The limits of star power

A picture of Raghuram Rajan So-called rock star central bank governor Raghuram Rajan faces a tough time ahead

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 inter-connected world economy.

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

With economic growth at the weakest pace in a decade at 5% 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.


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% on Tuesday - there is a greater return for investors putting their money into India.

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

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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. That was when it was headed toward 70 to the dollar. It is now closer to 60, which I wrote about in August.

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.

Mr Rajan, who took over in early September, has been credited with the "Rajan rally". The UK isn't the only country with a so-called rock star central bank governor.

Mr 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. Mr 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 Mr 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, 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 per day, while nearly 70% live on less than $2 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% and that's when it exceeded the $1,000 GDP per capita threshold. In other words, growing at less than 5% 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. Manufacturing can propel countries to grow quickly as they move out of agriculture and produce higher value-added products before eventually becoming more of a services economy like the UK and the US did after the Industrial Revolution.


India rather unusually has a larger services sector than industry at this stage of development. Services account for nearly 60% 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.

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 attempted to boost manufacturing through protecting its firms from competition from abroad. Import substitution industrialisation (known as ISI) didn't work very well, unlike in Latin America during the 1950s and 1960s.

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India has to be seen as an attractive market for banks to enter”

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Some factors haven't helped. A key issue is education. Even today, only 63% of secondary school-aged children are enrolled in school, according to the World Bank. That falls to 16% for higher education. The average number of years in education is just five years, which places India below the global average and is less than half of that for developed economies.

Education enrolment has improved in recent years, especially at the primary school level. This is, though, an issue that lies beyond what a central bank governor can do.


The other factor is a lack of bank financing, which has shepherded entrepreneurs into services rather than production. Starting a services company doesn't require a loan for machinery, for instance. And this is an area where the central bank can do something to help. It's one of Mr Rajan's five pillars. By opening up the banking system to competition, including foreign banks, he aims to increase credit that can help people start businesses.

It'll take more than the central bank relaxing regulation though. India has to be seen as an attractive market for banks to enter. Still, it's a step in the right direction.

But, the other parts of support that is needed for industrialisation, such as roads, telecommunications infrastructure, and a welcoming regulatory environment, will be largely out of the hands of the central bank governor.

Those structural reforms will be important to address the "twin deficits" that have caused the rupee to plunge and for many to worry about a repeat of the 1991 crisis.

Only by producing more can India close its sizeable current account deficit, which is the widest measure of the trade gap including investment flows. The second deficit is the budget which is in the hands of the government. Both are around 4-5% of GDP - which are worrying levels. The central bank supporting the currency is only a temporary bandage.

The central bank governor can't sort out the trade deficit, the fiscal deficit or the lagging education system. These are among the persistent issues that have plagued India's growth.

But, a central bank governor can inspire confidence that he can manage financial stability and has the tools to address a potential crisis.

So far, it looks like Mr Rajan has done a lot in just two months. But, can he prevent a crisis? And will the Rajan rally last? Find out tomorrow when I check out the star power of India's new central banker when I interview him in Mumbai.

Linda Yueh Article written by Linda Yueh Linda Yueh Chief business correspondent

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  • rate this

    Comment number 42.

    @41 arnab

    Do you honestly think the carnage that happened during the partition of India could only have taken place with the connivance of the British?

  • rate this

    Comment number 41.

    Comment 40 is a response to comment 39 by SRB: And people came to UK during the partition because you failed to maintain law & order, in a true sense Mountbatten & his fellow colleagues wanted it. True, couple of good thing happened between 1860’s to 1905 no one can deny that, but there are lots of inhuman things happened as well.

  • rate this

    Comment number 40.

    One day we prevented partition of Bengal (another effort to impose divide & rule policy) in 1905 by Curzon. It was again repeated in 1947 by the help British with the support of Gandhi, Nehru & Patel (then Jinnah). If we got independence through Bhagat Singh, Netaji & his Azad Hind Fauj (INA), neither partition happened nor did so many people lose their lives.

  • rate this

    Comment number 39.

    @36-38 arnab

    With respect, get over it and move on. British rule ended over 66 years ago.

    The Empire wasn’t all about bullets and exploitation, as I am sure you are aware. Moreover, the independence party was short lived for many Indians/Pakistanis.

    It’s worth noting that after a few years of independence a significant number of Indians chose to leave the subcontinent for Britain.

  • rate this

    Comment number 38.

