Chakravarthi Rangarajan on Monetary Policy After Liberalization

Shruti Rajagopalan talks with Chakravarthi Rangarajan about reforming the Indian economy after 1991.

In this episode, Shruti speaks with Chakravarthi Rangarajan about currency crises, how the post-liberalization reforms built on earlier reforms, fiscal dominance, capital mobility and much more. Rangarajan is an Indian economist, a former member of parliament and 19th governor of the Reserve Bank of India. He formerly chaired the Prime Minister's Economic Advisory Council. He is also the chair of the Madras School of Economics; a former president of the Indian Statistical Institute; the founding chairman of the C.R. Rao Advanced Institute of Mathematics, Statistics and Computer Science; former chancellor of the University of Hyderabad; and a professor at Ahmedabad University. His book “Forks in the Road: My Days at RBI and Beyond” describes the path-breaking reforms that he implemented during his tenure as governor of the Reserve Bank of India.

SHRUTI RAJAGOPALAN: Welcome to Ideas of India, where we examine the academic ideas that can propel India forward. My name is Shruti Rajagopalan, and I am a senior research fellow at the Mercatus Center at George Mason University.

Today my guest is Dr. C. Rangarajan. After three decades long as an academic economist in the U.S. and in India, Rangarajan joined RBI [Reserve Bank of India] as deputy governor in 1982. He served as a member of the Planning Commission in 1991. He was the governor of the Reserve Bank of India from 1992 to ’97. He also served as the governor of the state of Andhra Pradesh, as chairman of the Twelfth Finance Commission, as member of parliament when he was appointed to Rajya Sabha and chaired the Economic Advisory Council to the prime minister (Dr. Manmohan Singh). He currently serves as the chair of the Madras School of Economics.

We spoke about his latest book, “Forks in the Road: My Days at RBI and Beyond,” why India has not faced a currency crisis since the 1991 reforms, fiscal dominance and government dominance, inflation targeting, fiscal federalism, declining capital formation and more.

For a full transcript of this conversation, including helpful links of all the references mentioned, click the link in the show notes or visit

Hello, Dr. Rangarajan. Welcome to this show. It is such a pleasure to see you again.


Why India Didn’t Have Currency Crises After 1991

RAJAGOPALAN: Often people ask me, when we are working on the 1991 Project, about the experience of other countries that have had balance-of-payments crises followed by currency crises, and typically their story is that the IMF [International Monetary Fund] and World Bank intervene. They try and do a little bit of the reform, they devalue a little bit, and then they regress and end up in the same position after a few years. And this also happened in India. India had currency problems in the ’50s. In ’66, of course, it had the problematic devaluation, but it was very different after 1991.

Perhaps you can tell us what we got right, especially during your crucial time as RBI governor from ’92 to ’97, in three areas. One is monetary policy, the second is external sector management and the third is banking and financial sector reforms.

RANGARAJAN: Okay. This has been the experience of many countries which went to IMF, but the point is that we took reforms very seriously after we went to IMF. It is also proof of the fact that the reforms were not imposed. The reforms were our own making. We had decided that the time has come to move in a different direction, change from what we are doing earlier, and therefore, the additionality of the funds that came was a good thing.

They needed it at that time because the balance-of-payments crisis had to be overcome. Before we can initiate reforms, some degree of stability has to be established. Therefore, stability and reforms went together, and therefore we took the money from IMF and other international institutions and many others. The program that we wanted to initiate as a consequence of the crisis was something with which the IMF and other institutions were in agreement, and this was put down in the document of agreement. These are reforms which we thought were important from the point of view of the country, and this is what we want to do.

Therefore, very often people talk about the nature of conditionalities and so on. I would like to make a point: The conditionalities, if they want to call them that way, were conditionalities from their point of view. They were the reforms that we wanted to introduce at that particular time. Therefore, this is an important difference, perhaps, between the practices or between what happened in other countries or what happened to India also earlier.

Take one good example. We devalued the currency, but in the previous occasions when we devalued the currency, the steps that we took later on were essentially in the nature of controlling imports and so on. But whereas this time in 1991 when we devalued the currency, we went on to embrace, so to say, free trade and decided to become part of the global trade—in fact, reduce the tariff rates and remove the quantitative controls and so on. This is something contrary to what we used to do earlier after the decision to devalue the rupee. That will give you an idea of why the experiment this time, or results were far different from the earlier times.

I think the immediate thing to look at is really in relation to foreign exchange, because monetary policy and other things followed, but they were not the crucial ones on which the IMF and others were looking at. What will happen to our balance of payments? Will we be able to correct it, and whether after one or two years we will be on a firm path? In fact, I would say (and I have written it in the book also) the management of the external sector was a success story of the reforms. Immediately after we went ahead, reduced the tariffs, as I mentioned earlier, reduced as much of the quantitative controls as possible, a program was laid out for removing them.

As you know, very soon we moved to a new exchange rate system. Many people wondered whether we would be able to manage, but we really decided after initial one year of a dual exchange rate system, we finally went on to a fairly market-determined exchange rate system. Of course, we said we will intervene. I think that was important to say that at that time, and I think we continue to intervene even now. Basically, the exchange rate is getting determined in the market, by and large.

Therefore, if you look at the balance of payments, you really find that after the first year, the current account deficits started coming down. Another thing that we did, which has been noted, is that we opened up the avenues for the inflow of funds. It is not a good case where you have a balance-of-payments deficit, and we shut all doors through which funds can come in. We therefore decided we should change the exchange rate regime. We should also open up the opportunities for funds to flow into the country.

We were, and we continue to be, away from full capital account convertibility. That I think was not in the minds of the reformers, and it continues even now to a very large extent. The point really is that the opening up of the Indian stock market to the institutional investors, and the inflow of foreign direct investment into the country—previously, as you know, prior to 1991, the majority ownership was not even considered appropriate in most of the sectors of the economy.

