India, Rajan and the Great Man fallacy

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Indian markets are jubilant after Raghuram Rajan unveiled a host of measures designed to support the Indian rupee. (Reuters) Indian markets are jubilant after Raghuram Rajan unveiled a host of measures designed to support the Indian rupee. (Reuters)
SummaryBy creating an essentially off-balance-sheet way for the central bank to subsidize but not completely underwrite capital flows, Rajan intelligently worked around his main problem.

Enthusiasm for new Indian central bank head Raghuram Rajan is understandable, but blind faith in him is misplaced.

While Rajan, the former IMF chief economist who took over as Governor of the Reserve Bank of India on Wednesday, made promising first steps, he simply doesn't have the tools or levers to do what is needed.

Almost more to the point, the euphoria around Rajan is evidence of the Great Man fallacy of central banking, an always foolish belief that complex events can be bent to the will of one magical civil servant.

Indian markets were jubilant, and media portrayed him as James Bond, after Rajan unveiled a host of measures designed to support the rupee. Bank shares soared by 9 percent, the main BSE Sensex rose 2.2 percent and, best of all, the rupee rose by as much as 2.3 percent.

Rajan's raft of measures were both clever and far-sighted.

Of most immediate impact was a plan to attract investment from Indians living overseas by allowing banks access to preferential swap rates at the central bank. India thereby gets some of the money it needs to attract, banks make a nifty profit and the central bank avoids taking assets onto its own balance sheet.

By creating an essentially off-balance-sheet way for the central bank to subsidize but not completely underwrite capital flows, Rajan intelligently worked around his main problem. His predecessors, faced with what could be a ruinous and self-sustaining fall in the rupee, responded by tightening conditions to attract flows, thereby risking a credit famine and recession.

Rajan also indicated that banks should gradually be allowed to cut their now mandatory holdings of government paper, something which will make more funds available for loans to the productive private sector while imposing a measure of discipline on government borrowing decisions.

The RBI also reversed an earlier decision which further limited overseas borrowing by Indian companies, which had been a tightening of capital controls.

All of this is great, and it's easy to see why India enjoyed such a strong relief rally. That said, faith in Rajan raises some thorny issues, in and of itself.

One problem, of which Rajan is surely aware, is that the more the market respects him, the more international capital gives credit to his efforts, the easier it is for those in India with the real responsibility for change to avoid making it.

STRUCTURAL REFORM

Central banks can, by keeping inflation stable and regulating finance appropriately, create some

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