Raghuram Rajan: Strong sustainable growth for the Indian economy
Speech by Dr Raghuram Rajan, Governor of the Reserve Bank of India, at FIBAC 2015
"Inclusive growth with disruptive innovations", Mumbai, 24 August 2015.
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I thank Vivek Aggarwal, Alpana Killawala, and Dr. Prachi Mishra for comments.
We live in an increasingly uncertain world. Seven years after the financial crisis, advanced
economies are still growing slowly, while a number of emerging economies are experiencing
difficulty as the old export-led growth model flounders. In this environment, there is both
challenge and opportunity. Challenge because the world will not provide the strong and
supportive growth environment we had in the last decade, opportunity because global capital
is looking for investment opportunities.
As I said late last year in my Bharat Ram lecture entitled "Make in India, Largely for India", to
implement the Prime Minister's vision of producing in India at a time when trade across the
world is falling, we will have to strengthen the domestic market so as to absorb much of the
increased production until the global market recovers. This means we have to increase
domestic demand, while avoiding the booms and busts that typically plague such efforts by
emerging markets. My focus in today's talk will be on what the RBI is doing to help the
Government create the conditions for sustainable growth. Structural reforms will help
strengthen this growth - two weeks ago, the Government announced Indradhanush, last
week we licensed new payment banks, next month we will license new small finance banks,
two new universal banks are starting in October, the providers of the TREDs system will be
licensed in November, and so on, but these developments are best left to a future speech.
Challenges in the current macroeconomic environment
We have come a long way since the difficulties in 2012-13 as a result of actions taken by the
Government and regulators. Growth is stronger, the current account deficit has narrowed
significantly, the fiscal deficit is on a consolidation path, and inflation has halved. However,
three areas are still "work in progress" from RBI's perspective. First, economic growth is still
below levels that the country is capable of. Second, while consumer price inflation has
moderated, inflation expectations amongst the public are still high, creating a gap between
the real rates that savers expect and the rates corporations think they pay. Third, stressed
assets in the financial system continue to be high, which holds back growth and new lending,
even while dampening bank incentives to cut base rates.
The short term macroeconomic priorities of the Reserve Bank are therefore clear:
Help growth by bringing down inflation in line with the proposed glide path, thus
•
creating room for monetary easing; and
• Work with the Government and banks on speeding up the resolution of distressed
projects and cleaning up bank balance sheets.
Let me start first with inflation: I am sure many of you are interested in what we will do next
on policy. For that, I think the best summary is still our last policy statement, from which I
quote, "Significant uncertainty will be resolved in the coming months, including the likely
persistence of recent inflationary pressures, the full monsoon outturn, as well as possible
Federal Reserve actions. As the Reserve Bank awaits greater transmission of its
frontloaded past actions, it will monitor developments for emerging room for more
accommodation." Having said all I want to say on future policy, let me explain what we have
been doing so far, and why we have been doing it.
Inflation and growth
Despite India's known antipathy towards inflation, we have experienced an average of more
than 9 percent inflation between 2006 and 2013. The longer we had high inflation, the more
the public's expectations of inflation became entrenched at high numbers. Because the
public's inflation expectations are adaptive - meaning they change only after they see a
sustained change in realized inflation - we required a long period of low inflation before
expectations came down. Unfortunately, our past focus on WPI inflation, which puts weight
on internationally traded goods like commodities rather than domestic non-traded goods like
education and healthcare, meant that whenever international inflation came down, the
clamour for rate cuts increased. So we often did not take the fight to domestic sources of
inflation. Put in technical terms, the real policy rate was below the neutral real rate for years,
and coincided with a pick-up in CPI inflation.
The strong disinflation, even deflation, in the world in the last few years gives us a golden
opportunity to change. What better time than the current for an inflation prone country like
India to bring its inflation finally in line with the world's? With commodity prices declining and
astute food management by the Government, part of our work is done for us, without India
having to undergo the kind of extreme demand compression that was seen in the Volcker
disinflation. Indeed, with real expected policy interest rates in the 1.25-1.5% range and real
after tax deposit interest rates barely positive, it would be hard to argue that the
disinflationary glide path the RBI has embarked on is extremely onerous.
While low inflation for a while will lower the public's inflationary expectations and increase
their real disposable income, in order to achieve a sustainable victory against inflation the
public has to believe that inflation will stay low even after commodity prices start picking up in
the future. For the public to look through future price spikes without raising wage demands,
the RBI has to have credibility that it will act firmly against any future inflationary threats.
