Raghuram Rajan must show he is as good at managing financial crises as he is at predicting them. When he was chief economist of the International Monetary Fund, Rajan was a prescient critic of a finance-fuelled credit boom, warning of "hidden tail risks" as early as 2005. His first task as India's new central bank governor will be to avert the country's looming currency crisis.
The rupee is in free fall. It touched a record low against the dollar on August 6, just before the government announced that Rajan, currently chief economic adviser to the finance ministry, will replace Reserve Bank of India (RBI) chief Duvvuri Subbarao when his term ends on September 4.
Rajan's first challenge will be to quickly reverse the RBI's present strategy for defending the currency. In an effort to give investors in short-term rupee debt an incentive to keep their money in India, the RBI in July engineered an increase in money-market interest rates and forced a liquidity squeeze. But those moves have raised the risks of a "vicious slowdown" in the economy, according to Morgan Stanley economist Chetan Ahya.
There's more at stake, though, than a few quarters of sub 5-percent GDP growth. The ongoing mini-currency crisis could turn into a credit catastrophe if private borrowing costs start rising again. Construction, power and telecom companies as well as operators of infrastructure projects like airports and expressways are already highly indebted, according to research by Nomura economist Sonal Varma. Corporate distress and rising bad loans in an undercapitalized, state-dominated banking system make for a toxic cocktail.
So how will Rajan avert a disaster? His stance is pro-growth, says a person who attended a meeting between him and private-sector economists four days before the RBI launched its growth-busting emergency measures. But in order to lower domestic interest rates at a time when U.S. real rates are rising, Rajan will either need to introduce capital controls - as Malaysia did in 1998 - or win the confidence of global investors in India's growth revival plan. Rajan has strong credentials, and a winsome personality. What he doesn't have is time.
- India appointed former International Monetary Fund chief economist Raghuram Rajan as head of its central bank on August 6. Rajan gained fame with a 2005 paper warning that financial sector developments could trigger an economic crisis.
- Current head Duwuri Subbarao will end his five-year tenure on September 4.
- The rupee is down nearly 11 percent in 2013, making it the worst-performing currency in emerging Asia. The rupee stood at 60.78 against the dollar at 1:30p.m. on August 7.