For the last two weeks, the media have been obsessed with two pieces of news: the exit of the Reserve Bank governor, Raghuram Rajan (‘Rexit’), and the exit of Britain from the European Union (‘Brexit’). Today, the media present any such event from the angle of how it will affect speculative flows of foreign capital in and out of India. Indeed, the extent of attention given to these two events, Rexit and Brexit, seemingly far removed from the lives and livelihoods of most Indians, is itself testimony to the integration of the Indian economy with global financial flows.
In what is now a set pattern, Narendra Modi delayed discussing the actions of his partymen (here, Subramanian Swamy) until they achieved their aims (here, the removal of Rajan). Only after this did Modi break his silence, as usual uttering some stern platitudes and distancing himself from the actions of unnamed persons. It is possible that the Prime Minister and the BJP leadership now wish to rein in Swamy’s antics; but it no secret that Modi had problems with the RBI governor. Under the preceding government, Rajan had headed an official committee which ranked Gujarat as a “less developed state”, much to the annoyance of then chief minister Modi. After Modi came to power at the Centre, Rajan made a number of remarks which indirectly disparaged or undermined the BJP government: for example, on the Prime Minister’s ‘Make in India’ slogan, or on the Finance Minister’s claim that India had the fastest rate of growth. Perhaps Rajan believed his status as darling of foreign investors protected him from removal.
Moreover, the Government clearly wanted the RBI governor to reduce interest rates, hoping thus to revive growth without incurring additional Government spending. Contrary to this, Rajan reduced interest rates very slowly, so slowly that real interest rates (i.e., the interest rate minus the inflation rate) actually increased at times even after a seeming reduction. The Finance Minister and the Chief Economic Adviser repeatedly indicated their frustration at this policy. For this reason, the ministry and the RBI wrangled regarding the composition of the Monetary Policy Committee that will in future set interest rates.
The Government is also said to be considering other proposals which would be opposed by Rajan – for example, to use part of the RBI’s capital to clean up the bad loans of the public sector banks. It has also set up a committee to consider limited changes to the Act which compels the Government to reduce its fiscal deficit (the FRBM Act); that is, it wants a bit more room to spend, in order to revive the fortunes of the corporate sector. This too would have faced Rajan’s disapproval, which he might have countered by hiking interest rates.
And yet, so strongly did foreign investors and credit rating agencies back Rajan that he might have survived; for the differences between Rajan and the finance ministry were within a narrow frame, in which both sides treated the interests of foreign investors as paramount. What decided the question for the ruling party was that Rajan violated their most sensitive taboos, by criticising, albeit indirectly, their intolerance. At one point he even pointedly mentioned that Hitler’s “strong government” led Germany to ruin. On such core elements of its professed ideology the regime brooks no criticism. Indeed, the chief economic adviser recently joked that if he answered a question about the ban on beef, he would lose his job. Therefore Rajan’s departure was more or less to be expected, for reasons which had less to do with economic policy-making than with the political hegemony of the Sangh Parivar.
Nevertheless, various half-truths regarding the Rajan affair have been swirling around, creating confusion.
Rajan as US agent
The campaign against Rajan was launched by the ruling party’s recently-inducted political adventurer and fortune hunter, Subramanian Swamy. Swamy charged that Rajan, a US green card holder, was “mentally not fully Indian”, i.e., he owed allegiance to the US. He also charged that Rajan was suppressing domestic industry with high interest rates; this, too, was “anti-national in intent”. Thus Swamy presented his oust-Rajan campaign as a patriotic exercise.
If we ignore for the moment the person making the charges, there appears at first to be an element of truth to them. Rajan has indeed adhered to high interest rates regardless of the state of the productive economy; and, like many other top policy-making officials in India in recent years (Montek Singh Ahluwalia, Kaushik Basu, and Arvind Subramanian, to name a few), he is from the IMF-World Bank stable, wedded to neoliberal theories that serve the interests of foreign capital.