Therefore, when you look at the decision to devalue the rupee, you see what happened subsequent to it. Really, the exchange rate regime underwent a change. We decided to adopt an open, free trade system, become part of it, and then opened up the opportunities for inflow of funds into the country. Therefore, even if there is a current account deficit, meeting that deficit will not be a problem so long as we put up or we build up an economy which is attractive for the inflow of funds from outside.

That is what happened. We did not have to go anywhere for meeting the current account deficit because earlier the problem was twofold. One, the current account deficit was high, and also financing of the current account deficit was also very difficult in 1990 and ’91. These were the twin problems. It’s not just the high level, the current account deficit; there were not enough lenders in the market to give us the funds. That is what really made the change.

That is very clearly seen in the external sector, which is the main concern also of people from outside: whether we are investing, we are putting funds into the country, whether there will be enough stability in the external sector and whether they will be able to get back whatever they have invested and so on. All that we could assure. Therefore, between ’92 to, let’s say, ’96, ’97 and thereafter, you find that there was enough stimulus for exports and there was enough funds coming in from outside in order to meet the current account deficit. I think there was, a little later, one year in which there was a current account surplus also, but that is not the common thing even after the reforms.

There’s no urge to have a current account surplus at that point in time, or even now. By some call current account deficit is acceptable. Therefore, the funding and the financing arrangement was also put in place. I would say that look at the whole picture, you would find well-coordinated, well-integrated plan put in place along with the trade policy.

Trade policy by itself only said that, “Well, we will open up,” and so on and so forth. It has to be accompanied by certain changes in the financial system also. That is where the exchange rate regime and the inflow of funds, or the facilities for the inflow of funds, was also modified. That I would regard as the way in which we proceeded, and we were able to succeed in that. Since ’92, for example, you will see that there was no occasion for India to go to IMF or any other institution. If anything, there was a time when we were lending to IMF at some particular point.

Therefore, the reform—many people do not look at the whole picture. I mean, I think the whole picture is not only removing the controls and permits, and so on, liberalizing the industrialization policy, but also in terms of the trade, in terms of the exchange rate system, in terms of banking and so on.

Now, you also mentioned about the other areas like monetary policy, banking and so on, but the reforms that were introduced there all are concomitant to many of these measures we took, but they are also independent. They are not necessarily related to the balance of payments or to correct the balance of payments.

We really thought we needed a monetary policy which is not totally influenced by what the government is doing, and how the government and the reserve bank have to work together. Not in a way in which the overspending by the government is winked at. I think that’s not the way to do it. Therefore, your new regime, with respect to the coordination between the central bank and the government, was also put in place. The banking system had to be changed, had to be modified. If you have time, later on, we can discuss what happened and all that. The point really is that those are all part of the reforms that we really looked at.

Therefore, of course, the main thing is to remove the permits and licenses in terms of setting up industries and so on and so forth. That was followed up by development in many other areas: fiscal policy, monetary policy, trade policy, foreign exchange, management and so on.

Were the ’90s a Continuation of Reforms in the ’80s?

RAJAGOPALAN: The external sector management playbook that we followed since the reforms was really written by you, both in terms of your work as governor and also expert committee reports. That’s the playbook everyone has followed since then. We haven’t had any issues. How much of our success would you also credit to the fact that in the 1980s you had already started working with the IMF on the loan agreements that were given to India, especially after the oil crisis and the rising inflation and the rising import bill for the government of India? That’s part one.

Part two, the gradualism with which you had already started devaluing the currency by stealth, in a sense, because it was pegged to a basket of goods that was not completely disclosed or transparently disclosed. The adjustments were very much within the hands of the RBI, and not completely either to market forces or completely fixed. How much of that experience helped with what followed since 1992, especially given that you are the point of continuity, and Dr. Singh?

RANGARAJAN: Yes, in a sense it’s a continuation, but we should not also underestimate the changes that we made since ’91. True. We had felt that the exchange rate of the rupee, though determined by the Reserve Bank of India every day, has to, as they use the word, mimic the market. Therefore, we felt that even though the market is not in operation, then if you are modifying the exchange rate every day, it should conform to some principles. We were essentially looking at it—the real effective exchange rate should not increase.

Therefore, in a sense, we were adjusting the nominal rate of the rupee in such a way that the real effective exchange rate remained more or less stable. That is the only way to make exports competitive in that sense. You will find even in 1990, we had, even before the devaluation, depreciated by almost 10% by this method. That is really the continuation. Even at that particular time, the balance could be maintained only by controlling imports because this is only one mechanism through which you can manipulate the balance of payments, but the rest remained more or less the same.

There was in the ’80s an attempt to raise exports and so on. Therefore, the Alexander Committee report and so on pointed in the direction of what we should do in order to raise exports. On the import side, there was no great change. There is also the Abid Hussain Committee report, which also talked about effective import substitution or efficient import substitution rather than simply import substitution. We didn’t make much move in that direction. Certainly, with respect to foreign direct investment and all that, or investment in the Indian stock market by foreign, all that was completely outside the purview at that time.

Therefore, as I mentioned, it is not enough to look at only the trade and services side. We need to look at the financial sector side, which we did post-1991. Certainly, there were many things which we were doing in the 1980s which were in the right direction.

RAJAGOPALAN: Was your time as RBI governor easier because the finance minister was a former governor of the central bank and perhaps understood the problems a little bit better, or at least understood the technical side a little bit better? Or was it harder because the difference of opinion was sharper because the political incentives were different?

RANGARAJAN: No, I think two things have to be kept in the background. One is essentially that we were fighting a crisis, and in a sense, that brought everybody together. Therefore, it was felt that whatever differences there are must be closed and a solution found very quickly. That remained in the background at that particular time. Second, the fact that the finance minister of the country was earlier the governor of the reserve bank, and also the fact that the finance minister was a seasoned economist, let alone having been the governor of the reserve bank earlier, created a situation in which we could discuss very clearly the different viewpoints and come to a conclusion.

