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Well-timed move to preserve halo
Rarely do we find people in public life moving on at the right moment. Invariably, we find them sticking to their positions, well past what could be appropriate time for them.

For, most of the time, they do not realise that the time has come.

Politicians, policy makers, sports people are all vulnerable to this “sticky position” syndrome.

Not so RBI Governor Raghuram Rajan, who has decided to move on, early September, after the completion of his 3 year term at the RBI.

Whether well planned or fortuitous, Rajan’s moving on is most appropriate for him.

For, if he stays on, he will very likely be compelled to redeem his promise to keep Indian CPI inflation at 6 per cent – as there is a fairly high probability that this key metric of RBI’s performance could hit 7 or 8  per cent or even higher, in the next 6 to 8 months.

He may then have to contemplate stiff monetary policy measures which will squarely pit him against the Government. If then he may invite the wrath of the government.

As for Subramanian Swamy’s wrath, that would then boil over for he has already – even now - accused Rajan of keeping interest rates so high as to kill the economy.

From the foregoing it follows that so far Rajan has not done anything to deserve Swamy’s criticism.

Indeed, that is the truth despite the hype about Rajan being a great inflation fighter and the “brickbats” he has earned for that.

Just two measures of the level of financial accommodation in the economy will be enough to prove that.

a.    Size of the RBI’s balance sheet: at 25 per cent of the country’s GDP, it is as high as those in the advanced economies – such as the US, Japan and UK - which have undertaken massive Quantitative Easing (QE) operations and expanded their balance sheets in the past few years.

Prior to the commencement of QE in January 2009, the US Federal Reserve’s balance sheet was about 5 per cent of US GDP.

People who have been hailing RBI as a great inflation fighter should pause to examine and understand the purpose behind the massive expansion of the advanced economy central banks’ balance sheets in the past 6 years.

To put it simply, QE is aimed at keeping financial conditions very accommodative, ease liquidity and credit conditions and thereby stimulate the economy. It will work,  as the US economy has proved, where the central bank otherwise has a high credibility as an inflation fighter.

b.    The 10 year government bond yield – which is the benchmark for borrowing costs in the economy - staying put at the 7.5 per cent levels, as RBI keeps government borrowing well supported and represses financial yields.

During Rajan’s last 3 years, while “a” increased by 3 / 4 per cent points, “b” has remained stuck at that level.

It is instructive to note that bond yields have been boxed in the narrow 7.5 / 8 per cent range for a much longer period than the last 3 years. And, it is “a” which has ensured that “b” occurred.

To be fair to Rajan, the process of “a” increasing has been going for several years now – at least for the last 15 years from 2000 when foreign capital flows into Indian markets picked up in substantial measure.

That is the bigger story and the bigger reason behind the Indian economy’s current quagmire-like situation where real sector activity has slowed down considerably, non-performing loans in banking balance sheets have shot up to perilous levels; but overall household inflation expectations remain at the double digit levels.

Indeed, to have a proper understanding of Rajan’s tenure and the particular circumstances of his exiting, one has to go back at least 15 years. One can then understand that for any economy, its condition at any particular point in time is the cumulative impact of policies adopted over a period of time.

The most important underlying cause of stressed assets in Indian banking is the roller-coaster like macro-economic environment of the past 15 years.

Between 2000 and now in 2016, the Indian economy has swung from a boom caused by officially-generated high inflation to a bust marked by significantly high inflation expectations. Through a series of entirely discretionary moves, starting from the early 2000s, politicians and policy makers, who imagine a permanent trade-off exists between inflation and output growth, have landed the economy in the current, messy stagflation environment.

The consequences of that policy of generating high inflation through loose fiscal and monetary policies have been predominantly adverse, as is getting clear to all stakeholders now.  

Short-term trade off

To be sure though, the surge in inflation in the early years of this century did stimulate real sector activity. The inflation pick-up and the excessively exuberant demand scenarios it spawned did perk up investments. This was a typical example of mistaking an overall price level surge in the economy for a favourable relative price level shock and following up (that misunderstanding of the underlying economic forces) with large scale project borrowing (the famous Phillips curve syndrome).

Poor corporate governance in Indian banks only aggravated the damage fundamentally caused by flawed economic policies and poor macro-economic understanding. The investment and economic atmosphere was, of course, further vitiated by the series of scandals involving politicians and business people in key segments of the economy.

In time, as the underlying overall price level surge in the economy manifested itself explicitly, most of the projects have become unviable. Basically, all cost and revenue .

Projections of those projects have been rendered way off the mark and are obsolete now. Those who argue that consumer price inflation is irrelevant for policy decisions on corporate borrowing have to note, it is final consumer demand that drives corporate investment decisions – not the level of the WPI.

Therefore, the quantum of monetary fuel in the economy is still very high and out of tune with the overall state of the economy now.

The fact that Indian households’ inflation expectations have remained stuck at the 10 per cent levels right through the last 3 years – the so-called period of “dis-inflation” engineered by Rajan – is proof enough of the underlying inflationary pressures in the economy.

It is important to point out here that inflation expectations is not some abstract variable devoid of any real or practical consequences. On the contrary, it is high inflation expectations which keeps discretionary consumption spending in the economy muted, dampens borrowing and lending and overall keeps the economy in a weak, low confidence state.

So, where has Rajan increased interest rates to “killer levels” as Swamy has been alleging?

If Rajan had done anything of the sort he has been accused of, those two measures would not be where they are now.

At a minimum, the 10 year yield would be 12 or 13 per cent.  

Again, it is instructive to note here that when a central bank is doing QE of its balance sheet, its usual reference rates to set the price of money, such as repo rates, are not very relevant. Therefore, when Rajan initially raised the repo rate in 2014, it did not affect inflation expectations much nor is cutting the rate now perking up spending and investments.

But, Rajan is still moving on at a high – as registered CPI inflation in India, from the highs of 11 per cent in 2013-14 is some 50 per cent lower at 6 per cent now.  For that, he has to thank the spectacular collapse in global oil / other industrial commodities / food prices in the period from mid-2014.

Rajan also, of course, knows that well. He knows that when the trend in global commodities prices breaks or bends, Indian monetary and fiscal policy would be in quite a bind.

So, in moving on now, Rajan is making a well-timed exit that will preserve his inflation-fighting credentials. Short of another crash in global oil prices to the $ 20 levels or continued weakness in global food prices, Indian inflation is now looking poised to rise ominously. As pointed out earlier, there is enough monetary fuel in the economy to accomplish that.

As for his baiters in politics and government, acute embarrassment awaits them by the probable turn of economic events in the ensuing period.

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