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Updated: August 24, 2013 00:32 IST

The new note on Mint Street

T. T. Ram Mohan
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The governor-designate of the RBI will have to rethink or temper many of his past positions that have been at variance with the central bank and the finance ministry

Expectations are running high about the Reserve Bank of India (RBI) governor-designate, Raghuram Rajan — unusually for an RBI governor, his appointment was not just reported by but also commented on editorially in the foreign press. Living up to these expectations will be a huge challenge for Dr. Rajan. It is bad enough that the Indian economy has to cope with falling growth, high inflation and an adverse external position. What makes things more difficult for him is that many of his past positions are at odds either with those of the finance ministry or the RBI or both.

Three issues

Dr. Rajan needs to tread warily on three issues in particular. One, whether the RBI’s mandate should be confined to price stability or whether it needs to pursue other objectives as well, such as growth, currency stability and financial stability. Two, whether corporate houses should be granted bank licences and based on what criteria. Three, the role of the Financial Stability and Development Council (FSDC).

Begin with the mandate of the central bank. In its report in 2008, the Committee on Financial Sector Reforms (CFSR), that Dr. Rajan chaired, made its position clear. “This Committee feels that monetary policy should be reoriented towards focusing on a single objective, and there are good reasons why this objective should be price stability (defined as low and stable inflation). An exchange rate objective would limit policy options for domestic macroeconomic management and is not compatible with an increasingly open capital account.”

This is not and has never been the view either of the finance ministry or the RBI. That apart, the present economic situation makes it impossible to focus on price stability alone. The wholesale price index, which the RBI uses for purposes of monetary policy had, until the most recent month, shown signs of declining. Going by price stability alone, it could be argued that monetary policy must switch to facilitating growth.

Going by Reer

How do we square monetary easing with the fall in the rupee? Many in the political class are apt to see the rupee as a symbol of a nation’s virility but this is not a view that sensible economists would share. In judging whether depreciation has been excessive or not, they would go by the real effective exchange rate (Reer). In the year ended June 2013, the depreciation in the Reer, weighted by trade with respect to 36 currencies, was just three per cent. Over a much longer period, 2005-13, the depreciation in the Reer has been only six per cent, no matter that the decline in nominal terms in the same period was nearly 22 per cent. Even if we were to factor in the fall in the rupee since June, the decline in the Reer would fall broadly within the RBI’s comfort zone of five per cent in a given year.

Before the fall to around Rs.65 in recent days, there was thus a strong case for the rupee to decline in nominal terms. The case was particularly strong, given weak global demand for exports. This is one reason the panicky reaction to the decline in the rupee is overdone. Another reason is that it ignores the fact that currencies across a range of emerging economies have fallen sharply because of the sense that Fed is about to taper off Quantitative Easing, which had sent funds flooding into emerging markets. The contention that the rupee’s sharp fall is entirely or mainly because of some special brand of economic mismanagement on the part of New Delhi just does not wash.

Granting the case for depreciation, however, the RBI cannot allow the rupee to go into a free fall. Foreign inflows into India must be reckoned in dollar terms because the dollar is the reserve currency. Too steep a decline in the rupee with respect to the dollar could result in an exodus of Foreign Institutional Investor funds, no matter that the trade-weighted real exchange remains relatively stable. There will always be a case to manage volatility in the rupee so as not to upset foreign investors.

That is why the RBI thought it fit to clamp down on liquidity and tighten interest rates at the short end a few weeks ago. It took the view that too rapid a fall in the rupee could cause a potentially disastrous flight of funds. However, the markets were quick to latch on to another problem: the RBI’s attempt to shore up the rupee posed a threat to a third central bank objective, namely, financial stability.

Bank stocks were hammered heavily in the days after the RBI tightened liquidity — and with good reason. Banks had taken positions on bonds in the expectation that yields were trending down and are now incurring losses on these. Private banks, which depend heavily on wholesale deposits, faced substantially higher funding costs. Most importantly, an increase in interest rates increases corporate distress, which impacts on banks’ quality of assets.

