V. Anantha Nageswaran on Surveying the Growth and Financialization of the Indian Economy

SHRUTI RAJAGOPALAN: Welcome to Ideas of India, where we examine the academic ideas that can propel India forward. My name is Shruti Rajagopalan, and I am a senior research fellow at the Mercatus Center at George Mason University.

Today my guest is Dr. V Anantha Nageswaran, who is currently serving as the Chief Economic Advisor to the Government of India. He is also the co-author of the books Economics of Derivatives and The Rise of Finance: Causes, Consequences and Cures. 

We talked about import substitution and strategic resilience, futures and options market, gross fixed capital formation, crypto markets, India’s growth trajectory, and much more.

For a full transcript of this conversation, including helpful links of all the references mentioned, click the link in the show notes or visit mercatus.org/podcasts.

Anantha Nageswaran, welcome to the podcast. I'm so thrilled to have this conversation with you.

ANANTHA NAGESWARAN: Likewise. My pleasure, Shruti.

RAJAGOPALAN: I've been reading you for a really long time, and I feel like I've seen some of your views change. Though you've been remarkably consistent in your overall view of how the Indian economy has both performed and how you view it going in the future. I wanted to take a starting point. For me, the easiest was your lovely paper with Gulzar Natarajan in 2016, the one you wrote for Carnegie.

One, both of you were remarkably prescient about the changes that were coming 10 years ago. You diagnosed India's growth challenge as a structural problem, more than just a demand side or a supply side problem. You talked about the missing middle. You talked about the importance of medium-sized firms, the narrow industrial base, state capacity as a major binding constraint. You started looking at external factors. It was almost like a cautionary note that we need to temper our growth expectations.

When I read what you recommended in that paper and your four economic surveys, in your diagnostics and prescriptions, both sides are remarkably consistent, the emphasis on institutions, on federalism, the missing middle, state capacity, deregulation, all of it. The one place where the arc has changed quite significantly is on industrial policy and import substitution.

Import Substitution as a Policy 

In the 2016 paper, both of you quite explicitly said that India should still steer clear of state-led import substitution. The latest economic survey is quite a departure from that view, but you phrased it very differently. You talk about it as strategic resilience, not in the context of “Industrial policy gets us the greatest growth,” which was the whole debate 10 years ago. One, what shifted your thinking on this? What is a good way to think about this in terms of Indian policy going forward?

NAGESWARAN: As they say in the Indian game of cricket, especially in the T20 matches, you hit the first ball for six, and that's what you have done. You have hit the first ball for six straight away and gone straight into the game. That monograph that Gulzar and I wrote, Can India Grow?, I think you are right on that particular dimension. We have shifted. Not we, I should say, I. I have shifted my position. That has got largely to do with how the global political cycle has shifted. Both economic and political cycles have shifted.

A hallmark of an economist, or an open-minded economist, or what John Maynard Keynes once described what the ideal economist is, and it's a very beautiful description. He's part-philosopher, part man-on-the-ground, comfortable with the abstract, comfortable with the general, the specific, everything. I think one of the things which I don't know if he said it or not is to be able to adjust your attitude to policy-making in the context of changing context. That's what happened with me on this industrial policy thing.

Globalization was a cycle which lasted from, let's say, maybe 1980 until you might say 2015. Give or take a year, people can disagree on that. Let's say about three plus decades in this case. Then now we have shifted to a phase where countries are weaponizing supply chain, prioritizing domestic production, markets are no longer being neutral, and companies are forced to respond to what their governments tell them to do, whom to sell, whom not to sell, from whom you accept investments, etc.

Second, during COVID, if you remember, even Germany initially was hesitant to supply personal protection equipment to fellow European Union or European single currency members. That was a revelation to a lot of people. As they say, “In a foxhole, there are no atheists.” Similarly, in a crisis, there are no free marketeers, maybe. That's exactly what happened. Maybe there are no globalizers. Every country wants to look after itself and its own people. That has only become stronger and stronger, that tendency over the years. Unfortunately, it is going to remain strong or get even stronger. We haven't seen the full weaponization of capital markets, money markets, etc.

It is for that reason that we said, “Look, countries have to indigenize. Markets will not supply you everything you want.” Even the smallest of ingredients can be weaponized. We saw that in the case of permanent magnets. It could happen for active pharma ingredients, it could happen for food, fertilizer, you name it. There is a need, therefore, for countries to prioritize what is both feasible and urgent or important from a national development aspiration perspective. 

RAJAGOPALAN: Here, if I were to think very much like a narrow economist, to me, the question would be: let's say the old order was correct. That is, globalization leads to fast export-led economic growth, and import substitution is a bad recipe for export-led economic growth. If I had to look at it in the context of resilience, my automatic question would be, Am I willing to trade off so many percentage points of export-led economic growth for more resilience?

Is that the appropriate way of thinking about it, or is it that in a crisis, there is no real trade-off that's presented to you? We are making this up as we go along, while also simultaneously not just focusing on tariff policy, but building a whole other set of things as we go—deregulation, PLI schemes. There's a basket of policy instruments that you have for indigenization, which is not just import substitution based on tariffs. What's a good way to think about that?

NAGESWARAN: Again, a very well-crafted question. The thing is, first of all, import substitution or indigenization, if it is done properly—and that is what we write about in The Economic Survey 2025-26—isn't incompatible at all with export orientation or quality export competitiveness. All those things have to be there. It's about choosing the areas where you have to indigenize, where you can afford to. In fact, in The Economic Survey in Chapter 16, we have given a two-by-two matrix of what is feasible and what is desirable. If it is high feasibility but low desirability, let the market decide. The state doesn't have to intervene.

Where it is both feasible and highly desirable, or urgent, from a national security perspective, then, of course, the state has to actively encourage and catalyze particular production. One is, they are not mutually exclusive, in my opinion. It's about choosing the sectors or the product areas where you want to do this. The second thing is, you asked, “Am I willing to sacrifice a certain percentage points or basis points of growth for strategic resilience?” I would look at it this way. You are assuming, therefore, in the current global context, by doing this, I will be sacrificing growth. I even question that very premise. If I stick to that approach, I may be sacrificing more growth in the current context.

