After a triumphal visit to the US where he assured investors of economic stability and reform after two years in office, Prime Minister Narendra Modi and his team first gave lukewarm support and then seemingly dumped globally acclaimed central bank head Raghuram Rajan rather than extend his three-year term.

The academic, on temporary leave from the University of Chicago, a longtime bastion of conservative monetary policy, had a reputation for outspokenness, most notably during the US subprime crisis. He was appointed by the previous administration to help banish the “fragile five” large emerging economy label, and through a combination of higher interest rates and import restrictions, currency and current account weakness retreated.

Reserve Bank of India (RBI) Governor Raghuram Rajan delivers a lecture at Tata Institute of Fundamental Research (TIFR) in Mumbai, India, June 20, 2016. REUTERS/Danish Siddiqui
Reserve Bank of India (RBI) Governor Raghuram Rajan. REUTERS/Danish Siddiqui

Rajan vs. BJP

His agenda also promoted central bank independence and banking system modernization that put him at odds with influential ruling BJP party members and family business executives who have been big borrowers and defaulters. Foreign portfolio flows turned negative several months ago with these conflicts that now must be resolved by his successor, as broader questions remain over Modi’s promises to attack official and private sector cronyism and protection.

The rupee fell further in the immediate resignation wake as the worst Asia performer this year with a 2% loss against the dollar. Equities rose slightly on the prospect the next central bank governor may prioritize continued 7% growth rather than inflation toughness, with the consumer price index again creeping toward the upper end of the 4-6% target.

Local debt, which has become one of the most traded emerging market instruments according to industry body EMTA despite foreign allocation quotas, further sold off as the departure added to worries over higher food, energy, and public wage costs, as well as the imminent repayment of non-resident Indian special deposits which bolstered reserves during the 2013 Fed Taper Tantrum. The $20-30 billion to be redeemed over the coming months is not a large dent in the $350 billion stash on hand, but expatriate exit is a negative signal from a  loyal buyer base.

The government tried to quell the outcry by unveiling additional liberalization moves in the airline, defense, drugs, and retail sectors, after FDI jumped 30% to $40 billion in the fiscal year ended in March. The main headline impact may be that computer giant Apple will be able to open its own outlets after an India visit by its chief executive, as pharmaceuticals entry in particular remains complicated by easy generic copying to meet low-income consumer demand. New Delhi’s insistence on this stance has scuttled a proposed WTO agreement, and also is a sticking point for future participation in the Trans-Pacific Partnership. The domestic precedent of Kingfisher Air, a discount private carrier offers a cautionary tale in that field, with numerous rule changes and alleged founder abuses which contributed to its bankruptcy.

Pampered banking system

The state-dominated banking system, with dozens of loss-making institutions trading at a discount on the stock exchange, remains sheltered from competition in contrast, despite Rajan’s design of a sweeping road map for change. He began with an asset quality review, due for completion in March 2017, which initially found non-performing loans at 15% under stricter classification rules.

Foreign and local-owned private sector lenders are not as burdened, and they have taken the lead in new credit growth particularly to consumers, although the government units represent three-quarters of the total outstanding. Rajan tried to promote this rivalry and ease mandatory allocation in agriculture and industry which deterred corporate exposure, but was challenged by the Finance Ministry and longstanding political and commercial interests tied to state bank patronage.

Status quo defenders have opted instead for another bureaucratic layer, a special “bureau” to improve management and operations, while $3 billion in new capital is to be injected through end-decade. However, independent experts point out that costs are already out of control, absorbing 60% of revenue, and realistic recapitalization needs are in the $40-50 billion range. Rajan’s replacement, and Prime Minister Modi’s future policy credibility, will be judged by the ability to bridge this divide with a serious banking rehabilitation program. Hopefully, this will not provoke as much patient denial and rebellion as the outgoing governor’s “surgery” demanded.

Gary N. Kleiman is an emerging markets specialist who runs Kleiman International in Washington, D.C.

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