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Raghuram Rajan decodes impact of Ukraine Russia war on global economy

economy | Mar 8, 2022 10:39 PM IST

Raghuram Rajan decodes impact of Ukraine-Russia war on global economy

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Financial markets remain on edge due to sanctions on Russia and resultant supply disruptions in many commodities. More generally, every central bank and government is fighting challenges to inflation and growth because of high crude oil and energy prices. To get a perspective on how to think about the economic problems the world and India may face, CNBC-TV18 spoke to Raghuram Rajan, Former Governor of Reserve Bank of India.

Financial markets remain on edge due to sanctions on Russia and resultant supply disruptions in many commodities. LME had to suspend trading in Nickel as its prices trebled to $100,000 resulting in potential defaults.

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More generally, every central bank and government is fighting challenges to inflation and growth because of high crude oil and energy prices. To get a perspective on how to think about the economic problems the world and India may face, CNBC-TV18 spoke to Raghuram Rajan, former Governor of Reserve Bank of India.
Below is the verbatim transcript of the interview.
Q: Should we think of this inflation as a temporary blip which will smooth out when the war ends or is this likely to persist?
A: This is coming on top of a already high level of inflation in many parts of the world. So when you add the additional effects of war, it gives greater weight to inflation.
Inflation was already becoming more persistent certainly in the United States but also in Europe and with the additional boost to inflation from the war and from the shortages of commodities etc, there is a risk that inflationary expectations will become more entrenched and the fight against inflation will take longer. So this is not good news for inflation by any means and it will stay higher for longer.
Q: The bigger problem looks like the sanctions may stick now. Some experts are pointing out on the channel that sanctions against Iran, Korea, and even the controls imposed by President Trump on China did not go away when Biden came in. So sanctions tend to stay therefore, can this be a structurally much longer inflation?
A: Yes, and I will offer a qualified no also. Certainly the unprecedented nature of the attack on Ukraine has galvanised the western world along with Japan. And so I think they are very serious about sanctions. This is a violation of any notion of the world order, and therefore, it has to be pushed back on. So they are much more determined to implement the sanctions and prevent leakages. So that's on the yes side.
On the no side, given the kind of damage this could do to the global economy -- Russia being a huge exporter of certainly energy, but also of critical commodities such as nickel, palladium, neon, xenon, fertilisers and grains -- I think there is a sense that the damage, has to be limited by energising other sources of supply.
So on the oil front for example, we have talks going on with Venezuela, and certainly with Iran in an attempt to bring Iran's oil back with an Iran oil deal. And of course, shale, which has been very, very circumspect on production because they didn't want to invest too much, shale will also come back. So over a few months, the supply side will also start responding to the high prices, even as demand starts falling because of the high prices.
Q: But Jerome Powell's submission was that the US inflation has a huge labour wage price spiral. He said he would stick to his guns on raising rates. However the minutes of the RBI's MPC in India, clearly seem to suggest that this is supply-driven, and therefore we should not respond with interest rates, and that inflation will pass. Do you think the latter is a proper explanation for India? Or do you think we are in danger of violating the inflation-targeting framework?
A: Typically, short term supply disruptions you can look through. If the supply disruptions are longer term, then you have to react to them, because it's suggesting the supply potential of your economy has shrunk, and therefore it can support a less demand without inflationary consequences.
So while I do think the issue of demand in India is still up in the air, with the sort of the damage done to small and medium enterprises, the damage done to households, the lack of jobs, we don't have rip roaring demand except with the upper middle class with their sort of pent up savings, but nevertheless, if in fact, supply is also being damaged, that has to feed into your inflation considerations and your inflation outlook. So I think it's a more complicated situation than saying, we simply don't react to supply constraints. So it depends on the nature of the supply constraints, where they are binding, and whether in fact they hit against inflation.
Q: But the basic argument that if you keep on saying it's because of supply, then inflation targeting could go out of the window, isn't it?
