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Past Issue • Apr-Jun 2012

Raghuram Rajan on the World Economy

Raghuram G Rajan, Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business and the Chief Economic Advisor to the Indian government, was at ISB in April 2012. Following is an excerpt of the interview between Professors Sankar De, Rajesh Chakrabarti and Krishnamurthy Subramanian with the eminent economist.

What is  your assessment of  the  world  economic situation? Is the worst behind us?

We do not know. There are two reasons for this: First, Europe is still muddling through. Earlier, there were concerns about Italy. Some of these have been addressed but Italy still has to take some hard reform steps. Until there is growth in these countries, the spiral downwards will eventually become ver y problematic, both economically and politically. We hope that will not happen. Currently, Spain is in the limelight more than Italy. With its large deficits, the banking sector in deep trouble and the housing sector problem is still not fully reflected in the banking sector’s balance sheet. The European Central Bank (ECB) has bought time by taking on considerable credit risk on its balance sheet, and we have to wait and see if the governments can do enough to convince the bond markets.

The second reason is geopolitical uncertainty of which, Iran and the Strait of Hormuz are just an indication. Whether in fact there is an attack by Israel, and what consequences, intended or unintended, emerge from that attack are clearly a big source of concern. It is not just a question of whether the Strait would be blocked; that would be disastrous. There are other possibilities, such as that of Iran’s proxies in different countries escalating conflict here and there and of course the general uncertainty that would prevail in the Middle East if in fact there is an attack by Israel. I hope that dialogue prevails.

Another concern, which is not getting as much attention but is one I think we should keep an eye on, is China. The political uncertainty in China may be perceived as relatively small. There is a transition taking place, and just as the last transition occurred ver y peacefully, the next transition will, in all likelihood, also be peaceful. However, there is the question of whether there is some sort of internal battle happening there which we do not see. We see only the external manifestations. It is possible that there could be more uncertainty in China. Chinese uncertainty could be quite problematic because China relies on confidence in the government. For instance, people do not worr y too much that the banking sector has big bad loan problems because they think it will get fixed by the government.

What do you feel about Spain’s economic situation? Has joining the Euro zone helped Spain?

Whenever there is a crisis, the Keynesian view is that the level of demand before the crisis is what we must return to because it is the appropriate level. Obviously we have a demand shortfall, as the people who borrowed cannot spend now because they over- leveraged and now have to figure a way to get around that. It is questionable whether the nature or level of the demand was stable before the crisis. Thus, to say that we must go back to that level may not be the solution. If Spain grew because they built many houses, and the demand for houses has now fallen, how do you restore that level of demand? Certainly, you are not going to get demand for housing to the same level it was earlier, which means you are going to shift the nature of demand. Increasing aggregate demand may not create the right amount of demand for the kind of things that are in trouble. I keep arguing that there is also a supply problem, which is that there are too many houses and too many people in the construction sector. This has to change as supply was pushed unsustainably because households had easy access to borrowing.

Whenever there is a crisis, the Keynesian view is that the level of demand before the crisis is what we must return to because it is the appropriate level. Obviously we have a demand shortfall, as the people who borrowed cannot spend now because they over-leveraged and now have to figure a way to get around that. It is questionable whether the nature or level of the demand was stable before the crisis. Thus, to say that we must go back to that level may not be the solution.

Spain spent as though  there  was no  tomorrow, and now they want to get out of the mess. It is a bit like the Chakravyuha (labyrinthine militar y formation) described in Mahabharata. You know how to get in, but you have not memorised the path to get yourself out. People are saying that they should quit the Euro and get their own currency, in other words, go back to devaluation. That, however, was never a long-term solution. Devaluation soon resulted in higher inflation, so while they became more competitive  for a while, eventually  higher  wages made them uncompetitive. Moreover,   ever ybody   knew   they   would devalue frequently  and have higher inflation,  so there was an inflation premium built into their bonds, which made it harder for them to borrow.

Investors have interesting opportunities in Burma, Brazil and a number of African countries. Why do they need the uncertainty in India?

If Spain devalues and leaves the Euro, it will restore competiveness for a while. After that, they will return to the same old problems, this time without the safety net of the Euro as a stable currency. This solution is temporary.

You are obviously not satisfied with the pace of financial reforms in India. Where are we stuck and what can we do?

I think we have been making some progress on financial reforms. There is virtue in the financial sector proceeding steadily but cautiously, especially because of the great potential volatility of this sector. Over time I have become more convinced by the RBI’s strategy of experimenting – letting things start in a small way and then rolling them out. I believe that we should adopt the strategy more widely. You may wonder sometimes if the experiment is structured to succeed or fail, but you can’t fault the basic idea that this step-by-step process is better than dramatic changes. Mostly, I think we are moving in the right direction of steady liberalisation.

