Column: Christening by fire

Written by Rajiv Kumar | Updated: Aug 27 2013, 08:21am hrs
This is indeed a christening by fire for Raghuram Rajan as he steps into the top job at Mint Road. Growth and employment are falling; retail inflation remains stubbornly high with food inflation in double digits for the last 60 months; and to complete the trilemma, the current account deficit threatens to remain above 4% and the rupee, having declined 15% in the last three months, seems to be in danger of getting into a free fall despite the incredible rise on Friday, August 23. It really couldnt get tougher for an incoming Governor.

Going by his amazing credentials, there could hardly be anyone better equipped to take on this challenge; moreover, he has also authored a full-fledged report on the Indian financial sector reforms that would have given him a first-hand feel of the issues, challenges and reforms for the banking and financial sector. There are not too many people who are given the opportunity to implement what they have preached. And so the Governor should simply go for implementing his own recommendations and liberalise the banking and financial sector; introduce an arms length regulation with a lighter touch; make RBI a more market-friendly regulator; and consolidate fragmented capacities that presently characterise this sector. These reforms have long been in waiting and need immediate attention.

The minor hurdle he has to overcome before he can get down to implementing these reforms is to stop the ongoing haemorrhaging of the external account, halt the slide in rupees value, and get the economy out of its downturn, which threatens to become long and deep. At the present juncture, this may not be easy even for a man with his talents, because the task will presumably become even tougher as the electoral cycle enters its final phase and populist pressures become unrelenting. I wonder about his response when he suddenly finds that his former bosses and colleagues in the North Block or across the road in the PMO do not agree with either his diagnosis or prescriptions or both. The gulf between Mint Road and Raisina Hill is often far more than mere geographical distance. They can be poles apart. He would require all his skills at coalition building to get the job done. Lets hope that having worked in the IMF and as PMs special advisor should have given him persuasion and coalition-building skills as well.

The first step in bringing back macroeconomic management to some order would be for him to admit that the economy is in crisis and better still show some contrition on behalf of all of his former and present colleagues who have persisted in their denial of such a crisis. A straightforward mea culpa would begin to restore the credibility of the government, which today is at its nadir. He can afford to do this because he is one step removed from party politics, does not have to face irate and partisan MPs in Parliament and, as a technocrat, is expected to exclusively safeguard the countrys economic health. To continue blaming external conditions will only worsen the situation.

Second, he would do well to strongly advocate structural reforms that are needed today to restore investors confidence and stop the capital flight as reflected in the continuing demand for gold despite the imposition of the 10% import duty. While major confidence restoring measures lie outside his mandate, he should cajole and plead with the North Block and other ministries to do the right things. But he should appear to be reading from the same script as the finance minister and his former colleagues, because any spat, even if minor, between the North Block and Mint Road causes avoidable confusion and impairs investors confidence. However, he will do well to maintain his distance from the Vigyan Bhawan annexe (Prime Ministers Economic Advisory Council) from where he will only hear calls for clamping down on aggregate demand to bring inflation down below 5% even it that results in the economys demise.

A point for him to note would be that RBIs permission for banks to hold until maturity government securities under SLR, rather than mark them to market, combined with some open market purchases brought immediate relief to the market and did a lot to dispel the sense of deepening crisis in financial markets. So, perhaps, further liberalisation is required rather than continued demand repression. There are several arrows in the monetary policy quiver that can be used to signal that RBI is serious about restoring growth and one of them could be to reduce the CRR and encourage banks to reverse interest rate hikes and start disbursing credit. He should be aware that some banks are presently hoarding liquidity and not releasing credit even against sanctioned amounts causing undue stress.

Third, he may want to look at some rather nitty-gritty measures that will bring in investment into the priority sectors, which have strong multiplier effects. For example, the proposal for permitting housing finance companies to access long-term external commercial borrowings was hanging fire for 11 years. One year ago it was cleared but the NBFCs that applied for such ECB access have seen their applications shuttling between RBI and the National Housing Bank and clearance is still awaited! What a pity indeed as bringing long-term dollars into the housing finance sectors, of course with all due prudential regulations, would have multiple beneficial effects on investment, growth and employment.

Fourth, it is perhaps too much of a minutiae for the Governor to know that while commercial banks are allowed to include housing loans of up to R25 lakh per loan in their priority sector lending, this limit comes down to R10 lakh when the banks do so by off-loading the lending to NBFCs, which nearly all commercial banks do because the NBFCs are more efficient at disbursing these lower value home loans. Further, education loans are not included in the priority sector at all if given through the NBFCs. These anomalies need to be done away with and it is time RBI extricated itself from such micro-management of the banking sector.

Fifth, it is not clear to me why RBI should be running its own banking subsidiaries. This surely dilutes its attention from regulatory and monetary policy responsibilities. And while he is divesting RBIs holdings in these banks, he may as well recall RBIs representative from SBIs Board of Directors, even if the outdated SBI Act requires it. I have observed this anomaly for the past five years and seen corporate governance in the largest commercial bank becoming a bit of a shadow play. What else could one expect when the owner of the SBI represented by secretary, financial services and the regulator (deputy governor of RBI) are both present on the Board! The remaining independent directors simply dont matter even if they try. Most give up fairly early anyway. I am sure this is true of other commercial banks as well. Raghuram Rajan would do well to improve corporate governance in the banking and financial sector to set the right tone for the new banks.

Perhaps it is also time for him to push really hard to have the amendment in the banking sector law that precludes government share from coming down below 51% in the public sector banks. Is it not in line with his own recommendations from an earlier avatar This is quite an agenda for the incoming Governor to handle but lets hope he will rise to the task. A lot is riding on that.

The author is senior fellow, Centre For Policy Research