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.
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.
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:>firstname.lastname@example.org)