The Unfinished Agenda of Raghuram Rajan

Think increasingly the job of (a central bank) governor in a modern economy requires somebody with, if not training in economics, but a very good understanding of economics and finance and banking. They (governors) have to have a sense of the whole thing. If you are a macro economist, but don't understand finance and banking, you could be out of your depth very soon on the regulatory front."

Raghuram Rajan, 23rd governor of the Reserve Bank of India (RBI), was explaining what was required to head a central bank to Business Today. He had completed about two-thirds of his term as governor. And it was his second meeting with the magazine, the first having taken place six months earlier. His candid opinion on a range of subjects, which would lead many government officials and members of the BJP and RSS to criticise him, were still to come, but how he wanted to reform the overall financial system was already apparent.

Rajan had already made his presence felt at RBI and on the financial reforms front within those two years. He had made the monetary policy sharply focused on consumer price inflation (CPI). This was a departure from the past because earlier RBI governors used the monetary policy sometimes to tame inflation, and sometimes to intervene in the currency markets to keep the rupee value fixed. Moreover, when they used monetary policy to tame inflation, it was the wholesale price index (WPI) that would be taken as the target. Rajan had proposed shifting to CPI because that was what affected the bulk of the country's population, and not just the industrialists. He firmly believed that unless inflation was well below the fixed deposit rates, the saving class would see no return on their money.

Equally, he believed that while a central bank could intervene in currency markets to prevent excessive volatility, the tides and ebbs of global inflows made it impossible for a central banker to manage the nominal exchange rate beyond a point. In fact, he was focused on creating a monetary policy committee in line with his Deputy Governor Urjit Patel's recommendations to institutionalise the process of setting interest rates, and making sure that it would not let consumer inflation get out of hand. "It puts some discipline on the monetary policy setting process so that you have some clear objectives and try to deliver on them," said Rajan. That was probably the reason why self-made, successful entrepreneurs such as N.R. Narayana Murthy rooted for not one more term, but two for his exceptional track record in steering monetary policy. "I mean the results are there (for everyone to see)," said the Infosys founder to a news daily.

But the monetary policy was only one part of the changes he wanted to bring to the overall financial system. In the time he had been on the saddle, he had also issued two new universal banking licences (in line with his view that competition in banking helped the system become more efficient), developed guidelines for on-tap universal banking, and introduced two new types of banks into the system - the small finance banks and the payments banks.

The small finance banks were meant for the small borrower - and Rajan saw them as essentially taking the place of micro lenders in the long run. If it worked out well, he expected small finance banks to eventually replace the trouble-prone and relatively less regulated cooperative bank system. He had also set up a high-powered committee to see if the large, well-run cooperative banks could become universal banks instead. He was not comfortable with the concept of cooperative banks because the RBI did not have full control over them.

The transactions bank licences was an equally radical experiment he was embarking on. Rajan was not entirely sure that it would work out well - but if it did, he expected it to dramatically increase the reach of the banking system in the country and make it easier for poor people to transfer money to their relatives. The transactions banks idea was to take advantage of the rapidly evolving digital fintech technology. "RBI has become quite an exciting place to work in because of all the new initiatives. You can now attract people from all kinds of backgrounds," says Shyamala Gopinath, Chairman of HDFC Bank and a former RBI deputy governor.

The third area of his focus - the cleaning up of bad loans - had also started, though Rajan would change course and approach it over the next year. In his first year, he had exhorted banks to recognise stressed assets earlier and to sell as many bad assets as they could to asset reconstruction companies (ARCs). In the process he had revitalised the asset reconstruction industry (see Money from Junk, in BT's August 2, 2015 issue), though he soon realised that it wouldn't be enough to tackle the full extent of the bad loan problem. He had introduced the strategic debt restructuring initiative a few months earlier - in June 2015, to allow banks to take equity and change managements. But his all-out war on bad loans by pushing them to make higher provisions and giving them a deadline of March 2017 to clean up their books was still to come.

But essentially, Rajan did not see his role as only being in charge of the monetary policy. His earlier engagements with the government - as the chairman of the Raghuram Rajan Committee on Financial Sector Reforms in 2008 and, later, his stint as the chief economic advisor to Finance Minister P. Chidambaram (August 2012 to August 2013) had made him eager to reform the financial sector and transform the RBI itself, and make it a more modern central bank in line with the best central banks around the globe. He wanted to make a host of other changes including opening up and deepening the bond market to attract global investors into both corporate bonds as well as government securities, and set up a specialised unit within the RBI to spot financial frauds early on. He wanted to push financial inclusion, basing his approach on the Nachiket Mor committee report.

