India should consider itself lucky to have a man of Raghuram Rajan’s intellectual prowess to head its central bank, as announced this week, at such a precarious moment. Rajan will need all his academic and operational experience (professor at the University of Chicago, chief economist at the IMF, chief economic advisor at the India’s finance ministry) to rise to the occasion. He will also need one more attribute that I will discuss at the end of this piece.
In a now famous presentation made at the August 2005 Jackson Hole conference, Rajan, then at the IMF, argued presciently that financial sector development in the preceding years had counter-intuitively led to a concentration of systemic risk. Rajan was roundly criticized for coming up with a message starkly opposite to the groupthink of that period, which embraced the notion of the “great moderation”. His ability to recognize the hubris of the era made him stand out as the global crisis unfolded in the following years.
In his lucid, award winning 2010 book Fault Lines, Rajan connects numerous dots, from the political economy of financial sector regulation in the US to the global imbalances that distorted capital flows, showing that when financial imbalances come in touch with trade imbalances, an explosive combination gets brewed.
India is in the middle of a crisis of declining economic growth and a sharply weakening currency. This mix could become mutually reinforcing, as a declining currency forces a tightening of policy, which causes a worsening of consumption and investment sentiment, which in turn causes a sell-off in the asset markets, thus causing further depreciation pressure, along with financial sector instability and a rise in inflation pass-through risks.
Rajan has already been quoted stating the obvious, that he doesn’t have a “magic wand” to set things right and that all government agencies need to coordinate intensively to fight the ongoing fire. But a strong, decisive, credible and transparent central bank will help matters immensely, and I think Rajan will bring a much-needed freshness to the RBI’s tone, add stature to its stance and communication and bring a sense of ease to market participants. His calm, logical, and assured delivery style would help a great deal as well.
What can we expect from the new governor in terms of policy specifics? Judging from his published work, it is clear that he is a firm believer in single objective central banking, which is targeting stable inflation. The RBI has for too long aimed at stabilizing the currency, interest rates, and inflation, often failing to achieve any of those objectives. I fully expect him to make headway in this area during his tenure. Rajan is also a firm believer in reducing concentration risk to the financial system, and hence he ought to be in favour of introducing more competition in the Indian banking system, without loosening oversight. He will likely be in favour of bringing in stickier flows to finance the country’s current account deficit; hence I expect him to support FDI liberalization (as he has done in the past year) and open up the rupee debt market to real money investors.
On the latter, removing quantitative restrictions on local currency debt investment and a few other technical reforms would get India included in a global bond index, bringing in far more stable flows than the current, alpha seeking debt flows India has been getting (and losing).
Would Rajan support external bond issuance, unlike his predecessor? Perhaps yes, provided that the issuance is combined with a credible statement of macroeconomic reforms (subsidy reduction, cuts in discretionary spending) and structural reforms (easing regulatory and infrastructure bottlenecks, improved governance). As for the rupee, Rajan truly doesn’t have a magic bullet other than conveying to the market that the central bank will strive to ease dollar supply/demand imbalances through a mix of regulatory measures and FX intervention.
I mentioned earlier that Rajan needs one more attribute, and that is luck. A few things need to go the RBI’s way in the near term and that may well happen. If the trade data for the months of July and August suggest a trend decline in the trade and current account deficits (due to lower gold imports), if global financial market volatility declines, if the central government manages to get going with a bond issuance and privatization program, and if inflation does not show signs of FX pass-through, Rajan just might get some breathing room as he embarks on setting India’s monetary and financial market policies on a sounder plain.
Taimur Baig is chief economist for India and Asean at Deutsche Bank
Rajan arrives at critical time, FT
Vindicated economist looks to be saviour of rupee, FT
Rajan: in his own words, beyondbrics
Six things you need to know about Raghuram Rajan, beyondbrics