raghuram_rajan--621x414A central bank is a public institution charged with managing a country’s monetary policy and regulating member banks. The main objective of a central bank is price stability. By statute, many countries also require their central banks to support full employment. Governments often appoint influential academics as the Chair/Governor of the Central Bank. Ben Bernanke, Professor at Princeton University, served as the Chair of the Federal Reserve, the Central Bank in the U.S., from 2006 to 2014. Stanley Fisher, a prominent macro-economist from MIT, served as the Governor of the Bank of Israel from 2005 to 2013. An academic staff at Trinity College Dublin, Philip Lane was appointed the Governor of the Central Bank of Ireland in 2015.

In 2013, India’s then Prime Minister, Dr. Manmohan Singh, invited Raghuram Rajan, a high profile financial economist and a Professor at the Chicago Booth School of Business, to become the Governor of the Reserve Bank of India for a three-year term. When Dr. Rajan took over the reins of India’s monetary policy, India was grappling with high consumer price inflation, industrial slowdown, a free falling rupee, and a widening current account deficit.

Key achievements

During his short tenure span of three-years, Dr. Rajan is credited to have

  • Strengthened the Indian currency.
  • Boosted investor sentiments.
  • Contained the current account deficit from around 5% to around 1.9% by levying added import duty on gold.
  • Reduced inflation to 8% from 11%.
  • Established the “Joint Lenders Forum” to foster greater coordination among bankers and discuss every loan decision above Rs. 5 Crore in forum so that bad loans can be prevented.
  • Forced the recognition of non-performing loans (bad loans).

Non-Performing Loans

Mr. Rajan’s priority was to purge the banking system of bad loans by forcing banks to remove non-performing loans from their balance sheet. The de-recognition of bad loads forebodes bad news for banks because they would need to recapitalize the balance sheet if their equity cushion fell below the mandated levels. Moreover, banks would be forced to call out the bad players.

In country that wants to open up the economy, India has 27 government-controlled banks which account for 70% of the country’s banking assets. Much of the bad bank loans are confined to India’s state-owned banks. According to the Economist, nearly 17% of all loans need to be written off. Therefore, the problems of bad loans are quire severe.

Colliding Politics and Personalities

The Modi government, which came to power with a huge mandate in 2014, has had major disagreements with Dr. Rajan’s economic policies. The current government is more ‘dovish’ and prefers a low interest rate environment to spur domestic investments while electing to ignore the risk of higher inflation from pursing an aggressive monetary policy. In contrast, Mr. Rajan was more ‘hawkish’ on inflation and, as a result, he was more focused on controlling inflation by keeping the interest rates high even at the cost of choking potential investments. Also, the Central Bank’s aggressive policy to recognize bad loans may have contributed to the disagreement between the government and the governor of central bank.

The current BJP party is led by a charismatic leader who is predisposed to governing with an iron hand. The top gun of India’s Central Bank was also a high-powered intellectual, a renowned economist, and a man with strong economic convictions. Fireworks are inevitable!

The Outcome

After some modest ideological confrontations with the BJP party, Dr. Rajan abruptly decided to step down as the Governor of the Reserve Bank of India and not seek a second term. CNBC deems Mr. Rajan as the world’s best central banker because of his commitment to structural reforms and because of his ability to stabilize prices and exchange rate during his short term. Did he deliver? The market believes so!

Unfortunately, India is the big loser in this Bollywood-style drama. The country is deprived of the services of a financial superstar who could have guarded financial markets and helped the Indian government pursue pro-market reforms.

Helsinki, July 25, 3.36P

http://www.economist.com/news/leaders/21699911-proposed-reforms-indias-financial-system-are-welcome-insufficient-banks-and-bureaucrats

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