Game not over for banking crisis, have to wait and watch, says Raghuram Rajan

And the second is many of them have a lot of uninsured depositors and the toxic combination of these two asset values having fallen and uninsured depositors getting very anxious is what led to Silicon Valley Bank's failure. And what is being attempted now is to reassure both sides. On the one side, you can borrow against the full value of your assets, and on the liability side, don't run, we have got you covered.

So hopefully, that should be enough to quell concerns. Of course, you know, banking panics are things that happen. And you know, if I was a large deposit and a small bank, I might still say, 'Look, I don't really want to be dependent on the government, let me take my money to a money center bank, like JPMorgan or Citibank', and that might continue, the slow run may continue. So, that, the Fed has to watch and see what's going on.

Q: So this raises two questions I mean, before I come to the other banking crisis, which seems to be spreading. Only for the US itself, doesn't it create a moral hazard issue? One, because you are kind of forgiving recklessness and thoughtlessness on the part of the banks and two all this is easing the financial system. It is easing credit to that extent, it will dull the Fed's inflation fighting credentials, doesn't it?

A: It does, it puts the Fed in a tight spot. Certainly moral hazard is an issue. Partly these large depositors should have paid attention to the credit quality of the banks they were investing in. And of course, a lot of people say, 'Oh, don't worry about moral hazard right now, we will worry about it down the line'. The problem is that you will rarely spend time thinking about it down the line once the crisis is over.

We certainly need to ask why this happened, what were the supervisory lapses that led to Silicon Valley Bank holding such large assets in long-term bond portfolios. They were taking enormous duration risks and that's something any supervisor would question as they go into a bank. So those questions will have to be asked, and remedies found. The reason you bailed out Silicon Valley Bank — and I will use the word bailout — is that there's a fear that the contagion would spread to other small and medium banks which have similar problems. So the real question is so why do all these banks have this kind of problem? Were we not paying enough attention on the duration mismatch in their portfolios? So that's one.

The second, of course, is the Fed is in a tough situation. The CPI report that came out yesterday is not a comfortable one. Core inflation in the US is still growing strongly, inflation has come down, but that was, in a sense, the easy part, the supply chains, rectifying and so on. The tough part now comes bringing it down to the 2 percent, 2.5 percent that the Fed will feel comfortable with. And that's where, it's really overly strong.

Now, the Fed will hope, perhaps that some of this financial sector concern will slow the economy. But that's not the way it wants the economy to slow. It wants demand to come off, for good reasons, rather than because of fear. So I think if the Fed sees that the financial sector stabilizes, it may still go with a 25 basis point hike, I think 50 is off the table. And the reason for that is to just say it hasn't paused or it will do zero, but again, make the statement that it hasn't paused, it is just taking a little bit of time getting to where it wants to.

My sense is 25 basis points if the financial markets calm down, but it is in a tough place.

Q: You are saying 25 if the financial markets calm down, but now we have a new problem. Credit Suisse not finding any investor for its brave plan to overcome its compliance and risk issues. So if this persists, do you think the banking contagion will raise its head yet again? Actually, Dr. Rajan, let me read out to you what Nouriel Roubini has tweeted. He is tweeting, as I pointed out in my Bloomberg TV interview this morning, the Credit Suisse crisis is in ‘Lehman moment’ for European and global markets again, ‘too big to fail and too big to be saved’. It is not even clear what the various unrealized losses on securities and other assets are. So do you think that this is the start of a new problem?

A: I think Credit Suisse problem is that it doesn't have a business. I mean, this has been the problem for quite some time. These big Swiss banks used to be in the wealth management business, but also they had a leg in investment banking. And what Credit Suisse has done over the last few years, is participated in every sort of scandal there has been, whether it's our Archegos, or whether it is Greensill. So the real issue with Credit Suisse is what business does it. It is fine there is an attempt at a turnaround underway, but certainly they need capital at this point. They are also trying to hive off their investment banking arm.

I would say that Credit Suisse's problems are unique in the sense that it's a bank looking for a business. That said, yes, if the bank fails, and it is a large bank in Europe, there are interconnections between banks that will come under scrutiny. And of course, it does create a hangover for the entire system. I wouldn't say that this is an example of a systemic problem through the system, I would say more, this is a problem with a large bank and to the extent that the interconnections can be managed. It is something that can be managed. It's not, a problem for every bank.

