Month: August 2013

Vivek Kaul
Even the worst governments make some right decisions. The appointment of Raghuram Govind Rajan as the next governor of the Reserve Bank of India(RBI) is one of the few correct decisions that the Congress led United Progressive Alliance(UPA) government has made in the last few years. Rajan, an alumnus of IIT Delhi, IIM Ahmedabad and Massachusetts Institute of Technology, is currently the Chief Economic Advisor of the government of India.
Rajan was the Chief Economist of the International Monetary Fund(IMF) between October 2003 and December 2006. In 2003, he also won the first Fischer Black Prize, which is awarded to the most promising economist under the age of 40, by the American Finance Association. He is also a Professor of Finance at the Chicago University’s Booth School of Business.
So what can we expect from Rajan as the RBI governor? In order to understand we first need to understand what are Rajan’s views on various factors impacting the Indian economy right now, and which he will have to deal with as the governor of the RBI.
Rajan is a firm believer in the fact that high government spending in doling out various subsidies has been a major cause behind India’s high inflation. This clearly comes out in the Economic Survey for the year 2012-2013, which he was in-charge of as the Chief Economic Advisor.
A part of the summary to the first chapter State of the Economy and Prospects reads “With the subsidies bill, particularly that of petroleum products, increasing, the danger that fiscal targets would be breached substantially became very real in the current year. The situation warranted urgent steps to reduce government spending so as to contain inflation.”
This is something that he reiterated in a recent column as well, where he wrote “India needs less consumption and higher savings. The government has taken a first step by tightening its own budget and spending less, especially on distortionary subsidies.”
The RBI under D Subbarao has been very critical of the high government expenditure distorting the Indian economy. Rajan’s thinking on that front doesn’t seem to be much different from that of his predecessor.
Also Rajan firmly believes that Indian households need stronger incentives in the form of lower inflation to increase financial savings, which have been declining for a while. As the recent RBI financial stability report  points out “Financial savings of households…have declined from 11.6 per cent of GDP to 8 per cent of GDP over the corresponding period (i.e. between 2007-08 to 2011-12.”
Financial savings are essentially in the form of bank deposits, life insurance, pension and provision funds, shares and debentures etc. In fact between 2010-2011 and 2011-2012, the household financial savings fell by a massive Rs 90,000 crore. This has largely been on account of high inflation. Savings have been diverted into real estate and gold in the hope of earnings returns higher than the prevailing inflation.
Also people have been saving lesser as their expenditure has gone up due to high inflation. And the financial savings will only go up, if inflation comes down, pushing up the real returns on bank fixed deposits.
“Households also need stronger incentives to increase financial savings. New fixed-income instruments, such as inflation-indexed bonds, will help. So will lower inflation, which raises real returns on bank deposits. Lower government spending, together with tight monetary policy, are contributing to greater price stability,” wrote Rajan in his column.
Given this, the focus of the RBI on controlling ‘inflation’ which continues to be close to double digits (consumer price inflation was at 9.87% in the month of June, 2013) is likely to continue under Rajan as well. Hence, the repo rate, which is the rate at which RBI lends to banks, is unlikely to come down dramatically any time soon.
Lower inflation leading to higher savings will also help in bringing down the high current account, deficit feels Rajan. During the period of twelve months ending December 31, 2012, the current account deficit of India had stood at $93 billion. In absolute terms this was only second to the United States.
The current account deficit(CAD) is the difference between total value of imports and the sum of the total value of its exports and net foreign remittances. Since imports are higher than exports and foreign remittances, the country is spending more than saving.
As Rajan told the India Brand Equity Foundation in an interview “CAD essentially reflects the fact that you are spending more than you are saving. That’s technically the definition of the CAD, which means that you need to borrow from abroad to finance your investment. Ideally, the way you would reduce your current account deficit is by saving more, which means consuming less, buying fewer goods from abroad and importing less. Or, the other way is by investing less, because that would allow you to bridge the CAD. Now we don’t want to invest less. We have enormous investment needs. So ideally, what we want to do is save more.”
And to achieve this “the first way is for the government to cut its under-saving or its deficit and that is part of what we are doing” “The second way is when the public decides to save more rather than spend. We need to encourage financial saving,” Rajan said in the interview.
