Banks shouldn’t decide rates, markets should: Raghuram Rajan

Reserve Bank of India Governor Raghuram Rajan spoke to Manojit Saha in an exclusive interview. Edited excerpts

What was the rationale behind today’s policy stance?
We have cut the rates twice, they have to be absorbed and transmitted. We are giving it time to transmit. We have also seen some upturn in inflation in last three months, some of which is due to base effect. But there are some upturn due to vegetable prices. Weather has not been that favourable. And we have monsoon coming up. It does affect some prices.

Let us see how the transmission takes place. We are fairly confident that with liquidity situation easing in April and credit growth relatively modest, banks have the incentive to pass it on. And we will also get more information on how the recent development on inflation is playing out.

You seem to be quite upset with banks on policy transmission delay.
We will take steps to improve the transmission mechanism. But at the same time banks will also have to take a view. The question is where we should be as a country. Ideally, a lot of rates should be priced at a market rate, like the call money rate. That pricing should happen both on the lending side as well as the borrowing side. In most of the countries in the world, you don’t have a situation where banks are deciding what rate that should be. It is a market- based rate. We need to move towards that.

The corporate sector does not care from where the money is coming as long as they are cheap. So if the banks are not willing to cut rates, the borrower will go to the commercial paper market. So, I believe, banks can’t say we believe in this kind of base rate mechanism. They have to move towards a base rate mechanism which reflects their marginal cost of funds.

You had an interaction with banks post the policy announcement. Do you get a feeling that the marginal cost theory will be accepted by them?
If they don’t reduce interest rate appropriate with the fall in market rates, the large corporations will move away. May be that is what the banks will like to see, But I can’t believe that they would like to see that happen in a big way.

The government has increased the small savings rate recently, in an environment where interest rates are softening? Does it send a wrong signal?
I agree with the basic premise that small savings rate should move along with the market interest rate. They cannot be fixed at a level; otherwise they become the floor. Going forward, it has to become more flexible.

With 5.8% CPI inflation projected for December and you have earlier said that the real rate should be 1.5 to 2%, does it mean that the scope for further rate cut is limited?
No. This is our expectation of what inflation will be at the end of the year. And then you can gaze on how much room is there. As I said, if you are an optimistic in the market, you will look at the 1.5% figure and if you are pessimistic then you will say there is no room for rate cut. What is also important is the way inflation moves over time. Projection of 5.8% does not necessarily mean there is the realisation. If the disinflationary process is stronger in the economy, if the monsoon is a good one, if vegetable prices does not pick up that much, it is quite possible that disinflation will be stronger. The point we are making today is that we want to look at more data to get more confidence.

So, 5.8% could be revised, say, three months down the line?
Of course, it will be revised almost surely, based on the evolution of inflation. As inflation evolves, there could be room; there could not be any room. We have to see.

Have you started factoring in that RBI has to reach the 4% inflation target?
Like last year, we have a short term goal and a medium term goal. The short term goal was 8% retail inflation and 6% was the medium term goal; similarly now our short term goal by the end of the year is 6%, and medium term goal beyond that is 4%. We have two years to reach from 6% to 4%. We are not trying to disinflate faster than what is laid out in these goals. Does it mean that if for some reason oil prices collapse further and we reach 5% earlier, does what mean we will push up inflation to get 6%? The answer is no.

The concern among market players is that if 4% is factored in and if you have a feeling that 4% is getting tougher to achieve, then RBI may well start raising interest rates.
Remember, we have two years to get to 6% from 4%; so there is plenty of time. We have room to disinflate about 1% in a year.

The policy document sounded a positive note that growth will pick up. In the last one year, since the new government has taken charge, which is seen to be pro-reform, have you seen things are changing at the ground level?
There are two ways of ascertain this. One is through database and the other way is by asking the bankers and the companies. I think there is movement on the ground. There are projects which have been restarted. There are projects which are being completed after being stuck for a long time. The database also suggests the same thing. According to CMIE’s database on stalled projects, the number of stalled projects and their value is coming down, not as much as you like to be, but it is coming down because of government action. Also, new project intentions are also moving up, which includes private projects and not only government projects. So, I think we are seeing the beginning of pick-up. It is still early days but I am growing more optimistic.

How serious is the problem of unhedged foreign exchange exposure of Indian corporate sector? There is a complacency among players because the exchange has stabilised.
I think it is unhedged to a greater extent that we would like. We are a little worried that the players are paying attention. If they are playing with their own money, there is no issue. But we fear that some of them sometimes are playing with creditors’ money. If I have a big problem, I go back to my creditor and say I can’t make my payments to you, so why don’t you take a haircut. While on the other hand, if you bet big like this on the dollar remaining relatively low to the rupee and if you win, you will be paying dollar interest rate. And it is all upside for you. It’s like heads I win, tails you lose kind of bet, which we worry about.

