Raghuram Rajan Controversy: Why Subramanian Swamy HAS a Point

There is a sense of anger among Indian intellectual class, stunned by the demand made by Dr. Subramanian Swamy for the sacking of Dr. Raghuram Rajan – the most respected, ever charming, hottest RBI Governor India has ever had. From Shobha De to newspaper editors to the average Joe, Dr. Raghuram Rajan commands a following rivaling that of Salman Khan.

Not only analysts, commentators and financial daily editors have come out in support of Dr. Rajan, but the even common public also seems to be completely unanimous in their support of Dr. Rajan and all the good work he has been doing for the Indian economy. Going by the number of editorials/articles and public forum comments posted in support of Dr. Rajan, one can easily conclude that India is in safe hands, or at least perceived by the general public to be in safe hands.

There is no denying the fact that Dr. Raghuram Rajan is one of the finest brains when it comes to Economics. Applauded by some as one of the very few economists to warn about 2008 crisis much ahead of the time, he is widely respected and credited with a sound understanding of complex macroeconomics issues.

The last time a central banker got so much respect and public support was Alan Greenspan in the 2002 era. The other Economist, who got so much respect from Indian public/experts/intellectuals, was Dr. Manmohan Singh as India’s PM in 2004-09 era. Needless to say, public opinion is hardly the right barometer for gauging long-term impact if one goes by the disdain both these gentlemen now attract from academia and the general public alike – as public opinion, fickle at best, is always swayed by perception rather than hard facts.

The arguments made in support of Dr. Rajan are multifold and cover almost every possible ground to demonstrate how Rajan is the best man for the job and how wrong is Subramanian Swamy. The main arguments given by supporters of Dr. Rajan are as follows:

1. Dr. Rajan has been able to keep inflation under control by keeping interest rates high initially and didn’t succumb to political pressure (greatest virtue in the country of Singham). This hard stance towards inflation kept cheap money out and didn’t allow the buildup of another sub-prime scenario in India.

2. He has cracked open the NPA issue of banks and brought out the muck in open. This cleansing of bank balance-sheets will usher in a new era of transparency and will fix the nexus of politician-banker-bureaucrat forever, as the public sector banks are the primary source of crony capitalism and high real estate prices in India.

3. He has published far more papers than Dr. Swamy and is cited / peer-reviewed many times more compared to Dr. Swamy.

4. He is very well respected by International media and considered to be one of the best brains in Economics

5. He is a far better economist than Dr. Subramanian Swamy who is more of a lone ranger/fringe politician.

All the above arguments seem quite valid on the face of it, but then keep in mind that the criticism of Raghuram Rajan is not made by some usual analyst but none other than Dr. Subramanian Swamy – one of the sharpest brains around with an enviable track record of proving his points. So rather than jumping in defense of Raghuram Rajan, it is much better to have a deeper look at the critique, since Dr. Swamy has a reputation of not making false claims without support from necessary data. So rather than debating on issues like nos of papers published, who is the better economist, etc., let us focus on the major issue of interest rates and inflation, which seems to be the bone of contention among fan-boys and Dr. Swamy.

There is no debate that inflation has remained within limits since Dr. Rajan took over RBI in 2013; however, the low inflation has been more of a function of the massive drop in oil prices and commodity prices. Since 2013, oil prices have dropped from the heights of US$ 90 a barrel to US$ 40 a barrel (55% drop). Further, by choosing not to pass this price drop benefit to consumers, Indian govt has been able to manage its high fiscal deficit, which in turn calmed down its currency. Further, Modi Govt has been quite proactive in controlling food inflation by taking quick actions, be it the import of food items or action against hoarders. Hence, to say that inflation in India is down due to strong monetary policy and high-interest rates is nothing but a big myth. In fact, a little bit of movement in oil prices in last quarter has already perked up the inflation.

Hence, it is obvious that the high-interest rate regime has nothing to do with inflation and in fact everything to do with low growth faced by India. Interestingly, everyone has jumped on Subramanian Swamy, harping on the fact of rate cuts not passed by banks to consumers and talking of headline interest rate, while totally forgetting that Swamy is not talking of main interest rate but interest rate available to SME sector.  Interestingly, while interest rates for large corporate hover around 9%, interest rates for SME sector hover in the range of 16% to 22% and no attempt has been made to bring down this rate.