Growth forecasts, including that of the RBI, have been revised downward in recent weeks. When slow growth is combined with heightened problems in the banking sector, it greatly increases the chances of a rating downgrade — and the very flight of foreign investors that the RBI is seeking to prevent. The RBI seems to have realised that its attempts to tighten liquidity can at best be short-term therapy and it has taken steps to reverse its course. Once the rupee stabilises, it will be necessary to reverse this fall and move towards engineering decline in interest rates.

Banking and corporates

Yes, there is the danger of a flight of funds, especially funds invested in debt. But funds invested in equity might well choose to stay, given the boost to corporate profits from lower interest rates. They will also be encouraged by ongoing projects proceeding towards completion. At the same time, we must prepare for the worst contingency — a significant flight of foreign funds — by arranging capital inflows in every conceivable way: non-resident Indian deposits, overseas borrowings by public sector undertakings, negotiations with the International Monetary Fund for a line of credit. Whatever the course of action, Dr. Rajan cannot hold fast to the CFSR’s position that monetary policy must focus on price stability alone.

On the issue of bank licences, the RBI and the ministry are united in thinking that the time has come for the field to be opened to corporates. The CFSR, in contrast, had contended that it was “premature” to allow industrial houses to own banks. It cited the prohibition on the “banking and commerce” combine in the United States and said the same was necessary in India until “private governance and regulatory capacity improve.”

There is not just the conceptual issue of whether corporates should be allowed into banking. There is also the practical matter of ensuring that the selection process is not vitiated by charges of corruption. This is no easy task, given the clout that many of those in the fray enjoy. In a recent speech, RBI Governor Dr. D. Subbarao argued that letting in Indian corporates would “lead to innovation of new business models for financial inclusion…” If this is what the RBI believes, then Dr. Rajan must ensure that financial inclusion is made the primary criterion for the grant of new bank licences.

Regulatory body

Finally, there is the role of the Financial Stability and Development Council. This body has its genesis in the CFSR report. The CFSR had suggested the creation of an apex regulatory agency that would have responsibility for monitoring systemic risks and ensuring coordination among the different regulators in the financial sector. Thanks to the Financial Sector Legislative Reforms Commission (FSLRC), this idea has since metamorphosed into one of vesting statutory authority in the FSDC, with the Finance Minister presiding over it.

No doubt politicians and bureaucrats are smacking their lips in anticipation of an FSDC with greater powers but the RBI under Dr. Subbarao has bristled at the suggestion. He has insisted that the FSDC should be a coordination body and that every care should be taken to ensure that there is no infringement of the autonomy of regulators. He has expressed similar concerns about the FSLRC’s proposal to vest the conduct of monetary policy with a council dominated by outsiders.

Dr. Rajan brings to the job a degree of intellectual capital, perhaps unmatched by any of his predecessors. Still, in reconciling divergent views and revisiting his own, he has his work cut out. He must know by now that no RBI governor can afford to antagonise the finance ministry beyond a point. Nor can he afford to alienate the RBI community, one that is legitimately proud of its traditions and expertise and its standing in the world of regulators.

(T.T. Ram Mohan is a professor at IIM-Ahmedabad. E-mail:


Easing troubles in the long runSeptember 11, 2013

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The measures taken by RBI to reduce the inflation and price rice of indian economy got rippled with the immediate set back from Quantitative Easing policy of Fed reserve bank of US which led Indian rupee in the middle of nowhere. There is an urgent need to understand the basic functioning of democracy in India's lackadaisical mindset to wait till its over without taking preventive measures to combat the situation. Had RBI reacted earlier then the Indian economy would have not been in a situation as it is now. I feel there should be more emphasis on growth of manufacturing sector by opening up new avenues in terms of interest rates , encouraging research sector , investment in higher sector like M.TECH , PHD. etc. rather than taking short term measures like cut in CRR , draining liquidity ,FDI's and import duties hikes etc. which will again put pressure on common masses of this giant country.

