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As Dr. Raghuram Rajan prepares to return to the academia after three years at the helm of the Reserve Bank of India, he leaves behind a legacy and a notable contribution in the introduction of an objective and a legal framework for conduct of monetary policy in India with a focus on inflation-targeting.
The search for such a framework began, at least at a conceptual level, in the years following the agreement between RBI and the Central government way back in 1994 leading to the abolishment of automatic and limitless financing of deficit by way of money printing. But its progress was halting and lacking in focus, though from time to time the subject was the focus of rich debates and discourses, some of which were steered by the indefatigable S.S. Tarapore.
Two major issues stood in the way: Although India experienced consistently high consumer inflation in the recent decades, the effectiveness of inflation-targeting was seen by some as limited and growth-retarding because of the presence of severe supply-side constraints, especially in respect of food items which together have a large weightage in CPI. The second issue was reluctance on the part of the political and bureaucratic leadership in New Delhi to agree to a fundamental redrawing of the contours of relationship with RBI that this would entail.
It was left to Dr. Rajan to argue the case for inflation-targeting in a cogent and convincing manner and clinch the issue. The polemical rigour that he brought to bear on the debate about the right balance in monetary policy between growth and inflation as also between the interests of savers and borrowers will provide guidance to the RBI for years to come.
Dr. Rajan's immediate predecessors were not convinced on the issue of inflation-targeting, possibly seeing it as not pragmatic, given the imperatives of the Indian political economy. One of them, Dr. Duvvuri Subbarao, has made public the pressures of politico-bureaucratic interference in monetary-policy decisions during his tenure. It is common knowledge that this was not the first time a Governor faced such interference, nor would this be the last unless the goals of monetary policy are clearly defined and the RBI is held accountable for achieving them.
It was left to Dr. Rajan to argue the case for inflation-targeting in a cogent and convincing manner and clinch the issue. The polemical rigour that he brought to bear on the debate about the right balance in monetary policy between growth and inflation as also between the interests of savers and borrowers will provide guidance to the RBI for years to come.
Those with the view that the growth objective should also be an explicit consideration for monetary policy setting implicitly assume that there is a trade-off between growth and inflation in the medium to long term. If this is the case, then the government will be well within its rights to fix a higher inflation target that is consistent with its target for higher growth.
Dr. Rajan also put forth a home truth relating to the periodic turmoil that the domestic foreign exchange market faces whereby the accumulated overvaluation of the rupee due to higher inflation in India is adjusted by a resetting of its exchange rate, accompanied by some degree of overshooting as well: the choice is between a monetary policy framework that targets and keeps inflation low and bouts of destabilising volatility surge in the foreign exchange market, like the one that he had successfully faced in August- September, 2013, with some loss of sleep, though.
But the special FCNR(B) scheme introduced in the wake of that episode and which raised US$ 34 billion to bolster the foreign exchange reserves by providing exchange rate guarantee at a significantly subsidised rate was a decision that should have been avoided. Going by his recent public comments, it appears that Dr. Rajan has come to realise that it was a nostrum at best and possibly a mistake.
Dr. Rajan must also get credit for requiring the banks in India to come clean on their burgeoning NPA by way of full disclosure and appropriate provisioning within a tight timeline. It was a bold, immensely courageous and path-breaking step that was unthinkable before him. This has the potential to fundamentally change the way the banks are run and regulated in this country.
Right from the early months of 2012, when the first signs of a build-up of NPA in State-owned banks caused by a massive and questionable accumulation of “restructured loans” had surfaced, the response of RBI and the government was a familiar mix of denial and soft-pedalling. This was quite reminiscent of the late 1980s and early 1990s when no less than six State-owned banks were believed to be in trouble because of high NPAs.
Dr. Rajan must also get credit for requiring the banks in India to come clean on their burgeoning NPA by way of full disclosure and appropriate provisioning within a tight timeline. It was a bold, immensely courageous and path-breaking step that was unthinkable before him.
The rest is history by now - each new data and information on the NPAs of State-owned banks and a few private sector banks since the second quarter of 2012 exceeded the previous one, more so this year in the aftermath of the Asset Quality Review (AQR) exercise. According to a recent report of the Indian affiliate of credit rating agency Fitch, about 20 per cent of the gross loans of banks, involving Rupees 13 trillion (close to 9 per cent of India's GDP) are already stressed, the economic and fiscal costs of which are going to be enormous.
One hopes that Dr. Rajan's successor will complete the clean-up operations and that RBI and the government will learn from the mistakes of this experience and never allow such a build-up of NPAs again.
Clearly, the reforms in monetary policy with the adoption of an inflation-targeting framework and procedure are transformational. It is still early days, but one sees more quality in policy statements, surveys, annual reports and conduct of media and public relations. For lay readers of monetary policy statements, there seems to be some respite now from having to encounter hackneyed and trite usage of words and phrases such as “calibrated”, “trajectory”, “roadmap”, “control and contain” etc.
The three-year tenure of Dr. Rajan also saw him observe, with some dismay perhaps, the significant skills gap amongst his staff at all levels. He reportedly spoke about it on at least one occasion. It is doubtful whether his staff, as a whole, shared his vision about making RBI a front-line central bank comparable with the best in the world. A good section of them were not happy on his insistence on performance, professional excellence and continuous learning.
In sum, Dr. Rajan was a bit ahead of time for the government, the political class and even the team at RBI as it stands now.
Many years back, the noted economist Dina Khatkhate raised a question – why shouldn't RBI be headed by a professional and a relatively young economist? The received wisdom of that era, which finds its echo even now, was that a RBI Governor should preferably be an administrative hand with some experience in economic/financial policy-making and relatively young may have been a good disqualification! This suited the practice of the Indian version of what is called amakudari in Japan – descent from heaven.
The good news is that things are changing in India and hopefully the appointment of a new Governor will recognise this change and help us build on the strong foundation set by Dr. Rajan.
(The author is a former central banker and consultant to the IMF)