A: I think it is very important for any central bank to respect its mandate. India has a mandate, India's central bank has a mandate, which has served it well, in the sense of allowing it to react to some of the concerns during the pandemic, without raising rates, having moderate inflation. And like every other central bank, as we come out of it and face new challenges, we have to recalibrate and ask whether the old playbook sort still holds. And I think that's extremely important. Because otherwise, if you lose the battle against inflation, it serves neither the government nor the RBI.
Q: Let me stick to the big problem that's facing the world and India. How much can you snap these linkages with a large country like Russia? North Korea was done in another age before globalisation and it was a small country. Now, there are too many linkages. So do you think there can even be defaults -- financial instability?
A: So it is important to look at Russia's magnitude. It's about 1.5 percent of global GDP. And so it's not a huge player in that sense, even though its military might is significantly larger than its economic might.
I think what is important for Russia is the key part it plays in various supply chains, especially some of the supply chains, which have very low buffers right now, and which are already stressed. So for example, there's a lot of Russian inputs into the production of semiconductors. And semiconductors, we know are already stressed. They have a few months of supply, but if this lasts longer, elements like palladium, platinum, xenon, neon, those come into play, and, and so it does have an impact on global production.
So the real point is not so much Russia's size, but the role it plays in almost every supply chain because of its extensive production of commodities. And this is where every firm will have to scramble at this point to see where else can it get the commodities from.
In the medium run, I think certainly on the energy side, this is a good wake up call for the world that we are overly dependent on carbon energy and we have to sort of back off from it. There will be a greater push for renewables, etc, but in the short run, it certainly implies a lot more pain.
Q: I was speaking about defaults in the more trading and MSME and banking sense as well. LME nickel prices went to USD 100,000 and we heard that some parties which had gone short, probably defaulted, there could be that and there could also be financial entities, which are not getting paid. So can they be slightly largish domino effect?
A: So, clearly, we have had an extreme degree of market volatility in the last few days, actually ever since the turn of the year. And market volatility, if it falls on levered players does have effects. We know that there are some people who are sitting unhedged, there are some people with lots of exposures, and these come to light in a period of high market volatility. So almost surely, yes, there will be defaults. But if you look at the overall exposure of the world financially to Russia, again, it is moderate. If you look at the European banks, it's about 100 billion in exposure to Russian financial institutions. If you look at Russian dollar bonds, again, it's not huge. But we do know from the subprime crisis, it's not just the matter of the size of the problem of the default that matters, but also where it is located. And that's the bigger unknown -- who is exposed? If it is large banks with limited capital, that's a bigger problem than if it is some kind of a pension fund, which can absorb the losses. So the big unknown is where these losses are going to hit. Almost surely there will be losses. But at this point, I think it's too early to panic on the notion that there's going to be widespread problems across the financial system.
Q: Let me come to the most important question I wanted to ask you, these impounding of large amount of reserves of a large central bank. I mean, if you were sitting in Mint Street in Mumbai, or in the PBoC, how would you react? You also are sitting with 600 billion reserves, or probably 2 trillion in PBoC.
A: It is an issue. It is a concerning issue. I think as we come out from this crisis, we will have to develop rules of the game and it will be in the interests of the euro area as well as the United States to participate in developing those rules. The reality is that the old world order is broken. The United Nations is impotent in this crisis, simply because Russia has exercised its veto, and given that, the attempt to build up sanctions has gone around any kind of legitimate structure to a preponderance. The majority of the world thinks this is a wrong act and wants to act but has been stymied because the United Nations still reflects the post war sort of compromise.
So I do think we need a new world order. But the first step in that would be to allow for the possibility of sanctions even against large players, if a sufficient size sort of mandates it and then that becomes a legitimate sanction. But that also prevents you from arbitrarily having a pet hate -- I dislike such and such country because it irritated me for this reason or that reason or I have a border dispute with it, and therefore, we are going to apply sanctions. So it brings more of a rule of law into this process. And I think almost surely we will have to do something like that to reassure countries that the reserves that they rely on will not arbitrarily be taken away. So, yes, this is an important weapon. I think that given the magnitude of the action, it is certainly worth using, but I think we will have to sort of put some rules in place once the crisis is over.
