Foreign investors I met in Singapore in May were anxious to know whether Reserve Bank of India (RBI) governor Raghuram Rajan would get a second term. Almost all of them said that billions of dollars would flow out of India if Rajan was denied a second term.
When I wrote about the potential exit of tens of billions of dollars in a recent column, I faced a barrage of criticism. Are you trying to say that Rajan is indispensable? Can the entire worth and future of a country depend on one man, no matter how eminent? Surely the economic fundamentals of a country matter more than personalities? Why should India submit to such blackmail by foreign investors?
Do you really think that India, which has overcome so many crises, will not overcome the departure of Rajan? Are not the graveyards of the world filled with people once regarded as indispensable? When so many eminent economists have criticised Rajan’s policies, is it not possible that India will actually benefit from Rajan’s exit?
These criticisms fail to counter the simple point that foreign investors applaud Rajan’s steering of the Indian economy, and this affects the amount they will invest in India. Nobody can say that Rajan, or Narendra Modi, or anyone else, is indispensable. What investors do say is that good leaders are better than bad leaders, and they will put more money behind a good, proven leader than an unknown or bad one. That is just common sense.
Rhetorical questions like ‘Do you think India will disappear into a black hole just because Rajan leaves?’ miss the point. Countries do not disappear into black holes. But they do fare better or worse depending on who is in charge. India will physically survive a succession of bad prime ministers and RBI governors, but will surely suffer a fall in growth and prosperity. And that is good enough reason for foreign investors to look for greener pastures.
Some may return later if prospects improve. They have done exactly that on many past occasions. But the fact remains that repeated exits of foreign investors are hurtful, damage confidence, cause high volatility and affect long-term growth.
Policies Matter More
Critics are right in saying that a country’s economic fundamentals matter more than whether this or that person is in charge. Personalities matter. But economic fundamentals matter more. For that reason, the bulk of foreign investors will surely stay put in India. However, a modest fraction of foreign investment will be pulled out. The pullout may be especially strong in the debt market, which saw inflows of around $40 billion last year.
Is it possible that foreign admiration for Rajan is overhyped, and that his successors may be as good or better? Yes, indeed. History is full of heroes who fell from grace, and of modest replacements that rose to dizzy heights after assuming office. I personally think the powers and influence of central bankers is greatly overrated by the markets.
I think central bankers have far less ability to influence inflation or growth than many marketmen believe. But when it comes to investment flows, what matters is not my opinion or that of Rajan’s many critics. What matters is the opinion of foreign investors, even if they ultimately prove to be wrong.
Policies matter more than personalities, but the two are inter-linked. Rajan has been castigated by many businessmen and politicians for keeping interest rates and the exchange rate too high, hitting growth and exports. Rajan has firmly resisted pressure from business, the finance and commerce ministries on these issues.
This, in turn, has brought in a lot of foreign portfolio investment, especially in the debt market, which is sensitive to inflation and exchange rates. In earlier times, almost all FII investment went into equities and derivatives. But in recent years FIIs have poured billions into India’s debt market to take advantage of the country’s relatively high interest rates, and brought in a record $40 billion last year. They believe that Rajan will not depreciate the rupee so fast as to erase the dollar value of higher interest rates.
If Rajan Quits
But if Rajan is asked to quit, the markets will take this as a signal that the government will appoint somebody willing to lower interest rates and exchange rates much faster. This will be an excellent reason for debt investors to pull out as fast as they can, before the rupee depreciates much.
Many equity investors, too, will think it sensible to pull out while the rupee is still fairly strong, and may re-enter after the next RBI governor weakens the rupee significantly. Such expectations can be self-fulfilling: a big pullout of FIIs will by itself send the rupee lower.
The markets are not irrationally in love with Rajan. They do not think he is indispensable, or that India will disappear into a black hole without him. But they will see his exit as a precursor of falling interest and exchange rates, and adjust their investments accordingly