Rexit: This government has just shot itself in the foot

Even before Brexit, India has suffered Rexit. Raghuram Rajan has announced he will exit as RBI governor when his term ends in September. Every RBI governor since 1992 got an extension. So, Rajan’s case stands out.

Global investors widely view him as India’s best central banker ever. His exit sends worrying signals on both the political front (about the quality and independence of Indian institutions) and economic front (whether his battles against inflation, crony capitalism and fictitious bank balance will lose momentum).

I predicted a fortnight ago that tens of billions of dollars would exit India if Rajan was asked to leave. On Monday, the rupee fell (because of a sell-off in the debt market) but equities rose. There was no immediate panic. I could be proven totally wrong, but remain pessimistic about the coming months. Things will get ugly if emerging markets suffer another financial tempest, and the next RBI governor is seen to lack Rajan’s independence and skills. In May, Subramanian Swamy of the BJP castigated Rajan for not being ‘mentally Indian’ (Rajan has a US green card), and ruining the economy through high interest rates, an overvalued rupee and excessive toughness on bank bad debts.

Neither Prime Minister Narendra Modi nor finance minister Arun Jaitley defended Rajan strongly or condemned Swamy. Nobody knows if Rajan took this as a signal to go. But, clearly, the government did not strain to retain him.

Rajan’s bold, independent positions antagonised BJP members. They suspected Rajan was having a dig at this ruling dispensation when he warned against the attractions of political strongmen, and emphasised democratic accountability and strong independent institutions. Rajan voiced doubts about the accuracy of government data showing high GDP growth. He downplayed reports that India had, after China’s slowdown, become the world’s fastest-growing major economy, saying India was a one-eyed king in the land of the blind.

The government’s ‘Make in India’ campaign aims to make the country a global manufacturing hub like China. But Rajan warned against trying to ape China, and suggested that ‘Make for India’, emphasising the domestic market, might be a better approach.

Rajan assumed office during the ‘taper tantrum’ of September 2013. He tamed that panic by attracting $26 billion of dollar deposits from overseas Indians. Since then, he has brought inflation down from 10.5% to 5.8%. The current account deficit is down from a horrific 4.8% of GDP to almost zero.

Rajan has railed against crony capitalism, telling banks to go after the cronies and fully disclose and provide for bad debts. He deserves some credit for India’s economic fundamentals looking good today when many other economies are emitting distress signals. But many businessmen and serious economists are critical of Rajan. To tame inflation, Rajan has kept interest rates relatively high, and critics say this makes India uncompetitive with its Asian neighbours.

The global commodity crash has hit Indian producers of steel and other commodities, and high interest rates bloody their balance sheets with red ink and threaten their existence. Around 17% of public sector bank loans are under stress. The real effective exchange rate, measured against a basket of six major currencies, has appreciated 20% since 2005. It has appreciated 10% against a broader basket of 36 currencies that includes most of India’s Asian export competitors. Serious critics say this explains why exports have fallen 17 months in a row. They complain that in single-minded pursuit of inflation control, Rajan has been much too slow in lowering interest rates and the rupee’s value.

Rajan responds that since India is the world’s fastest-growing major economy, high interest rates cannot be killing business. The current account deficit is close to zero, so the rupee is not overvalued. Historically, big businessmen with political contacts have got banks to write off or evergreen loans, and Rajan is determined to stop this cronyism. He has ordered the banks to clean up their books even if that means raising huge sums for recapitalisation. From a political viewpoint, the greatest worry raised by Rajan’s exit is that Modi wants yes-men and political pals in top posts rather than independent experts, and this will deepen the steady erosion of Indian institutions. Many of the government’s appointments to educational and cultural bodies have already drawn fire for this reason. Economists Daron Acemoglu and James Robinson in Why Nations Fail conclude that a middle-income country can’t hope to get to high income status without strong, independent institutions. This government shows little awareness of this.

On the economic side, markets will take Rajan’s exit as a precursor of falling interest and exchange rates. Critics say this will be good in the medium term. Maybe. But portfolio investors could pull out billions of dollars in the short term. They poured $40 billion into Indian debt markets last year in search of high yields, betting that Rajan would check excessive rupee depreciation.

Now those bets are off, and debt markets are highly vulnerable to an FII sell-off. The resulting volatility could become a storm if Rexit is followed by Brexit.

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