Therefore, I think the political implications at that time were somewhat soft-pedaled, and really we were moving toward taking appropriate economic decisions. That was also there in the background. Certainly, the idea that we have to move forward, introduce reforms and all that—there was a consensus, and that also helped in order to find appropriate policy solutions.

RAJAGOPALAN: During your time as RBI governor also tried to severely restrict the problems caused by the fiscal deficit and fiscal policy of government of India. Until your time, the government had this big spending problem, and India had all sorts of strange things like automatic monetization of the government deficit. We weren’t very transparent really about how much the government was spending and how large the deficits were. A lot of it was hidden. And also rising SLR and CRR, those sorts of problems which were creeping into the banking system.

During your time, that was another major reform. This was, of course, not done in tandem with Dr. Manmohan Singh, but with P. Chidambaram. Two parts to this question. The first is, this seems like a much more politically sensitive area of reforms that you managed to push through. Was there a major difference of opinion with the finance ministry when you were trying to conduct these reforms? The second, how do you think this has played out in India since these reforms were put in place? Because one way of thinking about it is, India is at least much more transparent about the size of its deficit, the nature of its deficit. It’s not hidden in all different pockets of the banking and financial sector.

On the other hand, given that you and Mr. Chidambaram were effectively tying the hands of the government and its ability to spend and borrow, it has popped up in other areas such as we have, like priority sector lending, right? The government refuses to give up control over public-sector banks because that is another way to sort of push forth the agenda of the government when it comes to more populist policies and so on. How do you view this particular reform, which didn’t come in ’91 but a few years thereafter?

RANGARAJAN: Well, putting an end to the system of issuing ad hoc treasury bills, which essentially meant automatic monetization of the fiscal deficit, was an important step. This was discussed. I had outlined the proposal in one of my speeches, and later when we discussed it with the finance minister, who at that time was still Manmohan Singh, and he readily agreed. He said that, in principle, this is not correct, and it only took four years to implement it fully because the government has been used to getting this kind of funding and, therefore, you can’t suddenly stop it.

Therefore, it took us a few years to bring to an end the system of issue of ad hoc treasury bills. Then we said that the Reserve Bank of India will provide ways-and-means advance to the government of India because that was also required by the government. If your reserve bank is a banker to the government, and therefore, in some sense, there is a need to provide ways-and-means advances to the customer and in this case the government. And also another thing that one part of the reforms in the area of fiscal policy was also to reduce fiscal deficits. It is not as if this is essentially important for the monetary policy side.


Monetary Policy Reforms

RANGARAJAN: Monetary policy continues to emphasize because if you continue to borrow on a scale which is beyond what is admissible or what is desirable, which can be defined in some ways, then there will be only the monetary expansion and which results in increase in prices. One of the elements of the reform process was also to cut down the fiscal deficit. Therefore, it is not an antithesis to it. The government had difficulty in cutting the fiscal deficit; they did not fully conform to what they had thought they would accomplish. One or two years it did increase quite substantially the fiscal deficit.

That is also partly, for example, that as part of the policy of liberalizing foreign trade, we cut down the tariff rates. Therefore, on the one hand, you are cutting down the tariff rates because of liberalized trade policy. That had an impact on the government finances at a time when the government was trying to cut the fiscal deficit, so this was a problem that we faced at that particular time. Therefore, in spite of the best intentions and wishes of the government, the fiscal deficit did not come down as rapidly as we thought it should be. Therefore, it had its own impact upon monetary policy at that time. The focus was quite clearly different: not to go on a spree, so to say.

Therefore, the RBI and the government worked together to see that the fiscal deficit is brought down, and the monetary expansion that arises as a consequence of any rise in fiscal deficit is as limited as possible. That was one thing that we tried to do. Therefore, the next three, four years after 1992, there were one or two years in which it was comfortable, but there were one or two years in which it was not comfortable. We continued from the reserve bank to write to the government saying that look, you have to bring down all your deficit.

There was an intellectual agreement that there has to be some control over the fiscal deficit. It was somewhat much later that this was put into some concrete shape when the FRBM Act was enacted. That put numbers, but the numbers didn’t control. But the fact of the matter is that at least it was decided that these are the desirable numbers. As far as the government of India is concerned, 3% of the GDP as a fiscal deficit was appropriate, and I can give the reasons why that 3% was derived and so on.

The point is that the direction in which we were moving was very clear. Post-1991 we said, “Fiscal deficit must come down, and automatic monetization must go away.” Further on, an enactment was really introduced in order to put some concrete numbers into our thinking, so that was done. Therefore, the direction in which we were moving was quite clearly indicated. As you know, even after the enactment of the FRBM Act, there was only one year in which the central government was able to abide by 3% of the GDP as fiscal deficit; the other years it went up.

In fact, even in very good years—that means years in which India had the very high rate of growth of the economy—even in that year, I think the fiscal deficit was more than 3% of the GDP. Therefore, all these legislations also have their limitations. All that was required was for the government of India to put before the parliament why they could not abide by the rule. The point is that from 1991 onward, the direction in which we wanted to move was clearly stated.

I think that arrangement between RBI and the government has worked, but as I said, the fiscal deficit went beyond what is considered to be desirable and reasonable, then it has an impact on RBI. Therefore, in one sense, you’ll also see that immediately after ’91, when we put the limit on how much government, reserve bank will provide and so on, we also introduced another reform, which we should not forget. We forced the government to go to the market and to borrow from the market.

Therefore, for the first time, the rate of interest on government bonds was not predetermined. The rate of interest in the government bonds was actually determined by the market. Sometimes if the rate of interest in the auction was higher, then the government would say, “No, we are not taking it,” but if that amount was actually needed at some particular point, they will have to come to the market and abide by what the market says. In fact, Dr. Manmohan Singh once told me, “The result of all of this is my cost of borrowing has gone up.”

RAJAGOPALAN: Has gone up, yes.

