Raghuram Rajan sounds note of caution on growth

New Delhi: Reserve Bank of India (RBI) governor Raghuram Rajan on Friday urged the government to stay on the path of fiscal consolidation and stressed the need for macroeconomic stability to support growth.

Rajan’s comments come against the backdrop of a growing chorus for a fiscal stimulus, and weeks before the National Democratic Alliance (NDA) government unveils its budget for the next fiscal year.

Delivering the fourth C.D. Deshmukh Memorial Lecture on Friday, Rajan cautioned against growing too fast using fiscal stimulus measures and warned against overambition.

“The consolidated fiscal deficit of the states and centre in India is by far the largest among countries we like to compare ourselves with; presently only Brazil, a country in difficulty, rivals us on this measure,” Rajan said at the lecture commemorating the first Indian governor of RBI.

According to International Monetary Fund estimates, India’s consolidated fiscal deficit rose from 7% of gross domestic product (GDP) in 2014 to 7.2% in 2015.

“So we actually expanded the aggregate deficit in the last calendar year,” said Rajan, who will announce RBI’s monetary policy on Tuesday.

“With UDAY, the scheme to revive state power distribution companies, coming into operation in the next fiscal, it is unlikely that states will be shrinking their deficits, which puts pressure on the centre to adjust more.”

Under UDAY, an acronym for Ujwal Discom Assurance Yojana, the states will have to take over 75% of the debt of cash-strapped power distribution companies and issue bonds; the remaining debt will be converted into loans or bonds at concessional rates.

Rajan junked the argument that fiscal expansion is necessary to generate the growth needed to put India’s debt-to-GDP ratio back on a sustainable path.

“Unfortunately, the growth multipliers on government spending at this juncture are likely to be much smaller, so more spending will probably hurt debt dynamics. Put differently, it is worth asking if there really are very high-return investments that we are foregoing by staying on the consolidation path,” he argued.

The government, in its mid-year economic review, made a case for relaxing the fiscal deficit target for the next fiscal year, citing the need for higher public investment and steps to revive rural demand to resuscitate economic growth. Its finances will also be under pressure from the Seventh Pay Commission recommendations for pay and pension increases to government employees.

The government, in the 2015 budget, delayed its fiscal consolidation programme by a year, revising its fiscal deficit target to 3.9% of GDP from 3.6% in the current fiscal year.

The target for 2016-17, as laid out in the fiscal consolidation road map, is 3.5%.

N.R. Bhanumurthy, a professor at think tank National Institute of Public Finance and Policy, New Delhi, said too much focus was being put on the fiscal deficit number.

“Fiscal consolidation road map is not only about the fiscal deficit number. It is equally important to look at revenue deficit as well. The road map talks about bringing down both the numbers,” he said.

The revenue deficit this fiscal year is projected at 2.8% of GDP.

Rajan cautioned the government against raising import duties to protect domestic industries.

“...aside from the inflationary impact, for every happy domestic businessman whose prices are raised by the imposition of tariffs on imports, we have an unhappy domestic businessman whose costs are raised by the very same tariffs, as well as unhappy consumers,” he said.

Rajan also reiterated that the central bank has no intention of departing from the inflation framework that has been agreed with the government last year.

Under the framework, RBI was to contain consumer price inflation within 6% by January 2016 and within 4%, with a band of 2 percentage points, for all subsequent years.

“We look forward to the government amending the RBI Act to usher in the monetary policy committee, further strengthening the framework,” Rajan said.

The RBI governor also said the government and the central bank are working together to clean up banks’ balance sheets, which are laden with bad loans accumulated during the economic slowdown that made it difficult for borrowers to repay debt.

“It (RBI) is now working with the government and banks to ensure that the stressed assets are dealt with on a proactive basis, and that bank balance sheets both reflect a true and fair picture, and are adequately provisioned. The finance minister has indicated he will support the public sector banks with capital infusions as needed. Our estimate is that the support that has been indicated will suffice, especially when coupled with other capital sources that are
usually available to banks,” he said.

Overall, gross non-performing assets of listed banks in the September quarter rose 6.24% to ₹ 3.37 trillion from ₹ 3.17 trillion a year earlier.

Rajan added that RBI was working on identifying currently non-recognizable capital that is already on bank balance sheets, such as undervalued assets.

“The RBI could allow some of these to count as capital as per Basel norms, provided a bank meets minimum common equity standards,” Rajan said.

“In sum, we believe enough capital is available. While the profitability of some banks may be impaired in the short run, the system, once cleaned, will be able to support economic growth in a sustainable and profitable way. To be less proactive, as our past and the history of banking across the world suggests, will only see the problem get bigger and less manageable,” he added.

Stressing the need for professional boards for state-run banks, Rajan said board members of public sector banks must be paid market compensation.

“The Bank Board Bureau, which will select board members, will come into operation soon. We have to pay board members of PSBs (public sector banks) a market compensation if we are to attract decent talent—otherwise we risk attracting an unwieldy mix of the truly patriotic and the truly unscrupulous, with the latter intending to profit by their board position. When thousands of crores can be diverted by a bad board decision, should we not ensure we have adequate integrity and talent on bank boards?” he said.

The RBI governor also stressed the need for greater decentralized decision-making, with more power to state-run banks’ boards.

“If we want to address the concern that many public sector banks have identical strategies and are competing for the same pie, we have to allow the boards more freedom to differentiate their banks,” Rajan said.

He added that the issue of mergers of state-run banks can be addressed only after the financial health of banks improves.

“Almost surely, some banks will have to merge to optimize their use of resources. But talking of bank mergers, which take a lot of management attention, especially when each bank management is preoccupied with dealing with stressed assets, is probably premature,” the RBI governor said.

“At the same time, some banks could benefit from governance help to deal with their current problems. Is it an opportune time to induct skilled financial firms as strategic investors into public sector bank boards, perhaps with a 10 or 15% stake? Certainly, the experience of countries like China who inducted such investors is worth studying,” he said.