Rajan's Exit Opens Three Wounds

Has New Delhi had a change of heart about cleaning up bad loans and cracking down on cronyism?

Raghuram Rajan's departure from the Reserve Bank of India could unnerve investors for at least three reasons.

First, the timing. Although speculation that the Indian central bank chief might be denied a second term has been intense for several months, Rajan chose to make public his decision to quit a few days before the crucial Brexit vote.

Considering that the government is yet to announce a successor, and Rajan's term ends only on Sept. 4, the announcement could have been made at a less jittery time for financial markets.

Second, the seething discord. While Rajan's farewell note doesn't mention the campaign against him by a section of the ruling party, it makes plain he was "open to ... seeing through" the work  he had begun on inflation targeting and cleaning up the banking system, plagued by bad loans. Since he isn't getting a chance to do it, markets are bound to wonder if New Delhi has had a change of heart about one or both.

If the government wants accelerated monetary easing, then global money managers would have reasons to be skeptical about Indian assets. The time for boldness has passed. Even equity investors who rightly called Rajan out for keeping money supply too tight would hate to see the pendulum swing the other way now that inflation is once again quickening. Meanwhile, currency markets will wait to see if the billions of dollars that Rajan had attracted to India three years ago to prevent a rupee rout can now be safely repaid without causing fresh trouble for the Indian currency.

Rajan's Calming Influence

The outgoing RBI chief helped engineer a collapse in rupee volatility

Source: Bloomberg

On the other hand, if it's the bankers' lobby that's being appeased by not letting Rajan serve out even the customary five years, then the prognosis is direr still. About 14 percent of the banking system's assets are already either bad, restructured or have been written off, and the figure is getting worse every quarter.

Politically connected lending is a big part of the problem, whose full horror might never have been revealed had it not been for Rajan's asset-quality review. While RBI, as the banking regulator, deserves blame for being asleep at the wheel while the crisis was brewing, letting Rajan go back to his job at the University of Chicago is hardly the right response. Willingly or otherwise, the message India is sending to global investors is that New Delhi won't take its fight against cronyism to the finish line.

Comfortable Cushion

India's foreign-exchange reserves are at a record high

Source: Bloomberg

*Excluding special drawing rights at the IMF and gold.

Finally, investors will be hurt in the long run if Rajan's successor revives an agenda of marginalizing the RBI's regulatory authority in the name of financial liberalization. Rajan resisted those attacks, and to answer criticism that the RBI is a curmudgeonly institution opposed to all manner of financial experimentation, he backed an important innovation: a unified payment interface.

The tool, which allows any mobile app to move money between two bank accounts, could help India leapfrog from a financial regime dominated by decaying state-run banks to a modern, largely cashless payment system.

But investors should be wary if Rajan's successor demonstrates more enthusiasm for politically expedient ideas like an international financial center in Prime Minister Narendra Modi's home state of Gujarat than for promoting fintech aimed at making the domestic economy more efficient.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Andy Mukherjee in Singapore at amukherjee@bloomberg.net

    To contact the editor responsible for this story:
    Katrina Nicholas at knicholas2@bloomberg.net

    Before it's here, it's on the Bloomberg Terminal.