Few central bankers have had as much success in so short a period as India's Raghuram Rajan.
Eight months ago, when Rajan took over as head of the Reserve Bank of India, the rupee was in a free fall, speculators were betting on a debt crisis, and economists buzzed about India being the first BRIC (Brazil, Russia, India and China) nation to have its credit rating cut to junk. Today, India's central bank is back to battling more conventional foes such as inflation, not financial Armageddon, thanks to Rajan's decisive moves to stop capital from fleeing the economy.
But Rajan is about to confront an even bigger challenge: India's dysfunctional politics.
On Friday, India's 1.2 billion people will get a new government. Elections that began April 7 are widely expected to deliver Narendra Modi's Bharatiya Janata Party to power. Markets are rallying amid expectations he will cut red tape, attack corruption, and reduce the crushing poverty that leaves 800 million people living on less than $2 a day.
Since 2001, Modi has served as chief minister of the western state of Gujarat, where growth significantly outpaced the national average in 11 of the past 12 years for which data are available. Voters want Modi to replicate that performance across the nation. Yet as Modi will learn early on, enacting change in a region of 60 million people that was famed for entrepreneurship and industriousness well before he came along is one thing; doing it in corrupt, inefficient and ossified New Delhi is another.
As the magnitude of the task becomes clear and vested interests dig in, expect Modi to do what so many governments before have done: pressure the central bank to boost growth. Rajan should brace for unprecedented criticism that the Reserve Bank isn't doing enough to support the nation. He should stand firm against the politics of expediency and focus on establishing a foundation for sustainable growth.
The most important contribution Rajan can make is getting India's inflation rate well below the growth rate. Consumer prices rose at a rate of 8.59 percent in April, the fastest pace among the biggest emerging markets. The economy is expanding at barely half that rate: roughly 4.7 percent, near last year's 4.5 percent, which was the slowest since 2003. That right there explains so many of India's vulnerabilities.
Rajan has raised borrowing costs three times to 8 percent. The moves were partly aimed at stabilizing the rupee after it plunged to record lows. But Rajan is also trying to rid the $1.8 trillion economy of the chronic inflation that exacerbates poverty, damages competitiveness and inhibits foreign-direct investment.
Since taking over as the central bank's governor in September, Rajan has had reasonably free rein to shore up India's financial system. With crisis in the air, politicians were all too happy to defer to the central bank. But inevitably, Rajan and his team will find themselves in an uncomfortable spotlight.
Expectations are high for Modi. Businesses and households alike will be looking for fast dividends that will be very hard to deliver. The changes India needs will be nothing less than explosive for the country's leadership. Any moves to root out corruption, make government more accountable, and reduce the barriers to everything from trade to investment will require epic battles with entrenched interests. So will any effort to reduce government debt or narrow the current-account deficit.
It won't be long before the pre-election hype about Modi taking his "Gujarat model" nationwide meets governing realities, dragging down his approval ratings. The quickest way to calm the masses will be the central bank's compliance. But Rajan must resist the torrent of criticism sure to come his way. Giving in wouldn't just fan fresh inflation -- it would also remove the urgency for the government to internationalize an economy that risks getting left behind as China races forward.
Rajan has the gravitas to push back. The University of Chicago economist did India proud when he headed up the International Monetary Fund's research team from 2003 to 2007. Prominent economists such as Columbia University's Jagdish Bhagwati think Rajan is an obvious choice to replace IMF head Christine Lagarde someday, boosting India's global clout.
For now, though, Rajan faces what may be the toughest job in global economics. Instead of becoming Modi's monetary lackey, Rajan should speak truth to power the way central bankers in the U.S. and Europe did once upon a time. Rajan is just the man to play the honest-broker role New Delhi has lacked during the past decade. If he can turn the tables and prod Modi to alter the mechanics of India's economy, Rajan will be remembered as one of history's greatest reformers, and the world economy will be a better place.
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