RAJAGOPALAN: Fair.

NAGESWARAN: I think, therefore, it's a question of figuring out which one is going to force you into a greater growth sacrifice.

RAJAGOPALAN: You think that the higher growth trajectory is very much compatible with some strategic import substitution as long as you combine it with PLI schemes, deregulation, and all these other things. 

On that, the second part of my question was, you have long held the view that we can have PLI schemes as long as we are willing to let go of the poor-performing candidates and support the better candidates. There needs to be a very different relationship between the government and private enterprise, one which is not parasitical.

Usually, India's political economy ends up towards that cronyism, parasitical state, which is also something, again, going back to the 2016 monograph that you had with Gulzar, warned us about. What is a way to fundamentally reset that? It's very hard to do that when we are building resilience, because resilience also means that when corporate firms are sinking because of tariffs or something, we need to immediately inject support.

NAGESWARAN: Look, again, first of all, in an ideal world where you are able to completely avoid some of the attendant collateral package with which these policies come, some of it is inevitable. Obviously, in a vast majority of cases, you should be able to support and yet demand, in return for that support, a certain quid pro quo obligation on the part of the industry in terms of productivity, growth, investment in research and development, innovation, commitment to quality, and export competitiveness. Of course, countries have done that.

We know from Joe Studwell's How Asia Works, where he clearly points out that Korea did not reward its performers as much as it punished its non-performers. To some extent, we are doing that indirectly, to start with, by entering into free trade agreements with so many regions and countries and agreeing to lower import duties in the wake of such agreements.Therefore, you are exposing the industry to competition from imports by lowering the import duties. That's a protective barrier we had given, which we are now withdrawing.

That is one clear sign that the state is willing to subject the corporate sector or the commercial sector to the competitive pressures of foreign goods. I think that's one exact concrete manifestation of how you do this in the manner in which it actually boosts economic growth and potential growth as well.

RAJAGOPALAN: I completely agree that now there is a set of levers. It's not one lever or button we press at a time. Things have become quite complex. The Indian economy is much more complex than it was during the command-and-control days. It's a question of how finally we can pull these different levers together. 

Indian States’ Spending Problem

One of my favorite parts of your most recent economic survey is just how starkly you have described the expenditure at the state level. This has been a longstanding problem in India, where almost 60% of the state expenditure goes towards payroll, pension, and welfare transfers. The welfare transfers have really become rampant. Every election cycle, and now we have more and more of them, there are welfare transfers announced. You rightly point out that it's very difficult to roll these back as a political economy question. It is crowding out capital formation, and it is crowding out expenditure that could happen in long-term human capital formation, which includes health and education.

On these things, you're very clear. The part where I have the question is what are some of the mechanisms that the union government may have to start disciplining the states? The normal way I would think about disciplining the states is: get their balance sheets in order, have a thicker and more liquid bond market where they're actually ranked on their performance, and so on. That's not the world we live in at all. While it's very important to develop those markets, what are some of the levers we have in the short term, which are not just finance commission levers going from 40% to 42% to 48%, or whatever we are tweaking there.

NAGESWARAN: First of all, to talk of union government's levers when it comes to getting the states right. Before I get there, I want to make one small but important clarification. It is not exactly crowding out the private sector. It is crowding out capital expenditure on the part of the states themselves.

RAJAGOPALAN: Yes, but I thought you also pointed out that the state CAPEX will also encourage private CAPEX.

NAGESWARAN: Absolutely. To that extent, you can say that it's an opportunity loss. Not so much as active crowding out.

RAJAGOPALAN: Fair enough.

NAGESWARAN: It is definitely crowding out human capital formation in the states, because you are not spending on things which would have a long-term multiplier by just giving them cash for current expenditure. That's the first clarification I wanted to make. 

Now, in a federal setup—in a democratic setup, in a very competitive political space—even if the union government has certain levers to pull, pulling those levers is not particularly easy. It is sensitive. It's very difficult to think of situations where the union government would act as a very neutral arbiter. Just as today, in the global context, the institutions do reflect the power balance.

The same thing happens in a domestic context as well as in a federal setup like India. The institutional arrangement will reflect the power balance, and to the extent that they reflect the power balance, objectivity and even-handedness will be questioned, regardless of whether they are applied correctly or not. Then you have to come up with stripping away the cyclical contextual fluctuations over which the state may not have control over. Therefore, you must be able to isolate exactly where discretionary policy has contributed to fiscal slippage and all the attendant side effects, etc. How do you do that? 

Conceptually, you and I may agree on it, but practically, you will have all of these design issues. Nonetheless, Article 293 is there, where states are taking loans from the union government. The union government has the ability to impose certain conditions on their borrowing, how they spend the money, etc. I think the union governments over the years haven't really utilized that. Maybe now it is becoming more and more binding, and the thought of it is probably occurring in people's minds more often than they used to, given the extent of unconditional cash transfers going on.

I suppose slowly the market is now beginning to do that job. I can see that several of the states are not having the same bond yield or cost of borrowing as they used to, indistinguishable from the union government's cost of borrowing. That is no longer the case. Some states are now paying 70 to 80 basis points or even 100 basis points more than what the union government is paying. I think that is a welcome step.

The other thing is, I think as in human lives at some point, if there is some kind of major triggering event or a crisis where they are unable to meet some bills or payments, etc., if some state arrives at that situation, I think that will be an important trigger for reforms to happen, not just in that particular state, but also in several other similarly positioned states. I think we need to wait for that kind of situation to arise. As is always the case, crisis will be the important trigger and catalyst for this particular reform, which is quite important.

RAJAGOPALAN: One way is the crisis that forces the reform. If I were to look at some of the other chapters you have in the survey on urbanization, on strengthening local government user fees, on property taxes, and so on. Now I'm wearing my George Mason/public choice/public finance hat. The tighter the relationship is between the tax policy and the expenditure, the higher the quality that is typically generated. Some of those may also be good disciplining mechanisms if the states start generating more of their own state revenue instead of relying on transfers.

