Home / Opinion / Online Views /  Trial by fire awaits Raghuram Rajan as RBI governor

Mumbai: The Manmohan Singh government has done well to pick Raghuram Rajan as the new occupant of the spacious office on the 18th floor of the Reserve Bank of India (RBI) building in Mumbai. He will be the 23rd governor of the Indian central bank.

Rajan is an accomplished economist though his administrative experience is limited, a fact that could work to his advantage if he brings the natural freshness of an outsider to the job. But he will have to balance an urge to introduce new ways of doing things with an assiduous attempt to build trust with an organization that has been rattled by unnecessary interference from New Delhi in recent years.

The new chief of the Indian central bank will take charge of the monetary affairs of the country at a time when the economy is perhaps at its most vulnerable point since the crisis of 1991. The Indian rupee has been hit by a wave of selling ever since the US Federal Reserve said in May that it could soon begin to withdraw its extraordinary monetary stimulus. India will end the year with a current account deficit of around $85 billion. It will likely get around $60 billion of stable capital flows from foreign direct investment, trade credits and non-resident Indian (NRI) deposits. The remaining $25 billion needs to come from relatively unstable sources such as portfolio flows into the equity and debt markets; these could shrink in case there is a spurt in risk aversion as global monetary conditions tighten.

India may not be stumbling towards a full-blown economic crisis because it still has many policy options on the table, but the pressure points are too numerous to ignore. Rajan could thus be exposed to a trial by fire, as some of his recent predecessors have. S. Venkitaramanan had only a few months in office after he took over in the last week of 1990 before he faced the onerous task of keeping India solvent. Bimal Jalan took charge in November 1997 when the Indian economy was still trying to stay on an even keel following the shocks from the Asian financial crisis. Subbarao got the job just days before the global financial system almost collapsed into the deepest economic crisis since the Great Depression. In comparison, C. Rangarajan and Y.V. Reddy had to manage in relatively more stable times, though they had their fair share of problems.

The predecessors

Even though Rajan’s first task will undoubtedly be to stabilize the external sector, there will be bigger challenges for him to handle through the length of his tenure. Inflation control will—and should—always be the main gauge of performance. But, beyond that, there are three sets of issues that will also be salient: the analytical framework of the central bank, its relationship with the government and its responses to global economic events. One useful way to examine these three issues is to see what recent governors—from C. Rangarajan to Subbarao—have done. Here is an aerial, and hence imprecise, view of the territory.

The analytical framework: Rangarajan was a monetarist in the sense that he believed that inflation is essentially a monetary phenomenon. The theoretical underpinnings of this approach in India were established in the 1985 report of the committee to review the working of the monetary system headed by Sukhamoy Chakravarty, with Rangarajan as the moving spirit. The RBI under Rangarajan used money supply as the main instrument of inflation control. It was because of this belief that it induced a savage monetary tightening in 1996 to stamp out high inflation; its critics claim that it brought the economy to a screeching halt while its defenders say that the taming of inflation by the central bank set the stage for the subsequent economic boom in the first decade of the current century.

Bimal Jalan consciously moved RBI away from its monetarist corner. The monetarist argument is based on the key assumption that the demand for money function is stable; the empirical evidence by the end of the 1990s was that financial liberalization has begun to destabilize the demand for money in India. Jalan quietly buried monetarism. In its place came what has come to be known as the multiple indicators approach, which is still an article of faith in the central bank. Monetary policymakers began looking at a range of variables such as inflation, growth rates, money, credit, fiscal policy, capital flows and the exchange rate.

Once again, some have welcomed the eclecticism of the Indian central bank while others see its approach as intellectual confusion (and, sometimes, even as a case of shifting the goals so as to escape responsibility for failures). Reddy followed down the path laid down by his predecessor. He not only leaned against the global fashion of the day but also got into a spat with the finance ministry under Chidambaram, which was pushing for a formal inflation target that would be pursued with interest rates alone. Some of this style of thinking, which was then global conventional wisdom, was also evident in the report of the committee headed by Rajan on financial sector reforms.

The global financial crisis overturned the consensus. Central banking went beyond inflation control through the manipulation of short-term interest rates. Western central banks tried to revive economies by increasing the monetary base after the interest rate gambit was exhausted; some central banks such as Switzerland’s tried to manage the currency; financial stability became a concern as well (something that Reddy tried to focus on well before his peers elsewhere). Subbarao came to RBI from the finance ministry. Many believed he would reflect the view of New Delhi, but Subbarao very early in his tenure stood up in support of the RBI view.

RBI and the government

Rajan will have to once again decide on the key issue of what the analytical agenda of the central bank should be. Should it focus exclusively, or even predominantly, on inflation? Should it try to manage the economy only with interest rates or keep other tools such as capital controls ready? Should it choose to design policy using rules such as the Taylor Rule or should policy be discretionary?

Relations with the government: The early years after the reforms of 1991 saw the two masters of our economic universe working well in tandem, with Manmohan Singh in the finance ministry and Rangarajan at RBI. The mutual respect between the two is evident even today. The economic reforms in New Delhi were complemented with financial reforms from Mumbai. Rangarajan was also instrumental is signing a landmark deal with the finance ministry in 1997 when Chidambaram was finance minister in the United Front government. This agreement abolished ad hoc treasury Bills, and ended the malign practice of automatic monetization of government deficits. The weight of fiscal policy on monetary policy considerably eased after that (though it did not totally dissipate, so Indian monetary policy is still hobbled with the problem of fiscal dominance).

