India's New Central Bank Boss Heads Into the Storm

Rajan Photograph by Dhiraj Singh/Bloomberg

Raghuram Rajan has enjoyed a nice honeymoon since he became India’s central bank governor. The former IMF chief economist and professor at the University of Chicago took the helm at the Reserve Bank of India in early September, when foreign money was flooding out of the country, the currency was plunging to record lows, and consumer prices were rising at a nearly 10 percent annual clip.

Rajan moved quickly to restore confidence in the central bank’s ability to rein in inflation. Many investors were impressed. Rajan’s “arrival has given India a temporary but deserved bounce,” Neeraj Seth, Singapore-based head of Asian credit at BlackRock, told Bloomberg News on Sept. 10. “Rajan has the experience and, according to his first statements, the will to take tactical and specific measures.”

Last week, Rajan further enhanced his reputation as an inflation fighter by surprising the market with an increase in interest rates. The RBI increased the repurchase rate by 25 basis points, to 7.5 percent. That’s a bold move, since the Indian economy is languishing and politicians from the ruling Congress Party-led government must face the voters next year.

“The repo hike may not have made corporate India very happy,” HSBC India economists Leif Eskesen and Prithviraj Srinivas wrote in a Sept. 23 report, “but the hawkish economists out there, us included, were quite ecstatic about it given the lingering inflation risks.”

There are still a lot of skeptics, though. On Monday, Moody’s downgraded the credit rating for the government-owned State Bank of India (SBI) from Baa2 to Baa3, the same as India’s sovereign rating. Moody’s also lowered to negative, from stable, its outlook for the bank’s financial strength rating. In a statement, the ratings agency cited the “increasing pressure on credit fundamentals and the ongoing reliance on the fiscally constrained Indian government to maintain capital at levels desired by the Indian regulators.”

While the rupee has reversed its slide since Rajan started at the RBI, the Moody’s move could revive downward pressure on the currency. “The SBI downgrade may affect India through the equity channel as outflows will affect the rupee,” Vishnu Varathan, an economist at Mizuho Bank in Singapore, told Bloomberg News.

The SBI setback is also likely to increase investor concern that Moody’s, Standard & Poor’s, Fitch, or all of them will deal a much bigger blow to Rajan by downgrading India’s credit rating, which is now just one rung above junk statu

“The Moody’s step is not a sovereign downgrade, but it’s starting to signal that things are moving in that direction,” says Rajiv Biswas, Asia-Pacific chief economist at IHS in Singapore. India, he adds, is “on the precipice” of a downgrade to junk. The country’s economy is “now in a hard landing,” Biswas says, with growth in gross domestic product for the fiscal year ending March 2014 likely to be just 4.5 percent, down from the 8 percent to 9 percent levels of a few years ago.

Rajan’s move last week to raise interest rates will heighten pressure on the economy, which could increase the chances of a sovereign downgrade, which could in turn put further downward pressure on the currency. “India could end up in an even uglier downside scenario,” says Biswas. “It’s a huge vicious cycle we are now seeing in India.”

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