A ‘Jhatka’ To Push Formalisation In The Economy Could Come At A Cost: Raghuram Rajan

The move from an informal economy to a formal one will not be painless, cautioned Raghuram Rajan

A worker arranges strips of veneer at a plywood manufacturing workshop (Photographer: Prashanth Vishwanathan/Bloomberg)
A worker arranges strips of veneer at a plywood manufacturing workshop (Photographer: Prashanth Vishwanathan/Bloomberg)

The move from an informal economy towards a formal one could come at a cost unless the transition to the formal sector is made easy, cautioned Raghuram Rajan, former governor of the Reserve Bank of India (RBI) in an interview with BloombergQuint. From demonetisation to the implementation of the Goods and Services Tax (GST), the government has taken a number of steps to tackle black money and the informal economy. Most recently, the government has clamped down on more than 2 lakh shell companies and frozen their bank accounts, suspecting that these firms were used for money laundering purposes.

“One has to be careful on separating intent from cost,” Rajan said. “Intent is to reduce the extent of non-compliance with taxation, which in the long run would be good in terms of generating more revenue. The problem is at what cost?” Rajan asked.

In his recently released book ‘I Do What I Do’, Rajan disclosed that he had cautioned the government on the short-term costs of demonetisation while acknowledging that there could be some long-term benefits. Rajan, however, wrote that at no point in his tenure was the RBI asked to make a decision on demonetisation.

Demonetisation impacted growth at a time when a nascent economic recovery was already losing steam. GDP data released by the government showed that growth slipped to 6.1 percent in the fourth quarter of fiscal 2017 and further to 5.7 percent in the first quarter of fiscal 2018.

While Rajan said that it is difficult to separate the impact that demonetisation alone would have had, it could have added to weakness in consumption demand.

The immediate effect if you haven’t printed as much money as you should have is the chilling of transactions done in cash. I think that accounts for some of the fall in growth we have seen. We are measuring the formal sector, we don’t measure the informal sector. But the informal sector comes back to the formal sector through demand. So all this might be the combined effect of all that impacting consumption demand and growth.
Raghuram Rajan, Former Governor, RBI 

Rajan added that the economy has been weakened by a number of factors including the bad loan problem, the anticipation of GST and demonetisation.

“When private investment doesn’t pick up and you get this, you wonder whether you have impacted sentiment somewhat. And how long it will take for sentiment to recover. Because you really need that animal spirit to get back on track,” he said.

The Ostrich Attitude To Bad Loans

Rajan, who initiated the asset quality review of the banking sector in 2015, said resolution of bad loans and recapitalisation of banks need urgent attention.

The bad loan crisis has been one reason for the stress in the economy, said Rajan while explaining that lending from PSU banks had started slowing even before the asset quality review due to the stress on bank balance sheets. Year-on-year credit growth, which was holding at just under 10 percent last year, has fallen to near 5 percent in the months after demonetisation.

“The ostrich attitude of putting your head in the sand does not work. That is the history of all other financial sector problems,” said Rajan while explaining his decision to push banks to clean up their books.

As a result, gross non-performing assets of listed banks have more than doubled since the September 2015 quarter. As of the June 2017 quarter, gross NPAs of these banks stood at Rs 8.3 lakh crore.

Speaking in Mumbai on Thursday, RBI Deputy Governor Viral Acharya cautioned that delaying resolution and recapitalisation could cost the economy dearly. Acharya used examples from across the world, like Japan and Europe, where a delay in resolution of banking crises led to years of economic slowdown.

Does India face a similar risk?

“The numbers are still modest enough. Bank resolution problems can get to 10-15 percent of GDP. We are not there. But it’s important we understand this problem is not going to go away. We need to clean up bank balance sheets sooner rather than later. We need to revive whatever projects that can be put back on track and we need urgent task forces on each of these,” said Rajan.

Commenting on the RBI's decision to direct banks to refer specific accounts for resolution under the Insolvency and Bankruptcy Code, Rajan said that regulatory intervention in commercial decisions is not ideal. He, however, noted that at this stage, the RBI is essentially deciding the 'venue' for resolution and is not involved in the actual resolution plan.

I think the more the RBI gets involved in commercial decisions, the more there is a conflict of interest. That is obvious. The question is whether the emergency is so dire that you pushed the RBI into it. So long as it is ultimately a question of deciding venues for discussion, discuss out of court or discuss in bankruptcy court, is it a modest decision although it is still a decision. But if you start involving the regulator into the detail, then you raise the issue of judge, jury and executioner.
Raghuram Rajan, Former Governor, RBI 

Victory Over Inflation

Rajan stepped in as RBI Governor in September 2013 when concerns over the country's weak macroeconomic situation had sent the Indian Rupee tumbling.

In response, Rajan introduced the foreign currency non resident deposit scheme and then moved to try and stabilise inflation under the new monetary policy framework.

Four years later, India has added close to a $120 billion in forex reserves to its kitty which is on track to hit $400 billion. Inflation is likely to be close to 4 percent by the end of this fiscal, with some arguing that inflation is too low.

Has India won the war on inflation?

"It’s never won but I could say that we have at least won the first skirmish," said Rajan.

"Over the past five years, we have seen some progress at least on the macro stability side, both in terms of central government fiscal deficit narrowing as well as on the monetary side inflation coming under control," Rajan said while explaining that this has been key in attracting interest into Indian assets.

The Art Of Central Bank Communication

Rajan, whose book is a compilation of his speeches given during his time as governor, noted that communication can be a double-edged sword for any governor.

"If you can get your message through that is very useful and it helps bring the public on your side which is very important when you are trying to make changes. On the other hand, if it doesn't get through or if it is garbled, or put in such a way as to offend other constituencies in the country it makes your job more difficult," said Rajan in response to a question on whether the RBI has failed to communicate major policy changes such as demonetisation over the past year.

Everybody chooses at what level they communicate; my own sense was that to the extent you can explain what you’re doing you carry more of the public with you and in a democracy openness and transparency is extremely important. because ultimately that is what makes the democracy work, that the people know what is happening and I can act as a check on the powers.
Raghuram Rajan, Former Governor, RBI