RANGARAJAN: That’s what it happened because that is the way it operated. But then, even though he said that, he realized that if the reform had to be introduced, then this is the price that they have to pay. If the higher cost of borrowing will make the government introspect and cut down the borrowing, that will be good. That’s it.

Problems with Government Borrowing

RAJAGOPALAN: Actually, I’m glad you brought up the question of both government borrowing and the cost of borrowing and also government spending when it comes to banks. One thing I want to highlight here is they didn’t take into account all of your reforms. Because one part of your career was before you became RBI governor, after your time at planning commission, you were also setting up the disinvestment committee. You were talking about how the government needs to reduce the footprint through public-sector organizations or public-sector undertakings and also public-sector banks.

Given that you ended some of the jugglery tricks when it came to automatic monetization of deficit and so on, and given that you started imposing upon the government the true cost of its large deficits and its borrowing, some of your successors have had a lot of trouble with it. Because now there is a twofold pressure that is a constant tension between the ministry of finance and RBI. One is about interest rate setting because the government is, in effect, the biggest borrower and the most impacted by the interest rates that the RBI will determine through the market.

The second part of it is the management of public-sector banks because that is still one conduit that the government has, if not for transparent on-the-books spending, at least off-the-books spending to reach its populist electoral goals. Do you think, in one sense, because the government of India didn’t actually complete the reform process that you started, some of your successors have had all these problems and tensions, both when it comes to interest rates and it comes to managing public-sector banks?

RANGARAJAN: I think the management of public sector banks is slightly different. Let me explain what I feel. The point is that the whole question of what the rate of interest should be was left to the market. And we could not have gone back on that; I think that was well determined. The point essentially was how high it’ll go, and what impact it’ll have on the government. Is the government really sensitive to a rise in the interest rate? I think they are sensitive to the rise in the interest rate, in the sense that their deficit was going up or something.

It was not sensitive to the extent of they’re cutting down their borrowing. That really did not happen even though market borrowing rates were higher. The one important question which arises out of this relationship between the government and the reserve bank is the autonomy of monetary policy, a question which you raised first. Now, this autonomy of monetary policy is compromised to some extent because of what you call fiscal dominance. That continued in a sense that the government wanted to borrow, and because of the various measures that we introduced, it had some impact.

The point is that the subsequent development of introducing the monetary targeting regime has essentially put an end into that argument. Between ’92, ’97, 2000 and the monetary targeting regime, which is in the 2015/’16 kind of thing, that was the decade or more of a period in which the issue of what the level of the interest should be became bone of contention between the reserve bank and the other government. Post-adoption of monetary targeting regime, the setting up of the Monetary Policy Committee with the three outsiders as members essentially resulted in a situation in which even the finance minister was not aware of what the rate of interest would be.

Because the government Monetary Policy Committee decided or takes a decision on whether the policy rate should go up or go down or by what basis points and so on—it is communicated, after all—even the governor gets to know, in that sense, only at the end of the discussion. Therefore, in some sense, the conflict and the tension that prevailed for about a decade or more has been somewhat eased by the fact that the decision to raise a policy rate or to lower the policy rate by what quantum is left to be decided by a Monetary Policy Committee.

This, for example, has a complete statutory recognition because it is the amendment of the Reserve Bank of India that introduced the system. Therefore, to answer your question, it is getting resolved in some way. So far, the system has functioned reasonably well, and therefore, the question of discussion about the rate of interest is at least now taken out of the conflict area between reserve bank and the government.

Government Dominance, not Fiscal Dominance

RAJAGOPALAN: I agree with you almost entirely. I’ll explain why I say almost. I want to go back to the point that you made about intellectual congruence between the ministry of finance, government of India and the RBI that you said was your experience during your time as governor. There was some intellectual agreement that controlling deficits and controlling inflation and having a very independent central bank is actually good.

I am now worried that, having all these new reforms which effectively tie the hands of the government more and more, there is going to be a tendency to stack the Monetary Policy Committee with members favorable to the government as the final measure, because they can’t directly control the numbers. There’s going to be some indirect way to do this because there isn’t a genuine agreement or intellectual agreement that spending must be dramatically curtailed.

Is that your view? I also say this because the more recent RBI governors—Urjit Patel ended his term sooner than the term length. Viral Acharya resigned a few months before his term ended. And both of them have written about the problem of fiscal dominance, though the MPC [Monetary Policy Committee] is actual reform brought through by Urjit Patel because he was the chair of that committee. Do you see this problem of stacking the committee as another form of fiscal dominance which is going to pop up in the future unless there’s intellectual agreement?

RANGARAJAN: No, I think that the idea of introducing the inflation targeting regime is because of the acceptance of the idea that the central bank must be able to operate freely and decide on the rate of interest, and on the policy relating to expansion or contraction of liquidity. I think this is the starting point. There are people who do not agree with inflation targeting, that I know. There are several people, even influential people, in India who do not agree, but I am not one among them. I am one of those who has been talking always for a long time that there is a need for central bank to have price stability as a major objective of the policy.

That is there, but leaving out that, we have had two committees set up since that enactment was made, and I don’t think that your fear is in any way seen in the composition of these committees on these two occasions. Therefore, that question of packing the committee with appropriate members is an issue that arises in almost every field including judiciary. Therefore, that has to be kept. There can always be a fear on that score, but that doesn’t absolve the need for creating a proper system like this.

RAJAGOPALAN: The second part that I mentioned, the fiscal dominance, they say that it permeates virtually every aspect of the functioning of the RBI, including how it regulates public-sector banks. Do you think this has been one of the consequences of tying the hands of the government when it comes to fiscal deficit, when it comes to spending, when it comes to their ability to influence the cost of borrowing and so on? Now this has appeared in a new form through the public-sector banks, which are becoming very difficult for RBI to manage, and it’s a source of tension?

