Raghuram
Rajan, governor of the Reserve Bank of India, speaks about the challenges
facing emerging market central banks, spillovers and getting to know India’s
new prime minister Narendra Modi
You took on the role as governor of the Reserve Bank of India
(RBI) at a difficult time in September last year. Did you have any conditions
before you accepted the job, and how would you assess the success of your
immediate objectives?
You do not enter this job with conditions. But I had a good
understanding with the finance minister P Chidambaram and the prime minister
Manmohan Singh. It was based on a sense that we would have to work out what was
needed as time went on. There was a fair amount of turmoil in the financial
markets at the time. The rupee and the stock market were falling. There was a
lot of concern given India’s large current account deficit that the economy was
fragile. That sense of fragility was probably overstated, but there was a clear
need to restore confidence quickly to the financial markets as well as some
stability to the exchange rate. That was the environment when I came in. The
determination I made was that rather than trying to stabilise the exchange rate
directly by intervening in the exchange markets, a better way was to reassure
investors about the longer-term value of the rupee, which meant tackling
inflation. And as we tackled inflation, other things would fall into place.
Soon after taking office, I established the terms of what we would
do to create a clearer monetary framework, to focus on CPI inflation and
bringing it down, as well as introducing other structural reforms that would
help bring some confidence to the financial markets. In retrospect, it did seem
to work. One of the elements was to raise a fair amount of dollars quickly to
show we still had the capacity to raise money should the need arise. We didn’t
need that money, there was no urgent need for it and we took it directly into
reserves. But it was good to show the world that we had the capacity to tap
markets.
How well do you think the RBI is now addressing what some have
described as a continuing struggle with ‘growth-inflation’ dynamics?
This is more the description from outside the RBI than inside. I
am hopeful we have made the case – to people in government also – that without
bringing inflation down, there is no sustainable path to growth that we can
envisage. Both the RBI and, as far as I understand it, the government are on
the same page on this. We have to bring inflation down and it involves a number
of instruments. Monetary policy is one of them, but of course fiscal policy as
well as actions on the supply side to increase the supply and have better
management of food – these are also all central to bringing inflation down in
India. With all instruments working, hopefully we will achieve the goals we
have laid out for ourselves, which is 8% by the year-end and 6% by the end of
next year.
Your predecessor accepted that ‘baby steps’ tightening to address
inflation concerns a couple of years ago were too slow in hindsight. Meanwhile,
the IMF has called on the RBI to quicken your tightening efforts. What is
holding you back – is it the lack of influence rates can have on food prices?
Outside observers do not understand this economy as well as they
should. So their advice is probably not as useful as one might think. With
demand fairly weak in the economy, the key question is: ‘Are you going to get a
lot more mileage from weakening it further in the fight against inflation?’
Second, with stresses in the financial system at a relatively high level, you
have to be careful of somebody saying, ‘let’s do a [Paul] Volcker’ and raise
interest rates sky high as it will really kill inflation. The problem is that
it may also potentially kill the economy. And in India, unlike in the United
States, we do not have $500 billion to rescue the system. So you have to be a
little careful taking advice from people who haven’t fully thought through the
details of what needs to be done. What we believe is that, with the current
level of rates and in the absence of shock that we have not anticipated yet, we
are on a disinflationary path that is reasonable given the stresses in the
economy, and this will get us to 8% in a year and 6% by the end of next year.
If we haven’t calculated appropriately, we will make adjustments based on
outcomes as we see them.
Are India’s problems really the result of the Fed’s talk of
tapering and actual tapering?
What happened in May 2013 was a wake-up call. It came after
Indians had made a substantial expansion in our purchases of gold, which
widened our current account deficit. Those purchases of gold came in April and
May 2013 and were extraordinarily high. We were caught by the Fed announcement
at a time when we were, in some ways, least prepared for a tightening of
financial markets. We made necessary adjustments, so much so that in January
this year when we saw a fresh set of what people call ‘taper tantrums’, India
was relatively immune compared with other emerging markets. Given the political
developments in the country [with the election of Narendra Modi as prime
minister in May], there is much more confidence in India relative to before.
Obviously, we have to keep on doing our homework.
Is there an issue with the way industrial world central banks
unilaterally change their monetary policies?
