Modi is right. Raghuram Rajan is more Indian than his haters

How should a monetary policy strike a balance between the interests of millions of bank depositors/consumers reeling under inflation and stagnant income and a smaller chunk of corporate borrowers demanding lower borrowing rates? 

Has RBI Chief Raghuram Rajan inclined his policies towards interests of the former more than the latter - towards the majority middle class over minority corporate borrowers? Is the government more liberal towards borrowers, not depositors?  

The answers to these questions lie in taking a more nuanced call on the Rajan affair with an altered perspective on monetary policy.

The Indian monetary policy discourse has always revolved around barrowers’ interests even though 40 per cent of Indian adults are still without a bank account and only 6.4 per cent adults have borrowed from financial institutions (The World Bank’s The Global Findex Database 2014).

Regular borrowers will be even lower than this number.

In spite of a majority of banked masses not resorting to institutional credit, monetary policy changes have an impact on a huge section of the population in a very Indian fashion.

Millions of bank depositors and common consumers belong to the credit-agnostic mass. An effective monetary policy can protect them from the vagaries of inflation and insure a fair return on their hard-earned money or vice versa.  

Inflation is the fundamental factor that guides consumer expenditure and cost of living. It is defined as an increase in the price level. In normal economic circumstances, if the money supply grows faster than real output, it will cause inflation.

RBI uses interest rates to calibrate (increase or decrease) money supply, to maintain an optimum price level or inflation.

On the other hand, interest rates on credit and deposit usually move in tandem, thus influencing the return on bank deposits for a very large chunk of population.

Now, let’s deal with inflation, the perennial nemesis of Indian consumers.  

Rajan’s predecessor, Dhurauvi Subbarao, once said he used to pay Rs 25 for a haircut 20 years ago, which went up to Rs 50 even as his hair thinned. Now when he has virtually no hair left, he pays Rs 150 for a haircut. 

We don't know how much Rajan paid for his haircut but he effected a transition - from being a central banker who loosely targeted wholesale price inflation (WPI) to one who clearly focused on benchmarking consumer inflation (CPI), while deciding on interest rates. CPI is closer to our every day experience of inflation.

By doing so, RBI has not only effectively controlled price rise but also forced the government to bite the bullet on fiscal discipline.

The government is the largest borrower in India. Its massive borrowing programme compels RBI to maintain high money supply in the system even if inflation keeps soaring. 

The success of Rajan’s strategy is evident in numbers of tamed inflation and controlled fiscal deficit during the last two years. Now we come to the deposit side of banking. Rajan’s famous "dosa economics" is handy to understand the complex relationship of inflation and return on bank deposits.

He had once explained how a depositor or pensioner can have more dosas today despite earning lower interest on his savings in bank deposits, as long as inflation stays low. 

This was the first articulation of depositor’s perspective in monetary policy amid perpetual taper tantrums. Rajan is a votary of the idea of positive real rates of interest on bank savings. However, his formula that the real rate of interest on a one-year treasury bill should be 150-200 basis points above the consumer price inflation rate did not go down well with the government, which recently reduced the interest rates on small savings. 

The credit narrative of India’s monetary policy suits the government and big corporates as they dominate the borrowing scene of the Indian banking system. With humongous loans, even a 25 basis points reduction in interest rate matters a lot to the cost of debt servicing to them vis a vis the tiny EMIs of consumer loans. 

The top 10 borrowers account for Rs 28,152 crore of non-performing assets (NPAs) of state-owned banks. As many as 433 borrowers have taken loans of more than Rs 1,000 crore and above amounting to Rs 16.31 lakh crore, Parliament was informed last year.

It is not difficult to understand that the cost of credit can only come down when banks get rid of toxic NPAs eating into their profits and capital.  No surprises that Rajan forced banks to close the window of crony banking and effectively clean the NPAs, even if it is painful.

Unlike western economies, depositors and consumers are the predominant constituency of the Indian banking set up. Contrary to allegations of him being an American agent, Rajan has actually given serious thought to the majority stakeholders (read depositors/consumers) of India’s monetary system.

As Rajan packs his bags, new contours of monetary policy are on the anvil. With the notification on amendments to the Reserve Bank of India Act, 1934, the government has paved the way for a new monetary policy framework, which shifts the responsibility of maintaining inflation targets and setting of policy rates to a government-appointed six-member committee.

If the new framework goes ahead with borrower’s bias and doesn’t do justice to the interest of depositors and inflation-pinched consumers, we have every right to doubt the motives behind the ouster of India’s finest central banker.