Rajan’s surgical strikes

By:
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.

Euromoney speaks with Rajan a day after his visit to New Delhi, the political capital, to discuss the new government’s reform plans. In person, Rajan cuts a charismatic and affable figure, with little evidence that the domestic and international acclaim have gone to his head. What’s more, his tall, lean physique and passion for racket sports – in a nation with few jocks – has endeared him to Indian journalists. It’s easy to see why. Rajan is just as comfortable discussing the political economy of reform as well as the monetary micro, unlike many of his emerging-market and G7 peers. After spending years as an outside critic, Rajan instinctively gives straight answers, a breath of fresh air, and a feat all the more impressive as a member of the policy-making establishment.

Rajan’s market-savvy and domestic leverage stem from his stellar career as an international economist, including a tenured post at the University of Chicago, and as chief economist at the IMF in the mid-2000s. In the latter post, he earned global acclaim for his prescient warnings in 2005 of a “full-blown financial crisis”. A year before his RBI appointment, Rajan returned to his country of birth for the powerful post of chief economic adviser for the former administration, having established a reputation as a pro-market reformist after penning a blueprint for Indian financial-market liberalization in 2008.

Rajan is now seeking to make Indian monetary history by introducing an inflation-targeting regime. The rationale for lower rates is clear. Household financial savings rates have fallen from 12% of GDP in 2007 to 7.2% currently, in part, due to high inflation, keeping government bond rates structurally high and capping the supply of risk capital. Hitendra Dave, HSBC’s head of global markets for India, explains how Rajan’s disinflationary drive could revolutionize domestic financial markets: “India traditionally has a relatively high savings rate. What we lack is risk capital. In order to get this risk capital, we need a structurally low interest rate regime to trigger a hunt for yield and bring flows into riskier formal asset classes – equity market, mezzanine debt and private equity.”

Instead, India’s high interest-rate regime has crippled the development of a corporate bond market. It has also made investment projects dependent on an inefficient and capital-constrained state-dominated banking system, which notched big losses in the 2009-2012 credit cycle. What’s more, India remains dependent on fickle pools of foreign capital to finance investment, leaving the economy prone to external shocks. Lower inflation and, thereby, lower interest rates would build up risk capital to finance India’s fledgling industrialization, say economists. Failure to generate domestic pools of savings would leave Indian markets hostage to external fortune, reflected in current-account deficit shocks and capital outflows, akin to the ‘fragile five’ roller coaster of the last 18 months.

Since assuming office last September, the governor has already effectively shifted from the dual growth/inflation mandate to an inflation-targeting regime. A panel Rajan appointed has proposed targeting CPI growth of 4% plus or minus 2 points.

While a single focus on curbing inflation has proved contentious in the post-global financial crisis, there is a political consensus on its benefits, given the erosion of the purchasing power of the poor in recent years, Rajan says. Any inflation-targeting framework would be sufficiently flexible to counter-cyclically address asset bubbles, a key lesson of post-global financial crisis monetary-policy making. “If I see inflation low for the long-term but I see asset-price bubbles, I would prioritize the latter,” he says. “But, for now, the biggest threat to financial stability is inflation.”

Raghuram Rajan
“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].”  


In any case, market players fear an inflation-targeting regime runs the risk of sacrificing short-run output on the altar of an unachievable target. The 57% weight of food and energy in the CPI basket highlights the structural forces for inflation and the strong influence of fiscal policy, given the administered prices of petrol, cooking gas and coal, as well as the food-security law.

Analysts at Credit Suisse, for example, are unconvinced: “The trouble is the Bank has little chance of achieving [the inflation targets], in our view, and attempting to do so at this stage could inflict unnecessary damage on growth and the RBI’s own credibility.”

Though the establishment of the CPI as an anchor for an official inflation target has been debated for at least 15 years, market players reckon Rajan’s time-scale for its adoption is overly bullish. Its hasty implementation could sow the seeds of volatility, they argue.

K Vaman Kamath, chairman of ICICI, India’s largest private bank, agrees: “Inflation is fraught with fiscal and supply-side challenges, which are outside his control. He has few tools, especially since we have leakages and food distribution issues at the state level. I think at this point in time it would be premature to introduce such a framework as the RBI would be left with the monkey on its back.”

But Rajan remains unbowed. He reckons the 6% inflation target for January 2016, and 4% (+/-2%) thereafter is achievable, while underscoring the long-term benefits of stable inflation expectations backed by central bank credibility. “If you believe fundamentally that inflation reflects a mismatch between demand and supply, you can’t be hurting demand and having no effect on inflation. We do have interest-rate sensitive segments in our economy, though they are not as large as in industrial countries.”