RANGARAJAN: The fiscal dominance part is more related to the way in which monetary policy is formulated and implemented. The monetary authority is handicapped if the government is dominant and has its way in spite of all advice and so on. That is true. That is what is being, in my opinion, brought under control through the inflation targeting regime. I think if that regime goes through, then I would think that the exchange of, or an acrimonious debate between the RBI and the government on rate of interest and all that will die down.

The other aspect of the part of the banking system, the major part of the banking system being under control of the government raises other issues. To some extent, yes, it is related to the issue which you had raised earlier, namely that if the government cannot get its things done through the normal fiscal route, then they may push some part of the burden onto the banking system. Now, there are two aspects to it. One is essentially how the credit mechanism should function, namely the need for flow of credit to certain specific sectors of the economy.

Now, this is a matter of dispute. It is true that the Narasimham Committee report [1991, 1998], and more particularly the minutes of dissent in the Narasimham Committee report, were very strongly against the provision of credit for specific sectors being determined. Now, that is an issue on which you will find that there is no consensus in the country. All political parties clearly say that the very purpose of having a public-sector banking system is to facilitate the flow of credit for certain sectors.

According to them, the problems of the banks are not due to the flow of credit to two, three sectors, but the problem is all due to the flow of credit to other sectors which are considered to be always solvent and so on. That is the point. I think this is an issue on which there are considerable differences of opinion. We took the view immediately after the reforms that we will not have to meddle with it. What we did at that time, I write in the book also, is that the subsidization implicit in the priority sector credit was reduced.

For example, the provision of credit to agriculture is part of the priority sector. We essentially said that the rate of interest will depend upon the size of the credit rather than the purpose for which it is given. Yes, the purpose for which it is given is also important, and therefore, they are part of the priorities of the sector credit. Interest subsidization was determined according to the size of the loan. That is the departure that we made in terms of the flow of credit to those sectors. Therefore, on that particular issue we have to live with differences of opinion.

Therefore, one can use the word government dominance rather than fiscal dominance, because it is not so much the fiscal dominance. It is a government dominance in matters relating to how long a governor will be there in office. All those issues have been erased. Therefore, one has to take a relook at how some of those issues will be dealt with.

For example, the Reserve Bank of India Act is somewhat vague on the tenure of the governor. Therefore, whether one should really make it very clear and say that the governor is appointed for five years or six years or whatever it is—perhaps five years is a good period. I have also held the opinion that no governor should be reappointed.


RANGARAJAN: I think if you really want to remove what is being called the government or fiscal dominance, then I think we can make even the tenure six years, but make it only one term and that’s the end of it. Therefore, some such changes will be required. But to a large extent, the autonomy with respect to monetary policy, in my opinion, has been restored by the new regime that we now have in terms of inflation targeting.

Capital Mobility Under FEMA and FCRA

RAJAGOPALAN: During your time at the RBI, you also worked on the transition from the draconian FERA to a legislative framework more suited to a liberalized economy with growing openness to trade. This was eventually passed as FEMA, but a little bit after you had worked on it, a few years later. Since the passing of FEMA, India is much more integrated to global trade and capital flows. Remittances have grown exponentially, but simultaneously the transaction costs of capital flows, both inflows and outflows have also decreased.

Indian firms and startups, much smaller than anticipated earlier, actually receive a lot of foreign investment because the earlier conception of foreign investment was very large firms that the government would personally often invite to come set up in India. But now you have venture capital flowing from Silicon Valley to the Indian startups and so on. Simultaneously, India has also kept up with the times. It has introduced the India Stack and UPI. This is the payments interface that India now has, and now we also have alternatives like cryptocurrency.

Is FEMA still the appropriate framework today? If not, how would you reform it or replace it to keep up with the modern nature of capital inflows and outflows and foreign exchange management, both for individuals and investors, but also the RBI?

RANGARAJAN: No, this also takes you to the issue of capital account convertibility. How far will the country go and what modifications will be made? See, the FEMA is a new structure that has been brought. We almost finished working on it by the time I left, and then, of course, it was formally taken up later and passed. Therefore, I think the question is not with respect to FEMA. That’s a legislation which will accommodate whatever changes that you decide upon. Therefore, what you really have to decide upon is how far you will go on capital account convertibility, how far you will do the other things, and therefore, those decisions will have to be taken.

In a sense, these decisions are being taken almost every quarter, every month and so on and so forth. It is not the opening up of the country’s financial system to the other people, to foreigners. It’s happening in one way or the other. Therefore, I think the point really is that at what point will you enter into the next stage of your big bang capital account convertibility? What is happening in the rest of the world is not really encouraging anybody to go in that direction too fast.

RAJAGOPALAN: True, but also, what’s happening in the rest of the world and India’s capital mobility framework and especially capital account convertibility—it was still a regime that was worked upon during a different time when the balance-of-payments management and the integration to the global economy was happening in a very gradual and thoughtful way. India has fundamentally changed since then, so what is your view on capital account convertibility today, and how we should think about fully integrating with global finance in that sense?

RANGARAJAN: When the Tarapore Committee reported and all that, there was an indication that we can move toward capital account convertibility in a faster pace as and when we fulfilled some conditions. That condition again, essentially, was about the fiscal deficit of the country also. Therefore, in a sense that we need to make the FRBM Act more effective before you can start doing this thing. Because if you open up the capital account and if the government does not abide by any rule as far as the deficit is concerned, then it can land us in a big problem at some particular point in time. When there’s a crisis or something, then there can be an outflow very, very, very fast.

Therefore, I would say that you can’t decide on this until we take a view on what the FRBM Act should be and how strict it should be in terms of implementation. The act is there, but how strict that implementation should be? In a sense, what we should do in terms of capital account convertibility is move to another stage of liberalization as far as industrial units are concerned.

The further stage, where every individual can keep money outside, can invest and all that, will have to come later. The greater freedom for business and industrial units which conform to certain regulations and so on has to be done. Then we can move on to the other thing. I would say that the Tarapore Committee’s recommendation on some of the fundamentals that need to be fulfilled before you can introduce capital account convertibility should not be ignored.