    SRB: And today they are using our forces against us by using the laws made by you during colonial era. We can't do anything? Whether Armistice Day is not celebrated or remembered, that’s up to you. Do you know or have any feelings about 13th April-1919? The day when 8000 unarmed Indians were killed by British bullets? What a glorious past?

  • rate this

    Comment number 37.

    They are all that beneficiary class which was developed during British rule. And today they are in power because British appointed them at the time of leaving in the hope that British have a control over them. But later these people found much more clever than you. One day they came out from your control (early 70's) by securing a powerfull armed forces making an alliance with Russia.

  • rate this

    Comment number 36.

    SRB: If Britain colonise the other countries & use their resources for its own benefit, then why not Germans & others will not do this? The reason behind the wars is nothing but the colonisation only. I never said that today what is happening British are responsible but our present rulers are responsible. But if you see the history of these people, who they are?

  • rate this

    Comment number 35.

    @34 arnab

    I’m not sure that conflating a world war with colonial rule is altogether helpful.

    Moreover, after 68 years, Britain doesn't still blame Germany for its GDP per Capita figures. I am therefore baffled by why you seek to attribute India's current relative economic performance to the Raj.

    Armistice Day is not “celebrated.”

  • rate this

    Comment number 34.

    SRB, 66 years is less than 1/3rd compare to your predecessor’s rule (190 years) in India during which a beneficiary class was developed who are running the country today. If you think 66 years ago British left and today you people have nothing to do with this, then why you celebrate Remembrance Day? What Nazi Germans did that also 68 years ago?

  • rate this

    Comment number 33.

    James (comment 28), totally agreed but one thing to be noted that these 10-20% people (today who are enjoying the fruits of independence) were developed during the period of 1757 to 1947 to run the raj. Today these beneficiary people are either in politics or the lobbyist. That’s why they are reluctant to change the law.

  • rate this

    Comment number 32.

    There are LOTs of news between India Central Bank and gold & silver. It's amazing that this article doesn't even mention a single word of 'GOLD'. Rupee drops, ICB bans gold import, gold premium on spot reaches $100, record silver import, etc. Don't tell me that has nothing to do with the ICB.

    There are NO in-depth articles in BBC on the latest wave of bank fines. BBC is not a free press.

  • rate this

    Comment number 31.

    Linda, it would be interesting to hear your view on why the boom bust cycle seems to be playing out quicker in India than in west, ie why inflation is rising earlier. Is it because there was relatively more quantitative easing? (Was there?). How soon will the west follow suit and raise interest rates significantly? If they do sooner, will that stave off hyper inflation or is that inevitable?

  • rate this

    Comment number 30.

    Its unlikely that any country in crisis with finances will recover quickly with superpowers able to spy on leaders and financial minister phones giving them the edge in currency banking and share markets, Financial manipulation will cripple everyone if people know what you are doing before you can sort it out in the market place.

  • rate this

    Comment number 29.

    Purple (no 25), I am India is better off on her own than ruining herself by joining Euro. India will never do that even in her wildest dreams.

  • rate this

    Comment number 28.

    India suffers from similar problems afflicting most emerging market economies, namely the massive concentration of wealth within 10-20% of the population, while the remainder have almost nothing. In India's case, 80% live on less than $3 per day, which is hard to reconcile with few of the remaing 20% willing to even pay their taxes.

  • rate this

    Comment number 27.

    12 Hours ago
    "Can a central bank governor prevent a crisis?" - Yes !

    He can resign and advise the government to disband the central bank and abolish it's monopoly of money production.

    Couldn't have put it better Franco.

    Until we all do the same there will be no improvement anywhere.

  • rate this

    Comment number 26.

    @23 arnab

    By the term "sound money" I mean preserving the value of a currency.

    Not sure that really has anything to do with colonial rule, which, of course, ended in India over 66 years ago.

  • rate this

    Comment number 25.

    The only hope for India is to join the €uro.

  • rate this

    Comment number 24.

    that gold/diamond and/other resources which we lost during British rule, in that case not only the central bank governor will find some monies but our people also sleep over a bed full of Indian rupees and inflation will be 0% if we eliminate middle man & brokers by implementing the laws.

  • rate this

    Comment number 23.

    In response to comment 20, Yes SRB, if we can eliminate corruption, provide a better governance by implementing new laws instead of using the colonial judicial systems/penal codes/police laws and at the same time if we get back that gold/diamond


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