The insider

After being part of the problem, RBI’s new boss is now expected to be the solution


By Mohan Sule

The appointment of Raghuram Rajan as the new governor of the Reserve Bank of India was greeted with a giddy reception generally reserved for the coronation of a new captain for India’s cricketing squad, who is expected to lift sagging team morale. Impressive qualities were discovered, not the least his three-year stint as the youngest chief economist at the IMF in Washington and his prescient warning three years ahead of the global financial crisis. As is so typical of such rituals heralding the close of an era and beginning of a new phase, the hard knocks of the past year were attributed to the outgoing chief’s slopping fielding including failure to catch the hurtling rupee, inability to duck the bouncers thrown by speculators, and arranging the field to contain inflation rather than shaking up the opening batting lineup to speed up the run rate. The central bank has blamed speculation in the overseas markets, while the government has attributed ballooning imports of oil and gold for the woes of the Indian rupee. Currency manipulators are like short sellers in the equity market, spotting a stock whose future is likely to be worse than its present. They can also be compared with acquirers in the corporate world, hunting for undervalued preys. Unutilized cash and valuations below assets in hand reveal a driver sleeping at the wheel.

The similarities end here. Bears can drive down a currency or a stock, creating panic and pain. On the contrary, mergers and acquisitions can help a stock to regain some of its shine in anticipation of a better tomorrow. Whatever the aim, the process of beating down value or purchasing an asset cheaply hinges on the underlying weakness. To fend itself, the target can utilise its reserves to make an offer that cannot be matched by the attacker or enlist a white knight. The end result could be a hollow victory as the company may have staved off a takeover but is left depleted of its cash and could have ceded even some control. Though the RBI has not dipped into the reserves, tightening of liquidity and imposition of import barriers by the government will raise the level of stress for its citizens. Hike in FDI caps in various degrees in some sensitive sectors without paying attention to ground-level problems like dodgy infrastructure and convoluted regulations seems a desperate rather than a logical measure. Rajan can continue the process of making money costly and scarce and thereby set back the timetable for India’s recovery. He can hope that the higher interest rates could make some foreign money on its way out to the recovering US economy pause and rethink. At best, the quality of this money would be questionable. Perhaps the realization that the scope for the incoming governor to undertake radical steps to stem the fall of the rupee is so limited that the market hardly blinked. The BSE Sensex lost 0.36% and the rupee sunk 42 paise to 61.21 a US dollar the day after the announcement.

Also, despite his foreign stint, Rajan was the ultimate insider as the head of a committee on financial reforms, honorary economic advisor to the Prime Minister and lately the chief economic advisor to the finance minister. When he returned to India in November 2008, the economy was already slowing down after a spectacular 9.32% annual growth in the year ended March 2008 (FY 2008). Economic output was up just 4.99% last fiscal. Though wholesale prices are down, consumer inflation has risen 1.68% points in this period after peaking at 13.37% in FY 2010. Current account deficit has nearly doubled. The rupee was 45.91 to a US dollar end FY 2009. FDI is down by US$ 3500 million from a four-year-ago level. On the positive side, fiscal deficit has narrowed by nearly 1% point and forex reserves surged by US$ 40,000 million end last fiscal. Due to his low profile, it is difficult to know the policies that had Rajan’s stamp unlike the Sonia Gandhi-headed National Advisory Council, which is the source of the rural guarantee employment scheme and the food security legislation. What was the economist’s contribution in freeing the pricing of petroleum products? How much of his inputs were responsible for retrospective taxation on transfer of Indian assets owned by foreign companies or giving tax men the discretion to determine if foreign investors registered in offshore havens had done so to avoid tax? Has he agreed with the decision to ramp up natural gas prices? Did he concur with former Finance Minister Pranab Mukherjee’s creation of a super financial oversight body ostensibly for better coordination among various regulators but in practice an encroachment on their autonomies? With his cover of anonymity gone, the central bank’s new chief will have to take credit or discredit for his actions. Besides shoring up of the rupee, how he tackles the new round of licensing of private banks will also test his mettle.