RAJAGOPALAN: Absolutely. India seems to have gone in a slightly different direction. Maybe this is also post-financial crisis. Since your time, the FCRA has been amended. It has been strengthened. It applies now to all firms and nonprofit entities. Of course, in the case of nonprofits, the capital controls are also now a mechanism of controlling free speech, political activities, policy decision-making and so on. How do you think about the FCRA within this regime, and how it should be reformed? Is there any place for something like the FCRA in the modern Indian economy when we are trying to attract more investment for businesses and everywhere else?

RANGARAJAN: FCRA is not an investment. FCRA is essentially the flow of money which goes into some institutions, particularly nonprofit organizations, so on and so forth. I think that what is needed is greater transparency in the way in which the FCRA Act is implemented. It should not be as if that, administratively, a decision can be taken to permit or not to permit without making very clear what violations they have committed. Therefore, I think what is needed is some additional transparency to be introduced in the act.

Please think of this: The total amount that flows through the FCRA is not very high. Compared to what is happening in foreign direct investment or portfolio flows or something, this is little. This can be used to favor, disfavor and all that. This is the nature of all controls.

Therefore, I would say that the transparency in the implementation of the FCRA Act has to be improved because, in a sense, in India, people always used to talk of foreign hands all the time. It may be there, but the point really is that one should clearly know under what conditions action is being taken.

Mundellian Trilemma

RAJAGOPALAN: Yes. I agree that it’s too small, and capital controls in terms of external sector management is simply not a good reason to continue that regime as it goes.

I want to talk to you also a little bit about the Mundellian Trilemma. This is, of course, when an economy (or rather a central banker) must choose between free capital mobility, fixing the exchange rate or autonomy over monetary policy. In one sense, you are India’s first central banker to have truly faced the Mundellian Trilemma because you were part of opening up the economy and opening up to greater capital mobility and exchange rate management.

The way Mundell set it up, the trilemma, the way it’s set up is that only two of the three are possible. Of course, the way it plays out in India—and this is largely your playbook—is that we are not picking two out of the three, but we are trying to prioritize one or two out of the three while managing all three issues simultaneously. How did you face the Mundellian Trilemma during your time as governor between ’92 and ’97, and how would you manage the same trilemma today, post-COVID, in the face of high inflation in developed countries, given that India is so much more integrated to the global economy?

RANGARAJAN: Well, the impossible trinity, about which we talk, had its impact. In the early years of reform, none of the three poles were fixed, actually. All the three sides of the triangle that we talk about are not so firm. I think we didn’t have a fixed exchange rate, but it is not totally determined by the market. To some extent intervention was there. Price stability, the autonomous monetary policy was there, but then we were also talking about some other factors that were influencing the autonomy of the central bank.

Therefore, the capital mobility, again, was limited at that particular time. The capital mobility was what we allowed as we went along. As we saw the economy improving, then we relaxed in terms of the capital inflows into the country and so on. Therefore, the trilemma about which that they were talking was not present in that very rigid form, as far as India was concerned.

There were occasions—for example, I don’t remember exactly the years, it is something like 1995, ’96, and all that, when foreign capital inflows were coming in in large amount. Then as a result of it, the money supply expanded, but we could not do any open market operations because we didn’t have any government paper which is of market interest. The government paper we had in plenty, but they were all issued at 3% and 4% many decades ago.

That was a problem that we faced, that we allowed the capital inflows. As a consequence of it, money supply increased and the price level went up. Therefore, we had to really make some adjustments. We didn’t think that it was appropriate at that time to put any restrictions on the capital flows, and therefore, you will find in that one year that inflation really went up in India. It was not managed in that sense; it was allowed to have its impact on the system.

To come back now, we have matured much more over the last 20, 25 years or more, and therefore, we will face problems. I think we certainly do not have a fixed exchange rate, no. I think we say that, by and large, it is determined by the market, with which I agree. The capital mobility, again, is subject to whatever conditions that we have on capital account convertibility.

Now, in the current situation, what is the issue? For example, we had a level of inflation which was running above our comfort level, which is 6% at the upper limit, and the inflation was running about that level. Then we had a situation in which the interest rate had to be raised pari passu with what is happening in the rest of the world also; otherwise there will be capital outflows. At one point I really found that there was no conflict because what we really had to do to control inflation was to raise the rate of interest. Raising the rate of interest was also what was needed in order to prevent the outflow and maintain the inflows into the country.

Because at that time, if the U.S., the Fed was raising the rate of interest by a big measure, and we were doing it by somewhat of a lower order, that was a question. At that time, I was saying that, “Look, raising the rate of interest is what you should be doing for controlling inflation, and raising the rate of interest is what you should be doing in order to keep pace with the rest of the world and to prevent the outflow of money and the exchange rate.”

Therefore, in some sense, it was not a trilemma. I think it’s not a dilemma that we had. It is something that we had to do. There could be some occasions in which we will probably see sometime later that the domestic economy does not require a high level of interest rate. If the foreign exchange market is to be reasonably stable, it might require a rate of interest which is slightly higher. That situation could arise.

By and large, I had felt at that point, even though many people were raising the question, that no, I think the same stone, you can’t hit two targets. You can’t really get the inflows coming in and at the same time keep down inflation. Then the whole question is how much you value one objective against another objective. That’s it. I think it is the compromise that you would have to make.

RAJAGOPALAN: The government must agree that there is fundamentally no conflict. The conflict doesn’t exist for the central banker, but it exists in tandem with the government if they truly want to bring inflation down and how hard they are willing to work toward that. There’s a question of political incentives at play here.

RANGARAJAN: That is, but I think when it comes to the larger issue of looking at India in the context of the global situation and all that, I think that some agreement will be arrived at. I think this becomes a much wider issue than an issue between RBI and the government alone.