Worldwide, and especially in the Western world, monetary policies are effective tools to manage inflation; however, the economists trained in Western view need to understand that India is not West and does not have the luxury of enormous resources or well-oiled supply chain. Inflation in India is not a function of more demand but supply-side constraints, which become worse with higher interest rates and crony capitalism. So far, not only has RBI failed in bringing down overall lending rates in the general economy, but it has also not worked on main inflation which is plaguing middle class and poor in India.

Unfortunately, all discussions related to inflation in India revolve around food prices, while in actual the bigger share is consumed by the housing sector. On an average, almost 34% of a household income goes towards meeting the housing cost (Rent/EMI), and thanks to liberal policies/crony capitalism indulged by banks (primarily PSU Banks), the prices of housing have remained strong in India and in fact are much higher than even the prices in Dr Rajan’s adopted country. In 2008, when the whole world was reeling under severe liquidity crunch and asset prices collapsed like anything, Indian real estate and Indian economy remained insular and that was not due to sheer brain of Dr. Manmohan Singh but sheer luck in the form of 6th Pay Commission and crony capitalism of PSU banks (banks pumped capital in real estate firms and thus allowed them to keep prices high) that saved the day for Indian economy and builders.

However, this benevolence of Indian banks created other victims – that is overall economic growth in general and middle class in particular. The continued high real estate cost (EMI/Rent) left hardly any surplus cash in the hands of an average consumer and in turn led to continued slowdown in the Indian industry (a fact clearly visible if one goes by almost flat growth of white goods, commercial vehicles, etc.), which was already reeling under high interest costs.

Now one may argue as to what is the relation between housing prices with inflation and interest rates. By keeping interest rates for housing at 11% while the lending rate for SME at 14%, RBI has crowded out money from all sectors and diverted it to housing. Given the power of leverage and faulty income tax laws, investors are earning 30% to 36% returns from real estate and thus creating capital scarcity and higher interest rates. Today, an SME or a hospital or an educational institute pay interest rates in the order of 14%+ while housing loans are disbursed at 11% or lower, and on top of it get significant income tax rebate.

Dr. Rajan, in his 2005 address, had observed that ongoing financial developments had made the world a riskier place (no, he didn’t predict the 2008 crisis as believed popularly) and raised concerns regarding banks’ inability to handle risks beyond a limit due to flawed reward structure. Interestingly, despite deep insight into the workings of the banking system, the RBI Governor in India never restrained banks from providing additional liquidity to real estate or stopped fancy derivative schemes like interest subvention, etc. This continued liquidity given to the housing sector in the form of lower interest rates and subvention schemes has created a massive build-up of risk in the Indian banking system in the form of housing. Strangely, Dr. Rajan didn’t take any action in terms of normalizing exposure to the housing sector.

Hence, Dr. Subramanian Swamy is correct when he says that Dr. Raghuram Rajan has wrecked the economy by wrong policies since continuous 22% interest rate has wrecked SME sector due to high costs and low demand as an average household has hardly any cash surplus left after paying for real estate costs (Rent/EMI).

So rather than saving and steering Indian economy, the policies of present Governor have pushed India in a unique crisis with almost no industrial growth coupled with high-interest rates where there is massive unemployment or no job growth except some small slivers of hope on account of massive funding to startups.

Now with oil slowly limping back to US$ 50 per barrel and above, and 7thPay Commission on the horizon, Indian economy is going to face double whammy for which neither Indian Finance Ministry nor RBI is well prepared.

So why is there such wide support for Dr. Raghuram Rajan and so much disdain for Dr. Swamy? Interestingly, the reasons don’t lie in economics data or hard facts but in human behavior.

We all love Dr. Rajan because he is so much like us and represents our aspirations – be it his education (IIT, IIMA, MIT), his career path (Chicago Professor, IMF, RBI Governor), which we all aspire for us or for our kids to have. Not in the distant past, we all went gaga over a certain another economist who ruled this country for 10 years and despite all hard data/evidence about lack of moral compass and corruption, we kept him revered and on the altar of perfection. So this is basically about us and not at all about Dr. Rajan or Dr. Manmohan Singh.

Now on Dr Swamy – the reason for the disdain and smirks thrown at him by the great middle class is obvious as Dr. Swamy is that super-intelligent lone warrior in the class whom we all secretly admire but have none of the intellect, guts or courage, and hence mock him, because however hard we try, we can’t be him.

But then when was economics about data and not about human behavior!!!