However, we can neither ignore the person making such charges, nor the context for them. In fact, Swamy’s ‘patriotism’ is bogus and diversionary. After all, it is not Rajan’s policy alone, but the entire gamut of policies being implemented by the Modi government that militates against national interests. Indeed, the fear that the exit of Rajan might annoy foreign investors has spurred the Modi government to hasten further ‘reforms’, surrendering yet larger swathes of the economy to foreign capital. On the first working day of the share market after Rajan’s announcement, the government liberalised foreign investment rules in nine sectors – aviation, pharmaceuticals, defence, food trade, retail, animal husbandry, private security agencies, television broadcasting, and broadcasting carriage services.
Modi tweeted that these new moves would make India the “most open economy in the world.” Headlines in the Business Standard made the purpose explicit: “FDI Shower to Douse Rajan Fire” and “FDI gain blunts Rexit pain.” Far from denoting nationalism, the exit of Rajan became an occasion for ceding, or indeed soliciting, greater foreign control of the economy. Amid this torrent of liberalisations, Swamy’s ‘nationalism’ conveniently went to sleep. Notably, S. Gurumurthy, another Sangh Parivar pundit who claims to represent ‘economic nationalism’, issued a ringing endorsement of the latest FDI liberalisations.[1]
Even Swamy’s objections regarding Rajan’s nationality are hypocritical. The BJP-appointed vice-chairperson of the Niti Aayog, Arvind Panagariya, is a professor at Columbia University, New York. He was earlier chief economist at the Asian Development Bank, and has worked for the World Bank, the IMF, and the World Trade Organisation. The Minister of State for Finance, Jayant Sinha, has spent his professional career working for the international consultancy McKinsey, the global hedge fund Courage Capital, and the American Omidyar Network. Among those short-listed by the Government as Rajan’s replacement are those with similar credentials.
Indeed, the Government is likely to appoint, in place of Rajan, someone who differs only secondarily, if at all, with Rajan’s policies. The discussion in the media about Rajan’s replacement is quite explicitly framed as a search for who will be acceptable to foreign investors. In a sense, the frame for RBI policy was not set by Rajan; it was set fundamentally by international finance, which now has a tight grip on the Indian economy, and can veto with its feet any policy it does not like. International finance merely favoured Rajan for doing its bidding more aggressively and with slicker sense of public relations.
Rajan as economy-wrecker
As for the claim that Rajan is wrecking the economy with high interest rates, it is strange for supporters of the Government to make this argument. For, even with the limited aim of providing a stimulus to growth within the existing economic set-up, a far more effective way of stimulating demand is by increasing Government expenditure. Indeed without such a stimulus, a reduction of interest rates would have no effect in the present conditions. In the developed world, interest rates have been at rock bottom levels for years, and some central banks have even begun experimenting with negative interest rates, but the global recession refuses to end. Global demand is depressed by widespread government spending cutbacks. In India too, the Modi government, following in the footsteps of its predecessor, is restraining expenditure in the face of a paucity of demand: Central government expenditure has been brought down from 15.4 per cent of GDP in 2010-11 to a projected 13.1 per cent of GDP in 2016-17.
This reduction in Government spending is a much more powerful depresser of demand than high interest rates. A reduction in interest rates boosts growth only when businesses want to borrow; and in a situation of depressed demand, with large unutilised productive capacity, few businesses want to borrow in order to expand capacity. On the other hand, an increase in Government spending directly puts money in the hands of people, and boosts demand (and would thereby also stimulate businesses’ demand for credit). As such, the Government itself is principally responsible for the recession, and cannot displace its responsibility onto the RBI alone.
Rajan as anti-corporate crusader
Rajan, for his part, has been parading as the champion of the common man – the latter’s sole defence against inflation, resisting pressure from the corporate sector for lower interest rates. Speaking to an audience at the Tata Institute for Fundamental Research (TIFR) just after releasing news of his leaving the RBI, he strained to give a class angle to his allegedly anti-inflationary policies:
While higher inflation might help a rich, highly indebted, industrialist because his debt comes down relative to sales revenues, it hurts the poor daily wage worker, whose wage is not indexed to inflation.
Some of Rajan’s defenders, including his colleagues at the University of Chicago, have come up with another argument: Rajan was being victimised because he had taken stern action against delinquent corporate borrowers – ‘crony capitalists’, to use the currently fashionable term. These arguments are sheer nonsense, and are a camouflage for the real purpose behind Rajan’s policies, which we will come to later.
