THE CURIOUS CASE OF RAGHURAM RAJAN

Abhijit Mukhopadhyay currently works as an Economist at Economic Research Foundation, New Delhi. He taught at business schools and also worked at different research based institutes in New Delhi.

Abhijit Mukhopadhyay

Amidst a visible slowdown in the economy, a rising current account deficit and a resultant ominous fall in the value of rupee, Indian Government appointed a new governor of the Reserve Bank of India (RBI) in the beginning of August 2013. The man, Raghuram Rajan, was holding the post of Chief Economic Advisor, Ministry of Finance, at that time. The reaction to his appointment ranged from outright jubilation to skepticism – both in mainstream media and academia.

This gold medalist student of IIT Delhi and IIM Ahmedabad went on to complete his Ph.D. thesis from Massachusetts Institute of Technology. After that he worked in International Monetary Fund (IMF) and he is also on leave of absence from his post of Professor in Finance at University of Chicago Booth School of Business.

His big “claim to fame” is a cautionary presentation on risks of existing American and international financial architecture at a symposium sponsored by Federal Reserve Bank of Kansas City at Jackson Hole, Wyoming in August 2005. That presentation was based on a paper written at IMF and it talked about the inherent risk involved in “ever expanding” and “ever innovating” financial markets. Though he did not challenge the fundamental basis of wild speculations that now-a-days happen in the financial market, his was a well-guarded approach towards financial market functioning and regulation. His essential point was that existing financial markets show excessive volatility which can generate tail risk and subsequently has the ability to pull the entire market down. Tail risk is a form of portfolio risk that arises when the possibility of an investment moving more than 3 standard deviations (from the mean) is greater than what is shown by a normal distribution. Usually financial market agents are more bothered about such downward fall. He pinned the blame for this (potential) financial market volatility and instability on the financial agencies and intermediaries, of which a large part of the blame was directed towards private financial fund managers who, according to him, can “follow the herd into disaster” and “get a job in another fund.”

Raghuram Rajan (photo: IMF/wiki)

This presentation led to sharp criticisms from the participants of the symposium, majority of whom were financial high priests and mandarins of the new international financial architecture. Former U.S. Treasury Secretary and former Harvard President Lawrence Summers called the warnings “misguided” and went to the extent of calling Rajan a “luddite.” However, after 2008 meltdown in US the situation changed drastically and once “the reason of ridicule” transformed into the “raison d’être” for Raghuram Rajan. This bit of “prophecy” (in front of the heavyweights of international finance) catapulted Rajan to a sort of iconic status, and effected his arrival in Indian firmament as Honorary Economic Advisor. Subsequently he became Chief Economic Advisor to Government of India in August 2012. The month of August seems to be playing an important role in Rajan’s celestial fortunes of late.

As mentioned earlier, the thrust of his argument against financial excess seems to lie on financial regulation and monitoring financial agents’ behaviour, particularly the behaviour of the financial managers. He never questioned the efficacy of the so-called “mechanism of the financial market to spread the risk evenly to all involved.” On the contrary, he heaped praises on the system for creating more “depth,” more “innovative” instruments and more “spread” in financial market.
This takes us to the kind of economics he believes in – that is essentially supply-side economics. This kind of economics professes that most of the problems in any economy crop up because of supply side bottlenecks – be it infrastructure or raw material or capital in real sector, or be it credit delivery, capital mobilization in monetary sector. So according to the proponents of this theory, the remedy lies in removing all such bottlenecks from the economy. Many in this school of thought, generally, also adhere to fiscal austerity as they see that kind of austerity as a short term “pain” to cure systemic faults and subsequent prosperity. Raghuram Rajan is also in the similar category and he apparently believes in regulation to curb risk in financial markets but strongly opposes any kind of fiscal stimulus.

However, contrary to this position there are economists (ranging from Keynesians like Paul Krugman to critical Post-Keynesian and Marxist Economists) who believe that fundamental problems in an economy, more than often, lie in the demand side of the economy. In simple words, they believe that if enough demand is generated through increased employment and rising purchasing power in the economy then that culminates into increase in output year after year. For this set of economists, mere speculation in the financial market does not serve anybody’s purpose in the economy, except for the purpose of rent-seeking (financial) capitalists. They believe that fiscal policy plays a more important role than monetary policy, which plays a supplementary or complementary role to such an expansionary fiscal policy. The biggest examples of expansionary fiscal policies in the current context are the fiscal stimulus packages employed in response to recessionary trends in various countries including USA and China. The academic and policy debates in this area have so far been between these two conflicting schools of thoughts. Though just after the meltdown in USA the proponents of Keynes-style fiscal stimulus were holding the sway for a year and two, the mainstream neo-classical economists once again came back with their “tightening the belt” philosophy as things settled down, particularly in the USA.

Raghuram Rajan is no exception from these mainstream hawks that go for fiscal austerity which simply means government has to spend much less than what it ought to do. Without fail, the cut in any government’s spending usually is shorthand for little or no social sector expenditure and almost no government intervention to uplift the lowest and poorest section of the economy. In the time of slowdown or recession this in reality implies that by this set of policies the rich try to get a guaranteed return on their capital while the poor take the hit; in this way economy stabilises and recovers at the expense of the poor while the rich remains unaffected in troubled times.

This very same set of economists usually is also averse to the idea of financial regulation. As mentioned, Rajan is perceived to be a bit different in this aspect as he shot into fame by talking about financial prudence and regulation. However, after becoming RBI Governor the kind of speeches (or writings) he is making – create tinges of contradiction and suspicion about that reputation.