2014 : Economic Crisis at the Gate

The year 2014 onwards, one is bound to see India facing its worst economic crisis, irrespective of the fact whether Mr. Modi becomes PM or not. Since it is the first time India will face an economic crisis without any luck or local stimulant as Manmohan Singh’s actions (or rather lack of them) have exhausted India of any option, and India is staring at serious crisis without any arrow in its quiver. With 6th Pay Commission stimulus tapering off and with the almost negligible capital formation for last few years, attempts of bringing back growth by having same old & tired textbook measures – like interest rate cuts – are not going to yield any positives. The author argues that the only way India can escape this crisis is by building consumption in short-term and capital formation in long-term, which means taking extraordinary counter-intuitive measures like deflating real estate sector and boosting SME/manufacturing/infrastructure by simplifying rules/reducing the interest rate. 

2014 is here and somehow things look a lot better than what they were six months ago. Political change is in the air. AAP party, in a historical mandate, has been sworn in Delhi, and Raghuram Rajan, the new RBI Governor is making all the right noises. Suddenly from the despair of 2013, we seem to usher in a new year with a lot of positive vibes and hopes. No longer are talks of Indian rupee hitting a new low or Sensex collapse ruling news channels but newspapers are filled with reports of growth in hiring, salary increments and SENSEX hitting 25,000 by May 2014.

In fact, there is a wide-spread hope and belief that Indian economy will go in further overdrive if Narendra Modi / BJP gets the decisive victory which is, at best, a wishful thinking, and at worst, simply a mirage. This thinking stems from the fact or view that India was able to manage earlier economic disturbances on account of smart leadership maneuvers, and hence, coming crisis can also be taken care of by the sheer leadership of Narendra Damodar Modi. Before jumping to such conclusions, probably one needs to understand the Indian context and earlier brushes with economic crisis faced by the nation in a post-liberalized world.

India, despite being one of the ancient civilizations, has a very short history of being an independent state and even shorter history of being a liberalized economic market. This means that as a nation we have hardly any experience of boom/bust cycles as pre-1991, average household budget used to follow Hindu rate of growth governed by a monthly quota of ration and benevolence of state, while post-1991 India has just seen a phenomenal increase in overall wealth and conspicuous consumption.

Though post-1991, India did face an economic crisis in 2001 and 2008, but due to a variety of unintended situations, all these crises failed to make any impact as details below.

Dotcom Bubble and 2001 Economic Downturn

Post-liberalization (1991), the World and India stared at its first recession at the beginning of 21st century, when the dot-com bubble collapsed and 9/11 attacks happened, bringing global economic engines to almost a halt. However, other than some offer withdrawals at Indian management institutes, 2001/02 recession didn’t impact India at all for a variety of reasons. A lot of levers got in play to push the Indian economy on a growth trajectory despite the overall slowdown. Of all reasons, the foremost engine driver was BPO/KPO sector which not only created huge job opportunities in major cities but also absorbed the pain caused by the slowdown of IT industry. While BPO/KPO sector was keeping job growth fast and driving export income, on the domestic front, Infrastructure (road/port, etc.) and telecom sectors were taking shape.

The NDA Government, led by Prime Minister Atal Bihari Vajpayee, focused on building world-class roads all across India and rolled out the golden triangle. On the other hand, the entry of MTNL in mobile services with incoming calls becoming free led to price-drops and super explosion in growth of subscribers.

These two factors, i.e., improved road infrastructure and growth in telecom subscriber numbers, unlocked constraints in the economy and in fact paved way for one of the biggest GDP expansion India had ever seen, and year after year India clocked 7%+ GDP growth. This super rocket growth helped SENSEX break every record every quarter and India joined China in being the darling of fund managers on Wall Street. Billions of dollars were raised by funds to participate in India story. In a way, India had arrived on the world economic stage.

2008/09: Subprime Mortgage Crisis and Lehman Brothers’ Bankruptcy

While India was marching ahead to glory, far far away, USA was busy rediscovering nirvana in housing/mortgage driven by cheap Greenspan dollars whose solution for every problem was a little more liquidity. However, the party soon ran out of fuel and the world was hit by one of the biggest financial crisis with stalwarts like Lehman Brothers going bankrupt and 100s of banks in the US collapsing under subprime load. The whole world went into crisis except one country – India. While the majority of people were led to believe that India survived on account of the leadership of then economist PM; however, the truth is India survived the aftermath of Global Recession more by luck than any other thing, and least by Govt actions.