Rajan argues inflation in India is very much a monetary phenomenon, and that the efficacy of the repo rate as a transmission channel should not be dismissed. He says: “I do think there are aspects of CPI a central bank has some effect on. In any case, if food inflation is picking up in a secular way, you are ultimately responsible for that, since this is part of the inflationary experience of the people. In any case, food inflation exerts second-round effects, such as wage inflation and construction prices.” Rajan says this new framework would need some form of government backing, which “would probably be more substantial” than a letter from the prime minister, though a rewrite of the 1934 RBI Act might not be required.

Thus far, the governor has restored confidence to Indian markets, while embarking on a clutch of relatively uncontroversial reforms. These include a differentiated supervisory regime for financial institutions, new norms for recognizing impaired loans for the battered banking industry and the development of the interest rate-futures market. But the second year of his three-year term will require political nous to deliver on a welter of reforms such as establishing a rate-setting committee, building up day-to-day management of the RBI, and curbing judicial oversight of the central bank as financial regulator.

What’s more, Rajan is exhorting the government to meet deficit targets, pushing for subsidy reforms and seeking to liberalize the banking system. All these measures run against vested interests, from politicians with short-run growth objectives, incumbent industrialists that benefit from the status quo, especially the graft-prone subsidy system, to trade unions.

Raghuram Rajan
I would not say that we should turn around and say [G7] central banks should raise interest rates tomorrow as you will have a major market reaction. You can’t change expectations you have built up overnight. But it is a process that has to be started now

Raghuram Rajan 

Rajan says he has built up the leverage to tout the virtues of reform. “As a central bank governor, you need to convince people that you are capable on the practical side as well as theoretical side. But if they label you ivory-towered then they will say you don’t understand reality. The only way in my mind is to build credibility through successes, but you have to tell people you will stay the course.”

He has many a battle to wage. After all, vested interests in India’s corporate and political class have stalled India’s liberalization drive since the country embarked on its capitalist project in the early 1990s. Corruption, rent-seeking and patronage are rife in the economy. The Reserve Bank of India, however, is one of India’s most effective and independent institutions. By contrast, India’s bureaucracy is seen as one of the least efficient in the world and the country ranks a pitiful 134 out of 189 in the World Bank’s Ease of Doing Business ranking.

Few economists have a sense of the holes in the heart of India’s development model better than Rajan. In a seminal 2005 book called Saving capitalism from the capitalists, by Rajan and Luigi Zingales, two then-Chicago economists, conventional left/right political distinctions are subverted.

In the book, the authors launch a manifesto for financial liberalization to undercut incumbent industrialists that rig markets and feed off extractive political and economic systems that undermine private-sector innovation and the rule of law in emerging markets, especially. One extract notes: “The greatest political enemies of capitalism are not the firebrand trade unionists spewing vitriol against the system, but the executives in pin-striped suits extolling the virtues of competitive markets with every breath – while attempting to extinguish them with every action”.

It’s a description all too apt of modern India. The country lacks a strong bankruptcy law for corporates. The court system is over-burdened, graft-prone and subject to long delays, which make asset recovery rare. Meanwhile, the equity of industrial conglomerates is perennially protected by politically connected industrialists who exert pressure over public-sector lenders.

Rajan says the pile-up of bad loans from the 2009 to 2012 cycle is a wake-up call to the financial and political establishment. “I would not rule out that some loans in the recent credit cycle have been given without a free and frank valuation. The system is skewed in favour of the incumbents.”

The August arrest of the chairman of state-run Syndicate Bank, Sudhir Kumar Jain, on allegations of accepting a bribe in return for extending a loan to a weak borrower, the first-ever such arrest of a bank chair, highlights the deficiencies of the Indian state-led banking system, which controls 70% of sector assets. Also that month, the managing director of heavily indebted Bushan Steel, an auto-grade steel manufacturer, was implicated in a bribery case, threatening its $6.6 billion debt load and highlighting the lack of rigour imposed by lenders of borrowers’ asset quality and governance structures.

Relationship-based lending, the shortage of high-rated large borrowers and crony capitalism, more generally, create a system where promoters – as many of the main industrial groups, such as Adani, Essar and Tata, are known – are able to dictate borrowing terms to lenders.

