Challenges before the new RBI governor

Raghuram Rajan as the Reserve Bank of India governor is a difficult act to follow, but few are as well qualified to do so as Urjit Patel. His appointment has been widely welcomed, reflecting an appreciation of his impressive research record and wealth of practical experience in the International Monetary Fund, the finance ministry, the private sector, and most recently in the RBI itself as deputy governor.

Fortunately, he will be taking over at a time of relative calm, so he won’t be preoccupied with fire-fighting. This gives him more time to chart an agenda for the future. Here are my suggestions.

Many have expressed the hope that he will strike a balance between fighting inflation and stimulating growth. The issue is certainly relevant because the monetary policy framework agreed with the government states that the objective will be “primarily to maintain price stability while keeping in mind the objective of growth”. This is not a strict inflation-targeting formula, which would not have mentioned growth at all. In this, we are in good company: the US Fed has a similar dual objective.

Patel will be the first governor to make monetary policy with the new statutory Monetary Policy Committee (MPC) fixing the repo rate. Other aspects of monetary policy such as liquidity management and foreign exchange management remain with the RBI, but the MPC will no doubt express views on these issues also, as indeed they must to ensure that the repo rate mechanism works as expected.

The inflation target of 4%, with flexibility of 2 percentage points either way is a good objective. What it means is that the RBI must give primacy to bringing inflation down within the tolerable range, but once comfortably inside the range, it can calibrate monetary policy to achieve the growth objective if necessary.

The logic of keeping the “objective of growth” in mind assumes that there is an agreed growth rate around which monetary and fiscal policy will be calibrated. Jan Tinbergen famously said that you need as many instruments as you have objectives and this was simplified to read that if you want price stability and full employment (or growth), then monetary policy can do the one and fiscal policy the other. But Tinbergen never said that each instrument can be independently targeted, or even primarily targeted, at one objective. Optimizing outcomes requires a shared understanding of how the economy works, and the external constraints, and then setting the two instruments of monetary and fiscal policy to achieve the objective. The mix cannot be written in stone. If circumstances change, the optimum combination of both will change. And if one of the instruments goes off the mark, for whatever reason, you do not get an optimal solution by staying on course with the other.

All this suggests the need for close coordination of fiscal and monetary policy, rather than independence and exclusive targeting. However, there is no explicit provision for consultation on setting both monetary and fiscal policy to achieve a commonly agreed growth objective. This can create problems. For example, one can imagine a situation where the fiscal deficit is set in the Budget, together with a stated growth objective which is aspirational but not realistic. Should the MPC accept both and then try to set monetary policy to attain the target inflation? Or should it accept the fiscal deficit and make its own assumption about what is a realistic target growth rate, and set monetary policy on that basis? In the latter case, is it the lower target growth rate it must “keep in mind”, or the unrealistic higher one? There are no easy answers to this problem, but it is something the MPC will have to resolve.

The MPC can make a major contribution to improving the quality of public debate by demystifying the role of the repo rate in determining the rate structure. There are far too many people who view it as a magic wand determining the medium- and longer-term rate structure. This is why the RBI is under constant pressure to lower the interest rate in order to stimulate growth and employment. The fact is that interest rates are affected by the demand for and supply of financial resources, which in turn are determined by many factors.

Former governor D. Subbarao has written that he was under constant pressure from the government to reduce interest rates. There were strong objective factors which led to higher interest rates after 2007-08. Total household savings in 2007-08 were 22.4% of GDP and net financial savings of households were 11.3%. Since the combined deficit of the centre and the states taken together was 4.1% of GDP, this left 7.2% of GDP for the corporate sector (including PSUs). By 2014-15, household savings as a percentage of GDP had dropped to 19.1% and household financial savings had dropped even more sharply to 7.7%. The fact that inflation increased sharply in this period helps explain the shift out of financial savings. Since the combined fiscal deficit in 2014-15 had risen to over 6% of GDP, the resources available to the corporate sector declined to around 1.5%, down from 7.2% in 2007-08. There was no way interest rates could have been lowered through monetary policy interventions in the situation of resource scarcity.

The lesson to be drawn is that if inflation rises and the fiscal deficit expands, there is not much monetary policy can do to offset the effect without causing serious damage elsewhere. If legislators, politicians and opinion makers understand this, there is some hope that pressure will build to make corrections where the problem originates. Otherwise, the RBI will continue to be blamed for problems that arise elsewhere, and be pressured to adopt a more accommodating stance.

