Indian banking conundrum and Rajan\'s exit from RBI

Sayed Kamaluddin | Published: July 10, 2016 20:28:54 | Updated: October 24, 2017 09:04:16

While the Indians are grappling with apparent uncertainties caused by a sudden change of the governor of the Reserve Bank of India (RBI), the country's central bank, a top private banker has accused the banking sector of not being honest about the depth of its bad loans. The banker, Uday Kotak, managing director of Kotak Mahindra Bank, said that only about half of the distressed assets 'had been publicly identified so far.'  
This appears somewhat incongruous for an active banker to have said what he did. But he has reasons. His Uday Kotak Bank claims to be the country's biggest buyer of the 'distressed assets' or 'bad loans' for years and he is supposed to be aware of the extent of the bad loans that the country's banks are burdened with. In other words, what he suggests is that this stressful situation exists despite the central bank's recent crackdown on the banking sector's huge nonperforming assets (NPAs).   
The RBI had estimated in September 2015 that 'stressed assets' (including restructured and NPLs) of the state-controlled banks amounted to about 14 per cent of their total assets. This accounts for about three-fourths of the total banking assets. A quality asset review resulted in steep write-downs and cumulative losses of a whopping Rs 170 billion or $2.5 billion. The non-state banks' position was not bad but the big players in the private sector like the ICICI Bank and Axis Bank also reported heavy losses.     
Indeed, it was a bit of a shocker and not quite in line with Prime Minister Narendra Modi's decision not to renew incumbent governor of Reserve Bank of India (RBI) Dr Raghuram Rajan's contract which expires in September next. This decision, when made public, became a widely discussed subject in India.  Normally people don't bother much about who is going to be the next governor of the country's central bank. It is considered a routine matter. But Rajan's case is different. Besides, Prime Minister Narendra Modi's reluctance to offer Rajan the usual two-year extension granted to all former RBI governors since India's market liberalism began over two decades ago also raised a lot of eyebrows.  
INFLATION, ECONOMIC GROWTH AND BANKING: Dr Rajan, former IMF chief economist, was appointed RBI governor in 2013 by the Congress government at a time India was facing runaway inflation and its currency, rupee, was sliding. The country's business community welcomed it with open arms. Rajan was widely known for his 'prescient' and forthright warnings of the 2008-09 global financial crises. He has also been known for his plain speaking and willingness to tackle tough issues head on.
His policy was to lower inflation and help improve investment for achieving higher economic growth. His resolute anti-inflation policy and refusal to lower interest rates angered a group of influential industrial magnets, though under his leadership, the RBI has cut interest rates by 150 basis points since the beginning of 2015. But they wanted more. In addition, he also openly denounced crony capitalism and put pressures on the state-controlled banks (SCBs) to get tough with distressed borrowers. Those pampered group of industrialists were used to enjoy special preferences and privileges and the pliant banks always came to their rescue. But Rajan stood firmly against it.
In the process, he has made the rightwing leaders of the ruling BJP unhappy. Besides, his policy regime has also hurt the big industrial groups for not only lowering interest rates quickly but also on cleaning up the banks and people who were responsible for causing non-performing assets at those banks. One of Rajan's most vocal critics, prominent BJP lawmaker Subramanian Swami accused him of 'wilfully wrecking' the Indian economy and for being 'mentally not fully Indian'.    
ROLE OF A CENTRAL BANK: Earlier in April 2016, while speaking to banking and finance students in Pune, Western India, Rajan said: "As a central banker who has to be pragmatic, I cannot get euphoric if India is the fastest-growing large economy… Our current growth certainly reflects the hard work of the government and the people of the country, but we have to repeat this performance for the next 20 years." Without being specific, he pointed out that previous governments had become too complacent by periods of high growth and India remained a relatively poor country.       
Measures against rising inflation responded and it fell from previous average of 9.0 per cent between 2006 and 2013 to below six per cent after the RBI had adopted inflation-targeted monetary policy decision. But the criticism among politicians and big businesses reached its crescendo as they complained that high interest rates have discouraged private investment.
Undaunted, Rajan rebuffed his critics: "There is no long run trade-off between growth and inflation…. A central bank serves the economy and the cause of growth best by keeping inflation low and stable around the target it is given by the government… As soon as economic policy becomes painful, clever economists always suggest new unorthodox painless pathways…. Be very wary of economists who say you can have it all if you only try something out of the box".           
However, the RBI governor's most potent statement was that he asked all banks to 'fully disclose' for bad debt by March 2017 and called for 'deep surgery' to clean up the balance- sheets. Analysts of all hues believe that with this decision, he had thrown in the gauntlet and his opponents, instead of accepting the challenge, gallantly chose to stab him at the back through an amenable 'establishment' as his three-year contract was coming to end in September 2016.
THE LIKELY REPERCUSSIONS ON THE ECONOMY: Good-natured Rajan offered an advice for his successor (yet to be named) to stay the course he had charted and not to be tempted by any easy path to rapid economic growth and prosperity which could come at the cost of India's macroeconomic stability.
One report, quoting a senior government official, who refused to be named, insisted that Rajan's departure would not shift RBI's policy and a new governor would be named soon. However, he also said that the monetary policy would be set by a committee instead of a single person and the governor will have a vote. Then he 'firmly' added: "We thoroughly believe in an independent, professional central bank, able to make fact-based, data-driven decisions." However, media reports in India are sceptical.
Head of JP Morgan's emerging market economics Jahangir Aziz has said that in a world which is so volatile and where a large degree of uncertainty exists, people gather around or attracted to stability, and Rajan has epitomised that. Now, says he, "much will depend who is appointed as his replacement".
The Business Standard of India reported on June 29 that RBI in its latest Financial Stability Report has raised concerns over the capital adequacy ratio in 30 out of 50 banks which 'might not be able to meet the norms under extreme scenarios.' Tests conducted by RBI suggest that under a baseline scenario, gross non-performing assets (NPAs) could rise to 8.5 per cent of the total by March 2017 compared to 7.6 per cent in 2016. But if the banks' asset quality faces any severe stress, it could rise to 9.5 per cent.   
Interestingly, soon after Rajan announced his departure, Bombay Stock Exchange rose by 0.9 per cent as investors bet that his exit would herald an era of loose monetary policy and increase appetite for Indian equities. Reports quoting a senior economist with a western bank said, equity market reacted on the expectations that whoever comes next will not be so hawkish on inflation and 'it will be a party time for a while.'
Abhishek Bhattacharya, director of Fitch's Indian affiliate, India Rating and Research, has estimated about Rs 13 trillion (or $195 billion) - one fifth of bank loans - are 'stressed'. Now compare this to Rs 8.06 trillion of 'distressed' loans, which, reported as of December 2015 or 11.5 per cent of India's entire bank debt, calls for more pressure on profits.
Rajan's sudden exit has also raised questions about planned cleaning up of $120 billion in soured loans held by the banks, a key initiative of his three-year plan. Another New Delhi-based analyst felt that Narendra Modi's willingness to cut loose such a respected figure will prompt investors to take a close look at the degree of his rhetoric about transforming Indian's economy that is matched with action.

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