Isn't that a tool that the union government has at its disposal? I know the 73^rd and 74^th Amendments didn't allow for automatic devolution and so on, but aren't there other ways to push this through, especially given how much attention you have paid on urbanization and the role of cities?

NAGESWARAN: No, I think there's the recovery of user charges, economic costs being recovered from the users. I think the union government, over the years, when it comes to the special assistance scheme for capital investment, SASCI, etc. during the post-COVID years—when they allowed state governments extra borrowing limits—have sought to impose certain performance conditions on them. For example, smart metering, compulsory metering for power consumption, etc.

I think recovery of user charges for water, etc., is also beginning to happen very slowly. Of course, we can say that the pace should be faster, but then people outside, or people who are not exactly weighing the political economy, the costs and benefits, will be able to say how fast it should be, but the reality is a different situation. I think it will happen, but your point is conceptually very well taken. That is the direction in which we should be moving: recovery of user charges. The states are actually still leaving a lot of money on the table. I agree with you. That is an area where we have to constantly keep plugging away for that to happen.

Capital Formation

RAJAGOPALAN: Another area which has concerned me, and I've been thinking about this, I feel like for almost 15 years, is gross fixed capital formation. Gross fixed capital formation has been stable when we think of it as a percentage of GDP, but the composition has changed. More and more of it is government contribution towards CAPEX and fixed capital formation. The private CAPEX has actually declined. This is a little bit odd because when it first started declining, balance sheets were a mess. There was an NPA crisis with the banks, and that obviously trickled into corporates and so on.

When I look at what's happening with corporate balance sheets today, they are incredibly robust. What is going on with Indian corporates that there isn't private CAPEX and contribution towards the private gross fixed capital formation, and the government plugging that gap has not encouraged much movement? One way of thinking about it, maybe the government filling in is only going to take a longer time for private sector to catch up. Another is maybe wages lag behind profits. There needs to be more demand-side boost. Actually, all these welfare entitlements and transfers should plug some of that gap.

NAGESWARAN: To some extent, help. Yes.

RAJAGOPALAN: What do you think is going on with Indian private CAPEX and private gross fixed capital formation?

NAGESWARAN: No. In fact, you are right to say that if there is some usefulness that is arising out of the unconditional cash transfers, it is their contribution to the current aggregate demand, current private consumption. That, to some extent, does add to the demand visibility. Point well taken. 

You are right. In the second decade of this millennium, capital formation by the private sector slipped because there was excess investment in the years leading up to the global financial crisis due to the global boom—India also benefited from that, and then it continued for a few more years after the global crisis ended. Then came the payback.

Many of those investments became unviable because the kind of growth rates that were expected globally and in India did not materialize, and therefore became non-performing assets. That naturally led to the focus on balance sheet repair in the corporate sector and in the banking sector. And gross fixed capital formation ratio in the country, in the aggregate, came down by almost 10 percentage points. Even real estate sector was going through its own restructuring issues.

Then, as you said, by the time COVID arrived, I think the bank balance sheets had been fixed, recapitalized, corporates had finished repairing their balance sheets. Had COVID not occurred, I think maybe, and with the Government of India cutting corporate income tax in the September 2019 Budget after they came back to office, it might have paved the way for a big recovery in private sector capex.

Then COVID happened, and immediately, the Russia-Ukraine war started, which contributed to about five months of oil price increase, supply chain disruptions in semiconductor chips, etc. More importantly, I think the excess capacity in China and the deflation that is coming out of that are the biggest concerns because it is not happening only to India. If you look at what is happening to gross fixed capital formation in Thailand, Indonesia, etc., they have been hollowed out. I think they are even lower than India's, and much of it has to do with this export competition.

In the face of such aggressive pricing, and I think since China has not done much about its domestic demand for whatever reason post-COVID and the economy is pretty much running, to some extent, on fiscal policy stimulus because they are running a huge fiscal deficit by their standards and the external sector growth, it is effectively sucking out domestic demand from other places. Naturally, in that situation, there is reluctance to commit capital to the ground. On top of that, you can superimpose restrictive trade policies being followed by several countries and the lack of visibility of external demand, etc.

I think, therefore, putting these things together, in spite of that, I still feel that post-COVID, Indian financial years 2021-22 and 2022-23 saw a pretty decent pickup in private sector capital formation. 2023-24 has been muted, very muted in fact. 2024-25 saw a big improvement as we saw in the recent data that the ministerial statistics released around the end of February. We will have to wait and see what happens in 2025-26. It is not exactly a full disappointment. It is a partial disappointment, but in the context of what is happening elsewhere, I would say overall gross fixed capital formation rate of about 32% of GDP in current prices in India, I think it is a pretty respectable number.

RAJAGOPALAN: Again, my issue is not with the overall number.

NAGESWARAN: I understand. It's the private sector.

RAJAGOPALAN: It is more private sector. The very textbook way of thinking about when private sector fixed capital formation dips, is either there is a lot of global or domestic uncertainty. Or expectations are there is going to be low growth. While the former is true, actually India's growth numbers have been quite robust, which is one of the reasons I wonder about it. 

You definitely talk to a lot more people from industry than I do. One of the murmurs I keep hearing is domestic uncertainty, which is the changes in GST rates, maybe a new PLI scheme will be announced, and that will help us. I feel like all different sectors in Indian industry are waiting for a tailor-made PLI scheme. Is there a way to send a signal to private sector saying, "Hey, this is on you. You got to figure this out yourself, there are no more schemes coming”?

NAGESWARAN: Absolutely, you are right. Because when they talk about some of the policy uncertainties, and I must confess my surprise, because when India had very high private sector investment rates in the first decade of the millennium, I am sure you could have written much more about policy uncertainty and policy being less supportive at that point, obviously. If anything, at the margin, the policy change in the intervening two decades has been more in the direction of reducing uncertainty, increasing predictability, and making them more commercial-friendly, business-friendly, etc.

The direction of movement is in their favor. Obviously, that is not the marginal explanation. The marginal explanation for this marginal phenomenon could be, one is uncertainty globally. Partly, you must account for the fact that generational changes in the business families may also lead to less appetite for real investment, but more appetite for financial investment. That is also happening. Obviously, they will not say that. Therefore, it is very easy to externalize the problem. That is also part of the explanation.