Much like his immediate predecessor, Rajan had taken over at a difficult time for the Indian economy. Duvvuri Subbarao, the 22nd governor of RBI, had taken over just a week before the global financial crisis erupted in 2008. Although India had managed to avoid a banking crisis like the one that engulfed the rest of the world because of Yaga Vengugopal Reddy's (21st governor of RBI) calibrated approach to financial reforms and the tough lending standards that the latter had imposed on Indian banks, the country was not fully insulated from the global storm. Subbarao, during his five-year stint (2008-2013) had to deal with a decade-high stubborn inflation that started in 2009, followed by a sharp fall in the rupee starting mid-2012. Both Reddy and Subbarao had recognised the need for reforms in the financial system. Reddy had been the first to coin the term financial inclusion and propose a calibrated, slow opening up of the financial sector. Subbarao had his hands full with crisis after crisis, but he had commissioned reports on creation of a monetary policy, initiated the steps to give out new universal bank licences and taken other steps including tighter regulation of NBFCs. Neither, though, had the liberty of embarking on big changes in the financial system.Rajan took over when the rupee seemed to be in a freefall and inflation remained high despite the repeated interest rate hikes that Subbarao had implemented. In fact, Rajan's first monetary policy review saw him increase the bank rate to combat inflation, even as the then finance minister (Chidamabaram) was hoping for a cut after Subbarao's departure. (Chidambaram's main grouse with Subbarao had been that the latter refused to cut rates even though economic growth was sliding and the finance minister wanted a rate cut to spur growth once.)

He fixed the sliding rupee by introducing the FCNR (foreign currency non resident) deposits - where banks mobilised over $30 billion of dollar deposits from overseas markets. RBI took the dollars and issued equivalent rupee resources with a promise to return dollars after three years with a 3.5 per cent hedging cost. Meanwhile, luck played a role on the inflation front. Sliding oil and other commodity prices had already resulted in wholesale price inflation starting a steady fall. (WPI was at 7 per cent when Rajan took over but turned negative by November 2014 and has only in the last quarter returned to positive territory.) While the commodity price drop did not affect the CPI as much as it did the WPI, a combination of high rates and some government action had started cooling it.

But within a few months of Rajan taking over, the bad loan problem had started becoming apparent. He inherited the bad loans problem because of both global financial turmoil, some lax lending by public sector banks and, finally, the urge of previous finance ministers to push up growth. In the run up to the 2008 crisis, the global economy was booming, as was the Indian economy, and huge optimism was in the air. As Rajan himself pointed out in a talk to Assocham in Bangalore: "A number of loans were made in 2007-2008. Economic growth was strong and the possibilities limitless. Deposit growth in public sector banks was rapid, and a number of infrastructure projects such as power plants had been completed on time and within budget. It is at such times that banks make mistakes. They extrapolate past growth and performance to the future."But if the boom prior to the 2008 crisis was responsible for some of the bad loans, a bigger chunk took place because of the steps taken by the UPA government to revive the economy. As growth slid, the then finance minister Pranab Mukherjee tried to stimulate the economy in 2008/09 by loosening the fiscal deficit. Over the next few years, the government would actively encourage industrialists to take big loans and kick off big projects in the infrastructure sector. Eventually, most of these loans turned bad as projects failed to take off or get completed on time, and demand did not pick up as expected in a range of sectors.

By 2014, Rajan had started actively monitoring the bad loans crisis, setting a target to clean up the system. Two other objectives that he had set had taken a bit of a back seat, at least as far as most observers saw it - broadening and deepening the financial markets and increasing their liquidity and resilience so that they can help allocate and absorb the risks entailed in financing India's growth, and expanding access to finance for small and medium enterprises, the unorganised sector, the poor, and remote and underserved areas of the country through technology, new business practices, and new organisational structures.

Rajan's overarching focus on cleaning up bad loans brought him increasingly at loggerheads with his critics and others who advocated other priorities. His comments on the need for the finance minister to maintain fiscal discipline, his views on Make in India, on the new growth statistics released by the government, and on a number of other topics had also started raising temperatures among his critics. The sharper public attack against Rajan came when Subramanian Swamy entered the Rajya Sabha in April this year. Swamy attacked Rajan and wrote to the PM that Rajan is not fit to be RBI Governor. "The concept of containing inflation by rising interest rate is disastrous," said Swamy. Some finance ministry bureaucrats also accuse Rajan of being late in tackling the NPA problem. There were also voices of support when Rajan abruptly decided to leave RBI. M&M Group Chairman and MD Anand Mahindra, while acknowledging that Rajan substantially improved Indian's international credibility, tweeted: "We must not give the impression that there isn't sufficient talent in the country to succeed him and sustain India's credibility."Everyone agreed that Rajan was an exceptional, globally recognised economist, but many did not think it was part of his brief to comment on macroeconomic policies of the government. They also thought that his focus on cleaning up and disciplining state-run banks before anything else was too rigid a stance and hurting the economy.

