With Rajan out of the way, Modi needs to do what he’s been promising: Fix the economy

And it’s a wrap.
And it’s a wrap.
Image: Reuters/Danish Siddiqui
We may earn a commission from links on this page.

It’s all about the timing. Just ask Raghuram Rajan.

After three years of fighting inflation, stabilising the rupee, and cracking the whip on toxic loans, the Reserve Bank of India (RBI) governor will call it a day at a time when India is sitting pretty as one of the world’s fastest-growing major economies.

The straight-talking Chicago economist has made his move by not seeking a second term—and the ball is now in prime minister Narendra Modi’s court.

Half-way into his term, Modi’s much-publicised efforts at resuscitating Asia’s third-largest economy haven’t exactly delivered if you look beyond the dubious GDP growth numbers. On paper, the 7.6% annual growth looks promising, but on the ground industrial growth is still weak, exports continue to fall, and manufacturing is yet to revive. Therefore, if Modi is serious about a second term in power, he must turn around the economy and he must start soon.

Some have blamed the outgoing RBI governor for stifling growth.

After he took over in 2013, Rajan kept interest rates high in a bid to cool down double-digit inflation. The strategy was successful: inflation has nearly halved in three years. But the Modi government’s push for lower interest rates to accelerate economic growth has caused friction.

Now that Rajan will return to academia, Modi should have a free hand.

Yet, low interest rates alone aren’t going to boost growth. There are economies, including those of the US and Japan, which have kept rates at near-zero or even negative levels in the recent past but haven’t seen that translate into robust growth.

Instead, India needs to see a recovery in demand, from both corporates and individual consumers.

For the latter, inflation is key and the problem of rising food prices—which have been inching up lately—must be fixed. For India Inc, however, access to cheap capital is as important as the cleaning up of the banking system. Bad loans weigh down bank balance-sheets and risk-taking abilities, which consequently constrict their ability to lend.


Rajan’s containment of India’s sticky inflation problem will doubtlessly be listed among his major achievements. Sure, external factors, including the massive drop in oil prices, made it easier. But two continuous years of drought have also pushed up food prices.

In the last two months, retail inflation is inching up again, propelled by rising food prices. In May, the consumer price inflation was at 5.76%—the highest in 21 months. So, the real challenge for the government is bringing down prices of pulses and vegetables—and also keeping interest rates low. 

“The government needs to first reform the supply side,” said Rajrishi Singhal, a senior fellow at Mumbai-based think-tank Gateway House. “The last spike in inflation was mainly due to food prices. Critical reforms are required to fix the price chain where middle-men and traders are involved. There’s still hoarding happening.”

Prices of certain pulses such as dal (lentils) have spiked by over 30% in the last few months. High food prices would only hurt consumers as everyday household expenses rise, lowering overall demand. This is a drag on economic growth.

So lower interest rates alone aren’t the solution.

Private spending and consumption must increase. The government must fix the logistical chain for agricultural produce, which currently includes several middlemen who help push prices higher.

Cleaning up the banks

Rajan also succeeded in clamping down on non-performing assets in Indian banks, which has ballooned to some Rs13 lakh crore ($192 billion). He initiated the strategic debt restructuring (SDR) scheme which gives an option for lenders to convert a part of the troubled firm’s debt into equity.

Then he conducted a review of banks’ stressed assets and told the lenders to make provisions to cover loans that could turn non-performing. Rajan set a target of March 2017 for this.

In the letter that announced his decision to move on, Rajan said the work he’d begun in his first term wasn’t complete.

“Inflation is in the target zone, but the monetary policy committee that will set policy has yet to be formed,” Rajan wrote. “Moreover, the bank clean-up initiated under the asset quality review, having already brought more credibility to bank balance sheets, is still ongoing.”

Now, Rajan’s successor needs to continue this clamp-down. For this to happen, he or she should have the spine to stand up against big corporates with inflated debt and have the government’s backing.

Without fixing India’s banking system and defaulters, faster economic growth will stay a far-fetched dream.

But fighting crony capitalism isn’t easy, and Rajan’s departure is proof.

“It’s a big victory for the crony capitalists, unless the government appoints someone with immense credibility as next RBI governor,” Rahul Bhasin, managing partner of Baring Equity Partners, a money management firm told the Wall Street Journal.

A global face

There’s also the fact that Rajan, who had a chequered career as an economist before he came to the RBI, was something of a comforting factor for investors, especially those outside the country.

“Rajan’s exit is a clear setback for the Modi government. At a time when Modi is wooing foreign investors, the loss of the highly-respected central bank governor will dampen enthusiasm about India,” said Sadanand Dhume, a resident fellow at the Washington DC-based American Enterprise Institute (AEI).

Moreover, the notion that RBI is an independent institution and beyond political influence can be hit with Rajan’s exit.

“The longer term challenge is institutional; in a country marked by weak institutions, the RBI is perceived as a positive outlier. The danger inherent in the government’s actions is that the undermining of Rajan could end up undermining the institution,” said Milan Vaishnav, an associate in the South Asia Program at the Carnegie Endowment for International Peace.

The institutional damage to the RBI is a recurring concern. In a column for the Financial Times (paywall), Eswar Prasad, a senior fellow at the Brookings Institute and a professor at Cornell University wrote:

The RBI is the only one widely seen as credible and competent and the government’s unwillingness (or inability) to keep Rajan on is a blow to the bank’s perceived independence and to the broader institution-building that India needs. The RBI is a strong and storied institution but Rajan’s untimely departure will leave scars that could end up scarring the Indian economy.

But some believe Rajan’s absence wouldn’t matter to the government where economic reforms are concerned.

“The RBI’s role (to kickstart growth) is limited,” said Sanjaya Baru, a consulting fellow at the International Institute for Strategic Studies and a former newspaper editor. It’ll only cause the government “some embarrassment because of the public and media perception,” Baru said, adding that once a successor is named, things will move on.

Nonetheless, whoever succeeds Rajan will have big boots to fill—and Modi will have one less excuse for his mediocre economic performance.