country and estimates of this cost is 10 to 11 billion dollars and there are reports saying this is a very small number. I don't know when 10-11 billion dollars became a small number. It's not a small number.

Now what are you doing? You are effectively giving a subsidy which was being monetised immediately by these foreign savers because you're not willing to provide market savings to your own savers in India. Instead you're providing a subsidy to foreigners saying please put money at 6% 6 and a quarter percent leverage take it up to 14% dollar returns for India.

I mean this is ludicrous. So yes we have an impossible trinity and to come back to what you asked right in the beginning, what do we see? We are seeing that interest rates, capital flows and currency markets are deeply intertwined.

This is going well beyond the Mandel-Fleming impossible trinity which is a classical one. Let's keep that theoretical part and the academic part outside. My simple proposition is interest rates, capital flows and currency markets are deeply intertwined.

You intervene deeply in the interest rate markets to start with and don't blame the MPC. This was the RPI consciously deciding to buy bonds and droves. It's not the MPC and you sat on the interest rates that created a natural compact and the impact on the capital flows and on the currency markets and then you intervene by selling huge amount of dollars into the currency market trying to manage you know the flame whack-a-mole and trying to hit all these moles coming out of all these holes and then eventually you offer this massive subsidy for foreigners to get in these capital flows to plug the trilemma by getting subsidised dollars into the country. I don't know what 885 billion dollars which will come in eventually by 31st of August right.

So you're intervening in all markets and the question you have to ask yourself is, is it really worth it? I'm not saying don't intervene but is somebody taking a holistic view and seeing what the hell is happening and does it make sense for sustained capital formation in this country?

Puja Mehra: What are we gaining and at what price?

Ananth Narayan: Exactly. So I put it to you that here is what I would suggest. First, I think we should take a deep breath and acknowledge the interconnections between the markets.

Let's go beyond the theoretical economic textbooks and all that. Markets are interconnected. Ask anybody who's traded in markets.

Ask anybody who's an exporter and importer dealing in currency markets. Everybody will tell you that these are completely intertwined. Do not treat them as separate compartments where each is acting in a vacuum.

You're not acting in a vacuum. It's all interconnected right. Now here is my second proposition.

Second proposition is of course you should retain the right to intervene. In emerging markets, markets often fail. Markets often have asymmetry of information.

Markets sometimes go into this complete dizzy of a spiral of negative feedback and sometimes it's important for policymakers to step in and calm things down. That's absolutely required. Do not be textbookish about saying I'll never intervene.

But to start with, allowing markets to function is a great starting point. If you allowed your interest rate markets to function free where savers and borrowers, willing savers, willing borrowers determine where the interest rates are, chances are that your other markets would therefore become a lot more freer and natural and well-balanced as well. The flows going into equity markets would be tempered by people deciding which makes more sense.

For instance, if you told me that you're offering me 7% fixed deposit rates on a post-tax basis, I know I would take out money from equity allocations and put them into debt. I'm a cauterised eating conservative guy and I would love to do that. So I'm sure most people would start doing that rather than allowing tax to determine where I put in my money.

So if you had a freer interest rate market, you would probably have a freer equity market. Of course, there are thousands of other variables, including the AI story, including what's happening in Korea, all of those things. But I'm saying this is a great part of that equation as well.

And once you have stability in the interest rate markets and equity markets, I'm saying capital flows will make sure that your rupee intervention comes down as well. You don't need to intervene. Things will find its own stability.

Now, this is not to say markets are God and everything will be hunky-dory the moment you allow markets to be free. As I said, you have to be prepared to intervene. But if at all you have to intervene, you start with as free markets as possible.

Then you tinker around the edges. And when you tinker around the edges, be mindful of what the consequences on a holistic basis are likely to be. Do not assume that you're intervening only in one market.

There will be inevitable repercussions on other markets as well. I think it's extremely important that policymakers understand financial markets alongside understanding the theory of monetary policy and currency policy, etc. Make sure that you listen to the markets, you listen to market participants, you listen to the theoretical economists who are giving you the framework.

Put the whole thing together. Look at it in totality rather than trying to do things in a piecemeal manner. And I think if you go with the broader principle of allowing markets to be as free as possible at the margin, you will end up with a much more stable equilibrium, which is conducive for sustained capital formation than what you have today.

What I would also suggest, Puja, is now I know that if you allow interest rates to be determined by actual free markets, rates would probably be a lot higher than where they are currently. And that might not be to our liking. And I agree with that supposition that we have to give credit growth a chance.

Many of our SMEs really are struggling to get credit, and therefore you've got to give them a better shot at capital formation. Then change the taxation. If you move to a situation where this huge anomaly between interest rate taxation being so high and equity taxation at least optically being so low, if you at least remove that anomaly and bring it to a more even keel, as I said, you don't want taxation to determine asset allocation.

It should be based on risk perception and return perception. For instance, if you said interest income will be taxed at a maximum slab rate of 20% or lower, if you're a lower slab rate. If you said that capital gains and fixed income would be subject to the same capital gains in equity markets, which is beyond one year, you pay 12.5% on whatever your capital gains is. If you brought things to an even keel, you would allow for rates to remain low. At the same time, you would have interest rate markets on a much more sustained basis under free conditions, rather than RBI having to sit on it or FCRB funds coming into banks, forcing the interest rates to be low, as is going to be the case over the next one year. You won't have RBI intervention, but you have all this cheap money which banks are sitting on, which will keep interest rates low.

Again, it's not free discretionary savings, keeping the interest rates low. Instead, if you allowed for that, interest rates could be low if you change your taxation. For God's sake, don't increase the taxation on equities.

India is a capital-served country. Do not try to change this anomaly by raising the taxation on equities. That would be a disaster for us.

We need capital formation. Do not kill the goose that's laying the golden eggs. Bring down the capital gains tax on fixed income.

By the way, you won't lose much because discretionary savings anyway is not going to fixed income, which means nobody is paying capital gain or paying any tax on fixed income. Instead, people will start paying tax on 12.5% or whatever reasonable tax is on fixed income. You will see interest rate markets stabilise at some equilibrium, which makes sense.

You will see equity markets stabilise at levels which make sense. You will see capital flows much more incentivised to come in because the markets now are standing on their own without being propped by some anomaly here or the other. I would go one step ahead.

I would say, allow Indians to invest overseas through the mutual funds. Increase that $7 billion limit to buy $1 billion every month over the next 12 months. Take it up to $20 billion.

Of course, money will flow out. But guess what? If you allow markets to be efficient because people choose and have the choice of investing in different markets, you will ensure your domestic markets are efficient and you will get in money.

You will actually be letting some money out to bring money in. That's the only way you can bring it on a sustained basis that people know it's being sustained by true market forces rather than by anomalies. I think less intervention, less of this tax imbalance against fixed income, more freer savings avenues for domestic savers actually can lead to a far more sustained capital formation in this country, which is one way of saying allow the impossible trinity to do its work.