Rajan declared in June that he would return to the University of Chicago when his three-year term as the head of India's central bank expires. A widely respected thinker and academic, the International Monetary Fund's former chief economist was appointed to lead the Reserve Bank of India by Modi's predecessor in September 2013, a time when inflation was high and the currency was weakening. During Rajan's tenure, India's economic outlook improved: The rupee stabilized, the government's current account deficit shrank and inflation fell from 10.9 percent to nearly 5.7 percent. Although outside factors, such as stabilization in the global bond market and a steep drop in oil prices, undoubtedly played a role, international investors nevertheless praised Rajan's policies for improving the country's economic profile.
Butting Heads With the Ruling Party
Despite his success, however, Rajan will be the first central bank chief in over two decades not to have his term extended, for several reasons. First, he strayed beyond the confines of his post, which is meant to be a politically neutral role. He often took positions on issues that were at odds with Modi's conservative Bharatiya Janata Party (BJP), including harping against India's crony capitalists and wading into a national debate on religious intolerance. His frequent forays into politics agitated members of the ruling party's Hindu nationalist wing, including senior lawmaker Subramanian Swamy, who has been clamoring for Rajan's resignation and publicly questioning his patriotism.
The second reason Rajan and Modi will part ways is the bank governor's public demands for deeper reforms to sustain India's economic success. While the BJP issued optimistic declarations of a brisk growth rate of 7.6 percent, Rajan raised concerns about the quality and durability of that growth, saying major structural change would be needed to unleash India's true economic potential. Chief among the reforms Rajan pursued was the rehabilitation of India's banking sector, which has been hamstrung by $120 billion worth of nonperforming and restructured loans, making up nearly 12 percent of the country's total outstanding loans. Rajan ratcheted up the pressure on India's corporate and banking executives by initiating a six-month audit of the country's banks in October 2015.
The results were telling. Forced to open their books, banks reported that nonperforming loans actually equaled 7.6 percent of their total loans, not 5.1 percent as they had previously claimed. State-owned banks were even worse off; as of March, about 15 percent of their outstanding loans were stressed, compared with an average of less than 5 percent in India's private banks. After Rajan told the banks to clean up their balance sheets by March 2017, highly indebted firms were forced to launch asset "fire sales" to repay their debts. This did not sit well with the ruling party, since the loans that banks grant often help small businesses, an important BJP constituency.
The hawkish Rajan clashed with the Modi administration on the issue of inflation as well. The government is eager to cut interest rates and spur growth, but Rajan has been hesitant to slash interest rates below 6.5 percent. His reticence could be explained by any number of things, such as the anticipation of a potential rate hike by the U.S. Federal Reserve or the belief that India's underdeveloped economy would be incapable of absorbing more money. But it most likely stems from a fear of stoking inflation, which has long been a blight on the Indian economy. The logic behind his anxiety is clear: If Rajan were to cut interest rates, economic theory dictates that banks would give out more loans, thus boosting consumer spending, small businesses, job creation and growth. But the increase in money flowing through the economy would also risk jacking up prices, the very problem Rajan has spent his term combating. Conversely, if Rajan were to avoid lowering interest rates, banks would not loan out as much money, reducing the risk of inflation but also hemming in employment and growth.
As a public official who is appointed rather than elected, Rajan has the latitude to pursue policies independent of electoral considerations. Modi, however, does not. Instead, the prime minister has a clear incentive to prioritize growth, even if it comes at the expense of other, potentially more important economic goals.
Growth Doesn't Necessarily Mean Employment
One of Modi's biggest dilemmas, though, is that his two primary goals — promoting growth and creating jobs — do not always feed into each other. India is growing at an impressive rate, true, but that growth has not yielded jobs. This is due in large part to the fact that India's labor laws are some of the most restrictive in the world; it is very difficult to fire workers in India. As a result, Indian factories tend to invest in machinery instead of manpower when they expand. This capital-intensive approach means that even as the Indian economy grows, it does not create enough new jobs to employ the million or so Indians who enter the job market each month. Because the formal economy cannot absorb all of these workers, many of whom are uneducated, the majority turn to the informal economy. This sector, which includes street sweepers, rickshaw drivers, construction workers, shopkeepers and mechanics, employs at least 80 percent of India's 470 million workers but without providing fixed incomes, benefits or job security.
Though Modi would prefer to create labor-intensive growth, he recognizes that he will have a hard time passing and implementing the necessary land and labor reforms while the opposition Indian National Congress continues to hold a sizable bloc in the upper house of parliament. That is why he has resorted to other methods, including monetary policy, to promote economic growth — even if such measures bring few gains in employment or investment. Either way, Modi's maneuvering gives his administration something it can tout as proof of its skillful governance ahead of the next elections, which are set for 2019.
In the meantime, Modi will opt for more expedient ways of stimulating consumption. On June 29, the government announced a 23 percent pay increase for some 10 million federal employees and pensioners — what effectively amounts to a $15 billion stimulus package, even though its impact on GDP will likely be minimal. Modi also declared his intention to relax foreign investment requirements in the insurance, aviation, retail and defense industries. Furthermore, in what may be the final showdown between the Reserve Bank of India's outgoing chief and the government in New Delhi, Modi is pressuring the central bank to use $59 billion of its own funds to recapitalize Indian banks. Rajan has pushed back against the measure, saying it would create a conflict of interest and further erode the bank's autonomy.
When Rajan's term ends, Modi will likely replace him with a candidate who is willing to cut interest rates. But while the decision will be an important one, monetary policy can do only so much to reshape the contours of India's erratic growth. Until Modi revives the country's ailing banks, implements the dramatic structural reforms needed to capitalize on India's vast labor pool, and streamlines the land acquisition process, he will continue to fall short of resolving the Indian economy's deep-seated contradictions.