India’s New Bank Governor Expected to Advocate Structural Reforms

Raghuram Rajan becomes monetary policy chief at a time when India’s boom threatens to bust.

Reserve Bank of India Raghuram Rajan answers questions from reporters in Singapore, September 14, 2006
Reserve Bank of India Raghuram Rajan answers questions from reporters in Singapore, September 14, 2006 (IMG/Stephen Jaffe)

Named as one of Bloomberg Markets’ fifty most influential people in its upcoming October issue, Raghuram Rajan has been much more than a mere professor of economics over the course of the past decade. One part public intellectual, one part policymaker and perhaps the most famous Cassandra of the global financial crisis, he is widely considered to be among the world’s preeminent thinkers on economic matters. Yet few would envy Rajan today as he steps into the middle of his country’s growing financial maelstrom as governor of the Reserve Bank of India,

While nearly all emerging markets have suffered from capital flight in anticipation of the American Federal Reserve’s return to tighter monetary policy — including the winding down of its quantitative easing program — India has been especially hard hit. Its economy is suffering from multiple woes: a rupee diminishing in value every week and mired in inflation, uncontrolled budget deficits and subsidy programs and the world’s second largest current account deficit.

To some extent a crisis could result from any of these factors on their own but to be faced with a perfect storm of all three at once is especially tricky for Prime Minister Manmohan Singh’s government. India’s policymakers also do not have a particularly good track record of directing the economy, as current problems can be traced to a mix of misguided fiscal policy, corruption scandals and poor forecasting. (Projections of sustained 8 percent growth from as recently as two years ago seem silly in hindsight.)

One result of this has been a two speed labor force comprised of rural and low skill workers on the one hand and a smaller, service oriented workforce on the other. Because it failed to push through needed labor reforms when times were good, India now finds itself hoping for more international demand to prop up its contracting services industry. What is obviously lacking from this mix is a solid manufacturing base to pull more of the rural population out of poverty and diversify its export base. This lack of manufacturing also means that any benefit derived from a weaker currency is pretty much lost on the country’s economy.

Instead of using its growth to foster infrastructure development and reform, the Indian government addressed domestic issues through massive spending binges and subsidies for the rural poor through a set of programs that have only exacerbated the country’s financial problems by running fiscal deficits as high as 10 percent of gross domestic product in recent years. This spending could have been better directed toward utility and transportation infrastructure upgrades instead of subsistence wage payouts. India’s economic future would look substantially brighter if the country possessed both a reliable infrastructure and a more business-friendly regulatory environment.

As it stands, India’s anemic growth makes it a less attractive place to do business and invest. Partially because of this, there is immense pressure from India’s business community on Rajan to reverse the Reserve Bank’s recent course and lower interest rates as a way to jumpstart the economy.

This is all but impossible in light of the weak rupee. An interest rate cut would likely scare away investors even more and precipitate a higher volume of capital flight. It would also play to the hand of speculators betting against the rupee and could further increase inflation, making purchases of necessary commodities like crude oil (valued in American dollars) extremely difficult for firms.

Indeed, these problems are becoming so severe that the government is weighing a number of costly alternatives, such as a proposal by oil minister Veerappa Moily to risk America’s anger and import petroleum from Iran at a discounted rate.

Such a policy would ensure that the government can hold on to more of its foreign currency reserves even when it may have to use them to prop up the rupee via open market action. But such risky policies could be the norm in the short term as an upcoming election season drives politicians toward populist solutions that increase their domestic appeal.

There is little likelihood that they will be given much of a break by an Indian Reserve Bank headed by Rajan. He is an outspoken proponent of directly addressing an economy’s underlying structural and competitive weaknesses, often through measures that cause short-term pain. In a widely cited 2012 Foreign Affairs article, he blamed supply-side weaknesses as the real culprit that started and perpetuated the 2008 financial crisis and advocated the type of austerity measures many European citizens have come to loathe.

Assuming he follows his own advice, there is little reason to suspect Rajan will offer much help to politicians fighting for reelection in the way of immediate stimulus. As he has indicated, his priority as central bank governor will be enacting reforms aimed at cutting redundancies, waste and bureaucratic overreach.

While India’s economic output is weaker than it has been in a decade, the currency free fall is a much more pressing concern. With his focus on market fundamentals and competitiveness, Rajan’s international standing as a public intellectual makes him well positioned to win the confidence of the markets and shore up the rupee’s slide in the short term. He also seems uniquely well suited to this type of monetary crisis. However, only time will tell if his skills as an academic and economist will translate into a capacity to fully right the ship in India.

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