Again, as I said, this is happening across the board, developed or developing countries. Declining manufacturing investment is becoming a challenge, and partly because of the supply chain weaponization we spoke about. And excess capacity in one particular country, exerting its own deflationary pressure and reducing the financial viability of capital investments in other countries. These are all the factors. I think I am somewhat reconciled to a gradual pickup rather than a robust pickup in private sector capital formation.

Increasing Financialization 

RAJAGOPALAN: Gradual pickup, I will take, to be very honest. At this point, any pickup, I will take. You mentioned something interesting about how the next generation of the corporate families are now looking more and more towards financialization as opposed to brick-and-mortar investments. This is a broader trend in India. You are my go-to expert when it comes to the link between the financial markets and the underlying old sectors of the economy. If you do not mind, I have a bunch of questions on that. You have written two books on derivatives, so I feel like you are the right person to ask.

Maybe we can start with one of the older sectors, which is agriculture. The broad theme in both your books on derivatives have been that the core economic function of things like futures markets, and of developing futures markets, is risk management for both producers and consumers, especially those in very volatile price situations. Now, Indian agriculture has this chronic problem of price volatility. A lot of these instruments, especially futures markets, could address it, but they have also been actively suppressed.

The government has banned futures trading in at least seven major agricultural commodities. This is wheat, mustard, soybean, channa, oil, and that ban since 2021 extends till today. Simultaneously, if I look at the surveys, you have acknowledged the fiscal burden of MSPs [Minimum Support Prices] and procurement and how a lot of the demand for MSPs is to get over this volatility in the market, right?

NAGESWARAN: Obviously, it has to be a price insurance function.

RAJAGOPALAN: Exactly. Why are we not able to swap this out, actually use the financial markets and futures markets to smooth out that volatility, and maybe not overnight take away MSP, but maybe eclipse it out, 10% lesser each year or something like that.

NAGESWARAN: I agree.

RAJAGOPALAN: What is a good way to think about this? I'm not asking you to defend the government's position on why they've banned futures trading on this, but what is the trade-off that people are worried about? They must be worried about something when they've placed this kind of outright ban.

NAGESWARAN: I suppose it's sometimes a lack of familiarity and comfort and fear of the unknown more than anything very specific or concrete. An MSP is pretty much straightforward, guaranteed, it comes to you. Whereas this is subject to the vagaries of the financial markets and you could lose, and there is a general perception that urbane and urban city financial market persons might easily defraud you of your money, and whereas in this MSP, it is the government that pays this MSP, and therefore, I'm entitled to receive it.

These are all the psychological heuristics that people apply, and just one or two occasional episodes when somebody might have lost some money, become a huge lightning rod for a blanket approach. And as Daniel Kahneman wrote in his book Thinking, Fast and Slow, all it takes is one cockroach to spoil a bowl of cherries. One episode may be enough to set this back by a few years. In many of these things, I think India arrives at the right answer eventually. The question is, of course, we can always say the speed can be better and faster, but we will get there.

RAJAGOPALAN: Sure.What I meant to ask is: you don't think there is anything fundamental about Indian agriculture that futures markets cannot work or should not work? This is the direction we should pursue, right?

NAGESWARAN: No. I think so. We have written about it in The Economic Survey. We wrote about it in July '24 and even in this survey. In fact, a lot of people have provided empirical evidence to many of the committees set up by the government that they have not been the cause for lower realization for farmers, etc. They have not been the cause. I think this is, as I said, some kind of an irrational fear of the unknown.

RAJAGOPALAN: Okay. Again, I think very much in terms of trade-offs. Right now, we have farmers who are distressed by debt, and I will not even go to the farmer suicide part, but they have a lot of debt, and they are distressed because of volatility on one side. I understand futures can also cause some losses and maybe some speculation in the market, but you are basically trading one off for the other. Overall, this is a more robust way of using financial markets towards capitalizing agriculture and reducing volatility. That is the way I think about the trade-off.

Options and Futures Markets in India 

NAGESWARAN: I agree, but in the interest of a conversation or making it more interesting, I must say sometimes the financial market participants' own behavior, and you take the current retail participation in options and derivatives, options and futures, or derivatives in general. Creating these same-day expiry options or last 30-minute expiry options, etc. The tendency will be not only to offer the farmers the good ones, but also to package them with some extremely speculative instruments, saying, "Okay, I can help you not only with insurance, I can also help you make more money."

Then with that kind of pitch, you will end up selling them things that they don't need or understand, or both. That risk factor is there. I think that is playing out across countries, developed or developing, across seasons. I think we still have to get the financial sector to police itself far better. I think countries have failed in doing so, developed or developing. That is not an excuse for not doing this. I think there are better safeguards to do it, and you can create a fairly well-designed regulatory system that addresses this. It is possible, and we should try because we are depriving the farmers of some easier options to hedge .

RAJAGOPALAN: Less costly to the exchequer, basically. That is the other part of it, right?

NAGESWARAN: Oh, absolutely. Yes.

RAJAGOPALAN: Now that you have talked about the futures and options market, now if I were to go back to your book with T. V. Somanathan, the derivatives book. It is not a geeky derivatives book just in terms of pricing derivatives of something. You are asking the broader welfare question. You are asking, when do derivatives help an economy, and when can they hurt an economy? You basically talk about the trade-off or the line between hedging—and the benefits from hedging risk and smoothing out volatility—versus speculation, and how there is not a clear point at which those two things fall on one side or the other.

NAGESWARAN: True.

RAJAGOPALAN: Now, since you published that book, the Indian financial market has completely changed. It's become the single largest equities derivatives market in the world. Something like, I think, 80% of global equity options are traded in India, which is quite remarkable for a country of its GDP per capita.

Now, if I were to go back and ask you to apply your own framework from that book, where do you think India and India's derivatives market falls on the spectrum between the genuine economic function of managing risk and volatility, and so on, versus becoming speculative and jeopardizing household savings?

