Rajan’s surgical strikes

Sid Verma
Published on:

Reserve Bank of India governor Raghuram Rajan is battling inflation and crony capitalists to open a new chapter in the Asian superpower’s growth story. Rajan – Euromoney’s central bank governor of the year 2014 – reveals his blueprint for reforms and issues a stark warning about the cracks in the global economy.

Raghuram Rajan  

"Once genius is submerged by bureaucracy, a nation is doomed to mediocrity." Richard Nixon’s fateful proclamation on the dangers of red tape rings bells in modern India.

The country embarked on its capitalist project in the early 1990s and has notched China-style growth rates of over 9% in the boom years. But India’s promise remains perennially undercut by stifling bureaucracy and governance missteps.

The Indian state is still shackled by its colonial-era design to micro-manage the levers of the economy. It’s a handicap that all too often remains hidden during economic upswings.

The cost of India’s stalled liberalization drive has once again been brought to light over the past three years. A series of self-inflicted wounds savaged economic output to a mediocre, by emerging market standards, 5%. The power of crony capitalists was further entrenched, and private-sector growth in investment and production derailed.

It has been a very Indian crisis, squandering years of badly needed development. Unlike the demand-deficient West, inflation has hit 10% since 2009. The current account deficit was over 3% of GDP last year, which indicates the failure of the supply side of India’s economy to meet excess demand, say economists.

Instead, a comedy of governance errors under the accident-prone former Congress-led administration – such as delayed environmental clearances for new projects, land acquisition challenges and infrastructure bottlenecks – rocked the investment cycle and triggered stagflation. Gross fixed investment by the private corporate sector, for example, dropped from 14.3% of GDP in 2007/08 to just 8.5% in 2012/13.

Last year, Fed-tapering fears triggered investors to punish India for its fiscal and current-account deficits and poor growth outlook. The rupee dropped to historic lows. Prompted by capital outflows, fears snowballed that the country was on the verge of an Asia-crisis-style abyss.

In this baptism of fire in early September 2013, Reserve Bank of India governor Raghuram Rajan’s contrarian solution was to tighten monetary policy and adopt a new approach to stabilize the rupee by emphasising the battle to contain inflation as the principal anchor of monetary policy.

In the first few months, Rajan hiked rates to the positive surprise of the market. A majority of monetary policy committee members favoured keeping rates on hold or even looser conditions. The gamble, which earned comparisons to the former Fed chief Paul Volcker’s anti-inflationary zeal in the early 1980s, has paid off.

Growth has rebounded to reach a two-year high. The rupee has gained 10% against the dollar year-on-year and inflation has fallen by over two percentage points.

The market consensus at the time was that a pro-cyclical hike in rates would be counter-productive by savaging demand in an ailing economy. Rajan duly defied the consensus. It has convinced many of the leaders in India’s financial community that, at last, they have a central bank governor with the instincts and operational skills to help drive the country’s economy forward.

In a wide-ranging interview with Euromoney in the central bank’s headquarters, overlooking Mumbai’s monsoon-tinted skyline, Rajan reveals the rationale behind the tough monetary medicine. "I thought we needed to change the market language – not by direct interventions in the market but by signalling that we cared about the long-term value of the rupee. The key plank of this strategy was to send a very strong message about inflation. In that process, you don’t kill growth [by hiking rates to a high level solely for the short-run aim of attracting inflows]."

Investors credit the governor for bringing clarity and stability to the RBI’s policy framework. He has focused on the consumer-price index, rather than the lower wholesale-price index, as the monetary anchor. And he has sharpened monetary operations, with the repo rate as the benchmark tool. His package of quantitative measures to inject liquidity into the banking system and stabilize the current account, such as a swap window for deposits from nonresident Indians, served as a crisis circuit-breaker by courting badly needed capital.

These measures, in tandem with an easing of fears over the Fed’s loose-money policy, chart India’s exit from the group of 'fragile five’ emerging market economies. They also gave prime minster Narendra Modi’s reform-minded Bharatiya Janata Party breathing space to address fiscal and supply-side issues when it assumed office in May.

Buoyed by these market-soothing efforts, Rajan over the past year has reluctantly ridden a wave of domestic acclaim. Local media describe the governor as a "rock star" and a "sex symbol" with "chiselled" good looks and a tall frame. One India writer last year, with no hint of irony, stated: "The guy’s put 'sex’ back into the limp Sensex. That makes him seriously hot."

Rajan’s status as India’s top celebrity economist echoes that of Mark Carney, the former Canadian central bank governor turned Bank of England chief, whose pronouncements and charisma helped soothe financial markets in the teeth of the crisis.