Central Bankers globally have been playing a critical role in the fragile recovery of the global economy since the financial crisis of 2008. Starting with the US Federal Reserve, when Ben Bernanke was its chairman, Central Bankers have not hesitated in using non-traditional tools, as the limits to cut interest rates were often tested.
Global opinion remains sharply divided on these types of experiments taken up by the Central Bankers. After cutting rates sharply to near zero (Zero Interest Rate Policies, or ZIRP, transforming now to Negative Interest Rate Policies, or NIRP), the Fed went on an aggressive asset purchase program through three rounds of quantitative easing (QE). In December 2015, the Fed finally reversed its course with a 25-basis point hike in interest rates. However, the rate rise cycle seems uncertain as of now, with the market speculating on a number of possible hikes going forward in 2016, with repeated hints from the Federal Reserve about affirming "gradual hike and accommodative" policies. Central Bankers from the European Central Bank (ECB) to Bank of Japan have lately adopted some of these NIRPs aggressively to sidestep the deflationary environment.
Raghuram Rajan, governor of India's Central Bank, the Reserve Bank of India (RBI), belongs to the traditional school of economists. Rajan, as an economist, has repeatedly echoed his discomfort with non-conventional monetary policy tools, and is famous for predicting the 2008 financial crisis. As an academician, he is entitled to be conservative and a believer of a school of ideology. It is legitimate to question Central Bankers' attempts of pretending to be God in their non-stop pursuit of growth and employment with excessive money supply, as the inflationary environment globally remains subdued, with the danger of deflation looming over many economies.
At the same time, India, being a small part of the global economy, cannot have a monetary policy that is not in alignment with major expansionary and accommodative policies of the other major global economies. The country needs growth, development, jobs, and infrastructure. Low commodity prices have helped India in controlling its inflation, as Wholesale Price Index (WPI) remains negative for more than a year, whereas Consumer Price Index (CPI) still remains relatively high due to food inflation as per global standards, but moderate by Indian (and the RBI's own) standards. The RBI's monetary policies have less effect, as acknowledged by the Central Banker itself back in March 2014, and India has faced two consecutive years of drought.
Over the past few months, the RBI has been running a noisy media campaign of cleaning the balance sheets of the Indian banking system by writing off non-performing assets (NPAs, also called non-performing loans (NPLs) in many economies), more so of the country's public sector banks (PSBs), which have majority state ownership. The RBI and the Ministry of Finance, Government of India, as late as 2014, accounted for the vast majority of representation in the boards of the public sector banks - as high as nine or more out of fifteen. And much of these NPAs are carried forward prior to 2014.
The three-year term of Raghuram Rajan, the high-profile, media-savvy face of the RBI, ends in September 2016 unless renewed by the government. Unless Rajan knows for sure from the government that his term would get extended, he should not have got into this sledgehammer approach of banks cleaning their NPAs in two quarters. He surely could have done that in the early phase of his tenure, as many have now opined.
If one analyses this untimely noisy campaign of cleaning the banks' balance sheets, one can understand it may have resulted as Rajan was facing pressure with regard to rate cuts, although monetary transmission showed past cuts not being passed on for investment purposes. The reason was banks loaded with bad debts blocking the monetary transmission mechanism - many of these NPAs were not formally acknowledged in their financial reports. So, Rajan naturally stressed on cleaning those bad debts in two quarters, whereas experienced Central Bankers like Draghi recommend years for the same remedy. What followed is severe investor pain as bank stocks tanked, with short sellers riding on the policy paralysis, the possibility of banks becoming incapacitated - and thereby, a minor problem became a severe one.
The biggest mistake the RBI made was not working out a stress test with banks (as the US and Europe routinely do), and then sharing the same with banks and the government (for capital in PSBs where needed), and thereby, in public. Rajan felt weakening bank stock prices by a trial through media on banks' bad loans would help him achieve the goal of strengthening banks. Failing to clearly state the capital injection amount or the time frame in which it should be done, the RBI created an unprecedented regulatory failure that had never happened in the history of central banking anywhere.
The RBI, under Rajan, thereby made the blatant error of judgment by creating more uncertainty where none of it would occur had he adopted a different and appropriate methodology. But now, one can sense that what the RBI started in good faith and with good intent is increasingly getting out of its grasp as other state agencies get involved in the same, against the Central Banker's own will.
No one should question Rajan's intent, but what increasingly is falling apart is his methodology, message and timing. India's Supreme Court impleaded the RBI as a party to the NPA mess, taking suo motu cognizance. The court has suggested "write-offs" to be a fraud, whereas the RBI has gone one step forward and has been forcing banks to dispose of these bad assets at throwaway prices - without any detailed modalities yet.
The government has been thinking about involving its Vigilance Office (CVC), as large public sector banks are forced to sell non-performing assets with huge hair-cuts. India does not have a matured bond market, and private participation in riskier asset purchases is extremely shallow. Rajan remains against the idea of "Bad Bank" or CVC involvement; however, the government is also considering setting up a "Bad Bank" against the RBI's will. The idea may be not encouraging, but one cannot blame the government, as the Central Banker itself refuses to fulfill its role as a lender of last resort by lending money against some of these bad assets, which is routinely done in other advanced economies. Roping in its state investigating agency, the CBI, is also being speculated. The government is also considering seeking foreign capital for its ambitious National Infrastructure Investment Fund (NIIF) at 10% or more dollar returns, which can potentially be catastrophic, again as PSBs have been incapacitated.
Important bills like the bankruptcy bill, which may help banks recover their assets without lengthy and ineffective legal systems, often get routinely log-jammed in India's parliament due to partisan politics.
Banks anywhere have NPA issues, more so when the commodity cycle is at its multi-year lows. Regulators or banks do not overtly highlight the same, neither do the markets expect them to. India is least affected by this, as neither does the country face huge overcapacity, nor do its banks have huge exposure to the energy sector (although reported NPAs in India are now the highest in Asia, next to Russia's). The RBI's untimely and unwise decision to force banks to come clean without first arranging the capital by working with the government, and its steadfast refusal to act as a lender of last resort by buying bad loans has allowed the nation's Supreme Court, the Vigilance Commission, the Finance Ministry, the Investigating Body (CBI), the media, etc. to get into same NPA solution as a free-for-all childish game, against what the Central Banker wanted. Banking supervision is not merely an academic or transparent media exercise. It is extremely sensitive and serious business, where every utterance of the Central Bankers can move the markets.
Rajan often spoke out angrily in unexpected outbursts about the lavish lifestyles of India's willful defaulters, and he also engaged in speculating on China's stock markets along with the media. As RBI governor, he could probably have desisted from both of these. The role of an academician and a public intellectual is different from that of a Central Banker. He also failed to bring in necessary cultural changes in the RBI. The assignment would surely have been a great learning experience for Rajan, but India may have to pay a price for the mistakes the RBI made during his tenure. Knowing the character of the Modi government and that of the RBI governor, it is unlikely that Rajan would get a second term. The mess created by a great academic talent needs to be cleaned by someone else, and that would not be an easy exercise.
As a B-School faculty member, Rajan would get ample time to introspect over what Peter Drucker, the best management expert the world ever saw, implied when he said: "Company cultures are like country cultures. Never try to change one. Try, instead, to work with what you've got." Rajan probably tried to change too many cultures in India in three years, and the result is what could have been expected from doing that.
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