Jan-Mar 2015

Fundamental Financial Sector Reforms Needed to Reach Double Digit Growth: RBI Governor

Taking time off Governor Raghuram Rajan came over to ISB to interact with students on a wide ranging topics from the fiscal and monetary policy to job prospects at RBI. Reproduced below are edited excerpts from the interaction.

Monetary Policy and Demand Management

There are two elements to the monetary policy. One is to manage demand to control inflation. The other is that its impact is felt in variable lags. This basically means that if interest rates are changed today they have an effect on demand eight or twelve months down the line. Typically in India we feel it only after at least three to four quarters. So what you need to do, is to forecast what happens to the economy a few quarters ahead. And because forecasting is very difficult; since you must use all the data that you have, so it is a tough job. And that is why we typically wait for all the data to come in before making any decisions.

Economic Fundamentals 

We have seen a lot of improvement in some of the dimensions. We have brought the current account deficit down considerably. Even though our exports seem to have slowed down you must remember that the price of oil has also come down. We do export a lot of oil products and therefore there is an indirect effect. When the price of oil comes down our exports will also come down. Similarly, with the fall in the price of gold, jewellery exports have also come down. When you look at non-oil, non-gold exports, it is still doing reasonably well, recording a six to seven percent growth. And that is one of the strengths of are economy. The bottom line is that we do seem to be picking up in growth, our current account deficit is smaller and of course, the inflation numbers look a lot healthier than a few months back. So we are improving and hopefully we will see more sustainable growth in the near future. Now, what we have to do is to support growth in a strong way. For this, we still have work to do on the financial side.

Expectations are very high after the initiatives announced by the Prime Minister. We have to match them. My sense is that even without thinking of major reforms and by delivering on the plans we promised, we can put the economy back on track to a reasonable level of growth. So we are hoping 5.5 percent growth this year, or maybe a little more. Then into next year we go into the sixes and then hopefully to the sevens the year after. But to sustain that, and to take it to a higher plane, we will have to revisit the system for fundamental corrections. And this means improving the framework for doing business, to make it easy for business to grow and that means finance, that means regulations and that means skilled labour. And I think the government is working on all these fronts and is starting by trying to see what it can clear up. You will see this in the plans announced over time. And my sense is that if we do this and upscale the whole thing I don’t see why over time we can’t reach double digits, which is where we should be given our level of development.

Quantative Easing and World Economy 

The real issue across the world is how effective is quantitative easing? The first round of quantitative easing was repairing markets in the U.S., then it was repairing markets in the Euro area. Remember they were trying to deal with sovereign debt markets, which had gone haywire in Europe. In the U.S. the mortgage markets had broken down. I think quantitative easing (QE) has to be applied there. And this is something that I have been arguing in international fora. The main affect does not come through interest rates but it may happen if we depreciate the exchange rates. So what you saw is that while Japan, the UK and the U.S. had extremely aggressive policies on QE, the Euro area did not. And the Euro area strengthened quite a bit despite having very weak growth. Now that the Euro zone has joined the bandwagon even while the U.S. is moving out, the U.S. currency has strengthened while the Euro area currency has weakened. And you hear now, that John Williams of the Federal Reserve Bank of San Francisco says that maybe we should go in for QE4. This means that some policy makers in the United States are getting worried about the strength of the U.S. currency. My concern is that there is no easy exit. Once you have got in, what goes up when you go in, will come down when you get out. And if you are scared about the volatility then maybe you should not have got in, the first place. But now that you are here, I would hope that as the U.S. economy strengthens, the U.S. government will take calibrated and transparent measures to exit.

I think there will be some volatility when countries are exiting. But they have to. And for countries like India, my hope is that we have built enough credibility in financial markets and that we will have some volatility for a little while. But once, the first wave of selling abates, investors will look around and think which country looks better. Where else in the world can you find the kind of investment opportunity that you find here in India? Again there are lots of low-hanging fruit that we can pluck. When we pluck them let us clear the way for investments to happen. I am confident that we will grow very strongly.

The bottom line is that we do seem to be picking up in growth, our current account deficit is smaller and of course the inflation numbers look a lot healthier than they looked a few months back. So we are improving and hopefully we will see more sustainable growth in the near future.

Policy Making and Interest Rates 

On the issue whether fiscal policy or monetary policy is more effective, I would say both are necessary. You have to clap with both hands and I think what the government has done in terms of fiscal restraint is very important. Both, the previous government as well as this government, have set the course for a reduction in the fiscal deficit, which is extremely important. And the fact that they actually have a constraint in spending is part of why we see lower inflation. I also believe that monetary policy has played a role in ameliorating expectations not just of the public, but also of bond market participants, and of analysts many of whom are now convinced that we will hit a six percent target by the end of next year. So I think both are necessary and one can’t function without the other. The Central Bank can’t do its job if the government does not cooperate and vice versa.

The second question is on the interest rate being a blunt instrument. Of course, interest rates are is a blunt instrument. But if you could give me some other policies that would work, I would be happy to do away with them. For now, I think we have to live with the fact that we have a blunt instrument and the instrument works. Let me admit frankly that it works by constraining growth below where it would otherwise be. But if you have supply which is constrained, and demand, which exceeds supply, which is causing inflation, which I think is how inflation is generally caused, you have to bring supply, and demand back into a match.

