Indian reform: facts on the ground

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Marcuard's Market update by GaveKal Dragonomics

When Raghuram Rajan took over the reins of India’s central bank last September he faced a weakening economy and persistent capital outflow. His contrarian solution was to jack up interest rates and propose an accelerated internationalisation of the long cosseted rupee. This programme was not exactly popular, but it seems to have worked. Eight months on, India’s foreign exchange reserve buffer is back above US$ 300 bln and the currency has strengthened about 12% against the dollar. Moreover, growth looks to be picking up as entrepreneurs’ animal spirits are reawakened by hopes for a more business-friendly government in this month’s general election.
This success bodes well for Rajan’s longer term programme of enacting financial sector reform in the aftermath of an election that seems likely to produce a BJP government led by Narendra Modi. Rajan may be an international star due to his IMF and University of Chicago teaching pedigree, but he remains an outsider within the Indian political scene. His tough monetary medicine has upset part of the business-lobby attached to the BJP which wants low rates. And within the Reserve Bank of India hierarchy there is suspicion of his proposals to liberalise the capital account—memories of India’s 1991 balance-of-payments crisis remain strong and critics point to the damage done to East Asian economies in the late 1990s due to excessively aggressive and early capital account openings.
However, there are real questions about the political constraints on Rajan’s blueprint for ambitious financial sector reforms. To date, he has pushed through important but relatively uncontroversial measures. New bank licenses have been handed out, cash-settled interest rate futures were introduced and mechanisms forcing more timely recognition of impaired loans have been adopted. Next up, Rajan is pushing for all Indians to have access to basic financial services by 2016 (only about half the population has a checking account). The government’s involvement in banking is to be reduced and monetary policy is being framed around an inflation target with less emphasis placed on growth and other indicators. All of these measures are likely to face some form of special interest opposition.
Interestingly, a project which appears to be gathering some momentum, seemingly under the political radar, is a move to expand offshore use of the rupee. Earlier this month, the International Finance Corporation said it would double the size of its offshore rupee bond programme to $2 bln. The sums involved may be small, but perhaps not immaterial when compared to the $81 bln limit on foreign investment in local debt.
Ostensibly, the aim is to follow China and develop the rupee as a settlement currency with trading partners—the problem is that China started its programme when running an external surplus and a relatively stable currency system due to the renminbi’s de-facto peg to the dollar. By contrast, India has a structural trade deficit and a relatively free-floating rupee.
The debate on whether India should be pursuing accelerated financial sector liberalisation at this stage of its development will run for a while. What is clear is that the broad direction of politics and policymaking all point to a period of increased financial and economic reform. This is partly due to the bold initiatives taken by Rajan which, in a relatively benign global environment over the last six months, have borne fruit. Ironically, the measures are also getting a tailwind due to pick up in economic activity since the outgoing government late last year acted to salvage its reputation for economic competence by approving investment projects en masse.
A full scale economic revival still remains a few quarters away, but such an outcome can only buttress the reputation of Rajan and the reforming elements within India’s next government, whatever its stripe. In this case, fortune seems to have favoured the brave.