“We can’t change the past, but going forward we need new bankruptcy laws as well as a better system to absorb corporate distress and where equity-holders shoulder the risk,” the governor says.

It sounds like Rajan would like to introduce a US model of receivership. At present, however, asset-recovery companies, for example, typically take over a distressed asset from a promoter and take the underlying credit risk, but are then compelled to return the asset back to the promoter, rather than reselling it for a profit.

Rajan adds: “This structure does not make any sense because the very fact the asset-recovery company took the asset away indicates that its financeability was less than what the promoter owed in debt. Now, just because an asset-recovery company turned the asset around and made it work, why should it automatically go to the promoter?”

This is just one example of the rot in Indian finance, says Rajan. “No one is saying you should put borrowers into debtors’ prison. We are in the opposite situation. The former finance minister, for example, made the remark: ‘There are no sick promoters, only sick companies’. I agree. There is a general feeling amongst the public that in India it is a skewed form of capitalism. Promoters take the upside but the downside goes to the creditors, especially the public-sector banks. We need to change that system.”

In India, corporate chieftains from mining to telecoms, rather than senior bankers, are the principal target of public opprobrium. Deepak Parekh, chairman of Housing Development Finance Corporation, one of India’s largest financial conglomerates, adds: “Vested interests have always been a problem in India to reduce new market entrants. India has a problem of crony capitalism. Powers-that-be support one group over the other, and this is heightened during elections. But this government is different: it is against crony capitalism and for industrialization.”

More traditional financial capitalism – development of alternative financing avenues, such as a corporate bond market with credit-rating invigilation and mark-to-market discipline, and creative destruction through bankruptcy laws – would temper corporate excesses, Rajan says.

The governor perhaps unwittingly has proved a master in the art of critiquing market consensus from within the establishment. After all, in 2005, at the annual gathering of the world’s leading central bankers at Jackson Hole, Wyoming, Rajan, the then-IMF chief economist, earned global acclaim after warning a “catastrophic meltdown" could rock the global economy. Although this was not his benchmark scenario, he cited the growth of complex financial products and pro-cyclical compensation packages for risk-taking as seeds for the crisis. The speech – which swam against the tide of market triumphalism during an era economists dubbed the Great Moderation – reportedly earned a rebuke from former US Treasury secretary Larry Summers, who dubbed Rajan a “Luddite” for under-stating how financial innovation had structurally diversified risk.

Reflecting on the experience in his 2010 book Fault lines: how hidden fractures still threaten the world, Rajan would later write: “I felt like an early Christian who had wandered into a convention of half-starved lions.”

Rajan confounds left/right stereotypes. He is a supporter of free trade and relatively liberalized financial markets. But he is a critic of income inequality – citing this as a driver for the global crisis through subsidized mortgage credit in the West – and a proponent of strong financial regulation. His experience as a pre-crisis market Cassandra shapes his views today, mindful of the risks of financial globalization and the holes in the global economy.

On the former, India’s volatility in the global emerging market storm – sparked by the Fed-taper tantrum – last year underscored the negative spillover effects of US monetary policy. Euromoney understands emerging market policymakers, led by South Africa, engaged in fruitless discussions with other Bric economies about the prospect of coordinated interventions in the foreign-exchange market at the height of the sell-off last autumn.

HSBC’s Dave sheds light on the storm that unexpectedly ravaged India: “The lessons and the experience of 2013 were very clear – offshore investors bought zero/low risk, highly liquid INR T-bills on a fully hedged basis pre-taper talk; and in the post-taper months, there was a massive sell-off, which put enormous pressure on rates and currency, as the market suddenly seemed to have noticed India’s wide external sector deficit.”

The governor – who formally nailed his colours to the mast of capital-account liberalization as an independent economist – is still relatively bullish compared to previous RBI governors. He says he would like to see the rupee as a truly global reserve currency in 10 years’ time, with the IFC’s Rs6 billion bond in September, the first foreign issue in local currency, a format akin to China’s Panda bonds, a baby step on this journey. Rajan says the RBI will remove limits on foreign participation in the domestic bond market “once the world becomes excited in a more substantial way about the India story”. This could happen once the economy reaches potential output over two consecutive years and foreigners organically move to long-end maturities, giving regulators a degree of confidence about the stickiness of flows, he argues.