NAGESWARAN: Oh, that is a very easy question to answer. Unfortunately, it very much falls on the side of being a speculative play rather than a hedging play. You are right. While it may be true for almost all derivatives markets. We know that, for example, in the 2008 financial crisis, the credit default swaps outstanding, far exceeded the underlying volume of bonds to be insured. It happens time and again. I think India has been, unfortunately, no exception, except as you correctly pointed out, India may not be able to afford it at this level of per capita income.

I think definitely, in some respects, India is under-financialized, whether it is in debt markets, whether it is in financial inclusion, etc., although that gap has been bridged to a large extent by the government's financial inclusion program. In equity markets, probably with these derivatives, India is over-financialized for its stage of development. I would put it, therefore, as erring or leaning towards the side of being more of a speculative play rather than a hedging play.

Securities Transactions Tax (STT)

RAJAGOPALAN: The policy response to this has come in a couple of different ways. One has come through SEBI. It has started raising contract sizes and limiting weekly expiration, and so on. Another instrument has come through taxation. There have been STT [Securities Transactions Tax] hikes in consecutive budgets, but there is one thing about STT that I want to understand a little bit better from someone like you who has thought about this deeply.

Now, STT on futures is being levied on the notional value of the contract, which is the full traded price, whereas the STT on the options is levied on the premium, which is a small fraction of the overall underlying value of the notional exposure. The effective tax that is imposed is much more on the futures trade, manyfold more actually, than it is on the options trade, whereas the speculation is mostly happening on the options side, which is also where most of the retail investors are losing money because the futures side is much better capitalized, larger firms, and so on.

NAGESWARAN: No, also the futures side is probably used more by institutions, and therefore, they are able to put up the margin requirement, etc., better than the options trades, where the individuals are being sold almost like the ₹10 sachet-type options, and the options…

RAJAGOPALAN: Exactly, sachetization options, absolutely.

NAGESWARAN: Yes. Go ahead.

RAJAGOPALAN: Now with each successive hike in the STT, we're seeing the gap widen. It's on the margin, making futures relatively more expensive than options just because it's taxing each trade. It's like a toll fee that's paid almost on every transaction. Your book was precisely about understanding these kinds of policy instruments. Given that now we have a tax instrument which inadvertently favors the more speculative instrument. Is that a good way of thinking about it, or how would you think about this problem?

NAGESWARAN: No, I think you have given me a lot to think about on this. I probably haven't applied my mind as much to the mechanics of the STT being levied on the premium when it comes to options, but on the notional value of the contract when it comes to futures. Actually, you have given me something to think about. As you said, it could be having the unintended consequence of reducing the hedging role of futures, which probably is playing a better role there and encouraging the speculative element. Let me think about it and also probably take back this aspect of the conversation back to my colleagues in the revenue department, in the Ministry of Finance. Thank you for that, yes.

RAJAGOPALAN: No, since you talked about your colleagues in the revenue department. My charitable view is that there is this trade-off and we've just fallen inadvertently on the wrong side of it. Now, my worry going forward is a fiscal dependence, right?

NAGESWARAN: Yes, of course.

RAJAGOPALAN: There's a massive amount that is collected, I think it's about ₹70 - 80,000 crore in STT collections in the most recent round. There is an incentive within the government to reduce the speculative trade on one side and on the other side to increase the volume or the number of transactions because that's how the revenue is generated, and we're an incredibly revenue-starved country.

From the big picture point of view, and again, I'm not laying this at your table in any way, you understand this better than most of us. Are you at all worried about this kind of revenue dependence, where the government is never going to quite curb the speculative aspect, which means it becomes very difficult to really discipline markets? All of it falls on the regulator like SEBI, and they have only so many instruments at their disposal when there's this volume of trade.

NAGESWARAN: No, I'd like to unpack it a little more. First of all, I think while the absolute number, like ₹70,000 or ₹80,000 crores, sounds very large, and I think as the economy grows in size, it is not that big a component, because on a GDP of about ₹350 lakh crores or ₹350 trillion, even sort of ₹1 trillion is only about 0.3%, roughly put. It's not that critical. I don't think the dimension is that it has become such an important fiscal contributor that it cannot be changed or tweaked or modified. I don't think that constraint is as big as we think it is. It's not.

At the same time, I do have to say, all countries in the world use tobacco tax to discourage smoking, etc. Over time, it has become a huge revenue source as well. Every country is very comfortable in raising the tobacco tax almost on an annual basis. Nobody questions them, including the critics in the media, etc., because that is considered a good thing. That is something to keep in mind.

The only thing is we need to make sure is—I go back to your previous question—we should not be encouraging an unintended form of speculation. If it ends up being increased every year, but actually curbing the speculative dimension and helping the derivative markets to play the role of their hedging function, it still is a good thing, in my opinion. Revenue dependence will be somewhat incidental in nature.

That is the kind of position we should be moving towards. Also, we cannot measure the counterfactual. But for these, we don't know how much the volumes might have been in some of the speculative instruments. I will take back the feedback about the tax on notional versus tax on the premium between options and futures.

RAJAGOPALAN: I am writing something on that with my colleague, Shreyas Narla. I will share that with you as soon as we finish the next draft and we can have a chat offline also. 

Curbing Crypto

There is another speculative instrument: crypto trading, on which the government wanted to dramatically reduce speculation. Crypto has an additional element where it's not just about trying to increase financialization and so on. There is also a question of the implications for capital mobility and fiat currency and so on and so forth. The Indian crypto taxation regime since 2022 has multiple parts. One is just the flat 30% tax on gains, which is not distinguishing between short-term and long-term gains. The second is the 1% TDS on every transaction regardless of whether it's a profitable transaction or not. This is, again, the toll argument. Except that STTs are a fraction of the TDS, which is 1%. I think Esya also wrote a report on how over 90% of the Indian crypto trading volume just moved to foreign platforms between July '22 and July '23.

My first question is, overall, was this the intended outcome, and is this desirable? The other way of thinking about it is, is this just pushing people now more towards the options market and playing Ludo on their phone and other kinds of things? People who want to speculate will speculate, and banning entire asset classes from the market may not be the best solution to this. What is your way of thinking about this as a bigger problem?

