Why do we need RBI? What is the issue between Raghuram Rajan vs GoI

Raghuram Rajan
image courtesy: thehindubusinessline.com

"Emergency declared after Raghuram Rajan says no to 2nd term: the sun will not rise for next 15 days" read a heading in Unreal times. That faking news is kind of how paranoid and extreme the reactions have been. Of the 50,000 people who have tweeted about the issue 49988 don't seem to know what they are talking about! I see this as an opportunity for another "Made easy" article! Indian Economics and RBI made easy. I will write another piece on Stock markets. For now let us stick to RBI.

Why exactly do we need something like an RBI? For a variety of reasons. Say, you have earned 5 lakh Rs. Being a middle class guy you go and put that in an FD in ICICI Bank. What if the manager is secretly traveling to Kashi and dumping your money in Ganga ? Or worse, what if he is using this money to produce Himesh Reshammiya's next film("Hamaarrrrrraa Surroorrrr" with as many "R"s stuffed in as possible). There should be someone to question and regulate these banks. Enter Reserve Bank(Loud Music).

Think of this. Say, some prankster spreads a rumour that the State Bank of India is bankrupt and it is going to close by Next Tuesday. What do you think will happen? Panic will set in before you blink and 3 crore 45 lakh 23 thousand people will be standing in queue near the bank demanding their FD money back. This is called as a bank run. They would have given loans and all the money won't be in their vault. State bank or any other bank in the world cannot return the money if everyone were to come together ask for it the same day. Bank may actually become bankrupt because of such panic! Who can save the day if that happens? It is the RBI. RBI can actually print money, Raghuram Rajan can hop into an Ashok Leyland lorry, enter the scene and start throwing sacs of money to the crowd. People will realize that their money won't go anywhere and 90 % of them will head back home knowing that RBI will not allow the State Bank to go bankrupt (Most people would have gone back looking at the long queue anyway.)

That is not actually how RBI functions by the way. RBI imposes strict rules on CRR and SLR instead. CRR(Cash Reserve Ratio) is the cash banks need to keep with RBI: RBI can say that if bank has accumulated FDs worth 1 crore it has to keep 10 lakh with the RBI. This way if the panic sets in bank can take this 10 lakh and confidently give money to the first 100 people in the queue. Looking at this confidence will be restored for other people and they will go home. SLR is the amount of deposits banks need to be putting in Government Securities (G-Secs). Idea is the same.

This has another consequence. If the ratio is cut banks have more money to play with. If the banks have 1 crore and CRR is 10% they will have 90 lakh left for lending. If the CRR is only 2% they have 98 lakhs leftto play with. If they have 98 lakh they might give more loans. More loans will trigger more businesses. Rajan Bhai controls the flow of money by controlling this CRR and SLR.

Now the thing about interest rates. What if suddenly 40000 people arrive at an auto rickshaw stand wanting to go from Majestic to Basavana Gudi? Within ten minutes, most autowallahs will start demanding 10000 Rs for the trip. Or what if suddenly 50000 parents stand in queue with their kids for admission into the business centres(Schools!)? Schools will soon start demanding 1 Crore Rs for admission into LKG (Some might argue that the schools are already doing it!)

What is happening in schools and Rickshaw stands is called as Inflation. Inflation is something becoming costly. What if the interest rate is 0? Every Ganesh, Sateesh and Suresh will borrow money because it is cheap. With the borrowed money everyone will try to get their kids admitted to the posh schools, as a result there will be a queue of 50000 in front of the school. Admission price will increase because of this. Did you see the connection? Less interest rate = More money supply = More demand for schools = Price increase = Inflation. If the interest rate is less every Tom Dick and harry will borrow money and start a business. Umesh, Praksh, Gireesh, Ramesh everyone will start a hotel maybe. These hotels will hire workers. Workers will get salary.They will all try to buy a cell phone with the salary. Suddenly there will be more demand for cell phones. Prices will increase. Inflation!! Low interest rate = high inflation.

