Men behind the money: Book Review in Financial Express 25th August, 2013

There has been a lot of interest in what goes on behind the appointment of heads of central banks, be it the Reserve Bank of India (RBI) or the Federal Reserve. There is always discussion on the independence of the central bank and the extent to which politics plays a role in determination of monetary policy. It is only more than timely and appropriate that these issues are taken up by Neil Irwin in his extremely engaging book, The Alchemists: Inside the Secret World of Central Bankers, where he traces the evolution of central banking and little-known facts of how decisions are taken by these so-called alchemists.
The name of the book is quite significant and interesting. Alchemists are people who turn base metal to gold. However, when you are a central banker, you turn metals, which were used in the earlier years as currency (copper) to paper money by fiat. That is how central banking began way back in 1656 in Sweden when Johan Palmstruch first brought in such money. The story also goes on to say that when things went wrong and money went missing in the vault, he was to be executed, unlike today, when bankers get away with just the critic’s censure when systems collapse. Times surely have changed. The role of alchemy is also played out when central banks go in for monetary easing when all else fails by printing more notes through the buyback of bonds and other financial instruments, which was done by the Fed, Bank of England and ECB, which is also like creating money from nothing. Irwin’s story is focused on the three honchos, Ben Bernanke, Jean-Claude Trichet and Mervyn King, who led their central banks with aplomb. An interesting anecdote here is that quantitative easing is not really a new thing and was introduced and pursued way back in 1866 in England when Overend and Gurney collapsed and there was a bank run. The Bank of England took on bills that were ‘otherwise good in normal times’ at a haircut to rescue banks. So the concept of rescue at a cost was there at that time too. The same did not quite work out in Germany when the Reichsbank printed money when the Treaty of Versailles put strain on the finances of the German economy, which Keynes had warned was not fair. The result was hyperinflation. Therefore, printing more money when all else fails is not always the right solution. In the US, just when the oil crisis had spread in 1971, the concern was on unemployment, growth and inflation. Nixon had wanted to bring the Fed under the executive so that the policies would be more positive. Therefore, politics cannot be separated from economics. Irwin explains the various pressures on the chairman of the Fed under these conditions when interest rates had to be raised, against the president’s wishes. Therefore, relentless pressure on central bankers to toe the line, especially during elections, is not really something new. Coming back to contemporary times, Irwin writes about how the three protagonists were of a different nature. Trichet, with his perfect manners, was persuasive and would ensure that the ECB took decisions and never left anything hanging. He would delay the lunch that was served until a decision was taken. Bernanke, surprisingly, even though being an academic, had to take training from a speaking coach and was consensus-driven, which was a challenge because he was dealing with 19 members. King, on the other side, was snobbish, loved sports and western classical music, and was disdainful of bankers who did not have training in economics. But he had a way with words, which was typically British. All three of them were for injecting liquidity and King did it to rescue Northern Rock Bank. In the US, it was tough considering that the investment banks were not really regulated by the Fed and hence in order to provide support, they had to invoke 13 (3) of the Federal Reserve Act, which allowed the Fed to lend to any individual or entity. Trichet had a tough time with opposition coming from Germany, which was against supporting Greece when the default happened. Under the Maastricht Treaty, such support was