Dr Raghuram Rajan’s Trial By Fire

There are some clichés that ring especially true at certain times. “When the going gets tough, the tough get going” is one of them. Surely Dr Raghuram Rajan, who has recently taken over the reins of the country’s apex bank and regulatory authority, the Reserve Bank of India, would be familiar with the truism. With the kind of situation (read: shambles) the Indian economy is in, he needs to understand it in the truest sense possible.

Dr Rajan takes over the mantle from Dr Duvvuri Subbarao at a time when the economy is going downhill, with the GDP growth declining to new lows every quarter. The Indian rupee is in a seemingly unstoppable fall to touch a new abyss every few days. The equity markets are witnessing a high amount of volatility and the bond markets too are nervous. Along with this are other issues like a burgeoning Current Account Deficit (CAD) and inflation worries. The worst part is that the government has been trying to superglue the issue before the General Elections in 2014. Now, the Food Security Bill is the latest strain on the Union’s finances. 

All in all, Dr Rajan has a tough task cut out for him and everyone would be looking towards him to bring the economy back on track. What adds to the pressure is the weight of expectation thrust on him from all quarters. While the government wants him to wave a sort of magic wand to bring down the twin deficits, arrest the sharp fall in INR against the USD (naturally, strengthening of the currency is the immediate item on the agenda) and help economy get back to the higher growth rates achieved previously. Market participants (who consider him as pro-market) expect him to calmly and thoughtfully handle both the government and the economy.

As everyone on the street waits with bated breath to see what steps he takes to manage all these fronts, in this story, we at DSIJ attempt to ascertain the action that he may take.

The Backdrop 

Investors may recollect that the scenario in India Inc. was almost similar (or rather a bit worse) in 2008 when Dr Subbarao took over as governor at the height of the financial crisis. In his tenure, he both slashed and raised the rates drastically. Under him, the repo rate dipped from the higher levels of nine per cent to as low as 4.75 per cent and again rose to 8.75 per cent. All this happened in a period of five years. Along a similar trajectory, the economy, markets and currency were on a rollercoaster ride in the same period.

However, Dr Subbarao can scarcely be blamed for the same, as it has more to do with poor macro factors on the global front (especially the Euro zone) as also with some policy paralysis at the central level. Apart from that, the government and the RBI could not align themselves in terms of achieving goals. But as we have stated, the government and market participants both consider Dr Rajan as a close associate and have higher expectations from him. 

However, there seem to be certain doubts in the minds of investors, and this was evident from the fact that Indian equity markets did not welcome him. On the biggest question of whether the markets would be on his priority list, Nilesh Sathe, CEO and Director, LIC Nomura Mutual Fund AMC says, “Maybe he is considered pro-market, but the market did not welcome him and appears to be cautious. Further, the RBI has little role in the market. But if he is able to show growth, the market will respond”. 

Let’s take an overview of the pending issues and what can be expected from Dr Rajan in terms of tackling these.
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The Sliding INR – No Rash Steps 

On the exchange rate front, in March-April 2011, Dr Raghuram Rajan had been quoted in a story in the journal ‘Foreign Affairs’ whose title ‘Currencies Aren’t the Problem’ aptly sums up his view. Here he opined, “Fix domestic policy, not exchange rate”.

Dr Rajan said that the monetary policy would be more effective if it is focused on a single objective – low and stable inflation. This would imply minimal management of the exchange rate by the RBI, except perhaps to smoothen out the extreme volatility (including preventing significant departures from equilibrium). Put simply, he is unlikely to launch a flurry of measures in a panic to salvage the INR. In fact, in one of his columns, he had categorically stated that taking rapid reaction to any crisis can tie the central banker’s hands for years to come. 

Tirthankar Patnaik, Director, Strategist and Chief Economist, Religare Capital Markets agrees with this view saying, “Dr Rajan has been advocate of standard monetary economics. He believes that the frame-work of the central bank’s key role has to be targeting inflation above anything else”. So we are not expecting an extraordinary firefighting stance very soon.

