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.
Insight
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.
Task ahead
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.
Repayment
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.
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