Let us bring down inflation, it will help growth and it will also help external stability, says RBI Governor Raghuram Rajan

Few governors in the history of the Reserve Bank of India have had the kind of rousing reception or the steep expectations that Raghuram Rajan has had to contend with in the six months that he has been on the job. Bringing impressive academic credentials, international experience, formidable intellect, eloquence and rockstar glamour, along with a reputation for speaking truth to power, Rajan hit the ground running on day one in early September 2013.

Taking over in the midst of what then seemed like an imminent Balance of Payments crisis, he helped calm currency markets. He laid out a clear roadmap on what he proposed to do and was equally forthright that he would not rule out surprises. Rajan is not a great believer in big bang announcements or sharp shifts in policy. He is more likely to take a number of small steps, each, however, pushing the system steadily and imperceptibly in the direction that he wants it to take.

Asked him about his experience in the RBI so far, Rajan says, he has learned a lot more about the Indian system and praises his ‘excellent colleagues for their ability and integrity’. He says with disarming humility, “The important thing when you don’t know is to learn from somebody who does. That is true everywhere. You have to figure out a way to work with people.” He says he has not had any surprises so far. That’s partly because he knew some of the players in the system, having worked with the RBI more than a decade ago to recommend changes in its research functions. Has he enjoyed his job? He smiles and says cryptically, “so far, so good.”

Excerpts from an interview:

When inflation is a supply-side problem, requiring more action from the Government, why does the RBI want to paint itself into a corner by setting an inflation target?

When there is strong demand, you expect supply to adjust and it adjusts. But it may adjust slower than demand. Whether inflation is caused by too strong demand or too little supply, the net effect is that there is a mismatch. The more the Government can do on the supply side the more you will have an equality of demand and supply, which can allow inflation to come down. But we can’t step back and say it is all supply side, so let inflation go wherever it wants… If this (supply side) is not moving then I have to move this (demand side).

Banks don’t seem to be reacting much to RBI’s repo rate actions. So, what can the RBI do to make monetary policy transmission more effective?

I expected that (banks to not react). But what I am hoping is that monetary policy will start getting traction as inflation comes down. Then, our interest rates will become more relevant to the circumstances. If necessary, down the line we will cut rates if inflation comes down a lot, if it doesn’t, we will increase the rates.

So, you might ask, what is the point of this interest rate increase? I think there is also some signalling value to the monetary policy. So, we are at this point (even now when the interest rate effect is not necessarily being transmitted through) walking the talk, sending a strong signal that the RBI is very firm about inflation. I firmly believe the market will understand once we explain why we did what we did and recognise that the move was in the longer term interest of the economy, which ultimately drives market prices.

Will the tapering of the Quantitative Easing (QE) programme not trigger further hike in interest rates by the central banks in emerging markets (EMs)?

It (QE tapering) is detrimental in the following sense — that a lot of easy money flowed in during good times and a lot of easy money is flowing out, perhaps, at relatively bad times in emerging markets. Many of them are also tightening policy — fiscal, monetary, etc — in other ways and that creates problems. Tell me one emerging market which is immune to a whole rush of money coming in and a whole rush of money going out. In fact, industrial countries are also not immune — Spain got affected by it, US got affected by it. They have deeper pockets to deal with the problem but we have less deep pockets. So, it is a problem. They (central banks of advanced countries) should pay attention to it and they should not say our monetary policy is our problem, you (EMs) deal with it. They should be more sensitive to the problem that their actions cause.

That said, to the extent that tapering reflects a stronger US economy, that is beneficial because our exports will pick up. The worst thing that could happen is a tapering which happens when the US is not strong/not strengthening and it imposes costs on the rest of the world, which it is.

As for raising interest rates to prop up the currency, that is done so that the money comes in to benefit from the higher rates. But when your currency is depreciating, you have got to raise interest rates a lot — see what Turkey has done and that creates its own difficulties over time.

We raised interest rates, truth be told, not because others did it, but because we believed that maintaining the value of the rupee by lowering inflation is the best way and satisfy both internal and external constituencies. Our focus was on internal constituencies — our inflation rate is hurting our growth, let us bring down inflation, it will help growth and it will also help external stability. My sense is it will help because investors, especially long-term investors, now have greater faith that they won’t lose on currency depreciation the (investment) return that they made.

How prepared is our country to deal with the QE taper?

Better prepared than in May-June. Now, let me emphasise that even in May-June-July there was zero chance that we would have a Balance of Payments problem that we wouldn’t be able to finance. Even then, even at its low, we had $250 billion plus in financial reserves. We could finance even the elevated current account deficit (CAD) that was expected at that time ($88 billion last year). So long as there is confidence that the financing doesn’t absolutely dry up, we can plug the gaps. In fact, we can finance our entire CAD for three years so long as the stock — we have FIIs invested in this country — doesn’t go out. Today, we have a much lower CAD to finance. But I think the critical aspect on the external side is to get investors confidence that over time as growth resumes and as the economy picks up, we won’t erode the returns that they make through high inflation. And high inflation will necessarily cause currency depreciation over time.

So, they (foreign investors) won’t want currency depreciation to offset what they gain from investments. And I think that is precisely why what we are doing for the domestic economy is beneficial for the external economy.

In the backdrop of reversal in capital flows to EMs, what can be done to retain and attract investments?

You can’t prevent outflows. We have absolutely no intent, on the government’s side or the RBI’s side, of putting any constraints on investment money that has come in or going out.

What we do want to do is make India a more attractive place for the money to come in, which is why the government has liberalised FDI norms in many ways. We have to continue getting the fundamentals of the economy right. So long as we do that, things will work out. But, of course, there are circumstances in which economies go off-track — you saw our CAD build up suddenly because inflation was high, people were buying a lot of gold. So, the world has to be a little more tolerant of such deviations.

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(This article was published on January 31, 2014)
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