NAGESWARAN: I hear you, and there are no easy answers to this. For example, I wrote an article supporting the government decision to ban online gaming. Here, I feel that let's say, for example, it used to be said, and it is the favorite argument in the old days, argument of magazines and newspapers like The Economist, etc. Well, if you ban something, it doesn't disappear, it goes underground, etc.

It is true. I'm not denying that. The question is, how much of the volume goes underground and how much would have been the volume had it remained overground, so to speak. There are a lot of people for whom the ease of procuring something is a good incentive to continue to engage in that practice, but the moment you make it more difficult, the more desperate ones will continue to pursue it below the ground, etc. The easy speculators or the easy addicts will probably think the effort is not worth it.

To that extent, you are helping them. Therefore, this argument, which is very kind of a laissez-faire or libertarian kind of argument. I'm not particularly adherent to that argument, especially in a developing country context. Also, if you apply the work of Professors Kahneman and Tversky etc., or for that matter, more recent versions, more recent experts in this field, even people like Cass Sunstein, etc. What is the level of human agency in making these decisions, given the psychological influences that we all don't even know that exist? You combine that with the low per capita income situation; I think the state has an obligation.

RAJAGOPALAN: Fair enough. I wasn't so much advocating for a laissez-faire position as much as, are we using the appropriate regulatory tool for the appropriate regulatory problem? Is the appropriate tool a fiscal tool, like a 1% TDS, which may completely kill the market, or is the appropriate regulatory tool something like KYC. Do you need to have certain amount of liquidity before you can participate in the market? We have all these requirements for institutions. We don't have them for individuals. What is a good way to actually protect the people who need protection and let everyone else be? I guess that's where my question is going.

NAGESWARAN: I think in crypto, I don't think it is so much a question of needing protection because I think crypto, there are a lot of high net worth individuals. There is an income and wealth limit. We are not protecting. It is so much a question of trying to prevent money laundering or diversion of resources for criminal activities, terrorism financing, etc.

The small transaction tax is meant to impose a certain trail, basically, on the transaction. As for the right regulatory design, I'm sure it is an empirical issue. You will discover it over time. It can be fine-tuned. But I think, right now, the purpose is to trace the money trail, if you can, wherever possible, at least in one node before it becomes part of the dark pool. I think that is the purpose of it. I'm sure it will evolve.

RAJAGOPALAN: On that, then I would suggest that I think the 1% TDS needs to be maybe closer to the small STTs that are charged on options because this has completely driven the market abroad, which means it's even harder to track. Is that the appropriate problem.

NAGESWARAN: I think that's a fair point. At the end of the day, I think the proof of the pudding has to be in the eating. If it has basically resulted in an unintended consequence, then you have to rethink whether you have actually lost track of the very purpose for which you introduced it in the first place. That is a different issue in a way. Indirectly, you are raising, not directly, which is that, how open is policy to empirical evidence and course correction? It applies not only to this, but in several other areas of public policy.

How should we approach policy regulation?

RAJAGOPALAN: It's not as easy as open to empirical evidence because there is a question of, do we do policy from first principles and just announce and wait, or do we keep tweaking and keep making up the rules as we go along? This is a very important problem that we do face in a developing country context. The regulators are also developing their capacity.

NAGESWARAN: Absolutely.

RAJAGOPALAN: I think the problem is actually really complicated. One, we're tweaking tax rates. I have an appreciation for how difficult the task is. 

One example, again, going back to your work on how do we think about financialization as impacting some of the more physical, complicated parts of Indian political economy. You've written in the last couple of surveys with a very large emphasis on climate change, renewables and getting energy pricing right.

Now, one really problematic part of renewables is the challenge in the variability of production through the day, unlike fossil fuels. Now, this is an area where actually a lot of the financial tools can help a lot. Most importantly, contract for differences, which initially SEBI had prevented contract for differences, I believe, when it came to renewable energy, and then it changed its mind on it and so on and so forth.

What is a good way to think about the sorts of financial instruments you've written about in your book with T. V. Somanathan and these kinds of very knotty problems in India? The UK actually developed an entire system for contract for differences when it came to wind energy, which is one of the best places to deploy that kind of an instrument. What is a good way to think about that for India? 

Do we need an entirely new regulator, sort of like a super regulatorabove SEBI, above the insurance regulator, above the electricity regulator who can think of just the financial instruments? Is it just having capacity within each regulator? How do we solve this?

NAGESWARAN: To be honest with you, it will be presumptuous on my part to venture an answer straight away because I have not applied my mind to the question that you are posing specifically on how do you deal with this volatility or intermittency of electricity power generation from these renewable sources, and how do you use financial instruments? If you are going to use financial instruments and design instruments, then who gets to regulate it because it has got both a financial aspect to it and also an energy and technology dimension to it?

Do we need to create another regulator? I would probably err on the side of arguing for creating capacity within existing regulators rather than creating more and more bodies. That is one aspect of it. Parenthetically, I would also mention that the intermittency is only one part of the problem I have with renewable energy.

In the current global context, it is also about understanding the fact that generating one gigawatt of solar or wind energy requires expenditure of so much of energy in the first place. To produce the silver and the aluminum and the polycrystalline that is required, you have to use a lot of energy. I do not think we are fully accounting for all the cost of renewable energy generation before calling them an energy efficient solution. That is a separate issue. I know that you are focusing on a different aspect.

RAJAGOPALAN: Overall, relative to fossil fuels, we need to account for grid maintenance. We need to account for all the rare earths and critical minerals and all the energy that goes in processing that. I am totally with you on it. I think, hopefully, there are people out there who are writing papers on this.

More generally, as a policy principle, once the government sets out a goal and says, "We want to hit net zero by such and such year," or, "We want to slowly move towards renewables," how do we think about not just the renewable energy production, but all these other things that need to go alongside? I think that would be the broader question I have.

NAGESWARAN: I think that is a very fair point. I suppose, unfortunately, in most situations, public policy evolves more through trial and error than through a grand design at inception itself, unfortunately.

