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Do Raghuram Rajan's Five Pillars Stand Up?



I wrote this for Yahoo.

About two months after the entry of Raghuram Rajan as the new governor of the Reserve Bank of India, we have some kind of a scorecard to evaluate his performance – the five pillars that he said would form the basis of governance in the next few quarters.

Since Dr Rajan has come in, the dollar fell from Rs 67 to Rs 61 in October. One mechanism he introduced was a facility that allowed non-residents to invest in India without exchange rate risk (the FCNR Swap), which has brought in over $18 billion to add to our reserves.

Meanwhile, the rupee slide has meant we exported more and imported less, with the current account deficit expected to be $32 billion less than last year. Foreign investors brought in a significant amount of money in September, but they matched what they brought into equities with what they sold in debt markets in October.

However, the economy hasn’t done quite that well, posting a GDP growth of just 4 percent recently and inflation eating into savings and growth. Liquidity pressures have eased significantly, with banks borrowing less than Rs 1 trillion overnight from the RBI (they would borrow significantly higher earlier). Short term interest rates, which were around 10.25 percent or more, have eased towards the 9 percent range.

The overall fear of the US Fed tapering its massive bond purchases, of which some money trickles into India, has spooked both domestic and foreign investors. And with western economies improving it is quite likely that they will reduce their quantitative easing programmes – while that should be good news, it has been a steroid the markets are unwilling to shake off.

Amid all this, how do Dr Rajan’s five pillars stand up? And has the the RBI taken actions to address them?

In the first pillar, Dr Rajan intends to clarify monetary policy. Too many people don’t understand what our monetary policy is intended to do, a statement that seems to be true in every geography nowadays. In his maiden speech Dr Rajan made it clear that it was about monetary stability – to maintain confidence in the currency and to do it through low expectations of inflation. However, there is a committee that will give actual recommendations on what monetary policy will really mean.

On a consumer price level, inflation has gone up in October to 10.1 percent, and even after Dr Rajan has raised the interest rate marginally, inflation remains a major concern. While he maintains that inflation at the wholesale level remains benign, India is a service-led economy where input costs go up with consumer prices – think of a barber shop or a security guard company.

Even manufacturers – who are supposedly seeing low inflation on their input goods – are seeing high wage growth (largely driven by inflation) which hurts their businesses. Expectations of inflation have only risen.

But to his credit, Dr Rajan has unwound some of the monetary policy layers, that were created in July to stem the fall of the rupee, by limiting the "Repo" overnight borrowing that banks were allowed to do and instead, having them borrow in a significantly more expensive "Marginal Standing Facility".

While this resets monetary policy to using just one rate – the "Repo" rate – it is a very minor step in the larger scheme of things.

If you had slept through the last six monetary policy statements, with just a fixed deposit (whose rates have barely changed), you could be forgiven for wondering why this monetary policy business was required in the first place. The problem: rate changes at the RBI don’t translate to changes for consumers or businesses very easily.

The transmission of rates is broken and nothing has been done at the RBI to fix it. One fix would be to reduce the number of available opportunities to borrow short-term cash from the RBI – then banks would have to borrow from each other and raise deposit rates. Instead, Dr Rajan has just increased such opportunities by introducing a "term repo" where banks can borrow for 7 to 14 days, at an auctioned interest rate, up to Rs 40,000 crore.

The second pillar is about strengthening the banking structure. The idea is to encourage different kinds of banks, to allow branch expansions and to get foreign banks to be regulated better by the Indian system. In that, Dr Rajan has shown signs of success.

Foreign banks – which didn’t have to meet regulatory criteria at the same level as India-registered banks – weren’t allowed to have more than 10 branches, and banks such as Citi and HSBC had to cut their numbers to conform. Foreign banks now have a framework to register as subsidiaries rather than branches, which gives them the ability to add branches, but adds a complete regulatory layer including priority sector lending requirements.

But the RBI has continued to let them operate as branches if they were around before 2009, regardless of how unregulated their business is. Of course, if those banks expect to expand their branch network they will have to now become regulated by the RBI, and time will tell if they make the change.