to be eschewed. Therefore, the idea was floated to create an SPV funded by the Euro members that would then take on these bonds and provide liquidity. Also interesting is the fact that the ECB was in general averse to aid coming from the IMF as there was a feeling that allowing such a thing to happen would mean showing some kind of subservience to the power of the US, which it is believed had supreme control over the institution. However, the interesting part is that the central bank always operates under guidance from the political leader in any territory. In the US, the appointment is political. Bernanke was not supposed to be an Obama man, as he was appointed by Bush, but his policies of being accommodative had worked and given assurance to Obama that he would be the right person to continue. At that point of time, Larry Summers, who is again today a candidate for the same position, was also in the running and supposedly closer to the democrats. However, Bernanke’s performance, as well as the fact that Summers was not a consensus person, worked against him. In fact, the entire rescue act, starting from AIG to money market mutual funds, such as Reserve Primary Fund, had the support of the government with Bernanke being backed by Tim Geithner. This had provided succor to both the funds and corporates. Again the wand of the alchemist had to be waved and Section 13 (3) invoked to transfer funds to an SPV, which, in turn, bought commercial paper offered by the funds. Quite clearly, innovative methods had to be used to resuscitate the system.Irwin also gets into the details of the Dodd formula where there was an attempt made to separate the monetary policy function from regulation and supervision. He did not quite manage to push through on this score in the Senate and went down 91-8. Banks naturally wanted the Fed, as the latter had rescued them in hard times. Meanwhile, we have had other versions of easing coming through, including Operations Twist, where the tenure of bonds was swapped to provide liquidity. On the same issue, the British experience was different. Bank of England, under King, wanted to wrest power from the FSA, which had power on regulation and King never missed a chance to have a swing at the deficit being run by the government, which gives us a sense of deja vu when one thinks of how Subbarao had also played this tune in the last couple of years. In fact, King was quite blunt when he likened central banks to the ‘nation’s economist-in-chief’ and said they should stay away from ‘politics’. The author moves adeptly between the three sets of nations and central banks to give the reader the pain and anguish that the bankers go through, even though they do appear to occupy celebrity status for the rest of the world. The decisions taken, which look as simple as lowering rates or using innovative methods, are not without opposition and severe criticism even within their own committees. Interestingly, while the Fed and Bank of England put up their minutes on their websites, the same does not hold for the ECB, where the agreement is that everything remains secret for 30 years! Therefore, we will never get to know who said what. Towards the end, and quite appropriately too, there is a chapter on how China does it. Things are very much easier when the entity conducting monetary policy, enforcing regulation, directing lending and formulating fiscal policy is the same person—the government. Things work smoothly when there can be fiscal stimulus, rates lowered, banks willingly lend and asset quality does not matter that much. That is how China got out from the possible mess.This book is easy to read with its stories. The historical backdrop is even more interesting as Bagehot had said during the crisis of 1866—Bank of England lent to merchants and banks and this man and that man to stop the run on the system. Surely, given the fragile nature of relationships between various entities in the financial system today and the domino effect of a failure, one does finally end up lending to this man and that man, almost always to avert a crisis. This tune has not quite changed over centuries now.

