I Do What I Do

by Raghuram G. Rajan

India is becoming a large middle income country, too complex and varied to be controlled centrally. The government will need to withdraw from occupying the commanding heights of the economy, confining itself to providing public goods and the governing framework, and leaving economic activity to the people.

I wanted to send the message that India had strong institutions like the RBI that could push reforms forward even when Parliament was stalled, and international investors should not write India off.

I wanted to send four messages. First, we had to present a façade of confidence to assure the public and investors that the RBI knew what had to be done. Second, we would emphasize our commitment to bringing down inflation, which my friend, the Mexican central bank governor, Agustin Carstens, advised me, was in his long experience the best way to stabilize the currency. Third, we would signal the RBI could be bold and farsighted when the need arose – evidenced by the large number of measures that were announced, and our ability to look beyond the currency turmoil to discuss, for instance, the eventual internationalization of the rupee. Looking beyond the immediate problems would also suggest we were not overly pre-occupied with the current volatility. Finally, I wanted set standards for transparency and predictability, transparency through clear communication, and predictability by laying out what we at the RBI intended to do, so that we could be held to it. My

The primary role of the central bank, as the Act suggests, is monetary stability, that is, to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures.

primary role of the RBI as preserving the purchasing power of the rupee, but we have two other important mandates; inclusive growth and development, as well as financial stability.

Policy making is about deciding in the face of uncertainty, after weighing the alternatives as best as one can.

Policy making invariably involves taking measured risks in the face of uncertainty, for one has neither a prior template nor the luxury of indecision.

We plan to build the Reserve Bank’s developmental measures over the next few quarters on five pillars. These are: Clarifying and strengthening the monetary policy framework. Strengthening banking structure through new entry, branch expansion, encouraging new varieties of banks, and moving foreign banks into better regulated organizational forms. Broadening and deepening financial markets and increasing their liquidity and resilience so that they can help allocate and absorb the risks entailed in financing India’s growth. Expanding access to finance to small and medium enterprises, the unorganized sector, the poor, and remote and underserved areas of the country through technology, new business practices, and new organizational structures; that is, financial inclusion. Improving the system’s ability to deal with corporate distress and financial institution distress by strengthening real and financial restructuring as well as debt recovery.

But ultimately, inflation comes from demand exceeding supply, and it can be curtailed only by bringing both in balance.

Finally, together with the government, we designed the framework for an independent monetary policy committee, which would take over the setting of policy from the Governor. A committee would bring more minds to bear on policy setting, preserve continuity in case a member had to quit or retire, and be less subject to political pressure, which was why I supported this move strongly. I was the last Governor to set policy individually (albeit with full consultation with my colleagues). The Government nominated its appointees to the monetary policy committee soon after I left office, and my successor Dr Urjit Patel’s first policy was with the full monetary policy committee.

More generally, the way to fight inflation, given the inconclusive skirmishes we had had in the recent past, was to signal that we were determined to bring it under control. But we also needed to do it in a way that could be tolerated by the Indian economy, which has many people with minimal cushions against adversity – I felt right from the beginning that doing a ‘Volcker’, that is, raising interest rates so high that demand collapsed, was simply not right for the Indian economy.

Indeed, the reason the Malaysian Central Bank can keep rates low today to foster growth is because it has fought the battle against inflation and convinced its citizens that, if need be, it will smote the inflationary beast again if it rears its head. Put differently, in order to generate sustainable growth, we have to fight inflation first.

even if we cut policy rates, we don’t believe banks, who are paying higher deposit rates, will cut their lending rates. The reason is that the depositor, given her high inflationary expectations, will not settle for less than the rates banks are paying her. Inflation is placing a floor on deposit rates, and thus on lending rates.

remember the severe recession Volcker’s Fed brought about and the Savings and Loan Crisis that followed?

But when we look at the ratio of changes in input cost over the changes in the output price of agricultural commodities received on the basis of CACP data, it has remained flat, indicating that the gains from MSP increases have not accrued to the farm sector in full measure because the costs of inputs have been rising. This may indicate why production growth has not been stronger. What could explain this? One explanation could be that MSPs also drive input costs, so increasing MSPs is like a dog chasing its tail – it can never catch it.

It is useful, though, to look at the details of the cost increases. Prices of agricultural inputs, including wages, have recorded a sharp increase during 2008-09 through 2012-13 in comparison with the preceding five years (2004-05 to 2007-08). Perhaps the most significant increase has been in rural wages. Nominal rural wages have grown at a sharp pace during the last five years. Because so many Indian workers are at subsistence wages, higher food prices do drive rural wages higher, and there is some evidence for this before 2007. From 2007 onwards, however, econometric tests suggest causality has flowed from wages to prices, underscoring the role of rural wages as a major determinant in food price increases. So why has rural wage growth been so strong?

Clearly, everyone understands the costs of hyperinflation, when prices are rising every minute. Money is then a hot potato that no one wants to hold, with people rushing straight from the bank to the shops to buy goods in case their money loses value along the way. As people lose faith in money, barter of goods for goods or services becomes the norm, making transacting significantly more difficult.