Let us first dispose of the notion that Rajan was a crusader against corporate defaulters, and an advocate of transparency. In fact, the contrary was the case. On February 16, in the course of a public interest litigation regarding loans made by a public sector institution to defaulting corporate firms, the Supreme Court directed the RBI to provide a list of companies that have defaulted on bank loans in excess of Rs 500 crore. On 30 March, RBI submitted a list of such defaulters in a sealed envelope to the Supreme Court, with a request to not divulge the list to the public. Rajan defended his decision to keep names of large bank defaulters private, saying that such disclosures, if not seen in context, can “chill business activity”. He made an odd comparison: “Sometimes you default on a credit card bill. Would you like that default to be put up in public?” However, the funds involved are from public sector banks; the defaults are being paid for by the public, in the form of recapitalisation of the banks. It is strange to argue that the public has no right to know the names of those who have their money.
Rajan’s arguments on inflation
Next, let us take Rajan’s ‘inflation-hurts-the-poor’ argument. At one level, the argument is that, by controlling money supply, excess demand, and therefore price rise, can be checked. At a more sophisticated level, it is that, if the central bank sticks firmly to its anti-inflation stance, people will adjust their expectations of inflation downward, and will not peg up their wages/prices; this will prevent inflation from spiralling higher. However:
(i) The RBI cannot control consumer inflation through interest rate hikes. In the first place, economy-wide excess demand is not a problem in India, a backward country perennially starved of demand. The Indian economy also fails to ensure that its surpluses are invested in productive activity, as a result of which it suffers from periodic shortages, such as in agriculture, and these shortages can cause price rise even amid weak demand. The predominant contributors to consumer inflation in India are commodities such as food and fuel, the prices of which are not affected by the RBI’s raising or lowering interest rates. The general level of prices may rise because prices of imported oil go up, or because the Government increases taxes on that oil, or there is a crop failure (i.e., ‘cost-push’ inflation). It may have nothing to do with excess demand (‘demand-pull’ inflation); indeed cost-push inflation can happen even amid a recession. Trying to reduce demand in order to cure cost-push inflation may merely result in a combination of inflation and stagnation, i.e., stagflation.
Over the last two years, we have seen the inflation rate fall as a result of falling international prices of oil and other raw materials, which affect prices in a now-globalised India. The reason for this fall is the worldwide recession and economic crisis. According to World Bank data, global energy prices fell 40 per cent between May 2014 and May 2015; they fell another 27 per cent by May 2016. The corresponding figures for metals/minerals were 12 and 20 per cent. Global agricultural prices fell 16 per cent between May 2014 and May 2015; they grew a paltry 1.6 per cent by May 2016.
At times, we have also seen food prices rise in India, largely as a result of crop shortfalls and manipulations by speculators. Food inflation based on the Consumer Food Price Index increased from 6.4 per cent in April 2016 to 7.6 per cent in May 2016. Neither the falls nor the increases in the above prices have anything to do with the RBI’s interest rate actions.
In a strange demonstration of blind adherence to dogma, Rajan said in April that he was watching the monsoon rain forecasts in order to decide whether or not to lower interest rates. In other words, if the monsoon forecast were to be good, inflation would be likely to go down as a result, the RBI would consider lowering interest rates. From that, it is evident interest rates are not determining inflation. Indeed, going by Rajan’s statement, rainfall and other such phenomena would be determining the RBI’s decisions on interest rates.
Despite all this, Rajan claims credit for the fall in inflation during his governorship, rather like a priest who claims his rituals caused a bountiful monsoon.
(ii) It is true, as Rajan said, that a daily wage worker suffers as a result of inflation, since his/her wages only rise with a considerable lag, whereas the industrialist is able to immediately pass on increased costs to the consumer in the form of higher prices. And therefore price rise, especially of essential items of mass consumption, is of enormous importance to the people. However, inflation control is not an end in itself; the point is to protect the real income of the worker. The daily wage worker suffers not only when prices rise, but also if he or she does not get work, or gets work at a lower wage. And when the Government suppresses spending mercilessly, that is precisely what happens.
