Rajan Raj : The Vocation of RBI –watching



I don’t know how much we can credit Raghuram Rajan for being where he is (i.e. Governor of the RBI). He was who he was (i.e. Raghuram Rajan), but somebody needs to get some credit for ensuring that he is where he is, i.e. in the driver’s seat at the RBI……maybe the much-maligned Manmohan Singh perhaps, who stood up to let us know that the “spirit of ‘91” was still alive!

Declaimer: This article written was originally in December 2013, and some of the data points may be outdated.

given the number of inputs now coming out of the RBI

Just like Fed-watching is a minor vocation among Wall Street economists, we in India need to set up our cadre of RBI-watchers, given the amount of inputs now coming out of the RBI, after Rajan comes. This will help markets to be better forecasters of major macro-trends, rather than just reacting with surprise/ shock at every turn of events in the global money markets.

Many have written about him, mostly euphoric, some hyperbolic, almost all emotional…but let me take you through, in detail, the explanations and implications of some of his announcements:

  • The proposals to remove some of the requirements for branch licenses and to allow foreign banks to set up wholly owned subsidiaries and enjoy near-local bank benefits are almost as significant as abolishing licenses for manufacturing was in 1991.
  • The decision to “widen and deepen financial markets” could put Indian financial markets among the most sophisticated financial systems in the world. Remember, he has been a past critic of OTC derivative markets in general.
  • The “focus on the internal value of the Rupee” after handling the external crisis, is heartening, coming from a known Inflation hawk.
  • Ominously for certain Indian promoters, the emphasis on controlling NPAs and recognizing them early will clean up governance standards in Banks and Indian companies.
  • The “need to talk to markets more frequently” needs to be seen in the context of his desire to simultaneously deepen them, and set the ‘rules of the game’. In his role as ‘boundary-setter’ at the RBI, he needs to ‘guide’ markets to set the price levels sensibly, with low volatility, both daily (volatility) and more importantly, one-way (volatility), a.k.a. reflexivity.
Some possible agenda points that we should be expecting:
  • “Widening and deepening Indian currency markets”. This is a big one. India could be one of the first countries in the world to disable its Bank OTC derivative markets and shift all the volumes to the far more transparent exchange-traded markets. It would mean that corporates should develop their Proprietary Trading desks, forcing them to do their Risk Management.

He is reported to have remarked: “It is odd that $:: Re levels are decided by overseas markets (obviously referring to the NDF markets) rather than domestic Indian markets. We need to widen and deepen domestic currency markets to help them dominate the price discovery process”.

I would then expect him to insist on shifting all trading (and price discovery) onto the exchange-traded markets. This achieves multiple objectives: one, all OTC derivatives will shift to exchange-traded formats. Since only plain vanilla instruments can be traded on the exchange, it removes the possibility of any non-transparent, bilateral, exotic derivative being sold by a Bank to its clients. Any exotic strategy that is followed by a client, will have to be implemented by his own hands, in a free, transparent, perfectly competitive market with properly discovered prices.

On the one hand, this will severely restrict the kind of mis-selling of derivative structures that Banks have been doing. On the other hand, clients will be forced to do their Risk Management, taking responsibility for the risks that they seek to manage actively, or the ones they choose to ignore.  At least clients will no longer be able to blame the Banks for what is their responsibility. This will promote a culture of Risk Management, which is a much-needed survival skill for corporates in a fast-globalizing world.

Towards this end, one of the first things that I expect him to do is to remove client-wise and broker-wise position limits. In a little while, he should merge the inter-Bank Fx market with the exchange-traded Futures market. As the Govt brings down transaction costs, the Indian currency exchanges will rank on par with global exchanges, bringing in business from abroad. All this will help make the Rupee more acceptable as an international currency, provided Indian inflation is brought under control.

Managing the Internal Value of the Rupee vs just the external parity value
  • “Managing the Internal Value of the Rupee vs just the external parity value”. This is going to be very complex, and we have already seen the first baby steps in the last few Monetary Policy announcements. He has shown tremendous character in standing up to the various vocal lobbies, particularly industry, and Govt. And he has been even-handed in doling out the pain, but this is a continuing battle because the underlying drivers of inflation are structural, and not in his control.

In particular, the Fiscal Deficit remains out of control, even as the Current Account Deficit has shown sharp improvements. With 84% of the Fiscal Deficit target achieved with 5 months of the year left to go, it is unlikely that the Fiscal Deficit target will be met. The underlying drivers of this are fuel, fertilizer, and now food subsidies. There has been some letup in the MSP increases, but too much long-term damage has been done with past increases.

  • “A deeper understanding of trader psychology and the ability to talk to markets”. One of the biggest contributions of Rajan to the new Fx regime is his understanding of trader psychology and his ability to talk to markets in their language. He said recently that traders will go with you if they see your policies working, but will go against you if they see that your policies are not working. “It is usually a bad idea to bet against the Central Bank”, but not always. That happens only when the Central Bank is actually in control of policy.

This is a very loaded comment. Previous Governors have allowed the Rupee to over-appreciate when follows got bunched up and Forex Reserves ballooned. This is unlikely to happen under Rajan. He will be watching important liquidity ratios such as the ratio of short-term payables to Total Fx Reserves; ignoring these continuously deteriorating ratios for a long has been very hazardous to India Forex’s health in the past.

Most importantly, any over-appreciation of the Rupee puts excess Purchasing Power in the hands of Indians, and the money gets misused in the form of fuel subsidies, leading to further over-depreciation of the Rupee. Managing an appropriate balance of purchasing power that prevents such misuse is going to be good for the Rupee. This is going to be one of Rajan’s most important incremental contributions to the external management of the Rupee, and an area in which he will be substantially better than his illustrious predecessors.

Lastly, his popularity with the media and his ability to get onto public fora to espouse his philosophies will be watched by many. The underlying philosophy that I have put out in the previous paragraph is just a speculation, but it will get examined over some time and there will be continuous improvement in our understanding as we watch his future pronouncements. This creates an atmosphere of transparency and visibility, which will be good for both sides, the Central Bank and the trader community. Remember, it will be impossible to deepen financial markets if you don’t first make them safer…

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