Happily ever after? Rajan exits the Reserve Bank of India

21 June 2016

He was fast to act, promising reform and a firm focus on fighting inflation. Our view is that he has delivered on both, but the battle against inflation remains an unfinished job.

The fairytale partnership has ended. The Reserve Bank of India’s Governor Raghuram Rajan has decided to return to academia rather than extending his stay for another three years in Mumbai.

The unlikely partnership between the Congress Party appointed Governor and the BJP Prime Minister Narendra Modi has been built on pragmatism. We were hopeful that Rajan would extend his term, and indeed the indications were that he would have been willing to do the same. The decision was expected in August, so this is certainly a surprise to both the government and markets. It seems that in the midst of negotiations Rajan felt that the Prime Minister and Finance Minister did not sufficiently stand up for the central bank’s policy in the face of criticism from some senior BJP politicians that the Governor was too focused on fighting inflation rather than encouraging growth, amongst other things.  

So where do we go to from here? To understand that, we need to briefly remember the environment that bought Rajan into the RBI in the first place. Rajan became Governor in September 2013 in the midst of a domestic macro crisis focused on a dysfunctional government facing twin deficits, stagflation and collapsing growth. Appointing Rajan as Governor was a masterstroke. The fact that an internationally renowned economist agreed to take the helm of the RBI immediately bolstered credibility. He was fast to act, promising reform and a firm focus on fighting inflation. Our view is that he has delivered on both, but the battle against inflation remains an unfinished job. Perhaps his most significant reform was the introduction of an inflation targeting regime, albeit with extremely onerous targets for such a high growth economy. These targets require structural reform from government and it is here where the cold, hard reality of politics has caused some frustration.

He was fast to act, promising reform and a firm focus on fighting inflation. Our view is that he has delivered on both, but the battle against inflation remains an unfinished job.

Modi was elected two years ago on a platform of growth and reform. Growth has been frustratingly tepid and uneven, which is a large reflection of the state of the economy and banking system that he inherited on his election. However, we note that commentary from many of the companies that we cover in India has indeed perked up lately and we see a gradual broadening of the recent improvement in various on-the-ground indicators. On the reform front many of the headline reforms have been stuck in the Upper House, where Modi’s party still does not have enough support to drive through contentious issues. However, even here there has been some progress recently, although it is fair to say that the reform agenda has so far been incremental. Where Modi has had some success is in re-setting the balance between the government in Delhi and the states, to encourage a more competitive India.

The partnership between Rajan and Modi has on the whole been a success. India desperately needs foreign capital and investment to fulfil its potential, as well as better harnessing domestic savings to encourage a switch out of non-yielding assets such as gold into domestic financial assets. Inflation is at the core of both these issues and the Governor spent a good deal of his time focused on this area.

Clearly whoever eventually gets appointed as Rajan’s successor will tell us a great deal about the government’s intentions going forward. We are already being inundated with suggestions of an easing to the hawkish inflation stance and interest rate policy. The RBI as an institution has had a long history of “independent” Governors, with enough institutional depth to ensure that the overall policy direction is unlikely to be overturned. The focus on inflation will continue, as will the need for further structural reforms (it is no co-incidence that India today announced a slew of reforms to the foreign direct investor rules into India).

There are plenty of good candidates to choose from, but few exceptional ones and certainly none with the international credibility of Rajan. We would finish however with the comment that one man alone will not derail the India story, be it either Rajan or Modi. India has changed – the power of demography will ensure a focus on development and growth, with good governance being rewarded both at the polls and India’s capital markets.