RAJAGOPALAN: I don't think they need to have a grand design. I think they should read your and Somanathan's book, because the trade-off is set up so clearly at the first-principles level. Of course, the applications need to be worked out and things like that. I'm not saying that is an easy task, but you set up the problem very, very clearly on how it applies to India. Now, everything else, I would imagine, can just quite simply follow from that.

NAGESWARAN: Maybe either Somanathan or I should evangelize our book with these regulators or with the policymakers in the respective ministries first.

Deregulation

RAJAGOPALAN: [chuckles] That would be excellent. 

Another major area in the last few economic surveys has been deregulation. Deregulation is, of course, India needs to get its house in order. It needs to have greater ease of doing business, lower corruption. All the very obvious low-hanging fruit that we need to have with deregulation.

The second aspect of it that you have written quite a bit about is just sheer compliance cost. Which is, how do we think about what it costs us as individuals, as firms, as societies to comply with regulation? Therefore, your old point about state capacity, and do we really have the capacity to regulate at the granular level at which we are currently attempting to regulate the economy?

A couple of questions. There have been big moves in the last 10 years to deregulate. In fact, currently, there are two sitting committees and task forces which are doing precisely this work to figure this out at the state level. Where do you think we are, as a country, on this spectrum? I imagine we're heading in the right direction. How would you view this, given that you've seen this trajectory over the last few years?

NAGESWARAN: No, you are right. The country, as a whole, is heading in the right direction. Both states and the union government, there is no question about it. How far we have gone, I would say probably we have gone, optimistically, maybe we are two-fifths of the way there. Maybe pessimistically, I would say we are only about one-third of the way there, because there are multiple areas.

Because the system has evolved over 70 years in terms of coming up with this labyrinth and a comprehensive network of procedures, compliances, inspections, and licensing, it cannot be eliminated with one or two economic surveys. Even if action is taken based on that, I'm sure it will take at least one-tenth to two-tenths of that period which we have erected over 70 years to eliminate that.

In that sense, I would think that this is a focus that needs to be kept up for almost the next decade before we can say that we have broadly brought the problem under control and it will not recur. I think more importantly is to create the ecosystem that we don't have to keep going and the system by in and of itself will focus on efficient and minimal regulation rather than excessive regulation. I think we have to bring that mindset shift. I would give ourselves at least another decade before we get to that kind of nice situation.

Digital Public Infrastructure

RAJAGOPALAN: You've written both in columns and also in the economic surveys on digital public infrastructure. One, of course, it's one of India's great achievements, and it's led to a lot of good things. Not just the identity layer, the financial inclusion has been a huge part of it. That celebration is not premature, and the achievements are very real.

I can think of at least two unintended consequences, which you have also worried about in the survey. One is this rampant welfare expenditure growth, which has obviously been made much easier because of Jan-Dhan accounts and you press a button and now the beneficiaries get the money. That's one part of it.

The second is since 2016, the combination of Jio, Aadhaar, and UPI has led to a lot of the futures and options market, and playing Ludo, and those sorts of things online. Again, the digital public infrastructure has definitely made it much easier for retail participants to engage in the options market.

What is a good way you think about this going forward, which is, of course, we need DPI and we need it for financial inclusion, but how do we think about this as a regulatory problem going forward? Do we do it at the architecture stage of DPI, or do we do this at the SEBI, IRDA, all the other stages?

NAGESWARAN: Again, I think with the caveat that one has to reflect on this and probably think through the pros and cons of doing this. With that disclaimer out of the way, if I have to give a response on the spot, so to speak, I would probably err on the side of saying that because it will be difficult to visualize the various applications or end uses to which the DPI architecture or any architecture for that matter may be applied. Therefore, if we try to think through all of that, then it may also even delay the innovation leg of it. We may over-design the system, and it may even delay the technological catch-up and the technological implementation aspects of it.

I would rather err on the side of letting the innovation proceed without burdening it too much with these considerations and leave it to the regulators to think through at the application stage for specific end uses, which we think is not necessarily most optimal from the country's point of view or from the user's point of view. Then apply those interventions at those stages rather than burdening it at the architecture. This is my preliminary reaction to you.

India’s Growth Trajectory

RAJAGOPALAN: A couple of questions on India's growth rates. One, I want to, again, go back to the head of the conversation and your paper with Gulzar Natarajan, where you had cautioned that 8% growth rate is incredibly optimistic. It's likely going to be below that, given global headwinds. In the last couple of years, you have been much more optimistic about India's growth rates, and it's also panned out. You've upgraded India's growth rate potential to about 7%.

NAGESWARAN: Yes, that's right.

RAJAGOPALAN: One is, how do you see this going forward, because the fundamental uncertainty and especially the geopolitical uncertainty that you had talked about in the 2016 paper actually hasn't gone away? If anything, it has maybe become a little bit more acute.

NAGESWARAN: That's right.

RAJAGOPALAN: What is a good way to think about this 7% growth rate number going forward?

NAGESWARAN: Look, I was not very optimistic about the 7% GDP growth number even when I took up my role as chief economic advisor. At that time, I was more comfortable with 6.5%. I wrote about it in the first economic survey (2022-23) I published in January 2023. Also, at that time, we did lay out a roadmap where we could consider upgrading it depending on the government addressing many of the legacy distortions in different markets, labor, land, and, of course, more generally on the regulatory architecture, etc.

Because that has happened, and then nobody anticipated the unprecedented commitment to infrastructure, which went from ₹2 lakh crore in 2015 to something like ₹12.2 lakh crores in '26-'27 budget, six times. I think that has also played a big part in relieving some of the supply-side constraints in the economy. We just spoke about the digital public infrastructure and various deregulation efforts that have gone on, etc. That is what gave us 7%.

Now, I certainly still think 8% will be a challenge in the current global context, because if you look at the empirical history of how many countries achieve sustainable 8% growth, in what context? In the 20^th century, you mainly had the East Asian experience, nothing more. This were a handful of countries with very special circumstances: a huge security umbrella from the US, a ready-made market in the US again, and small open economies.

RAJAGOPALAN: Global peace, which we can no longer take for granted.

