Dr Subbarao's first challenge

It is curious that not many in the media have started referring to the new RBI chief as Dr Subbarao, whereas his predecessor was always referred to as Dr Reddy. It is not that the media is unaware of Dr Subbarao's doctorate in economics from Andhra University; almost all his profiles have included that fact.

Or is it it is because he is a career bureaucrat and is not yet being seen as an economist, which most central bank chiefs are thought to be, and hence worthy of being addressed as Dr Subbarao.

Therein lies the new governor's first challenge. The early reactions from many economists and industrialists to the news of his appointment were like, "there will be better coordination between the finance ministry and the RBI". That is a not too subtle reference to Dr Reddy's differences with the government over monetary policy.

Dr Reddy was widely perceived as a hawk when it came to inflation control. One commentator said he was more of a Trichet type than a Bernanke type, rather unwilling to accommodate short-term market and political demands to protect long term monetary stability. Though Dr Reddy's early cautiousness on inflation eventually proved to be prescient, many commentators still blame him for hiking rates too soon and causing the current growth slowdown.

We may never know why the government chose Dr Subbarao over Rakesh Mohan to head the RBI. The latter, a RBI deputy governor for many years who has also served in the finance ministry, was seen as the frontrunner for governorship because of his wider experience as a central banker. If the government wanted continuity in policies, Rakesh Mohan was the obvious choice.

The fact that it has chosen to bring in Dr Subbarao may indicate that the government wants a change in policy direction, more in line with the finance minister's preference for protecting growth. At least the equity market seems to believe that is the case, if the big rally in interest-rate sensitive stocks after the new governor's appointment is any indication.

It is indeed true that the RBI is not a fully independent policy authority and often has to accommodate the wishes of the government of the day, even if they are contrary to the central bank's own judgement. We have even seen attempts by the government to blunt the RBI's policy initiatives, like the present finance minister's repeated directives to PSU bank chiefs to hold lending rates when the central bank had hiked its key rates. But, that is hardly the ideal scenario.

If it is to be effective and taken seriously, the RBI must be seen as independent and not easily swayed by the diktats of mandarins in Delhi. As one newspaper editorial put it, "the RBI is a rare institution whose independence has been painstakingly built over the years by a long line of illustrious governors despite the bank not being independent in law". The RBI should not be seen as the finance ministry's branch office in Mumbai. Dr Subbarao starts with a handicap on that front.

Leading the war on inflation
Framing monetary policy is widely perceived to be an activity driven by philosophy. Very often the policy responses of central banks depend on the theoretical convictions of the governors and chairmen as far as economic philosophy is concerned. As policies should ideally run ahead and should not always wait for hard data, they are deemed to depend on the instincts and convictions of the person heading the central bank. Though policy decisions are almost always taken by committees, the central bank head invariably set the policy direction.

So, what kind of a central banker will Dr Subbarao turn out to be? Will he be a classical monetarist who will always give preference to fighting inflation? Or will he be a more market-friendly governor than his predecessor was perceived to be? It is difficult to tell, because not much is known about the new governor's convictions or instincts as career bureaucrats are rarely required to reveal them. Before his last stint at the finance ministry, he was away in Washington as the lead economist of the World Bank. In other words, he is kind of a closed book as far monetary policy inclinations are concerned.

In one of the recent interviews as finance secretary, Dr Subbarao said "inflation is beyond tolerance levels". He also said, "managing the growth-inflation trade-off is a tough call and that monetary tightening will compromise growth is an obvious concern". That is neither here, nor there. The quintessential bureaucrat?

But, the RBI under Dr Subbarao cannot afford to go soft on inflation. At least not yet. It is true that oil prices have come down and most analysts are busy writing the obituary of the "great commodities bull run". Unless oil prices halve from the present levels which will enable retail fuel prices to be cut, inflation will remain in double digits in the near term. While it may fall to high single digits by the end of this financial year and could be even lower same time next year, it is still too early to lower the guard.

One worrying factor is, like many others, Dr Subbarao also seem to believe that much of the inflationary pressures in India are "imported" in the sense they are mostly because of global factors like higher commodity prices over which domestic policy makers have no control. They conveniently forget that domestic prices are shielded to a large extent through heavy subsidies. When that is the case, placing the blame for inflation on imported factors can bring in a sense of complacency in policy making which can potentially be dangerous.

And lead the financial services sector reforms
It is only expected that most of the debate about the new governor's likely path is limited to monetary policy, since inflation is the biggest concern these days. But, the RBI performs another significant role as the financial sector regulator. If there is no change in the already announced road map, Dr Subbarao will usher in probably the biggest ever reforms in the Indian financial services sector next year. His legacy as governor may eventually be judged more on his performance as a regulator, than his inflation fighting or other monetary policy credentials.

The RBI is the regulator of all kind of financial institutions, from large PSU banks to single-branch foreign banks, from cooperative banks to shady nidhi companies. The role of a regulator is not easy even in the best of times and it is all the more difficult in a diverse economy like ours, especially when the global financial services industry is undergoing unprecedented turmoil.

Next year will see the country's banking sector being opened up to foreign investors, if the RBI and the new government do not change their minds by then. It is quite possible that we will see significant consolidation in the industry, with PSU banks merging with one another and foreign banks acquiring even large private Indian banks. Some of the global banks which are now active only in consumer finance will seek full banking licenses.

These dramatic changes will open up a phase of serious challenges for the smaller banks, regional banks and the cooperative banks. The RBI will have its job cut out to ensure that the smaller banks remain solvent as competition intensifies. The regulator will have to be judicious in allowing new entrants to open up branches and ensure that the consolidation process does not cause large scale disruptions in the sector.

There is also the unfinished task of winding up parallel banking networks called NBFC's. As repeatedly shown in the past, these networks place huge financial assets in the hands of few and are not supervised as they should be. As Dr Reddy's attempts to bring improved regulatory oversight over one such NBFC, Sahara India, shows, this will be not be an easy task.

Then there is the bigger question of whether the RBI should in fact take the burden of financial sector regulation. Global practices vary from country to country. The US Fed is also the banking regulator, but the Bank of England has no such role and the financial services industry in UK is supervised by the FSA. This is a debate that will continue for a while, but the ultimate decision will depend on Dr Subbarao's performance as a financial sector reformer and regulator over the next few years.

There is no doubt that Dr Subbarao is taking over as RBI governor in an environment which most of his illustrious predecessors would have found extremely challenging. He has to first establish his policy independence, then prove his inflation fighting credentials and then go on to manage transformational reforms for the financial services industry. Will that be too much of an ask for a man with no experience as a central banker? Let's hope not.