It’s the Governor, Stupid!

It’s complicated.” That’s probably how the Narendra Modi Government would describe its relationship with the High Priest of Mint Street, Raghuram Rajan, were it to be spelt out as a ‘status’ update on social media. That’s sort of putting it mildly, though. Two years down in office and one still to go, Rajan, ushered in by the Manmohan Singh Government at a time when India’s economy was in crisis back in September 2013, is becoming something of a bugbear to the Finance Ministry. Enough, indeed, for some of its senior officials to describe—in private—the relationship between the Reserve Bank of India (RBI) Governor and the tallest men in the Government as “verging on the dysfunctional”.

The perceptions of the two differ fundamentally on the state of the economy, primary macroeconomic risks, metrics to measure inflation and, of course, the solutions. And these differences are widening.

The RBI believes inflation to be the biggest risk, while the Ministry of Finance (MoF) argues the obverse, maintaining that India’s economy is actually at risk of deflation if corrective measures are not put in place rightaway. This is perhaps the first time such a sharp divergence has emerged between the RBI and the MoF on assessing the economy and chalking out how the challenges it faces are best tackled. The dissonance is confusing various stakeholders— particularly corporate India.

At a meeting convened by the Prime Minister on 8 September at his 7 Race Course Road residence, many business leaders expressed concern over the economy’s disappointing pace of growth and pushed for faster reforms as well as an immediate rate cut by the RBI to help revive investment and thereby give GDP expansion added impetus. However, the RBI chief has so far refused to oblige. He has made three policy rate cuts in 2015, but the magnitude of these and their timing have come under intense criticism not just from Government leaders but also economists, analysts and sections of India Inc. They contend that the complexity of the economy and variations in growth across sectors call for a remedy other than one that is text-bookish in style and fixated on inflation. Instead, it should be based on a study of multiple parameters and ought to recognise that growth is uneven from one sector to the next.

All the more since numbers reveal that the country is in the midst of a fragile and haphazard recovery. According to the latest data released by the Central Statistical Office, India’s gross domestic product (GDP) growth slowed to 7 per cent in the April-June quarter from 7.5 per cent in the January-March quarter, as measured at market prices. Disaggregated, the data set points to differences across sectors. While agriculture, despite a sub-par monsoon, grew 1.9 per cent in the quarter ended 30 June, manufacturing went up by 7.2 per cent, and trade, hospitality, transport and communication rose by double digits, at 12.8 per cent. Clearly, growth is uneven and reflects varied uncertainties that dog the Indian economy as it scripts a recovery in a volatile global economic environment.

The end of the global commodity super cycle provided enormous relief to India’s beleaguered corporate sector by reducing their inputs costs. It also offered fiscal relief to the Union Government—lower petroleum prices have reduced the subsidy burden. Regardless, the view within government circles is that unless urgent and timely action is taken by the RBI to lower the cost of capital by effecting an interest rate cut, there is risk of a further squeeze in demand and consequent delay in a proper across-the-board investment revival. Especially since globally many economies are suffering. This is largely because Russia, Brazil, South Africa, Australia and others that are dependent on commodity exports have been severely hit by collapsing global prices for these products. Even Indian exports, declining for the last seven months, face a bleak future as myriad factors—such as currency fluctuations—turn rivals more competitive. Further, the current downturn in oil prices is projected to reverse next year, ending India’s run of luck on this.

The NDA Government recognises these challenges and believes that the present moment—when the global economy is wrestling with the problem of China—opens a brief window of opportunity. Already, the unravelling of the yuan and slow implosion of the Chinese economy as it comes off its high-growth plane, coupled with the likelihood that the US Federal Reserve will raise its rate of funds, has become an economic imponderable. While China’s slowdown makes India a relatively attractive destination for investment, an increase in the US Fed’s policy rate can trigger an outflow of portfolio capital. Note that since China devalued its currency last month, FIIs have withdrawn over $3 billion from Indian assets.

“The onus is clearly on the Reserve Bank of India,” asserts an economist who attended the meeting convened by the Prime Minister on 8 September. But the RBI is obstinately refusing to see eye to eye with the Government on this key issue. Worse, their perceptions differ so much that few see a way to reconcile the two. After the recent release of the April-June GDP figures, Chief Economic Advisor (CEA) Arvind Subramanian cautioned that India could be risking a period of deflation. “Price-wise, the economy appears to be in or close to deflation territory and far away from inflation. Deflation, in fact, could be India’s main concern, not inflation.” The RBI, on the other hand, has a completely different view of the threat in question. In its Monetary Policy review last month, the central bank discounted the current downward drift in inflation numbers highlighted by the Government. In some quarters, the Centre’s reference to ‘deflation risk’ is being interpreted as inappropriate, a case of scaremongering aimed at pressuring the RBI to ease money supply through a rate cut.