from:  ashish kr gupta
Posted on: Aug 26, 2013 at 13:09 IST

As a common man and also a senior citizen, I expect the new RBI governor to ensure that all
my savings and investments during my work life are not so much depreciated that I will have
to spend sleepless nights in the last phase of my journey. All the macroeconomic policies
being talked about are not worth to people whose real incomes are eroded every day for no
fault of theirs and who have no access to additional earnings which is the forte of the
politicians and business houses who can talk about lofty ideals of growth and development.

from:  MvjRao
Posted on: Aug 24, 2013 at 16:32 IST

Conflicting situations well articulated. The fact of the matter is that nearly 80 percent of the banking is in the public sector fold. The suggestion of the Narasimham Committee to reduce the role of Government in reining the banks fell in deaf ears. If the Government thought that by allowing the re-entry of corporates, that too, when their contributions to the NPA portfolio is the highest, taming the shrew would not be possible. Regarding financial inclusion, in the context of corporate social responsibility, an expected voluntary effort at inclusive agenda from the corporates failed and had to be legislated into Companies Act 2012, it would be imprudent to expect them to embrace this agenda. Mismanagement of the economy by the Government cannot anyway be corrected by the RBI, however sagacious the Governor is. Correction lies in easing the rules of entry and exit.

from:  B. Yerram Raju
Posted on: Aug 24, 2013 at 16:28 IST

It is ironical to state of the general perception and the act of the present government has been to create additional statutory bodies in the concerned ministries to overtake the autonomy and independency of institution which the constitution has provided and not to work on cohesive and on united basis. Thus the motive of central babus and the central ministers is that all the powers be vested with them even at the cost of infringement and violation of federal structure provided by of our constitution
RBI has been doing the task which it has been assigned to do so without crossing its boundaries of Finance Ministry and if govt wants other financial parameters to be formulated, monitored and regulated by RBI then the powers to be given to them
With regards to entry of corporates into banking sector can the govt and RBI mandate that two third of their branches & focused operation is in the rural areas(where it is really required) as we have enough of banks in the class A,B cities

from:  Mukesh
Posted on: Aug 24, 2013 at 14:23 IST

Lot of hope is pinned on Dr Rajan for building the credibility of Indian economy, which has taken a serious drubbing owning to slow growth, high inflation, exchange volatility, external situation and the corruption scandals. It will be BIG ask to change in short span with a magic wand from the well reputed, experienced and erudite but given his proven fore-sighted vision, one can expect positive steps leading to building the credibility of India ad Emerging Tiger over medium term of couple of years. This needs much greater support from political elite and current scenario in our parliamentary politics does paint a grim picture. Political leaders must raise above their vote bank poltics to suport RBI or any other institution working towards bringing in financial credibility to our slipping economy. Else there is a potential danger in not only FIIs pulling out but also cost of debt will be significantly higher for Indian corporations looking to expand globally.

from:  Aslam Mohammed Allugundu
Posted on: Aug 24, 2013 at 13:33 IST

It gives some sense of relief that things are not that bad with the
Indian economy. But it is well known by now that the economy is under
serious stress and unless it is managed efficiently we are going to be
in trouble. Even though highly qualified people understand the problems
better; their efficiency in offering solutions to problems is not in
direct proportion to their (educational) qualification. What finally
matters to the common man like me is a low inflation and a stable
currency, which in turn will ensure stable prices.

from:  D. Darwin Albert Raj
Posted on: Aug 24, 2013 at 12:53 IST

Prof Mohan will be well served by making effort to interact and listen more with
investors (companies/portfolio managers) and bankers whose actions determine the
exchange rate movements. As a currency trader, i can say that his sweeping
statement exonerating the government of 'some special brand of economic
mismanagement' is laughable. Day-in day-out, companies and bankers are talking
about nothing else but massive decline in investments (approvals, land acquisitions,
environmental clearances, scant regard for contracts, retrospective amendments,
anti-corporate hostile commentary from politicians and bureaucrats etc etc), large
fiscal deficit fueling inflation (directly impacts currency) etc. In this backdrop, the
forward looking sentiments around attracting flows to the country are very poor. On
top of that there are chances of third front coming to power. These are the reasons
that traders sell rupee at every opportunity. The problem will explode if actual
outflows pick-up.

