Raghuram Rajan's agenda: Damage control through independence

The new RBI governor could instill a sense of calm through clarifying his objectives, and being independent while awarding banking licences

As the next governor of the Reserve Bank of India (RBI), Raghuram Rajan, the professor-turned-policy-purveyor, will be stepping unto the breach of the besieged Indian economy. Economic growth has decelerated sharply, the government deficit is about ten per cent of GDP, inflation has remained elevated at close to double-digits for over three years, and the current account deficit has widened sharply to unsustainable levels. Sensing trouble, short-term investors have fled, and perceiving an uncertain, unfriendly regulatory regime, long-term investors are wary of stepping in. As a result, the rupee keeps plummeting, imparting a distinctly pre-crisis reek to the Indian economy.

As if this weren't enough, the country is also gearing up for two bouts of elections within the next nine months. The ruling Congress party is unlikely to be coy about opening the fiscal spigots to counteract a possible swing toward the opposition leader Narendra Modi in urban India. Fiscal prudence could well be a casualty, further burdening the RBI and endangering the macroeconomic situation.

In these circumstances, what should Mr Rajan aim to do? His immediate objective will be damage control on two fronts. On the macroeconomy, he will need, above all, to dispel panic and restore calm to the currency market, which will allow investors to return in sufficient strength to finance India's external borrowing needs of about $25 billion in the next six months. That will head off the crisis that India can ill afford at this juncture.

A second damage-control exercise relates to the government's intention, which the RBI has been charged with implementing, to award new banking licences. Substantively, the RBI has to reconcile competing tugs. On the one hand, the banking system, dominated by public-sector banks, needs private-sector vitality; on the other, awarding licences to some of the prominent applicants that are big industrial houses will further entrench their economic and political power. To paraphrase one of his book titles, Mr Rajan will have to save the banking system from wannabe bankers.

The trickier issue with these licences is in the short run. The RBI will have to fend off pressures to award licences not to the merit-worthy but to potential greasers of the election war chest. This government had become what I have called a Rents Raj because of the corruption in the allocation of scarce resources such as spectrum, land, and coal. In the months ahead, the RBI will have to prevent its spread to the allocation of banking licences.

How much can Mr Rajan do? On the macroeconomy, not very much. Like all central banks, the RBI has no control over the fiscal deficit and, for that reason, little control over its external counterpart. The RBI can reduce inflation through its control over interest rates and liquidity. But the puzzle is that over the last few years there has been no real clamour to reduce inflation - and, instead all the difficult-to-resist pressures on the RBI are not to choke off growth by tightening policy. This political inability to sustain tight policy is also why the RBI cannot really defend the rupee. Investors simply shrug off the tightening, confident in its transience.

But Mr Rajan can instill a measure of calm by clarifying the key objectives (price stability not the level of the rupee), adopting a coherent strategy to avoid flip-flops, focusing on broad policy instruments rather than targeting particular segments of the financial market or actors, and above all, daring to sustain and defend uncomfortable choices such as tightening should that prove necessary.

This same quality of independence will be especially important in awarding bank licences. Central bankers gain credibility by taking tough decisions, and Mr Rajan's RBI is bound to be a beneficiary if bank licences are awarded through a transparent and accountable process. All of India is watching, and the RBI, which remains one of India's few respected public institutions, must be beyond reproach on this delicate issue.

There is a tricky balancing act that he will have to pull off. With a firm, steady hand on the tiller, and with oodles of luck, Mr Rajan can help stave off a financial crisis; but he cannot afford to be so successful and create so much calm that India's politicians revert to being fiscally reckless in the run-up to elections. So, until the elections, Goldilocksian competence, or perhaps incompetence, may well be in order. Once they are over, Mr Rajan can move on to the more normal reform agenda: modernising the institution, improving communications, cleaning up the banks' balance sheets, strengthening financial sector regulations, developing markets, and promoting financial inclusion.

And should he need relief from the routine rhythms of central banking, he could always speak on the revenge of the financial Luddites at future gatherings of central bankers - and, who knows, Larry Summers may well be in attendance.

The writer is a senior fellow at the Peterson Institute for International Economics and Centre for Global Development. An abbreviated version of this article appeared in the Financial Times on August 8