RBI influences the interest-rates through repo and reverse repo, rates at which RBI lends to and borrows from the commercial Banks. This is what people mean when headlines read that RBI has cut the rates. Why will banks borrow from the RBI? Remember the CRR? If CRR is 10% banks should keep 10 lakh in RBI. What if they have only 9 lakhs? They will borrow 1 lakh from RBI for short term.

Consider another case. What if Rajan Bhai increases the rate to 40%? Not a single person will borrow money, no businesses will start. No money will circulate. Nobody will buy anything. Economy will halt. Everybody will keep the money in FD. Even Pakistanis, Americans, Nepalis etc will park their money in India since they can get 40%. Now suddenly there will be great demand for Rupee, a bit like 40000 people going to auto rickshaw stand and creating high demand for auto. Rupee will appreciate just like the autorickshaw fare. See! A high interest rate lowers inflation as it makes people want to spend less and save more in FD. A high interest rate also attracts foreign investment(Pakistans trying to deposit money here) and increases the demand for local currency, which is all favorable for the exchange rate.

This way Rajan Bhai is like a Don who can manipulate Rupee conversion rate, Inflation, economy, business etc just by playing with Repo rate, CRR and SLR and few other such things. We neither want 40% interest nor 0 %. There should be a balance. We want a good economy, stable exchange rate, good foreign trade, less inflation etc. Touching one will impact another. When Rajan entered there was high inflation, so he increased the interest rate, SLR, CRR etc. Rupee was at an all time low, so he made an attractive FD type of offer for NRIs. Suddenly some 20 billion poured in, so exchange rate recovered. Things like that. Rajan Bhai tamed both.

The debate is about should he reduce the interest rates further? Less interest = More cheap money = Easy borrowing = More business. Guess What Modi wants? He wants more business, so he wants less interest rates. Rajan thinks that Less interest rate = More inflation(As described earlier). One point is that Inflation is not always controlled by interest rates. What if Oil suddenly costs 1000 USD? Petrol and Diesel prices will skyrocket. If Diesel is costlier everything from Milk to vegetable to paani puri will be costlier. This is an inflation that has nothing to do with interest rates. Food grain prices in India also depend on Monsoon.

So Swaami probably thinks that cases like this show that Rajan Bhai is wrong, inflation is not always dependent on Interest rates. Modi thinks that Make in India is good. Rajan thinks that depending too much on Manufacturing is bad. Govt and Rajan Bhai do not agree on some things like that. And NPA. Cases like loans to Mallya where they do not pay the money back are called as Non Performing Assets. Many biggies like Adani, Reliance etc have such bad loans. Banks were hiding such NPAs. Rajan Bhai like a strict headmaster made it compulsory for banks to show these NPAs. Big companies might not like that. Borrow 10000 Crores and not pay it back, who wouldn'twant that ?!

Another thing is that these banks are like sons who have joined underworld. Parents do not kill the son because he has joined underworld. Say, these banks have paid 50000 Crores to Reliance, Adanis, Mallya and all. Say Nobody pays back. What next? All the bank managers can buy one kerchief each, go to Modi and cry for half an hour. What can Modi do? He can line them up and shoot them one by one or he can announce a 1 lakh crore bail out package to save the banks. Most people do the latter. There can be no economy without banks. Even if they do something wrong Govts will try to save them. Rajan wants to be strict on these banks which is the right thing to do, Modi might want to be a little lenient which also is required if businesses have to flourish.

Such differences of opinion are common, Chidambaram and Subba Rao have had big fights for instance. Not giving a 2nd term is also not unheard of. Obama rather than giving Ben Bernanke an extension(which many in market wanted) chose Yellen. Some RBI Governors have resigned in the past because of difference of opinion. What next? Will Indian economy collapse? Rajan is definitely highly qualified but he is not the only one. We have had many highly qualified and able people like Man Mohan Singh, Bimal Jalan, C Rangarajan, YV Reddy, Subba Rao who have steered RBI in challenging times. We will definitely find a replacement for Rajan. Rajan was good and he achieved many things. Someone else will continue the good work. The show must go on. And it will !!

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