Rajan is a fervent believer in reducing Government spending, so much so that before the Union Budget he made clear that he would not reduce interest rates unless the Government cut the fiscal deficit.[2] In that sense, he is not only complicit in, but a co-architect of, the demand-suppression programme of the Central government. When we talk below of Rajan’s policy, we mean this two-pronged demand-suppression policy.
Let us compare two situations. In the first, inflation is 10 per cent per year, but the labourer’s nominal earnings are rising by 15 per cent per year, partly as a result of rising wage levels, and partly because there is more work available. In real terms, i.e., once we discount for inflation, the labourer’s earnings are rising by 4.5 per cent per year. In the second situation, inflation is just 5 per cent, but the slow growth of wages and the paucity of employment keep the labourer’s nominal earnings at the same level as the previous year. In that case, the labourer’s real earnings are actually going down by 5 per cent per year. Clearly, if the so-called fight against inflation produces the second situation, the daily worker for whom Rajan’s heart allegedly bleeds is worse off.
Indeed, the RBI’s Monetary Policy Report of April 2016 notes that “wage growth in rural areas as well as the organised sector remained weak” in the second half of 2015-16. “Rural wages… recorded moderate growth in nominal terms and remained almost stagnant in real terms. Wage growth in the organised sector, reflected in per employee cost, decelerated in Q3 of 2015-16 for both manufacturing and services, with the manufacturing sector registering a sharper decline.” Moreover, employment growth in the manufacturing sector, already poor at the start of the Rajan period, appears to have sharply dipped in 2015 (see Chart below). There would also have been a much larger decline in agricultural employment (as well as other rural employment) as a result of two consecutive years of drought in 2014-15 and 2015-16. In other words, there has been stagnation/decline in real wages combined with less employment In this situation, the RBI’s self-congratulation about the fall in inflation is grotesque.
Source: Labour Bureau. The sectors surveyed were apparels, leather, metals, automobiles, gems & jewellery, transport, IT/BPO and handloom/powerloom.
(iii) In fact the effects of this demand-suppression programme are known to Rajan. For some time now the RBI and the Government (the latter in its Economic Survey) have been celebrating the fact that rural wage growth has plunged since early 2014, and by the end of 2015 was lower than inflation (i.e., real wages were going down). They also applaud the niggardly increases provided by the Government in minimum support prices of crops. They do this because their method of inflation control hinges on shrinking real wages (as well as the real incomes of small producers such as peasants).
It is for this reason that, rather than use the Wholesale Price Index, or WPI (which would be an approximation of the prices of all goods in the economy) as the relevant measure of inflation for determining interest rates, the RBI chooses to use the Consumer Price Index, which measures inflation only in the basket of consumption goods. Indeed, Rajan said bluntly in his TIFR lecture, “Since monetary policy ‘works’ by containing the public’s inflation expectations and thus wage demands, Consumer Price Inflation is what matters.” (emphasis added)
Now, one cannot rule out that this programme may eventually bring down inflation, but it would be an exceptionally painful way to do so. As we have seen, the major sources of price rise in India lie not in excess demand, but in developments such as oil prices and crop failures, which do not respond to demand-squeezing measures like interest rate hikes and Government spending cuts. However, if the purchasing power of workers, peasants and other petty producers were to be squeezed enough through Government spending cuts and high interest rates, that would affect demand for various goods and services, and thereby eventually affect prices. Of course, that involves ruthlessly suppressing consumption by the masses, and suppressing employment in different sectors. Having caused mass suffering, the Government can celebrate it as a victory over inflation. This is what Rajan actually meant when he said, in the same lecture, that “we can control demand for other, more discretionary, items in the consumption basket through tighter monetary policy. To prevent sustained food inflation from becoming generalized inflation through higher wage increases, we have to reduce inflation in other items.”
As the fruit of this policy, the prices of the basket of goods consumed by industrial workers (CPI-IW) rose 5.6 per cent in 2015-16, largely on account of crop shortfalls and traders’ manipulations; but the WPI, representing a broader range of goods, fell by 2.5 per cent, reflecting the broader drought of demand. The huge gap – 8 percentage points – between the two measures tells us of the dual sufferings being endured by the masses: inflation in mass consumption goods and depression of economic activity and employment. Says Rajan:
The wrong thing to do at such times is to change course. As soon as economic policy becomes painful, clever economists always suggest new unorthodox painless pathways…. Adjustment is difficult and painful in the short run. We must not get diverted as we build the institutions necessary to secure a low inflation future, especially because we seem to be making headway.
