Monetary Policy And Financial Reform: RBI under Raghuram Rajan

Background

     Despite predictions of a bottoming out of economic growth, the rate of growth of the Indian economy fell to 4.4% in Q1 of 2013-14 from 4.7-4.8% in the previous two quarters.  With the government and the Congress party (UPA II) focused almost exclusively on welfare laws and expenditures,  any remaining hope of decisive action on investment-growth enhancing reforms was rung out of the markets.  This led me to say a week ago that the Government-RBI had boxed themselves into a corner with little room for policy maneuver, and only an unorthodox fiscal-monetary policy, the “Macro-twist” accompanied by bold reform could now get the economy out of this situation.  In this context the appointment of Prof Raghuram Rajan as Governor of RBI was the only silver lining on the dark clouds hanging over the economy.  Raghu, on the day of taking over as Governor of RBI on 5^th August, 2013 used his international credibility among the Global Brahmins of Money and Finance and the World’s Central Bank Governors to expand the box, the range of options available to the RBI.

RBI under Raghuram Rajan

    Raghu’s first speech as governor(4^th Sept 2013), coming as it did on the day that he took charge,  surprised with the  speed with which he spelt out his vision for the RBI. In hindsight, it actually reflects the fact that he is probably the first RBI governor (in my memory), who in a manner of speaking was groomed for the job. Six years ago he was appointed chairmen of a committee on financial sector reforms and developed his ideas on banking, financial and institutional (RBI) reforms needed in India.   Since then he has been an external advisor to the PM, allowing him to keep in touch with the problems facing India.  Last year he was appointed as Chief Economic Advisor, to gain experience of the inner workings of the Ministry of Finance and the Government in General.  He was thus in a position to ‘hit the ground running,’ and he did so!

Given this background, including his international standing as a star economist and the indications he gave in his first speech, I predict that Governor Rajan will follow a two pronged approach to Monetary and Financial policy

(1) He will adopt a modern, neo-conventional monetary policy, and The epitome of ‘conventional monetary policy’ was “inflation targeting” based on the assumption that in the long run this is also the best policy for full employment/maximum Output (growth).  The “Neo” refers to the lessons learned by the Global financial-monetary czars about systemic risks and macro-prudential regulation, after the Global financial crisis (which he was the first to warn about).  Having, warned him about the problems of “inflation targeting” in India and heard his response, I would expect him to adapt it to Indian conditions and move cautiously in implementing this policy.  The new committee under DG Urjit Patel will likely draw up a road map for implementing this and supporting institutional reforms (like the ‘Monetary Policy Committee’).  As he said, he will spell out his monetary policy stance to current and expected  developments, like the unwinding of QE3, in his monetary policy statement on September 20^th , 2013

(2) He will forcefully pursue liberalization of financial markets, including foreign exchange markets and banking, institutional reform of the RBI & other financial institutions, and universalization of modern payment systems, banking & financial instruments (inclusion). He has already announced a number of specific liberalization on banking and foreign exchange.  Liberalization and promotion of competition are risky at a time of low growth and high uncertainty.  Thus timing and sequencing of liberalization measures needs to carefully weigh the gains against the risks: The latter can only be minimized through skillful but ruthless prudential regulation, e.g. on “Non-Performing Assets” (NPAs) and “ever-greening”.  Therefore he has already warned that he may have to take unpopular actions.  Some of the measures, such as new Banking licenses to industrial houses can also be politically contentious.  He has therefore wisely set up a committee under former RBI Governor & Member of Parliament (MP) Dr. Bimal Jalan, to act as the last word on new Banking licenses.

The RBI has been excessively cautious on the use of new technology to spread modern payment and banking systems.  Since the introduction of mobile pension payments in rural South Africa  and MPESA mobile cash in East Africa, I have been pushing the RBI to adopt these systems. As Raghu’s committee strongly advocated inclusion, I expect these to be speedily introduced in India.  This, and his committee’s innovative proposal to introduce ‘tradable priority sector lending commitments’ and other new ideas for inclusion will be chalked out under the ‘Nachiket More’ committee.

Conclusion

    In my view, these reform measures are Raghu’s answer to those of us who have argued for giving greater priority to economic growth.  With the reforms log jam persisting in Delhi, he is implicitly saying that he will follow a relatively conventional monetary policy and it is up to the government to do its part on the fiscal and structural policy side to promote growth.  At the same time he will try to help market expectations and confidence through a new more aggressive financial reforms policy, which will promote efficiency, investment and growth in the medium term.  Having expanded the range of Macro options, through his personal credibility and decisive start, it is now up to the government to act. 

[Note: This article was written on September 5th 2013, a day after Raghu's maiden speech, but has been pending with a newspaper since then.]

Monetary Policy & RBI

Q&A with Bloomberg on August 3, 2013

Q1: How do you assess India's current economic situation? Can you think of an adjective or a phrase to define India's current situation?

A1: India’s current Economic Problems are due to widespread Growth Complacency following the successful recovery from the Global Financial Crisis.
Q2: The U.S. Fed tapering is explained as one main reason why India is seeing a huge pain in terms of outflows and plunge in the rupee. What's your outlook on the Fed unwinding and what does that mean for India? Do you see it stretching over a 1 to 2 years timeframe and, if yes, what does that mean for the entire world, including India?  Do you see India going through a prolonged period of pain?
A2: The main reason for the Rupee depreciation is the loss of competitiveness of the Indian economy due to high inflation and low corporate investment, resulting in appreciation of the REER. With the rupee at 65/$ this has been offset for the time being. The Fed unwinding was a trigger for the depreciation.  The uncertainty arising from the Fed will reduce considerably once the new Fed Chairperson is selected by President Obama. However, another US interest rate rise, with its effect on capital outflows from Emerging markets is still possible.