The problem with monetary policy changes by developed world
central banks is the uncertainty created. The changes are at the time of
choosing of the central banks of the industrial countries. This may come at a
time that does not suit us. Of course, there is the age old mantra ‘let the
exchange rate do the talking and then you are insulated’. That advice is
garbage. A number of emerging markets are not insulated – you are affected,
regardless of what kinds of policies you follow. So, it causes us to have to
adjust to a different timetable than we may want. I am not saying we were in a
good place in May 2013 – we were not in a good place and therefore we needed to
adjust – but even if we were in a better place, we would still need to adjust.
The question is: ‘is this a reasonable thing’? The reaction you get is: ‘should
industrial countries change their policies according to the needs of emerging
markets – are you so presumptuous that this should happen?’. And the answer is:
‘Maybe not.
But should emerging markets forever tailor their needs to the
demands of industrial countries?’ Certainly some industrial countries have been
asking emerging markets to tailor their policies to the needs of the industrial
countries. A case in point being exchange rate intervention: People say, ‘do
not do exchange rate intervention because it harms demand for us’, or ‘do not
run large surpluses because it hurts demand, start moderating those surpluses’.
Is that not a case of asking other countries to tailor their policies to the
demands of the global economy? A better way to check whether a policy is
reasonable is to ask whether the policy hurts the rest of the world more than
it helps the country undertaking it?’ If it does, the policy should be avoided.
My point is that in a world that is where we are all integrated everyone has
responsibilities, not just the emerging markets.
What concrete actions can actually be taken?
The fact we have started raising these issues has created greater
awareness in central banks around the world as well as among policy-makers that
there are spillover effects and countries need to take them into account. It
has also raised awareness in mulitlateral agencies. The IMF has recently
suggested it is going to examine these policies, not with a view of blessing
them unilaterally but by trying to see if on net they are beneficial. That is a
big change from where we were at the beginning of this year and that is wonderful.
The sensitivity this kind of discussion raises in central banks will make them
think about the value of policies and whether they are helpful elsewhere. I
have no doubt countries will still do what is largely in their interest. But
over time we need a little more effort looking at the global interest. My sense
is that once the debate is engaged, we will figure out a way to move in that
direction.
So debate and empirical evidence could result in even central
banks such as the Fed considering ‘spillbacks’ in the future?
It is not just an emerging market problem. What is the euro area’s
problem today? It seems to be facing at least a disinflationary environment,
some say close to deflation, and needs to accommodate more. But from an
historical perspective, euro policy is already very, very accommodative.
Interest rates are close to zero, which is why there is talk about going to
negative rates. So why does accommodative policy seem un-accommodative? It is
because everyone else’s policy is even more accommodative. You see the
spillover effects even among the industrial countries. If you look at euro area
disinflation, a fair amount of it is because of the exchange rate. The exchange
rate is too strong given the euro area’s economic standing. Why is it so strong?
Is it because monetary policies elsewhere are even more accommodative? So, in a
world where demand is weak and not strongly influenced by monetary policy, the
effect of monetary policy may be more ‘demand shifting’ that is operating
through the exchange rate, rather than ‘demand creation’ that is operating
through credit growth and credit flows domestically. So we are back to the
1930s, in a world of competitive easing. Back then, it was competitive
devaluation, but competitive easing could lead to competitive devaluation. If
there were no consequences to competitive easing, fine. But there are
consequences.
So the eurozone is experiencing a similar problem as emerging
markets due to fund inflows as investors chase yield?
Similar problem as the emerging markets have – a whole lot of
money pouring in. It may bring down yields and push up asset prices, but it
also pushes up the exchange rate. That creates a self-fulfilling process as
more money comes because returns have gone up and the exchange rate has gone
up.
Are monitoring bodies, such as the IMF on top of the situation?
My sense of alarm about the situation is due to the financial
sector imbalances that build up, and that the financial cycle is ahead of the
economic cycle. The problems arising are not so much from credit growth, which
is relatively tepid in the industrial markets and has been much stronger in
emerging markets, but from asset prices due to financial risk-taking and so on.
