Will Raghuram Rajan be right this time around too?

By Saurabh Gandhi

Edited by Namrata Caleb, Senior editor, The Indian Economist

Less than a decade ago when the world was witnessing high economic growth, Raghuram Rajan took a contradictory stand in front of an audience of renowned economists and bankers and predicted that the world had become a riskier place thanks to complex financial instruments (like the mortgage backed securities, which were one of the reasons behind the 2008 crisis) that had grabbed the attention of the financial world. He was speaking at a celebration honoring Alan Greenspan, former Chairman of the US Federal Reserve, in his capacity as Chief economist of the International Monetary Fund (IMF). He had to face criticism from all quarters with some going to the extent of calling him a ‘Luddite’. Come 2008 and he was proven right.

Back to his own country as the Governor of the Reserve Bank of India, Rajan has now sounded the gong once again – this time in an interview to London-based ‘Central Banking Journal’.  “We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost,” he told the journal. The last major crash was in 2008 and the world economy cannot be said to have fully recovered from it. So then, what is it that makes Dr. Rajan think that another crisis is in the offing and the more important question; will he be right this time around too?

Dr. Rajan compares the present situation to the pre-1930’s depression time. He says, “As was the case in the 1930s, the lack of coordination between central banks across the world is producing spillovers that may be difficult to control and could plunge the world’s financial system into another crisis”. The year 1930 is famous for the Great Depression which had engulfed the world economy. Rajan says that the Great Depression was a result of a long period of competitive devaluation of national currencies by the central banks of many economies. In today’s times, this competitive devaluation has been replaced by competitive easing, which in turn could lead to competitive devaluation, he opined.

Rajan is referring to the easy money policies adopted by various central banks across the world, most notably, the US Federal Reserve, which has not only  kept overnight interest rates in the US near zero but has also pumped in billions of dollars into the world economy in a bid to ensure US economic recovery. The Bank of Japan and the Bank of England have also been pursuing loose monetary policies in the aftermath of the 2008 global crisis. It is this approach that Rajan is wary of. He says, “My colleagues in industrial countries are trying too hard (to revive their economies), and I would prefer monetary policy to do less and other parts of the economy, including the political system, to do more. If we try too hard, then we raise the probability of a crisis.“ He goes on to add, “Instead of the political system taking action, reforming the economy, etc., as industrial countries also need reforms, they are relying on the monetary authorities to provide whatever boost that was required. I thought this was dangerous because monetary authorities across the world are boosting asset prices rather than real activity.”

It is this monetary policy stance that he is saying can lead to another market crash on the lines of the one that happened in 2008. The low interest rates in the advanced economies, coupled with the huge pumping of dollars by the Federal Reserve, have made global investors shift to the emerging economies in pursuit of higher returns. This proved like a blessing for emerging economies like India in 2008-09 as it recorded high growth rates in spite of the world economy reeling under a crisis. However, in reality what this did was inflate asset prices and now, when the US recovery is looking possible and the US Fed is cutting down on its ‘dollar pumping’, the emerging markets are at the risky side.

“We will be tested by capital outflows and my hope is that we have done enough in terms of strengthening the macroeconomic fundamentals of the country…as well as in building up reserves,” Rajan said. If one reads between the lines in the above statements, one can understand all the actions that Rajan has taken ever since he took over the reins of India’s central bank. He has worked overtime to increase India’s foreign exchange reserves. He is aware of the risks of pursuing easy money policies at a time when asset prices are inflated. This is why he shocked the markets when he raised the interest rates in the beginning of his tenure as RBI chief when the markets were expecting him to reduce the rates to spur growth.

So, then what is the way ahead if there is an imminent danger of a market crash in the emerging markets? “To safeguard against such an eventuality, all central banks must unwind their monetary policies in a coordinated fashion,” Rajan said. He has also been a keen votary of greater co-ordination among the various economies in the world when they set their respective monetary policies. This is more important for countries like the US which have an influential place in the world.

If we look at this warning purely from an Indian perspective, then it is a mixed bag for us. On the external front, we have achieved stability and the markets are at an all-time high due to the euphoria around our Prime Minister. However, this means that the asset prices are more inflated in India than around the world as the high prices have factored in many assumed policy initiatives that they expect the new government to take. But what happens when political realities sink in? Sure, this government has a huge majority in the Lok Sabha but it is in a minority in the Rajya Sabha and the recent fate of the Insurance Bill at the altar of politics means that markets will have to correct themselves and asset prices will have to come back to their fundamental values unless the expectations are met fully. What remains to be seen is the manner in which the markets correct themselves. Will it be smooth or will it be rough? It depends completely on the government. One wrong move (like the previous government’s retrospective taxation) and the road will be all downhill from here.

So, will Rajan be right this time around too? It depends to a great extent on the speed with which the developed world, especially the US, winds up its extremely loose monetary policy and the manner in which emerging markets are able to strengthen their respective balance sheets. Surely, India has fortified itself with increased foreign exchange reserves and lower current account deficits (albeit by cutting down on imports) but more needs to be done to ramp up exports and spur growth and lower inflation, most of which requires political, rather governmental, action. All eyes are now on the Rajan-Modi combo.