Lessons from the National Spot Exchange episode: Financial Express 22nd August 2013

The fissures in the National Spot Exchange model have quite expectedly been greeted with umbrage given the loss of money involved due to a failure of systems. The fact that the ministry of consumer affairs had warned of the inappropriate contracts much earlier did not lead to any action as the system was working just fine. The amount involved is quite large and it appears that the combination of the settlement guarantee fund as well as commodities stored in the warehouses cannot match the payments that are to be made. What are the implications or rather the lessons to be learnt from this story?
The idea of having an electronic spot exchange is to mimic what happens in a mandi in a transparent manner so that there is efficient price discovery and all parties are better off with counter-party risk guarantee being provided by the exchange. To make this work, systems of warehousing, assaying and weighing have to be in place, which improve the quality of infrastructure in the farm sector. This was the idea when these exchanges came on board, and the recent episode of what can go wrong is a lesson for all of us.The two immediate takeaways are that we require regulation at the top and adequate risk practices in place within the exchange so that there is orderly trade which results in delivery. The absence of regulation was the first lacunae because the way contracts were structured, it could be defined as being a spot or futures transaction. Also, given that players took advantage of the settlement cycles of 11 or more days, there was inherently interest arbitrage at the corner. This allows speculators or investors to buy and sell without having to take delivery of the commodity.Therefore, APMCs, FMC and probably a combination of RBI and Sebi would all be potential regulators as it involved spot sale, futures sale and financial investment. But the sector got away with no regulation. Ideally, all contracts should have been settled and delivery taken on the same day which would have been cumbersome but with less risk.Second, the exchange should have had its risk as well as surveillance systems in place. Typically, all contracts should result in delivery which was not the case here. Therefore, for this market to develop delivery should be mandatory. The surveillance systems were lax as it was assumed that nothing could go wrong as most transactions were by investors where the commodity was being traded multiple times. It was not expected that the ministry would ban these contracts as they overlapped with the futures market. Therefore, neither the physical commodity nor the positions taken really mattered. So, for a stock of, say, 100 tonnes, there could be 10,000 tonnes worth of contracts. The same is less likely to happen in a futures market as the regulatory systems are in place with margins, position limits and mark-to-market processes being in place.At a fundamental level it raises the question of whether or not commodities should be treated as financial products. This question takes the trail back to the Jalan committee which raised the issue of financial infrastructure companies being profit motivated. For an exchange to be profitable it has get volumes, and to enable this goal, it has to reach out to a vast community. We need to generate liquidity and a pure hedgers market will not do. Therefore, the spot or futures transaction in commodities has to resemble a financial product—just like, say, equity. The National Spot Exchange model was mimicking more the futures market rather than a mandi and was attractive on account of the assured returns that could be procured on the basis of a simultaneous buy and sell transaction. If the conventional mandi model is followed there would not be too many players at the terminal and the price discovery process would be less robust. So, it was necessary to get in more players with trading ability.Treating commodities as a financial product has its own set of issues as it becomes analogous to dealing with shares of a company. The difference is that when it comes to a share, there is no underlying risk and the only people affected by the share price going wrong are the owners of the company. But when it comes to commodities, the players who determine the price, especially in the spot market case, were generally investors who probably would not have known what commodity they were dealing in. But their decisions can affect the price of the product across the country and hence the ultimate consumers.Intuitively the concept of treating commodities as a financial product is compelling because inflation is normally always positive, which means that one will always gain in such a situation. There can be seasonal variations that add to volatility and make it an attractive investment option. Thus, in the medium term, one has to gain in commodities and any statistical exercise on returns on commodities which is found in presentations made to potential investors talks of returns of 20% on bullion, 10-20% on metals and 8-15% in farm products, in normal times. Add a crop failure and the returns on farm products could be upwards of 30-40%.An interesting question posed is whether financialisation of commodities also poses a conundrum for the commodity futures market. Does the futures price drive the spot price? If it does, then such trading runs the risk of being responsible for price inflation, which was the reason behind various bans imposed. On the other hand, if it is not, then there is no sanctity to such a market because we are not really talking of price discovery.Quite clearly, the commodity market has gotten into yet another controversy with the futures segment living with a shadow of bans while the present story would mean revisiting the ground rules of a spot market. The FMC will now be the regulator, but the question really is once we set the house in order, will the market ever be what it was like before?A corollary is whether commodity markets, either in the physical form or as financial futures, better off if they are overseen by a regulator which is savvy in terms of the product being dealt with. As both e-spot and futures in commodities are financial products, there is now a strong case for shifting the FMC to the ministry of finance. This has been debated for a long time with the clinching argument for being that the ministry of consumer affairs is more tuned to commodities. But as things have turned out, commodity trading without a large element of financialisation is not sustainable. Thus, the case can be transferred to the ministry of finance for better oversight with FMC, like Sebi, being made an independent regulator.

