The limits of star power

A picture of Raghuram Rajan Image copyright Getty Images
Image caption 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.

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.

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.