Given this, Rajan has never been a great fan of subsidies and he looks at them as a short term necessity. In an interview I did with him after the release of his book Fault Lines – How Hidden Fractures Still Threaten the World Economy, for the Daily News and Analysis(DNA), I had asked him whether India could afford to be a welfare state, to which he had replied “Not at the level that politicians want it to. For example, the National Rural Employment Guarantee Scheme (NREGS), if appropriately done, is a short term insurance fix and reduces some of the pressure on the system, which is not a bad thing. But if it comes in the way of the creation of long term capabilities, and if we think NREGS is the answer to the problem of rural stagnation, we have a problem. It’s a short-term necessity in some areas. But the longer term fix has to be to open up the rural areas, connect them, education, capacity building, that is the key.”
This commitment came out in the Economic Survey as well. “The crucial lesson that emerges from the fiscal outcome in 2011-12 and 2012-13 is that in times of heightened uncertainties, there is need for continued risk assessment through close monitoring and for taking appropriate measures for achieving better fiscal marksmanship. Open ended commitments such as uncapped subsidies are particularly problematic for fiscal credibility because they expose fiscal marksmanship to the vagaries of prices,” the Survey authored under the guidance of Rajan pointed out.
So what this clearly tells us that Rajan is clearly not a jhollawallah. The last thing this country needs at this point of time is an RBI governor who is a jhollawallah.
Another important issue that Rajan will have to tackle is the rapidly depreciating rupee against the dollar. RBI’s attempts to control the value of the rupee against the dollar haven’t had much of an impact in the recent past. On this Rajan has an interesting view. As he said in an interview to the television channel ET Now “When we have capital either coming in or flowing out, sometimes it is very costly standing in the way. We would rather wait till our actions have the most impact. It would wait till the moment of maximum advantage and then use all the firepower that it has to pushback.”
What this means is that under Rajan the RBI won’t try to defend the rupee all the time. Given this, the rupee might even be allowed to fall further. What Rajan does on this front will become clear in the months to come, but this will be his biggest immediate challenge.
Another factor working in Rajan’s favour is that this is clearly not Rajan’s last job. He is still not 50. Also, he has a job at the University of Chicago, which he can always go back to.
Given this, it is unlikely that he will make any compromises to help the politicians who have appointed him and is likely to make decisions that are best suited for the Indian economy, rather than help him win brownie points with politicians.
For anyone who has any doubts on this front it is worth repeating something that happened in 2005. Every year the Federal Reserve Bank of Kansas City, one of the twelve Federal Reserve Banks in the United States, organises a symposium at Jackson Hole in the state of Wyoming.
The conference of 2005 was to be the last conference attended by Alan Greenspan, the then Chairman of the Federal Reserve of United States, the American central bank.
Hence, the theme for the conference was the legacy of the Greenspan era. Rajan was attending the conference and presenting a paper titled “Has Financial Development Made the World Riskier?”
Those were the days when the United States was in the midst of a huge real estate bubble. The prevailing economic view was that the US had entered an era of unmatched economic prosperity and Alan Greenspan was largely responsible for it.
In a sense the conference was supposed to be a farewell for Greenspan and people were meant to say nice things about him. And that’s what almost every economist who attended the conference did, except for Rajan.
In his speech Rajan said that the era of easy money would get over soon and would not last forever as the conventional wisdom expected it to. “The bottom line is that banks are certainly not any less risky than the past despite their better capitalization, and may well be riskier. Moreover, banks now bear only the tip of the iceberg of financial sector risks…the interbank market could freeze up, and one could well have a full-blown financial crisis,” said Rajan.
In the last paragraph of his speech Rajan said it is at such times that “excesses typically build up. One source of concern is housing prices that are at elevated levels around the globe.” 
Rajan’s speech did not go down well with people at the conference. This is not what they wanted to hear. He was essentially saying that the Greenspan era was hardly what it was being made out to be.
Given this, Rajan came in for heavy criticism. As he recounts in his book Fault Lines – How Hidden Fractures Still Threaten the World Economy: “Forecasting at that time did not require tremendous prescience: all I did was connect the dots… I did not, however, foresee the reaction from the normally polite conference audience. I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticized by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself…Rather it was because the critics seemed to be ignoring what going on before their eyes.” 
The criticism notwithstanding Rajan turned out right in the end. And what was interesting that he called it as he saw it. India needs the same honesty from Rajan, as and when he takes over as the next RBI governor.
The article originally appeared on www.firstpost.com on August 6, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)