A twist in the rupee tale: Financial Express 20th August 2013

If FY12 and FY13 were the years of our battle against inflation, FY14 has been a war against the falling rupee. The decline in the value of the rupee has been quite prodigious from R53.74 as of May 1 to R62.35 on August 19. We have taken our balance of payments for granted for a long time and have been liberal with imports with the comfort that foreign inflows would protect the current account deficit. But there has been, what Jeffrey Archer would have called, a twist in the tale, this time when the inflows got converted to outflows, and the rupee went down.
RBI, as usual, has been left holding the baby, as it is the case when anything goes amiss. It also runs the risk of facing the flak because every economic decision has a tradeoff, and some constituency gets affected. The latest buzzword is ‘collateral damage’ caused by too much intervention as bond yields have zoomed and the stock market has plummeted. The alternative would have been to do nothing and let the market decide the exchange rate, in which case the participants would have panicked in the expectation that RBI was targeting a higher number. The more uncharitable would have likened the state to that of Nero. Really, a hard choice to make under these circumstances.To cut short the often-explained story, the rupee has fallen due to fundamentals turning sour and adverse sentiment caused by the QE withdrawal. The government and RBI have acted together to control the fall in the value of the rupee and the approach has been, to use the oft-repeated cliché, calibrated. The fundamentals have been drawn down in a granular fashion and measures have been invoked to control the outflow of dollars and increase the inflows. The inflows will increase through FDI only over a period of time as India is no longer a hot destination under the given circumstances. ECB norms have been relaxed, which will help. NRI deposits have been provided an impetus with the increase in interest rates, which could get in more dollars in the medium run only. But none of these measures will get in dollars on a daily basis to strengthen the coffers. Sadly, a declining rupee has not quite spiked exports, which appear to be driven more by demand conditions in the West, which are still lacklustre.The so-called crusade against outflows has started off with the war against gold where the duty is now 10% and channels of finance have been cut drastically with only exporters and jewellery makers having relatively easy access. This has helped, going by the government data on import of gold, though one is not really sure whether the harvest and festival season will cause a reversal.More recently, curbs have been put on current account with the reduction in limit on outflow through remittances. Add to this restrictions on outward FDI, and the measures have been fairly stiff. Given that there are not too many companies that are investing 4 times their net worth or even a multiple of 2, and that there are not too many opportunities overseas given the stagnation there, the savings in dollars will not be significant. The curbs on external remittances are more of a nuisance at the household level, and will not really help to shore up the rupee. The next target could be non-essential imports, which cannot be ruled out considering that a very determined FM has averred with certainty that the CAD will be at 3.7% just as the fiscal deficit will be at 4.8%. Making imports more expensive is a good way of installing a deterrent as was the case with gold as a combination of additional 6% in duty plus depreciation of 16% actually pushes up the cost by over 20%. Has this worked?The answer is ‘not really’, because while imports have slowed down, at least for the time being (these months are also not the marriage season), the fall in the value of the rupee appears to be almost continuous. RBI has simultaneously squeezed liquidity by tightening the CRR norm, half closed the LAF window, sold bonds through OMOs, introduced weekly CMB auctions to ensure that no speculative positions are taken in the forex market on account of arbitrage opportunities. This worked in a time frame of 1-2 days, after which it appeared to be a ‘fall as usual’. The NDF market has been held responsible at some point of time, but all legitimate participants have to inform RBI of their actions, and while the volumes are substantial in this market, the impact would be low as it is only the difference in price that has to be paid for which will impact the spot market locally. The forex derivative market which is mainly on NSE and MCX-SX have witnessed volumes halve in the last month with curbs being placed on margins and position limits. The average daily volumes on NSE have come down from R25,000-30,000 crore to R10,000-12,000 crore. The rupee still seems to keep falling. FIIs in August have been positive in equity and negative in debt.RBI had sold $1.8 billion up to June (the number would be higher in July) while our foreign currency reserves have declined by $8.4 billion. The decline in reserves is symptomatic of the decline in the value of the rupee while the sale of dollars by RBI indicates that this also has not really helped. Quite clearly, the sentiment factor has been working in pushing the rupee down.What next then? It looks like once we put in additional curbs on imports, the government and RBI would have done all that is possible from the point of view of fundamentals. Speculative activity, to the extent that they are being played through the institutional route, has also been addressed. The impact has been limited. In a way, it is more like what Shakespeare would have said, “full of sound and fury, signifying nothing”. The logical corollary is to now sit back and let the rupee find its own level. That would lead to market equilibrium. But yes, we have to bear judgment here that a free fall in the value of the rupee is self-fulfilling—FIIs keep out, ECBs come down and FDI starts rethinking. Are we prepared for that?