Q3: How serious the current crisis is with the rupee plunging, IIP in negative, CPI inflation in double digits and widening deficits? Do you see a possibility of a recession or recession-like or stagflation or stagflation-like situation in India?
A3: The economic situation is extremely serious.  Barring bold policy reforms, I expect continued slow growth and persisting CPI (new) inflation in the 8-9% range.

Q4: What's your outlook for economic growth? Do you see a protracted growth slowdown in India?
A4: I first coined the word “Growth recession” to describe the Indian growth slowdown in 1997. I expect growth to bottom out in Q2 of 2013-14 (Q3 of 2013), but a very slow and protracted recovery, in the absence of bold policy reform to restore macro balance and revive corporate investment and growth.

Q5: What's your outlook for the rupee? Where do you see the rupee by the end of December? Do you see it touching 70 against the dollar? Or even lower than that?
A5: I think there is a high probability of the rupee ending 2013 between Rs65 –Rs70/USD.  However, I cannot rule out the possibility that another negative external shock could push it above Rs70/USD.

Q6: The rupee has continued to fall despite a slew of measures by the RBI and the government. What does the steep decline in the rupee indicate about the management of the crisis? What are the markets signaling about the management of the crisis?
A6: The depreciation of the rupee to about Rs 65/dollar was primarily due to the loss of competitiveness.  However, the attempt to keep it from moving to that level through various control measures backfired, with markets interpreting it as a return to old discredited methods of the 1970s.  the loss of credibility made it more difficult to keep the rupee from overshooting above Rs. 65/USD.

Q7: Why is India in such a mess? As an economist, who has analyzed India for more than three decades now, what do you think has gone wrong?
A7: There are four reasons (each of which I had warned about in 2009 my last year as CEA, MOF).    (a) High growth cannot be taken for granted and must be nursed through pragmatic measures to deal with bottlenecks and shocks.  The failure to institute policy regulatory & institutional reform measures has led to a down trend in growth.  (b) Old and new problems in the agriculture supply chain have resulted in inadequate supply while demand accelerated with per capita income resulting in and high food inflation. (c) Delay in pulling back on growth of government consumption (including subsidies) and reducing revenue deficit, and thus crowding out Govt.  investment and  leading to a demand bubble in 2010-11 (with its bursting from subsequent external shock). (d) Encouraging Capital inflow surge, instead of restraining it with predictable appreciation of the REER and consequently on Balance of Trade and Current Account Deficit.  

Q8: How do you think the Reserve Bank of India has tackled this crisis? What can the RBI do in such a situation to support growth and contain rupee's plunge and curb inflation?

A8: Reserve Bank assumed that the depreciation was due to credit financed speculation and tried a mix of traditional control measures and conventional liquidity tightening. As the move from Rs 55/USD to Rs. 65/USD helped correct the earlier appreciation (inflation differential) it was unsuccessful in doing so.  It also weakened its credibility.  In my view it should have let Rs depreciate to a point between Rs65 and 70, that it could successfully intervene to demonstrate effectiveness and give a message to speculators.

Q9: Do you think, we are in a somewhat a similar situation the U.S. faced in 70s (Nixon era) when it had a huge cad problem, that resulted in the dollar crumbling and forced Paul Volcker to raise rates aggressively? Do you see Volcker-like tightening as the final solution to get a grip on the currency crisis?

A9: I believe that a conventional monetary policy of raising interest rates in response to a rise in US rates will lower growth rates without stemming rupee depreciation or slowing CPI inflation which is largely due to Agriculture.  I have suggested an unconventional policy called the Macro-Pivot that would reduce government expenditure (including subsidies) to reduce government dis-saving and demand for non-tradables and loosening monetary policy to promote private investment and demand for consumer durables.

Q10: Do you think that the RBI is done with the rate easing cycle? What will be the future moves  towards tightening the rates (having already raised MSF and bank rate)?

A10: RBI’s policy will now be determined by the new RBI governor. We will have to wait till he takes over and signals his intentions.
Q11: What more do you think the RBI and the government can do to contain the currency crisis?

A11: The immediate crisis arising out of the rise in US interest rates has been contained.  Further shocks can only be dealt with by taking control of monetary policy (flexible exchange rate) combined with the “Macro pivot”.

Q12: Dr. Rajan in his 2009 financial reforms report advocated for a complete overhaul of the economic policy making in India, including, inflation targeting and operational freedom for the RBI and government cutting down deficits. Do you think Dr. Rajan will be able to push for the implementation of those reforms? What will enable him to do that or what will prevent him to do that?

A12: Raghuram Rajan as RBI governor has the authority to carry out all financial reforms pertaining to the RBI itself.  He can also influence the financial reforms pertaining to other financial regulators and the finance ministry, as historically RBI is viewed as more resistant to change. He has the blueprint of the committee that he chaired 6 years ago.  However, I would strongly recommend against introducing “inflation targeting” at this sensitive time.  Raghu will have little influence on what the government does on the deficit front.