Monetary Policy And Financial Reform: RBI under Raghuram Rajan

Background

     Despite predictions of a bottoming out of economic growth, the rate of growth of the Indian economy fell to 4.4% in Q1 of 2013-14 from 4.7-4.8% in the previous two quarters.  With the government and the Congress party (UPA II) focused almost exclusively on welfare laws and expenditures,  any remaining hope of decisive action on investment-growth enhancing reforms was rung out of the markets.  This led me to say a week ago that the Government-RBI had boxed themselves into a corner with little room for policy maneuver, and only an unorthodox fiscal-monetary policy, the “Macro-twist” accompanied by bold reform could now get the economy out of this situation.  In this context the appointment of Prof Raghuram Rajan as Governor of RBI was the only silver lining on the dark clouds hanging over the economy.  Raghu, on the day of taking over as Governor of RBI on 5^th August, 2013 used his international credibility among the Global Brahmins of Money and Finance and the World’s Central Bank Governors to expand the box, the range of options available to the RBI.

RBI under Raghuram Rajan

    Raghu’s first speech as governor(4^th Sept 2013), coming as it did on the day that he took charge,  surprised with the  speed with which he spelt out his vision for the RBI. In hindsight, it actually reflects the fact that he is probably the first RBI governor (in my memory), who in a manner of speaking was groomed for the job. Six years ago he was appointed chairmen of a committee on financial sector reforms and developed his ideas on banking, financial and institutional (RBI) reforms needed in India.   Since then he has been an external advisor to the PM, allowing him to keep in touch with the problems facing India.  Last year he was appointed as Chief Economic Advisor, to gain experience of the inner workings of the Ministry of Finance and the Government in General.  He was thus in a position to ‘hit the ground running,’ and he did so!

Given this background, including his international standing as a star economist and the indications he gave in his first speech, I predict that Governor Rajan will follow a two pronged approach to Monetary and Financial policy

(1) He will adopt a modern, neo-conventional monetary policy, and The epitome of ‘conventional monetary policy’ was “inflation targeting” based on the assumption that in the long run this is also the best policy for full employment/maximum Output (growth).  The “Neo” refers to the lessons learned by the Global financial-monetary czars about systemic risks and macro-prudential regulation, after the Global financial crisis (which he was the first to warn about).  Having, warned him about the problems of “inflation targeting” in India and heard his response, I would expect him to adapt it to Indian conditions and move cautiously in implementing this policy.  The new committee under DG Urjit Patel will likely draw up a road map for implementing this and supporting institutional reforms (like the ‘Monetary Policy Committee’).  As he said, he will spell out his monetary policy stance to current and expected  developments, like the unwinding of QE3, in his monetary policy statement on September 20^th , 2013

(2) He will forcefully pursue liberalization of financial markets, including foreign exchange markets and banking, institutional reform of the RBI & other financial institutions, and universalization of modern payment systems, banking & financial instruments (inclusion). He has already announced a number of specific liberalization on banking and foreign exchange.  Liberalization and promotion of competition are risky at a time of low growth and high uncertainty.  Thus timing and sequencing of liberalization measures needs to carefully weigh the gains against the risks: The latter can only be minimized through skillful but ruthless prudential regulation, e.g. on “Non-Performing Assets” (NPAs) and “ever-greening”.  Therefore he has already warned that he may have to take unpopular actions.  Some of the measures, such as new Banking licenses to industrial houses can also be politically contentious.  He has therefore wisely set up a committee under former RBI Governor & Member of Parliament (MP) Dr. Bimal Jalan, to act as the last word on new Banking licenses.

The RBI has been excessively cautious on the use of new technology to spread modern payment and banking systems.  Since the introduction of mobile pension payments in rural South Africa  and MPESA mobile cash in East Africa, I have been pushing the RBI to adopt these systems. As Raghu’s committee strongly advocated inclusion, I expect these to be speedily introduced in India.  This, and his committee’s innovative proposal to introduce ‘tradable priority sector lending commitments’ and other new ideas for inclusion will be chalked out under the ‘Nachiket More’ committee.

Conclusion

    In my view, these reform measures are Raghu’s answer to those of us who have argued for giving greater priority to economic growth.  With the reforms log jam persisting in Delhi, he is implicitly saying that he will follow a relatively conventional monetary policy and it is up to the government to do its part on the fiscal and structural policy side to promote growth.  At the same time he will try to help market expectations and confidence through a new more aggressive financial reforms policy, which will promote efficiency, investment and growth in the medium term.  Having expanded the range of Macro options, through his personal credibility and decisive start, it is now up to the government to act. 

[Note: This article was written on September 5th 2013, a day after Raghu's maiden speech, but has been pending with a newspaper since then.]