In the financial sector, I worr y about the need to finance the current account deficit. It would be better if FDI flowed into the country in a big way, rather than financing this deficit through short- to medium- term capital flows. This is where policy uncertainty in the rest of the economy hurts us. Some policy makers still believe that the India stor y is alive and well, and that because we are set to grow at 7-8%, people would be foolish not to invest in India no matter how much uncertainty there is. I think that is overstating the attractiveness of India in the perspective of the international investor. Investors have interesting opportunities in Burma, Brazil and a number of African countries. Why do they need the uncertainty in India?

Take the case of Vodafone. The government’s attempt to issue retrospective tax legislation on Vodafone and nullify the court verdict is hard to defend. Essentially the government is saying that even if it gets a judgment from the legal system, it can decide whether to accept it or not. There is a huge amount of policy uncertainty created by this. The notion that the government can do what it wants could hurt FDI.

Anybody who looks at our macroeconomic picture, at the recent headlines, at the policy paralysis and asks, “Is this a country I want to invest in?” is probably not going to give us the answer we would like.

You have authored  models that have looked at different classes that have pushed for reforms. There were times when the constellations worked towards change and sometimes people blocked them. Is there a broader political economic story here?

I don’t fully understand it, but it seems to me that we are seeing a reversal in the preference for urban- and upper middle class-oriented policies towards more rural-oriented policies. If this was done in a way that would expand productive resources, it would be wonderful. We need better schools in the rural areas and more investment in certain areas of agriculture, such as seeds. My worry is two-fold:

The problem with much of these reforms is that they are not increasing productive capacity as much as catering to consumption. Moreover, they are not catering to consumption by increasing choice, but by telling rural people that they must have grain or ser vices whether or not they are going to use them and whether or not they are going to be provided efficiently. While these reforms may be redressing an imbalance, they are doing so in a way that does not increase productivity or growth, but instead increases demand and consumption. Some of it is sustainable, but there has to be growth elsewhere.

This is why it is important for reforms to expand growth in the other areas. If you don’t, you end up placing tremendous pressure on government finances and then something has to give way. They have to find new ways to generate revenues that will not upset the rural electorate. Hence, all the talk about increasing the tax rate on the rich or applying retrospective tax on Vodafone. The search for revenue alights on the classes that are already paying. The one good thing we did was have fairly low tax rates across the board, which creates incentives to declare income and generate growth. We are headed in a bad direction along with the rest of the world by increasing rates. Instead, we should focus more on expanding the tax base. Far more people stay outside the net than within it. For instance, industrial houses don’t have a particularly high tax rate because they find ever y loophole, and rich farmers have a way to evade taxes completely. I worr y about the political constellation changing and I don’t think that the response is the right one.

There are people who have made money the right way, by building better products, standing by them and selling them more widely. I have enormous respect for that. You also have to respect people who have found a way within the system to create value. What I worry about is creating a structure that enables people to make their money from the system itself rather than from better products.

A few years ago, in a newspaper interview, you pointed out that  India has the  second highest number of billionaires per trillion dollars of GDP (after Russia). You also said that most of them made their money by manipulating the government.  You went to the extent of saying that if you call Russia an oligarchy, how long can we resist calling India one? Having seen what we have seen in recent months, whether it is the 2G spectrum, coal or defence scam, what is your thinking on those lines?

With our stock market decline, some of our billionaires have become millionaires once again. Evidently, we’re not doing that badly on that dimension! There are people who have made money the right way, by building better products, standing by them and selling them more widely. I have enormous respect for that. You also have to respect people who have found a way within he system to create value. What I worry about is creating a structure that enables people to make their money from the system itself rather than from better products. My point in that inter view was that we have too many of those people as well. This goes back to the fundamental issue of government reform in India. How do you generate the pressure for those reforms? The middle class did join in the protest against corruption headed by Anna Hazare last year. Unfortunately, that middle class movement for better governance seems to have died down. How do you get a sustainable movement against corruption, particularly when a politician knows he can bypass it by appealing directly to the rural lower middle class voter on caste grounds or on hand-outs ? We have seen some evidence in recent elections that those voters are also anxious about governance, but politicians have to change their mind-sets to accept that governance is an issue on which people will base their votes. Some politicians still believe that the old ways will work. We will have to see how it evolves. There is a lot of churn in the Indian economy now, which can be good for the medium term. We have a democracy, imperfect though it sometimes may be. I think that churn will bring us something better than we have now.

ABOUT THE AUTHORS

  • Raghu-L

    Raghuram G Rajan

    Katherine Dusak Miller Distinguished Professor of Finance, The University of Chicago Booth School of Business; Vice-Chairman of the Bank for International Settlements; Former Governor of RBI.
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