Will new RBI chief Rajan end India's economic nightmare?


India Inc is keyed up waiting for the Reserve bank of India’s first policy statement under its new governor, Raghuram Rajan. The mere fact that he is the first professional economist to hold this post since Bimal Jalan, has sufficed  to arrest the slide in the rupee and push share prices up by 8 per cent.

When the latest industry data showed a growth of  2.6 per cent in August, and that the trade deficit fell to $10.8 billion, four billion less than a year earlier, economic commentators immediately announced that the economy had turned the corner. It was clear that ‘Dr feelgood’ has returned to India.

Is the optimism justified? A close look at Rajan’s first statement as Reserve Bank governor shows that, unless he picks a rabbit out of a hat on September 20, he will change very little in the RBI’s current policies. I sincerely hope I will be proved wrong, but if this grim premonition comes true: foreign investors will continue to pull money out, the slide of the rupee will start once more and the sensex will lose between 200 and 400 points in a single day.

The clue to what Rajan has in mind is to be found in his mission statement: “the RBI was constituted ‘to regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage;’ The primary role of the central bank, as the Act suggests, is monetary stability, that is, to sustain confidence in the value of the country’s money.

Rajan has somehow managed to overlook the fact that the Reserve Bank of India was set up in 1934 when the world was unrecognisably different from what it is today. In 1934 the Gold Bullion standard that the British had sought to reinstate after the first world war, had  collapsed only three years earlier. Maintaining monetary stability, and the peoples’ confidence in their currencies therefore required the central banks to emphasise continuity. This meant making as few departures from the principles underlay the defunct gold standard as possible. This required them to maintain as stable a relationship between the supply of currency and the reserves of gold and foreign exchange (then almost exclusively sterling) as possible. It required them to prevent a runaway printing of currency such as happened during the German hyperinflation, but also  to increase its supply when imports fell and reserves began to rise.  In 1934 it did not even cross central bankers’ minds that they could use their control over money supply as a tool for making economic policy. That conceit came only in the 1980s with Milton Friedman.

The second half of Rajan’s statement is even more disturbing. “Ultimately” he went on, “this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures.”

Untimely rains

In other words, Rajan is even less prepared than his predecessor, Subbarao, to draw a distinction between cost-push and demand-pull inflation. For him it doesn’t matter whether prices are being pushed up by profligate government and private spending, or by increases in  administered prices, supply shortages caused by poor monsoons and untimely rains, a rise in  oil prices, by galloping demand for raw materials and steel in China, or a general increase in all costs brought about by  the devaluation of the rupee. For him one size will fit all: if consumer prices rise, the interest rate must do so too.

Equally significant are the omissions from Rajan’s statement. He makes only a passing mention of the  unprecedented economic crisis that the country is passing through. He harps on a 5.5 per cent growth of GDP being not too bad, but makes no mention of the  near-zero industrial growth of the past  21 months; the steep decline in hire-purchase, the strangulation of the real estate sector,  the  70 percent decline in fresh investment since 2010-11, the  denial of  jobs to 34 million young people who would have had them if growth had continued; the complete absence of Initial Public offerings in the share market during the  past three years; and that while  industrialists are broadcasting their loss of confidence in the government by investing abroad, the poor and the middle classes are doing so by making a headlong rush for gold. 

Rajan may have felt inhibited from doing so by a belief that these issues should be addressed by the government and not the RBI. So he has busied himself making long overdue reforms in the banking sector and financial markets. But this  does not explain why he has maintained such a studied silence on the one policy parameter that falls squarely within his bailiwick, but upon which the fate of the nation rests. This is  the lowering of the interest rate.

The electrifying impact that a sharp reduction will have on consumer spending and investment has been dwelt upon too many times to need repetition. Today the risk that this could increase imports and worsen the current account deficit in the balance of payments has already passed for , with five months’ trade data in hand it is possible to  predict with a fair degree of confidence that the CAD  will come down well below 3 per cent this year. Fifty years ago any economist who suggested that the way to revive an economy was to make borrowing prohibitively expensive, would have been sent to a psychologist for examination. Today it is the mantra of three quarters of the policy entrepreneur-economists of the world. All that Rajan needs to do is break the shackles of monetarism and see how the economy  really works.

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