BackGoodbye, RBI governor
MintAsia examines the implications of Raghuram Rajan's decision to step down at RBI in the last leg of the relentless fight he has waged against inflation
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Mumbai: In September 2015, when he was asked at a press conference whether he was a hawk or a dove, the Reserve Bank of India (RBI) governor had this to say: “My name is Raghuram Rajan and I do what I do."
The remark, made after he had just cut the policy rate by a higher-than-expected half a percentage point, and many others like it, built a public perception that Rajan didn’t exactly conform to the image of a traditional Indian central banker.
His announcement on 18 June—an otherwise quiet Saturday when the all financial markets were shut—reinforced that perception.
In a letter he wrote to RBI staff and put up on the central bank’s website for “wider dissemination", the 53-year-old former International Monetary Fund (IMF) chief economist said he would demit office after his three-year term expires in September.
“I am an academic and I have always made it clear that my ultimate home is in the realm of ideas..." wrote Rajan, who is on leave from the University of Chicago, where he is the distinguished service professor of finance at the Booth School.
In the letter, he detailed the RBI’s achievements over the past three years and the work in progress, including the clean-up of bank balance sheets ridden by bad loans and the setting up of a monetary policy committee.
The bank clean-up is by no means over. The monetary policy panel is yet to be formed. A new generation of payments banks and small finance banks to widen financial inclusion aren’t yet in place.
“While I was open to seeing these developments through, on due reflection, and after consultation with the government, I want to share with you that I will be returning to academia when my term as governor ends on September 4, 2016. I will, of course, always be available to serve my country when needed."
Finance minister Arun Jaitley said the government appreciated Rajan’s “good work" and respected his decision. “A decision on his successor would be announced shortly," Jaitley tweeted.
Rajan’s decision to step down at the end of his three-year tenure, one of the shortest for an Indian central bank governor, followed a campaign by the ruling Bharatiya Janata Party (BJP) member of Parliament Subramanian Swamy for his ouster.
Swamy had written open letters to Prime Minister Narendra Modi demanding the sacking of Rajan, whom he accused of holding back economic growth by keeping interest rates high.
He said Rajan was “mentally not fully Indian" and that he had planted a time-bomb in the financial system—a reference to $24 billion in three-year time deposits that will mature later this year; commercial banks mobilized the money to help stabilize a tottering rupee in late 2013, and some of them may come under redemption pressure.
“The government had invited this development (Rajan’s exit) through a craftily planned campaign of insinuations, baseless allegations and puerile attacks on a distinguished academic and economist. As I had said some time ago, this government did not deserve Dr. Rajan. Nevertheless, India is the loser," former finance minister P. Chidambaram said.
To be sure, it was an open secret that differences existed between the RBI governor and the government over the depth and pace of interest rate cuts. Rajan’s comparison of the Indian economy, which some economists have described as a rare bright spot in the world, to a “one-eyed man being king in a land of the blind", was criticized by finance minister Jaitley, his junior Jayant Sinha and commerce minister Nirmala Sitharaman.
Predictably, Swamy was jubilant after Rajan announced his exit. “You people said I don’t count for anything and Rajan will be given a second term and the prime minister likes him very much and the finance minister is in love with him," Bloomberg cited Swamy as saying. “What happened in the end? You looked all silly."
That wasn’t the reaction of market participants and observers. “We are quite baffled by the development as continuity would have been preferable...," wrote Sanjeev Prasad, senior executive director and co-head of Kotak Institutional Equities, an arm of Kotak Securities Ltd, on 19 June.
“Before the potential Brexit shock, the Indian market will need to weather the Rexit shock," securities house CLSA wrote in a note on 20 June. Brexit is a term coined to describe the British referendum to decide whether the UK should leave the European Union.
Investor nerves were fraught when the markets opened on Monday, 20 June. The worst didn’t come to pass, and the Bombay Stock Exchange’s benchmark Sensex index ended the day almost 1% higher, soothed by a government announcement on opening the doors wider to foreign investment in areas including defence, civil aviation, food products and pharmaceuticals. Still, foreign investors sold $342.66 million in debt and $78.27 million in equity on Monday. The rupee closed at 67.32 per dollar, 0.35% down, but off its lows amid market speculation that RBI sold dollars through public sector banks to stem its weakness.
