The 3 'mistakes' of Raghuram Rajan (or what makes a good RBI chief)

What makes a good Reserve Bank of India (RBI) governor?

Is it someone who would cut the interest rates on demand from the North Block, limits his lectures to monetary policy and banking and at the most give gyan on the importance of Hindi on the Rajbhasha day at the central bank?

Or is it someone who would have an independent mind on monetary policy, no matter what the government and industry think, speak up on socio-political issues relevant to the country overstepping his mandate and regularly comment on the government’s policies.

It is a no-brainer that any government, especially a government that has no high level of tolerance to criticism, would choose the former.

Rajan, the outgoing RBI governor, isn’t of that kind.

It isn’t hard to understand that there are ample reasons why Rajan had to end his three-year term at the RBI’s helm despite his willingness for continuation (as evident from his farewell letter) beyond his academic aspirations.

On Monday, delivering the foundation day lecture at Tata Institute of Fundamental Research, Mumbai, Rajan strongly defended his rate moves without reserving his words and as if he is giving a direct answer to the North Block and to the interest-rate lobby.

For anyone keen on the inflation-interest rate debate that has been among the issues that led to Rajan’s exit, the TIFR speech is a good study material. “…We have not been overly hawkish, and were wise to disregard advice in the past to cut more deeply,” Rajan said. “If a critic believes interest rates are excessively high, he either has to argue the government-set inflation target should be higher than it is today, or that the RBI is excessively pessimistic about the path of future inflation. He cannot have it both ways, want lower inflation as well as lower policy rates,” Rajan said.

The disagreement within the Narendra Modi government and among hardliners in the BJP camp, led by Subramanian Swamy, on Rajan’s reluctance to cut interest rates is now famous. Rajan has this simple reply for them. “If the central bank cuts the interest rate by 100 basis points today, and banks pass it on, then demand will pick up and we could get stronger growth for a while, especially if economic players are surprised. The stock market may shoot up for a few days. But you can fool all of the people only some of the time. If the economy is producing at potential, we would quickly see shortages and a sharp rise in inflation.”

The RBI has cut its key lending rate, repo rate, by 150 basis points since January 2015 after keeping it steady for long.

Rajan is right when he says the central bank cannot “abandon inflation for growth”. The RBI’s primary mandate as per the law that governs its functions is to ensure financial stability in the economy not create growth. But, what his critics fail to understand is that when inflation remains low for a sustainable period, that paves the way for a period of sustainable high growth in the economy in the medium to long term.

“When people say “Inflation is low, you can now turn to stimulating growth”, they really do not understand that these are two sides of the same coin. The RBI always sets the policy rate as low as it can, consistent with meeting its inflation objective,” Rajan said.

Rajan’s short answer to his critics on his interest rate policy, including the you-know-who is this: If the government wants lower interest rate it should either keep the inflation target way above than what is today or let the RBI act upon its own judgment on the inflation dynamics.

So, that’s about the interest rates.

But, beyond this, what else cost Rajan his chair on the 18th floor of the RBI headquarters in Mumbai?

One big mistake Rajan did was he failed to fathom the tolerance level of ruling political dispensation to criticism, especially on political matters. Rajan was still in the mindset of a Chicago professor or IMF chief economist when he went on discussing, debating and pointing out the issues in India’s social-political landscape while wearing the hat of RBI governor since September 2013 after a brief stint in the North Block.

In a country, where all government bureaucrats are supposed to toe the line of their employer, no government servant, even if he is the RBI governor, is supposed to speak his mind on sensitive political issues. That’s a taboo.

One should be foolish to imagine that Swamy’s persistent personal attacks on Rajan were without the backing of someone powerful in the government and its ideological parent, RSS. It’s just not possible. Swamy is merely a warhead. Rajan would have been much more acceptable to the government for a second term at the RBI if he confined his talks to defending economy, explaining RBI policies and general economics during his lectures.

But his convocation lecturers often took the shape of heavy, covert criticism on government policies and claims on a range of issues such as actual state of economy, need for tolerance, criticism on the government’s flagship schemes such as Make in India and the pace of rollout of Jan Dhan Yojana. This was unacceptable to many in the Modi government.

“The moment Rajan stepped out of his mandate and started commenting on political issues, the discord between him and the government started. Rajan should not have done that if he wanted to continue," said a former top bureaucrat in the government, who spoke on condition of anonymity.

Sections in the Modi government felt that Rajan may be a great economist but his policies as RBI governor were not fit for India, including the sudden massive bad loan clean up exercise, the official said.

Also, there is also reason to believe that there was an element of discord between the RBI and the government on the utilisation of RBI funds for public sector bank recapitalization.

As this report in The Time of India says, with Rajan going and if a more ‘friendly’ figure is appointed at the RBI as governor, the government might tap the central bank’s funds to recapitalise public sector banks.

The RBI has total equity of 32 percent of its assets and the government wants to draw this fund, which is a combination of contingency funds, capital and retained earnings, to bail out the cracked balance sheets of state-run banks.

The current leadership of RBI seems to have reservations about this move since it perceives that a strong corpus of contingency funds with the central bank is crucial for the country in the long term. Even more critical, infusing these funds in sarkari banks may prove to be a dangerous idea in the long term since the issues of these lenders are more on account of operational inefficiency and not just capital shortage. The government should instead privatise these banks and let them compete in the free market.

Rajan is not the end of the world. But, it’s not Rajan, the individual, but the circumstances that led to his exit that one should be worried about. A new RBI governor will come and life will go on. But, the larger question is whether India wants a ‘Yes man’ who is programmed to toe the government line as the head of its central bank or an outspoken but trusted official one could count on.