Interest Rates - Keep Expectations Low 

One factor that is holding back India Inc. is the higher interest rates, which are resulting in lower capex. Hence, there are higher expectations from the new governor on the interest front too. However, we do not expect to see any fireworks from him here too. 

To quote the governor from ‘Money Magic’, an article published by web portal Project Syndicate in June 2011, “More than any other policy action, monetary policy suffers from the sense that there is a free lunch to be had. Yet the interest rate is a price for the savings that are transferred to spenders. To the extent that the Fed manages to push this price down (and some economists will dispute its ability to push any meaningful interest rate down), it taxes the producers of savings and subsidises the spenders of savings.” In short, he feels that there should be equilibrium in terms of interest rates and not just based on the whims of governors and expectations of market participants.

In fact, on the rates front, Dr Rajan has always advocated that the rates should be decided by a committee and not the governor who has the veto. In the US, it is the FOMC which decides the rates. We would not be surprised if something along similar lines happens here, with a committee being formed to decide the interest rates. Thus, we do not expect any tinkering on the interest rate front either. 

In an interview, when asked about the slower IIP growth, his views came across quite clearly. “The slow industrial growth, in part, is due to some of the aspects of industries such as power production and other infrastructure areas. I think that by getting some of the large projects restarted and completed, you will, in a sense, re-energise growth in a number of ways; including the fact that when these projects are completed, their promoters have more cash flow coming in”. He further added, “My sense is that if we can get some of the growth momentum, partly by completing large projects and partly by creating better sentiment, we will see a turnaround from the current pessimism. I think the turnaround is underway”.

Dr Rajan’s focus is clear that execution of some large and key projects will keep the ball rolling. Hence, we do not expect any hasty actions on the interest rate front to bring growth back on track. 

Amit Majumdar, Executive Director & Chief Strategy Officer, Angel Broking says, “For now the external sector con- cerns are dominant in influencing the monetary policy stance. During his stint as the Chief Economic Advisor, he has played an instrumental role in the recent policy announcements to support the rupee, and he is likely to continue taking policy action on this front. I believe that once there is stability in the exchange rate going ahead, the monetary policy is likely to veer back towards supporting growth. Until then, the recent liquidity tightening measures are likely to stay in place”.
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CAD – Will Provide A Long-Term Solution 

The Current Account Deficit (CAD) has been a pressing worry for the Indian equity markets and needs to be addressed as soon as possible. From a strictly cause-effect standpoint, it is in fact the increasing CAD which has affected the INR. 

Dr Rajan maintains a very clear view on CAD. He says, “The Current Account Deficit is more a residual of policy rather than a target of policy”. He clarifies his position by explaining that CAD essentially reflects the fact that you are spending more than you are saving. This is essentially the definition of CAD, which means that you need to borrow from abroad to finance your investments.

In an ideal situation, the way to reduce the Current Account Deficit is by saving more, which means consuming less, buying fewer goods from abroad and importing less. The other way to achieve this is by investing less, because that would allow you to bridge the CAD. However, India has enormous investment needs. So, the bottomline is that there is a need to save more. 

The best solution for this problem is when the people of the country as a whole decide to save more rather than spend. When Dr Rajan takes office, we can expect encouragement on the financial saving front. Only an increase in financial assets can spur people to move out of gold. This would be beneficial as gold imports also add to the CAD burden. One can definitely expect more offerings in financial savings to help reduce the CAD.

Apart from this, Dr Rajan has suggested shifting our lens to the trade deficit as another way in which to address CAD. Can we reduce the trade deficit? One way is to import less and the other is to export more. As the country is hugely dependent on crude imports that are naturally difficult to reduce, it is important to create the conditions for India to export more. 

One can expect a focus on competitiveness, which is where all the infrastructure spending and investment in human capital will help. Though a long-term measure, we expect the new governor to focus on investments. Any short-term measures, though, seem unlikely.