Jalan also shared a cordial relationship with the finance ministry, especially when Yashwant Sinha was in charge of national finances in the National Democratic Alliance government. The past 10 years have been completely different, with tension in the air. Much of the fault lies with the two Manmohan Singh governments, whose attempts to invade RBI’s turf is part of a broader attack on institutions.

Reddy did not see eye to eye with Chidambaram on financial sector reform, especially on liberalizing the capital account in a hurry. They also disagreed on interest rates, with Reddy pushing up rates to cool down an overheated economy while Chidambaram clearly tried to protect the rapid pace of economic expansion through low rates. It soon became an open house, with various worthies in New Delhi making statements on interest rates, a cacophony that first confused and then infuriated the bond markets (though Rajan did well during his stint as economic advisor in the finance ministry to desist from commenting on monetary policy). Later, Pranab Mukherjee set up a super regulator for the financial system—the Financial Stability and Development Council—in New Delhi in what many experts say is an attempt to clip the wings of the central bank.

The 2008 crisis pushed the differences into the background for a few months, but they have resurfaced since then. Subbarao has gone public with his doubts, both on the new financial architecture that is being sought to be put into place as well as how the fiscal expansion by the government in recent years has made his task more difficult. Critics of the central bank have meanwhile claimed—not without reason—that it is trying to protect an empire that needs to be rationalized; for example, financial products such as interest rate derivatives that are traded on public exchanges should be under the purview of the Securities and Exchange Board of India or the management of public debt should be hived off to a separate agency.

Perhaps the biggest institutional challenge for Rajan will be to define the role of the central bank. Building on the recommendations of the committee headed by him as well as another one by Percy Mistry, the Financial Sector Legislative Reforms Commission (FSLRC) headed by B.N. Srikrishna, a retired judge, has proposed a radical overhaul of financial law in India. Some of its recommendations deal directly with RBI. For example, it has suggested that monetary policy decisions should be made by a panel of experts rather than the governor alone, an arrangement that Rajan has spoken in favour of. Many other countries follow this model, but the devil is in the details. The FSLRC recommendations could increase government control over monetary policy. The monetary policy panel will be headed by the RBI governor, but five of its seven members will be outsiders. The finance ministry will also send a representative, but without a vote. That means the majority of members will come from outside RBI—and they will be appointed by the government. In the UK, the nine-member monetary policy committee (MPC) has only four external members. The US Federal open market committee—a quasi-MPC—has no outside members. In effect, the RBI governor will no longer have sole control over monetary policy, though he will still have the power to “override the MPC in exceptional circumstances".

‘The impossible trinity’

Managing the external sector: India is now an open economy, so global developments have had an important impact on monetary policy. It is no surprise Subbarao said in his July policy statement that India is facing the classic “impossible trinity" of monetary policy. It cannot at the same time keep an open capital account, run an independent monetary policy and manage the exchange rate. It has to compromise on one of the three variables.

The most striking challenges on the external front are during global crises. As mentioned earlier, Jalan and Subbarao had to undergo trials by fire. Subbarao has been at the helm during a period of unusual global instability; many of the criticisms against him for failing to raise interest rates till well after inflation peaked do not take into account the fact that the global situation was very volatile, with almost a mandatory scare every summer. Raising rates at the height of the European debt crisis could have been a risky bet, for instance.

The external account has to be managed even during good times. Jalan did well to begin building up reserves after the Asian crisis, in tandem with what many other regional central banks did, in a bid to buy insurance against a 1997-style panic. Reddy continued to buy dollars, especially in 2007 and the first half of 2008, when strong capital inflows threatened to overwhelm monetary policy. The table on the economic indicators during the tenure of the four governors tells us why this was possible: the rupee was very stable during the tenures of Jalan and Reddy. They tried to prevent appreciation, and they could build reserves by buying dollars in a bid to keep the rupee down.

Building reserves imposes fiscal costs on the economy. It also creates other challenges such as sterilization, or selling bonds to absorb excess liquidity. So Jalan and Reddy did have critics who argued that their sterilized interventions in the foreign exchange markets kept interest rates higher than they would otherwise have been. Meanwhile, Subbarao faces mounting criticism for overseeing the decline in protection for the Indian economy during a global shock, especially the relative inadequacy of reserves.

Rajan will first have to get these issues sorted out. The Indian central bank has stayed clear of fixed exchange rates, and has allowed the rupee to decline because of high inflation at home. Once again, the data shows that rupee depreciation was lower when average inflation was lower, in the Jalan and Reddy years.

Rajan will take charge with the currency under attack. He will have to grapple with a challenging inflation situation, especially if consumer prices are taken into consideration. But he will also have to take a close look at the analytical framework of the central bank, protect it from the pressures that usually emanate from New Delhi, and rebuild the external defences of the Indian economy.

He will need to put his considerable expertise to work as he takes over the job at a difficult time for the Indian economy.

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