Modi and Rajan: Unlikely Allies Battling India's Oligarchy

  • India's macroeconomic stability contrasts with panic in 2013
  • Feb. 29 budget to test cohesion of fiscal and monetary policy

In the months after Prime Minister Narendra Modi’s landslide 2014 victory, speculation swirled of a rift with central bank Governor Raghuram Rajan.

Members of Modi’s party saw Rajan, a former International Monetary Fund chief economist, as a loyalist of the ousted Congress-led government that appointed him to run the Reserve Bank of India eight months earlier. One even called for him to be fired if he didn’t cut interest rates.

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Yet when the pair joined together in Mumbai last April to celebrate the central bank’s 80th anniversary, Modi lavished praise on Rajan. The prime minister called him “the best teacher" thanks to his ability to simply explain complex ideas, adding: “He makes me understand them so perfectly that I don’t need to question anything."

The positive working relationship -- featuring moves to control inflation, narrow the fiscal deficit and boost foreign reserves -- is helping counter the narrative of disappointment since Modi took office. While investors remain frustrated with failures including a delayed tax overhaul, India isn’t currently gripped by the sense of panic that struck in 2013, when emerging markets last came under pressure.

‘Fundamental Reset’

And while joint efforts to clean up banks, end power shortages and curtail corruption face substantial obstacles, they have the potential to upend a growth model that funnels wealth to a small elite. In the process, that would empower a younger generation with lower business costs and a more level playing field.

“Modi and Rajan as attackers of vested interests -- and technology as a tool for a new generation of entrepreneurs to change the system -- is creating a fundamental reset on how India works," said Saurabh Mukherjea, chief executive officer of institutional equities at Ambit Capital Pvt. in Mumbai. “I don’t think foreign investors have fully understood the scale of how dramatically India has been changed by these three forces.”

While that’s good news for the economy over time, he said, it’s bad for stocks in the short term. Mukherjea said banks will suffer dealing with bad debt, real estate will be deprived of under-the-table funds and corporate earnings growth overall will be stagnant -- similar to the period after India swung open its doors to foreign investment in 1991.

In many ways, that represents a best-case scenario for India. Dozens of things could go wrong: A sudden surge in oil prices could stoke inflation and blow out the fiscal deficit. Modi could succumb to populism to boost flagging poll numbers. Unrest over religion, free speech or affirmative action could spread. And business elites, local mafias and village chiefs could thwart reforms aimed at cutting off the flow of easy money.

The biggest question mark, perhaps, is whether Rajan will get an extension when his three-year term expires in September. His outspoken call for tolerance last year amid a debate over religious discrimination agitated Modi’s party, and Finance Minister Arun Jaitley defended the government’s record the next day.

“The government realizes that -— like it or not -- Rajan has given it enormous credibility on the global stage," said Milan Vaishnav, associate in the South Asia Program at the Carnegie Endowment for International Peace. “The market would certainly have a negative reaction if Rajan’s term is not extended."

Falling Stocks

Negative global sentiment is already taking a toll on Indian asset prices. The rupee, sovereign bonds and stocks posted their steepest January losses since 2011. India’s benchmark stock index has fallen 12 percent this year, while the yield on the 10-year government bond has risen six basis points to 7.82 percent. The rupee is the second-worst performer in Asia after South Korea’s won.

At first glance, Rajan and Modi couldn’t be more different. Rajan, 53, has been lecturing at the University of Chicago for a large part of his career. He is more comfortable speaking English than Hindi, and easily hobnobs with the brightest financial minds at places like the World Economic Forum in Davos.

Modi, 65, grew up in Gujarat state in western India, where as a child he sold tea. He walked away from an arranged marriage at 17 to embark on a religious pilgrimage in the Himalayas, and spent much of his adult life spreading the ideology of Hindu nationalism before entering politics. He’s now a fierce orator and showman, rousing the masses with charismatic speeches in Hindi and filling stadiums when he goes abroad.

Disdain for Oligarchy

But Modi and Rajan share some key things in common: A disdain for oligarchs, a vision to modernize and a desire to leave a meaningful legacy in India. Perhaps most importantly, both are anti-establishment outsiders.

Modi’s teetotaler lifestyle and early-to-rise work ethic came as a jolt to bureaucrats in New Delhi used to extravagant late-night dinners and mornings on the golf course. He regularly flaunts his working-class roots, telling a group of farmers this week that his enemies “can’t swallow" having a tea seller as prime minister.

Rajan’s academic background put him at loggerheads with the career bureaucrats in India’s central bank. He has sought to modernize the institution, telling employees in a New Year e-mail to get tough against defaulters, read more magazines and stop giving everyone an “excellent” performance review.

“Rajan for the first time brought developed country style monetary management" while Modi is “a decision maker," said Meghnad Desai, professor emeritus at the London School of Economics. “They’re basically making the system work better.”

Modi’s first two years in office have been marred by his inability to pass key legislation, disappointing investors who expected his popular mandate to lead to big-bang reforms. A measure to simplify the tax regime is stuck in parliament and proposals to ease land and labor rules have been shelved.

Even so, other moves are gaining steam. He’s backed a formal inflation target to guide monetary policy, a plan to end chronic power shortages by restructuring 5 trillion rupees ($73 billion) of debt at state-owned power producers, and efforts to clear 8 trillion rupees in stressed assets that are holding back investment.

The next major test will be the budget on Feb. 29. Rajan has warned that bond yields could rise if Modi strays from the path of fiscal consolidation. Any deviation from a roadmap to narrow the budget deficit to 3.5 percent of gross domestic product in the next fiscal year might force the central bank to step in and buy the government’s debt, risking higher inflation.

On the other hand, Modi faces pressure to boost civil-servant wages and increase spending in rural areas hard hit by drought. With as many as nine state assembly elections coming up in the next fiscal year, a frugal budget risks hurting him politically.

Either way, Rajan doesn’t have much room to add to 125 basis points of interest-rate cuts last year and still hit his inflation target for early next year. That means it’s Modi’s turn to start doing the heavy lifting.

“It is complementary," said Taimur Baig, Asia chief economist at Deutsche Bank AG based in Singapore. “If the government remains committed to cutting the fiscal deficit, the RBI will certainly entertain further rate cuts."

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