Banking – Focus On Financial Inclusion 

In one of his comments, Dr Rajan had said that, “The current formal system is simply not serving a majority of our citizens, despite the tremendous steps taken in the past to expand the rural banking network, the grand schemes targeting rural credit and the considerable attempts to impose interest rate ceilings to protect the poor against predatory lending”. 

He had also provided certain proposals for the remedy. The first was to allow more small banks. Though it is risky, he opined that higher risk is the price we will have to pay for more growth and inclusion and that excessive risk aversion imposed on the regulatory system will only hold us all back.

Secondly, he suggested competition and costs. Here the idea is that the government does not ensure that the poor get low prices by capping prices or interest rates at low levels. Instead, it ensures that they get no service and have to resort to very highly priced, unsavoury alternatives. 

He has also advocated minimum government holding in public sector banks saying, “I see little evidence that state ownership helps significantly in achieving public aims such as greater inclusion. It makes sense to rethink the state presence in the financial sector. It should be reduced at a pace consistent with the private sector’s ability to absorb it”. This clearly suggests his focus on financial inclusion through smaller, and more importantly, private banks. In this light, we feel that the foutier structure proposed by the RBI is a step towards the same and would be very helpful in facilitating financial inclusion. We expect this process to speed up after Dr Rajan takes over.
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New Banking Licenses – Expect More Accountability 

There has been a good amount of enthusiasm on the street about which of the 26 applicants will be awarded the banking licenses. Here, Dr Rajan has some different views, as he is not in favour of the government giving banking licences to corporate houses. He had categorically stated that the old RBI policy of not allowing corporate banking licences was a good one and he seemingly still stands by that. 

Dr Rajan always suggested that existing peers like non-banking finance companies (NBFCs) and microfinance institutions (MFIs) should be given preference over corporates owing to their experience in this business. If at all corporates are provided with banking licenses, the regulator needs to ensure there is no inter-company lending, proper risk management processes are followed and that there is enough transparency.

Thus, it would not be wrong to expect a higher number of new licenses given out to NBFCs. But the others should not be worried, as he also advocates the idea of continuous issuance of licenses rather than issuing periodic ones as we have seen in the past. We feel that this is a positive stance and would help in terms of financial inclusion. 

A Stooge For The Government? 

Dr Rajan’s core strength as an economist is that he is able to grasp complexity – in the developed and the developing world, in development economies and in financial markets – very well. Furthermore, he is able to articulate such complexity for the layman in lucid terms. However, his failing thus far is that he has not been a politician, neither a civil servant, nor a seasoned banker. The risk, therefore, is that in the absence of politically-oriented ideological anchors, he will be made to pander to the government’s whims. 

Realistically, though, we feel that he would already be aware of these risks and hence would be unlikely to become a puppet in the hands of the Central government. In the past, he has criticised the easy money policy of the US Fed and would possibly take a similar stance in India too. 

Of course, some alignment would be in order here. Gaurav Dua, Head – Research, Sharekhan says, “In my view the larger onus lies with the government, which has power to legislate policies, compared to the RBI, which has a limited mandate. In these circumstances, the RBI and the government should work in a co-ordinated manner to pull the economy out of the larger crisis which is knocking at the door”.

A Tightrope Walk 

To sum up, while the expectations are high from the new governor, we are not quite expecting anything dramatic, at least just yet. Rather than trying to pull off the impossible trinity of growth, inflation and an added dimension of managing the rupee volatility in face of a loose fiscal policy, Dr Rajan is expected to focus on inflation – the mother of all issues. Instead of providing short-term panic-driven measures, his focus is likely to be on long-term solutions. 

Considering all the factors we feel that the vast experience and academic credentials of Dr Rajan do suggest that he is a suitable candidate for the post of RBI Governor in these trying times. Needless to say, the hostile circumstances will definitely put his abilities to the test. It does look clear, though, that this change of guard will add more vigour to the functioning of the regulator.