Raghuram Rajan alone cannot save India’s economy

India’s new central banker Raghuram Rajan, second from left, is doing what he can. But the government needs to step up to restore investors’ confidence too.
India’s new central banker Raghuram Rajan, second from left, is doing what he can. But the government needs to step up to restore investors’ confidence too.
Image: AP Photo/Rajanish Kakade
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KOLKATA, India—A couple of weeks ago, the ubiquitous socialite Shobhaa De wrote an entire column in a leading business paper gushing over India’s new central banker. She delved deep into the “unbearable hotness of being Raghuram Rajan,” albeit without apology to Milan Kundera.

To be sure, she was not alone in finding the governor of the Reserve Bank of India to be irresistible. The market blushed at his sight, the benchmark index of the Bombay Stock Exchange giggled its way up to almost the level it was at before the US Federal Reserve’s May 22 announcement and the rupee regained some of its lost ground against dollar. It seemed that Rajan had an invisible magic wand in his hand and he could, at his will, paint the Indian economy in a happy pink hue. Suddenly everything started looking good. It was this India that welcomed Ben Bernanke’s decision to postpone tapering.

Leaving the US fiscal stimulus unaltered, at least for the time being, is unadulterated good news for developing countries. Keeping quantitative easing in place means a weaker dollar and that in turn means that capital will look outward for better returns. To keep the QE juice flowing, the rate of interest in the US will hover around zero. India is certain to look like a natural destination for US investments with gilt yield at 8% annually. Signs already are positive. The post-May 22 exodus of foreign investment has been reversed to a substantive extent. The news of the zero taper was greeted positively with equity markets rising sharply on early trades on the day after Bernanke made his announcement. The benchmark BSE Sensex was up 2.61%, or 520 points, at 10:55 a.m.

What a central bank supremo needs to do to fully utilize Bernanke’s sudden generosity is a no-brainer—at least the Indian media made it look like one. As the immediate threat of a dwindling rupee looked less dangerous, the market expected Rajan to take a cue from his Washington counterpart and tread a softer monetary policy line. He was expected to make more funds, at a more affordable price, available in the market. “We expect the new RBI governor to initiate measures that would enthuse the market participants, boost investor sentiment and bring confidence back in the economy,” said Sidharth Birla, senior vice president of the industry body known as Ficci.

But Rajan, in his maiden monetary policy announcement on Friday, delivered a second round of surprise to the market, albeit not as pleasant as the first one. He declared that curbing inflation, and not boosting GDP growth rate, remains the core focus of RBI. To the utter disbelief of the market, he raised repurchase rate by 25 basis points. The market didn’t take it kindly. The Sensex headed south and the rupee also slipped against the USD. Surprised and rather hurt expressions could be heard all around. It was as if Rajan refused to enter the Fed bonanza party. His honeymoon with the market seemed over, too.

To decide whether Rajan chose his priorities right, we must look deeper into India’s current “crisis” and situate it in the global frame. How bad was India doing before a finance professor at the University of Chicago’s business school was handed the reins? The current account deficit was increasing at an alarming rate, and the rupee depreciated in tandem, turning in its worst performance this year. Foreign investment dried up following the May 22 announcement of the Federal Reserve that it will start tapering the stimulus. In the three months following the Fed announcement, foreign investment to the tune of $4 billion flew out of India. The Sensex slipped below the 18,000 mark. The current account deficit kept widening and shot up to almost 5% of GDP. India has the third highest current account deficit, in absolute value, in the world.

Having said that, India is not the only country witnessing the economic turmoil. Peers such as Brazil or South Africa are facing the same set of problems. Secondly, the present crisis is not as severe as most of the recent downturns. While previous exoduses by investors from volatile emerging markets have caused waves of bank failures, corporate bankruptcies and mass layoffs, the latest retrenchment has been much milder. The effects have also been limited partly because banks, companies and their regulators in many emerging markets have become more careful about borrowing in dollars over the last two decades, except when they expect dollar revenue with which to repay these debts.

What the market conveniently forgets is crucial—the flow of foreign capital did not dry up because of the so-called high interest rate regime that India’s central bank kept in place for the last few years, but because India has a host of domestic problems, some of which are structural. So joining the Fed’s party and lowering interest rates won’t work. The fundamental issues that stare at India must be addressed. Rajan’s decision to focus on inflation is bang on. He was clear about his intentions, saying “the postponement of tapering is only that, a postponement. We must use this time to put our house in order, to create a bulletproof national balance sheet.”

To be bulletproof means that when the Fed eventually starts tapering, be it in October or in December, the economy does not falter again. The rupee does not go down the spiral; the current account deficit does not go off the hook. To be sure, India has some factors on its side. The international market is heading toward stability. The US and some European economies are settling down to a new equilibrium. War on Syria does not loom large on the horizon, at least as of now, so crude prices are also stabilizing. Rajan claimed that India can manage its current account deficit without dipping into reserves. Whether Rajan can achieve the feat is yet to be seen, but the deficit crisis does not look as bad as it did a month ago.

Salvaging the rupee must remain a paramount objective. Its plummet has spooked foreign institutional investors. If the external aspect of rupee’s value restoration, at least partially, is taken care of by the newfound international stability, then managing the rupee essentially boils down to managing domestic inflation. Rajan has been arguing for the last five years or so that the central bank should have a single focus and that should be curbing inflation. His maiden policy statement treaded that line.

Some have argued that controlling inflation is beyond the RBI’s ability as the government holds two prime keys to inflation. This argument is not without merit. The government determines the amount of food grain to be held in stock. It may indeed ease food price inflation by selling grains in the market at a comparatively lower cost. It is the government that sets the fiscal deficit, too.

But the fact that Rajan cannot really control these two important factors bolsters his position that the RBI needs to rein in inflation. Given the forthcoming general election in 2014, it is rather improbable that the government will try to control the fiscal deficit by cutting subsidies. For example, the Right to Food act legally binds the government to provide two-thirds of the population their monthly food grain ration at a token price. So the government cannot and will not do much about inflation. Hence, it is up to the RBI and its monetary policy that India can rely upon.

Unfortunately, curbing inflation is not the only problem that Rajan cannot expect the government of India to resolve. The policy and implementation paralysis, rampant corruption, impasse in major industrial decisions such as coal block allocation are only a few things on a long list that are not helping India to create an environment conducive to investment. It’s not the so-called high interest rate regime but these factors that let India down in the global investment market. The Fed cannot solve these.

Nor can Rajan.

Market sentiment is not the real issue in India. India is low on international investment because of a host of problems, namely structural low productivity, inadequate infrastructure, and bureaucratic delays. Most of these challenges are beyond Rajan’s control. To his credit, he did not shake his head in despair and jump on Bernanke’s bandwagon. Rajan did his best to ensure India is not caught off guard once the party is over.