The third chapter

The 1991 and 1997 foreign exchange crises were turning points for India’s reforms. Is history repeating?

/By Mohan Sule

The plunging rupee finally forced the Union government to shake off its policy paralysis. However, the prescription has the potential to do more harm than cure the disease. It took one (Singapore) to four (Thailand) years for the East Asian economies to recover from the depreciation of their currencies, triggered by Thailand’s move to float the bath in July 1997. The Asian Tigers were running large current-account deficits. Some of them had foreign debt in excess of 100% of GDP. Compounding the problem was the recovery in the US. The resultant increase in interest rates by the US Federal Reserve proved to be a magnet for foreign funds. As a counter-attack, most ramped up interest rates to stem the flight of capital. The IMF had to step in with US$ 40-billion infusion to stabilise the region, particularly Indonesia, South Korea and Thailand, in exchange for austerity measures. The collateral damage was the end of the 21-year-old reign of President Suharto of Indonesia as the depreciation of the currency resulted in sharp increase in prices. In India, which was undergoing political uncertainty as minority coalition governments had twice lost the vote of confidence between 1996-08, the rupee dropped 12%. The nuclear test carried out by the two-month-old BJP-led government in May 1998 resulted in international sanctions, end of assistance from the World Bank and Asian Development Bank, and downgrading by credit rating agencies, leading to withdrawal of foreign funds. The Reserve Bank of India had to increase its lending rate by 2% points to 11% and the cash reserve ratio by 50 basis points to 10.5% .The State Bank of India had to issue US$ 4.2-billion sovereign Resurgent India Bonds to stabilize the rupee.

Even then the Indian currency depreciated 16.7% in the 10 months to June 1998. Yet, the impact was not severe. External debt as a proportion of GDP (25%) in 1996–1997 was meager compared with that of Indonesia (61.3%) or Thailand (62%). GDP growth dipped to 4.8% in 1997–1998 but rose again to a healthy 6.5% next year. By the end of 1999, foreign exchange reserves were adequate to cover six months of imports. Even the current account deficit fell to just 1% of GDP. Is history repeating? And will India bounce back again? Take the ingredients. India is grappling with foreign debt as high as 20% of GDP. Foreign funds are exiting on the Fed’s hints of an end to the easy-money policy. There are two options to support the currency. The first is to bring down the fiscal barriers to foreign fund inflows and raise import tariffs to conserve foreign exchange. Telecom has been opened to 100% FDI and insurance to 49%, though the cap in the aviation and defence sectors has been left untouched. The downside is that there is a lag effect before big-ticket investments start coming in. There could be a gap between intention and execution. Despite opening multi-brand retail to 51% FDI, global supermarkets are still waiting and watching as this is a state subject. Also, opening up the economy is meaningless if investors face constant insecurity about pricing, sourcing of raw materials, and tax issues. Foreign investors will have to weigh the cost effectiveness of buying into an Indian company or going it alone. Worryingly the government is toying with more import penalties apart from making overseas gold costly. This could push demand underground and fuel inflation.

The second route is using monetary tools including ramping up interest rates to attract capital. The RBI has indirectly hiked interest rates by 200 basis points and tightened credit outflow. This action had an immediate impact. The rupee appreciated above the 60 level but bond prices plunged, adversely impacting the income of banks and retail investors. Companies will have to borrow at higher rates, too. Besides pressure on the margin, non-performing loans could rise as recovery gets postponed. The equity market might not get the inflows looking for higher yields. Yet there could be a silver lining. The crisis has been a warning that populism is not a substitute for pragmatism. The huge domestic market is no doubt an attraction, but foreign capital cannot be taken for granted. Investors would stay invested as long as returns are appealing. For that to happen the economy has to grow at a steady clip. To facilitate expansion, regulations have to be so tailored that there is transparency, quick and just grievance redressed mechanism, and absence of shocks such as stalling or reversing of policies to meet short-term objectives. Just like the 1991 forex crisis, which sowed the first wave of reforms, and the 1997 currency crisis, 2013 could well be a turning point in the process of unshackling India.