NAGESWARAN: Exactly. Global peace and no constraints on energy transition, energy diversification, climate change, and all of that. Then the one country that did it for much longer than other East Asian countries is China. While Korea and Japan may have done it for a decade-and-a-half or two, China did it for three decades from 1979 to 2008. Even then, subsequently, they have been able to maintain the growth rate until about 2015 or 2018 only by taking excess amount of debt in the process.

In the current circumstances when we have to focus on energy transition, we have to worry about availability of ingredients, raw materials amid supply chain weaponization, etc. I think 7% seems more realistic and, more importantly, the global GDP pie may not be growing as quickly as it used to in the past. Natural volumes of global trade lifting India's export growth may not be happening as easily as it did for other countries or for India itself between 2003 and '08.

That's why I think 7%–if we can sustain that over a 10-year period…Honestly, after Operation Epic Fury started, we need to worry about how things will shape up over the next five years on the geopolitical front. Even maintaining the 7% number will turn out to be no easy achievement.

RAJAGOPALAN: In particular, I think there is a dual problem. We managed to achieve 7% in the last couple of years with relatively low levels of inflation. Now, that's the other part of the puzzle, which is under question, given that now oil prices are going up, the import bill will go up. Oil prices affect underlying inflation in the Indian economy. There's a very old problem that we have. Both the high growth rate with the low inflation will be even harder than just the high growth rate.

NAGESWARAN: Oh, fair point. I think we must remember one thing: the kind of inflation shock that India has been experiencing due to oil prices, the intensity has been coming down.

RAJAGOPALAN: Has been coming down, absolutely, though we don't know how this war will play out. That's what I meant.

NAGESWARAN: First, let me get the oil question and the inflation question out of the way before we come to this war and the impact on growth and inflation. If you look at '22-'23, when the Ukraine-Russia War started, oil went to the $130s [USD per barrel] very briefly. Then, of course, it lasted for four months in general, but the very high point only lasted very briefly. India's inflation rate at that time peaked at a level of around 7.8%, which is historically very, very creditable because India's average inflation rate in the first six and a half to seven decades since independence has been around 7%.

To have a peak inflation at 7.8% when your average has been 7% is very creditable. Developed countries experienced double-digit inflation rates, partly because they had the huge fiscal overhang and loose monetary policy, which India did not have. You can, therefore, attenuate or cushion the impact of energy prices if you have the right policy framework, which I think has been one of the good achievements of the post-COVID Indian policy environment. Monetary and fiscal policy have been generally prudent and responsible, and have placed a lot of emphasis on stability.

Coming to this particular situation, the conflict in the Persian Gulf at the moment, I think this is just not an oil price shock, which you know very well. It is an energy complex shock—both supply and prices. You have a logistics shock.

As we speak on March 12th, I feel that there's a supply and a price shock and a logistics cost shock. More importantly, it is a supply-chain disruption shock, both for imports and for exports, for every country.

For India, it may also result in a reduction in remittances coming from Gulf countries. If economic activity in those countries descends very steeply and takes a very long time to recover. If that is the case, then that will also be impacted. I think this one is going to be a fairly more complex shock than the Russia-Ukraine war energy price shock or the previous energy price shock. This seems like a different ballgame altogether and a much more complex one.

RAJAGOPALAN: I think going forward, India has to expect this. We are more and more integrated into global markets. Our diaspora is spreading to more and more countries. India and Indians are much more integrated into in the global order than they were, say, during the '70s oil price shock, the Gulf War, and so on. We should expect this complexity going forward in general, irrespective of this war.

NAGESWARAN: That's true. I totally agree. You mentioned the diaspora numbers, etc. Also, you see it in the trade statistics. Total trade as a percentage of GDP is close to 50%. Even if you exclude oil trade, it is still more than 35% or so. It's a huge integration that has happened, and the services sector as well. This particular conflict is quite multidimensional and quite worrying.

RAJAGOPALAN: Last question before I let you go. Overall, are you optimistic, pessimistic, or cautious? Again, I keep going back to that 2016 note because when I read it now in 2026, I'm like, wow, you were really prescient about things before the demonetization, Trump's first term, GST, COVID, or any of the big uncertainties or shocks that India faced, and it holds up remarkably well. I feel like I should ask you now in 2026, how you view the next 10 years, or what is your overall thought? Is it optimistic, pessimistic, or cautionary?

NAGESWARAN: No, I have to separate my response for the Indian context and for the global context. I think when it comes to the global context and the geopolitical and geo-economic cycles, I'm less of an optimist. I think we are going to go through convulsions before we settle down, and then a new era of growth and stability will begin, because having experienced a lot of stability in the last 30 years in particular, including globalization, and then post-World War II, generally at the global level, stability being there, etc.

If you look at long cycle analysis, we have to cross a valley before we hit the new peak at the global level. There, I feel that I'm more of a realist. I don't call myself an optimist or a pessimist. I'm more of a realist because I focus on what is in our control and the efforts we continue to take, because optimism or pessimism is governed by the outcomes that one expects.

I dissociate myself from the outcome because that's not in my hands. Therefore, if you focus on the effort, then it's all about being realistic as to what you can do. There, I think on the Indian side also, I feel there is a lot of scope to do. There is much more scope to do the things that we need to do. That will give India some sort of growth cushion, regardless of what happens on the external front, because there are still some important low-hanging and mid-hanging fruits in India on the domestic side which we can pluck to be able to maintain a certain growth rate.

Now, whether that number will be adequate to achieve a particular growth outcome, or a per capita GDP outcome or prosperity, I tend not to worry about it too much. There's no point either. From the Indian perspective, you can call me a realist-optimist. In a global perspective, you can call me a realist-pessimist.

RAJAGOPALAN: [chuckles] I think that's very fair. Given your track record, I would usually bet on your prescience.

NAGESWARAN: Thank you.

RAJAGOPALAN: Thank you so much for doing this. This was such a pleasure. I learned a lot, and I hope you come back.

NAGESWARAN: Thank you, Shruti. I learned a lot, too. It was a very wonderful conversation. You kept me on my toes for the last one hour.

RAJAGOPALAN: [laughs] Thank you.