In 2006, Indian Govt without any idea of the upcoming 2008 financial crisis, set up 6th Pay Commission to review and revise the salary of Govt employees. The Commission came with its report in 2008 and released arrears in 2009-2010. This commission impacted almost 20 million Govt employees (Central and State Govts) and resulted in an annual increase of INR 12,561 Cr per annum (USD 2.5 Billion per year) and one time arrear of INR 30,000 Cr (around USD 6 Billion). As expected, this worked as mini-stimulus, as almost all of it went into auto and housing sector. The table below is almost self-explanatory where one can see growth in sales of passenger cars which witnessed the largest increase of 27% in the year 2009/10 and 2010/11, while the commercial sector was hardly growing. 


However, lack of any new initiative and slowing down of the economy due to policy paralysis resulted in almost zero job growth scenario and impacted car sales. Automobile sector faced slower growth in 2011-12, which turned into negative growth as automobile sale decreased every month in 2013.

2013 Onwards: Of NREGA / Fiscal Deficit and Real Estate

The year 2009 saw the re-election of Dr. Manmohan Singh led Congress Govt, which made analysts believe the beginning of another golden era since the government was no longer at the mercy of mercurial left parties and a prison to their economic agenda. It was expected that government emboldened by its electoral win, will unleash economic reforms, which coupled with GST and DST will catapult India much ahead of China.

However, in a karmic turn of events, all deeds of UPA I came to haunt UPA II. Bad moral hazard expenditure, like NREGA, increased labor cost for marginal farmers, thus created supply-side challenges while 6th Pay Commission returned to haunt Govt in the form of the high fiscal deficit which ballooned to 6% from earlier range of 2.5% to 3.0% in 2006.

Hence, despite all the talk of big revival and growth, India, in fact, is in the middle of a crisis as is evident by the following:

  • The automobile sector is seeing negative growth: 9-month consecutive drop in sales. Leading companies like Ashok Leyland, Tata Motors, etc., are cutting production schedule and realigning workforce.
  • Telecom sector after posting consecutive growth is now slowing down and is no longer front end driver of the economy.
  • Infrastructure remains in the middle of nowhere as no large projects are being announced while earlier projects which had absorbed billions of dollars are yet to see the light of the day, thus creating a real crisis for investors as all invested capital remains locked as an unproductive asset.
  • PE funds who had invested big time in Power / Infrastructure and roads in 2007-09 are yet to see any return of capital and majority of investment remains under water.
  • PSU banks, which helped real estate sector weather the storm in year 2009 by restructuring loans and saved it from big crash, is again staring at next level of restructuring, since the real estate players got greedy post-2009 and led to a price growth of 3x in the last 5 years and focused on EBITDA protection rather than cash flow management.

Real Estate – The Double Whammy

Real estate in India remains an interesting asset class, which has given best returns among all asset classes since 2000 and continues to rise despite the call of bubble burst now and then. In a way, the real estate sector in India, while showcases success and growth, also symbolizes as whatever is wrong with the Indian economy. Today, the real estate sector poses the following challenges:

  • Very high housing prices in comparison to median earning. Housing in India is expensive or at par with housing cost in the developed world.
  • Debt level at real estate companies is at an astronomically high level where some of the companies, like Jaypee Infratech, have a very high level of debt posing a systemic risk to Indian banking sector, as noted by RBI Governor in a recent statement.
  • Real Estate sector growth has to lead to jumping in housing prices by 5x to 10x in last 10 years while rentals have also jumped by the same level, though salaries have not kept pace at the same level. Today, the majority of free cash flow at the household level is going either in EMI payment or rent, which is restricting discretionary spend and thus creating a slowdown in consumption.

Road Ahead

As one can see the Indian economy is facing a unique crisis of having high inflation and very low growth. This unique scenario has made limited options available to RBI, which anyway never moves beyond Keynesian models. High inflation will eliminate the possibility of a rate cut as there is this naïve belief in India that low-interest rate will fuel inflation and will further impact growth. The powers in finance ministry need to understand that India is not west and does not have the luxury of enormous resources as well as well-oiled supply chain. Inflation in India is not a function of more demand but supply-side constraints, which becomes worse with higher interest rate and crony capitalism.

The only way Indian economy will find wings again is if real estate sector collapses (price reduction of 30% to 50%) and help to unlock all productive capital locked there and manufacturing becomes friction-free, which is the elimination of red-tapism and paperwork for small and medium enterprises.

So in a nutshell, RBI and finance ministry need to reduce interest rates for SME sector and agriculture while doing away with housing loan interest tax breaks, increase interest rates for housing by at-least 300 basis points for the additional house. Till this is done, the local economy will remain sluggish and will not witness any fundamental shift at grass-root level and 2010-2020 will be more of a lost decade than an Indian decade.