Unfortunately, a number of macroeconomists have not fully learned the lessons
of the great financial crisis. They still do not pay enough attention – en
passant – to the financial sector. Financial sector crises are not as
predictable. The risks build up until, wham, it hits you. So it is not like
economic growth, where unemployment offers a more continuous indicator. At the
moment you see favourable unemployment and low levels of inflation, and think
you have a lot of policy room for manoeuvre. The concern is that central banks
may be exhausting room on the financial side and creating a situation where
there will be a discontinuous movement in the financial sector. That is my
worry. Some of our macroeconomists are not recognising the overall build-up of
risks. We are taking a greater chance of having another crash at a time when
the world is less capable of bearing the cost.
Are central banks encouraging the situation?
I see our vulnerability is increasing to discontinuous changes in
asset prices, which could happen in a variety of ways. The kind of language we
hear is akin to gaming. Investors say, ‘we will stay with the trade because
central banks are willing to provide easy money and I can see that easy money
continuing into the foreseeable future’. It’s the same old story. They add ‘I
will get out before everyone else gets out’. They put the trades on even though
they know what will happen as everyone attempts to exit positions at the same
time. There will be major market volatility if that occurs. True, it may not
happen if we can find a way to unwind everything steadily. But it is a big hope
and a prayer.
What do you make of efforts to reform regulation of the financial
system, through Basel III and the G-20 process?
We have addressed some of the issues. But the underlying problem
is that the measured risks do seem to come down as volatility falls, and
central bank accommodation is a very good instrument to reduce volatility. We
have a lot of accommodation, so volatility and measured risks are also likely
to be low in the regulated sector. Then a fair amount of the risks may not
reside in the entities we have decided to regulate more forcefully. We haven’t
done a lot on the shadow-banking system. But ordinary pension funds and mutual
funds could be taking on some of these risks. So I worry about that.
What can you tell us about the conversations you have had with
prime minister Narendra Modi and finance minister Arun Jaitley following the
recent election. Do you expect government and RBI actions to be more closely
aligned?
To some extent, in India, we have always had a fairly close
dialogue between the central bank and the finance ministry as well as with the
prime minister. That dialogue continues. I do not expect a significant change.
Occasionally there have been differences that have been expressed in public in
the past. But those differences should be seen as a reflection of the
independence of the central bank – while we talk a lot and confabulate
occasionally, we don’t see the issues in exactly the same way. But I do not see
these differences as big. And I do not think we are any different in this
respect to other major countries.
The RBI has a broad mandate, including keeping inflation low,
supporting economic growth and minimising foreign exchange volatility, as well
as being the regulator for banks and other deposit-taking institutions, having
overall responsibility for financial stability, and for the government’s debt.
Is it too broad?
Yes and no. We are a developing country and some of these areas
require an entity that straddles different areas. To illustrate the point, we
need to bring more liquidity to the government bond market where liquidity is
focused only on just a few bonds. Since we manage government debt issuance,
hold government debt as part of our asset portfolio and frequently take action
in the market to meet policy objectives, we have a strong sense about how to
increase liquidity in the government debt market. This also undoubtedly creates
conflicts of interest, so we have to manage those. Some people have said the
fact we manage the government’s debt makes us more lenient towards monetary
policy or more eager to purchase government debt as part of our portfolio.
Those conflicts of interest exist elsewhere and we have to make sure our
policies make it clear we are not succumbing to them. For example, we have to
make it clear that we will not purchase government debt to bail it out; that
the government has to sell its debt in the primary market and others have to
purchase it. Whatever actions we take in purchasing government debt are purely
for monetary or liquidity purposes, not for fiscal funding. Over the last year
we have done very little purchasing of government debt for example, because
there was no need to do it for liquidity purposes.
As chair of the Committee on Financial Sector Reforms it appeared
you favoured reducing the scope of the RBI. Has your view changed?
No, I do not think I proposed cutting back on what the RBI did.
The committee’s report was that the RBI should continue its supervision
functions etc. It was more that the RBI should allow a greater flourishing of
the financial markets and, to some extent, be less protective of the banks
under its regulation. In fact, that is consistent with the actions we have
undertaken in the past few months. We have tried to deepen the financial
markets while liberating the banks. We are creating more competition within the
banking system and between the banking system and the financial markets.
The RBI has issued new banking licences but none of the major
corporate groups have secured licences so far. Are you worried about the impact
of giving bank licences to very powerful business groups that may have
significant political connections?