There are many others, though, who also argue that the macroeconomic threat is no longer inflation. Taking a dig at the Rajan school of thinking, economist Surjit Bhalla has noted: ‘The simple fact is that the world has changed, and radically so, from when most of us studied monetary economics. Just look at what has happened in the rest of the world for the last 20 years and continuing. Most major economies have reduced policy rates to zero and inflation has declined. It is high time the monetarists woke up and smelt the cheap coffee or anything else they are fond of.’ Bhalla maintains that deflation is likely to become a key concern for India soon.

But Rajan so far has refused to blink and has instead been dismissive of his critics, both within and outside the Government. In response to a query on whether a timely booster rate cut by the RBI would have been a better way to go—as urged by some analysts—than the smaller cuts effected as part of its monetary policy, the Governor recently asserted: “The RBI is not a cheerleader. There are other people in the economy who can play the role of cheerleader. Our job is to give people confidence in the value of the rupee, in prospects of inflation, and having established that confidence, create a longer term framework for good decisions to be made.”

Although sections of India Inc rooted aggressively for a 50 basis points or 0.50 per cent rate cut, the RBI’s last monetary policy move only allowed for a 0.25 per cent cut in its repo rate (which is the interest at which RBI lends short-term money to banks), bringing it down to 7.25 per cent. “Every time an exporter comes to me and says that stability has been very valuable for us to make decisions, that reinforces my view that these are our main roles,” Rajan said.

Interestingly, Rajan continues to enjoy intellectual appeal. As the person who was prescient about the 2008 global economic crisis, drawing from his criticism of excesses in the US economy, the former chief economist of the International Monetary Fund brought the heft of a seasoned academic-cum-practitioner to Mint Street when he took charge two years ago. Despite the growing criticism of his alleged ‘professional misjudgements’, this credibility remains intact.

Within the Government, the prevalent feeling is that with the economy yet to achieve its potential expansion rate of 8-9 per cent, it’s imperative that all policy moves are in synchrony if the global gloom is to be shrugged off. A demand slump has been evident across several sectors, slowing India’s growth. Offtake in the coal sector has plummeted, even as rail freight earnings nosedived. Real estate majors have started looking for bulk buyers, luring them with deep discounts in order to revive revenues. Retail buyers have gone missing. But the RBI Governor has obstinately declined a rate cut as relief, preferring to err on the side of caution. In a recent interaction with the media, Rajan said: “The RBI can’t be reckless, we need data to give us more room to move on rates.” He added, “We have done what we could, given the current room. We have erred a little towards giving impetus to investment.”

In times past, such sharp differences between the MoF and the RBI have been few and far between. There’s a reason for this. For long, the Centre has preferred to appoint RBI governors drawn from the MoF, primarily in order to ensure harmony on prescriptions for growth and on how to contain inflation. Ministry appointees to the RBI’s top job has been an old tradition, and the Secretary of Economic Affairs, the Chief Economic Advisor and the RBI Governor have usually worked as a team. Often, it was a senior official in the Ministry who would graduate to the post of RBI chief. This was so of IG Patel, Manmohan Singh, RN Malhotra, M Narasimham, Bimal Jalan, YV Reddy (from the MoF) and D Subbarao. Apart from synchronising perspectives on the economy, that tradition also ensured that the political objectives based on the country’s economic well-being were not put in jeopardy by a divergence of views between the RBI and the Centre.

“The concept of autonomy for the RBI became entrenched after the 1991 balance-of-payments crisis. Otherwise, there has been a tradition of consultation and discussion leading to concurrence between the RBI and the Government on the state of the economy and the measures to be taken on boosting growth, both short and long term. The UPA’s decision to bring in an outsider to head the bank has added to the RBI’s own sense of independent decision-making and creative interpretation of its own mandate,” says a former bureaucrat of the MoF.

Rajan was an exception to the MoF-appointee rule, although he did serve a short stint as India’s CEA in New Delhi. In that sense, he was a genuine outsider. This, some surmise, may have made him disregard the prevailing but unwritten ‘bro’ code that orders the relationship between the Government and the RBI, despite its autonomy. The code demands that the MoF remains a crucial player in all decisions made on India’s monetary policy.

While the past year or so has seen some unease in the relationship between the new Government and Rajan, the depths now being plumbed have taken observers aback. After the May 2014 election of Narendra Modi as Prime Minister, boosted by plunging oil prices, India’s coffers swelled with foreign exchange reserves touching an unprecedented $355 billion by mid-2015, compared to only $275 billion in mid-2013. Foreign Direct Investment inflows rose by 40 per cent to $34.9 billion in 2014-15. Capital account inflows went up significantly, too, with stock markets galvanised by a ‘Modi rally’. All of this added to Rajan’s reputation and let the Centre claim brownie points on India’s economy. But with the start of the inflation-deflation row, Rajan was seen in New Delhi as being in violation of that unstated ‘bro’ code.

