India's New Central Bank Governor Will Need Serious Political Skill

Op-ed in the Financial Times

August 7, 2013

As the next governor of the Reserve Bank of India (RBI), Raghuram Rajan, the professor turned policy purveyor, will be stepping unto the breach of India's besieged economy. Economic growth has decelerated sharply, the fiscal deficit is about 10 percent of GDP, inflation has remained elevated at close to double-digits for over three years, and the current account deficit has widened sharply to unsustainable levels.

Short-term investors have fled. Perceiving an uncertain, unfriendly regulatory regime, long-term investors are wary of stepping in. As a result, the rupee keeps plummeting, imparting a distinctly pre-crisis reek to the Indian economy. As if this were not enough, the country is also gearing up for two bouts of elections within the next nine months. The likely strategy for the ruling Congress party is to blanket rural India with money to counteract a possible swing toward the opposition leader Narendra Modi in urban India. Fiscal prudence could be a casualty, further burdening the RBI and endangering the macroeconomic situation.

So what should Rajan—an academic coauthor of mine—aim to do? His immediate objective will be damage control. First, he will need to restore calm to the currency market, which will allow investors to return in sufficient strength to finance India's external borrowing needs of about $25 billion in the next six months. That will head off a crisis that the country can ill afford.

A second damage control exercise relates to awarding new banking licenses—a task that the government has charged the RBI with performing. Substantively, the RBI has to reconcile two competing tugs. From one side, the banking system, dominated by public sector banks, needs private sector vitality. From the other, awarding licenses to some big, prominent industrial houses will further entrench their economic and political power.

The trickier issue with these licenses is in the short run. The RBI will have to fend off pressure to award licenses not to the merit-worthy but to greasers of the election war chest. This government had become a rentiers' raj because of the corruption in the allocation of scarce resources such as mobile spectrum rights, land, and coal. In the months ahead, the RBI will have to keep the allocation of banking licenses honest.

How much can Rajan do? On the macroeconomy, not very much. Like all central banks, the RBI has no control over the fiscal deficit and little control over its external counterpart. The RBI can reduce inflation through its control over interest rates and liquidity. But the puzzle is that in the past few years there has been no real clamor to reduce inflation. Indeed, all the pressures on the RBI are to avoid choking off growth by enacting tighter policies. The difficulty in resisting these pressures is also the reason the RBI cannot defend the rupee. Investors simply shrug off the tightening, not believing it is here to stay.

But Rajan can instill calm by clarifying key objectives (price stability, not the level of the rupee); avoiding flip-flops; focusing on broad policy instruments rather than targeting particular segments of the financial market or actors; and daring to sustain and defend uncomfortable choices such as tightening, should they prove necessary.

This same independence will be important in awarding bank licenses. Central bankers gain credibility by taking tough decisions; Rajan is bound to be a beneficiary if licenses are awarded through a transparent process. The RBI, one of India's few respected public institutions, must be beyond reproach.

With a firm hand on the tiller, Rajan can help stave off a financial crisis; but he cannot afford to be so successful and create so much calm that politicians revert to being fiscally reckless in the run-up to elections. Until the elections, he might want to stay his hand. Once they are over, he can go on to the more normal reform agenda: modernizing the institution, improving communications, strengthening regulations, developing markets and promoting financial inclusion. He has more academic heft than necessary to run the RBI. The question is whether he has sound judgment and political courage. After all, effective central bank leadership is often an unpopularity contest.