The Reserve Bank of India does not directly operate at the long end and we have no desire to fix the long end of interest rates. So there is a misconception sometimes that we are trying to determine what the long end of interest rates are. That is not how we determine policies. We determine policies at the short end. We have set a policy rate of eight percent. Through our new liquidity measures we are trying to maintain the short term interests at this rate and we have been quite successful. Now some banks have been cutting their deposit rates in some segments. I don’t see a uniformity across the rates and many are awaiting for a sustained signal that inflation is falling, that the central bank is going to turn to transmit that into lending rates.

Legislative Reforms and Rbi Freedom 

The Government and the Reserve Bank enjoy a free, frank and cordial relationship. We discuss many things and we try and do what is in the best interest of the country. I think there is a discussion going on right now on a couple of things. One is, of course, the number of institutional structures that will improve the functioning of the financial sector. For example, we really need a financial resolution authority so that we can close down financial institutions that get into trouble without necessarily merging them and taking up the losses and feeding them back into the system. We need to clean up institutions, close down poorly functioning ones while resurrecting well-functioning ones. So the financial resolution authority will be an entity doing that. But we also are in discussion about a monetary policy framework, which again is a far-sighted move on the part of the government. It is an attempt to move us to standards that other countries have reached. The discussion will be on making the objectives of the Central Bank more explicit. One explicit objective could be a certain level of inflation or a certain band where inflation can move. Another objective could be financial stability while the third could be growth. Do you do it through a monetary policy committee? Who appoints the members of the monetary policy committee and what are their terms of reference, what is the term of the management of the Reserve Bank? How do you ensure that there is enough independence so that the targets can be met but at the same time the Central Bank is doing what is determined by parliament or the Government? So these are issues that have to be discussed. I don’t think ‘immediately’ means that there is a conflict between the bank and the government nor does it mean that the autonomy of the institution is under threat. These are issues that need to be resolved.


To sustain growth, and take to take it to a higher plain, we will have to think of how we reform the system fundamentally. And this means, improving the framework for doing business to make it easy for business to grow and that means finance, that means regulations and that means skilled labour.

Emerging Markets and Portfolio Investment 

Let us accept the fact that we are a country running current account deficits and that we are likely to have them for the foreseeable future. It is not a bad thing because we are letting foreign investors fund a part of our investment that our own savings cannot finance. Of course, we don’t want to rely too much on foreign investment. If you start relying too much, you become vulnerable. But some reliance is not bad. Countries like Canada and Australia have run current account deficits from time immemorial as they funded their growth. Once you are reliant on foreign money you have to ask how we can bring it in more safely. Most people would say FDI is better. That is wonderful except that you may not have enough FDI. So we have to move to other forms of financing. Portfolio investment is one form of financing. Generally, it is coming in and investors are willing to stay longer. I think on the debt side, we have seen that short term debt is a little volatile. And so we have been pushing the debt into the longer maturities especially as far as the government debt goes. So yes, there will be some volatility in foreign institutional or portfolio investment in debt. But you have to live a little bit with that – recognising that in the longer run it is both more useful for liquidity in the markets and also for the fact that you have to get finance – some investments from abroad.

We need to clean up institutions, close down poorly functioning ones while resurrecting well-functioning ones. So the financial resolution authority will be an entity doing that.

RBI Norms and Npas

Fundamentally, RBI norms on NPAs force the recognition of a problem. Secondly, they force some provisioning for that particular problem. Now supposing you change accounting treatment in a way that hides your problems, does that mean that your investor will be ok with it? No. Because you have changed the accounting standards, it is no longer transparent and your share will anyways be discounted even more because the investor doesn’t know what you are truly doing. Similarly, if you don’t provision for bad debts that are going to come and you say I will do it when the time comes, what is going to happen? They will say your profits are not as rosy as you make them to be. They are actually worse because you are not provisioning. Again your shares will be discounted. So, ask who are you fooling? If you change the norms for recognition of bad loans etc. you are not fooling the markets, you are not fooling the public, you are not fooling the investor. It may look rosy but instead of calling it an NPA, you are calling it a restructured asset, instead of calling it restructured you are calling it a performing asset. So what I have been trying to say, in public and in private to everybody, is putting lipstick on a pig does not turn it into a princess. You cannot overnight turn your balance sheet into something smelling of roses simply by changing the NPA norms. I would say instead work on putting the asset back to work and that means real sector changes, it means financial sector changes, it means restructuring the loan profile. On all those, we have worked to give the financial sector more leeway. For example, if you want to restructure a loan which, the firm is paying for eight years, you have to realise that eight years is too short a time for a 30-year project. We have allowed the bank to now restructure it into a 30-year project provided it can get somebody else to come in for 25 percent of the loan and thus ensure that this is not ever-greening. So we have done many things like this. I think putting the project back on track, allowing it to function in a better way is better than just pushing the bad loans under the carpet and saying See No Evil, Do No Evil and Say No Evil. It’s high time to adapt the best business practices.

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