Getting behind poverty numbers: Financial Express August 12th 2013

The recently-released data on poverty is quite interesting. The poverty ratio as measured by the Tendulkar methodology has come down to 21.9% in 2011-12 from 37.2% in 2004-05. This is certainly a major achievement. There can be debate about whether the criteria used is right or wrong, as the average monthly expenditure (which is the route chosen here) has been pegged to R816 per month in rural areas and R1,000 in urban areas. But, in economics, once we define a criteria and stick to it, there is nothing amiss as long as we are using the same yardstick at two periods of time. At a broader level, one can ask whether anyone can actually live on an income of R26-27 a day, which is a third of what the World Bank would define as a poor person based on $1.25 a day, which comes to around R78 based on exchange rate of 2011-12? But, even so, the fact that the level of deprivation has come down based on certain criteria is a good sign.
In the current context, two questions arise. The first is when we are going for food security, we are covering around 70% of the population, and while it has been admitted that the aim is not to cover just the poor but also the not so poor, the difference in numbers is quite large. The Food Security Bill (FSB) makes sense if we link it to the $2 a day criteria of the World Bank, which, by the 2010 estimate, comes close to the number of 800 million population. The conundrum is that if the government gives importance to the Tendulkar poverty ratio, it would actually be opening the door for controversy because by these criteria we have only 269 million poor people in India and, by covering 800 million under FSB, we could be overdoing it. Alternatively, we should not pay heed to the Tendulkar criteria and use it more as a theoretical reference point as it cannot really be linked to the actions of the government.The second contextual issue raised is how has this number come down sharply from 407 million in 2004-05 to 269 million in 2011-12, while it remained flat between 1993-94 and 2004-05 (404 million in 1993-94)? Of late, there has been a war of words, which is quite typical in the context of economists, between Sen and Dreze at one end and Bhagwati and Panagariya at the other. The former have been stressing on tackling poverty directly through schemes and measures which include things like the MGNREGA while the latter have followed the capitalist model of growth from above which will trickle down. Now, if poverty has come down so drastically in the last 7 years, is it due to high growth or direct intervention?GDP growth was 8.5% in the period 2005-06 and 2011-12 while in the preceding 7 years or the period from 1993-94, it was around 6.2-6.4%. But under the UPA government, we have had the largely successful MGNREGA programme, which has provided about R25-30,000 crore on an annual basis to the rural families, which has also helped to push up the average wage in the country for unskilled labour from R60 to R130 per day. Thus, it looks that both the factors have been at play; but given that rural poverty has fallen sharply (by 110 million while that in urban by 28 million) and most of the growth has been urban-centric, one may tend to support Sen and Dreze here. Any way, such data is a scoring point for the present government as it shows improvement in poverty numbers.The other interesting takeaway from the poverty data is the spread of this ratio across states (the smaller states of north-east are ignored as they tend to have extreme numbers due to their small size). The lowest poverty rates are in states like Andhra Pradesh, Himachal, Delhi, Kerala, Tamil Nadu, Punjab, etc. Andhra is significant because it is also a large state with a ratio of just 9.2%. Rajasthan, once a part of BIMARU states, does very well with 14.7%.The unsatisfactory numbers come from the usual suspects who are also large like Chhattisgarh (39.9%), Bihar, Jharkhand, MP, Orissa and UP. The surprise package here is Karnataka that has a high rate of 20.9% considering it is one of the better performing states in other respects. Quite clearly, action needs to be taken here to lower these numbers not just from the point of view of alleviating the condition of the poor but also because it has other social consequences, which include the birth of extremist activity that is also visible in some of these states. Overall, there are 10 states that have higher poverty ratios than the national average. States such as Maharashtra, Gujarat and West Bengal have a median level ratio of 15-20%.These high numbers are also reflected in the rural poverty ratios in these states with Chhattisgarh and Jharkhand crossing 40% followed by Bihar, UP, MP and Orissa. Maharashtra also comes quite high with 24.5%. Urban poverty ratios are also higher in these states though Maharashtra does well with 9.1 (13.7% for the country).Some thoughts pop up when looking at these distribution numbers. First, our poverty alleviation programmes should probably begin from the states that have higher numbers so that we are able to address their concerns and lower this rate. Second, at the political level, the state governments in power must divert more funds from their budgets for such programmes to supplement the efforts of the Centre. Third, given the wide scale disparity across states, there could be two repercussions. The first is migration to the better performing states and the second is the threat of insurgency given our experiences from the past. Fourth, we need to draw lessons from what states like Andhra have done to bring down this number as given the size, the progress has been remarkable. The same holds for Tamil Nadu. There is, hence, hope for the food security programme as these two states are definitely the success stories for PDS. Last, while it is nice to have these numbers down, the next line of action must be to sustain the same and push these households on to the next step of the consumption ladder. That would be a real achievement.