On getting new banks in, there is a committee – a word you’ll hear a lot – to evaluate new banks. With 26 companies in the fray for a licence, we have to wait till January to see who will get a piece of the action.

The third pillar is to strengthen financial markets. While this sounds like it will attract investors from all over the globe, it does not reflect in the actions taken so far. Restrictions on foreign and local investors continue, especially in the foreign exchange markets; onerous registration procedures, limits on open positions and multi-layered regulations still exist.

The RBI now plans to introduce Consumer Price Index (CPI) based inflation-protected securities sold to individuals and trusts, sold by banks (and not in an exchange). This will give you a fixed interest rate plus the inflation in the CPI, which runs at 10 percent.

However, details are still sketchy with the program yet unimplemented, other than that you will only get the interest as a lump sum at redemption, which is 10 years later.

Other measures, such as cash settled interest rate futures or credit enhancement in corporate bonds, are simply ways to give large institutional participants more products to buy.

However, at the retail level, participation in markets is not being actively encouraged, especially in fixed income instruments. You can’t easily buy a government-issued 30 year security – whose current yield is over 9.3 percent a year – because the method to do so is extremely cumbersome.

Expanding credit to small and medium enterprises (SMEs) and financial inclusion forms the fourth pillar. Guidelines are expected soon where SMEs will be able to use a "General Credit Card", which was earlier only given to farmers, for short term credit. There are numerous committees – that word again – that will introduce a General Interbank Recurring Order (GIRO) based settlement, expanded access to mobile banking and co-operative bank improvements.

Some of these are fancy names with an unclear purpose: for instance, the GIRO system expects you to be able to pay your school or utility bills electronically, which we have been able to do for the past three years anyway through NEFT or ECS Debit. The problem, however, is in our inability to stop such billers from overbilling us and to get redressal without having to go through a long
court process.

At this time, prepaid instruments like mobile currencies and prepaid shopping websites are not allowed to let you take money back into your bank account, or as cash.

The RBI might let you do so through Aadhaar-based identification; however, the money laundering implications are very large. If you can buy a prepaid instrument without proper identification and convert it back to cash easily, the tax department might find it difficult to track.

The fifth pillar is about dealing with distress, of how the ‘system’ will behave when corporate debt has to be restructured or when debt has to be recovered. However, the RBI has not been put to test on this yet. Large scams like the NSEL exchange default have been borne by non-banking participants. Debt restructuring continues, even in cases where banks know there has been siphoning of funds.

Politicians have openly asked people to default on their loans. A real test will come when there is stress, and given our slow court system and the inability of the RBI to resolve cases through harsh measures, the preferred approach might simply be to find better ways to shove all of this under the carpet.

While the pillars themselves are very important, actual actions that seem to address them have been left wanting. As an outsider to the RBI, Dr Rajan has taken the politically correct measure of involving important people through committees and working groups so that any action isn’t attributed to a single person.

But this introduces layers of indecision and the RBI would do well to create less subjective process-based frameworks so that there is clarity on what needs to be done to do a certain thing. Part of this is also in the effort to ensure that proper information is provided (like how one can buy inflation protected securities, for instance), a transparent redressal system for grievances (better than the current ombudsman mechanism) and an effort to audit and improve the processes constantly by leveraging technology.

It would indeed be great to have a central bank that addresses all these five pillars appropriately. In the bargain, we must not overlook one thing that excited us about Dr Rajan’s initial speech – of making the rupee more international, of settling trade with rupees and of opening our markets to such trade.

Additionally, the RBI isn’t the correct institution to do all that it’s doing right now – for instance, the fact that it is the merchant banker for government debt and is also a regulator of the bond market, and a buyer of this debt, is a conflict. This can only be resolved by putting a debt management office owned by the government, not the RBI.

Furthermore, the five pillars must be supported with much more data disclosure and transparency – a fact sadly lacking in many of the actions taken so far (like the swaps).

These are not pillars, actually. They are more like a new foundation, and I hope we address them soon.


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