Worst fears realised? Raghuram Rajan's exit means rupee volatility will grow

The author is a senior economist and vice president at Ambit Capital.      Through our notes in April-June 2016 we had been highlighting risks to the extension of the current RBI Governor’s term (see our 21 April, 2016, 24 May, 2016 note and 13 June, 2016 note for details). Our worst fears came true when Dr Raghuram Rajan, over the weekend, announced that he will not serve a second term as the Governor of the RBI. In light of this development, we highlight that volatility in the INR is likely to increase owing to the heightened probability of RBI’s independence being institutionally compromised. In terms of alternatives that could be considered, we continue to highlight that Dr Urjit Patel appears to the best option given that he possesses the appropriate skills from a macroeconomics perspective besides holding out the promise of independence. Much as we feared, Rajan will not be serving his second term On 18 June, 2016 the RBI released the Governor’s message to the RBI staff saying that, “While I was open to seeing these developments through, on due reflection, and after consultation with the government, I want to share with you that I will be returning to academia when my term as Governor ends on 4 September, 2016. I will, of course, always be available to serve my country when needed.” In our note dated 24 May ( New Delhi Takeaways - Rajan, reforms and a reshuffle ) we had made the point: “The Rajya Sabha has passed a bill calling for setting up of a panel for monetary policy making that envisages lesser independence for the RBI than prescribed by the Urjit Patel committee. Hence, we reiterate risks to the extension of the current RBI Governor’s term.” [caption id=“attachment_2844782” align=“alignleft” width=“380”] RBI Governor Raghuram Rajan. Reuters[/caption] Again, in our note dated 13 June titled After Rajan, who?,  we highlighted that the current RBI Governor’s second term is in jeopardy owing to three sets of complications, namely: (1) The Central government has been taking decisions that are diluting the RBI’s powers, (2) There appears to be palpable political resistance to Rajan’s term renewal, and (3) Rajan is known for speaking his mind on matters of political import – a dynamic that New Delhi does not appreciate. In our 13 June note, we said that “Even as all RBI Governors since 1992 have been granted an extension, the current Governor’s term extension is in jeopardy mainly owing to resistance from two important power centres that this dispensation is beholden to — the RSS and the senior bureaucracy in the Ministry of Finance. In view of these unique complications, we reiterate our point that there exists material risks to Dr. Rajan continuing as the RBI Governor post-September 2016." After Rajan who? In our note dated June 13 titled ‘After Rajan, who?’ we had listed probable candidates who will succeed Dr. Rajan at RBI. Our candidates were:

1. Urjit Patel,
2. KV Kamath,
3. Arundhati Bhattacharya,
4. Arvind Subramanian,
5. Arvind Panagariya, and,
6. Shaktikanta Das

Now, we add the following names to the list of candidates:

1. Ashok Lahiri,
2.  Vijay Kelkar,
3. Rakesh Mohan,
4. Subir Gokarn,
5. Ashok Chawla

in view of media articles suggesting that the Ministry of Finance is considering these candidates. Even after extending our list, Dr Urjit Patel appears to be the best placed candidate as he possesses the appropriate skills from a macroeconomics perspective besides holding the promise of independence (see exhibit below).

Significant risk to RBI’s credibility as a serious inflation targeting central bank emerging In our note dated June 13 titled ‘After Rajan, who?’ we had highlighted that the independence of the RBI Governor matters for three sets of reasons, namely: (1) Credible inflation targeting can lower the risk free rate, (2) an independent Governor is required to combat the conflicts of interest created by the absence of an independent debt management office, and (3) credible inflation targeting lowers market volatility. There are serious risks to the RBI’s credible inflation targeting if an independent central banker is not at the helm of the RBI owing to two sets of reasons. Firstly, the RBI’s new monetary policy committee (now enshrined in law) envisages lesser independence of monetary policy making than envisaged by the Urjit Patel committee which was set up by Raghuram Rajan ’to revise and strengthen the monetary policy framework’ in September 2013 (see exhibit below).

Secondly, Rajan’s successor term renewal will be due in September 2019. Given that General Elections will be due in Apr-May 2019, it is possible that the central government will be sorely tempted to exert pressure on the RBI in the run-up to the 2019 General Elections. If the subsequent Governor fails to bring independence to the monetary policy committee, the RBI could potentially give in to such pressure. Baptism by fire for the next RBI Governor – third time in a row Both Dr. Subbarao and Dr. Rajan took control as the RBI Governor when there was considerable volatility in the forex market (see exhibit below).

The RBI Governor who will succeed Rajan will have to deal with a similar episode of volatility owing to two reasons, namely: (1) Britain’s decision to potentially exit the European Union is likely to create considerable volatility in forex markets globally, and (2) the redemption of foreign currency non-resident (FCNR) deposits raised by banks in 2013 (which matures in September-November 2016) could lead to outflows to the tune of about $20 billion which could exacerbate volatility in the forex markets. Investment Implications The most likely casualty of Rajan’s exit would be the INR because: (a) India’s faces a potential $25 billion in outflows when FCNR deposits raised in 2013 matures in a time when India’s Capital Account Surplus (KAS) has been diminishing quarter after quarter and is now close to zero; and (b) the INR appears to be overvalued by 4% from an REER perspective (see exhibit below).

As described in our June 13 note ‘After Rajan, who?’, Rajan hawkish stance on inflation forced the central government to deliver on fiscal deficit target in Financial year 2015 and Financial Year 2016. As a result, 10-year government securities yield has fallen 90bps since Rajan took office. A less independent RBI Governor is more likely to be behind the curve on monetary tightening and will pose a threat to a structural reduction in India’s risk free rate. In the near term, the impact of Rajan’s exit on equity markets could be ambiguous especially if the government brings in a new Governor who promises easier monetary policies and who takes it easy on the banks (in terms of forcing them to clean up their balance sheets).