Promote significant reforms going forward in order to elevate growth: Raghuram Rajan

“Well the Chinese economy will probably recover towards the second half of next year simply because the shocks it has been subject to have been pretty significant this year,” says Raghuram Rajan, Former RBI Governor & Prof, University of Chicago Booth School.


Mythili Bhusnurmath: Do you see the IMF’s forecast of one-third of the global economy facing recession happening and if yes what might be the reason for it?

Raghuram Rajan: Certainly, the Russia-Ukraine crisis has aggravated the already existent problem of inflation with the rising commodity prices as well as supply chain disruption. And now after global central banks have been complacent in early 2022, they have geared up by raising interest rates which has led to this rise in mortgage rates, the decline in housing. These are all causing the possibility of a recession next year. Also, as per the current circumstances, the most prominent scenario can be of a slowdown which may technically become a recession but will not necessarily lead to deep-deep job cuts that at least is the hope of the Fed and other central banks.

Mythili Bhusnurmath: The US inflation is above the Fed’s targeted 2% and the Fed seems determined to get it back to that 2%. What will this lead to? How will this impact the US economy, the global economy and emerging markets, especially markets like India?
Raghuram Rajan: Fed’s recent actions are now showing up with inflation coming down from about 9% level to 7% in the November reading. Incremental inflation has also come down significantly. Goods price inflation is falling a lot, partly compensating for the earlier rise, what is left is services inflation which is still strong. Now this is where the labour market matters because the labour market is very tight still. Chairman Powell has been insistent that he wants to see labour slack, of course, the Fed has already raised interest rates quite a bit, probably will do another 25 basis points for the next two rounds and then somewhere around 5.5 will pause to see what happens.

Now the market is betting that this will be enough for the economy to see significant slowdown and that shall prompt the Fed to cut rates soon. Also, I think disinflation is already on the way unless we have another oil price shock or something like that. We will see significant disinflation over the next year.

The key for the Fed is to bring inflation back to its target range of around 2-2.5 on the CPI. Concluding, I do not think anybody really knows what growth will really be next year; and how long the Fed will have to stay with higher rates.

Mythili Bhusnurmath: Which just shows how economics is anything but like a physical science, all the rocket scientists who have entered economies it is very much a political economy, would you agree?
Raghuram Rajan: Well, I mean partly it is political in the sense that one of the impediments to inflation fighting today is the willingness of governments to spend yet more. Of course, the central bank is always to some extent political and so I think the inflation fight is being subject to it also. But I think at this point it is also a technical issue as we need to know how much do central banks need to keep the rate high in order to bring economic activity down to a level that they feel comfortable with.

It is more of a problem in Europe where the shocks are more on the supply side rather than demand. In the US it is clearer that it is a demand shock and the Fed needs to keep going until demand slows down.

Mythili Bhusnurmath: We in India are very hopeful about China plus one working out, the plus one of course being India, but do you think India will really be able to benefit substantially from what the kind of turmoil that we are seeing in China, the fact that many MNCs are moving away from China? How does this impact us, do you see the Chinese economy recovering next year?
Raghuram Rajan: Well the Chinese economy will probably recover towards the second half of next year simply because the shocks it has been subject to have been pretty significant this year.

Certainly some of the policy shocks such as the action against the private sector that China took up and the fight with the rest of the world, primarily with the United States on tariffs have been problematic. Also, the concern now that China at some point may take action against Taiwan is something that certainly sort of worries a lot of businesses and, of course, the zero COVID policy which was maintained for far longer and now has reverted to a sort of free for all is causing enormous havoc in China in terms of the spread of COVID as well as deaths

We are seeing the fall out from the actions on real estate that China took a couple of years ago. Also we have seen the fallout of zero COVID policy so that kind of policy volatility and uncertainty makes companies want alternatives.

Now India is among the countries companies are looking at. I would say India is not necessarily number one on that list though the Indian market at large as it is is an attractive option, countries are also looking at Vietnam where the policies are a little more certain, a little less volatile and they have many of the characteristics of China.

So Vietnam often is the China plus one but Mexico for US firms is another China plus one because it has the benefit of being much closer and, of course, being within NAFTA.

I think for India to be well and truly the China plus one has to make changes on the policies that it has including to stop raising tariffs. Tariffs are a deterrent to firms locating in India. It has to make policies much more certain and less against foreign direct investment (FDI), some of which we have seen for example against companies like Amazon and Wal-Mart to favour domestic participants.It is definitely in the consideration set of many companies but it can do far more to benefit from this moment and that requires good sound policy.

