WF: There is a considerable debate about the strength of the global recovery process and the possible negative implications of the withdrawal in 2010 of the various stimulus packages that helped start the recovery process. How realistic are these concerns?

Narayan: I would say that I am cautiously optimistic as opposed to being consciously skeptical and the reason I think is that the lessons from various past episodes have been absorbed. For example, particularly related to the banking system and the need to protect aspects of the banking system. A lot of lessons were learnt from the depression era in terms of both monetary policy and fiscal policy. As regards the speed and intensity of response, I think the lessons were learnt primarily from the Japanese episode in the 90's.

So I think that the skeptical have a view that is arising from a replay of some combinations of those stories. But my own guess is that neither of those stories will replay exactly and we have some room for cautious optimism. The epicenter of this global problem is a weak US economy. I think the US economy - in terms of basic flexibility - is in much better shape than it was in the 1930s and better than Japan was in the 1990s. So I think the past is not necessarily going to play out again - though I would not want to get too exuberant with an overdose of optimism.

WF: The recent rebound in the dollar is worrying some market participants who fear that a strong dollar can upset the dollar carry trade - which has fuelled buying in risk assets globally - including India. To what extent are these fears of a possible unwinding of the dollar carry trade justified and should we be worried about this from a domestic market perspective?

Narayan: I don't think they are independent really. Markets are going down at the same time as the dollar is appreciating and markets are going up at the same time the dollar is depreciating. So I don't think you can use one as the leading indicator of the other, they are contemporarily correlated so to speak at the moment. And therefore I don't read too much into it.

On a structural basis, I do think that the dollar will continue to erode with episodes like the one we are having, where dollar strength will be seen. So the line will be a negative sloping one, but it won't be smooth. There will be the occasional zig and zag and we are in one of those zig-zags as we speak.

If this is a question of sustainability - ie, is this a new pattern for the equity markets - are they heading down - I would say no. This is not a sustainable trend - and to that extent, equity markets I believe are in a pause mode rather than a trend change mode.

Markets have got slightly ahead of the real economy in 2009 and time is being used to reset the valuations in 2010. Pretty much from October 2009, markets have gone nowhere - that's about 6 weeks or so by now . My own suspicion is that this pause can be there for few weeks more. In the next few weeks, the earnings calander will begin shifting by a year - we will all start looking at FY 11. If earnings projections for FY 11 are 25% above from what we see today, then valuations will look a lot better than now - a pause can help reset market valuations to healthier levels.

WF: While markets are in this pause mode, retail investors in India have been continuously redeeming their mutual fund holdings over the last 3-4 months. Valuations at 20X plus seem to be unnerving some investors. Mutual funds are finding it difficult to sustain inflows into the industry. Are valuation concerns warranted, and if not, what is the way forward to sustain healthy long term flows from retail investors?

Narayan: Any domestic market has maturity and depth only if it has long term institutional players like pension funds and insurance companies. India has begun the journey there, but it will take a very long time. The other way of saying the same thing is that, at the moment the price discovery mechanism in the Indian equity market still remain largely dominated by FIIs which is the flip side of the same point that you don't have domestic long term investors in India. Retail investors world wide are typically momentum led. It is too much to expect them to be early cycle value investors. So in a sense you can't blame retail investors for what is happening.

Mutual funds in India are still a small but growing institutional constituency. AMCs and the distribution community have been distracted by the way the regulatory changes have taken place in the last few months. As a result of which they are still adjusting to the new regulations and therefore significant new money has not been added into the mutual fund pool in the last few months. So as a consequence you have the retail players who were necessarily not useful to pull in the other direction and the institutional players even if they are smaller in size in the whole market sort of not participating for reasons extraneous to capital market. So as the consequence of which the retail Indian investor has been largely out of the market's upmove over the last few months.

From the perspective of the fundamentals of the market, if we get earnings growth that is north of 25% on a Y-O-Y basis, there is a decent chance that markets will climb and climb reasonably. If you get a number in the low teens - 13-14%, I think we will have a couple of difficult quarters. So the real judgment is, is it possible for earnings growth to come in at a healthy number? I believe there is a reasonable probability therefore worth playing.

WF: You talked about the distractions for the fund industry and distributors hampering growth. What are the catalysts that you would look for that will enable the mutual fund industry to harness the vast savings pool and scale up into a meaningful institutional segment in the equity market?

Narayan: In a very long term sense the combination of very positive savings environment, the low penetration levels of capital market products and a micro structure that broadly allows you to compete effectively and deliver a healthy return to your shareholders - are the three basic building blocks that this industry can and will leverage

From a nearer term perspective, there are two catalysts that will drive growth of this industry. One factor is that if the market gallops then that creates demand by itself for mutual fund products.

The second is that the industry will need to seek a better balance between stakeholders. Right now, the balance has shifted almost entirely towards the investor - in terms of pricing etc. To move ahead and grow on a sustainable basis, you need the other two stakeholders - the AMCs and the distributors too - to be reasonably compensated for their service to the investor. You also need to be adequately compensated if you are to increase MF penetration and deliver on the goal of financial inclusion. I do hope that the MF industry will do its own soul searching as well as influence the broader universe on the need for this pendulum to swing back into equilibrium and to restore a healthy balance.