The real interests behind ‘inflation targeting’
If this programme, far from protecting the daily wage worker, suppresses his/her wages and employment, whom is it for? It turns out that foreign speculative investors (for example, FIIs who invest in Indian markets), are keenly interested in keeping down inflation in the rupee. Why? One major reason is that inflation may lead to a decline in the rupee’s exchange rate; and such a decline can wipe out the gains made by the foreign investor.
To take an example: Say the exchange rate of the rupee is Rs 50/dollar on a particular date. A foreign investor brings in $2,000,000 (Rs 10 crore) and buys 100,000 shares in an Indian company at Rs 1,000 a share. Further, say that the price of the share climbs 20 per cent over the course of a year, and the foreign investor’s holding is now worth Rs 12 crore. At this point, he wishes to reap the gains of his investment by selling the shares and repatriating the proceeds abroad. However, by that time the rupee’s exchange rate has fallen to Rs 60/dollar. In that case his Rs 12 crore would be worth only the same $2,000,000 that he brought in a year ago. All his gains would be wiped out. Therefore, foreign speculative investors demand deflationary policies in India, in the expectation that these will strengthen the rupee, and protect the repatriable value of their investments.
At the end of his TIFR speech, Rajan brings forward his real concern, i.e., to gain the confidence of foreign investors:
The rewards will be many. Our currency has been stable as [foreign] investors have gained confidence in our monetary policy goals, and this stability will only improve as we meet our inflation goals. Foreign capital inflows will be more reliable and increase in the longer maturity buckets, including in rupee investments. This will expand the pool of capital available for our banks and corporations.
The Rajan effect
In fact, the most celebrated achievement of Rajan during his tenure was to stabilise the rupee and revive capital inflows. When he came into office in September 2013, the balance of payments situation was critical. In May 2013, the US central bank indicated that it would be tapering off its expansion of money supply, which ever since the onset of the financial crisis in 2008 had pumped a sea of US dollars across the whole world. In anticipation of the reduction of dollar flows into India, funds started to flow out in July-September 2013, and the rupee’s value fell to a low of Rs 68.4 on August 28, 2013.
In this situation, the Government and the RBI under Rajan took several steps. The Government placed curbs on gold imports, which had soared during the previous two years, but fell steeply after the curbs were instituted. This old-fashioned measure, harking back to the pre-liberalisation era, was the single most effective step in checking the soaring trade deficit. However, the Government instituted it merely as a temporary measure, out of desperation, to be withdrawn as soon as the immediate crisis passed.
Meanwhile, Rajan shored up the falling foreign exchange reserves with high-cost foreign borrowings. He provided a heavy subsidy to banks to attract foreign currency non-resident (FCNR) deposits at high interest rates.[3] The scheme attracted a massive $34 billion in FCNR deposits in just three months, by November 2013 (of which $25-27 billion in three-year deposits are maturing in September-November 2016). This giant inflow, as well as the reduction in the trade deficit, helped shore up the falling foreign exchange reserves. Rajan also raised the rate at which the RBI lends to the banks (the repo rate) by 0.75 percentage points by January 2014, in order to restrict domestic demand and attract foreign inflows into debt.
Along with such measures, Rajan set up a series of committees to reshape monetary policy and the banking sector. Among these was the Urjit Patel committee, which in January 2014 recommended that the RBI be given the single aim of inflation targeting and that monetary policy be set by an independent committee (in effect, a body beyond the reach of the Government). All this was music to the ears of foreign investors. Beyond such individual measures, too, foreign investors felt confident that with Rajan in place their interests would be taken care of.
Thus during 2014-15, net foreign investment surged to $73.5 billion – nearly triple the $26.4 billion in 2013-14. Within this, net portfolio investments in India’s share and debt markets surged to reach their highest level so far of $42.2 billion in 2014-15 ($32.4 billion in 2009-10). Net capital inflows were 4.3 per cent of GDP during 2014-15 (as against 2.6 per cent during 2013-14). This resulted in the foreign exchange reserves rising by $61.4 billion in 2014-15. All this was seen as the Rajan miracle.
