Will a Governor’s Exit Really Hit the Indian Markets?

Published on 11 Aug, 2016

India Investment Research

When one of the world's best central bankers calls it quits, markets will wince, policies will change, and economic reforms will unravel.

Or will they?

At the helm since 2013, Reserve Bank of India Governor Raghuram Rajan has been a beacon of hope for Indian banking.

He’s kept a $1.7 trillion economy steady in a turbulent global economy.

He steered the mammoth economy true, slashing inflation by half.

He did that while keeping interest rates low — their lowest in over five years — spurring economic growth and consumer spending.

He put a successful plan in play to curb bad debt, restoring faith in the nation’s credit growth.

He ushered in a new age of banking, making services available to over two-thirds of a population that was otherwise cut off from mainstream banking.

He tackled the Rupee’s volatility head-on, reducing India’s foreign exchange deficit by $118bn.

He did it all in three years.

Through sustained policy focus and structural reforms, Rajan has completed some herculean tasks without faltering. With the worst behind him, a second tenure as Governor would be a milk run as compared to the past few.

And that’s precisely why his decision to drop out dropped jaws everywhere. 

Raghuram Rajan took the world by surprise when he announced that he wouldn’t serve a second term as Governor. Indian markets and the Rupee saw a knee-jerk reaction, but soon recovered.  With Rajan all set to bid adieu in September, many believe India has a tough road ahead. 

Opinion is divided on whether Rajan’s exit — popularly known as Rexit — could stall the momentum of India’s economic recuperation.  As investors fret about the possibility of resurging inflation and a volatile currency, there’s probably good reason for them to doubt the Indian economy’s ability to come out unscathed. 

Speculators are wary of a Foreign Institutional investor (FII) sell-off in debt markets. 

Foreign investors have poured USD40bn into the relatively stable Indian debt market, hoping for high yields. They were counting on  Rajan to stave off the Rupee’s depreciation. A Rexit could lead to falling interest and exchange rates, pushing foreign investors to pull out in the short term.

There’s also growing uncertainty over many unresolved issues such as injecting liquidity into distressed public sector banks, implementing a nation-wide Goods and Services Tax (GST) , as well as the land acquisition bill, that are damping investor sentiments. 

The State Bank of India (SBI) believes India has nothing to fear from a Rexit however. 

They’re cautioning against taking drastic action based on speculative assumptions. It’s arguable that India has been grappling with inflation since ’83, well before Rajan’s time. In any case, the consumer price index (CPI) would not have any stable correlation with monetary policy instruments over short and medium terms, simply because it’s susceptible to supply-side tremors.

Some even believe Rajan has been given more credit than due. 

When Rajan took over, the Rupee was in a stable position due to a digression from quantitative easing and low interest rates as the economy improved. While India’s inflation seems to have been reined in during Rajan’s tenure, some attribute it to the massive decline in oil and commodity prices. Since 2013, oil prices have dropped to less than half of what they used to be.  The low current account deficit could be attributed to the fall in crude prices as well.  In this light, it wouldn’t be fair to say that inflation is under control only due to the RBI’s monetary policy and high interest rates.

Rajan’s move to cut interest rates in order to control inflation was also slower than the banking industry expected, adversely impacting the amount of India’s capital inflow. This particularly hit SMEs, who now have to pay higher interest rates (16-22%) than their larger corporate counterparts (9%).

While Rajan’s exit would cause some inevitable market fluctuations, they’re likely to be knee-jerk reactions that’ll diffuse in the long run. If the next Governor can strike the right chord on continuity versus change, shifting the markets’ focus toward improving macro fundamentals, such short-term volatility won’t amount to much. 

India’s economy seems to be doing well, bolstered by favorable reform as much as by the will of the Gods. Given its steady momentum and relative isolation from upheavals in global markets, it’s unlikely that a single factor, even one as significant as the Rexit, would significantly sway the Indian markets.