Limits of power: Can a central bank governor prevent crisis?

BY LINDA YUEH

NAIROBI, KENYA: Can a central bank governor prevent a crisis? The answer will matter not just to India and other emerging economies facing the looming end of the era of cheap money, but to all countries that have gone through a banking crisis and those worried about the impact of a crisis in an interconnected world economy.

Expectations are high for India’s new central bank governor Raghuram Rajan, who has increased confidence so far, but it is a tough time for Asia’s third-largest economy.

With economic growth at the weakest pace in a decade at 5 per cent, and expected to slow further, the Indian central bank is in the unenviable position of having to raise rates to combat inflation.

When rates rise, borrowing is more expensive and it is harder for firms to invest and for households to manage their debt.

Shore up currency

One of the reasons for a rate hike under these circumstances is to shore up the currency, the Indian rupee.

When rates are higher — they were raised for the second time in as many months by the new governor to 7.75 per cent on Tuesday — there is a greater return for investors putting their money into India.

That helps to support the rupee that has hit record lows against the US dollar.

A weak currency contributes to higher inflation that squeezes people’s livelihoods and could cause foreign firms to leave as the real returns to their investment would fall.

So, India is between a rock and a hard place: Raising rates to combat inflation and support the currency, but it hurts growth.

Yet, despite these challenges, the Indian stock market is near all-time highs and the rupee has moved away from where it was in September when it was the weakest on record against the US dollar.

The rupee was weaker than even during the 1991 balance of payments of crisis.

It was exacerbated by the Fed’s talk of tapering its cheap cash injections, which has now receded due to the US government shutdown.

Rajan, who took over in early September, has been credited with the “Rajan rally”.

Rajan says that Japan’s prime minister Shinzo Abe has three arrows in his economic policy dubbed Abenomics, but he has five pillars: Improving the monetary policy framework, reforming the banking system, liberalising markets, increasing financial inclusion, and sorting out financially distressed financial institutions.

The reforms of the banking system are particularly welcome, but notice there is a lot which isn’t included and understandably so as it’s beyond the remit of central banks.

Rajan’s five pillars lack the deep, broad-ranging structural reforms that comprise the third arrow of Abenomics, which will have the most lasting impact.

A central bank governor can do a lot these days. But, even a central banker as respected as Rajan cannot address the lagging structural reforms that have affected India’s development since independence in 1947.

For instance, India was richer than the other billion-plus population country in 1980, but now average incomes are a quarter of that of China. It was only in the past five years that India’s GDP per capita exceeded $1,000 (Sh84,500), the level that demarcates the poorest countries in the world.

And, the absolute number of people who live in poverty has risen since 1980 and about one-third of the population live in abject poverty of less than $1.25 (Sh107) per day, while nearly 70 per cent live on less than $2 (Sh171) per day.

Average incomes have also barely risen in the past couple of years and only sped up with growth accelerated in the 2000s to 8-10 per cent and that’s when it exceeded the $1,000 GDP per capita threshold.

In other words, growing at less than 5 per cent isn’t fast enough to significantly raise average incomes, which matters — especially for a growing population.

Coming back to why India has lagged. One reason is the challenge of industrialisation.

India rather unusually has a larger services sector than industry at this stage of development. Services account for nearly 60 per cent of GDP while industry is about a quarter, which hasn’t increased by much in the past few decades.

As China was industrialised in 1980, rather forcefully during the centrally planned period, it is one of the explanations for the difference in growth rates.

Technology and fast growth

Services can generate economic growth, but not as much as industrialisation which is based on technology that can drive fast growth.

It was what generated the strong growth rates seen in other countries in Asia that have industrialised, and in the West during the Industrial Revolution that exponentially increased incomes.

So, the question is why hasn’t India industrialised? There isn’t one answer as there have certainly been attempts, such as when India.