V Anantha Nageswaran, economist and co-founder of Aavishkaar Venture Fund and Takshashila Institution, was among those present at the Prime Minister’s meeting on 8 September. He too has questioned the RBI’s rationale in making choices. The RBI, by his argument, has been following the remedial measures set out by the IMF. “For India, the IMF might have recommended extra vigilance on inflation to offset the fact that monetary policy was too loose in 2011-13. In other words, some over-compensation might have been deemed necessary. It might have also recommended an inflation-targeting framework for India because inflation is a tax on the poor,” in his words. While none of this was sinister, he has noted, the absence of debate is more than worrisome in a fast changing and complex economy. In particular, he questions the timing and magnitude of rate cuts by the RBI in aid of the Indian economy. Referring to the RBI’s fixation on inflation targeting with little reference to other macro parameters such as real exchange rate appreciation and credit growth in the context of the West’s post- 2008 financial crisis response (some countries have started debating the wisdom of this knee jerk recourse), he dubs the RBI’s act as “ideological obduracy rather than empirical flexibility”. Holding that a multiple indicator approach worked well for India in 2008, he adds that the IMF may have erred in recommending a restrictive monetary policy that pays disproportionate heed to inflation.

At the beginning of 2014, Rajan had set targets for bringing down inflation after an internal RBI panel headed by Urjit Patel (who had also served at the IMF) recommended such an approach, even though the Government had not concurred with it at the time. Patel’s report had suggested that RBI adopt a flexible inflation- targeting regime with an aim to bring it down to 4 per cent within a band of plus or minus 2 per cent. The preconditions for this included the Government achieving a fiscal deficit target of 3 per cent by 2016-17.

Notwithstanding the superlative praise that the RBI got for the inflation-targeting cause that Rajan championed, some risk management consultants and market watchers are of the view that since it was food and fuel prices—in combination with demographic factors—that were the key drivers of inflation in India, monetary policy had little or no role in addressing it. Rajan, though, has continued to use a working paper prepared by three officials (two of whom were from the RBI) on the impact of monetary policy on food inflation to defend his claim that falling fuel prices, the Centre’s food management practices and the global environment were the key factors in containing inflation. Bhalla recently put out data from previous years to refute this conclusion.

If there had been no divergence of perspectives, the NDA Government at the Centre would perhaps have swiftly got Parliament’s endorsement of the new monetary policy framework by amending the RBI Act to expand the central bank’s mandate, something that is still officially on the Centre’s agenda. But the debate over the conflicting elements of the RBI’s existing mandate and its ‘creative interpretation’ of its autonomy appears to have hampered progress on this front.

Clinching an understanding with the Government in the first place had not been easy for the RBI Governor. The formal agreement on the new monetary policy framework came after the Government introduced a brand new statistical methodology to compute GDP, besides effecting data revisions. According to Rajiv Biswas, Asia Pacific chief economist at IHS, an analysis firm, this not only showed the economy in a healthier state than previously recorded (it had better industrial productivity, for instance), it made it harder for the RBI to assess actual economic growth (and arrive at the policy measures needed).

Souring relations with the Government further, Rajan stepped into what the Centre considers ‘definitely not his territory’, economic reforms, and that too at a time when the Modi regime’s liberalisation agenda was being blocked by the Congress-led opposition. In the RBI’s annual report, for example, Rajan noted: ‘For a country as big and populous as India, reforms cannot be shots in the dark, subjecting the economy to great uncertainty and risk…Wherever possible, we have to move steadily but firmly, ever expanding the scope of reforms while always limiting the uncertainty they create. The Chinese term this ‘crossing the river by feeling the stones’. It is an appropriate metaphor to guide our own reforms.’

The Goods and Services Tax, Land Acquisition Bill and other reform intiatives of the Government are yet to be approved by Parliament.

Speaking later in Panaji, Goa, Rajan vocalised his disapproval of a proposed tax on inheritance. “I would argue, rather than a blanket inheritance tax, let’s change the culture. Make it such that people don’t want to leave a lot of wealth for their children.” A tax on inheritance would only help tax lawyers who’d get paid to conceal property, he maintained.

Together with other such remarks, Rajan has only widened a rift that is harming the country’s economic policy cohesion. Indications are that the Government is running out of patience now. It is for Rajan to reduce the distance between Mint Street and North Block.

About The Author

PR Ramesh