Rexit Reality Check: Investors dont have much to fear

Rexit Reality Check: Investors dont have much to fear

Now that Brexit is done, dusted and fading from the front pages of Indian newspapers, it is time to return to a question that has more immediacy in the domestic context: What after Rexit The shrill reactions have subsided. Knee jerk reactions like “After Rexit, ruin,” have, fortunately, proved premature and alarmist. Rexit, of course, borrowing a reference from Brexit or Britain′s exit from the European Union (EU) to reflect Raghuram Rajan′s impending exit as Reserve Bank of India (RBI) governor. Now that the dust is beginning to settle over Rajan's surprise announcement that he will be returning to academia at the end of his term as India's central banker, it is a good time for a reality check on how his decision will impact the Indian economy. Let us begin by acknowledging his stellar role in rescuing and stabilising the Indian rupee, which was almost in free fall when he took over as RBI chief in September 2013. Since then, he has kept his focus firmly on inflation control, declared a war on crony capitalism and launched a much-lauded attempt to clean up the stressed balance sheets of the entire Indian banking system. If India, which was being counted as among the Fragile Five economies three years ago, is once again the toast of global investors, the credit should go as much to Rajan as to Finance Minister Arun Jaitley and the rest of his team. His presence and his international profile provided investors with added assurance and confidence. But the howls of protest against the government that greeted Rajan's decision not to seek a second term look more emotional than rational. It also underlines the outgoing RBI governor's rock star status among analysts and commoners alike. Whenever a superstar moves on, his legions of admirers despair for the future. We've seen it in the cases of legendary corporate and banking leaders such as Jack Welch, Louis V Gerstner Jr and Alan Greenspan. Their shoes, big as they were, have all been filled by men of very high calibre, albeit lacking in similar star value. Rajan's successor, who will be stepping into very large shoes, will have to ensure that his unfinished initiatives are seen through to their logical end. That will not be an easy task. The RBI governor has three primary responsibilities:

  • Controlling inflation
  • Regulation and supervision of India's financial system
  • Issue of currency and monitoring of its value
Rajan has gone full pelt against inflation and brought it under control. He has also declared a war on crony capitalism and initiated measures to bring the bad debt problem of the Indian banking system under control. He has issued new bank licenses as well as licenses for payments banks that promise to broad base the financial system and take forward the goal of universal financial inclusion. And finally, he has restored global respect for the integrity of the Indian financial system, which has ensured that the value of the rupee remains stable. These measures have led to an institutional strengthening of the Indian financial system that is expected to outlast his tenure. So much so, that foreign investors, who, many said, would wind up their dollar investments in the country and withdraw to safer climes, are staying firmly put. Leading foreign investment firms such as CLSA, Nomura, BofA-ML, Credit Suisse and Barclays, among several others, have predicted short-term turbulence in the Indian stock and currency markets but have been unanimous in their view that long-term fundamentals and, indeed, the “India story” remains intact. Ace investor Rakesh Jhunjhunwala, who is often called India's Warren Buffet, also feels Rajan's decision to move on from RBI will not have any negative impact on the economy. The World Bank, too, feels the banking reforms begun by Rajan will continue after his departure. “I really want to point out that India has really strong macro-economic policies and an effective and conservative supervisor. So, there is no reason to expect banking reforms to change,” said Onno Ruhl, World Bank's India Country Director, reacting to Rajan's impending departure from the central bank. The next RBI chief will have a tough act to follow but there are one or two areas he may want to differ with his rock star predecessor. An agreement signed between the government and the RBI on inflation targeting set the consumer price index (CPI), and not the traditionally followed wholesale price index (WPI), as the benchmark. Since the CPI (rural and urban combined) allocates a high 46 per cent weight to food items compared to a weight of less than 25 per cent in the WPI, retail food prices began to play a disproportionately important role in determining monetary policy under Rajan. Now, inflation can result from both demand side and supply side factors. For example, if excessive supply of cheap loans fuels a housing price bubble, the real estate sector can be “cooled” by raising interest rates. This is an example of how monetary policy can be used to control demand side inflation. But supply side inflation is much less amenable to such fiscal interventions. In India, for example, food and vegetable prices rise and fall seasonally. Prices can spike sharply in case of supply side disruptions like freak weather conditions, strikes or hoarding. There is no way such price hikes can be controlled by raising interest rates.
This doesn't matter when WPI and CPI move largely in tandem but problems arise when they diverge on a massive scale. In November 2014, the WPI entered the negative zone and remained there for almost one-and-a-half years. Retail inflation, meanwhile, continued at high levels. The divergence between the two reached a high of about 9 per cent by the early months of 2015. This meant real interest rates for Indian industry and many individual borrowers (nominal interest rate minus WPI) was in double digits as the RBI was setting its benchmark repo rates with reference to the CPI - clearly an economically unviable and unsustainable situation. Consider this: in the latter half of 2015, most banks had a base lending rate of about 10 per cent. WPI was at -4 per cent. The real interest rate for many borrowers was, therefore, around 14 per cent - and that too at a time when they were facing deflationary pressures when selling their goods. When Indian industry was complaining about excessively high cost of funds, it wasn't entirely unjustified. And those who alleged that Rajan was behind the curve on cutting rates - and encouraging growth - were not entirely wrong. This has contributed, at least partially, to the persistent sluggishness in the Indian economy. This situation could have been avoided if the RBI had benchmarked the repo against a combination of the two indices. The new boss of India's Mint Street may, therefore, want to take a closer look at how RBI tracks inflation. The Modi government has been criticised for the perception that it wanted Rajan to cut rates. But as an elected government with a specific mandate to increase growth rates and create millions of new jobs, the government can well feel justified in expecting the RBI to be a little more accommodative of its compulsions - without in any way sacrificing the autonomy that the central bank enjoys. Then, Rajan may also have erred in trying to combine the roles of banking regulator and public intellectual. By commenting on political issues such as the debate over tolerance in the country and taking public positions on issues outside the remit of his formal job description, Rajan had clearly overstepped his brief. Yes, he was cheered on by India's intellectual elite but the political overtone of that support was unmistakable. This could be another pitfall the next RBI Governor may want to avoid.

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