Understanding federal systems: Book Review in Financial Express 11th August 2013

The approach and process of reforms are extremely important in countries that have a federal structure. There are some measures that can be implemented unilaterally with ease by the Centre such as those relating to, say, financial reforms or delicensing or foreign trade. These are ‘national’ in level and do not prima facie affect any of the sub-nationals such as state or local governments. However, when reforms involve the ‘power’ or ‘finances’ of the sub-nationals, there is an inherent conflict of interest, which makes the reforms process more challenging because it is necessary to ensure that there is responsibility and accountability at each and every level for the system to succeed. In fact, invariably, reforms are always targeted at the national level to begin before moving over to the second level, where alternative approaches have to be used to assure compliance before being implemented.
Howes and Rao, authors of the book, Federal Reform Strategies, study in great detail the structures that exist and the success attained in countries like India and Australia, while there are also contributions on China and Indonesia. While they do not attempt to come up with a prescription, they do create theories on how things could work, based on experiences in these countries. The conclusions drawn by them are engaging. In a federal set-up, reforms related to economic integration, or natural resource or environment management, cannot be made effective without the active participation of sub-national governments. They look at the issue more on how central governments can motivate, influence and ensure the coordination of sub-national policies. The authors believe that there are certain structural pre-requisites that are needed for success. First, there needs to be a hierarchy of governments in any country, which are clearly laid out, preferably by statute. Second, sub-nationals should have priority in their own regions or territory so that they are responsible for the same. Third, the national should be allowed to police the sub-nationals or else it will get chaotic. Fourth, all of them should have budgets and work under this constraint so that they have something to look forward to from the central government. Last, there has to be allocation of responsibility across each levels, which can be done institutionally, like, say, the Constitution for India.Studying the way federal systems operate, the authors interestingly conclude that there are basically five strategies, which, though similar in nature, are used to make federalism work. Cooperative federalism is probably the best option where tax reforms are concerned as the Centre works with the sub-nationals to garner and allocate resources. There can be conditional federalism, wherein states are provided benefits subject to certain conditions being met. A variant is programme federalism where the linkage is with a specific programme such as, say, an education or health scheme that has to be implemented from above. Parallel or centralised federalism is where the Centre changes policies for the states, which becomes imperative if the other systems do not work, while in case of competitive federalism, the state which does better based on certain performance parameters is allowed to go ahead with Centre’s support. Their own observations are that most reforms fall within these categories of federalism. In Australia, they have used cooperative approach for taxes, conditional recipe for reforms, programmed structures for transfers, centralised solution where there are disputes such as in case of the use of water and competitive strategy to provide more funds to the state of Victoria where the state had spent a lot on health facilities relative to others. In India, we have a federal structure where the Constitution lays down the structure of devolution of power, while the finance commission addresses issues of allocation of funds. Of late, however, there has been a case of the polity becoming complex with regional parties dominating in states and the Centre being run by coalitions. Federal reforms become necessary for further progress. With the abolition of, say, licensing, investment will automatically go where the environment is the best, which should lead to competitive federalism. Gujarat has been a beneficiary here. The states have also agreed to follow VAT which is an achievement though the GST has gotten stuck with states wanting compensation for potential revenue loss on account of this system. The pictures of China and Indonesia are also interesting. Both countries have grown from starting off as controlled economies but the challenges have been significant. Indonesia has had to provide incentives to states for protecting forests as they were a state subject and there was revenue to be foregone if deforestation was stopped. To ensure that this was curtailed an incentive programme had to be launched. China faces problems in controlling the emission of carbon. While the Centre is keen and aggressive, once it goes to the states, there is little will to do the same. But given that the powers exercised are higher for the Centre and the parties in power similar at both levels, the task became easier in case of China. Do they have preferences for any form of federalism? The Indian system faces challenges while adopting their models. The authors show how the centralised model has been followed by imposing rules through the department of personnel for, say, the arbitrary transfer of IAS officers by state governments especially when the parties change. In Uttarakhand, there had to be intervention from the Centre to ensure that the environment was protected even as the state was keen on leveraging on the hydro-electricity potential. States are trying to get competitive and the best examples are Bihar and Gujarat where higher governance levels have delivered success. In fact, they feel that structures based on ‘conditions’ may not work. This was seen in India, too, where grants were linked to certain conditions being satisfied. But they were not attractive enough to prompt any action. Centralised solutions are required when all else fails, especially in issues relating to environment or water. But still strains remain when the parties in power are different at the two levels in which case there has to be cooperation. But the important message they leave behind is that the Centre has to take the lead any which way to ensure that the goals are met. For this to be successful, it has to be proved that the measures to be implemented have an impact on the target goals. Further, the incentives provided to the states must be strong to make them act irrespective of their political affiliations. It would work then. This volume of collection of articles would be more useful for policy makers, especially in India where such conflicts have arisen on a number of occasions leading to an impasse quite often. While it is not unequivocal that a single system works, we need to have a combination of all these models depending on the situation to ensure that policies can be made to work through the appropriate federal reform module.