But what if inflation were only 15 per cent per year? Haven’t countries grown fast over a period of time despite high inflation? The answer is yes, but perhaps they could have grown faster with low inflation. After all, the variability of inflation increases with its level, as does the dispersion of prices from their fundamental value in the economy. This makes price signals more confusing – is the price of my widget going up because of high demand or because of high generalized inflation? In the former case, I can sell more if I produce more, in the latter case I will be left with unsold inventory. Production and investment therefore become more risky. Moreover, high and variable inflation causes lenders to demand a higher fixed interest rate to compensate for the risk that inflation will move around (the so-called inflation risk premium), thus raising the cost of finance. The long-term nominal (and real) interest rates savers require rise, thus making some long-duration projects prohibitively costly. These effects kick in only when inflation is noticeably high.

why do most countries set their inflation target in the low single digits – 2 to 5 per cent rather than 7 to 10 per cent? Three reasons come to mind. First, even if inflation is at a moderate level that does not hurt overall growth, the consequences of inflation are not evenly distributed. While higher inflation might help a rich, highly indebted, industrialist because his debt comes down relative to sales revenues, it hurts the poor daily wage worker, whose wage is not indexed to inflation. Second, higher inflation is more variable. This raises the chance of breaching any given range around the target if it is set at a higher level. To the extent that a higher target is closer to the threshold where the consequences on growth are adverse, this makes it more likely the country will exceed the threshold and experience lower growth. Third, inflation could feed on itself at higher levels – the higher the target, the more chances of entering regions where inflation spirals upwards.

central bank serves the economy and the cause of growth best by keeping inflation low and stable around the target it is given by the government. This contrasts with the earlier prevailing view in economics that by pumping up demand through dramatic interest rate cuts, the central bank could generate sustained growth, albeit with some inflation.

four criticisms. First, we focus on the wrong index of inflation. Second, we have killed private investment by keeping rates too high. Somewhat contradictorily, we are also hurting the pensioner by cutting rates too sharply. Third, monetary policy has no effects on inflation when the economy is supply constrained, so we should abandon our attempt to control it. Fourth, the central bank has little control over inflation when government spending dominates (what in the jargon is called ‘fiscal dominance’).

reliance on WPI has two problems. First, what the common citizen experiences is retail inflation, that is, Consumer Price Inflation (CPI). Since monetary policy ‘works’ by containing the public’s inflation expectations and thus wage demands, Consumer Price Inflation is what matters. Second, WPI contains a lot of traded manufactured goods and commodity inputs in the basket, whose price is determined internationally. A low WPI could result from low international inflation, while domestic components of inflation such as education and health care services as well as retail margins and non-traded food are inflating merrily to push up CPI. By focusing on WPI, we could be deluded into thinking we control inflation, even though it stems largely from the actions of central banks elsewhere.

If policy interest rates are set to control CPI, they may be too high for manufacturers who see their product prices appreciating only at the WPI rate. I am sympathetic to the argument, but I also think the concern is overblown. Even if manufacturers do not have much pricing power because of global competition, their commodity suppliers have even less. So a metal producer benefits from the fall in coal and ore prices, even though they may not get as high a realization on metal sales as in the past. The true measure of inflation for them is the inflation in their profits, which is likely significantly greater than suggested by WPI.

In the last decade, savers have experienced negative real rates over extended periods as the CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits. This meant that India needed to borrow from abroad to fund investment, which led to a growing unsustainable current account deficit.

Some argue, rightly, that it is hard for the RBI to directly control food demand through monetary policy. Then they proceed, incorrectly, to say we should not bother about controlling CPI inflation. The reality is that while it is hard for us to control food demand, especially of essential foods, and only the government can influence food supply through effective management, we can control demand for other, more discretionary, items in the consumption basket through tighter monetary policy. To prevent sustained food inflation from becoming generalized inflation through higher wage increases, we have to reduce inflation in other items.

The high prevailing borrowing rate of some small borrower – say 15 per cent today – is held out as Exhibit A of the central bank’s inconsiderate policies, never mind that the rate charged includes the policy rate of 6.5 per cent plus an additional spread of 8.5 per cent, consisting of a default risk premium, a term premium, an inflation risk premium, and the commercial bank’s compensation for costs, none of which are directly affected by the policy rate.

the saver eventually recognizes that high inflation erodes the value of his financial savings and switches to real assets like gold. Since we do not mine gold in the country, this also puts pressure on the current account.

I also felt many of the potential benefits of privatization could be achieved if PSB governance could be improved substantially.

Competition is the life force of a modern economy – it replaces dated and inefficient methods while preserving valuable traditions; it rewards the innovative and energetic and punishes the merely connected; it destroys the stability of the status quo while giving hope to the young and the outsider. True competition eliminates the need for planners, for as gravity guides water through the shortest path, competition naturally guides the economy to the most productive route.

healthy competition needs the helping hand of the government; to ensure the playing field is level, that entry barriers are low, that there are reasonable rules of the game and clear enforcement of contracts, and that all participants have the basic capabilities such as education and skills to compete.

