Both finmin and RBI may be wary of Raghuram Rajan

Raghuram Rajan comes in with a greater fan following than any other Reserve Bank of India (RBI) Governor that I can remember. His age and his excellent academic credentials give him a popularity usually reserved in India only for cricketers or filmstars. Such an image, however, leads to an excess build-up of expectations. So it’s worth looking beyond the certificates.

Academic qualifications are, of course, a huge asset. Especially when, like Rajan, the credentials have been endorsed by an international peer group. It’s not just MIT and the Chicago Booth School that burnish his CV. His greater claim to fame is that he called the excesses of financialisation of the US well before his peers did - and there’s no better certificate than predicting a market collapse well before time. This means finance ministers and secretaries in the ministry will have to respect his authority if they ever have to criticise his moves as governor - as they inevitably will. Critics in India Inc and media will also have to concede that “the governor knows better.”

[caption id=“attachment_1017877” align=“alignleft” width=“380”]  The RBI is a marginal player in the ultimate scheme of things. AFP[/caption]

Rajan has also been a ringside observer of the global financial system, thanks to his long stint in a top-notch school and as Chief Economist at the IMF. But the advantage ends there.

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On the downside, he has never made policy. Unlike D Subbarao, YV Reddy and Bimal Jalan - his three immediate predecessors at RBI - Rajan has not had the experience of taking large macroeconomic policy decisions before being crowned king of Mint Street. Administering macroeconomic policy, with its huge overall impact, is an art in itself. This means he won’t have an old-boy network of IAS officers to lean on. If anything, they may already be looking at him as an adversary, having usurped their job.

Heading the RBI comes with another challenge. It is an institution with vast and deep experience and often has a mind of its own. Its arch adversaries in the finance ministry accuse the institution - in private, of course - of stubbornness and of fighting turf wars in the guise of public interest. I don’t think these are entirely fair accusations to be made of the RBI, but the perception is important.

Till 2008, when Rajan presented his report on financial sector reforms, he was almost seen as part of the cut-RBI-down-to-size brigade. That may be an unfair charge. But I am quite sure that this perception lingers within the RBI. Rajan and the RBI will have to make their peace with each other. The onus lies on Rajan as the new CEO.

On one issue, however, Rajan will find more allies within the RBI. Both are congenitally scared of large fiscal deficits. This issue may lose Rajan any friends he may have left in the ministry. But it may find many supporters in the organisation he will head from next month.

A lot of Rajan’s challenges relate to the 2008 report on financial sector reforms that he had authored. Its major recommendations have been more or less faithfully incorporated by the Financial Sector Legislative Reforms Committee (FSLRC). The FSLRC and the Rajan report call for a near hands-off approach on the rupee, with the RBI only targeting an explicitly agreed level of inflation. But can Rajan have his way on this? Can he, even if he wants to, stand by and let the rupee depreciate? Indeed, the buzz from Delhi is that he and the finance ministry goaded an unconvinced RBI into defending the rupee by pushing up overnight borrowing costs. If this is true, it would mean that Rajan no longer is fully convinced of his own 2008 recommendations.

Rajan had also supported removing all restrictions on FII investments in Indian corporate and government debt. That is completely contrary to what successive RBI governors have professed. Already, the rating agencies and market participants are looking askance at India’s external debt-to-foreign exchange reserves ratio. Will Rajan give up his position to accept the RBI’s orthodoxy? Or have the post-Lehman events, especially in debt-ridden countries like Greece, already chastened him?

Rajan, during his term, may find the government legislating some of the changes recommended by the FSLRC. These include making monetary policy with the help of a collegium, in which only one member is chosen by the governor and other four are independent members appointed by the government. Even the Bank of England and the US Fed chiefs don’t work with external members in a majority. Will Rajan stick with his earlier recommendations or will he see justice in fighting for the governor’s rightful turf? This could be one big battle for him.

Rajan, likewise, has publicly opposed banking licences to corporates but has supported licensing many small banks. RBI orthodoxy has been scared of small banks since the institution is conscious that its bandwidth is inadequate to police small deposit-takers. Rajan, in his report, wanted branch licences, remuneration of bankers, etc, to be off RBI scrutiny. Now western regulators are scrutinising bankers’ remuneration. Also, in cases involving know-your-customer (KYC) violations by banks, these are the few levers RBI uses to punish banks. As banking regulator, I am not sure Rajan will sympathise with his own earlier recommendations.

But these are philosophical issues and potential battles. The here and now battle is on the rupee. Besides the theoretical issue of how much the RBI must influence the exchange rate, he needs to be aware that a governor’s communication skills are as important as his actions. Often by “sounding” menacing, Governors like YV Reddy have changed the market’s psyche and had their way.

If Rajan has a lot to learn and unlearn, the media and his audience have to be sensitive in judging him. His rock-star like image should not lead to runaway expectations. Let us admit, central banks in a country like India can’t do much. Progress is ultimately about schooling children, reducing malnutrition, building railway tracks and putting in fair rules for the allocation of resources. The RBI is a marginal player in the ultimate scheme of things.