Q: Now, the PBoC is sitting with over USD 2 trillion of reserves and Reserve Bank of India is with USD 630 billion, would you not worry that you want to diversify into something else? How would you have exercised? How do you think they will think about this problem? And more importantly, do you think they will also look at different ways of getting and receiving payments? Like, the BIS is experimenting with some kind of a digital payment between central banks, where you don't go through payment systems and settlements in the US, you think all these are going to be explored a lot more?
A: I think they will. But let's first say that hopefully, India is different from Russia, and we don't plan to attack a neighbour in an unwarranted fashion. Given that, I think that we certainly should have more confidence that the international system will not turn against us. But I think you are absolutely right, that there will be questions about how safe reserves are. And, there aren't that many alternatives. What are you going to do - invest in Brazilian Real or Turkish Lira?
Q: Gold, perhaps?
A: How are you going to sell the gold? I mean, we had an experience selling gold in the early 1990s, right? You actually have to move the physical bullion somewhere, you could hold gold ETFs, but then you are reliant on the ETF being functional and not being prohibited.
So there are some physical assets, but they do require sort of storage and movement. And that too is very complicated. So I really think that we will have to develop systems post this crisis so that people regain confidence that their central bank reserve holdings in other countries will be safe, unless they violate every sort of international norm.
I think certainly China will press for it, certainly India will press for it and hopefully, we will get action because the west will also want to do it.
On the issue of digital currencies, I think the problem is not so much that the payment routes can be disrupted. The problem is that if you do any business as a bank, with the United States, you can be sanctioned. And a lot of banks have very important business in the United States, they want to participate in New York markets and if they are excluded, it's really the kiss of death.
So for example, in India, when we did business with Iran, under sanctions, with sort of the acquiescence of the US, we had one bank, which didn't have much business elsewhere doing business with Iran. And that sort of make do is what many countries will have to resort to because the main banks will not be able to deal with the sanction country if there's a threat that their western operations will be affected.
So it's not so much the flow through SWIFT, that does create a certain amount of friction, but it is also the fact that you are do doing business with a sanctioned entity, which is very easily sort of identified. And then there's a threat of further penalties, both financial through the legal system, but also stopping you doing business in Europe, United States.
Q: That was my question, every entity today in India or abroad, is looking behind their shoulder to read the rule. Am I doing something which is sanctionable? This is hegemonic. I mean, it almost borders on bullying. So do you think that reaction to it can come? Or do you think the world will believe that this is a heinous crime that Russia is perpetrating? Will it change behaviour permanently?
A: I think that there has been some frustration with the sanctions regime, which is so amorphous and what are the safe harbours etc, there's been some concern for some time. At the same time, I think you would argue that there are certain actions, which do deserve a reaction short of actual conflict. And so the question is, how do we limit those sanctions to the really heinous actions, rather than every time I dislike a government that emerges, I impose sanctions on it. So, we need a more systematic procedure which probably should be multilateral, which should probably be as de-politicised as this can be and that is what we need to work towards rather than saying, this is broken etc. We really have a world with, on the one hand, extremely weak multilateral options and on the other hand, fairly strong unilateral options, and we need to find something in between.
Q: Now, let me come to the more important India questions. What's your worry about the India growth story now? There is an impact because global trade will decline, there is a much bigger impact because of the huge terms of trade, which will be against us. Crude, perhaps, we thought would be USD 80 when we do our GDP and budget forecasts, and now probably USD 100 or USD 120. What implications?
A: A huge negative. We benefited from the low crude prices from 2014 onwards and now it is payback time. The reality is that our growth performance has been poor for quite some time. The government keeps throwing this that against it, but we haven't really had a strong recovery, ever since the 2016 demonetisation. So I do think that this hopefully, will create some fresh introspection - what is it that we need to do in order to re energise the Indian economy?