As Rajan said recently in a speech in Bangalore at an Assocham forum, if he were to make a choice between cleaning up bad loans and growth, his advice to banks would be to clean up first - and growth would follow. Rajan wanted to make the public sector banks with their bad loans get ready for the BASEL IV norms, which would kick in by 2019. And he wanted the government to reduce its interference with the banks it owned once the books had been cleaned up and fresh capital injected. The way Rajan saw it, the PSBs needed better regulation and lesser political direction or oversight.

But not everybody has been comfortable with those views in the government and outside. His insistence on cutting interest rates slowly was already seen as a hurdle to faster growth of the economy. But that tussle and friction has always existed between Mint Street and North Block. Finance ministers often see lower interest rates as a prerequisite to boosting growth, while central bank governors in India invariably see lower interest rates as the precursor to all sorts of problems from asset bubbles to higher inflation hurting consumers. In the past, Chidambaram and Subbarao had sparred over interest rates and it was no secret that Jaitley and bureaucrats in the finance ministry would have preferred interest rates to be reduced quickly, especially as WPI was in negative territory and CPI itself had halved. On the other hand, Rajan is a bit of an interest rate hawk and he firmly believes that low interest rates and easy money of the kind that central bankers in the west followed was the prime reason for the 2008 crisis (along with lax regulation and increasing sophistication and complexity of financial instruments). "I have yet to meet an industrialist who does not want lower interest rates, whatever the levels of rates," Rajan once joked.

But the speed of lowering interest rates would not have been the major discomfort if it were not accompanied by two other stands that Rajan took. The big one was, of course, the war on bad loans, which put enormous pressure on the government. The Modi government and especially the finance ministry had already initiated a number of steps for a cleanup of the books of the PSBs. The biggest among them was the enactment of the Bankruptcy Act, which is expected to ensure quicker resolution of bad debts and allow lenders to take over assets and liquidate them quickly. But the Rajan war also ensured that the government had to find capital quickly to recapitalise all the banks it owned at a particularly difficult time for the government finances. The finance minister had committed himself to sticking to the strict fiscal deficit targets while simultaneously boosting economic growth and alleviating the distress of farmers after two consecutive drought years. The Rajan war on bad loans would only increase the need for the government to cough up fresh capital, while the RBI governor seemed disapproving of some of the possible options the government was proposing.

For example, the government has been mulling the creation of a bad bank that would hold all the NPAs of the public sector banks but Rajan did not think much of this proposal. Also, Chief Economic Advisor Arvind Subramanian had mooted the idea of using RBI capital to recapitalise the PSBs, but Rajan thought it was a bad idea. His view is that the government should instead use the dividends RBI gives it, instead of dipping into the capital itself. The fact that Rajan spoke his mind on a range of subjects and was often seen to be critical of government policies -- ranging from his views on Make in India to his comments of India being the One Eyed King in the Kingdom of the Blind when it came to economic growth -- did not go down well with a range of people who had been used to more discreet governors.

At any rate, it is not yet public what happened between June 7 and June 18. On June 7, Rajan was telling journalists that he would not spoil their fun by giving them news whether he was going to remain RBI governor or not. The message at least for the world at large was that Rajan fully expected to get a fresh term, and he was not averse to taking it. On June 18, he sent out a mail to RBI employees that after due consultation with the government, he had decided to return to academia when his term ended on September 4. Whether the government had indicated to him that he would not get another term or whether he was simply sick of Swamy's attacks, which the finance minister and the prime minister had not condemned in public, or whether his conditions for a second term were not acceptable is not very clear. But since making public his decision to relinquish charge once his term ends, Rajan has indicated that in the remaining part of his tenure he will try and push his unfinished agenda.

However, it is unlikely that Rajan will be able to complete any of the four tasks he set for himself. The bad loans clean-up will only be half done by the time he leaves. That is, the banks may be forced to recognise the bad loans, but their resolution can happen only much after he leaves. Similarly, he has just about started deepening the bond markets - and there is a lot of work on that front to be done.

The financial inclusion initiatives and the deepening and broadening of the financial system are also work in progress. Rajan has started on them with the small financial banks and other initiatives but that has not yet started rolling out.

Finally, his efforts to turn RBI into a model central bank by bringing in outside talent, adding new divisions, and new initiatives like bringing all the regulatory functions under one division to make things more organised is still a half-way house. He had initiated setting up of a deeper research wing, while also building expertise, but as is usual in such cases, it has met with mixed reactions. Some RBI senior officials are extremely supportive of the changes Rajan is trying to make while some have also opposed the induction of outsiders laterally. "There is a sharp focus on accountability under Dr Rajan. There are timelines set. We also hold ourselves accountable," says H. R. Khan, Deputy Governor of RBI.

At any rate, it will be for his successor to decide on how many of the Rajan reforms he wants to carry forward -- and which ones are not necessary. Meanwhile, Rajan himself says that journalists have been too quick to write his obituary. He intends to come back regularly... and continue playing a role. Additional inputs from Anilesh S.Mahajan & Shweta Punj