Q: What you are saying is it's not systemic, both Credit Suisse and SVB type of problems are idiosyncratic, and therefore need not be compared to Lehman?

A: I will say differently, I will say SVB is more systemic, because the same problem exists across a number of small and medium sized banks in the US that they have splurged on deposits. This is something we pointed out at Jackson Hole in a paper, and that they have invested and that's what's coming to light in long term assets in a search for yield, and therefore are subject to a lot of duration risk. That's, I think, a common problem for a number of small and medium sized banks. That's why, there are a large number; it's not a problem for the money center banks in the US.

In Europe, Credit Suisse is a large bank. Large banks, if they run into problems, are systemic because they have interconnections with everybody but it's not that every other bank has the same problem that Credit Suisse has.

Q: I take your point, it is nothing like the ninja loans and the completely undercapitalized banking system that we had in 2008. But what are you expecting the Fed to do going forward? What will the dot chart also say? Do you think 6 percent is off the table? Because the labor data is still very strong?

A: That's absolutely right. Try finding a worker in hospitality today, it's very hard, especially at the lower end, it's very tight. Part of it is the labor market has been impacted by the pandemic, the elderly workers have retired, immigration has been down. And of course half a million plus people have died during the pandemic. So as a result, the labor markets are tight. I think there was some good news in the last labor report, participation rates came up slightly. But yes, in many sectors, especially this labor intensive service sectors are very tight.

The Fed has to do more, in a sense, the Fed is in a funny equilibrium. People weren't firing because they couldn't hire and so layoffs were contained. A lot of small and medium firms are still looking for people. And then second, if people do have their job, demand is still strong. And also, when you look at some of the elements like housing, which the Fed is trying to slow, if mortgage rates are 7 percent I don't sell my house. So house prices stabilize. But with supply being really low, people aren't selling their houses. As a result, trading in the housing market has come down, but prices aren't falling. I think this sort of benign equilibrium is being established. And to make a change here, either we have a lot of fear of financial sector turmoil, or the Fed has to go higher.

Now the Fed will have to choose, depending on what it sees before its next meeting. And I do hope that the financial sector calms down and it is really, the fed back on track. In that case, it does have to raise rates beyond where it is, in order to calm down inflation, usually the last mile in quieting inflation is the toughest.

Q: Assuming the Credit Suisse kind of issues keep lingering and markets are still in doldrums, after all it is not long way to the 22nd of March. Is there a possibility of a zero rate hike on March 22? If that were to happen, what would your comment be?

A: It is possible. Now what the Fed doesn't want is the markets to start celebrating, saying the Fed has paused, because that will undo all the good work it has done so far. Because then, people will feel again, quite comfortable and you won't get the kind of slack in the labor markets that the Fed absolutely wants in order to feel confident that it is winning the fight against inflation. So even if the Fed does zero, which, at this point, if the financial markets calm down, I think is a low probability. Even if the Fed does nothing I think it's going to make statements saying we haven't paused, we are just observing. But my sense is if the financial markets are calm, it will do 25 it won't do 50. That seems like a pre-Silicon Valley Bank idea, which I think is completely off the table. But 25 seems to me still a strong possibility.

Q: Which still means that financial market tantrums can arm-twist the Fed from its inflation chasing trajectory, or at least that's the massive message the markets may get?

A: It's a different problem from just the markets swooning, supposing it was the market fell 10 percent that I think at this point, the Fed would say is okay, that's the market adjusting, we are not going do anything about it. It's when it hits the financial sector, especially the banking sector, that the Fed gets more concerned because that's a more medium term problem, which could hold back growth. So as I said some of the Fed's work is done for it. If you have a bunch of bank failures, and people get very anxious about the state of the economy, reining their spending, it's as good as the Fed hiking rates — but of course, coming in a very bad way, through a very bad channel. So my sense is the Fed is not going to add to that by significant interest rate hikes on top of financial sector turmoil. It's either one or the other.

Q: Would you say now that, at least in the US, the financial markets, equity markets, in particular, will come back to swinging between inflation and growth fears and will be off this banking crisis issue; will it move on from that?

A: Look it is hard to tell that it's over. I think the Fed and the Treasury have taken the actions that should make depositors feel comfortable. But I think what still remains to be seen is if we see a silent run going on. Because even though the Fed, for example, told banks, you can put your bond for portfolios to us and get the full value, there is still a capital loss that has to be eaten over the coming year. And so depositors will scrutinise their banks to see is this bank going to be safe? How much has it invested in long term bonds, what is the mark to market losses, it has to take over time. Remember, it's not just bonds, but it's also loans.