from:  enjay
Posted on: Aug 24, 2013 at 12:48 IST

There is some misunderstanding here - to focus on price stability
doesn't mean that the RBI cannot take exchange rate related
considerations into account in exceptional circumstances. There are
excellent reasons for focussing on price stability alone - the central
bank has only one instrument with which it can target one goal - if it
tries to do more it risks diminishing its credibility - you need to
understand modern monetary theory to get that.

from:  Mitra
Posted on: Aug 24, 2013 at 07:56 IST

Dr.Rajan is credited with the foresight to predict the 2008 depression which rocked
the Western economy. The world paid a very high price for ignoring his prediction.
He would do well to predict the fate of Indian economy so that ordinary citizens(
include the seniors also) may take necessary steps to protect their hard earned
savings. Hope he will not fall into the trap of mouthing false assurances as people
in power are wont to do. Hope and pray he will not fall into the classical
bureaucratic double speak

from:  Velamur Janardhanam
Posted on: Aug 24, 2013 at 05:59 IST

Prof. Ram Mohan ought to know a muddled mandate is a first class recipe to achieve nothing. That has pretty well been the case since independence: high inflation, low growth and low employment. It would be interesting to see the figure on how much India's Rupee has declined against the US Dollar or agianst a strong currency like Swiis Franc since independence. India's unchecked inflation has robbed our poor and powerless the most. Since they have little ability to raise their incomes in line with inflation, they have suffered the most. Even businesses done't want to enter into contracts in a currency whose value can't be predicted a few years out from the day of signing a contract. A solid, reliable currency can help remove tremendous uncertainty both for businees and for labour. Devauling one's currency is hardly the way to long term economic growth. Let us stop living in a muddlled dreamland and be clear sighted about what a central bank can do.

from:  Hoshiar Singh
Posted on: Aug 24, 2013 at 05:54 IST

Ram Mohan 's arguments feel quite circular, one minute he argues the Rupee has really not gone down against a theoretical currency that nobody deals in and the next minute he says that Rupee's value against the US Dolar is important because of the flight of foreign capital concerns. The foreign capital if not leaving India in big numbers, is certainly not coming in. As to Mr. Mohan's main point about the appropriate role for the Reserve Bank, most big economy governments and their central bankers have learnt thru difficult experience over the last several decades that a central bank can't be all things to all people and must pick a mandate that it can deliver on. Hence the changes in the manadates of central banks. Of course, to keep inflation under control, the bank has to know what is happening in the real economy. Let the politicians be all things to all people at the same time. Spare the bank and let it build confidence in the value of the Rupee.

from:  Virendra Gupta
Posted on: Aug 24, 2013 at 03:01 IST

One more solution can be found: In the early or middle of 70s the Govt.
announced "Demonitisation" of higher value currency and asked all the
Banks to take the names and addresses of those who exchanged beyond
certain limit. I know of large number of Politicians and those who were
hoarding huge value of currencies (Black monies) literally had to
destroy their bundles and wades of their higher value currencies at
their backyards! I am at a loss know if that can be done now. Only the
people at the higher levels, will be able to throw light on this.

from:  K.Sankaranarayanan.
Posted on: Aug 24, 2013 at 02:35 IST

What India needs from the new RBI Governor Dr. Rajan is to support the Government's push for higher growth. This may not be the mandate of the RBI but, minus growth, it is the poor who will hurt most. In order to achieve growth, India should boost manufacturing to around 20% of GDP. This will automatically make this an export driven growth and thus ease the problem of foreign debt. The Industrialized Countries are starting to bounce back. This is the right time for Dr. Rajan to help reboot the financial markets by some creative policies, which will make Chidambaram smile

from:  gita
Posted on: Aug 24, 2013 at 02:27 IST
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