Raghuram Rajan >assumed office a year ago at a time of soaring inflation, receding growth prospects, widening deficit on the current account and a veritable run on the rupee which was in free fall. A year since, inflation is under control, the economy is bouncing back, current account deficit has been whittled down to an insignificant statistic and the rupee has reversed trend to such an extent that it is the best performing emerging markets currency in the last one year.
Admittedly, not all of it is the Rajan effect. The heavy lifting in terms of shoring up the rupee and reining in the current account deficit was done by his predecessor D. Subbarao but Dr. Rajan managed the fallout well and rolled out further nuanced policy measures such as the special foreign currency swap arrangement with banks for attracting deposits from NRIs. It would not be an overstatement to say that the >background of Dr. Rajan — his formidable academic credentials, his initial sure-footed moves that were closely watched and his confident statements — went a long way in calming the nervous markets. So much so that when the markets began to reverse direction soon after, pundits were quick to term it the “Rajan rally.”
Battle against inflation But combating currency speculators and steadying the rupee was just the immediate priority; there remained the larger problem of quelling inflation and helping the Centre pursue its growth agenda. This is where Dr. Rajan surprised long-term Reserve Bank of India (RBI) watchers who, given his Chicago school moorings, did not expect him to adopt a conservative approach. Yet, that is exactly what he did — raising benchmark interest rates twice within the first two months and raising them yet again in January 2014. It must not have been easy for the RBI Governor, given that the government was in election mode, growth was slipping and the corporate sector was screaming from the rooftops for a reduction in rates.
What’s more, he took the battle against inflation to the next level by targeting consumer price inflation rather than wholesale price inflation, which has traditionally been the benchmark for the RBI. This was one of the important recommendations of the Urjit Patel Committee that he constituted on his first day in office and a >key reform measure that he accomplished within a few months of assuming office. The RBI may have tasted greater success in quelling inflation if only it had got adequate support from the Centre, as much of the price rise, especially in food commodities, was due to supply-side factors.
Dr. Rajan also managed to make the process of handing out new bank licences transparent and controversy-free, though he is still far from redeeming his initial promise of licences on tap. The RBI Governor has also not been able to persuade foreign banks to open wholly owned subsidiaries in India, which is important from the regulatory >point of view given the experience with the 2008 crisis . Despite the freedom to open more branches that comes with subsidiarisation, foreign banks have refused to take the RBI bait and this will be a work in progress for Dr. Rajan for the remainder of his term.
Some limited successes
The RBI Governor has also tasted only >limited success in prodding banks to move away from their “lazy banking” habits. The two cuts in statutory liquidity ratio aggregating to 1 percentage point have to be seen in this context. Dr. Rajan was clear in his view that banks should be more active in lending rather than simply parking their funds in government securities. That bank lending has not picked up in the last one year is something that the Governor must surely be conscious of.
Dr. Rajan may also derive only limited satisfaction from his moves on reining in bad loans. He had signalled an aggressive intent in that speech on his first day when he said promoters do not have a divine right to stay in charge even when they mismanage. It has taken more than a year to see the first impact of that aggression — just this week United Bank of India (UBI) declared Vijay Mallya and Kingfisher as “ >wilful defaulters .” The RBI’s resolve in pushing banks to clean up their balance sheets and haul up recalcitrant borrowers will be fully tested in the months ahead. As banks begin to crack the whip, there is bound to be political pressure from influential borrowers, some of whom also occupy public offices. Handling the fallout will be one of the most important tasks for Dr. Rajan in his second year in office.
The RBI Governor also faced his first setback on reforming the central bank when his proposal to appoint a chief operating officer elicited opposition from within, including the unions. Though he moved quickly to control the situation, his moves on this front will be closely watched.
The tricky path ahead As the growth impulse returns in the economy, the RBI will be faced with the renewed threat of a bounce back in inflation. The RBI Governor has set a target of 8 per cent for consumer price inflation by January 2015 and 6 per cent by January 2016 and he will be tested to the full in meeting those targets. With retail inflation close to the targeted level now and wholesale inflation also soft, pressure is already mounting on the RBI to take a re-look at interest rates. This is where the tricky part begins for Dr. Rajan — while he has to be conscious of his responsibility to keep prices in check, he also needs to ensure that his moves do not end up discouraging investment.
The good news though is that he seems to have struck a >good rapport with the powers in New Delhi . This is important, not just in the conduct of monetary policy, but also in the context of the recommendations of the Financial Sector Legislative Reforms Commission which, if implemented, will curb the role of the central bank. If Dr. Rajan’s good understanding with the Centre is sustained, we could well see more reforms from the RBI in the months ahead.