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Imperatives for Reserve Bank of India – Agenda for Raghuram Rajan

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Imperatives for Reserve Bank of India – Agenda for Raghuram Rajan ECON/044 IBS Center for Management Research Imperatives for Reserve Bank of India – Agenda for Raghuram Rajan This case was written by Hepsi Swarna, under the direction of G V Muralidhara, IBS Hyderabad. It was compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. 2014, IBS Center for Management Research. All rights reserved. To order copies, call +91 9640901313 or write to IBS Center for Management Research (ICMR), IFHE Campus, Donthanapally, Sankarapally Road, Hyderabad 501 504, Andhra Pradesh, India or email: [email protected] www.icmrindia.org Licensed for use in the Case Writing Workshop at Bapuji B - Schools, Davangere on March 16, 2019. Faculty Nqame: Prof. G V Muralidhara. ECON/044 Imperatives for Reserve Bank of India – Agenda for Raghuram Rajan INTRODUCTION On August 28, 2013, the value of the Indian rupee vis-à-vis the US dollar plummeted to a record low of INR68.80.The stock market took a plunge and on the same day, the BSE SENSEX touched an intra-day low of 17,720, down a whopping 13.6 % from January 2013’s high of 20,500. Foreign investors pulled out an staggering INR620 billion (USD10.5 billion) from the Indian capital market during June-July 2013 amid concerns over the depreciating rupee. Inflation in India had been running high at above 7% since December 2009; current account deficit had expanded to record levels (4.8% of GDP in 2012); and several projects were reportedly stalled due to policy bottlenecks.1 The investment climate was not seen as encouraging by corporates. In the first quarter (April-June) of the fiscal year 2013-14, India’s economy grew at its slowest in the previous four years and recorded a growth rate of 4.4%.2 In October 2013, the World Bank revised India’s economic growth forecast for the fiscal 2014 to 4.7 % against the earlier estimate of 6.1%.3 Experts pointed out that the Indian economic condition in 2013 was the worst since 1991. At a time when India was facing its worst financial and economic crisis in decades, with slowing economic growth, high inflation, a record high current account deficit, and the rupee hitting record lows, Raghuram Rajan (Rajan) was appointed as the 23rd governor of the Reserve Bank of India (RBI) on September 04, 2013, for a period of three years. The day after he was appointed, Rajan outlined a reform plan focusing on boosting investor confidence and stabilizing the falling rupee. As a result, the rupee and stocks strengthened. On September 05, 2013, the rupee gained 1.58%, going up to INR66.01 against the dollar and the stock market closed up by 2.22% to 18,979.76.4 By October 16, 2013, the rupee recovered by almost 9% since September 2013, to INR61.83 against the dollar.5 Rajan was described as a person with the Midas touch and was portrayed as a rock star governor, both in the national and international media, for stopping the rupee fall. Questions were, however, raised about Rajan’s capacity to bring India out of its economic crisis, given that he had control over only the monetary policy. Economists and analysts kept a keen watch on Rajan’s moves to see if he could contain the crisis in India and bring it back on growth path. The answer to this question was expected to matter not just to India but also to other emerging economies embroiled in a similar crisis. 1 “Economic Survey 2012–13”, http://indiabudget.nic.in, 2013 2 “Estimates of Gross Domestic Product for the First Quarter (April-June) of 2013-2014”, Press Information Bureau Government Of India, http://mospi.nic.in , August 30, 2013 3 K R Srivats, “World Bank lowers India’s GDP growth forecast for 2013-14”, http://www.thehindubusinessline.com, October 16 , 2013 4 “Raghuram Rajan comes in as RBI governor, rupee and stocks rise”, http://www.hindustantimes.com, September 05, 2013 5 Sachin Kumar, “The Rajan effect: rupee rises again”, http://www.hindustantimes.com, October 16, 2013 1 Licensed for use in the Case Writing Workshop at Bapuji B - Schools, Davangere on March 16, 2019. Faculty Nqame: Prof. G V Muralidhara. Imperatives for Reserve Bank of India – Agenda for Raghuram Rajan BACKGROUND In 1926, the Royal Commission on Indian Currency (Hilton Young Commission) recommended the establishment of a central bank to be called the Reserve Bank of India (RBI). On March 05, 1934, the Reserve Bank of India Act, 1934, (II of 1934) was passed which provided the statutory basis for the functioning of the RBI. On April 1, 1935, the RBI commenced its operations with Sir Osborne Smith as its first Governor. The Bank was constituted as a shareholders' bank6.7 In one of the major events at the RBI, in 1938, the first RBI notes were issued. The