Credibility comes from frameworks and institutions. In this regard, the RBI has signed a
historic agreement with the Government, wherein RBI's mandate is clearly spelled out in
terms of an inflation objective over the medium term. In the coming year, the Finance
Minister proposes to lay out, after consultation with RBI, the structure of a monetary policy
committee that can be formally and legally entrusted with policy decisions. These are
welcome steps in building the institutions we need for transparent and independent monetary
policy.
Responding to the inflation commentariat
Let me address some popular misconceptions now. Modern economic theory suggests there
is indeed a short run trade-off between inflation and growth. In layman's terms, if the central
bank cuts the interest rate by 100 basis points today, and banks pass it on, then demand will
pick up and we could get stronger growth for a while, especially if economic players are
surprised. The stock market may shoot up for a few days. But if the economy is supply
constrained, we could quickly see shortages and a sharp rise in inflation. The central bank
may then be forced to raise interest rates substantially to offset that temporary growth. The
boom and bust will not be good for the economy, and average growth may be lower than if
the cut had not taken place. This is why modern economics also says there is no long run
trade-off between growth and inflation - the best way for a central bank to ensure
sustainable growth is to keep demand close to supply so that inflation is moderate.1
Put differently, when people say "Inflation is low, you can now turn to stimulating growth",
they really do not understand that these are two sides of the same coin. The RBI always sets
the policy rate as low as it can, consistent with meeting its inflation objective. Conversely, the
best way the monetary authority can support growth over the medium term is to anchor
inflation at low levels so that policy rates can also be low. We can never abandon inflation to
focus on growth, nor do we focus on inflation to the exclusion of growth. The extended glide
path over which we are bringing inflation in check appropriately balances inflation and
growth.
The statement "Inflation is low, you can now turn to stimulating growth" also perhaps reflects
a misunderstanding of how central banking works. Monetary policy works with a lag of 3 to
4 quarters. So in deciding policy today, we need to predict how inflation will look
approximately a year ahead. Today's inflation therefore matters only in informing us about
future inflation. However, today's inflation measured on a year on year basis may be low
because there was an unexpected price spurt last year - the so-called base effect. So we
need to take out base effects before we even assess the information from current inflation,
something many observers fail to do. Also, there may be many sources of uncertainty that
cloud the future inflationary picture and disconnect it from current inflation - the strength and
distribution of the monsoon, the extent and persistence of low commodity prices, the effect of
external disturbances on the exchange rate, etc. In practice, we use models to project how
all this might play out on inflation, and we overlay the models with the subjective
assessments that our internal committee and its advisors offer, to ultimately arrive at a policy
decision.
Our model based assessments of the inflation path are almost surely going to differ a little
from the realization, given that the world is uncertain, but they are our best professional
assessments, and we set policy based on those assessments. As information comes in,
monetary policy is adjusted - for instance, the substantial disinflation from November 2013
gave us confidence about the persistence of low inflation into the future, allowing us to cut
the policy rate three times.
What such an approach rules out is what might best be described as "inflation following
policy" that some populist commentators on monetary policy advocate. Starting with the
premise that all economic forecasting, especially about the future, is impossibly imprecise,
inflation followers advocate cutting policy rates whenever inflation is low until inflation starts
picking up. I have never heard them say what we should do then, but I presume that they
would advocate raising rates at that point. But because monetary policy works with long lags,
inflation could surge significantly before policy starts working. A policy that tracks current
inflation, rather than anticipates inflation, is inherently biased towards more volatile inflation,
which is not in the public's interest.
Another set of commentators write articles arguing that monetary policy is impotent for a
variety of reasons, ranging from its irrelevance in taming food inflation to the small size of
interest sensitive sectors in the economy and the lack of transmission by banks. Yet, they
somehow always end the article by advocating rate cuts. Now why would rate cuts matter if
monetary policy was impotent in affecting demand? Perhaps more informative is a recent
study which suggests that the disinflation that has happened over the last year and a half
follows from a combination of good food management by the Government, good luck
because of external factors such as lower crude prices, and monetary policy, including the
new framework.2 We believe this is a fair view of the disinflation so far, entirely uninfluenced
by the fact that two of the three authors are from the RBI.
