Ensuring Continuity: Urjit Patel as new RBI Governor

By: Prateek Godara

After months of speculation, the Appointments Committee of the Cabinet (ACC) on 20^th August 2016 announced the appointment of Reserve Bank of India Deputy Governor Urijit Patel as successor to Governor Raghuram Rajan. The appointment was made based on the recommendation of the Financial Sector Regulatory Appointments Search Committee (FSRASC), headed by the Cabinet Secretary P.K. Sinha.

Institutional Investors both domestic & foreign have welcomed the appointment of Dr Urjit Patel as successor to Dr Raghuram Rajan as it signals continuity in the monetary policies pursued by the RBI.

It was Dr Patel's path-breaking report that has helped India join the league of developed nations where adoption of flexible inflation targeting has helped anchor inflationary expectations and brought about a structural control over inflation for which Dr Rajan was greatly applauded.

 

The main Expected areas for the new governor to work on:

Inflation-targeting

The appropriateness of inflation-targeting in India is still questioned.

As agriculture products, which reacts very little to monetary policy, makes up half of India’s inflation basket, and a routinely loose fiscal policy has threatened to blunt monetary decisions in the past.

At the same time, the Government has given fiscal consolidation precedence over growth, thus providing a more conducive environment for effective monetary policy. Further support to iron out structural constraints of physical and soft infrastructure is also required to ensure supply-side don’t change disinflationary trends.

Until these problems are solved, there is a risk that an inflation-targeting RBI might tend to run a tight monetary policy during phases of food price shocks. Which could prove to be a big problem if the food price shock coincides with a phase of weak aggregate demand and subdued growth. Hence, RBI will need to be adaptive, that is, to differentiate between supply-induced shocks to inflation and demand-driven pressures so that they don’t harm growth

New Framework

The decision to retain the 4 per cent CPI inflation target (2-6 per cent range) for the next five years points towards policy continuity. It also lowers concerns that growth would take precedence over inflation. While the decision to maintain these targets is encouraging, achieving the 4 per cent target on a sustainable basis will be a challenge.

CPI inflation fell to 4.9 per cent in FY16 from 6 per cent the year before and 9 per cent the year before that. But the downward move was largely due to cyclical factors — global disinflation and easing rural wages at home. In recent months, inflation has begun to creep up again (at 5.9%). The structural hurdles of poor infrastructure, rain/groundwater dependency and agricultural bottlenecks must be addressed if inflation is to continue further towards the Government’s 4 per cent target. The market also awaits clarity on how the incoming governor and the new committee will view this new inflation target. How it reacts to any possible overshoot from the 4 per cent mid-point also remains an open question.

At present, it is assumed that the officials will view 5 per cent as a step target this year and move towards 4 per cent next fiscal. Working with this assumption and a conservative governor, set against a background of firm April-July inflation numbers, the odds of a rate cut in October is low.

December will be the next window, hinging primarily on the inflation outlook and the appointment of a dovish policy committee. Further, it is expected the rates to remain steady as the bulk of the disinflationary phase has passed and full-year inflation looks set to miss the 5 per cent target. Apart from the volatile food component, demand dynamics will also be important to monitor ahead of an increase in public sector wages and a pick-up in rural demand due to a good monsoon.

With targets in place, Patel’s views will be important to get a clearer sense of policy direction. Inferring from the tone of his monetary policy report back in January 2014 and his sparing comments since, he appears to be largely aligned with Rajan’s views. This lays the ground for a cautious approach towards rate cuts, while being critical of excessive public spending. Thus, one should expect the new governor to push for active fiscal management and structural reforms to improve the effectiveness of monetary policy on price expectations.

Unknown Quantity

While much of his views on mainstream policy can be inferred from past academic papers and occasional public comments, little is known of his thoughts on other aspects, including plans to deal with banking sector stress and financial sector reforms. As a governor, clear and frequent communication on policy and other related issues will become important.

Besides mainstream policy, the new governor will also take office in the midst of the FCNR maturities, where some short-term impact on balance of payments are expected, strain on domestic liquidity conditions and a temporary bout of rupee volatility. However, active liquidity management and tapping available tools are likely to ensure that this impact does not persist. Measures to tackle banking sector stress will be important, especially amidst signs that there is more pain ahead.

Apart from the change of leadership in the RBI, the make-up of the policy committee will also be important.

While the committee marks a shift towards collective decision-making, the known two (of six) members fall in the relatively cautious camp. If the rest of the panel carries shades of the present technical advisory committee, the overall policy bias would be more balanced.

It is worth remembering that Raghuram Rajan took office in the midst of the US taper tantrums when the rupee had depreciated to record lows and foreign investors sold local assets heavily. This required him to immediately take corrective measures. The new governor, by contrast, will assume responsibility in a relatively calm environment, with the emphasis likely to be on policy continuity and maintaining macro-stability.