His views on inflation-targetting and the rupee apart, the new RBI Governor has more up his sleeve
Rajan's views on deregulating interest rates for MFIs,more niche banks, a greater role for banking correspondents and mobile-payment services, apart from freeing up branch licensing, signal a new approach to central banking
Given how Raghuram Rajan earned his spurs by taking on Alan Greenspan at the height of his popularity and even got labelled a Luddite for this—by former US treasury secretary Lawrence Summers, the frontrunner for the Fed chief’s job—his stint as RBI Governor promises to be an eventful one. While finance minister P Chidambaram has been known to be impatient with central bank chiefs who have not supported growth by cutting interest rates, Rajan’s stated position on containing inflation is not too different from that of current RBI Governor D Subbarao.
The Committee on Financial Sector Reforms headed by Rajan said “RBI should formally have a single objective, to stay close to a low inflation number … RBI should be as willing to cut rates when inflation is expected to fall below the objective … as it is to raise rates when inflation is expected to exceed the objective because growth exceeds the economy’s potential”. The big difference between 2008 when the report was written and now, of course, is that central banks the world over have moved away from inflation-targeting in the context of the need to stimulate growth—in a March interview to Reuters, though, Rajan plumped for a 5% medium-term inflation goal.
Exchange rates are another area where it would be interesting to see how Rajan’s views have evolved. Rajan’s views, as reflected by his committee report, are that exchange rates are determined by a country’s competitiveness and other such factors “that are not changed by central bank intervention against the dollar … so given that the real appreciation has to take place, the country has the Hobson’s choice of taking it as inflation or as a nominal exchange rate appreciation”. In the event, he plumps for the central bank intervening in currency markets only to limit excessive volatility.
If the rupee continues to weaken—as it is today—despite RBI’s liquidity tightening last month, this suggests the problem is not due to excessive speculation, much as RBI would like us to believe that is the cause. In any case, with overseas trade credit—repayments of $86 billion are due in FY14—slowing down, and hedging costs for FIIs investing in India going up dramatically, RBI’s view that higher interest rates will attract more debt funds appears a long shot; indeed, the funds flow could further slow as it is for trade credit. The choice before Rajan then will be to dramatically increase costs for the economy as a whole or to simply let the economy adjust to a falling rupee. At some point, sooner or later, Rajan will likely be forced to sing the Subbarao tune, that if the government doesn’t do its share of reforms, the central bank alone cannot protect the rupee or spur growth. Indeed, Rajan’s view has been that fiscal discipline is a necessary adjunct to financial reforms, as well as for short-term demand management—were the government to stray from its promised path of fiscal rectitude in the run up to the elections, chances of rate cuts will get pushed further away.
While other aspects of Rajan’s tenure will not be as contentious, they signal a changed emphasis at the central bank in many important areas. Rajan is a believer in completing India’s ‘missing markets’ such as those for corporate bonds and will do his best as Governor to take action in these areas—a central problem, of course, is that higher fiscal deficits lower the attractiveness of corporate bonds and the weak credit recovery process also makes such bonds less attractive. In which case, one of Rajan’s key initiatives could be to make it tougher for banks who wish to restructure loans. Whether RBI will look at high group exposure norms in this context is not clear.
One of the 100 small steps Rajan spoke about for India’s financial markets, for instance, relates to converting trade receivables into an electronic format so that these can be sold as commercial paper—an NSDL-type of organisation, he is of the view, could help facilitate this.
Like Chidambaram, Rajan is a believer in more niche banks—he will award the new bank licences—which are geographically focused with greater local knowledge of their customer base. The poor, to quote Rajan’s report, “need efficiency, innovation, and value for money, which can come from motivated financiers who have a low cost structure and thus see the poor as profitable”.
And while many have questioned RBI’s desire to push for greater non-bank (as in mobile telco-driven solutions like Vodafone’s M-Pesa) cash transfer solutions, Rajan is in favour of greater use of existing networks like cellphone kiosks and kirana shops—so chances are the restrictions that telcos claim banks are putting on their expansion may get relaxed once Rajan takes charge, certainly the telcos will get a more patient hearing. Given the heavy weather the banking system is making of opening bank accounts under the direct benefits transfer scheme, were Rajan to experiment with using telco-channels, the move could also get the government’s enthusiastic support.
Though the final RBI guidelines on micro-finance institutions (MFIs) issued in 2011 were less stringent than those suggested by the Malegam committee—and those, in turn, was less stringent than what the political class in Andhra Pradesh had suggested—they remain restrictive and have hurt the MFI business, driving a large part of the consumer base back to traditional moneylenders. Subject to full transparency on what loans will cost, Rajan is in favour of relaxing interest rates to help increase credit flows.
How much leeway a central bank chief has to implement new ideas is not clear, given the overwhelming pre-occupation the job demands with the value of the rupee and with inflation, but Rajan has interesting ideas on lowering the social obligations of banks—opening no-frills accounts or making priority sector loans, for instance—and paying banks for achieving them instead. He is also in favour of more bank mergers, lowering government shareholding/interference in PSU banks through, if need be, the use of a holding company structure; even freeing up branch licensing for everyone subject to prudential norms. Unlike many times in the past, we have an RBI Governor whose stance on financial sector reforms, and not just those concerning the central bank, are well known. His success in implementing them, or at least pushing them forward, is critical since, as Rajan has maintained, financial reforms can add between 1 and 2 percentage points to annual growth.