Can Rajan make a difference as RBI Governor? - YES: Hindu Buisness LIne 9th August 2013

While much of the conjecture on what Raghuram Rajan will do differently has been on monetary policy, little attention has been paid to his core competence in banking systems and regulation, where he has made a major contribution. Having authored the Report on Financial Reforms and gone through the financial crisis advising what to do, he would be expected to take the Indian banking system to a new level, given the twin goals of meeting the regulatory challenges while bringing about financial inclusion.

On the side of monetary policy, there is a lot of guesswork especially within India Inc, given the impatience at the current interest rate policy. However, monetary policy options are always driven by theory and presently it is not known whether Rajan is a monetarist or Keynesian or follower of rational expectations. Normally it is difficult for any central bank Governor to be committed to any specific school of thought, as the response is always situational.

Continuity, alongside tweaks

Today the currency is the major challenge and the present stance is that a free fall is not advisable as it is destabilising and therefore, intervention is necessary. All options, such as curtailing liquidity, restricting advances for gold, discipline in derivative trading and intervention through currency sale, have been tried out. If anything more has to be done, then it will have to be more of the same, or similar indirect options. Therefore, till the rupee stabilises, it is unlikely that the die can be cast on the growth-inflation trade-off. The only change in approach can be that we allow the rupee to slip to what the market dictates, which is not presently the RBI’s stance.

Today, inflationary expectations are high as the impact of rupee depreciation has not yet been felt on core inflation. Yet, Raghuram Rajan can take a call that the present conservative monetarist approach to policy has not quite brought inflation down and therefore, we can move the trade-off to a higher level by lowering interest rates. Anecdotal experience in the last year shows that lowering of the repo rate has not quite brought down lending rates.

Therefore, there is weight in the argument that if high levels of interest rates have not brought down inflation, lowering the same has also not brought about growth. This will be the conundrum for the new Governor.

He has already indicated that he does not have a wand. Lowering rates in the next policy cannot be ruled out to provide a fillip, but it may not keep the engine going forward. Given that monetary policy is only a facilitator and one of the many factors that bring about growth, continuity in general with tweaks here and there could be the short-term response.