To improve the public understanding of these issues, the minutes of the MPC should not just report the decisions and the voting but, as is the case in the UK, they should report the discussions in full, including disagreements. Members should also be encouraged to submit notes which should be put in the public domain. Everyone knows that experts often disagree on important issues, but frank expression of disagreements will help policy formulation.

An obvious point is that the decisions of the MPC will be only as good as the quality of the data they work on. The inflation target is based on the consumer price index (CPI), but the quality of the CPI is definitely not up to the demanding standards that should be used for such a key ingredient in decision-making. This calls for urgent review.

Fixing the public sector banks is in many ways a more difficult challenge than monetary policy because it is today a critical constraint on growth, and all the levers are not in the governor’s hands. I wrote at some length on this subject two months ago in this column and the situation has only grown worse, with non-performing assets still growing, though at a slower pace. The resulting erosion in the capital base of PSU banks has brought new lending to a halt. Private sector banks are in much better shape, but they are as yet only 25% of total banking sector assets. There is no way the economy can have a sufficient expansion of bank credit to support growth without a revival of PSU bank lending.

The RBI has tried to help by allowing the banks to restructure problem loans, revaluing their real estate assets, introducing the Strategic Debt Restructuring (SDR) scheme and its more recent substitute, the Sustainable Stressed Assets Scheme. These initiatives have been much less successful than was hoped. The SDR empowers banks to convert their debt into equity, remove existing managements from troubled projects, and look for new managements who can bring in fresh equity and run them. However, the deterioration in the cash flow and balance sheets of these projects is such that new management is unlikely to be interested unless the banks take substantial haircuts on outstanding loans, which bank managements are reluctant to do. The size of the haircut will also differ from project to project and in the absence of a transparent bidding process—which is not feasible in such cases—bank managements fear that they will be seen as unduly favouring a particular investor. Incumbent project managements will be the first to complain that they could have turned around the project if they had received similar benefits.

If the RBI can help broker haircuts, perhaps they should. Otherwise as a regulator, they should resist any further regulatory forbearance and insist that PSU banks make full provisions and get on to a new trajectory. The erosion in capital will need to be offset by fresh injection of capital, much more than was envisaged a year ago. Ideally, this should be raised from the market by reducing the government equity below 50%. There would be substantial interest in investing in banks once they are freed from majority government ownership, even if the government remains the dominant partner. However, going below 50% does not seem politically feasible. Indira Gandhi’s nationalization of banks in 1969 has surprisingly wide bipartisan support even three-and-a-half decades later!

Since resources are scarce, government resources for recapitalization should be injected into the better-performing PSU banks. The others should live with much lower growth of commercial credit until their performance improves. An important step the RBI could take to further banking reform is to reduce the statutory liquidity ratio (SLR). With the fiscal deficit on a downward trajectory, a reduction in the SLR is eminently justifiable. Banks that are inadequately capitalized can be encouraged to pick up government bonds, which involve less risk.

Another challenge on the horizon is the transformation of the banking industry by new technology. IT connectivity, combined with smartphones which allow easy identity verification through Aadhaar numbers via fingerprint and iris scans, and the new unified payments interface, will produce an explosion of new forms of financial transactions. Cashless consumer transactions are only about 32% in India at present, compared with 60% in China and 90% in the UK. Banks that are nimble and tech-savvy can carve out a role for themselves in this situation. Those that stick with legacy systems, based on brick-and-mortar branches, will become much less important.

PSU banks will need flexibility to compete with private sector banks in this new world. They have been losing market share and if they are not given greater flexibility, the loss of market share will accelerate. On some projections, the share of private sector banks in the total banking system assets could rise from around 25% today to 50% within 15 years.

Governor Rajan’s policy of expanding bank licences and keeping new licences on tap has created the preconditions for a more competitive banking system to emerge. Governor Patel would be well advised to ensure that the regulatory system encourages such competition, allowing more modern banks to expand rapidly. This will put pressure on the government to give more flexibility to the PSU banks. Perhaps this could be done selectively to begin with by giving the better-performing PSU banks some kind of navratna status, which would give them more flexibility in recruitment, salaries, promotions and other compensation.

The most important change needed is to make these navratna banks truly board-driven, including in the matter of the appointment of senior management. The new Bank Boards Bureau could make a major contribution in this area.

Montek Singh Ahluwalia was the deputy chairman of the erstwhile Planning Commission.