Raghuram Rajan is currently having what I would like to call an “aaya aaya toofan, bhaga bhaga shaitan” moment. For those who are not as fond of trashy 80s cinema as I am, this needs some explanation. “Aaya aaya toofan, bhaga bhaga shaitan (Here comes Toofan, there runs the devil),” is a song from the Amitabh Bachchan starrer Toofan, which released in 1989.
The film has a character called Toofan (played by Bachchan) who plays a superhero, fighting evil. And the song keeps playing in the background whenever Toofan is out taking on the evil forces.
Rajan took over as the twenty third governor of the Reserve Bank of India (RBI), yesterday. He had his first press conference at 5.30pm in the evening. In this press conference he outlined a stream of measures that he plans to take over the next few months.
Within seconds of his press conference ending television channels, started to go gaga over his performance. The feeling one got while watching was that all of India’s economic problems have/will come to an end because Raghuram Rajan had taken over as the governor of the RBI.
This excitement seems to have rubbed off on the newspapers as well. The Economic Times has compared him to James Bond. The Times of India called Rajan’s entry “a big bang entry”. Business Standard said that “Rajan hits the ground running” and so did The Indian Express. Firstpost has called Rajan a Rockstar.
The impact of Rajan’s maiden performance has been seen great. The rupee has risen against the dollar and is currently quoting at 66 to a dollar. The stock market has rallied around 400 points, as I write this. This is in response to a slew of measures that Rajan announced yesterday.
Rajan announced plans to internationalize the rupee, several steps to improve the inflow of dollars into India and improve exports. He also said that the RBI would allow ‘good’ banks to open branches without approaching the RBI for a license. To control the appetite Indians have for gold, he announced that the RBI would soon launch bonds indexed to consumer price inflation.
Some of the capital controls introduced sometime back to prevent the rupee from falling have also been done away with. Individuals will be allowed to spend more than $75,000 per year abroad, if the money is being spent on education and medical treatment. Rajan also announced plans for a nation wide bill payment system for payment of utilities like medical bills and school fees. A string of technical measures to shore up the value of the rupee against the dollar, were also announced. All in all, a great first day at work.
Having said that, there isn’t much that Rajan can do to improve the major ills that are plaguing the Indian economy. Let’s start with inflation. As Rajan said yesterday “the RBI takes its mandate from the RBI Act of 1934, which says the Reserve Bank for India was constituted “to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.””
Hence, the primary role of the RBI is to ensure monetary stability. Or as Rajan put it “That is, to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures.”
There isn’t much that the RBI can do to control inflation. The primary reason for the same is that the government of India is the main creator of inflation. The expenditure of the government has jumped considerably over the last few years and this has created inflation. As Ashok Gulati and Shweta Saini write in a research paper titled Taming Food Inflation in India “RBI has indicated time and again that government needs to rein-in the fiscal deficit before it can reduce interest rates,else, too much money in the system will be putting further pressures on prices in general and food prices in particular… The Economist in its February 2013 issue highlights that it was the increased borrowings by the Indian government which fuelled inflation and a balance-of-payments gap. It categorically puts the responsibility on the government for having launched a pre-election spending spree in 2008, which continued even thereafter.”
There is nothing that the RBI can do about this. With many state elections due this year and a Lok Sabha election due towards the middle of next year, the chances are the government is likely to continue spending big money. Several boondogles to influence the voters, might be on their way.
Also, a lot of the inflation created by the government shows up as food inflation, on which RBI has no control. As Gulati and Saini write “High food inflation, which has averaged 10 percent during FY 2008-09 to December 2012, has been a major concern for policy makers in India.” Even after December 2012, food inflation continues to be higher than 10%.
The RBI has tried to control high inflation by maintaining interest rates at high levels. One school of thought goes that since the RBI cannot do much to control food inflation, so it might as well cut interest rates. The risk here is that low interest rates might fuel other kinds of inflation. So, it remains to be seen whether Rajan is ready to take on that risk or not.
High inflation can come in from other areas which Rajan has absolutely no control over. It can come from rising oil prices due to threat of an American attack on Syria. As an international fund manager told me earlier this week “if that happens(i.e. American does attack Syria) we can have oil prices touching even $150 per barrel.” In that scenario, inflation will spike and that will have a huge impact on economic growth, something an RBI governor has no control over.
Also, if the Federal Reserve of United States, RBI’s American counterpart, decides to go slow on printing money, that will lead to further economic problems in India. The Fed has indicated in the recent past that it plans to go slow on the $85 billion it has been printing and pumping into the American financial system every month, to keep interest rates low. The hope is that at low interest rates Americans will borrow and spend more, and that will help revive the American economy.
The danger of course is that all the money being printed and pumped into the financial system can create high inflation. So at some point of time the Federal Reserve needs to start going slow on printing money.
If the Federal Reserve decides to go slow on money printing, as it has said in the recent past, interest rates in America will go up. This will lead to foreign investors selling out of India and other emerging markets. This will put further pressure on the rupee against the dollar. As the rupee will lose value, it will mean that our main imports i.e. oil, coal, fertilizer, palm oil etc, will become costlier, leading to a rise in inflation. If this scenario plays out, there is not much that Rajan can do about it. The RBI can sell dollars and buy rupees to stop the rupee from depreciating against the dollar. But it is worth remembering that the RBI does not have an unlimited supply of dollars.
Another worrying factor is the slowdown in economic growth and the impact that it will have on government borrowings. The government expects the GDP to grow by 13.4%(in nominal terms) during this financial year (as per the annual budget). This is unlikely to happen.
As Dylan Grice, formerly with Societe Generale and now the editor of the Edelweiss Journal wrote in a February 2010 research report titled Government hedonism and the next policy mistake “If I’m a finance minister mulling out how much money I should be borrowing, I want my GDP growth (and therefore my tax revenue growth) to pay coupons (i.e. interest) on any debt that I take on today…If the interest rate is higher than GDP growth, my incremental tax revenue won’t cover interest payments. I’ll be in deficit and I’ll have to issue more debt to plug the gap and my debt ratio will rise.”
What this means is that the tax revenue collected by the government should be rising at a rate which is good enough to pay the interest on the accumulated debt. If that does not happen, the government will have to borrow more money to make its interest payments. And that is not a good sign. The government will either end up with a higher fiscal deficit or it will have to cut its expenditure in other areas to maintain the fiscal deficit. Fiscal deficit is the difference between what a government spends and what it earns. India is in that kind of a situation right now and there is nothing that Rajan can do about it.
Also, to repeat a point that is made often, India’s economic growth is being hurt by the poor physical infrastructure that we have. The country needs better roads, more ports, better railway infrastructure and so on. These are things the RBI governor cannot do much about, even though as Rajan said the RBI has “additional tools to generate growth”.
All this is not to suggest that Rajan is not a good choice for the governor’s job. He is an excellent choice given his impeccable credentials, but expecting him to do miracles is unjustified.
To conclude, let me quote what Jerry Tsai, a famous American fund manager had to say about the penchant of the media to create heroes. “And I can say this from experience: the trouble with getting a little bit of good publicity is, when something goes wrong they love to kill you on the way down. The media like to build things up so they can tear them down.” (Source: What Goes Up – The Uncensored History of Modern Wall Street by Eric J Weiner). Rajan should keep that in mind as he goes about his business of rescuing the troubled Indian economy.
The article originally appeared on www.firstpost.com on September 5, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)