No, as we said explicitly when giving the licences, we were being
conservative. We are reopening the licencing process for ‘differentiated banks’
– payment banks as well as small banks – and entities can throw their hat in
the ring again. The process is ongoing and we will take a view when a new
application comes in.
The RBI is currently in the third phase of a restructuring review.
How is that going?
We are trying to align the organisation to the new needs that are
being thrown up in the economy. So we are trying to reorganise the structure by
making as few changes as necessary to achieve what we need to do. There is also
the issue of internal human resources development – how do we measure
performance as we make these changes, how do we create promotion opportunities,
how do we build skills we need and how do we recruit talent from outside? As I
understand it, these are the same issues every central banks faces. Some, such
as Bank Negara Malaysia, have done an extraordinary job changing in the past so
many years. We have made changes over time, but this is a good opportunity to
take a look to see what we need to do internally to meet the external
responsibilities we have.
You have described foreign exchange limits, such as the
liberalised remittance scheme, as macro-prudential tools. What exactly do you
mean?
Let me give you an example. On June 3, we allowed individuals to
take out $125,000 a year out of the country, up from $75,000 per year, so a
family of four can take out $500,000 per year in terms of capital outflows.
Earlier last year, we had shrunk this amount when we were faced with
substantial outflows. Even though it was a relatively small amount at that
point, it was a macro-prudential tool used to shrink what people could take
out. Then at times when you have greater access to foreign liquidity it makes
sense to liberalise it a little more. I see this as a tool, not as something
that needs to be changed every month; I would change it infrequently. When
there is a lot of money coming in, you should let some out – I did a paper on
this when I was at the Fund. But when there is a lot of money pouring out,
perhaps you can be a little more restrictive without people immediately saying,
‘this is now a reversal of capital controls’. You are not changing foreign
investors’ ability to take money out – the people that have brought money to
the country will still be able to exit freely. But to your own citizens, you
are saying, ‘Yes, we understand you have some diversification needs, and we
will keep some minimum to allow you to do it, but we will also move that over
time, based on the macro-economic situation so you can help to some extent in
running the macroeconomy’. I see it as a macro-prudential tool, rather than
something moral or anything. Some people saw it as against free markets. No, it
is macro-prudential. It is opening the spigot wider and then closing it a
little bit, depending on the extent of flows and thereby helping regulate the
economy.
So that does not get in the way of rupee internationalisation?
No, to the extent that over time we expand the minimum and do not
go below that – so, for now, the minimum seems to be $75,000 from where we have
expanded. Over time, that minimum will keep going up. At some point we will be
able to open up fully, when the rupee and our financial sector are strong
enough. I do not see that as something that happens next year but within a
decade, why not?
You have one of the largest foreign exchange reserves in the
world, holding more than $315 billion in assets. There must be quite a high
cost of carry. What is being done to minimalise that, or is it not particularly
an issue?
This is the cost of not being a reserve currency. It is the cost
of being an emerging market. You have to carry large reserves and have to fund
the debt of a variety of other countries, simply because it is extremely costly
to be short of those reserves. It is a mark of confidence. So, yes, there is a
cost of carry and, yes, we don’t want too much of it. One of the reasons to
open the spigot wider is to let outflows happen when the money is pouring in. In
foreign countries where the spigot is fully open, private individuals build up
assets in other countries when money is pouring in. In India, where the spigot
is half closed, private individuals cannot build up, so the central bank has to
build up. This is precisely related to our previous issue.
But when the pressure is on us to build up and buy relatively
unproductive assets, maybe we should allow more of our citizens to buy foreign
assets instead. That is the intention of macro-prudential, because the movements
in the exchange rate caused by changes in the risk perception of the country
may be too much for the country given its economic situation. So we build what
we need to build but we have no intention to build a huge hoard in any way.
Will it fall more heavily on the private sector to address the
imbalance in the longer term, as markets develop?
Yes, we intend to let the private sector manage the adjustments
that are needed. You see the movement in industrial country currencies has been
much less volatile than the movement of emerging market currencies. So the
intention is to move to the kind of volatility that industrial countries have
over time. But I do not see that happening overnight. Again, it is a process.
We have to develop our markets, make them deeper and more liquid, and we have
to develop the resilience of our real economy. But we will reach that. And the
bottom line is that there is no intention of creating massive hoards of foreign
assets like some other emerging markets.
- Central Banking
- Central Banking
