The government withstood the criticism for not letting interest rates decline more rapidly, as many demanded and argued with empirical evidence in support. (Source: Reuters) The government withstood the criticism for not letting interest rates decline more rapidly, as many demanded and argued with empirical evidence in support. (Source: Reuters)

The die is cast. Raghuram Rajan has announced his return to academia. Evidently, this was separation by mutual consent. So we should let it rest at that. Looking forward, the relevant questions to ask are: Does this reflect the NDA government’s inability to retain talent? Did Rajan, to some extent, bring this upon himself? Would this precipitate action by Rajan result in calamitous outcomes for India? Were Rajan’s policy priorities in sync with the government’s policy goals?

Having inherited Rajan as governor of the RBI, Narendra Modi and Arun Jaitley gave him maximal support and the widest space to implement the plan he had announced after taking over in September 2013. The government withstood the criticism for not letting interest rates decline more rapidly, as many demanded and argued with empirical evidence in support. That Rajan succeeded in restraining inflation was partially plain good luck and partly staunch support by the government in maintaining tight fiscal discipline. The government also backed down twice in the face of opposition by Rajan, first to the Financial Sector Legislative Reforms Commission (FSLRC) recommendations and second, to the creation of an independent public debt office in the ministry of finance. Moving Rajiv Mehrishi suddenly and unexpectedly out of the Department of Economic Affairs (as secretary) was also perhaps done partly with an eye to placate Rajan. What more would a government do to retain talent? The more pertinent question is perhaps why Modi took away his support during the last few months.

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The principal economic reason would seem to be the continued extreme weakness in credit off-take from commercial banks. This is at a decadal low at 8-9 per cent, compared, for example, to 27 per cent in 2009. This signifies both a loss of private investors’ appetite for investment and the commercial banks’ reluctance to advance credit as their balance sheets take hard knocks in the face of unremitting pressure from the RBI to surgically clean up their loan portfolios. A government deeply concerned with generating more jobs and raising the rate of economic growth could have expected a helping hand from Rajan. Instead, the governor seemed bent upon completing the cleaning up even if it implied significant corporate and commercial banks. The danger could surely be that the damage in the short term would outweigh the uncertain positive long-term consequences.

But the other, perhaps more plausible reason, was Rajan’s attempt to combine the role of a senior policy mandarin with that of a public intellectual. I wonder how he did not realise that this is an impossible mix. Not only did he advise the finance minister to stick to the fiscal target, which was clearly stepping over red lines, he also chose to speak publicly on the state of tolerance in the country and whether or not a strong government faces the danger of succumbing to dictatorial tendencies a la the emergency in India or Hitler’s Germany. Taking on the role of principal critic is perhaps not conducive to working as part of a team.

This may be in line with glorifying the RBI’s independence. I, for one, would rather have the RBI work closely with the government to achieve optimal macroeconomic outcomes. After all, the Peoples Bank of China and the Bank of Japan and even the US Fed are known to work closely with the government in office and not stake out their independent paths. Could Rajan, an excellent networker otherwise, have become a victim of excessive adulation from the community of fawning financial analysts and breathless media anchors who in their selfish interests made him into a prima donna who was beyond all established norms.

Rajan also riled a few of Modi’s cabinet colleagues by not engaging with them as equals and instead responding to them through public platforms, almost in hectoring tones. The remark on Make in India; letting the minister of commerce know about the correctness of his foreign exchange stance through the C. D. Deshmukh lecture; exhorting small and medium entrepreneurs to not expect any relief from a depreciating rupee — could all have been handled more discreetly and less dismissively.

Third, it is surely a gross exaggeration to claim that come tomorrow, foreign investors will boycott India and decamp in hordes from our shores. The markets have taken this in their stride and shown that they believe while individuals are important, it is institutions and their inherent capabilities that drive economic outcomes. All major brokerages have already announced that the India story remains intact. With my high respect for Rajan’s undoubtedly superior intellect and capabilities, I still have to insist that India’s structural strengths, that include its robust institutions and future growth prospects, will continue to attract investment.

Fourth, having announced flexible inflation targeting as his preferred policy objective, Rajan was unremitting in his drive for squeezing out all inflationary expectations from the system. In this, he was lucky as global oil prices plummeted soon after he took over. One wonders the extent to which Rajan would have hiked rates, had global oil prices remained in the vicinity of $140. Food prices are an important driver of inflationary expectations. These are driven more by the supply-demand dynamics than by the interest rate policies especially when the transmission mechanism is weak. Could better results not have been achieved if the RBI and relevant government agencies worked together, behind the scenes, to address supply constraints that push up food inflation in the country and raise the price of wage goods, thereby pushing up costs? This, in turn, forced the RBI to keep interests rates high, delivering a double whammy to the industrialists as they end up suffering from both high wage and capital costs.

Therefore, it is, as I said earlier, sad to see Rajan return to Chicago. However, it is not entirely the government’s fault and he would have to share part of the blame for this unfortunate situation. The most important lesson to my mind is for the government to choose a substitute who has not only the domain competence but also the ability and humility to work as an effective and a somewhat self-effacing member of India’s economic policy team. The collective aim would be to generate maximum employment growth while retaining macroeconomic stability. This can be achieved without generating so much heat or light.

(This article first appeared in the print edition under the headline ‘It takes two’)

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