The Legacy: Raghuram Rajan is leaving the battlefield just when he was getting the better of his rivals

India’s debonair central banker, Raghuram Rajan, leaves behind many broken hearts and disappointed souls. Chronicles of his legacy will list many achievements, but will also note that he left the battlefield just when he was getting the better of his rivals; what’s surprising is that the commander-in-chief agreed to his pre-mature withdrawal even though the general’s strategies could be seen bearing fruit.

Equally perplexing will be the choice of his replacement.

Both the government and Rajan personally have been advocates of an alternative global financial architecture. He has also been proposing for a while that it was time for a new Bretton Woods mechanism. And Rajan had taken the battle to the enemy camp. At the April 2016 spring meetings of the International Monetary Fund and the World Bank, Rajan observed how deeply multilateral financial institutions were in thrall of western economic orthodoxies. He even wryly remarked how ideas from emerging economies were dismissed as “crankiness.”

He was prescient about the trans-Atlantic financial crisis. He took on former US Federal Reserve chairman Ben Bernanke when US domestic monetary policy spilled over into the global economy and led to severe volatility in emerging markets. He is unlikely to have fond memories of the period: he had to douse this particular fire soon after his appointment in Sept. 2013.

So, here is question number one: Will his successor have the same zeal about promoting an alternative global financial architecture that is sensitive to emerging economy needs and is not partisan about any particular economic ideology?

Rajan also quits before another crusade could be brought to its logical end. He’s been battening down the hatches that allowed a cosy nexus between large corporate borrowers, bankers, politicians, and bureaucrats, to bleed public sector banks through questionable debt write-offs. Rajan had taken a large broom to bank balance sheets and forced them to take drastic action against defaulters.

Many large—and over-stretched—corporate borrowers have been carping about Rajan’s reluctance to reduce interest rates, which, when lowered, would have certainly helped moderate their interest burden. These same corporates also turned into quack economists on the matter of interest rates: in their collective view, only lower interest rates could bring back high rates of economic growth. This view is oblivious to the fact that the low interest rates in the US, or negative rates in Europe and Japan, have failed to promote any economic growth.

Time for question number two: Will Rajan’s successor have the stomach (or benign sanction from the government) to continue with the clean-up act? Or to hold rates steady when required?

So, what does Rajan’s legacy look like? Apart from the well-documented success in fending off volatility from the US Fed’s tapering in 2013, his tenure will be remembered for three systemic changes he fostered.

One will be the differentiated banking landscape that he designed and left behind. As RBI governor, he grandfathered the emergence of a new breed of universal, small, and payments banks. He was in the process of adding two more categories—custodian banks and wholesale (or long-term) financing banks—to the mix. We will now have to wait and see if his successor has the same enthusiasm for a differentiated banking model.

These new categories come in addition to existing myriad forms of cooperative banks, regional rural banks, local area banks, public sector scheduled commercial banks, State Bank of India group of scheduled commercial banks, old-generation private sector banks, new-generation private sector banks, and foreign banks.

Restive signs mark the payments banks space—three companies which received in-principle approval to launch payments banks (Cholamandalam, Tech Mahindra, and Dilip Shanghvi of Sun Pharma) returned their licences stating that the project was not economically feasible. Undeniably, and in true RBI style, the initial architecture is anti-profit and has flaws in it.

The second marquee item is his strict action against non-performing assets (NPAs) that continue to impair bank balance-sheets. This was viewed as his struggle to end Indian-style crony capitalism: large volumes of loans remain unpaid every year and yet defaulting borrowers manage to get fresh loans unfailingly with some help from politicians, bureaucrats, and complicit bankers.

The staggering amount of NPAs is a direct drain on taxpayers, since loss to state-owned bank balance sheets must be compensated with fresh equity infusion by the largest shareholder—government— every year.

Finally, the outgoing governor will be remembered for installing a new monetary policy framework, which uses inflation-targeting as its driving philosophy. It also includes a monetary policy committee comprising three government representatives and three central bankers, with the RBI governor getting the casting vote. This new structure overhauls the old belief that the economy’s fiscal (the government) and monetary policy (central bank) sides should remain out of each other’s hair.

While the government has been uncomfortable with Rajan’s public comments about governance and broader political economy trends—saying that central bankers should not interfere with the fiscal side—it has not shown the same restraint when trying to influence monetary policy.