The latter is a pan-emerging market challenge. The Fed’s uncompromisingly domestic focus in its policy framework forced emerging-market current deficit nations to engage in pro-cyclical monetary tightening over the past year, to stabilize besieged currencies and combat volatile Fed-induced credit cycles. However, domestic policy redress remains in a bind given the challenge of managing exchange rates, allowing the free movement of capital and boasting an independent monetary policy all at the same time. Even countries with fully floating exchange rates and strong prudential regulations are at the mercy of the US monetary cycle, given the structure of global financial markets, Rajan says. “The whole mantra used to be: ‘Let your exchange rate be flexible and then you will have no problem’. That is not useful advice. Sure, you have to allow some flexibility, but that alone won’t protect you when you have crazy credit cycles overlaid to this macro policy challenge.”

Rajan says the IMF needs to redouble efforts to stabilize the international financial architecture. “The IMF is becoming more sensitive to the issue of spillovers. And over time, the notion that whatever industrialized countries do is right and the best of all worlds – and emerging markets better figure out how to react – is something it is moving away from.”

He says the IMF’s relatively new multilateral surveillance programmes, including of G7 monetary policies, are steps in the right direction. Rajan is outspoken about the western-centric global financial architecture, from emerging markets’ dependence on the Fed’s monetary cycle to the lack of reform of the IMF’s quota to reflect the new-found clout of developing markets. “As a former IMF official myself, I think it would be good, and beneficial for the world if we could strengthen IMF governance, make it impartial, and use its undoubted resources as a stabilizing force.”

Rajan fears failure to establish global safety nets – to give policymakers confidence about the provision of emergency short-term balance-of-payment or liquidity support – will trigger trade mercantilism and a futile dependence on export-led growth. “Without safety nets, current-account surplus countries will continue as they are, and countries will feel more weary about running deficits and so placing pressure on reserve-holding countries to stimulate global demand [such as the US consumer]. Without safety nets, volatile credit and demand cycles will be reinforced and pressure points in the global economy will remain. And yet, sometimes speaking from an emerging-market perspective, you sound shrill when you are actually trying to oppose any degeneration into mercantilism.”

The former Chicago economist also fears a breakdown in global monetary co-ordination has taken root, with a disconnection between bullish G7 financial cycles and anaemic real economies as central banks engage in competitive-easing wars at the mercy of financial markets and fiscal reform-inertia.

“The politics are not working in a number of areas in industrialized countries. The pressure has been on the central banks to do all the heavy lifting in an environment when demand can’t be generated through normal means. What you see now is extraordinary monetary policies creating pressure on exchange rates to be lower than would otherwise be the case. Pressure for competitive exchange-rate easing is taking place while financial markets get overly boosted without meaningful investment.”

He adds: “Until the politics starts working and the real economy starts up, pressure on central banks will remain. But for how long can central-bank accommodation continue? At some point, however, they should say: ‘We have gone thus far and no more. Don’t push me further.’ There is a collective action problem, of course – if one central bank stops its accommodative policies and another continues, it will immediately have an impact on the exchange rate.”

But central banks are caught in a do-or-die situation. “I would not say that, given expectations in the market, and where we are today, more generally, that we should turn around and say [G7] central banks should raise interest rates tomorrow as you will have a major market reaction. You can’t change expectations you have built up overnight. But it is a process that has to be started now.”

If I see inflation low for the long-term but I see asset-price bubbles, I would prioritize the latter,” he says. “But, for now, the biggest threat to financial stability is inflation.
Raghuram Rajan

Rajan’s alternative policy mix – supply-side reforms to boost long-run output – is a bitter pill to swallow for growth-minded politicians in the short-run. What’s more, many economists fear the next global crisis will be closer to home, as China nurses its hangover from its six-year debt binge and unsustainable investment spending. Still, Rajan, emerging Asia’s second-most powerful central bank governor and a former senior IMF official, surprisingly proffers no strong view on China’s debt burden, citing the opacity of Asia’s largest economy.

The governor bats off suggestions he could lead the IMF after Christine Lagarde in 2016, citing the scale of his RBI challenges and the excitement posed. The IMF’s loss would be Delhi’s gain. Rajan’s battle to undercut inflation, build up savings and deepen financial markets will prove the key to power Modi’s bid to shift India to an east Asian growth model, with heavy infrastructure spending, a large manufacturing base and urbanization. India’s reputation as an economic dynamo to rival China needs a revival.

HDFC’s Parekh concludes: “To some extent, India is ungovernable. The economic and political issues are so complex, so diverse and all need to be addressed at the same time. But, nevertheless, the youth of today are optimistic about the new Modi government, which is backed by a reformist RBI.”