Some issues in tackling inflation
Let me turn to some other issues in inflation management. First, in picking the policy rate
path and the pace of deflation, we have to be mindful that there are multiple players in the
economy; consumers and producers who need to borrow, households that need to save, and
banks that need to do both. Producers love lower interest rate, and they do not hesitate to tell
us. But saving households balk as deposit rates are cut, especially if rates do not
compensate adequately for inflation. The fall in household financial savings, the increase in
gold purchases, and the widening of the current account deficit in recent years was partly
caused by negative real after tax deposit rates. If we are not to see distortions in the
economy, therefore, any policy rate path has to balance these interests - in other words, be
a Goldilocks rate path which is neither too high nor too low.
Of course, banks stand partially in between borrowers and lenders, and to transmit rate
reductions they should be able to cut both borrowing as well as lending rates. Concerns have
been expressed about Government small savings schemes that pay a high rate to
households, making banks reluctant to cut their own deposit rates for fear of being
disintermediated. While Government small savings rates should be readjusted more frequently
to market rates, the growth of these schemes is small for the most part, and at least for now
these schemes should not be an insuperable barrier to transmission.
Second, because of a large divergence between WPI and CPI, some economists have
argued there is a difference between the real rates manufacturers face and the real rates
savers get. I am sympathetic to the argument, but believe the only way to tackle it is to get
inflation of all kinds down - so long as the divergence between inflation in traded goods and
in non-traded services is large, the problem will not go away. But I also think the concern is
overblown. Even if manufacturers do not have much pricing power because of global
competition, their commodity suppliers have even less. So a metal producer benefits from
the fall in coal and ore prices, even though they may not get as high a realization on sales as
in the past. The true measure of inflation for them is the inflation in their profits, which is likely
greater than suggested by WPI. So the real interest rate they face is lower than that obtained
by subtracting WPI from the nominal interest rate.
Third, I have said in the past that the central bank is not a "cheerleader" for the economy. By
this I did not mean that the RBI does not want to do its utmost to see the economy do well.
Far from it! What I meant is that it is not the role of the central bank to elevate sentiments
unduly, to deliver booster shots to the stock market so that it can soar for a while, only to
collapse when reality hits. We do not have to look too far beyond our borders to see the
consequences of such boosterism. Rate cuts should not be seen as goodies that the RBI
gives out stingily after much public pleading. Instead, what is important is sustained low
inflation, something the Prime Minister emphasized in his Independence Day speech, and
rate cuts are a natural consequence that the RBI has no hesitancy in delivering.
Stressed assets and speedy resolution
Let me turn to stressed assets. In dealing with stressed bank assets, RBI has been focused
on getting the underlying real project back on track. There are a number of impediments
here. The stigma as well as the provisioning (and the associated fall in profitability) attached
to a loan being labelled "non-performing" makes banks eager to avoid the label. In some
cases, they ignore the reality that existing loans will have to be written down significantly
because of the changed circumstances since they were sanctioned (which includes
extensive delays, cost overruns, and over optimistic demand projections). The Debt
Recovery Tribunal system has not been speedy, which also emboldens uncooperative
promoters and keeps them from accepting their share of the losses.
Regulatory forbearance, where RBI makes it easy for banks to "extend and pretend", is not a
solution. Since no other stake-holder - such as the promoter, tariff authorities, tax authorities,
etc. - contributes to resolution, the real project limps along becoming increasingly unviable.
Meanwhile, analysts grow increasingly suspicious of bank balance sheets and the growing
volume of "restructured" assets. Also, some large promoters take advantage of banker fears
about assets turning non-performing to extract unwarranted concessions, without any
sacrifice in the value of their stake. Regulatory forbearance therefore ensures that problems
grow until the size of the provisioning required to deal with the problem properly becomes
alarmingly large - which then prompts calls for yet more forbearance. Forbearance is also a
disservice to the bank's owners (which may include the Government) who, instead of being
faced with a small problem early and being given the opportunity to apply corrective action,
are faced with large problems suddenly when they cannot be pushed into the future any
more.
One example of the difficulties stemming from forbearance is the plight of state power
distribution companies (DISCOMS). In 2012, a number of states signed up to a financial
restructuring plan (FRP) with banks and the central government, based on which the RBI
permitted restructured loans to DISCOMS to be treated as standard. Unfortunately, three
years later, states have not undertaken many of the actions promised under the FRP,
perhaps because the urgency to act was not there so long as banks continued financing
losses. Meanwhile, debt has built up further, and the cost of power, including line losses and
interest costs, is mounting inordinately. The central government and the RBI are taking the
lessons of recent experience into account as they discuss remedial action with the states.
