India′s Rexit: A reality check for foreign investors

The shrill reactions have subsided. Knee-jerk comments like “After Rexit, ruin,” have, fortunately, proved premature and alarmist. Now that the dust is beginning to settle over Reserve Bank of India (RBI) governor Raghuram Rajan's surprise announcement that he will be returning to academia at the end of his term as India's central banker, it is a good time for a reality check on how his decision will impact the Indian economy.Let us begin by acknowledging his stellar role in rescuing and stabilising the Indian rupee, which was almost in free fall when he took over as RBI chief in September 2013. Since then, he has kept his focus firmly on inflation control, declared a war on crony capitalism and launched a much-lauded attempt to clean up the stressed balance sheets of the entire Indian banking system.If India, which was being counted as among the Fragile Five economies three years ago, is once again the toast of global investors, the credit should go as much to Rajan as to finance minister Arun Jaitley and his team. His presence and his international profile provided investors with added assurance and confidence.Rajan's successor, who will be stepping into very large shoes, will have to ensure that all these unfinished initiatives are seen through to their logical end. That will not be an easy task.But for now, foreign investors, who, many said, would wind up their dollar investments in the country and withdraw to safer climes, are staying firmly put. Leading foreign investment firms such as CLSA, Nomura, BofA-ML, Credit Suisse and Barclays, among several others, have predicted short-term turbulence in the Indian stock and currency markets but have been unanimous in their view that long-term fundamentals and, indeed, the “India story” remains intact.Ace investor Rakesh Jhunjhunwala, who is often called India's Warren Buffet, also feels Rajan's decision to move on from RBI will not have any negative impact on the economy.The World Bank, too, feels the banking reforms begun by Rajan will continue after his departure. “I really want to point out that India has really strong macro-economic policies and an effective and conservative supervisor. So, there is no reason to expect banking reforms to change,” said Onno Ruhl, World Bank's India Country Director, reacting to Rajan's impending departure from the central bank.The next RBI chief will have a tough act to follow but there is one area he may want to differ with his rock star predecessor.An agreement signed between the government and the RBI on inflation targeting set the consumer price index (CPI), and not the traditionally followed wholesale price index, as the benchmark. Since the CPI (rural and urban combined) allocates a high 46 per cent weight to food items compared to a weight of less than 25 per cent in the WPI, retail food prices began to play a disproportionately important role in determining monetary policy under Rajan.Now, inflation can result from both demand side and supply side factors. For example, if excessive supply of cheap loans fuels a housing price bubble, the real estate sector can be “cooled” by raising interest rates. This is an example of how monetary policy can be used to control demand side inflation.But supply side inflation is much less amenable to such fiscal interventions. In India, for example, food and vegetable prices rise and fall seasonally. Prices can spike sharply in case of supply side disruptions like freak weather conditions, strikes or hoarding. There is no way such price hikes can be controlled by raising interest rates.This doesn't matter when WPI and CPI move largely in tandem but problems arise when they diverge on a massive scale. In November 2014, the WPI entered the negative zone and remained there for almost one-and-a-half years. Retail inflation, meanwhile, continued at high levels. The divergence between the two reached a high of about 9 per cent by the early months of 2015.This meant real interest rates for Indian industry and many individual borrowers (nominal interest rate minus WPI) was in double digits as the RBI was setting its benchmark repo rates with reference to the CPI - clearly an economically unviable and unsustainable situation.Consider this: in the latter half of 2015, most banks had a base lending rate of about 10 per cent. WPI was at -4 per cent. The real interest rate for many borrowers was, therefore, around 14 per cent - and that too at a time when they were facing deflationary pressures when selling their goods.When Indian industry was complaining about excessively high cost of funds, it wasn't entirely unjustified. And those who alleged that Rajan was behind the curve on cutting rates - and encouraging growth - were not entirely wrong. This has contributed, at least partially, to persistent sluggishness in the Indian economy.This situation could have been avoided if the RBI had benchmarked the repo against a combination of the two indices.The new boss of India's Mint Street may, therefore, want to take a closer look at how RBI tracks inflation. Lower interest rates will not necessarily signal a dilution of the central bank′s independence.