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What Does a Raghuram Rajan Reserve Mean?

I was thrilled to hear that Raghuram Rajan was tapped as D. Subbarao’s successor at the Reserve Bank of India. Rajan’s firepower is welcome at a time when India’s financial markets are running amok. What should we expect from a Rajan Reserve and – more importantly – what will be at the top of his task list.

A few months ago, I argued that we ought to be cautiously optimistic about India’s economic future. Though I wrote before the rapid depreciation in the Rupee, I maintain my position that India’s economic fundamentals are stable. Unfortunately and unsurprisingly, the Indian news media is missing the forest for the trees in their coverage of the falling Rupee and “soaring” inflation.

Let me be clear: Raghuram Rajan’s chief objective will not and should not be “stabilizing” the Rupee. The amount of Indian debt held in foreign – usually dollar-denominated – currencies is not substantial, and hence the Rupee depreciation poses no immediate pressure since the exchange-rate value of repayment will has not increased too much.

More importantly, all signs suggest India’s recent depreciation isn’t the result of a significant structural shift emanating from a loss of confidence in the Rupee, but the consequence of “taper talk” across the pond. As markets anticipate tighter monetary policy in the future, we would expect a rising dollar.

Unfortunately, a falling Rupee precipitates more expensive energy imports. Since the Government of India spends nearly $10 billion on fuel subsidies – which have incredible political support – weakening terms of trade may induce deeper deficit spending. Rajan’s first step towards a more independent RBI should be to stop providing the government with artificially cheap debt by creating a captive demand for Indian bonds. Rajan has expressed similar sentiments:

[T]he RBI still forces banks to invest 24% of their core deposits in government bonds, far above what is needed to give banks a safety buffer of liquid assets. This creates captive demand for public borrowing (although during an economic soft patch such as today’s, cautious banks may voluntarily hold more than the minimum). The RBI also buys government bonds in the market. It argues this makes markets work smoothly, but most outsiders think the aim is to put a lid on government-bond yields. A spike in yields in November has been followed by a big, $14 billion RBI bond-purchase programme.

Reducing the capital reserve ratio hits two birds with one stone – deepens the expanding private credit market while signaling independence from the central government. Rajan, unlike his predecessors, has an intellectual starpower that suggests he can enact such institutional change. As I’ve noted, the Indian credit market has been very resilient to the financial crisis. While growth halted significantly, gross credit as a percent of GDP continued its steady climb – something that cannot be said for other developing countries.

Rajan’s most important task should be moving the RBI towards a rule-based exchange rate policy. The debate between rules and discretion in the developed world largely concerns some permutation of a Taylor rule stipulating the optimal policy rate given a level of inflation and output gap. India is not ready for this debate – and that’s for the better. A healthy Taylor rule requires an accurate estimate of the output gap which is founded on long-run trend growth. “Trend” growth is a useless concept in countries like India and China, whose growth rates have both a high mean and variance.

Rather, India should adopt a form of rules-based intervention in the foreign exchange (FX) market. Today, the RBI operates on spot and forward interbank FX transactions “depending on monetary conditions” to moderate volatility. The well above-normal correlation between FX interventions and the exchange rate – as opposed to exchange rate movements – suggests the RBI’s modus operandi is very discretionary at the time being. This May, Kaushik Basu (formerly India’s Chief Economic Adviser) and Aristomene Varoudakis released a study suggesting emerging market central bankers would benefit from a rules-based intervention in the interbank market.

The reasons for this are multifold. Quite simply, a credible rule allows a central banker to set expectations to achieve a result without actually doing anything, in this case purchasing reserves. A large-build up of un-steralized foreign reserves tempts a flood of liquidity with unanchored inflationary expectations that countries like India cannot afford. On the other hand, sterilization entails fiscal costs which is the interest rate paid on external liabilities: a study by Gustavo Adler and Camilo Tovar estimated that this costs Latin American emerging economies 0.5% of GDP on average.

In spirit of Basu’s best work, How to Move the Exchange Rate If You Must, employs intuitive game theoretic concepts to further his assertion. Basu and Varoudakis note that since FX markets exhibit a dynamic with many, price-taking agents juxtaposed with a few, strategic oligopolists who can affect the exchange rate: tempting Cournot competition.

Basu and Varoudakis show, qualitatively, that under imperfect conditions, large players benefit from committing to a demand curve. But once it announces its intention of achieving this demand curve, actual operations are unnecessary:

Note that once the central bank makes the schedule intervention and moves the demand curve to D1 equilibrium exchange rate will be p1. At that rate the central bank does not buy or sell dollars. In other words, the exchange rate will have been moved with the announcement of the intention to accumulate or drain specific amounts of reserves at various exchange rate levels.