Mythili Bhusnurmath: With the latest print showing a terrible picture with the CAD at an alarming level of 4.4, are we in for the double whammy of high current account deficit as well as the fiscal deficit? Also, as rupee depreciation of 11% this year adds to inflationary pressure, how should we cope with burgeoning CAD if we do not raise the tariff?
Raghuram Rajan: As economic activity has picked up, private spending has increased and as a result the current account deficit has ballooned especially because the government has not cut back on its spending, including the spending on for example food security for poorer people but put that aside there is another problem which is emerging which is partly contributing to the current account deficit which is the distributional consequences over the last few years.

The lower middle class has been hurt much more by the effects of the pandemic, by the effects of demonetisation of the trend towards formality caused by the GST and what this then means is that their saving, their spending have been much more limited. You can see it for example in the complete collapse of the two wheeler market relative to say the passenger car market. On the other hand the rich have more money at this point in India, their jobs are still secured, they are earning much more and their spending tends to fall much more on foreign goods.

Take for example Mercedes cars which the ultra rich spend on there. What you are seeing is a substantial growth in sales this year coming back to 2018-19 levels when it had record sales. So we are seeing a distributional change in spending in India also partly because the lower middle class has been significantly hurt both in terms of jobs, employment as well as in spending power and so the natural consequence of all this is the current account deficit is blowing out.

We have to act on the high CAD number. But the answer does not lie in raising tariffs and trying to do import substitution as it will deter foreign investment, fund flows into India which are more stable and make it much harder for us to reach a proper balance. But the solution can be to promote significant reforms going forward in order to elevate growth.

Mythili Bhusnurmath: Now the RBI is also on the monetary tightening path and has so far raised rates by about 225 basis points, so will further rate hike hurt growth? So how much further tightening can we have? What is the inflation growth trade off? Is there a trade off at all?
Raghuram Rajan: Recent inflation numbers have come down. The CPI has come down because of vegetable prices but it is not something that one can rely on. What one should be looking at is core inflation as an indicator of CPI inflation going forward and I think those numbers are not comfortable. Also, the inflation being within the band which we just achieved with the CPI number last month is not the ultimate goal of monetary policy, it is to keep it at a reasonable level which typically I would mean somewhere around the centre of the range that is around 4% rather than just at the outer limit of 6%.

That said, I would not ignore the benefits of having kept inflation relatively under control this time around. The rupee has depreciated but if you look at in relative terms compared to some of the other currencies, thus far at least it has done reasonably relative to some of the other currencies. The real issue has been dollar strength rather than the weakness of other currencies but that said I think we cannot afford to lose the fight against inflation.

Mythili Bhusnurmath: On interest rates and liquidity, the question is that in the past the MPC has been hiking rates but liquidity very often has been kept accommodative or even now it is just focussed on withdrawal of liquidity as a result of which we have seen disagreement even within the MPC. Dr C Rangarajan, the former governor of the Reserve , in his recent book said that interest rates and liquidity must move in the same direction, we have not seen that in the past. How important is it for these two to move in sync?


Raghuram Rajan: Ultimately what the central bank is trying to do by raising policy rates is to tighten financial conditions, reduce activity and therefore make it more commensurate with the supply capacity of the economy and thus bring inflation down. Now I think that what Dr Rangarajan must be referring to is the way liquidity can some time sort of support activity even while you are raising interest rates to shrink activity and then you have the central bank’s liquidity function acting at cross purposes to its monetary function.

We have highlighted the problem for the Fed that in the last few years central banks have flooded the markets with liquidity and as a result what they find is that much of that liquidity has in effect been absorbed by the markets and the markets are constantly clamouring for and that means that when the central bank is tightening conditions and it starts withdrawing liquidity very quickly you see strains showing up in the financial markets.

This does suggest that a policy of abundant liquidity is a little bit like chakravyuh, it is really hard to get out of it once you get into it and this is something that central banks have to reflect on. I think Dr Rangarajan is right that in order to tighten monetary conditions you have to tighten liquidity but central banks have to tread on that path very-very carefully because too tight liquidity can create financial complications including potential failures of some financial institutions so they have to be careful about it and examine how they do it but certainly it will be a help in the fight against inflation.