RBI was formed to: regulate the issue of bank notes; maintain reserves with a view to secure monetary stability; and to operate the credit and currency system of the country to its advantage.8 The RBI’s monetary policy throughout its history focused primarily on inflation control and expansion of bank credit to support economic growth.9 By 2008, with the development of a broad- based financial market with closer global inter-linkages, financial stability was included as another important objective of monetary policy in India POST INDEPENDENCE EVENTS A major milestone in the history of the Reserve Bank was its nationalization in 1949. The RBI was nationalized with the passing of the Reserve Bank of India (transfer to public ownership) Act in 1948. In terms of the Act, all the shares were transferred to the central Government on payment of compensation to the shareholders.10 Thus, after January 1, 1949, the Reserve Bank of India functioned as a state-owned and state-controlled (nationalized) bank. The nationalization of the RBI was also supplemented by the passing of the Banking Regulation Act, 1949, conferring on the central bank the vast power to control the activities of the commercial banks. In the same year, the Banking Companies Act (later renamed as the Banking Regulation Act) was passed, which required the banks to maintain liquid assets for the first time. On September 19, 1949, the rupee was devalued by 30.5% as a defensive measure, due to devaluation by other ‘sterling area’ countries.11 After 1951, there were major changes made in India’s economic and monetary policies. In 1951, five-year plans were launched, which took India toward a more planned economy. The State Bank of India was formed in the year 195412, to bring rural credit to the center stage of central bank activism. On October 6, 1956, to meet the expanding currency requirements of the economy, the system of note issue changed from the Proportional Reserve System (PRS) under which the RBI was required to maintain 40% gold and forex reserves against note issue, to a Minimum Reserve System (MRS)13. 6 Initially, the RBI was established as a shareholder’s bank. Its share capital was INR50 million, divided into INR0.5 million fully paid up share of INR100 each. Out of this, shares of the nominal value of INR0.22 million (2200 shares) were allotted to the Central Government. The remaining share capital was owned by the private individuals. Thus, the control on the policy of the RBI remained with the Government. 7 Reserve Bank of India, “Chronology of Events: The Early Years – 1935 to 1949”, http://www.rbi.org.in 8 Reserve Bank of India, “Chronology of Events: Brief History”, http://www.rbi.org.in 9 Amaresh Samantaraya, “Monetary Policy of the Central Bank:Simplifying the Mystique”, http://cab.org.in, April-June 2008 10 “Role of RBI in Indian Economy”, http://www.scribd.com 11 Reserve Bank of India, “Chronology of Events: The Early Years – 1935 to 1949”, http://www.rbi.org.in 12 “Glimpses of RBI’s history”, http://www.bankbazaar.com, January 21, 2010 13 Minimum Reserve System means that the RBI can issue any amount of currency notes provided it keeps the minimum statutory limit of INR2 billion in gold and government securities, of which INR1.15 billion should be in gold. 2 Licensed for use in the Case Writing Workshop at Bapuji B - Schools, Davangere on March 16, 2019. Faculty Nqame: Prof. G V Muralidhara. Imperatives for Reserve Bank of India – Agenda for Raghuram Rajan In 1960, the policy of reconstruction/compulsory amalgamation of banks was introduced to consolidate the banking sector.14 Around 200 banks were merged or liquidated between 1960 and 1982.In 1962, H V R Iyengar, RBI governor from 1957-1962, identified four areas of conflict between the RBI and the government –interest rate policy, deficit financing, cooperative credit policies, and management of sub-standard banks.15 Under his leadership, the monetary policy for the very first time used the variable Cash Reserve Ratio (CRR)16 and selective credit controls. In December 1967, social controls over banks were introduced in India to align the banking system with the needs of the economic policy. As a result, 14 major Scheduled Commercial Banks (SCB) with deposits of INR50 million, were nationalized for the development of the economy. After the nationalization of the banks in the late 1960s, monetary policy in the form of credit planning17 assumed a lot of importance. During the early 1970’s, inflationary trends in the country led to the initiation of strong measures by the RBI. To tame inflation, the RBI increased the Statutory Liquidity Ratio from 25% to 28% and hiked the bank rate18,19 In 1973, there was an oil shock, wherein oil price quadrupled, resulting in double digit inflation and recession in the country.
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