World's Top-Performing Economy Suffers Central Bank Shock

 | Jun 20, 2016 | 8:00 AM EDT
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The first thing Asia traders had to get their head around on Monday was that the outspoken, but well-respected chief of the Reserve Bank of India will be stepping down.

Raghuram Rajan said he wouldn't re-up when his term expires on Sept. 4. The reform-minded central banker will be heading back to the University of Chicago, saying he was returning to his "ultimate home in the realm of ideas." 

India has posted remarkable economic growth of late. It is the top-performing major economy on the planet. Will Rajan's sudden move disrupt that?

Rajan, the former chief economist at the International Monetary Fund (IMF), felt undercut by a lack of support from Prime Minister Narendra Modi and Finance Minister Arun Jaitley, according to Reuters. Without warning, he sent a letter to staff on Saturday announcing he would step down.

He was reportedly going to have to fight for an extension to his post among a field of candidates, essentially forcing him to reapply to his own job, which he felt belittled his position. It would have been quite an insult, since RBI governors are normally granted at least a two-year extension, no questions asked. He's the first governor since 1992 not to sit for a second term. 

The markets were expecting him to stay on for a second three-year term. Rajan has been a bit of a darling for international investors, many of whom have long steered clear of a market they felt was too tough to predict because of heavy-handed government regulation. 

The gossip is that Modi felt that Rajan had too high an international profile, stealing the limelight from the PM. The departure of one of the most-admired members of the administration certainly raises questions about Modi's ability to turn fiery rhetoric into action.

Rajan predicted the global financial crisis three years before it occurred, to much amazement among leading bankers and economists. At the RBI, he launched broadsides at India Inc. and its "crony capitalism" -- making enough enemies that it has finally cost him his job. 

Member of parliament Subramanian Swamy, who is part of the ruling party, said he "certainly wanted him out" and had told Modi as much. "His audience was essentially Western, and his audience in India was transplanted Westernized society," he said, according to The New York Times. "People used to come in delegations to my house to urge me to do something about it." He thinks Indian industrialists will be rubbing their hands with glee. 

Rajan's departure strikes a blow to those who would like to see a notoriously bureaucratic country shed some of its infamous red tape. When he took office in September 2013, Rajan said he didn't expect to get a lot of Facebook "likes" for his steps to shake up the Indian economy.

Labor-market reforms and scrapping bottlenecks on building much-needed infrastructure, especially in power generation, are top of the list. Sadly, India has shown little interest in containing greenhouse gases, so that will normally involve coal-fired plants, meaning its 5.8% share of global greenhouse-gas emissions is only set to climb. 

None of the candidates to succeed him carry the same weighty reputation as Rajan. A few former RBI deputy governors, finance secretaries and economic advisers are in the running -- stablishment players that may show little of Rajan's fire for change.

India gets far fewer headlines than its fellow Asia heavyweight, China. Yet at 7.5% for this year and next, according to projections from the IMF, its growth is running a full percentage point higher than the Middle Kingdom. It also happens to be the best rate of growth in the world for a major economy -- only Bhutan and Burma outstrip it.

Indian markets shook off the shock of the central-banker's resignation, although investors will likely remain jittery until the replacement is named. The iShares India ETF (HK:2836) gained 1.1% in Hong Kong trade on Monday, while its counterpart in Singapore, the iShares MSCI India Index ETF (SGX:I98) rose 1.0%. Similarly, the Sensex, the main index of Indian stocks, was up 0.9% in late-afternoon trade.

Rajan was dubbed a "rock-star economist" in the press. More than one observer joked he had put the "sex" back in the Sensex after taking office and arresting the rupee's freefall. 

U.S investors can play the Indian market via listings such as the iShares MSCI India ETF (INDA) or the WisdomTree India Earnings Fund (EPI). There are even esoteric products such as the VanEck Vectors India Small-Cap Index ETF (SCIF) or, if you want to go all in, the Direxion Daily India Bull 3x Shares ETF (INDL).

It is the Indian currency that has suffered most as a result of Rajan's resignation. It fell 0.9% when trading began on Monday, exacerbating its massive slide since May 2014, although it cut that loss to 0.6% in the Asian afternoon. The rupee lost 20% in the year before Rajan took office. It is the worst performing Asian currency at a time that emerging currencies have been hammered.

Under Rajan, the rupee lost only 5% against the U.S. dollar, impressive given the strength of the greenback. Nomura expects the rupee to underperform Asian currencies temporarily. But if a credible successor is appointed quickly, the rupee would then rally and give a good reason to go long the currency. Worth watching. 

The currency gives plenty of reason to steer clear of Indian equities, unless accessing them through a currency-hedged product. But with India's fast pace of growth, the rupee should eventually come under control and even change direction.

Having posted inflation of around 10% in the years immediately after the global financial crisis, India has brought it down to 5.3% under Rajan, in line with its historical average. The pressure to curb inflation should continue. "We do not believe monetary policy can turn a blind eye to inflation, irrespective of who the RBI governor is," Nomura's economics and currencies analysts wrote in a note on the transition. 

In announcing his departure, Rajan cited as his key accomplishments the move to inflation targeting, the stabilization of the currency, and an increase in foreign-currency reserves. He forced Indian banks to recognize their bad debts, which didn't go down well with bankers but will be positive for the sector in the long term.

While there's little that will likely hit India's growth in the near term, it is now an open question as to whether the world's largest democracy will swallow the bitter medicine that its economy needs to get better for good. 

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