In the statement after taking office as RBI Governor (September 4, 2013), he mentioned about freedom of all domestic commercial banks in establishing new branches. The statement also talked about providing new licenses for commercial banking. The informed people know that there are big private entities like Reliance Group and quite a few suspicious (chit fund) operators in the list of the applicants. A natural reaction would have been caution, but Rajan intends to complete the process (tentatively) by January 2014. He has also shown his interest in exploring possibility of providing continuous or “on-tap” licensing of banks.

He also wished to encourage foreign banks to move towards a wholly owned subsidiary structure, which will enable them to attain “national treatment.” This may imply shift of financial capital outside the country, in the longer run. The statement also finds a mention of reduction in need for regular commercial banks to invest in government securities. Within statutory liquidity ratio (SLR) requirements, the banks are bound to invest a certain part of their deposits in government securities. If the Governor feels the need for a reduction then the central bank may be bereft of one important policy instrument to control money supply in the future. Moreover, SLR also provides avenues of resource mobilisation for the central government, so indirectly it may also turn out to be a veiled attempt to curb government’s fiscal ability.

In another bit of surprise, his statement also mentioned about intention to liberalise the financial market apparently in order to distribute the financial risks away from commercial banks. We have seen, particularly in American crisis, that this model of “spreading the risk equitably in entire financial market” actually means “shifting the risk to the end-holder of the financial instrument, making them vulnerable and creating a fertile ground for financial crisis.”

He also announced enhanced limits for exporters and importers to re-book cancelled forward exchange contracts. In addition, he also introduced interest rate future contracts in future agenda. He even mentioned a possibility of introducing interest rate future contract in overnight interest rates. If futures in overnight interest rates are introduced then it is very difficult to imagine a scenario where there will be no unnecessary speculation. And this may even undermine the RBI’s ability to effectively use interest rate as a monetary instrument in certain situations.

RBI Seal

In surprise of the surprises, he said – “This might be a strange time to talk about rupee internationalization, but we have to think beyond the next few months.” He went on further to say – “we have decided that the current overseas borrowing limit of 50 per cent of the unimpaired Tier I capital will be raised to 100 per cent and that the borrowings mobilised under this provision can be swapped with Reserve Bank of India at the option of the bank at a concessional rate of 100 basis points below the ongoing swap rate prevailing in the market.” This is serious attempt to liberalise the capital account – at a time when worsening current account deficit and foreign exchange rate of rupee silenced (albeit temporarily) even the most ardent supporters of capital account convertibility.

Without clearly mentioning so, the contour of the statement makes no bone about hiding the intention to replicate an US like model of financial market when even the US economists are, in general, skeptical about the efficacy and robustness of it. As David Pais aptly put in his op-ed article in The Hindu (September 14, 2013), “He intends to open up the capital account and replicate the United States financial system in India with all its bells and whistles. Given recent global economic and financial history, this is a shockingly disastrous set of objectives to be setting.”

However, later when the mid quarter monetary policy review came out in September 20, 2013 it turned out to be a conventional one. The repo rate, which is the benchmark rate of interest, was raised by 25 basis points (by 0.25 per cent). This also came as a bit of surprise for many so-called industry watches as they expected a rate cut after all these noises. But given the inflationary situation in the economy the RBI preferred to stay in the conventional line of increasing the rate of interest slightly. This is done with the conventional wisdom that a hike in the rate of interest will contract the money (or credit) supply which will suppress the price level. Though critical economists point out the absence of such strong relationship between money supply and inflation, still within the realms of operations of the RBI this increase in repo rate is seen as a signal to tackle inflation.

Raghuram Rajan started his inaugural address by emphasising the need to inculcate transparency and predictability, but apparently he also has a knack for surprising. The bigger issue, of course, is that in such a chaotic and troubled time as we are facing currently in the economy, and with his expressed intentions to replicate the western financial model, may be our newly appointed Governor will be surprised in future. And the price, as usual, will have to be paid by the economy in general and the poor of the country in particular – as we have seen in the recent history of all troubled countries, irrespective of their developed or developing status.

In India, like in many other developing countries, there is always a craving for a prophet or a messiah (or a superman) who will pull the country and society out of trouble in no time. After liberalisation a new prosperous middle class has also evolved and that class is also showing fair amount of panic in the backdrop of a slowdown. This class essentially is impatient and wants to reach a higher level of income and standard of living in no time, and more liberalisation is the best hope for them. This class is searching more desperately for a saviour (after Manmohan Singh on whom they lost faith) and they thought that they found one in Raghuram Rajan. His brilliant academic career, his associations with organizations like IMF and his prophetic reputation of predicting a financial crisis sealed the deal of his becoming the next hope of liberalisation. Some of this middle class are a bit disappointed at his first policy making though.

However, the “man of the moment” has his plate quite full and absolutely scrambled. Though his intention to further open up the financial sector is in consonance with his academic and professional credentials, he also now has to reconcile with the existing focus on inflation in the central bank. Last three Governors of the RBI (D. Subbarao, Y. V. Reddy and Bimal Jalan) were known to be cautious in their approach to open up, but whether Rajan would break the tradition (true to his background) towards a more liberalised monetary sector or not – remains a question of immense interest in near future. Meanwhile, his posturing is generating fair amount of curiosity in the minds of everybody involved and interested in the monetary affairs of the country.