Raghuram Rajan (University of Chicago Professor) – A Jhatka To Push Formalisation In The Economy could Come At A Cost (Sep 2017)

Chapters

Abstract

Navigating the Complexities of India’s Economic Landscape: Challenges, Strategies, and the Role of the Reserve Bank of India

In the intricate tapestry of India’s economic landscape, several critical challenges and strategic responses emerge, primarily guided by the Reserve Bank of India (RBI). The nation grapples with inflation control, the stabilization of currency, bad loan management, the transition from informal to formal sectors, and the need for transparent communication. Raghuram Rajan, a prominent economist, and other experts have highlighted key aspects such as the partial victory against inflation, the need for a robust bankruptcy regime, the RBI’s role in commercial decisions, and the impact of demonetization on growth. This article delves into these multifaceted issues, offering a comprehensive overview of India’s economic status and the RBI’s pivotal role in shaping it.

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Inflation and Currency Stability:

Raghuram Rajan, a renowned economist, acknowledges that India has made significant strides in combating inflation and stabilizing its currency. The progress is evident in the narrowed fiscal deficit and controlled inflation rates. A key indicator of this success is the increase in foreign reserves and the confidence of investors in Indian rupee-denominated bonds, signaling enhanced economic stability. He further emphasizes the importance of maintaining inflation within the 2-6% band and achieving the 4% target by the year-end, highlighting its significance in attracting foreign investors and creating new opportunities.

Measuring Success in Inflation Control:

The credibility of the Reserve Bank of India (RBI) is closely tied to its ability to maintain inflation within the targeted band. Rajan points out that adhering to the 4% inflation target is crucial for demonstrating the RBI’s commitment to price stability, an essential aspect of economic health.

Bad Loan Clean-up and Recognition of Problems:

The Indian banking sector has faced challenges with non-performing loans. Rajan criticizes the previous approach of under-reporting bad loans and emphasizes the importance of the Asset Quality Review (AQR) in bringing transparency and accountability. Prompt recognition and resolution of bad loans are crucial to prevent economic repercussions. Rajan further elaborates on the AQR exercise conducted during his tenure, asserting that the RBI’s intention was to ensure proper accounting and transparency rather than creating bad loans. He stresses the need for cooperation between the government, industry, and banks to tackle the bad loan problem, warning against complacency and the self-defeating nature of ignoring the issue.

Inadequate Resolution System and Bankruptcy Regime:

The inadequacy of India’s loan resolution system was a significant concern. The RBI’s initiation of an out-of-court bankruptcy process filled a critical gap before the introduction of a legal bankruptcy regime. Rajan views this transition as a necessary evolution in managing distressed loans. He acknowledges the inadequacy of the bank resolution system during his tenure and explains that the RBI’s schemes were an attempt to create an out-of-court bankruptcy process in the absence of a legal framework. However, he expresses concern about the RBI’s involvement in commercial decisions and potential conflicts of interest as a regulator. He believes that the RBI’s role should be limited to deciding between venues for discussion, not delving into the details of specific cases.

RBI’s Involvement in Commercial Decisions:

Rajan raises concerns about the RBI’s involvement in commercial decisions, especially in government-owned banks. He cautions against potential conflicts of interest and suggests limiting the RBI’s role to choosing the appropriate discussion venues rather than delving into specific loan resolutions. He believes that the RBI’s involvement in bank resolution should be limited to deciding between venues for discussion, not delving into the details of specific cases.

Banking Sector’s Responsibility for Bad Loans:

The issue of accountability for the surge in non-performing assets (NPAs) during the economic crisis is raised, with a focus on why no one in the banking sector faced consequences. Rajan acknowledges the need for cautious public disclosure to avoid undue panic while ensuring adequate capital raising. He explains the RBI’s decision to not publicly disclose the AQR (Asset Quality Review) report in real-time, emphasizing the need for cautious release of data to avoid undue public anxiety and highlighting the importance of explaining data in detail and allowing sufficient time for capital raising before making public announcements. The AQR findings were disclosed in three stages to ensure adequate capital availability for the banking sector, clarifying that some Category 2 and Category 3 assets were expected to improve over time and announcing them prematurely could have raised concerns. He cautions against attributing every bad loan to incompetence or corruption, recognizing that bankers take risks and sometimes those risks result in bad loans. He also highlights the role of irrational exuberance in the industry contributing to bad lending decisions, suggesting focusing on a series of bad decisions rather than one-off incidents when assessing accountability.