Correcting the fault lines: Financial Express 8th August 2013

The appointment of Dr Raghuram Rajan as the Governor of RBI does not really come as a surprise but certainly ends speculation on the issue. The obvious question that arises is whether or not there will be change of stance in monetary policy once he takes over and, as a corollary, will the solutions be any different given the multiple conundrums we face on growth, inflation and currency.
First, the choice of Rajan appears to be more on the global lines where the Bank of England has appointed Mark Carney from Canada. We have opted for this route as Rajan brings with him a lot of experience from the West, especially the IMF, and has the reputation of the one who saw the crisis coming. The fact that we are exploring options of raising funds from international markets is pertinent here as he could steer the ship in this direction. This is a big advantage for us too when we talk of Basel III and banking regulation in India at a time when the entire system is under various pressures imposed by the new regulatory regime.Unlike Carney, Rajan has the added advantage of having worked with the PMO and the finance ministry and hence understands what goes on at the ground level to better appreciate how various segments are affected by policy measures. This is important because Indian banking has different priorities given the focus on inclusion, which is not the case in the western countries. Further, the fact that he has studied and authored an entire report on financial sector reforms indicates his expertise in all areas.The next question is more speculative in nature on how he sees the economy going and the kind of measures that would be taken. On the face of it, so far, the CEA has been in consonance with the moves made by RBI and hence there has never been any overt disagreement on the approach taken by RBI. Therefore, one may expect continuity in approach in general. So far, RBI has a priority list of currency, inflation and growth in the pecking order. Will this change? This could be possible because there are evidently multiple views even among economists on what should be the main priority. And also it is quite possible that conditions could be different in September when he takes over in which case it could be a no-brainer.Assuming the present situation prevails, can anything be done differently on the currency? RBI along with the government has covered virtually all possibilities. Measures have been invoked to curtail imports, while the government has worked to increase exports. RBI has curbed the speculative routes to influence the rupee by tightening liquidity. More elbow room has been provided for higher ECBs and FIIs flows (along with Sebi) while the government has done its bit on the FDI front. So, it looks like all options have been covered that also includes direct intervention where our reserves have been drawn down too since April. Can anything more be done? Probably not, unless the new RBI Governor takes a view that the rupee is not properly valued presently and should be allowed to gravitate towards a lower number of, say, R65. That would be self-fulfilling. But, at any rate, irrespective of who occupies the position, the rupee has to be brought under control or else it could retard the flow of foreign funds, which is but natural when the currency is considered to be weak.On the issue of growth versus inflation, Rajan could have a different view. The ministry of finance has felt often that we should change gear and move towards growth and not get obsessed with inflation. While the CEA has not taken this stance, this view could get a prominent place in the scheme of things provided there is conviction. This can be a change of stance where we accept a higher inflation rate on grounds of it being structural in nature and pitch for growth. Hence, it could become a valid possibility and, theoretically speaking, there is nothing right or wrong in either of these stances, because when there is a tradeoff, the Governor has to choose the line of best fit in this scatter graph, which, in turn, will guide the market. Since we have been living with low growth and high inflation in general, there are expectations that the stance will change. It may or may not work, but still a change could be worth experimenting with.Thus, Rajan will actually be taking over at a time when the economy is in a difficult state. For three years now, growth has been down, and inflation not really at a comfortable level. This would not have been an issue in the past, but after being used to 8% growth number with visions of 10% growth being spoken of, 2 or more likely 3 years of low growth is hard to digest. Expectations from RBI have been high and while RBI has lowered rates, banks have not followed suit to the same extent, which creates another set of problems for the Governor. In fact, another task will be to ensure the stability of the banking system in the midst of high NPAs and restructured assets and an economy that is sliding downwards. Add to this the challenge of banks adjusting to the new capital framework, banking regulation and supervision becomes as important as monetary policy.The real point of interest would be of any change of stance which can possibly turn things around. We normally tend to personalise such policy priorities which may be interpreting more than what may actually be. Normally the approach is of the central bank as an institution that is driven by members of the institution rather than a single view. Nonetheless, it is still interesting to formulate conjectures as the market is always looking for the same.