The Reserve Bank of India (RBI)'s Governor Dr Raghuram Rajan, as per his own communication to his colleagues, will not continue at the post after 4 September 2016. Following this, the domestic and global media have gone into paroxysm of lament and berated the Narendra Modi government for letting Dr Rajan go. There has been a dire prognosis of a hundred billion dollars leaving India, rupee collapsing and interest rates turning volatile. However, after the news of Dr Rajan quitting actually came out, all markets have been calm. The rupee has barely budged and stock indices are up. Meanwhile, more and more opinions are coming out that find holes both Dr Rajan’s policies and his attitude and public pronouncements.
Rajeev Kumar, senior fellow at the Centre for Policy Research in an article in the Indian Express says, "...it is sad to see Rajan return to Chicago. However, it is not entirely the government’s fault and he would have to share part of the blame for this unfortunate situation. The most important lesson to my mind is for the government to choose a substitute who has not only the domain competence but also the ability and humility to work as an effective and a somewhat self-effacing member of India’s economic policy team. The collective aim would be to generate maximum employment growth while retaining macroeconomic stability. This can be achieved without generating so much heat or light."
Finding holes in Rajan’s textbook of controlling inflation, disclosure of all bad loans at one go and keeping the rupee artificially high that is affecting exports, Ajay Chhibber, former director general of Independent Evaluation Organisation, Government of India, says, RBI must give equal importance to growth and inflation, the central bank needs to change its policy of keeping the exchange rate appreciated, through a managed float, to contain inflation and there is a need for a more calibrated approach to current banking problems. "An RBI policy that favours importers and short-term portfolio investors is not in India’s long-term interests. Successful governors Bimal Jalan and YV Reddy followed more flexible and competitive policies, and kept as much focus on growth as they did on inflation. We need such a practical approach now, not a textbook one," he wrote in an article in the Economics Times.
Meanwhile, the equity market experts have stopped painting scare scenarios and have done an about-turn about the impact of Rexit (Rajan’s exit). Nomura says, except for a small fall as a knee jerk reaction, Dr Rajan’s exit may not be negative for equities market. "We do not think that Dr Rajan's exit will mean large rate cuts or that banks will relax control on their asset quality. Of course, whether the market accepts that view, depends, to a large extent, on the new governor. A credible face at the helm of the central bank may significantly calm market jitters," it says in a report.
Nomura says it do not expect a significant correction in Indian equity market. "Recently, the Indian market has generally outperformed significantly due to visible signs of a recovery in earnings growth. The market is no longer cheap on an historical basis but neither is it very expensive and therefore was more a "buy on dips" market and we see no reason to change our view," it concluded.
Mr Kumar thinks Dr Rajan succeeded in restraining inflation was partially plain good luck and partly staunch support by the government in maintaining tight fiscal discipline. He says, "...having announced flexible inflation targeting as his preferred policy objective, Rajan was unremitting in his drive for squeezing out all inflationary expectations from the system. In this, he was lucky as global oil prices plummeted soon after he took over. One wonders the extent to which Rajan would have hiked rates, had global oil prices remained in the vicinity of $140. Food prices are an important driver of inflationary expectations. These are driven more by the supply-demand dynamics than by the interest rate policies especially when the transmission mechanism is weak. Could better results not have been achieved if the RBI and relevant government agencies worked together, behind the scenes, to address supply constraints that push up food inflation in the country and raise the price of wage goods, thereby pushing up costs? This, in turn, forced the RBI to keep interests rates high, delivering a double whammy to the industrialists as they end up suffering from both high wage and capital costs."
By accepting the new monetary policy framework underlined by inflation targeting, Mr Chhibber says, the (Indian) government accepted the idea that the RBI be allowed to give precedence to inflation over growth. "Inflation targeting is an old ‘stabilisation first’ policy that the International Monetary Fund (IMF) used to follow in the last century. But even the IMF discarded it after being criticised for hurting growth and recovery. Even if inflation targeting works in some developed economies, it is meaningless in a developing country where more than half of inflation comes from food items where supply side constraints dominate price movements. In any case, the fall in inflation is largely due to declining commodity prices, and has little to do with tight monetary policy. With commodity prices rising again, inflation will increase and the new monetary framework under inflation targeting will force the RBI to maintain — and perhaps even increase — interest rates," he added.