The real issue is that we had a period of extremely easy liquidity when interest rates were very low, where banks splurged on longer term assets in an attempt to increase yield. Now we have seen perhaps the fastest increase in interest rates over the last year — 4.50 percent. And of course, that really does a lot of damage to long term asset portfolios. So where those losses are and how they are absorbed is something that depositors will look at keenly. So I don't think we can be clear game over, we have to watch and wait, and hope that what has been done is enough.

Q: So either it is these credit concerns, or it is the Fed going hammer and tongs at inflation, either ways, do you think we are headed for a fairly serious recession in the US?

A: Well, I think it's hard to imagine inflation will come down without a recession. And in fact, the data, the evidence is that every disinflation we have seen since the 1950s, has come with a recession, a falling growth over multiple quarters. Now, that said, I think there is still a question of serious recession and moderate recession. The problem with a financial sector-led recession, a financial sector turmoil-led recession, is those tend to be longer in duration, as we saw with the global financial crisis. I hope it doesn't get there, because then that transforms the inflationary situation, to perhaps even a deflationary situation. We don't want to go there. We want a disinflation and so I do hope that that we get at worst, a moderate recession, but we are, in some sense, very optimistic if we believe that it will still be a soft landing.

Q: Now we come to India and to emerging markets, given the developed world is or the US is in this kind of situation, and we know that China is barely recovering. What's the takeaway for India? Is it going to be of extreme serious global headwinds? How can that impact growth?

A: There will be potentially headwinds. Again, we have to see how the developed world sort of progresses. To some extent, we do need to up our rate of growth. Even before the pandemic, we were down to 3.9 percent, during the pandemic, we have been averaging at 3.2 percent a year compounded growth. So over the last four years, we are about 3.4 percent. And obviously, that is unsatisfactory for India, we need to up our rate of growth.

There are pieces of good news, I think the trade numbers over the last few months have shown that our service exports, especially skilled services is picking up very strongly. And this is something I have been saying for a couple of years now, this is something that will be India's strength going forward. I am glad to see that it is showing up.

On the other hand manufacturing, even within the country is not doing that well. The big question is private investment. When will private investment pick up? We are seeing capacity utilization 73-74 percent, it has been that way for a fair amount of time. And we have seen a strong government investment in infrastructure, we are not seeing the private sector ramp up. And of course, with private consumption slowing once again, I think there are worries about India's growth going forward. We certainly need to up the rate of growth in order to employ fully the millions of youth coming into the labor force. And certainly, if you look back at the past, we need to do a lot better than we have done in the last four years.

One last point, if you look at the pandemic experience in India, you look at our growth, then relative to our growth in the five years before, we have done very badly during the pandemic relative to other G20 countries, we are at the bottom of the pack. So there's a lot to recover from and I hope we can do that over the coming years.

Q: Would you at least agree that the Reserve Bank can kind of decouple from the kind of rate positions that the developed economies have to take?

A: I do think that inflation in India may be of a different nature, that is something the Reserve Bank will have to, take a view on. (There are) Some signs that over the year, it may come back within the Reserve Bank zone, so it will have to take a view. Certainly, with policy rates where they are, the Reserve Bank has room if inflation comes down to help support the economy. But that is a decision the Reserve Bank will have to take. But it will have to also watch and wait and see how inflation plays out and that's something that I don't want to second guess the Reserve Bank on.

Q: I just wanted to include that because you spoke of those services exports, we have got the February data and the difference between imports and exports. The deficit goods and services as narrow as $2.8 billion last month, it was $1.28 billion. We are in a current account surplus quarter. So, isn't that a big achievement and therefore, the Reserve Bank does not have to worry about any run on the rupee. Now, isn't that a signal achievement?

A: I think the issue is not so much the rupee itself, but inflation. I think central bank should not worry too much about the position of the currency. Instead focus on inflation, the rupee will do whatever adjustment it needs to and I think that adjustment should happen to the extent that Indian growth, for example, needs the additional benefit of more exports. The rupee will have to do appropriate adjustment, but that will be helpful to Indian growth. So, rather than worry about the rupee vis-à-vis other currencies, I think it's important for the Reserve Bank to focus on its primary mandate, which is keeping inflation under control.