June, 2016
Issue No. 7
Policy Watch

Sometimes, incumbency is better than regime change

The Reserve Bank of India governor has to be a man of vision and ideas. Rajan has both, says Srikanth Srinivas

Almost a century ago, American entertainer Will Rogers humorously said that there were three big inventions since the dawn of time: Fire, the wheel, and central banking. Reading media reports on the kerfuffle around Reserve Bank of India (RBI) governor Raghuram Rajan’s reappointment for a second two-year term – or not – it seems sort of hard to disagree with the late Rogers.

The reappointment of a central bank chief has signal value. Rajan’s appointment in September 2013 was intended to calm the volatility in financial markets following the United States’ Federal Reserve Board announcements of ‘tapering’ its quantitative easing program. Looking back, the plan worked.

In the last three years, we have seen Rajan’s deft hand at policymaking; he has brought inflation down to the level of 6 per cent, a goal he set; he has also stabilized interest rates. From an institutional perspective, he had initiated long-term change in the governance of monetary policy making that will make it predictable, sustainable and transparent. Why are we debating his departure then?

Which also begs the question: How does one pick a central bank governor?

Since 1992 – the beginning of liberalisation, so to speak – every governor has served a term of five years. This is a function of design, based on a review of central bank independence set in motion in 1991 by then RBI governor S Venkitaramanan. The draft report of the review recommended a five-year term for the Governor for effective reform or strengthening the foundations of policy-making or both. It seems a political fig leaf that the government breaks that up into two terms.

Secondly, central bank governors tend to be independent; we actually value them for it. It is another matter that his independent thinking on what the political establishment considers off-limits for a central bank governor is at the base of all this kerfuffle. Sadly, independence is not so easily parcelled or compartmentalised.

Rajan’s metaphors about hubris about our GDP numbers – the RBI’s caution over the new series hasn't been well received by some of the powers that be – and other non-central bank related comments are being used as an excuse to question his loyalties, a favourite tactic of his critics.

Even on matters of policy, media reports have been fond of juxtaposing his comments with that of the Finance Minister Arun Jaitley; some presentations of two very independent viewpoints can easily be misread as conflict. But in our complex times, multiple views are essential to ensure we are headed in the right direction.

Around the world, like the Bank of England, countries are looking to find the most able minds to head their central banks. Rob Carney, who succeeded Mervyn King as Governor of the Bank of England, was Canadian. Central banks from other countries are not averse to considering nationals from other countries. The search is for the best and the brightest.

So what characteristics should a central bank governor ideally have?

Rajan’s so called superstar status aside, it is clearly a job that matters, and besides having a qualified person, his/her independence from government is crucial, and must be accepted. That said, it is ultimately a political appointment and the government’s – perhaps even Prime Minister Narendra Modi’s privilege.

He (the Governor) will have to be harsh on the banks regarding matters of asset quality, will have to disagree with the government and yet, fight for India’s position in the global economy. In other words, as was said about another central bank governor, it's a job for a “big and independent brain”.

There has been considerable academic research on the role that the personality of a central bank chief has on monetary policy and other macroeconomic policy. Many have demonstrated, for example, that central bank governors with backgrounds in the financial industry have tended to be faster reformers than those who are not.

A study of 600+ central bank governors, conducted between 1970 and 2011, found that governors with financial industry backgrounds accounted for 20 per cent of that number. Another 30 per cent came from the United Nations and the Bank for International Settlements. Oddly enough, these individuals tended to be far more conservative and much slower reformers.

Yet another 30 per cent come from academia and the International Monetary Fund (IMF). Like former US Federal Reserve chairman, Ben Bernanke, Rajan is an academic, but has also been chief economist at the IMF.

Wherever they may come from, central bank governors have to be people of ideas and vision.

Whoever is finally picked as RBI governor in September 2016, the battles will nevertheless be the same. The banking system is far from normal; credit growth has been the slowest in years, and the scale of bad assets is the highest. As credit growth is a key proxy of economic growth, good news on this front is essential.

Yet, encouraging banks to lend while also managing the strength of their balance sheets is going to be near impossible. Industry and government will demand lower interest rates for borrowers; banks will have to get profits up quickly and will have to make some harsh decisions. Picking a governor, therefore, to replace Rajan is not going to be easy. No one, perhaps not even Rajan, will tick every box.

To reiterate: The historical record since 1992 shows that every central bank governor has served a five-year term, widely accepted as the minimum needed years for effectiveness. Rajan has begun a process of modernising the RBI – let us give him another two years to put the foundations in place.