That is why we are pushing banks to ensure these people hedge by raising their capital requirements. We cannot micro manage this process. Perhaps the only way to create incentives is to hope that there is significant episodes of volatility of rupee. Do we want to engineer those volatilities? No.  Sometimes small accidents help you to keep away from big accidents.

RBI always says that it does not target an exchange rate. Then why the interventions in foreign exchange markets are so high?
We don’t. But what is happening is that in some days and in some situations, everybody is saying the right place to be is India and Indonesia. And so, when the market fixates on this, we get a lot of money.

If we allow the rupee to appreciate based on all the inflows that are coming in and when we stop becoming the flavour of the month, a lot of money is going to go out. That creates undue volatility in the rupee. So our worry is when we see we are the flavour of the month and money is pouring in, should we keep some reserves for when the money is going out? We also want to tell people, go look elsewhere, if they are only interested in tourism. That is why we say invest in longer term securities.

I am glad that a fair amount of money is coming into equity and not only in debt. And the fact that the government debt limit is full means more debt is going to corporates. So, corporations are able to borrow at a relatively lower rate. We have to be vigilant.

The economic survey points out that India should have foreign exchange reserves of $ 750 billion to $ 1 trillion. Do you think building that kind of reserves is desirable?
Many economic commentators in India argue that somehow we can magically tag it with the level of the rupee. Implicitly what they have in mind is that you buy so much that it moves the rupee to whatever level you want. There is a cost to do this. You are financing another country by building reserves at a very low interest rate.

To the extent reserves are precautionary, doing some of these is warranted like protecting against significant crisis, etc. But beyond a certain level, you have to recognise there is a potential cost to it.

A lot of people will say we should intervene to keep the rupee really low so that our exports flourish. It may not be necessarily true as your import costs will also go up. Today, most exporters also import a lot. It is not unmitigated blessing. Also, if you push the rupee far down, inflation will pick up. Sometimes the commentary on this issue is very shallow and one-sided. It says buy up more and more dollars and we will be really competitive and that will be Nirvana!

What we have to do is to be careful and follow a policy that is moderate, not allow too much appreciation when there is a lot of money flowing in and at the same time not try to aim to take the currency to some level. We are not trying to fix a level for the rupee…we are too much of an open economy for that to succeed in the longer run.

The economic survey was talking about $ 750 billion over a long period. The appropriate level of reserves that will depend on the size of the economy. Now we are a $ 2 trillion economy and we have reserves of around $ 350 billion. If we became a $ 5 trillion economy and still developing then there might be a different level of reserves at that point.

What gives you confidence that the government will not push the fiscal deficit target further?
This is where certainly the credibility of the government comes into play. Market participants will rely on the government to follow through on its promise to stick to the fiscal consolidation path. Now, there is an open question that the expenditure reforms committee and other committees raised, that the country needs more mechanisms to ensure that either there is a watchdog on the size of the fisc or there are hard commitments. Hard commitments in a country like us is difficult, unless they are constitutional commitments which have to go through multiple legislations in the country.

My sense is that the government has said quite firmly that this is a one year postponement. Certainly I have to believe that. But there is a need for open debate along the lines that the expenditure committee has suggested — that we should build more institutions that ensures the consolidation process.

The Finance Bill has proposed to shift money market regulations from RBI by amending sections 45U and 45W of the RBI Act. What will be the implications?
The finance minister has said publicly that he will make a statement in Parliament. So, we have to wait for that. I have said quite explicitly that those provisions are not related to the debt management office. The DMO is something which is independent of RBI, Sebi and presumably independent of the government. So, for DMO, you don’t need to shift regulations from RBI to Sebi. So, in that sense, we have to wait and see. Technically speaking there is no necessary connection.

After the government selectively decided to infuse capital in public sector banks, those which have not received capital has gone to LIC. Are you worried that LIC is investing in so many banks?
We have to examine that issue also on how much can any single owner have in the entire banking.

Ambit Capital came out with a report on Monday that you are not interested in continuing as RBI governor beyond the three-year tenure and most likely succeeding Christine Lagarde at the IMF. Your comments.
(Laughs) This is one of those speculative stories that have speculation at every different level. Lagarde is doing a fine job at Washington and that job is not open. She may well go in for a second term.

I am right in the middle of my tenure here. I am not even thinking about what would happen at the end of my three years term. Earlier, some people wanted me to pack off to the BRICS Bank. They seem to find a new job for me every few months. I have said it earlier and will say it again.  I have a perfectly good job in academia. I am not looking for any new opportunities when my term here comes to an end. What I want to do right now is to do the best job I can for whatever time I am here.

When are the payments bank and small finance bank licences are expected to be announced?
I am hopeful we can do it in six months from the last date of receiving applications. That is an outer limit.