To deal both with project paralysis as well as the unfair distribution of losses, RBI ended the
forbearance accorded to restructured loans. Henceforth, restructured loans will be classified
as non-performing loans. However, RBI has made it easier to recognize and deal with
distressed projects. In other words, while ending forbearance, we have introduced flexibility
for those who recognize and deal with stressed assets. Consider some measures.
First, RBI has created a database of loans over Rs. 50 million (the CRILC database), and
has required banks and NBFCs to report regularly on the status of the loans. Early
identification of distressed projects offers the best opportunity to put them back on track. So if
a loan is identified as more than 60 days overdue, all lenders to the borrower have to come
together in a Joint Lenders' Forum (JLF) to see how the underlying problems can be fixed.
The JLF has to follow strict timelines, failing which the project loans' classification will be
downgraded. On the other hand, if the timelines are met, the deterioration in loan
classification is halted. Furthermore, by bringing the banks and NBFCs into one forum, RBI
has made it easier for the promoter and the creditors to reach a consensus on actions, even
while making it harder for the promoter to play one creditor off against another.
Second, to deal with genuine problems of poor structuring, it has allowed bankers to stretch
repayment profiles for performing loans to infrastructure and the core sector (the so-called
"5/25" rule), provided the project has reached commercial take-off, has a genuinely long
commercial life, and the value of the NPV of loans is maintained. RBI is undertaking periodic
examination of randomly selected "5/25" deals to ensure they are facilitating genuine
adjustment rather than becoming a back-door means of postponing principal payments
indefinitely. Also, in cases of restructuring, RBI and SEBI have together allowed banks to
write in clauses that allow banks to convert loans to equity in case the project gets stressed
again. Not only will such Strategic Debt Restructuring give creditors some upside in return for
reducing the project's debt, it can also give them the control needed to redeploy the asset
(say with a more effective promoter).
We have discussed the experience with the JLF with banks, and we will shortly announce
some measures that should improve their functioning. The move by the Government to
recapitalize banks is welcome, as is the proposal to reward bankers based on progress in
cleaning up balance sheets and generating healthy growth. The innovative proposal to create
a fund with majority private ownership and minority Government participation to lubricate the
process of resolution could be very helpful. RBI and Government are also discussing ways to
revitalize Asset Reconstruction Companies so that they can play a greater role in resolving
distress. The Finance Minister spoke last week about accelerating the working of Debt
Recovery Tribunals through the use of information technology, an idea whose time has
certainly come.
Given the state of the world economy, firms in some industries are in deep real distress.
Some firms can survive with a little help from the Government, but others are unviable. Too
much help to unviable firms can also cause distress to spread to healthy firms. In this regard,
the country needs rapid progress in the coming year on the creation of the institutions
necessary for resolution such as the new Bankruptcy Code and the Company Law Tribunals
that will administer it as well as the Financial Resolution Authority (for resolving financial
institution distress). On-going government efforts in this regard will pay rich dividends.
Conclusion
Let me conclude. My focus on the challenges in ensuring sustainable growth should not
detract from the tremendous progress we have made. There is much to be optimistic about,
including the massive investments that are starting in infrastructure, the tremendous sweep
of information technology across every facet of Indian life, and the radical changes that are
taking place in the financial sector. The Indian economy is full of possibilities, even as much
of the world is mired in pessimism. Indeed, I have been arguing that the fragility of the world
economy is precisely because it has focused on quick fixes rather than deep reform.
At the same time, we should not delude ourselves into thinking our work is done, or postpone
hard choices to a seemingly easier tomorrow. The question for us as a society is whether we
have the discipline to do what is necessary at a time when global conditions are propitious -
commodity prices look like they will stay low for a time, helping the fight against inflation, and
there is plenty of money around the world and at home, looking for investments, including in
distressed assets, that can help us clean bank and corporate balance sheets. As India
strives to regain its place in the ranks of prosperous nations, we must remember that what
sets poor nations apart from the rich is not people or resources or even luck but good
governance, which comes from strong frameworks and strong institutions. A summary
explanation of the economic problems of the recent past is that they arose because India
outgrew its institutions. A summary of the Government and the Reserve Bank's measures to
restore sustainable growth is that we are building the necessary institutions. Thank you.