Back to future

Controversies such as pricing of gas and sovereign guarantee for a private
deal become irrelevant in a capital-starved economy

By Mohan Sule
Reform has become a fashionable prescription for economic woes. The one-size-fits all solution is offered for all sorts of headwinds facing a country including growth slowdown and surging inflation. There seems to be surprising unanimity that undertaking structural changes would enable a country to come out of its misery. Yet there is no consensus on what constitute reforms. Take the slump in the US economy following the failure of big banks. Liberals backed the US Federal Reserve’s decision to loosen money supply to ensure that lack of liquidity did not hamper risk taking, considered vital to boost expansion. The downside of this strategy is formation of asset bubbles. Conservatives protested, finding virtue in cutting public expenditure to balance the budget, which would support lower interest rates and thereby encourage capital expenditure. The flip side of this approach is invitation to recession. No wonder reform has become a loaded word. For proponents of free market, withdrawal of government from running businesses is an essential ingredient even though this may lead to strong players overwhelming the market. At the other end are those who hold government responsible for creating jobs, keeping prices low, and ensuring affordable housing despite the danger of snuffing out the animal spirits of entrepreneurs. It is when neither system is able to achieve the desired result that there is a clash, with either side wishing for just that much supervision or back-off by the government but not able to agree to the extent of this meddling or non-meddling. The issue has once again come center stage in India following two decisions of the government.

The Supreme Court in its wisdom has classified natural resources as the country’s assets, thereby consigning its monitoring to the government. This could be viewed as an assertion that government has a role to play even in the reforms process or a setback to the concept of letting markets take care of demand and supply. Subsequently, the government okayed hiking the price of natural gas to bring it on par with international level and airline seat capacity on the Gulf route to attract foreign investment. On the face of it, the government is exercising its discretion to effect these changes, which it feels are crucial to carry forward the reform process. Embedded is the contradiction: government presence is sought to check price rise and protect indigenous interests. Higher gas pricing is bound to have a cascading impact on end products. Investors in domestic airports and airlines will see a large chunk of lucrative traffic shift to foreign shores. The end result, as per the government’s justification, would be more gas as well fertilizer and power output to fuel the growth engine and restoration of the health of the airline sector as Jet is the market leader. Thus, the pricing of gas and backing for an aviation deal between two private parties symbolise the unintended consequences of the reforms process that came to the fore during the launch of PSU divestment. To ease pressure on interest rates, investment spending has to shift to the private sector. Divestment of PSUs is an important component of this process. Investors, however, will participate enthusiastically if they have the freedom to a market their products and services. It is at this point that the tug-off between striking a balance between public good and private initiative becomes pronounced.

The example of the US government in bailing out bankrupt banks with tighter operating rules shows the advantages as well as the disadvantages of an economy where the private sector is asked to thrive under increasingly restrictive regulations. To prevent monopolies in the telecom market, policies frown on consolidation and pricing is reviewed by the regulator periodically. Yet the liberal grant of 2G licences in 2008, which can be viewed as an effort to encourage competition so integral to reforms, invited the SC’s ire. The net effect is an industry stunted by uncertainty. Unsure of the regulatory landscape a few years down there is no surprise that foreign investors like UAE national carrier Etihad are insisting on sovereign guarantee to avoid future uncertainty. Now 100% foreign direct investment has been allowed in telecoms, a policy that was resisted for so long because of the sensitive nature of the sector. So the initiation of reforms by allowing private investment in hitherto prohibited sectors but checkmating investors from undue profiteering by keeping them on a tight leash is racing to a conclusion that was sought to be avoided: the slow but sure crumbling of entry barriers is diminishing the power of intervention. In a throwback to the post 1991 opening up to stave off an economies crisis triggered by the drying up of foreign capital, any doubts about the side effects have been rendered irrelevant.