While the economic benefits of achieving exchange rate stability without a buildup of foreign reserves is tremendous, the political benefits are greater still. Rajan, de jure, is beholden to a government founded on shaky parliamentary conditions that will almost certainly be predicated on volatile coalition governments. 

This limits central bank independence regardless, but if the Bank has clearly committed to a rule-based regime, the barrier for political disruption will be greater. By engaging in openly discretionary policy, the Bank today implicitly announces a tryst with the governing coalition as it has no credibility to burn. Furthermore, while no man is above the mess that is an Indian Parliament, the international, intellectual, and disciplinary prestige of Rajan is likely to serve as a force towards more determined reasoning, even in the midst of irrationality.

Ultimately, monetary and fiscal policy are not divorced as in the United States. While Rajan has correctly expressed interest in loosening liquidity requirements that artificially depress yields, he can play a key role in India’s political decisions:

  1. Inflation derives from expectations on the future. With the current deficit and consumer price inflation, it would not be surprising if the market expects significant monetization in the future. India must restrain its future self. The best way to achieve this is to set a minimum target for the percent of all debt sold in inflation-protected contracts. Earlier this summer, India engaged in its first inflation-indexed bond (IIB) auction: for a paltry sum. Rajan should play a key role in amping this up: IIBs will not only offer India cheaper financing by removing the inflation-risk premium, but will convince the market that future inflation will be lower as monetization is not as viable.
  2. Widespread success of such an auction might curtail a rapidly rising demand for gold, which accounts for a whopping chunk of India’s trade deficit.
  3. If Rajan is unwilling to rein in depreciation against the dollar, food and energy prices will continue to rise. As the government is deeply involved in both markets, he will shape debates on India’s future welfare goals.

Ultimately, those approaching the RBI through the lens of a “Taylor rule” or “NGDP target” will be disappointed. Rajan will not be independent of governmental forces and, for the large part, this is okay. There is no currency crisis that’s endemic to Indian monetary mistakes, and even if there were India has less to worry about than most developing nations.

The leading light at the end of Rajan’s tunnel will be deeper liberalization of capital and retail markets. As a democracy, it is subgame imperfect for India to default on its debt, and hence the Rupee has a natural advantage to the Renminbi in international capital markets. China has paced well ahead of India in structural growth, but unique institutional arrangements suggest India can lead the BRICs in monetary policy.

Rajan will never lead an independent reserve, but he can start the transition. And that’s infinitely more important than changing the repo rate by a point or two.

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7 comments
  1. ogeid said:

    Hi Ashok,

    I enjoyed the post very much and hope you don’t mind if I ask a classificatory question. In the penultimate paragraph you mention India’s democracy and how it may give the Rupee an advantage over the Reminbi in terms of international appeal. Could you elaborate how China’s political system may make it NOT “subgame imperfect” for China to default on its debt?

    Thank you.

    • Of course. I’ve written about it in detail here: https://ashokarao.com/2013/05/09/renminbi-a-reserve-it-is-not/

      But the short answer is consider the United States. Even at the brink of the debt ceiling debate, uncertainty didn’t spike too much and yields remained low. That is because the voting public owns most of the debt which is held in municipal and other pension funds: Congressmen wouldn’t dare default on their own people, so the democratic system keeps them in check.

      In fact, after the Glorious Revolution in England, yields fell because the electorate – even if not universal – held the debt, which guaranteed a check on reckless default.

      What such accountability exists in China – where SOEs will getaway with backdoor deals? Foreigners cannot trust that a Chinese default will not just be an economic, but also political, storm.

      It’s one of the few examples where political will tempers economic uncertainty.

      • ogeid said:

        Thank you for the generous response!

  2. Venkata said:

    Really? FUn stuff. Looks like you really saw through this. But .but..I mean..but..but..hmmm….Rajan has nothing in common with Chidambaram just like Basu has nothing in common with Mukerjee..hmm..really nothing ..just nothing..Subbarao dumping Chidambaram on 2G has nothing to do with this..you know..nothing..this is political agnostic independent monetary policy..Rajan.Ludite terrific..you know..nothing to do UID which has nothing to India Banking Report …which has nothing to with Neo-somethings..who are Harvard educated..which has nothing to do with UPA with nody but CHidambaram which has nothing to do with body but Chidambaram as economist magazine pointed out.. magazine it itself has nothing do with..chidambaram,.,hmmm..realy …nothing to do…

  3. Prakash said:

    A major awaited reform/change in India is allowing mobile phones for payments without the need of a bank account as a go-between. Allowing this would make a major difference to financial inclusion. Whether it would happen under Raghuram Rajan, we really don’t know.

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