Opinion Towards a new RBI

On September 20,Rajan came in to bat again. Surprising everyone,he sounded no different to his predecessor D. Subbarao,and no different than what the IMF would have said. The fact that he indulged in deep IMF-speak is not necessarily indicative of scoring few runs. After all,it was as an IMF chief economist that Rajan was prescient in his forecast that the world economy was heading towards a crisis. But his second innings at the RBI was a dud,as he flailed about scoring (charitably) less than 10 runs. There have been only 17 batsmen in Test history who have scored a debut century and followed it up with a single digit score in the second innings. Not an auspicious beginning for Rajan; however,in this select club is W.G. Grace,who scored 152 on debut and 9 in the second innings. And the betting should be good that Rajan can be,and likely will be,an economist’s Grace.

There were several inconsistencies that were responsible for Rajan’s low score. What has US tapering or no tapering got to do with Indian inflation,where most of the inflation is due to food,and when much of the food inflation emanates from administered minimum support prices? It is true that the taper provides incompetent governments with an excuse for their domestic failures,but for Rajan to offer this exscuse was a snick that did not carry. He seemed to be worried about the recent rise in WPI inflation “as the pass through of fuel price increases has been compounded by the sharp depreciation of the rupee and rising international commodity prices”. There is precious little the RBI can do about price increases beyond its control,like domestic food and international commodity prices. And was the depreciation of the rupee to near 70 because of the inevitable possibility of the US taper?

There were other snicks in Rajan’s presentation,like the undue haste with which he raised the repo rate by 25 basis points. Just recently,he has argued that interest rate policy is a weak instrument to encourage growth. This might be his view on tapering,but good central bankers around the world have consistently believed that both fiscal and monetary policy matters,and matters for both growth and inflation. In any case,logical consistency would dictate that a lowering of repo rates is equally ineffective. But lowering repo rates would have helped confidence,and some investment. So why not do it? Given the economic circumstances (see below) Rajan’s attempted drive for applause as an inflation hawk most likely backfired. Rajan could have achieved his goals better with a different emphasis,a different speech and a slightly different policy. This is what I would have said.

My first task as RBI governor is to help resurrect the Indian economy,to gradually bring it back to its normal and/ or potential. While estimates of normality vary,everybody admits that a 4.5 per cent GDP growth rate is subnormal,and a 10 per cent inflation level is way above normal. Indeed,one can make a reasoned argument that part of India’s growth problem is the high inflation level. While I do not believe in targeting the exchange rate,it is also the case that many businessmen and economists believe that a rupee at 67 to the US dollar (value on my first day as governor) is unreal.

On July 15,the RBI initiated a series of measures to help contain the rupee to a value below 60. The number one achievement of these measures was to achieve zilch; number two,to render impotent the repo rate. As you know,these RBI measures were consistent with an alphabet soup — pick any three letters and you will have a policy. MSF,CRR,SLR,LAF,etc — even I don’t remember all the combinations the RBI and/ or the ministry of finance dreamed up. Most people said on July 16 that these policies would be a failure,and spectacularly fail they did. The rupee went as high as nearly 70,confidence was dented severely and even fewer people believed that the government had any clue about monetary or fiscal policy. What did the RBI achieve? A 300 basis point increase in the effective cost of funds. And this on top of industrial growth,which has averaged -3.1,2.9 and -3.5 per cent since April 2011!

The first and most important lesson of policymaking is the following: learn from your mistakes. To make a mistake is human,to continue believing that the mistake was the right thing to do is arrogant stupidity. So my first policy goal is that effective today,we are going back,monetarily speaking,to the world that existed before the RBI’s “night of the long knives”,July 15.

I have been reminded by some that this action would have meant a drastic “reduction” of borrowing rates. How can interest rates be cut by 300 basis points in one go? The same way they were raised in one go. A mistake is a mistake. The eventual goal is to have one policy instrument — the repo rate,and a sensible level of the rate. This will take time,but the journey has started.

There is another objection to getting back to July 15,ex-ante. It is that given double-digit inflation,shouldn’t interest rates be raised? India’s double-digit level of inflation is of paramount concern. CPI inflation averaged 8.4 per cent in 2010. After the RBI started tightening policy rates in 2010,CPI inflation has recorded 9,9.9 and 12.9 in 2011,2012 and 2013 (till August). This suggests that the Indian economy is topsy turvy and upside down — the RBI raises interest rates and inflation goes up!

We know that killing demand should not mean higher inflation. While food inflation has zoomed up,non-food core inflation has systematically declined — from 9.6 per cent rate in 2011 to 7.6 per cent in August. My dream is to make the RBI the number one macro policy research organisation in India (and just like the US Fed). It is high time policy was informed by research,or PIR in short. (No coincidence that pir also means a wise person in Punjabi and Hindi). PIR should emerge as our most effective policy instrument.

The first task of PIR,and the new RBI,will be to study the determinants of inflation in India,and reconciliation of and explanations for the unusual phenomena of the CPI showing consistently higher rates of inflation than either the WPI or the GDP deflator. I have asked my staff to comprehensively answer the question before the next RBI meeting: What is going on with Indian inflation data and Indian inflation? Only after I receive their report will I decide on the future course of the single policy instrument — the repo rate. Watch this space — and we are not in the old-fashioned and outdated central bank game of surprises. There will be no mystery about what the new RBI is looking at: growth,core inflation and the rupee.

The writer is chairman of Oxus Investments,an emerging market advisory firm,and a senior advisor to Zyfin,a leading financial information company.