Challenges before the New Governor

As this column goes to press, comes the news that Dr. Urjit Patel has been appointed as the 24th Governor of the Reserve Bank of India. His appointment signals continuity in the overall policy stance of the RBI. Dr. Patel has been Deputy Governor for three and half years, and in that sense is an insider. He was head of the monetary policy department, among other things. He also chaired the committee that laid the framework for inflation targeting. This became the predominant mandate of RBI, when the Government of India and the RBI signed an agreement last year. That agreement gives priority to inflation control over other objectives. As a follow up to that agreement, this month the government notified and formally adopted the consumer inflation (CPI) target of 4% plus or minus 2% for the period till March 2021. If RBI misses the inflation target for three consecutive quarters, then it has to explain to lawmakers as part of the new statutory process. The CPI inflation has already inched past the 6% mark, which has surely put RBI on full alert.

Since a big component of inflation is due to food items, it is beyond the immediate influence of interest rates. Nevertheless, the central bank can’t be seen as cutting rates while the inflation rate is climbing. Also with high consumer inflation, the depositors earn a negative return, if rates are cut too aggressively.

Being Governor of the central bank of the third largest economy (in size measured by purchasing power parity) is itself quite a formidable responsibility. In addition, Dr. Patel is also filling in the shoes of Dr. Raghuram Rajan whose tenure has been absolutely impressive. Firstly, is Rajan’s inflation fighting record. Average inflation in the five years prior to Rajan was about 10.4%.  This came down to an average of 6.6% in the past three-year period. Secondly, the exchange rate stabilized, with the rupee down only moderately in the past three years, as compared to the panic fall prior to August 2013. Even the volatility in the exchange rate movement has become subdued. Thirdly, the benchmark interest rate, as measured by the yield on ten-year government bond has come down sharply, being close to 7% now. Fourthly, under Rajan there was an extensive asset quality review of balance sheets of all banks. This was to get a more accurate and transparent picture of the bad loans situation. No doubt this revealed large amount of stressed assets (loans) of banks, but it also led to relief that much of the bad news is behind us.

In the coming days the new Governor has four major challenges to tackle. Firstly is the inflation challenge. The CPI based inflation has already crossed the red line of 6%, which is the upper band permissible according to the new framework. Of course, henceforth the rate will be decided by the Monetary Policy Committee, and not by the Governor alone. It is also true, that since a big component of inflation is due to food items, it is beyond the immediate influence of interest rates. Nevertheless, the central bank can’t be seen as cutting rates while the inflation rate is climbing. Also with high consumer inflation, the depositors earn a negative return, if rates are cut too aggressively. This causes depositors to flee the financial sector, away from bank deposits to gold and real estate. Dr. Patel already has the reputation of being an “inflation warrior”, thanks partly to the committee report that he chaired. Hence a sharp focus on inflation would be second nature to him.

The second challenge is to tide over smoothly the large forex repayment that is becoming due in a couple of months. Three years ago, in a bid to rescue the rupee, the RBI devised a subsidised scheme to attract dollar inflows of three-year maturity. That scheme was hugely successful and brought in more than 30 billion dollars. That has to be repaid now.  The country’s forex reserves are at an all time high. The RBI through forward purchases has made adequate provisions already. It is also possible that instead of an outflow, much of these dollars may be redeployed in the country. Even then, the Governor and his team has to ensure that the process is smooth and not disruptive to the forex markets and the exchange rate.

Dr. Patel’s three predecessors have been known to lay extra emphasis on communication. Former Governor Dr. Subbarao  said that he was keen to “demystify” the functioning of the central bank, and even his recent book goes a long way in doing that. Dr. Patel would do well to strengthen this aspect of his role as leader of the central bank.

The third challenge is to guide banks to come out of their stressed assets situation. This is an ongoing battle, and will take several years. If interest rates come down, then banks make profits, through capital gains on their bond portfolio. This extra profit helps them increase provisioning against bad or doubtful loans. That in turn frees up bank capital, and fresh loans can be made to new businesses. We may be at the bottom of the credit cycle, since non-farm credit growth hit a multi-decadal low. For a quick upswing we need the help of lower interest rates. This is tricky, because sharp rate cuts will undermine the fight against inflation.

The fourth challenge is that of communication. This is not an immediate issue, but an ongoing one. The central bank’s actions and policies affect the entire economy, and the common man. Yet very few understand the intricate connection, and even fewer, the import of words like “repo rate”. Every Governor has had an imprint on the way in which the RBI has articulated its actions. Dr. Patel’s three predecessors have been known to lay extra emphasis on communication. Former Governor Dr. Subbarao  said that he was keen to “demystify” the functioning of the central bank, and even his recent book goes a long way in doing that. Dr. Patel would do well to strengthen this aspect of his role as leader of the central bank.

None of these challenges are new, nor is the incoming central banker new to the task. Beyond these, there’s a myriad daily issues to solve and hurdles to surmount. But RBI at 80 years of age is older than the republic, and is a repository of solid trust and spotless reputation. To protect, strengthen and solidify that trust and reputation is perhaps the single and most important charge of the Governor. Congratulations, and best wishes, Dr. Patel.

The writer is a senior economist based in Mumbai.