The big worry had been the currency and how it would react. That’s not surprising, given that bringing stability to the rupee has been one of the significant achievements of the RBI under Rajan.
It started with Rajan’s plan to boost reserves to provide a buffer to the currency in 2013, when it was at its most vulnerable and fell to a lifetime low of 68.85 against the greenback.
Also Read: RBI should not capitalize public sector banks: Raghuram Rajan
A special swap window opened then brought in $34 billion, including $24 billion in foreign currency non-resident (FCNR) deposits, and comforted investors. The one-time measure was followed by an intense focus on inflation control, which reinforced foreign investor confidence and led to strong overseas inflows into the debt market.
To be sure, a decisive victory for the BJP-led National Democratic Alliance in the 2014 general election and the subsequent fall in oil prices, which helped lower India’s current account deficit, were equally critical in reversing the fortunes of a currency, which only three years ago was among the “fragile five"—a term coined by Morgan Stanley to describe Turkey, Brazil, India, South Africa and Indonesia.
The subsequent turn in the investor mood around India and its economic policies translated into a steady flow of portfolio money.
Foreign portfolio investors (FPIs) have invested $30.8 billion in Indian equities and $29.3 billion in Indian debt over the three years since Rajan took charge.
Now, with oil prices rising, nearly $25 billion in foreign currency deposits coming up for redemption and the global environment looking shaky, Rajan’s exit couldn’t have come at a worse time.
“The immediate near-term impact is negative for INR (rupee) and equity markets, especially in the context of the upcoming Brexit worries and large US dollar outflow worries as NRI deposits mature," CLSA analysts wrote.
However, once the initial shock of Rajan’s announcement abated, analysts said they expect Indian markets to go back to focusing on global triggers, the progress of the southwest monsoon and, most importantly, the naming of a new governor.
“...we expect the markets to wait for more clarity on the new governor’s name and, more importantly, his views on continuity vs change. If the new governor is able to strike a right balance between the two, then he will gain credibility and market focus is likely to shift back to improved macro fundamentals," said Samiran Chakraborty, chief economist for India at Citibank NA.
RBI deputy governor Urjit Patel, who heads the central bank’s monetary policy division; State Bank of India chairperson Arundhati Bhattacharya; Subir Gokarn, another former deputy governor and former chief economic adviser Ashok Lahiri have been mentioned as potential candidates for Rajan’s job.
On Monday, 20 June, Rajan stepped out to deliver a lecture in Mumbai in which he sent a strong message to policymakers.
Through his tenure, Rajan has raked up a number of crucial issues in his speeches, including some that were clearly outside his remit—whether it was making a case for tolerance at a time when the country was debating a ban on beef, warning of the dangers of dictatorship or labelling bank defaulters as freeloaders. In fact, some would argue that his decision to speak out publicly on many of these issues was the reason that he fell out of favour with the political establishment.
Now, with his resignation delivered, Rajan chose to make another crucial point—don’t give up the fight against inflation, however tough it may get in the months ahead.
Under Rajan, RBI has moved to targeting a level of consumer price inflation and intends to bring the rate down to 4% (+/-2%) over the medium term. The government is also in the process of setting up a committee mandated to steer monetary policy.
As he demits office, Rajan urged that these reforms be taken to their logical conclusion.
“In the days ahead, a new governor as well as the members of the committee will be picked. I am sure they will internalize the frameworks and institutions that have been set up, and should produce a low-inflation future for India," said Rajan.
Rajan noted that fighting inflation is never easy and results in a push-back by those who benefit from negative real interest rates as a consequence of high inflation. All constituencies must make adjustments if the country is to benefit from a sustained fall in inflation, he said.
“For example, if industrialists want significantly lower rates, they have to support efforts to improve loan recovery so that banks and bond markets feel comfortable with low credit spreads. The central and state governments have to continue on the path of fiscal consolidation so that they borrow less and, thus, spend less on interest payments. Households will have to adjust to lower nominal rates, but must recognize that higher real rates make their savings more productive," he said.
