Raghuram Rajan needs to think fast and creatively as he prepares to lead the RBI and its efforts to stabilise the rupee
One of India’s most astute Central bankers, Y.V. Reddy, once said that when faced with a very complex macroeconomic and political environment, what really matters is your intuitive capacity to take the right decision based on experience and knowledge. Some of these intuitive calls may even go against the grain of what well-established technical templates of economics might dictate. After all, “rational policy” has been conspicuous by its absence since the world economy went into a slump in 2008. Every conventional rule of economics has been turned on its head over the past five years.
Indeed, the big challenge for Raghuram Govind Rajan, who will be among the youngest governors of the Reserve Bank of India when he assumes charge on September 4, will be to hone his intuitive ability to do the right thing in the crisis-like situation that has engulfed the economy.
Mr. Rajan is credited with having displayed a sharp, contrarian insight in 2005, in the middle of the global economic boom, at a function held in honour of the then awe-inspiring Federal Reserve Chairman, Alan Greenspan. In the midst of the Greenspan-led liquidity and credit boom in America, Mr. Rajan had raised the question of whether banks will be able to provide adequate liquidity to the financial markets in the event of large-scale credit defaults. He had also asked whether in such an eventuality “how financial positions would be unwound and losses allocated in a manner that the consequences for the real economy [would be] minimized?” This question remains valid today as large-scale socialisation of losses continues to weigh down sovereign balance sheets, causing social unrest across the developed world, especially Europe. While losses have been socialised, private bankers are fully back in business.
Mr. Rajan, a Professor of Finance at the Booth School of Business, University of Chicago, came as an honorary economic adviser to Prime Minister Manmohan Singh in early 2008. In that year itself, he headed a 13-member committee which recommended far-reaching reform of the financial markets as well as the banking and regulatory system. Some of the big ideas generated by this committee, including fuller capital account convertibility, had lost intellectual support after the 2008 global financial meltdown when reigning market theologies underwent a big change. The role of central banks also altered fundamentally.
For instance, the Rajan Committee in mid-2008 had recommended that the RBI should confine itself to formal inflation rate targeting for the economy as some western central banks do. The job of regulating banks should be done by a different authority. However, the RBI resisted this idea and D. Subbarao publicly declared that the global consensus after the 2008 financial crisis was that central banks must pursue multiple objectives, including overseeing financial stability. Mr. Subbarao had implied that in Indian conditions, the narrow mandate of inflation targeting would not work. The RBI indeed went on to pursue multiple objectives. The governor was supported by reputed former RBI Governors like Bimal Jalan, Y.V. Reddy and even C. Rangarajan in this argument. This debate remains inconclusive. Mr. Subbarao’s stance was seen by critics, including members of the Rajan Committee, as the RBI’s reluctance to give up its turf.
However, it will be interesting to see how Raghuram Rajan, as RBI governor, views his own recommendations of the past. He cannot bring about any radical change in the bank’s functioning without taking the RBI bureaucracy, which seems quite formidable, into confidence. The RBI has institutional credibility flowing from its history and is known to have fought successful intellectual battles in recent times to preserve its core mandate.
For instance, Pranab Mukherjee as finance minister created an overarching financial stability body called the Financial Stability and Development Council (FSDC). This body, headed by the finance minister, was meant to supervise all regulators, including the RBI. The RBI resisted this idea vigorously and managed to get Mr. Mukherjee to considerably dilute the idea. As a result, the FSDC exists largely on paper today.
Interestingly, the idea to create this body came from the Raghuram Rajan Committee. Will Mr. Rajan, as RBI governor, try to breathe new life into FSDC? If he were to pursue some of the bigger ideas he has espoused personally and through formal committees, he would end up whittling down the RBI’s current mandate.
In any case, in the immediate short to medium term, Mr. Rajan will be fully preoccupied in the firefighting exercise to stabilise the currency market which is the single biggest challenge for the central bank and the United Progressive Alliance (UPA) government. The rupee’s value has gone down from Rs.45 to a dollar in May 2011 to Rs.60 plus today. In just over two years, the rupee has lost over 30 per cent of its value. The rupee’s value crossed the first psychological threshold of Rs.50 in 2011 and stayed mostly above Rs.50 in 2012. This year, it breached the second psychological barrier of Rs.60 and, in spite of all efforts by the government and RBI in recent weeks, the downward pressure on the currency continues.
The RBI today is caught between a rock and a hard place. Economic growth has collapsed and the central bank wants to ease interest rates to boost the economy. If the RBI eases interest rates, it is feared the rupee may weaken further causing a spiral effect. Currently, the RBI cannot address growth and its sole focus is on curbing the rupee’s volatility and letting it come back to its fair value. C. Rangarajan, Chairman of the Economic Advisory Council to the Prime Minister, reckons the appropriate value of the rupee based on the commonly accepted 6 country or 36 country trade-weighted basket is about Rs.59 to a dollar. Going by this metric, the rupee is clearly undervalued. The RBI’s challenge is to see that the rupee does not slide further to Rs.65 to a dollar, which many analysts predict.
The government needs to pay about $172 billion of short-term debt within one year, by March 2014. Then there is a current account deficit of about $80 billion which needs to be met with capital inflows. It is estimated that Indian corporates have taken foreign loans of over $200 billion and over 50 per cent of this dollar credit exposure is unhedged. This means these companies have already suffered an extra $30 billion loss in their books because of 30 per cent rupee depreciation in two years. It must be remembered that the high corporate foreign currency loan defaults had primarily caused the East Asian currency crisis and capital flight in 1997.
Mr. Rajan will also have to grapple with the sharply deteriorating loan portfolio of banks. Since 2008, Indian banks have restructured loans of business houses which, if strictly accounted for, may take the non-performing loans to about eight per cent to 10 per cent of the total credit outstanding. This is another time bomb ticking. A large number of influential businesses have used their political clout to postpone repayment of loans even as their extravagant, personal lifestyles have not changed. Mr. Rajan may have to draw some ideas from his first book, co-authored with Luigi Zingales, titled Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity in dealing with future loan defaults by big corporates. All in all, he is walking into rather rough weather.