This is the first part of a two-part series outlining the nature of macroeconomic and financial challenges in front of the new RBI governor, Sanjay Malhotra.
The sudden, less-expected appointment of Sanjay Malhotra as the new Reserve Bank of India (RBI) governor comes at a critical time for the governing dynamics of the Indian economy, which is currently grappling with structural challenges of increasing growth, a need to keep inflation in check, and creating good jobs., while allowing non-performing assets and credit flows to essential job creating sectors.
Each of these challenges remain central to the RBI’s mandate of balancing growth needs with inflationary pressures, while also working closely with the Union Ministry of Finance. The sudden transition in this monetary policy-anchoring institution’s leadership has the market and its investors a little tense. Especially as the new governor’s stance on either of these areas or critical policy issues is not very clear nor publicly known yet.
With Shaktikanta Das’s exit after a long six-year term – the longest for any RBI governor in the post-liberalisation era – what is needed (and perhaps) expected is a renewed focus on tackling critical economic issues, and driving a sustained growth-focused agenda which will have far-reaching implications in safeguarding monetary and fiscal policy flexibilities.
On the surface, the macroeconomic challenges facing the new governor are not just multifaceted but deeply entwined.
India’s economy, recovering to a normalised growth trend which is yet quite suboptimal, after the pandemic’s up-and-down volatile aftermath, is now contending with inflationary pressures driven by both global headwinds and domestic structural issues, which has kept food inflation continuously high.
Latest quarterly growth numbers add to the worry. The chart below reveals interesting data points (between trends of Consumer Price Index and growth rate over the last three years).
Source: Author’s Deductions from Trading Economics
While growth is collapsing across quarters, slowly but surely, some might say that the trend on growth is normalising now to a lower benchmark point, after the volatile disruption witnessed during pre-post pandemic terms. Inflation, measured via CPI, has continued to grow, which is what made Malhotra’s predecessor more hawkish on his monetary policy outlook.
Some, including us, may sympathise with his hawkish stance since India’s CPI trend has been troubleshooting at a precariously high mark (anchored by a high food inflation level) and yet, most monetary policy interventions hardly helped in reducing it (if not increasing it further). A loose monetary policy, if Malhotra chooses to pursue it, may further accentuate the inflation issue, with or without accompanying growth since the use of traditional monetary policy tools do not proportionately drive growth in low private investment cycles.
At the same time, an imperative to reduce monetary policy interest rates, or reduce the cost of borrowing for creating additional credit supply in the economy (at the obvious risk of further inflation) to accelerate economic growth remains strong, especially how sluggish domestic consumption demand is, and how weak domestic and foreign private investment growth has been under the Modi regime. This, for worse, has been combined with accentuated issues of a jobless form of growth which continues to see an uncomfortably high youth unemployment rate, all of which, present major hurdles for the government and the RBI.
Addressing and proportionately balancing these competing priorities will both, define the new governor’s term and test the efficacy of the institution’s policy toolkit.
On inflation
Inflation has been a persistent concern, with supply-side shocks such as rising food and energy prices exacerbating the problem. Inefficiencies in agricultural supply chains and India’s dependence on imports for critical commodities further complicate the situation. On the growth front, the economy faces challenges from weak global demand and disruptions in supply chains, compounded by high interest rates that have tightened credit availability.
Adding to these complexities is the evolving relationship between the RBI and the Ministry of Finance. Over the years, the government’s dependence on the central bank for financing fiscal deficits has increased significantly. This growing reliance raises questions about the RBI’s autonomy, as its monetary policy decisions are often influenced by the fiscal needs of the government.
Shaktikanta Das was, in much of the last six years, involved in ensuring this, while contributing to a ballooning government debt-to-GDP level. Such “fiscal dominance” at the risk of debt expansion and monetary policy risks could undermine the RBI’s primary mandate of maintaining price-exchange rate stability, essential for controlling inflation and maintaining a stable Rupee.