There are bright spots, let us not forget our service exports are doing extremely well, at this point. The IT sector, for example, I am told by my friends in the IT sector, it's extremely hard to find people because we are we are running full tilt.
At the same time, look at those medical students in Ukraine, why did they have to leave India to get a medical degree, especially a degree in a foreign country with an emphasis on foreign diseases, which is going to be hard to translate into working back in India. So, why are we exporting our human capital in such a big way? Could we not retain more of that human capital in India? I am not saying it's a bad thing, but I am saying it reflects the fact that we trained up these people and we are not able to use them. I think we should focus on what our strengths are, and enhance them as we go forward.
The playbook that we have used over the last, I would say almost a decade is proving to be subpar. Just look at the enormous number of people looking for jobs. I mean, we are really underperforming and I think we should recognise that.
Q: I did read a couple of your pieces on this emphasis on manufacturing, you think PLI and schemes like that will not bring home the beacon, we have to remodel the growth path?
A: I would love to see a careful analysis of PLI. And thus far I haven't seen a careful analysis. What is PLI? On one hand we elevate tariffs for the production of certain items and on the other hand we give production subsidies. And, manufacturers love this because it looks like the old licence permit raj again, they get protection and they get subsidies and they go out and produce stuff.
The whole issue is, if you remove the tariffs, if you remove the subsidies, can they stand independently? Or are we in a permanent situation of subsidising manufacturing and essentially using taxpayer money to produce? We don't know. And I would say that the sort of message from the old licence permit raj is the manufacturers will try to do their level best to try and keep the subsidies going and the protection going.
Already now you hear some manufacturers saying, we had two years of COVID, that wasn't a time when we could benefit from the PLI scheme, so extend it. So there will be enormous pressure to extend it indefinitely.
Second, the real problem in our economy now is a damaged small and medium sector. They are not big beneficiaries of the PLI. PLI is going towards the bigger firms, the well connected firms. And there is an implicit sort of benefit to scale as the government chooses the beneficiaries.
So the question we have to ask is, why do our biggest entities have to be subsidised? Don't they have the scale to make it on their own? And the argument is the old one, we have poor infrastructure, we don't have skills, we don't have this, we don't have that and therefore they have to be subsidised. But those aren't going to change in the next two or three years. Work on improving your capacities, rather than protection seems to me the way to go.
My fear is we are going to be locked in to protection for much longer. And of course, every protection demands a new protection, we can't compete in cars because you have elevated the price of steel, therefore, let's protect ourselves in cars. I mean, this is endless. So I just think we are going down an old path, which was a failed path. We have rebranded it and I fear the same outcome.
Q: You mentioned in your piece that this money perhaps should be spent on services rather than manufacturing, and perhaps on education.
A: Let me give you a quick example, any chip factory worth its name, which is going to be globally competitive, will require an investment of USD 10-20 billion at the minimum, that's what Intel is talking about. Think about how many universities USD 10-20 billion would create for India - top class universities with top class engineers and scientists and think of how much software how much chip design they could do without building the chip? Do we really need to start building chips, when in fact, what we should be sort of doing is assuring ourselves of chip supply, maybe doing deals with the US maybe doing deals with Taiwan and so on, but at the same time, enhancing our capacity on our strengths, which is our minds, our software engineers rather than rebuild the hardware. We have a fixation with hardware, with assets, which is old and to my mind dated now.
Q: Do you think we should worry about high fiscal and current account deficit? This crude is going to take us to 3.5 percent current account deficit?
A: I think both are a concern. So the three sort of problems -- inflation, current account deficit and fiscal deficit. So this is a time of extremely careful management, we do need to manage. We have the capacity to do it. But it has to be extremely carefully done. It is a time when certainly we should re-energise some of the asset sales that don't show up in the budget, but is something that would help if done carefully, alleviate some of the budget stress but I also think we need to think about the priorities in our budget. I think the damage done to our school children needs to be remedied otherwise, our long term future is at stake. So reprioritize the spending also in such a way that we use the resources as carefully as we can, looking to the future.
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