It will have to be seen how future central bankers and monetary historians view Rajan’s acquiescence to large government presence in monetary policy making.

The article first appeared in www.qz.com/india and can also be read here.

The Great Indian Rupee Trick - Redux

A lot has already been written about why the Indian rupee has gone into a free-fall. Some of it is utter nonsense, such as stuff which claims rupee should actually be appreciating instead of depreciating. But, otherwise, the narrative has mostly been sane and restricted to the straight and narrow.

What, however, does not get written is Indian government's strategic intent, or the lack of it. Most analyses tend to paint the Indian government as a hapless bystander, hit athwart and stunned by debilitating global financial flows. The fact is this: the portends were strewn in the four winds many moons ago. But, our policy makers were busy frying other fish.

Authorities have been blaming "global conditions" for the rupee volatility. This is an euphemism for Federal Reserve Bank's loud thinking about ending its accommodative monetary policy, or now known as "tapering" in the international bond markets. In essence, it implies the Fed is thinking aloud about when to start reducing (or tapering off) its $85-billion-a-month bond buying programme. 

Arguably, if this does materialise (as some are convinced that it might in September or October), then interest rates in the USA are bound to rise from their current near-zero levels. Plus, that would also imply an improvement in the US economic prospects, because the Fed has categorically stated that it would "taper" only if unemployment rates fall and inflation bumps up.

Now, given all the problems with the Indian economy -- widening current account deficit, slowing economic growth, stubbornly high consumer inflation, stagnant industrial production, a spike in short term foreign debt, growing reliance on populist measures, corruption scandals and impending elections -- the US bond market definitely looked more interesting. Therefore, as soon as news started filtering in about "tapering", investors dumped Indian stocks and bonds and rushed to get back into dollar assets, such US treasury bonds.

This rush to sell Indian assets, take the rupees and exchange them for dollars, created a spike in demand for dollars, leading to the rupee's fall. As the rupee started to fall, more investors started getting out because staying on would mean a further erosion of yields. This self-perpetuating crisis was fed a bit of fuel by emergency measures implemented by Reserve Bank of India.

One leg of the strategy should have been to encourage flow of foreign direct investment which is typically sustainable and long term in nature. But they made a complete mess of it.

But the point here is that the Fed has been talking about "tapering" for quite some time. Sample Fed chairman Ben Bernanke's testimony to the joint economic committee of the US Congress on May 22: "At its most recent meeting, the Committee made clear that it is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes." (read it here)

On the same day, the Fed released the minutes of the meeting of the Federal Open Markets Committee (the round table of Fed knights that sets the interest rate) held on April 30 and May 1. This is the paragraph that showed up on investors' radars with a loud bleep: "Participants also touched on the conditions under which it might be appropriate to change the pace of asset purchases. Most observed that the outlook for the labor market had shown progress since the program was started in September...A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome. One participant preferred to begin decreasing the rate of purchases immediately..." (read the full text of the minutes here)

Fed chairman Bernanke testimony to the US House of Representatives on July 17 had similar strains (read it here). Please note: he never once mentioned that the Fed had decided to withdraw the accommodative measures, leave alone finalising a date to begin the tapering off. He only reiterated that the economy was doing well, there was still some distance left to cover, that the expansionary strategy would continue even after Fed began  "tapering off" and so on.

In addition, many Fed governors had been debating the same point -- about the appropriate timing of the Fed's "exit strategy" -- in their various speeches for months. 

It is, therefore, surprising that while the whole wide world, its grandmother and all the portfolio investors could feel their antennae tingling, the Indian government and its various policy-making arms were oblivious to these developments. There was no counter-strategy, no emergency measures. Nothing.

Forget the past six months. Ever since Fed launched its expansionary monetary policy and flooded the global markets with excess liquidity, it was well known that this money would flow back as soon as there were hints of increases in US bond yields. And, yet they dithered. 

A columnist in Washington Post also said:  "The Fed has telegraphed the tapering and eventual end of its QE policies with with increasing specificity for months now, so you would expect, in a perfectly rational world, for currency and bond markets to have long ago priced in plans of Bernanke & Co. The wild thing about the most recent bout of market volatility in the last few weeks is there's been no earth-shattering news about the prospects for the Fed tapering and then ending its bond purchases. Both US economic data and comments out of senior officials have been broadly consistent with where they were a month ago." (read the column here).

There's only option left now: pray.