The degree of competition in the banking sector in India is best seen as the product of two grand bargains.

The first was between successive governments and the banks, whereby banks got privileged access to low-cost demand and time deposits, to the central bank’s liquidity facilities, as well as some protection from competition, in return for accepting obligations such as financing the government (through the Statutory Liquidity Ratio or SLR), helping in monetary transmission (through maintaining the Cash Reserve Ratio or CRR), opening branches in unbanked areas and making loans to the priority sector.

The second grand bargain was between the public sector banks (PSBs) and the government, whereby these banks undertook special services and risks for the government, and were compensated in part, by t...

Private investment is risky, so there has to be more risk-absorbing financing such as from corporate bond markets and from equity markets. As more sources of financing emerge, not only will banks no longer be able to have a monopoly over financing corporations and households, they will also have to compete for the best clients, who can access domestic and international markets. Similarly, deposit financing will no longer be as cheap, as banks will have to compete with financial markets and real assets such as housing for the household’s savings. As households become more sophisticated, they will be unwilling to leave a lot of money in low-interest-bearing accounts. Of course, households will still be willing to accept low interest rates in return for liquidity. So privileged access to the central bank’s liquidity windows will allow banks to offer households these liquidity services safely and get a rent, but this advantage will also become eroded as new payments institutions and technologies emerge.

Many promoters came from rich storied families, were well-connected and dominated the society pages. To ask the banker to get tough with the promoter was to ask him to take on an icon of society. Some bankers could do this with ease, many could not.

the sanctity of the debt contract has been continuously eroded in India in recent years, not by the small borrower but by the large borrower.

The promoter who misuses the system ensures that banks then charge a premium for business loans. The average interest rate on loans to the power sector today is 13.7 per cent even while the policy rate is 8 per cent. The difference, also known as the credit risk premium, of 5.7 per cent is largely compensation banks demand for the risk of default and non-payment. Since the unscrupulous promoter hides among the scrupulous ones, every businessperson is tainted by the bad eggs in the basket.

There are two sources of distressed loans – the fundamentals of the borrower not being good, and the ability of the lender to collect being weak. Both are at work in the current distress.

liberal democracies, which seem to be best at fostering political freedoms and economic success, tend to have three important pillars: a strong government, rule of law, and democratic accountability.

a fourth pillar, free markets, which are essential to make the liberal democracy prosperous.

Strong government does not mean one that is only militarily powerful or uses its intelligence apparatus to sniff out enemies of the state. Instead, a strong government is also one that provides an effective and fair administration through clean, motivated, and competent administrators who can deliver good governance. Rule of law means that government’s actions are constrained by what we Indians would term dharma – by a historical and widely understood code of moral and righteous behaviour, enforced by religious, cultural, or judicial authority. And democratic accountability means that the government has to be popularly accepted, with the people having the right to throw unpopular, corrupt, or incompetent rulers out.

as class differences create differentiated capabilities among the public, governments can either continue choosing the most capable applicants for positions but risk becoming unrepresentative of the classes, or they can choose representativeness over ability, and risk eroding effectiveness.

Robert Solow won the Nobel Prize in Economics for work that showed that the bulk of economic growth did not come from putting more factors of production such as labour and capital to work. Instead, it came from putting those factors of production together more cleverly, that is, from what he called total factor productivity growth. Put differently, new ideas, new methods of production, better logistics – these are what lead to sustained economic growth.

If we start buying dollars in a big way to depreciate the exchange rate, we will be able to buy fewer government bonds if we are to maintain control over liquidity. The consequence will be higher interest rates in the bond market. Moreover, the depreciated exchange rate will mean higher inflation, which in turn will mean higher policy interest rates given the inflation objective the government has set for us. Once again, this means higher interest rates. Just look at Brazil or Russia to understand you cannot have a significantly depreciated exchange rate and lower interest rates at the same time if you want stable growth!

there are only a few sources of alpha for investment managers. One comes from having truly special abilities in identifying undervalued financial assets – Warren Buffet, the U.S. billionaire investor, certainly has these, but study after academic study shows that very few investment managers do, and certainly not in a way that can be predicted before the fact by ordinary investors. A second source of alpha is from what one might call activism. This means using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. A venture capitalist who transforms an inventor, a garage, and an idea into a full-fledged profitable and professionally managed corporation is creating alpha. A private equity fund that undertakes a hostile corporate takeover, cuts inefficiency, and improves profits is also creating alpha. So is a vulture investor who buys up defaulted emerging market debt and presses authorities through various legal devices to press the country to pay more. A third source of alpha is financial entrepreneurship or engineering – investing in exotic financial securities that are not easily available to the ordinary investor, or creating securities or cash flow streams that appeal to particular investors or tastes. Of course, if enough of these securities or streams are created, they cease to have scarcity or diversification value, and are valued like everything else. Thus this source of...