The finance ministry’s borrowing needs have remained high due to sustained fiscal deficits and high government spending needs (on capex not welfare). The RBI’s role in supporting this borrowing through market interventions and direct lending has been critical, but it also creates potential friction.
Differences in priorities between the RBI’s inflation-targeting focus and the ministry’s growth-oriented agenda could lead to disagreements – Das managed this well and Malhotra too as a government pick may toe the ministry line which will impact the autonomous, independent functioning of the RBI affecting the nature of choices and decisions it makes. Moreover, the challenge of managing liquidity to accommodate fiscal needs without fuelling inflation will test the economy and the consequential, coordinative relationship between the two institutions.
On MPC’s own functional role
As the new governor takes charge, changes in the functioning of the Monetary Policy Committee (MPC) are also anticipated. The MPC, responsible for setting interest rates, usually adopts a cautious, data-driven approach before taking any drastic measures.
Inflation targeting will remain a key priority, with efforts to anchor inflation expectations through timely interventions. Liquidity management is also likely to gain prominence, with tools like Open Market Operations and Variable Reverse Repo Rate auctions being utilised to maintain financial stability.
Interest rate policy is expected to strike a delicate balance between controlling inflation and supporting economic growth. The Governor’s strategy may also include measures to improve essential credit flow to key sectors such as agriculture and micro, small, and medium enterprises (MSMEs), which since demonetisation days, has adversely been affected for cash-credit needs. MSME’s growth and expansion, which is also critical for employment generation, needs also require the utmost priority of the public banking landscape with a strong nudge needed from the RBI.
Additionally, there could be a push for greater financial inclusion through the expansion of digital banking and fintech solutions. In alignment with global trends, the promotion of sustainable investments through green financing initiatives might also emerge as a focus area for the governor.
On fiscal policy-monetary policy coordination
The finance ministry’s fiscal policy will play a complementary role in addressing India’s economic challenges. Fiscal consolidation is expected to feature prominently, with efforts to mobilise revenue through increased tax compliance and asset monetisation.
Rationalising expenditure by prioritising capital investments over subsidies could help contain the fiscal deficit, in the government’s view. Simultaneously, growth-oriented measures such as massive capital-induced infrastructure development under the National Infrastructure Pipeline and incentives for manufacturing and exports are likely to continue, which so far, have yielded mixed results, and primary contribute to a government spending fuelled low-growth cycle.
Social welfare initiatives also remain central to fiscal policy, with programs aimed at boosting rural demand through direct benefit transfers and employment schemes. The ministry and the RBI will need to collaborate closely to ensure that fiscal and monetary policies are aligned, particularly in managing inflation and liquidity. Debt management strategies to reduce borrowing costs and enhance market confidence will be another area of joint focus.
The impact of these policy measures on the Indian economy may only unfold in phases. Traditional monetary policy tools tend to have a limited and direct effect in shaping, yielding intended or unintended outcomes. In the short term, a cautious monetary policy stance could moderate growth while bringing inflation under control. Improved coordination between monetary and fiscal authorities is expected to stabilise markets and bolster investor confidence. Over the long term, structural reforms and prudent policymaking will pave the way for sustainable and inclusive growth.
Effective management of growth-inflation dynamics will also enhance India’s resilience to global economic shocks and solidify its position as an attractive destination for investment. As the new RBI governor begins his tenure, the stakes and responsibilities for him to perform remain high, and the decisions made by his office and through his consultative interventions in the coming months will have far-reaching implications for the economy’s future, which remains in a highly uncertain, mysterious zone now.
Part two looks more closely at the NPA issue, which despite reducing volume and increasing write offs, has a sectoral problem.
Deepanshu Mohan is a professor of economics, dean, IDEAS, and director, Centre for New Economics Studies. He is a visiting professor at the London School of Economics and an academic visiting fellow at AMES at the University of Oxford.
Aryan Govindakrishnan is a senior research analyst with Centre for New Economics Studies (CNES), O.P. Jindal Global University.