Rajan, 50, will succeed D Subbarao, who by his hawkish policy stood his ground on continuing with a tight monetary policy despite repeated entreaties from the government to ease interest rates to boost growth. Subbarao will demit office on September 4.
"Prime Minister Manmohan Singh has approved the appointment of Dr. Raghuram Rajan as the Governor of Reserve Bank of India (RBI) for a term of three years, vice Dr. D. Subbarao upon completion of his (Dr. Subbarao's) tenure," an official release said.
Rajan, a former IMF chief economist, was appointed as the Chief Economic Advisor in the Finance Ministry in August last year. His appointment as the 23rd central bank chief comes at a challenging time, when the economy is battling industrial slowdown, declining rupee, rising prices and all-time high current account deficit (CAD).
"These are challenging times for the Indian economy and the RBI and government will work together," Rajan said in a statement shortly after the announcement. "We don't have a magic wand to make the problems disappear. But absolutely we will deal with them."
Rajan noted that the RBI has a tradition of integrity, independence and professionalism.
Known for his frank views, Rajan was acclaimed for predicting the 2008 global financial crisis. In 2005, Rajan had delivered a lecture severely critical of the financial sector and argued that a financial disaster might be looming.
Rajan, who was honorary economic advisor to the Prime Minister earlier, is an alumni of IIM-Ahmedabad and IIT-Delhi. He had replaced Kaushik Basu as Chief Economic Advisor in the Finance Ministry last year.
He did his doctorate from the Massachusetts Institute of Technology. He was professor at the University of Chicago's Booth School of Business before taking over as CEA.
Rajan was also involved with the report on Financial Sector Reforms, which was authorised by the Planning Commission.
His appointment was generally welcomed by economic administrators and the industry.
"Rajan will make an excellent Governor at the moment" as he has been dealing with the problems in the last one year, said C Rangarajan, Chairman of the Prime Minister's Economic Advisory Council (PMEAC) and a former RBI Governor.
Planning Commission Deputy Chairman Montek Singh Ahluwalia said Rajan was coming in at a tough time but he has a terrific academic and professional background.
"It's a very tough time, we need someone who can give direction...the important thing is giving leadership for the next five years on how should the Indian financial system move. I think Rajan will be the best person to do that," he said.
Adi Godrej, industrialist and former CII president, welcomed Rajan's appointment, saying his experience globally and as CEA in the government would stand him in good stead.
INSTANT VIEW/COMMENTARY (Reuters)
NAVNEET MUNOT, CHIEF INVESTMENT OFFICER, SBI MUTUAL FUND, MUMBAI
"RBI has multiple objectives and several times they are at odds with each so it's very difficult to say at this stage if this person will be hawkish or dovish, but given his background and stature, this should send the right signal to investors."
ROBERT PRIOR-WANDESFORDE, ECONOMIST, CREDIT SUISSE, SINGAPORE
"He is a highly credible, experienced economist. He has no central banking background so it will be a steep learning curve. Effective credible communication with market is an important part of the job.
"The jury is out on his monetary policy views. My assumption is he will be pragmatic. Hopefully he will be a safe pair of hands."
SUJAN HAJRA, CHIEF ECONOMIST, ANAND RATHI, MUMBAI
"Rajan has previously worked with RBI as a consultant and with the government. He also has international experience with the IMF. I would think he would have a holistic view.
"He is familiar with Indian policy circles and has ground feel. We have seen people like Stanley Fischer (Israel) have played a good role as governor after coming from IMF.
"He is clearly emphasizing the need to bring back growth. He will be more pro-growth."
A PRASANNA, ECONOMIST, ICICI SECURITIES PRIMARY DEALERSHIP LTD, MUMBAI
"We welcome the move. This will give lot of confidence to the market since he is a well respected economist.
"I expect Dr. Rajan to take more steps for bond market development, set up the monetary policy committee to formulate monetary policy and separate the debt management functions of RBI, as part of these were his own recommendations.
"I expect these to happen over a period of 18-36 months. His international experience will stand him in good stead to fulfill RBI's mandate."
RADHIKA RAO, ECONOMIST, DBS, SINGAPORE
"This appointment is a positive development for the markets though it would be premature to assume that this change will mark a reversal in policies.
"The new appointee will be taking over the mantle at a challenging juncture and weighing inflationary risks, rupee depreciation and growth headwinds, he might also lean towards status quo on the rates front. Nonetheless some stop-gap measures to plug rupee depreciation might be resorted to in a bid to calm the markets."
SHUBHADA RAO, CHIEF ECONOMIST, YES BANK, MUMBAI
"Given the concerns on the external sector, the policy focus will essentially remain the same, that of containing the volatility in the rupee without jeopardizing growth in the medium to long term. While we still believe that with stability returning to foreign exchange markets, there is a case for rate cuts to spur growth and we hold on to our view of 50 bps (cut) for the rest of the year."
SIDDHARTHA SANYAL, INDIA ECONOMIST, BARCLAYS, MUMBAI:
"Raghuram Rajan seems to be maintaining a growth supportive stance in the medium term. In the long run, expectations will be there that he will lead further development of various segments of the financial markets.
"In the last two months, he has been taking a key role on rupee-related steps, and his appointment as the governor will lift expectations of constructive and positive steps to lift the rupee."
* The partially convertible rupee trimmed losses to trade at 61.35/36 per dollar from 61.45 before the announcement.
* The benchmark 10-year bond yield dropped 2 basis points to 8.21 percent.
* The stock market closed ahead of the announcement.