Given it was his committee that recommended India move to inflation-targeting, new RBI Governor Urjit Patel is expected to be an inflation hawk. Yet, given the new monetary policy framework allows inflation targets from 2% to 6%, Patel would do well to keep in mind the limitations of monetary policy. In a period of high food inflation, rigid inflation-targeting would imply an exceptional squeeze on other sectors. Similarly, as a recent IMF working paper by Prachi Mishra, Peter Montiel and Rajeswari Sengupta points out, India’s small formal financial sector “limits the reach of monetary policy, thus reducing its impact on the economy … it is therefore clear that India operates in a very different domestic financial environment than that which tends to characterize advanced and emerging economies”. The authors go on to say their results “provide no support for the second step of monetary transmission, or any effect of monetary policy shocks on aggregate demand, as recorded either in the IIP gap or the inflation rate”. And those who believe it was Raghuram Rajan’s high repo rates that curbed inflation would do well to read Sajjid Chinoy, Pankaj Kumar and Prachi Mishra’s paper that brings out how difficult it is to figure out what caused disinflation over the last few years—while their model shows the ‘new regime dummy’ for inflation-targeting has the greatest impact, they concede it could be capturing other factors like the impact of the dramatic fall in oil prices.
More than that, Patel will be judged by how he carries on with the Rajan legacy on bank NPAs. While Rajan forced banks to recognise dodgy loans, not only have NPAs continued to rise despite measures taken by the government to fix the problems in different sectors like steel, and banks have not really made any meaningful strides in terms of getting rid of these assets. Along with the government, Patel will have to come up with solutions that encourage bankers to take large haircuts and sell these assets.
Urjit Patel Begins 3-Year Term As RBI Governor by FinancialExpress
A related issue will be the demand to use RBI capital to fund a faster clean up of bank balance sheets. As the Economic Survey had pointed out, RBI’s equity capital which equals a third of its balance-sheet is much higher than the ECB’s 20%—indeed, central banks in the US and the UK work with less than 2%. If Rs 2 lakh crore of this is used for setting up a bad bank to buy the bad debts of PSU banks, RBI will still have an equity-to-asset ratio of around 25%. FE has earlier argued that nearly two-thirds of RBI’s equity capital of R9 lakh crore is in the form of Currency and Gold Revaluation Account (CGRA) and a tenth is in the Contingency and Asset Development funds—the CGRA, however, isn’t real money, it is the un-realised gain/loss in the value of gold and foreign exchange RBI holds based on movements in their value. So, if this money is to be used, effectively it means the central bank will have to create fresh money—or finance the government deficit, a practice ended a long time ago—which is inflationary. How Patel views this is not known, but while Rajan favoured this as chief economic advisor, he publicly denounced it as RBI Governor—Patel would do well to set up a technical committee to examine the idea at the earliest.