Mr Kumar, in his article, opined that the principal economic reason (for Dr Rajan's exit) would seem to be the continued extreme weakness in credit off-take from commercial banks, which is at 8%-9% compared with 27% in 2009. He said, "This signifies both a loss of private investors’ appetite for investment and the commercial banks’ reluctance to advance credit as their balance sheets take hard knocks in the face of unremitting pressure from the RBI to surgically clean up their loan portfolios. A government deeply concerned with generating more jobs and raising the rate of economic growth could have expected a helping hand from Rajan. Instead, the governor seemed bent upon completing the cleaning up even if it implied significant corporate and commercial banks. The danger could surely be that the damage in the short term would outweigh the uncertain positive long-term consequences."
Mr Chhibber feels that by following a very strict approach, the RBI may have ended up exacerbating systemic problems in banking. "Crafting a more nuanced approach will be vital for the next RBI governor. Once classified, the only approach will be to recapitalise the banks. Amore nuanced approach is needed to distinguish between wilful defaulters (cute bank terminology for crooks) and those where some temporary forbearance may help regain the ability to repay once the economy recovers. The strict approach makes the RBI look tough and reform-minded and against crony capitalism. But it puts all non-performing loans into the problem category. If a strict textbook approach is pursued, India could well slide into a full-blown banking crisis as the government will need extra financing of some $200 billion through an IMF programme that must be avoided. A more measured approach with tougher tools to the banks for collection to go after wilful defaulters and a careful industry-by-industry approach will help resolve sectoral issues," he says.
The impact on fixed income markets may be greater and Indian rupee could be under pressure, in Nomura's view. However, it says, nominal equities prices tend to react positively to currency depreciation as long as nothing else changes. "Indian rupee depreciation, if any, would be positive for technology stocks. Banks, ironically, may actually do well as after the RBI push to clean up their balance sheets financials underperformed the market rally overall".
Mr Chhibber further argues that the RBI has followed a policy of keeping the exchange rate appreciated, through a managed float, to contain inflation. He says, with current account deficit (CAD) under control, the real exchange rate is at the right level. But CAD has fallen because imports fell sharply and an appreciated exchange has hurt export growth. "If India is to achieve 8%-10% GDP growth, it must have a more competitive exchange rate policy. An importer lobby has emerged in India that is hurting our domestic industry and helping deindustrialisation in the country. An RBI policy that favours importers and short-term portfolio investors is not in India’s long-term interests," he stated.
The rupee is kept appreciated by inflows of portfolio capital attracted to India with higher interest rates and an RBI policy of managing an orderly float, Mr Chhibber alleges. He says, "This has allowed portfolio managers to make large profits in India over the last two years. The government has even removed the alternative minimum tax on such capital gains under pressure from the investor community. These inflows have also propped up the equity markets temporarily and will leave once the interest rates fall and the rupee is allowed to depreciate faster."
"The RBI did well to reverse the steep rupee fall in August 2013 when the taper tantrum hit India. But in hindsight, the extra interest premium it offered investors in dollar-denominated debt was probably unnecessary. The RBI will now have to redeem some $30 billion of these in September. The appointment of a new governor gives the government the opportunity to recalibrate monetary, exchange rate and banking sector policies," Mr Chhibber added.
In his article in the Indian Express, Mr Kumar also highlighted some personal issues with Dr Rajan, like the RBI Governor's attempt to combine the role of a senior policy mandarin with that of a public intellectual. He says, "I wonder how he (Dr Rajan) did not realise that this is an impossible mix. Not only did he advise the finance minister to stick to the fiscal target, which was clearly stepping over red lines, he also chose to speak publicly on the state of tolerance in the country and whether or not a strong government faces the danger of succumbing to dictatorial tendencies a la the emergency in India or Hitler’s Germany. Taking on the role of principal critic is perhaps not conducive to working as part of a team."
He says, "The government also backed down twice in the face of opposition by Rajan, first to the Financial Sector Legislative Reforms Commission (FSLRC) recommendations and second, to the creation of an independent public debt office in the ministry of finance. Moving Rajiv Mehrishi suddenly and unexpectedly out of the Department of Economic Affairs (as secretary) was also perhaps done partly with an eye to placate Rajan. What more would a government do to retain talent? The more pertinent question is perhaps why Modi took away his support during the last few months."
"Could (Dr) Rajan, an excellent networker otherwise, have become a victim of excessive adulation from the community of fawning financial analysts and breathless media anchors who in their selfish interests made him into a prima donna who was beyond all established norms," Mr Kumar wonders.
Nomura feel the frameworks put in place by Dr Rajan are likely to remain, and thus unless the new governor changes these frameworks, the credibility of monetary policy will be intact.