Rajan has often been criticized for not lowering rates quicker although RBI has cut its benchmark repo rate by 150 basis points since the start of 2015.
At its last policy review on 7 June, RBI kept rates steady, citing the resurgence of inflation pressures. Consumer price inflation quickened to 5.7% in May, well above RBI’s target of lowering it to 5% by March 2017. “Adjustment is difficult and painful in the short run. We must not get diverted as we build the institutions necessary to secure a low-inflation future, especially because we seem to be making headway," said Rajan.
His pitch came at a time when only a part of the new monetary policy framework is in place. While the inflation targets are in place, the monetary policy committee is not. Also, as is widely accepted, the last leg of the inflation fight will be the toughest since the benefits of low commodity prices and sluggish demand are ebbing.
Economists are hopeful that the progress in fighting inflation will not be undone.
“We think that some of the changes brought in by Rajan (flexible inflation targeting doctrine, CPI headline being the target) are irreversible. However, the new governor might have different views on the appropriate level of real interest rate, pace of attaining the 4% target, given growth considerations, and liquidity management framework," said Chakraborty.
Rajan would also want to see his efforts to clean up the banking sector and improve what he termed as the “sanctity of the debt contract" carried forward.
His desire to put an end to years of crony banking in India was obviously right from the start.
“Promoters do not have a divine right to stay in charge regardless of how badly they mismanage an enterprise, nor do they have the right to use the banking system to recapitalize their failed ventures," said Rajan in his opening comments on the day he took over as governor.
He proceeded to ask the then deputy governor, K.C. Chakrabarty, to look into the issue of rising bad loans and the restructuring of bad loans that had been used as a way to evergreen assets gone sour. The process was carried forward under S.S. Mundra, who is the deputy governor in-charge of the banking supervision department.
What followed over the next three years were a series of steps intended to bring the actual level of bad loans in the Indian banking sector to light and to try and resolve them effectively.
In January 2014, RBI put in place a new framework for the resolution of stressed assets which laid down the processes to be followed by banks. But the problem was that no one actually knew the real amount of bad loans in the system.
Borrowers had gamed the system for years by borrowing across different banks without adequate disclosure. And so, RBI proceeded to set up a central repository of information on large credits (CRILC).
With the information in place, RBI moved ahead and conducted a first-of-its-kind asset quality review (AQR) across the banking sector in fiscal 2016.
The result was that bad loans across the 40 listed banks had increased to ₹ 5.8 trillion at the end of March from ₹ 4.38 trillion at the end of December. At the end of the September quarter, before the review, bad loans across 39 listed banks were estimated at ₹ 3.4 trillion. The data for the September quarter excluded IDFC Bank Ltd, which started reporting earnings as a bank only in the December quarter.
RBI also provided banks with a number of tools to deal with stressed loans. Some of these tools are potent and can be misused unless closely monitored by a strict regulator.
Among them is the strategic debt restructuring (SDR) scheme and the scheme for sustainable structuring of stressed assets (S4A). The former allows banks to take over majority ownership of a stressed company and turn it around or sell it, while the latter gives banks the option to convert at least half of the debt of a stressed company into long-dated equity-like instruments.
The fear now is that efforts to put an end to the cozy relationship between bankers and industrialists will suffer and the resolve to clean up the banking sector will be diluted.
“RBI has also been working with the government on banks’ bad loan recognition and in empowering banks with new structures to recover dues," said Sonal Varma, managing director and chief India economist at Nomura, in a 19 June report.
“Dr Rajan’s exit could slow down the process of bank restructuring, particularly if the new governor is not as firm about bad loan recognition. Bank non-performing loans have continued to rise and inadequate capital injection by the government into public sector banks has meant that weak bank balance sheets may remain an overhang on the economy," she added.
Rajan’s successor, whoever it is, would do well to pay heed to something he said in his first speech after becoming governor.
“Any entrant to the central bank governorship probably starts at the height of their popularity," he said. “Some of the actions I take will not be popular. The governorship of the central bank is not meant to win one votes or Facebook ‘likes’. But I hope to do the right thing, no matter what the criticism, even while looking to learn from the criticism."
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