The Telegraph
Tuesday , September 6 , 2016
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The Rajan legacy

- No RBI governor has been quite so famous among the public

U lundu kozhukattai is a savoury rice flour dumpling stuffed with a spicy mixture of urad dal. Most bankers, except possibly those hailing from Madhya Pradesh, are unlikely to know of its existence. That may soon change, however, because a food company in Bangalore has decided to introduce this dish from Madhya Pradesh, the state where Raghuram Rajan was born, on its menu as a tribute to the Reserve Bank of India governor whose term has come to an end on September 4. "He has touched the lives of commoners and entrepreneurs like us in a positive way," remarked one of the founders of the company. It is safe to place quite a large bet that this is the most unique tribute ever received by a central bank governor. Having said that, perhaps it is not completely unexpected because no central banker has become quite as famous amongst the lay public as Raghuram Rajan.

Of course, Rajan has had more than his fair share of critics. His frank views on the economy, often contradicting important functionaries in the government, have raised several ministerial eyebrows. He has even had the temerity to question the wisdom or rationale underlying the prime minister's slogan of "Make in India" by pointing out that it was too late for India to be a global hub. He argued, instead, that the effort should be to "Make for India" since the domestic market itself was so large.

Perhaps the comment which turned out to be the most controversial was his remark that the Indian economy was a one-eyed king in the land of the blind. He was trying to deflate the euphoria generated by the fact that the Indian economy was the fastest growing in the world by pointing out that virtually all major economies were in a near recessionary situation. He has also pointed out that the flattering comparison of our superior growth rate with that of China was misleading since the size of the Chinese economy is so much bigger than that of ours. His frankness on these and several other issues was partly responsible for his harshest critic - Subramanian Swamy - calling into question Rajan's sense of patriotism.

Of course, the passage of time will help the dust to settle down. The layperson will probably not remember him at all. But economists and professional bankers will typically compare him with governors who have come before him as well as those who follow him. What are the major issues and policy decisions during his tenure that they take into account when they make their comparisons? How will they rate him?

Rajan took charge as the RBI governor at a time when the rupee was facing its stiffest challenge after 1991. It was truly a case of baptism by fire. The apprehension that the West could launch military strikes against Syria had caused crude oil prices to shoot up and also spooked investors across the world. The external value of the rupee plummeted to 69 rupees to the dollar while the Bombay Sensex also crashed. There were fears that there would be a run on the rupee.

Of course, Rajan, by virtue of being the chief economic adviser in the finance ministry, was well aware of the turmoil in the foreign exchange market. His predecessor and he worked jointly to calm the foreign exchange market in India. Rajan announced measures such as opening a foreign exchange swap window to oil companies, providing dollars by a forward agreement. Essentially, this took the demand for dollars of the oil companies out of the foreign exchange market. The RBI also allowed commercial banks to raise tier-II bonds from overseas markets and swap them with the RBI.

These measures went a long way in resolving the crisis, and the external value of the rupee gradually moved upwards. The RBI during Rajan's tenure as governor has built up a formidable stock of foreign exchange reserves - there is little doubt that shoring up the strength of the rupee has been an important contribution of Rajan.

But, perhaps the efforts to improve the strength of the banking system as a whole has been Rajan's most important contribution. He has been instrumental in focusing attention on the need for banks to reduce the proportion of non-performing assets in their portfolio. During the course of the last three years, the RBI has introduced a number of policy measures aimed at helping banks to clean up their balance sheets. An early initiative was the creation of a data base of all loans above five crore rupees, thus enabling banks to identify early warning signs of distress in a borrower such as habitual late payments to a segment of lenders. The RBI also took steps to prevent banks from restructuring bad projects without calling them NPAs, thereby forcing banks to explicitly recognize losses. Banks were also allowed to replace weak promoters by converting debt into equity. Overall, these and other measures created a sort of arbitration system resembling an out-of-court bankruptcy settlement.

Rajan has also worked closely with the government to build up a well-articulated monetary policy framework. Inflation targeting has now been formalized, and the RBI will now work to keep inflation based on the consumer price index at 4 per cent, with a band of two percentage points on both sides. This relatively large interval will provide the necessary flexibility to work with short-run issues. A monetary policy committee will now be constituted to decide policy rates. While this will rob future governors of dictatorial powers to set rates, it will also ensure that the government of the day (and future Subramanian Swamys?) cannot put undue pressure on the governor. This will ensure greater autonomy for the RBI. Another important aspect of the monetary policy framework was to move towards a new liquidity framework that will mitigate some structural difficulties.

Rajan earned the label of an "inflation hawk" because his interest rate policy has given overwhelming primacy to curbing inflationary pressures rather than to promote growth, even when the external environment facing the Indian economy has been quite hostile. Several economists - and certainly officials in the finance ministry - will argue that he erred on the side of caution by refusing to lower the interest rate regime even during times when prices seemed to be relatively stable. Rajan's own defence is that there was sufficient liquidity in the banking system, and that the effective constraint on increased lending to industry was the disinclination of public sector banks to lend to infrastructure projects because of the high proportion of NPAs in their existing balance sheets. Time - and more careful analysis - will tell which side is right.

Some reports suggest that the government was not particularly happy with his frank comments as well as his refusal to implement a lower interest rate regime. This may well be the reason why he did not get an extension. Rajan himself has given some credence to this by hinting that he was not averse to continuing in office. There is no doubt that he has done wonders during his short innings, leaving behind a record that will be very hard to emulate.

The author is professor of economics, Ashoka University