Phased Disclosure of AQR Findings:

The AQR was conducted in stages, allowing banks to announce their financial status progressively. This phased approach aimed to ensure capital availability for disclosed issues, mitigating the risks of premature alarm over potentially recoverable loans.

Assessing Responsibility for Bad Loans:

Rajan emphasizes the need for a comprehensive analysis of bad loans, considering various factors beyond mere incompetence or corruption. He advocates for a nuanced approach, examining the broader economic context and individual circumstances. Rajan cautions against attributing every bad loan to incompetence or corruption, recognizing that bankers take risks and sometimes those risks result in bad loans. He also highlights the role of irrational exuberance in the industry contributing to bad lending decisions, suggesting focusing on a series of bad decisions rather than one-off incidents when assessing accountability.

Importance of Contextual Analysis:

A contextual approach to analyzing bad loans is recommended. Rajan suggests that assessing a series of decisions, rather than isolated incidents, provides a more accurate understanding of the banking sector’s health.

Growth Concerns:

India’s economic growth, slowing to below 6%, raises alarms. The stagnation of private investment, despite positive market sentiments, and underutilized resources indicate significant economic challenges. Additionally, the persistence of stalled projects exacerbates these concerns. Rajan expresses concern about India’s economic growth, particularly the decline in private investment, noting the lack of enthusiasm among private sector executives and the low capacity utilization, indicating that companies are not making significant investments. He highlights the issue of stalled projects, which have remained a problem for some time, and questions whether these projects are unviable or if there are obstacles hindering their progress.

Demonetization’s Impact:

The abrupt demonetization policy impacted the economy, particularly the informal sector. While it disrupted cash transactions and consumption demand, leading to a short-term growth decline, its long-term benefits, such as increased tax compliance, are yet to be fully realized. Rajan states that demonetization, the sudden withdrawal of high-denomination banknotes from circulation, had immediate effects on cash transactions, leading to a decline in growth. He acknowledges that the informal sector, which is not fully captured in official measurements, may have been affected by demonetization, impacting consumption demand and overall growth. He also mentions potential long-term benefits of demonetization, such as increased tax revenues and compliance, but emphasizes the need to evaluate whether these benefits will outweigh the short-term negative effects.

Challenges of Formalization:

The government’s effort to transition the informal sector to the formal economy is noted. However, this process requires careful management to minimize disruption and job losses. A gradual approach with supportive measures is advocated to ensure a smooth transition. Rajan discusses the government’s efforts to combat black money and move the economy from the informal to the formal sector, warning against unintended consequences of this transition, particularly for businesses that may not be viable if they are forced to operate within the formal regulatory framework. He emphasizes the importance of making formalization easy and reducing regulatory hurdles to ensure a smooth transition, acknowledging that the process of formalization may lead to some disruption, unemployment, and the need for careful pacing to avoid adverse effects on economic growth.

RBI’s Communication and Transparency:

The RBI’s communication strategy is critiqued, with a focus on the need for clarity and transparency. Effective communication is vital for public trust and policy effectiveness, yet it must be balanced to avoid misinterpretation risks. Rajan acknowledges the challenges of communicating economic policies and decisions effectively, noting that the Reserve Bank of India (RBI) has faced criticism regarding its credibility and transparency in managing currency and non-performing assets (NPAs). He emphasizes the importance of clear and timely communication to maintain confidence in the RBI and its policies.



India’s economic trajectory is currently facing several hurdles, including sluggish private investment, the aftermath of demonetization, and the challenge of formalizing the informal sector. The RBI’s role in this landscape is pivotal, not only in policy implementation but also in maintaining transparency and public trust. The bank’s approach to communication, information disclosure, and handling of sensitive economic issues will significantly influence India’s future economic stability and growth.

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This comprehensive analysis reveals the complex interplay of factors influencing India’s economic environment. The RBI’s strategies and responses, under the scrutiny of experts like Raghuram Rajan, are critical in navigating these challenges and steering the economy towards stability and growth.

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The Importance of Communication and Transparency for Central Banks

Importance of Public Support:

– Central banks should strive to carry the public with them when making changes.

– Clear and effective communication is key to gaining public support.

Impact of Communication:

– Garbled or offensive communication can hinder the central bank’s mission.

– Openness and transparency are essential for a functioning democracy.

– The public should be informed about central bank actions to act as a check on power.

Selective Disclosure:

– Central banks must balance the need for transparency with the potential for disruption.

– Some information, such as the process for estimating inflation, can be disclosed without causing harm.

– Other information, such as specific models, may need to be kept confidential.

Conclusion:

– Central banks should choose a communication strategy that balances transparency and effectiveness.

Notes by: Rogue_Atom