The miracle was aided by some luck: the US central bank decided to delay the process of tapering which had triggered the crisis in the first place, and thus postpone the crisis; and oil prices fell, bringing down India’s trade deficit. But more fundamentally, the Rajan miracle itself was essentially the instituting of policies which would attract foreign capital flows, no matter how fickle, leaving India vulnerable to outflows at any time in the future.
India’s External Debt, Foreign Exchange Reserves, Short-Term Debt, & Volatile Capital ($ bn.)
Sources: RBI, Ministry of Finance.
n.a. – not available. Debt service payments (principal and interest payments) as a ratio of current foreign exchange receipts.
* Short term debt by residual maturity – all debt, including long-term debt, falling due within one year from the date.
** Volatile capital here defined as short term debt by residual maturity plus cumulative portfolio investment.[4]
As can be seen from the above, while the foreign exchange reserves rose by $83 billion between end-September 2013 (when Rajan was appointed) and end-March 2016, the country’s external debt rose by $85.3 billion over the same period. That is, the reserves are built on additional borrowings. That these are high cost borrowings is indicated by the rise in the debt service ratio, from 5.9 per cent at end-March 2013 to 8.8 per cent in end-March 2016.
The ratio of external debt to GDP has not declined, and indeed is slightly higher than in March 2013. The net international investment position of India (India’s international assets minus her international liabilities) was negative, at minus 17.6 per cent of GDP in March 2013; it was minus 17.7 per cent of GDP in March 2016.
Most tellingly, the ratio of short-term debt to the foreign exchange reserves, while marginally better than in March 2013, remains very high, at 57.4 per cent; and the ratio of volatile foreign capital to the reserves too remains very high, at 120 per cent. That is, the vulnerability of India to sudden capital outflows has not diminished under Rajan’s rule. This vulnerability keeps resurfacing periodically: for example, during the first half of 2015-16, net portfolio investment saw an outflow of $8.7 billion (compared to an inflow of $22.2 billion in the first half of 2014-15).
Irrespective of whether these outflows trigger a full-fledged foreign exchange crisis, these mini-crises regularly trigger further ‘liberalisations’, i.e., further concessions, incentives and give-aways to foreign capital. Skillful managers of these mini-crises, like Rajan, press the case for further concessions. And indeed, within the existing frame of integration with global Capital, there is little option for the rulers but to pursue precisely such policies, failing which they will be punished with capital outflows. Rajan’s replacement, whoever he may be, may differ with him on secondary matters, but on the broad tenets of managing an economy helplessly dependent on flows of foreign speculative capital, he cannot afford to deviate too far from the path laid down by Rajan – for the path is actually determined by that dependence. Only a regime capable of snapping that dependence is capable of determining its own policies; and such a regime requires a political basis which does not exist at present. In that sense, Rajan has exited, but the forces which created Rajan remain in place.
[1] Interview with Economic Times, 27/6/16, http://economictimes.indiatimes.com/markets/expert-view/culturally-rajan-is-more-indian-than-many-of-our-liberals-my-objections-are-about-his-policies-s-gurumurthy/articleshow/52918515.cms
[2] In his policy statement of February 2, 2016, Rajan said that “fiscal rectitude…. needs to be maintained…. Structural reforms in the forthcoming Union Budget that boost growth while controlling spending will create more space for monetary policy to support growth…” This meant: no interest rate cuts unless fiscal deficit reduction and other such ‘reforms’ are implemented by the Government.
[3] Under the scheme, Indian banks would raise three- and five-year deposits from NRIs at interest rates much higher than the prevailing rates abroad (4 percentage points higher than Libor); this was very attractive to depositors. On maturity, the banks would repay the depositors in foreign currency. Normally, this would have posed a problem to the banks, since in the interim the rupee might have fallen sharply in value. However, under the new scheme, the RBI protected the banks against a fall in the rupee’s value, by giving them rupees at low interest rates (3.5 per cent) in exchange for the foreign currency at the start of the period, and returning them dollars at the end of the period. In essence, the RBI bore the losses that would have been borne by the banks, in order to attract dollars.
[4] This differs from the RBI’s definition, which takes only short term debt by original maturity + portfolio investment.
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