Decline in Capital Formation

RAJAGOPALAN: I also want to talk to you about your time much after you were the governor of the RBI. You’ve, of course, been in public service pretty much your entire career, but from 2009 to 2014, you were part of the prime minister’s Economic Advisory Council, and you were chair. This is of course when Dr. Manmohan Singh was prime minister, and you revived the council in one sense.

During your time there, and toward the end of your term, you start highlighting the problem of investment in India, especially fixed capital formation, gross fixed capital formation. You start hinting and sounding an alarm at that point. One of the trends in the Indian economy since 2011 is a decline in gross fixed capital formation, especially private fixed capital formation. This is also run parallel with a secular decline in growth rates during the same time, of course exacerbated by some domestic policies like demonetization, GST [goods and services tax], the now-global pandemic and so on.

What do you think are the reasons for the decline in gross fixed capital formation, and why has the private sector lost momentum in terms of investment in India? This momentum was very strong for the first two decades after the ’91 reforms, and the trend seems to have turned.

RANGARAJAN: In one sense, the explanation for the fall in the gross fixed capital formation rate, let us say from 2011, ’12 to somewhere around 2014, ’15, or something like that, is basically cyclical. We had a very sharp rate of growth in the economy between 2005, ’06 to almost up to 2009, ’10. That was a big growth, and that was accompanied by a very strong growth in the investment rate, the gross fixed capital formation rate. Therefore, it is almost like a business cycle, that they reached the top of the cycle and then there was a recession that it is coming down.

Now, that happened, and that’s the time at which capacity utilization was at its maximum, and therefore, we were at almost the full potential of the economy, and then it started. In some sense, I think the recession was not that well managed at that time, but there were other factors operating at that time, political and others, which really hindered the way of taking strong action and all that. The fact is that if that recession has been managed better, I think perhaps the pickup would have happened much earlier. Then it came, and then after some time, we got into complications of the GST and the demonetization and so on.

In a sense that two or three years of a decline in the investment rate after reaching a peak, after reaching a real short peak, was not unexpected. I think that would happen in all economies. After that time, then came these complications of this. Then thereafter you see some pickup in growth, but not so much in investment because the capacity utilization was not that high.

Therefore, immediate factors contributed to the decline in the investment rate or the gross fixed capital formation rate. It has picked up a little bit in the last one year or two years, but that is actually largely accounted for by the increase in the capital expenditures of the government rather than by the private investment.

Therefore, the issues are complicated in the sense that they are partly cyclical and partly due to some immediate actions that were taken, and then the pandemic and the Russian-Ukraine war and so on. Therefore, the whole thing is really in creating an investment climate. After all, reforms are supposed to increase the nature or the hospitality or the investment climate. That is the way through which they really push up the investment and push up the growth.

Two things need to be done at the moment, and one thing is really to look at the overall climate, whether it is really because that the output levels are adequate or considered to be adequate. Therefore, there is a clear need to raise the investment rate by creating an appropriate climate. The second is to look at individual sectors of the economy and really figure out what are the blocks or what are the impediments.

Talking about the investment rate, gross fixed capital formation rate in general, is relevant from the point of view of the overall growth rate of the economy. If you really want to improve it, what you will really need to see is what are the sectors of the economy in which the investment is not flowing? Or is the investment flowing only into sectors like, let us say, IT and so on and so forth, where the nature of the output is very different from the nature of the output in the other sectors of the economy? I think that is where we really need to look at it.

Lack of Private-Sector Investment

RAJAGOPALAN: I have two views on this secular decline. Perhaps you can tell me your view on it. I feel like one, you already hinted at: We never did the next stage of reforms, which is the reforming of the factor markets. When it comes to transactions to do with land, when it comes to hiring labor, when it comes to scaling small enterprises into large enterprises, I think somewhere there the reforms lost momentum—also because a lot of these areas are state subjects. They are not union-government subjects where it is easier to have one-stroke reform the way we did with dismantling industrial policy.

The second, I think, is some regime uncertainty. I feel like the dividing line is Pranab Mukherjee’s retroactive taxation and that whole issue, which suddenly put the brakes on how private sector viewed the government and the regime uncertainty of, oh, suddenly there can be a lot of changes. Even the reforms that were brought forward were sudden, things like GST and demonetization, not well thought through, not well implemented. In some sense, I feel it’s a combination of the kinds of reforms and also not a very smooth, gradual transformation, the sort that happened in the ’90s and the 2000s.

RANGARAJAN: Some of these I refer to in my book also, I think in the last chapter on my ruminations. Also, I refer to the particular retro-effective taxation also in my book. Therefore, in a sense that, as I said, part of it is cyclical and it came down. That is why I said that the recession was not that well managed and the reforms were also needed. The point which we need to elaborate a little more is because why should the investment rate fall? I think the investment rate may not rise up further. After all these reform measures, nobody has detracted from it. They have not taken it away. They were all there.

The point is that there are areas, which I also indicated in my book, where reforms are introduced. I talk of agricultural marketing. I will talk of governance. I will talk of the financial system and certain other things. Therefore, the problem about factor market is that you need to choose the right time. I am of the opinion that labor market reforms cannot be introduced during a time of decline in a growth rate. You have to wait when the economy is actually picking up. Then they will realize that these labor market reforms are not counter to the growth of the economy. Otherwise, they will only blame the reforms for decline in the growth rate. I think really, we need to wait for that.

Yes, I think reforms are also needed to be done, and I think that could help. Some, shall we say, exogenous factors like Russia-Ukraine war, pandemic, all of that, have also contributed to it. The main fact that I would like to emphasize now is really create an investment climate now, and perhaps some of the actions on the corporate taxation side and some of the production-linked incentive schemes, and all that may bring about some change in the attitude.

The other thing is really to look at—I personally believe that that was being done at one time when I was chairman of the Economic Advisory Council. I used to look at investment in every sector of the economy and then talk to the prime minister and say what needs to be done. Then we used to have a meeting with people to find out why investment is not coming up in that particular area. Therefore, there may be sector-specific problems that need to be resolved. I think that’s the way to go ahead.

