All big disasters start off as small events. Hurricane Katrina was a small ripple in the South Atlantic Ocean before it killed 2,000 people in New Orleans ten days later. Research conducted by a group of scientists who replicated avalanches using sand grains found remarkably that it is always a small perturbation in one grain of sand that eventually causes an entire mountain to collapse. They concluded that even the greatest of events have no special or exceptional causes.
The recent treatment meted out to Reserve Bank Governor Raghuram Rajan by the political class in India makes me wonder if this may be such a watershed moment in Indian history–a small perturbation in one grain of sand–nothing serious, of course, for politicians used to treating people like paper towels–but an event that may cause the world to pause and look at the nature and role of government in India and how that may affect India’s credibility in the world. After all here was a man with an impeccable track record, a man acknowledged by central bankers the world over as the beacon of the Indian economy ( Wall Street Journal 2015), a man of unquestioned integrity, a man of courage who was not afraid to provide serious reflection on a wide range of issues, and a brilliant economist. His own peers acknowledged him as the best central banker in the world. Yet the Modi government did not afford him the courtesy a serious professional deserves.
And as I reflected on Mr. Modi’s treatment of Mr. Rajan I began to wonder how my hero, Ronald Reagan, would have handled the situation. He too had inherited a brilliant and outspoken central banker named Paul Volcker from the previous administration. Inflation in the US was running north of 14% when Reagan came to power. But Reagan was smart enough to realize that he needed someone with experience and knowledge to help him turn things around. He also believed that true leaders surround themselves with the best talent, delegated authority and then got out of the way. So he kept Volcker who helped bring down inflation from its peak of 14.8% in 1980 to below 3% by 1983.
Rajan did for Modi what Volcker did for Reagan; he inherited inflation running at around 11% in 2013 and brought it down to around 5% in 2016 ( despite two bad monsoon years). Volcker got another term but Rajan did not. The difference is Volcker had Reagan and Rajan had Modi. Reagan believed that government was not the solution to people’s problems, but that government itself was the problem. Modi, on the other hand, believes in government and its ability to solve people’s problem–damn the evidence of course. Reagan believed that the best leader was not one who did the greatest things, but one who got people to do the greatest things. Modi, on the other hand, believes that he is destined to do great things himself. He exercises complete control over senior bureaucrats, is not comfortable surrounding himself with smart people, does not delegate and certainly does not get out of the way. Even his most ardent admirers will admit that Modi does not encourage very much independent thought among his deputies. Letting an independent thinker like Rajan go at a critical juncture when the fragile Indian banking system needed his experience and wisdom is a reflection of Modi’s lack of true leadership.
Another thing that perhaps galled Mr. Modi was the attention and adulation Rajan got from economists and bankers across the world. With his charming and erudite persona, Rajan was labeled a ‘rockstar’. He was also being credited, rightly or wrongly, for putting in place a monetary regime that was instrumental in India’s growth. This must have surely irked Modi and members of his government for whom getting credit is paramount. They recently spent Rs. 2,000 crores of taxpayer money on their ‘second year anniversary’ to ensure that people gave them credit for all the good they proclaimed to have done. If Mr.Modi really wants to do good for India he would be well served to reflect on Reagan’s words: “There is no limit to the amount of good you can do if you don’t care who gets the credit.”
Rajan’s unceremonious exit has suddenly drawn attention to Modi’s leadership. And this is where the sand pile begins to shift. Is Modi truly a transformational leader who can be trusted to find the best people to solve India’s myriad problems or is he another one of India’s long list of egoistic politicians who are elected to represent people but end up representing themselves. Modi goes abroad and tells Indian professionals to bring their skills back to India. He extols the virtues of India and proclaims that it has turned the corner. “ Your good work will be rewarded in India,” he told an audience in New York. Yet, when he had an opportunity to show that India today is different and that meritocracy truly was being embraced he pushed Rajan out of the door. This cannot be very comforting to Indian professionals contemplating coming back to the motherland. It tells them it is business as usual in India. The government still “ rules” every aspect of Indian life, politics is the only thing that matters, cronyism is still how money is made in the country, and that good work and merit do not get rewarded. And while for many it may be just a grain of sand I strongly believe that it sets the country back many years. India needs serious talent, it needs research, it needs world-class scientists and engineers who can ‘Make in India’. Unfortunately, the Indian educational system does not produce such talent. It is Indian professionals studying, training and working in other countries whose return will infuse the talent required to grow the country. And now they have all seen how they might get treated if they come back.
But what about the Katrina hurricane from the Rajan affair? How can Rajan’s ‘non-extension’ cause a major disaster? Well here’s a glimpse of how things might unfold. As an economics professor Rajan wrote extensively against crony capital, and as Governor of the Federal Reserve, he began to clean up the balance sheet of Indian public sector banks by requiring that bad loans be brought out in the open. That opened up a Pandora’s box because a large portion of these unpaid bank loans belonged to politically influential crony capitalists who had made a habit of borrowing large amounts of money from State-run banks ( almost always by bribing bank officials) and then not paying back the loan. Conspiracy theorists have even concluded that perhaps that’s why Rajan was forced out. He was going to clean the banking system and make things very uncomfortable for a lot of very powerful and politically connected people. Nevertheless, a result of such blatant stealing is that Indian public sector banks currently have over 3.5 lakh crores ( about $ 60 billion) of bad loans on their books.
And this is where the rubber meets the road. It is estimated that in the wake of commitments under Basel III and a rapidly growing problem with nonperforming assets, Indian banks would require additional capital to the tune of about Rs. 6 lakh crores ( about $ 100 billion). Where is the capital for this infusion going to come from? The grains of sand are suddenly shifting rapidly.
Economist Hyman Minsky pointed out that the more comfortable we get with a given condition or trend, the more dramatic the correction when it occurs. Indians have become obsessed with an 8% growth; most, of course, don’t understand what causes this growth. The problem with macroeconomic stability, as Minsky points out, is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be better than last week and last year, we are more willing to add debt or postpone savings in favor of current consumption. And this is precisely what Rajan was trying to avoid. He knew that the growth giddy Indian politicians would force excess liquidity into the system if they had their way. He also knew that a loose money, low-interest rate policy, would add too much risk to a financial system that was not mature enough to handle it. Rajan, very wisely, was trying to avoid the unstable financial arrangements that would eventually lead to a dramatic correction.
But now with Rajan out it is quite likely that new money will flood the system and the emphasis on public banks cleaning up their balance sheets would lose momentum. The government may haul in a token defaulter like Mallaya to pay lip service to the bad loan problem. But a serious banking crisis looms and it could be India’s, Katrina.
But a serious banking crisis looms and it could be India’s, Katrina.
That’s when Modi will miss Rajan and his intellect and experience in handling such crisis. There is currently no one on the Modi team that has the depth of knowledge to understand the stunning complexity of the modern economy, the myriad variables and correlations involved in a banking crisis, and its contagion effect on the overall economy. As Minsky suggested, the correction from steady state is swift and dramatic. The Indian growth story may well fizzle out before Modi goes up for reelection in 2019.
It is perhaps then that Mr. Modi would reflect on what Reagan said: “There are no easy answers, but ….. we must have the courage to do what we know is morally right.” Letting Rajan go may have been politically expedient, but it was not morally right, and in the long run may also turn out to be a very bad political and economic decision. In today’s world, capital markets have a huge influence on economic growth, and markets move on perception. The perception now in international markets is that in India it’s business as usual: politics trumps good governance.
The avalanche may slowly be starting to move.