India’s Choice of Central Bank Governor Signals Continuity

Mr Patel’s ap­pointment signifies a continuation of Mr Rajan’s policies, which the markets will cheer.
August 21, 2016 • Commentary
This article appeared in Financial Times on August 21, 2016.

When Raghuram Rajan quit in June as governor of the Reserve Bank of India, and after scurrilous at­tacks on him by a prominent legislator of the ruling Bharatiya Janata party, fears abounded that the government would replace him with a yes‐​man instead of an independent technocrat; an inflation dove instead of a hawk; and a softie rather than a hardliner on the bad debts of well‐​connected businessmen.

Those fears have been eased with the appointment of Urjit Patel, a former International Monetary Fund technocrat and since 2013 Mr Rajan’s deputy governor in charge of monetary policy.

Earlier, Mr Patel had headed a committee that recommended in 2014 that the central bank should adopt flexible inflation targeting — aiming for 4 per cent plus minus 2 per cent. This aimed to anchor inflationary expectations in an economy that had averaged well above 7 per cent annual inflation for five decades. Mr Rajan backed inflation targeting, and the government eventually accepted it. Mr Patel’s ap­pointment signifies a continuation of Mr Rajan’s policies, which the markets will cheer.

Many businesspeople, and some economists, have long argued that inflation targeting is a bad policy that gives insufficient weight to economic growth. These critics repeatedly urged Mr Rajan to cut interest and exchange rates much faster, but in vain. Exports and capital goods production have registered negative growth for most of the past two years. Mr Rajan defended his policies by pointing out that India was already the fastest growing major economy in the world (7.4 per cent gross domestic product growth), with a current account deficit of just 1.1 per cent of GDP. If it ain’t broke, why fix it?

Historically, prime ministers have relied on their own discretion to choose RBI governors, but this time an official search committee was set up for the job. Many past governors have been former bureaucrats used to accommodating political pressures, whereas Mr Patel — like Mr Rajan — is a globally respected academic with a mind of his own.

He has a PhD in economics from Yale University, and started his career with five years at the IMF. He served on several key official committees in India. When prime minister Narendra Modi was chief minister of Gujarat, he appointed Mr Patel as a director of the Gujarat State Petroleum Corporation.

Following the Urjit Patel Committee’s recommendations, interest rates in future are going to be set by a seven‐​member monetary policy committee, not by the RBI governor alone. This should help insulate monetary policy from political and business pressures.

Mr Patel faces several immediate challenges. During the financial convulsions of the “taper tantrum” of 2013, Mr Rajan devised a special scheme to at­tract large dollar deposits from overseas Indians. These are maturing in September, threatening a sudden outflow of $26bn. Mr Patel needs to persuade depositors to roll over their deposits. This should not be difficult.

Second, consumer price inflation touched 6.07 per cent in July, breaching the target and requiring prompt re­medial action. Mr Rajan was able to halve inflation over three years, mainly because of the crash in oil and other commodity prices, but those prices are rising again. Fortunately, the monsoon has been bountiful and agricultural prices could fall sharply within months.

Third, the banking system remains a mess. Bad debts are projected to rise to 8.5 per cent of bank assets in 2017, and almost one‐​fifth of public sector bank loans are stressed in some measure. Mr Patel will have to ensure the banks clean up their act, adopt higher standards for future lending and stand up to political pressures to favour crony capitalists.

The RBI awarded very few new bank licences after the Asian financial crisis of 1997–1999. But Mr Rajan decided to liberalise licensing, and decreed recent­ly that new bank licences would be available “on tap”. The risk is that this could lead to a plethora of new banks and cut‐​throat competition that once again impairs lending standards. On this, most of all, Mr Patel must be on guard.

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