Enthusiasm for new Indian central bank head Raghuram Rajan is understandable,but blind faith in him is misplaced.
While Rajan,the former IMF chief economist who took over as Governor of the Reserve Bank of India on Wednesday,made promising first steps,he simply doesn’t have the tools or levers to do what is needed.
Almost more to the point,the euphoria around Rajan is evidence of the Great Man fallacy of central banking,an always foolish belief that complex events can be bent to the will of one magical civil servant.
Indian markets were jubilant,and media portrayed him as James Bond,after Rajan unveiled a host of measures designed to support the rupee. Bank shares soared by 9 percent,the main BSE Sensex rose 2.2 percent and,best of all,the rupee rose by as much as 2.3 percent.
Rajan’s raft of measures were both clever and far-sighted.
Of most immediate impact was a plan to attract investment from Indians living overseas by allowing banks access to preferential swap rates at the central bank. India thereby gets some of the money it needs to attract,banks make a nifty profit and the central bank avoids taking assets onto its own balance sheet.
By creating an essentially off-balance-sheet way for the central bank to subsidize but not completely underwrite capital flows,Rajan intelligently worked around his main problem. His predecessors,faced with what could be a ruinous and self-sustaining fall in the rupee,responded by tightening conditions to attract flows,thereby risking a credit famine and recession.
Rajan also indicated that banks should gradually be allowed to cut their now mandatory holdings of government paper,something which will make more funds available for loans to the productive private sector while imposing a measure of discipline on government borrowing decisions.
The RBI also reversed an earlier decision which further limited overseas borrowing by Indian companies,which had been a tightening of capital controls.
All of this is great,and it’s easy to see why India enjoyed such a strong relief rally. That said,faith in Rajan raises some thorny issues,in and of itself.
One problem,of which Rajan is surely aware,is that the more the market respects him,the more international capital gives credit to his efforts,the easier it is for those in India with the real responsibility for change to avoid making it.
Central banks can,by keeping inflation stable and regulating finance appropriately,create some of the preconditions for economic growth,but no matter how much they support asset prices,they do not actually create any wealth.
Thus Rajan can buy India some time,but the real task lies elsewhere.
The immediate cause of India’s distress comes from outside,in the form of the expected tapering of bond purchases by the U.S. Federal Reserve. But really that is only tightening conditions which had been left unnaturally loose for much of the world’s economy.
That allowed India to limp along quite happily with a deep current account deficit for which there was,seemingly,so long as global liquidity was deep,little penalty.
Those times are apparently about to end.
Indian growth figures released last week showed second-quarter GDP expanded at a 4.4 percent annual clip,down from 4.8 percent the quarter before and less than half the boom-time run rate. Manufacturing is shrinking,and recent steps to tighten conditions will have caused credit to contract,likely indicating that the third quarter will look even worse.
India’s real problem is that it took a pass on deep reform during its pre-financial-crisis boom and is now faced with what,in the absence of a wider tax base,feels like a structural government deficit. And India is heading into elections,never a time for painful reform.
This is the huge problem with the Great Man fallacy of central banking. It is used,by those who ought to know better,as an excuse to avoid doing painful things. Fed by credit and asset inflation under Greenspan,the U.S. failed to reckon with the hollowing out of its middle class,creating instead an economy too dependent on real estate jobs for those with fewer skills,and financial intermediation jobs for those with more. Similarly,Bernanke’s creative work during the crisis has allowed the U.S. to more painlessly avoid reforming its financial system.
Rajan has been a perceptive and prescient critic of central bankers before him.
It would be a terrible irony if he played a similar role in India. I am betting he won’t,which may be reason to steer clear of the rupee.
By James Saft
(At the time of publication,Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund)