Raghuram Rajan said goodbye to the Reserve Bank of India (RBI) in style. And with a fair warning to the governments and central bankers across the globe, including his key aide at RBI-turned successor Urjit Patel and former bosses in the Narendra Modi-government that don’t rely too much on low interest rates to propel growth or use it as a substitute to key structural reforms in the economy.
Patel took charge as the new RBI governor on 4 September after Rajan's controversial 3-year stint in that role.
Lower policy rates are often an easy solution. But they can trap economies with fear that when they normalize the rates eventually, it could hurt growth and distort markets making low interest rate-stance difficult to abandon, Rajan, 53, said in an interview to the New York Times published on Monday.
This time, no one will dispute the warnings from Rajan, who earlier had predicted the 2008 global financial meltdown three years before in 2005, then inviting sharp criticism from some well-known economists. Exiting from the too-low rate of interest is a real problem faced by giant economies worldwide such as the United States, as every time they attempt (or even hint) to do so, a fear psychosis grips the global markets (primarily emerging markets).
To be sure, this isn’t the first time Rajan is arguing against the use of monetary policy stimulus (too low interest rates) as a remedy to stimulate quick growth beyond a point. For long, the former International Monetary Fund (IMF) chief economist has been a critic of such policies by developed countries and the potential troubles cross-border capital flows can inflict on poorer countries when interest rates are reversed.
In May, 2016, while speaking to the Financial Times, Rajan had said that “slower growth was probably a part of ageing economies and perhaps the result of low interest rates, which protected inefficient companies from going out of business,” highlighting the perils of a prolonged monetary stimulus.
Rajan’s caution comes in the context of global economies. But his warnings on relying heavily on lower interest rates as growth stimulus has much significance for India too, in a separate context. Here, the Narendra Modi-government is struggling to find out ways to lift economic growth to a higher orbit. In a scenario, where the structural reforms are progressing at a slow pace, thanks to recurring political showdowns and implementation hurdles, often the onus falls on the RBI to go for sharper rate cuts to presumably achieve the objective of cheaper bank money to small and medium-sized companies and industries so as to achieve a quicker pace of growth.
Urjit Patel, who devised the consumer price-focused monetary policy strategy to fight inflation as Rajan’s deputy three years ago, is vulnerable in his new role to heavy pressure from political and corporate lobbies on the issue of interest rates as well as to go ahead with the process of structural reforms -- such as the ongoing bad loan clean-up exercise. Unlike his predecessor, Rajan, who took on critics publicly and dared to go ahead with unpleasant decisions, Patel is seen as a low-profile, soft-spoken technocrat, whose ability and willingness to take the lead of RBI’s tough policy measures is yet to be tested.
Patel’s biggest dilemma will be in finding a balance between the demand for lower rates (from powerful political and industry lobbies) and ensuring the central bank doesn’t lose sight of the inflation-battle.
The RBI currently isn’t in a comfortable position as far as CPI inflation, it’s primary target, is concerned. The index showed a 6.07 percent increase at the last reading, crossing the upper band of 6 percent earlier agreed with the government (On the lower side, it is 2 percent). The government has set a 4 percent (plus/minus 2 percent) target for the central bank in the medium-term.
But, with upside risks to inflation persisting, economists warn that the RBI will have to struggle to meet even its near-term target of 5 percent by March, 2017. This is despite a good monsoon this year. If the central bank goes for further rate cuts when the inflation is not contained yet, it can become further inflationary.
On the other hand, cries for sharper rate cuts have already begun. One such instance is the recent demand from Union Commerce Minister, Nirmala Sitharaman, who asked for a 200 basis points rate cut from the RBI to enable banks to lend cheaper money to micro, small and medium enterprises. The problem is when a Union Minister holding an important portfolio makes a public pitch for rate cuts, it puts pressure on the central bank. Sitharaman isn’t the only one who has put forward this demand. Senior members in the BJP, such as Subramanian Swamy, too have criticized the RBI for keeping interest rates high and ‘wrecking the economy’.
Though the Modi-government has agreed to the 4 percent inflation target of RBI, one needs to wait and watch how much tolerance it will have to high interest rates (if the RBI chooses to keep rates high for longer-than-expected duration) since governments typically take a short-term pro-growth view, while the RBI looks at financial stability in the long-term.
Patel’s second problem will be to continue with the bad loan clean-up, a key structural reform, in the banking sector. Rajan’s attempt to dig out the dirt from the bank balance sheets had irked crony capitalists. Till then, it was an easier option to draw large loans from banks and not repay on time. Instead, these loans would masquerade as a Non-Performing Asset (NPA) -- as a restructured advance that can be ever-greened for long with technical adjustments.
A big question here is whether Patel can take the process to its logical end. For now, banks are hesitant to take fresh lending exposure. But, if Patel manages to complete the clean-up exercise and strengthen the bank balance sheets, the banking sector can resume fresh funding contributing to growth. Key structural reforms in the areas of taxation, labor and land, easing the process to do business and, subsidies cut, can significantly add to growth, economists have long argued. Interest constitutes only part of the overall problem faced by firms.
In the Indian context, in fact, a further cut in interest rates can severely harm depositors rather than benefit borrowers. This is because the reason banks refuse to lend rates to companies are high NPAs on their books and poor economic activity on the ground, rather than RBI rate cuts. This is also the reason behind banks’ tepid response to RBI’s 150 basis points rate cut since January, 2015.
Rajan, in his foreword to RBI’s annual report had highlighted in the recent past that higher investments and not rate cuts can give the desired impetus to economic recovery.
If banks are pushed to a corner to cut loan rates, they will first slash deposit rates to manage their costs. This will hurt savers especially in a rising inflation scenario. Remember, the government had to cut returns on small savings schemes to align the rates in the banking industry, again hurting (and also displeasing) savers. The point here is that lower interest rates come with a cost to the government as well.
Patel, 52, who took charge as the 24th governor of the RBI can hit the ground running with his experience in the private sector, government and the central bank as he does not face the issue of continuity.
As the Rajan era ends and Patel becomes the face of the central bank, there is a fire test awaiting the Kenya-born economist, who studied in the UK and US before moving to India. Some of Patel's predecessors who came to Mint road with a perception of being ‘government’s men’ had later locked horns with North Block on policy issues.
One needs to wait and watch how Patel’s equation with the Modi-government and the hardliners in the BJP evolves. Chances of bonhomie between the two are unlikely.