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How Raghuram Rajan Radicalised the Indian Economy

Updated on September 14, 2017

How he came to recognition before being the RBI governor

Being a Finance professor at the University of Chicago,Rajan was an unknown entity among the Macro Economists who populate the IMF.
Anne Krueger, the then second in command of the IMF read a book which Rajan co authored with Luigi Zingales named "Saving capitalism from the capitalists" (2003). After reading she asked Rajan whether he would be interested in being the Chief Economist of IMF. Rajan honestly replied he did not understand a thing about macro economics. To this statement Krueger replied neither did she. He decided to give it a shot any way.
And thus from October 2003 to December 2006,he served as the Chief Economist at the International Monetary Fund.
His stint at the IMF not only gave him valuable experience in policy making but also enriched him with advanced economics. He was also one of the few persons to have guessed the US financial crisis in 2007 which led to the global economic crisis in the following year. The stint gave him enough time to sharpen his macro economic skills and also the art of global economic policy making. He lead a team at the IMF to help some major economies reduce their huge balance of payment imbalances.
However, everything was not hunky dory for him during his days at the IMF. In August 2005 he came under severe criticism following what turned out to be a prescient speech about the dangers lurking in the financial system. He said, he expected to find dramatic expansion in the financial markets which had reduced the risks for the banks. But instead the figures that his staff assembled showed the opposite. He delivered a speech based on his paper "Has financial development made the world riskier?" and warned there was a probability of a catastrophic global economic meltdown. The message did not go down well in some quarters, for this he was even called "slightly luddite" and "largely misguided" by former U.S Treasury Secretary Lawrence Summers. High ranked officials even suggested Rajan was against change and he was nostalgic about the old bank-dominated systems.
In 2007 his warnings did come true. The U.S market for sub prime mortgage securities began to implode leading to a global economic crisis.

Reforms he did after coming to office

On 6 August 2013 it was announced that Rajan would take over as the next Reserve Bank of India Governor for a term of 3 years, succeeding Duvvuri Subbarao.
When he came to office, the Rupee was going down hill to some predictions of crossing 70, but within a year it rose to 58-59 against the Dollar. His reforms had such a widespread impact that the Rupee rose to 61-62 in just four months by November 2013 as compared to 68.85 against the dollar on the day of his appointment.

Rajan took steps to control the rupee's slide. At a time when foreign fund inflow had slowed down and the government was contemplating a sovereign bond issue, Rajan opened a swap window for deposits from non-resident Indians. The swap window has attracted $12 billion in just two months. He also allowed banks to borrow more from overseas. These measures, along with easing worries of a US strike on Syria and the continuation of the US Federal Reserve's steps to revive its economy, have helped stabilize the rupee.

Rajan's economic mandate rests on five pillars of reforms-->

  1. Strengthening monetary policy tools in a globalized world.
  2. Reforming the banking sector,new banking licenses and national treatment to foreign banks.
  3. Creating in-depth financial markets by allowing new players and introducing new instruments.
  4. Providing access to finance the SMEs and the unorganized sector and support financial inclusion.
  5. Dealing with corporate distress by speeding up debt recovery tribunals and asset reconstructions firms.

Was he an inflation hawk during his first months at office?

Asserting independence during his first two months at office Rajan raised the main lending rate to tame inflationary expectations. He raised it from 7.25 to 7.75 to fight inflation. He stressed upon the fact that growth with low inflation should be the common goal of the government and the RBI. Although both of them have different time frames to achieve the same.
Before he took over at the RBI, the difference between the repo rate and the MSF, the rate at which banks borrow from the RBI, had widened to 300 basis points. This had prompted large banks such as State Bank of India(SBI) and ICICI Bank to increase their base lending rates. At the same time the repo rate was not increased. Rajan slashed the MSF rate in three phases and raised the repo rate, bringing the gap now to a normal level of 100 basis points. What Rajan has brought during the early days of his stint was two powerful characteristics to the RBI - accessibility and transparency.

Graph of the improving Rupee within one year of Rajan coming to office


The lesson from Brazil; Macro Economics and Dosa Economics

In 2010 Brazil set an example of its growth and then it's economic downfall happened in 2015. It made robust economic growth and enormous strides in reducing inequality. It grew at 7.6 percent in 2010, and had discovered huge oil reserves which the then President Lula related to “winning a lottery ticket”. Then what went wrong?
The country's economy shrank by 3.8% and the debt downgraded. The real picture was Brazil grew too fast for its own good. In an attempt to keep growth rate high, the central bank was pressed to reduce interest rates. This fueled a credit spree that overburdened customers and they struggled to repay. Further, Brazil’s government funded development bank which started giving subsidized loans to corporations.