Fiscal Federalism

RAJAGOPALAN: During your time as the chair of the 12th Finance Commission, an aspect that you worked on was, of course, to increase the share of devolution to the states. You were also quite particular about thinking through the states’ ability and capacity to raise revenues and rely less on intergovernmental transfers. What is the best way to achieve that, to get to the point that you wanted to get to, which is harder budget constraints for the state?

Is it to increase the revenue-raising capacity through instruments like state income taxes, which will, of course, be kept in check through interstate competition? Is it to directly work on the revenue-raising capacity of local governments through property taxes and so on, and increase that base? What is the way forward to both increase the revenue base but also have harder budget constraints and reduce reliance on intergovernmental transfers?

RANGARAJAN: Now, it’s not very clear whether we can reduce intergovernmental transfers, because so long as there are differences among states in terms of their ability to deliver services, and there are states with much lower per capita income than the others, the intergovernmental transfers will be needed. That is the main purpose for which, actually, the whole system of the Finance Commission was introduced.

They did do two things. One is the vertical imbalance, namely, between whether states taken as a whole do have adequate revenue to meet their expenditures. Then, if it is not, then that should be the transfer. Then second was how that amount of resources to be transferred from the center or the union government to the states is to be distributed among the states, because a lot of state governments which are somewhat well off, are all upset about the fact that they are getting less and less as a proportion from the total. That is because the poorer states, they were catching up for a time.

It’s happening, but there are some poorer states which continue to remain at the bottom, and the rank is not changing very much. Therefore, intergovernmental transfers will be needed. As I also write in one chapter in the book, there is also a need to look at the imbalances, and correcting the imbalances by raising their capacity to raise revenue, rather than lead only through intergovernmental transfers. I think that’s also there, but after the introduction of the GST, the scope for the state level is getting even less, because of the fact that GST is also determined not by the union government but by central authority.

RAJAGOPALAN: The council.

RANGARAJAN: In that sense, the center is also losing some sovereignty in that way, because the GST rates cannot be determined by them on their own, so that’s there. Therefore, after some initial years of bad management and other things, the GST has now picked up, and I think now the revenues are gaining momentum. Therefore, state governments will have fewer reasons to complain on that score. The point, really, is that there are some taxes which are vested in the center because of the ease with which the tax can be collected and preventing the unnecessary mobility in the factors of production.

I think that was the idea, let’s say, for example, investing income tax or corporate tax with the center—more particularly with the income tax; corporate tax has other problems as well. The point really is whether some additional revenue-raising capacity can be given to the states. I had also suggested in my book that income tax can be done, but in a very limited way, because I think even in the United States, there are many states which do not levy income tax even though they have the power to levy income tax.

Some amount of authority can be given to the states, and that will go to satisfy to some extent the well-off states because they are the ones who are complaining that the ratio is coming down. That is what can be done. But otherwise, the whole point is that when the 14th Finance Commission raised the ratio, actually what they did was to take away what the Planning Commission was giving and put it in this basket.

That’s all. I think it is not as if the total has changed really much. But what Planning Commission was giving was put as part of the tax devolution, and there was a substantial rise from 32% or 33% to 42%. I do not know what will happen if some future day a Planning Commission will come, and then the Planning Commission will say that we also need to have the power to give resources.

The government of India have not been playing fair after this introduction of this thing by unnecessarily raising the cesses to a very large extent. I think that is something that the government of India must give up. I think we can do it either stipulating cesses cannot be levied beyond one year or something like that, and therefore it is a temporary and not a permanent thing, or put a limit on what the total amount of cesses can be as a proportion in some way. I think there ought to be a clear case of limiting the cesses, and therefore the available transfer of resources will be larger than what it is now. I think that may be the approach we can take.

RAJAGOPALAN: You’re absolutely right, the GST has now become so complex that there are seven non-zero GST rates. The cesses and the multiple rates also complicate the GST itself, which was supposed to be a relatively simple tax system.

The Future of the Indian Economy

RAJAGOPALAN: Before I let you go, are you hopeful, optimistic or pessimistic about the state of the Indian economy and the future?

RANGARAJAN: Well, I am largely of the view that the system has evolved in such a way that something like a growth rate of 6% per annum is perhaps built into it. In fact, what is really required is some effort to get a rate which is higher than 6%. Therefore, in that sense, whether that is optimism or pessimism, I do not know. But the fact of the matter is that over years, we have built up the infrastructure, the reforms have introduced certain changes in the way people approach the economy, and so on.

Therefore, in some way, the minimum rate at which we will grow is perhaps about 5% to 6%. 6% looks like a possibility. If you really want to raise it beyond that, and that is what the rate of growth that will be required if you want to become a developed country by 2047—that requires a lot of effort. And that may run into real problems because of the changed global environment, the change in attitude on global trade and also actions which are required to be taken in order to take care of climate change and other problems.

Because if you want to cut emissions, probably the globe as a whole, the earth as a whole will have to cut down its rate of growth. That’s the only way in which it can happen. The burden should not be too much shifted to the developing countries, but the point really is that that will also act as a damper of the overall growth rate.

Those things are there, but at the same time, I think we really need to grow faster because if you really want to become a developed country by 2047, India’s per capita income will have to grow from the present level of something like $2,000 to something like $13,000. That is the required trajectory. That will come little above 7%, 7.5% or something like that, but that is based on a number of assumptions regarding exchange rate and price level and so on. The point is that somewhere around 6% seems to be possible to go on its own steam, but to raise it to some other level, like higher level, will require a lot of effort.

RAJAGOPALAN: Yes. Thank you so much, Dr. Rangarajan. This has been a pleasure. The book is fantastic. It is so detailed. Thank you for taking the time to do this.

RANGARAJAN: Thank you very much. It was a pleasure talking to you.

About Ideas of India

Host Shruti Rajagopalan examines the academic ideas that can propel India forward. Subscribe in your favorite podcast app