Thus budget deficits increased and inflation touched double digits in the 4th quarter of 2015. Of course, India is not in the same situation today. Given the inhospitable world economy and two successive droughts, either of which would have thrown the economy into a tail spin in the past. Rather it is to the immense credit of the government that Indian economy have managed over 7% growth, low inflation, and a low current account deficit. But it is at such times that the policy players should not be overambitious or the economy might crumble under its own growth. That is where managing a macro economy comes in handy. As Rajan has already warned about the global slowdown in 2008 beforehand because of his experience with macro economies, he tread carefully to control inflation and growth.
India's GDP grew from 7% in 2014 to 7.2% in 2015 and now it is the fastest growing economy in the world. There would have been a next brazil around the corner but for a cautious low inflation rate, rising growth in a steady manner and macro economic outlook, Indian economy was saved. Rajan and the RBI was in no mood to let that happen. In 2013 he was awarded the fifth DEUTSCHE BANK PRIZE IN FINANCIAL ECONOMICS for his "ground-breaking research work which influenced financial and macro-economic policies around the world".
To make things clearer Dr Rajan gave an example of Dosa Economics.(Dosa being a South Indian delicacy). For example let's say a pensioner wants to buy dosas and at the beginning of a period, the cost was Rs 50 per dosa. Let us say he has savings of Rs 1,00,000. He could buy 2,000 dosas with the money today, but he wants more by investing.
At 10% interest, he gets Rs 10,000 after one year plus his principal. With dosas having gone up by 10% to Rs 55, he can buy 182 dosas approximately with the Rs 10,000 interest.
At 8% interest, he gets Rs 8,000. With dosas having gone up by 5.5%, each dosa costs Rs 52.75, so he can now buy only 152 dosas approximately. So the pensioner sees that: With lower interest payments; he can now buy less.
But the reality is the pensioner is getting his principal back and that too has to be adjusted for inflation. In the high inflation period, it was worth 1,818 dosas, whereas in the low inflation period,it is worth 1,896 dosas. So in the high inflation period, principal plus interest are worth 2,000 dosas together, while in the low inflation period it is worth 2,048 dosas.

He is about 2.5% better off in the low inflation period in terms of dosas. Thus with lower inflation rate the pensioner is better off and thus lower inflation goes hand in hand with economic growth which Rajan made very clear through this example.

Increasing tolerance towards the usage of money for Inclusive Growth

One aspect stressed upon by him was Inclusive Growth. He believes that the Indian society should be more tolerant towards the usage of money rather that prohibiting it's usage. For the usage of money there needs to be investment in the country which in turn will create jobs. With the start up culture coming up in India in recent times, investments and jobs are also increasing. So basically job creation leads to more usage of money and hence growth. His advice to the start ups is not to capture markets by deep discounting but to be more socially appealing. The idea follows a saying "The enterprise started by an entrepreneur can fail, but the people should not fail".
76% of Indians are financially illiterate, keeping this and inclusive growth in mind, he stressed upon eradicating the inequalities in the country. He stressed upon financial literacy right from the school level. Education and economy seems to be favoring the ones who have plenty. His advice to the larger population is to spend to create value however small the it is. So to keep the best not only for the fortunate few, but also he emphasized on the need for affordable education throughout the lengths and breadths of the country.

Cutting down on Non Performing Assets(NPA), Fostering Competition and driving India to a near double digit growth through technology and innovation

One very important contributor to macroeconomic stability is healthy banks. Banks in India have a number of stressed loans on their balance sheet. For example in case of a project organization, if loans are written down, the promoter brings in more equity. Other stakeholders like the tariff authorities or the local government chip in, any project may have a strong chance of revival. The promoters will be incentivised to try their utmost to put it back on track. But to do all this, the bank has to classify the asset as a Non Performing Asset (NPA), a label banks are eager to avoid because that amount of money is going down in the bank's book as a liability.
A number of good banks in the Indian banking system have taken the necessary action to recognize and resolve stressed loans in a timely fashion. But some others need to take more proactive action. Over the last few quarters, the Reserve Bank has expanded the tools banks use to recognize and deal with stressed loans. Cleaning up the bad loans takes more pro-activeness which was lacking in the past. Enough capital is already available and once it is cleaned, the system can support economic growth in a sustainable and profitable manner.
In order to get sustained growth, more competition is needed. Especially from new entrants who are in a better position to reach the so called excluded parts of the Indian economy. Two new private banks entered in 2015. Following this a number of payment banks and small finance banks entered in 2016 after nearly a decade of stagnancy on this front. Rajan's stress on the banking sector resulted in him treating foreign banks at par with Indian banks in terms of branch expansion. Hence there should be no disparity in their growth.
Public sector banks (PSBs), with their large branch network, will have to adapt. Some of these new entrants will extensively increase their customers base. But to create a healthy and competitive field for the banks the level playing field of the PSBs are to be encroached so that they come up with innovation. Thus employment is going to increase in full time or contractual basis which in turn translates into growth. Mergers and acquisitions are also on the card for ailing banks.
The RBI taking the Chinese saying "Cross the river by feeling the stones” seriously. They tried to tread a path of experimentation and innovation. The next generation of on-the-go youth workforce need payments to be made hassle free saving their precious time. The RBI keeping this is mind, allowed small value card payments without two-factor authentication. As technologies emerge it can liberalize further. Now comes the question of how new technology shall fit into the already existing banking system. More importantly RBI and other banks incorporate the changes to function better and efficiently. This will indeed be a huge boon for the system and for growth so as to keep up with an ever so challenging and developing world.
Sitting at the head of the RBI, Rajan carved his path linking all of the above mentioned aspects and radicalized Indian economy. In 2014 he was conferred the Best Central Bank Governor award by EUROMONEY Magazine and On 9 November 2015, Rajan was appointed as Vice-Chairman of the Bank of International Settlements (BIS).
Because of his stint of 3 years as the chief economist at the IMF along with having a global reach, he is suggested to take over the IMF head post post from Christine Lagarde after the completion of his tenure as the Reserve Bank of India governor in 2016.

© 2016 Ankush Mukherjee


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