On September 5, Raghuram Rajan took over as Governor of the Reserve Bank of India (RBI). His predecessor, D. Subbarao, had made several controversial decisions in his five years in charge. His last two months in office were especially difficult. In an effort to control inflation, Subbarao raised interest rates again and again to bring down liquidity — but he failed. In July, the Wholesale Price Index (WPI) rose to 5.79% against 4.86% in June.

The Bombay Stock Exchange Sensitive Index (Sensex) reflected this pessimism. The markets had been dropping vertiginously the past few weeks. Then, on September 5, came the appointment of Rajan. In the next three days, the market rose from 18,567, to 18,979 to end the week at 19,270.

Monday was a holiday in the Indian markets. Tuesday saw the Sensex gain 727 points or 3.77%, just three points short of the psychological mark of 19,000. The rupee — the public face of the crisis — closed at 63.84 per dollar, up 2.20% from Friday’s close of 65.25. It had gained on Thursday (1.6%) and Friday (1.2%).

“On the surface, it may appear that the fall of the Indian rupee is a bolt from the blue. It is not. The underlying issues have been building up for some time; they did not happen overnight.”

The media has started calling this the “Rajan effect.” It is true that Subbarao generally swam against the tide when it came to taking policy decisions. Consir interest rates. Finance Minister P. Chidambaram had often called for a cut in rates. Industry leaders wanted lower rates so that they could borrow and invest in growth. But Subbarao insisted that his job was to contain inflation; growth and the rupee were subsidiary. Inflation has thumbed its nose at Subbarao; and, from January this year, the rupee has weakened 7.45%. It is currently 63.84.

The New Measures

In a speech on the day he took over, Rajan announced several steps and intentions to prevent further downturns. First, he said, the RBI “should be a beacon of stability as to its objectives. That is not to say we will never surprise markets with actions. A central bank should never say ‘never’. But the public should have a clear framework as to where we are going, and understand how our policy actions fit into that framework. Key to all this is communication.”

Rajan said he would step on the gas as far as licensing new banks is concerned. More interestingly, he said: “We will not stop with these licenses.” He encouraged “foreign banks to move to a wholly-owned subsidiary structure, where they will enjoy near national treatment.”

On the rupee Rajan does not appear to favor more controls. “This might be a strange time to talk about rupee internationalization, but we have to think beyond the next few months,” he noted. “As our trade expands, we will push for more settlement in rupees. This will also mean that we will have to open up our financial markets more for those who receive rupees to invest it back in. We intend to continue the path of steady liberalization.”

Will Rajan’s approach succeed in turning around the Indian economy? The country faces enormous problems. The biggest is the current account deficit (CAD). Chidambaram says that the CAD will be contained at 3.7% of GDP in 2013-2014. (In 2012-2013, it was 4.8%; the comfort level is 2.5%.) Chidambaram is counting on US$12 billion of additional foreign exchange inflows. But observers are skeptical whether the new measures — some of which are yet to be announced — will deliver.

The Missing Link

The missing link in the India story is reforms. In fact, the reverse seems to be happening today. The Food Security Act passed by the government aims to provide subsidized foodgrains to poor families. The budgeted amount for 2013-2014 is US$1.6 billion. “The impact of the National Food Security Act on food subsidies is manageable for 2013-2014,” according to the RBI. “In the years to come it will add to the fiscal pressure.” That pressure has been compounded by another populist measure — the National Rural Employment Guarantee Act of 2005. This guarantees 100 days of wage employment in a financial year for every family in rural areas. It costs some US$6 billion annually. More importantly, it has stopped the migration of construction workers from the villages, causing a huge shortage of manpower for infrastructure projects.

The real impact of that shortage has yet to be felt since infrastructure projects, like many other sectors of the economy, are almost at a standstill. The prime culprit here is the interest rate. This is where a new approach from Rajan may help, observers say.

So what lies ahead for the Indian economy and what impact will Rajan’s policies have? Jitendra V. Singh, a Wharton professor of management, notes that the recent precipitous fall of the Indian rupee and the volatility in the Indian financial markets is a hot topic. “On the surface, it may appear that the fall of the Indian rupee is a bolt from the blue. It is not. The underlying issues have been building up for some time; they did not happen overnight.”

According to Singh, a close look at India’s recent macroeconomic data points to quite serious underlying issues: a significant CAD, a fiscal deficit and a trade deficit. “FII [foreign institutional investor] inflows have helped finance part of the CAD in recent times. However, with the possibility of ‘tapering’ by the U.S. Federal Reserve, there have been outflows of foreign capital, putting even more pressure on the rupee. Some are questioning confidence in the India story,” he says.

Singh suggests that “even as we consider what can be done to stem the decline of the rupee, the question must also be asked: Just how did we get here, and what can be learned from this experience?” The responsibility, he says, appears to lie primarily with the incumbent Indian government. “Little wonder, then, that many in the international community have pointed their fingers that way. The real task ahead is to rebuild confidence in India, and this may take time.”

The one good recent decision, Singh notes, is the appointment of Rajan as Governor of the RBI. “He is first-rate, but he has his work cut out for him. His choices will not be easy, since he will inherit a difficult situation.

“On the face of it, raising interest rates might reduce capital outflows, help prop up the rupee and control inflation,” Singh continued. “But that will also reduce the growth rate of GDP. The period ahead is likely to be challenging, and thoughtful consideration of available alternatives is needed. Surviving the short term without too much damage is essential to realize the long-term potential that lies ahead. But will [Rajan] have a free hand in doing what is in India’s long-term interests?”

According to Kartik Hosanagar, a Wharton professor of operations and information management, the two main factors for the problems in the Indian economy are the increase in long-term interest rates in the U.S. and sluggish growth in India. “Higher interest rates [and expectations of further increase] in the U.S. have contributed to dollars being pulled out of many markets causing currency devaluation in them. India has fared particularly poorly because growth has been slow the past couple of years and investors are losing confidence.”

“People look at India as a large and diverse place with enormous potential. And it is. But it’s one thing to be the most populous economy and another to realize that potential.”

The short-term prognosis, Hosanagar says, is very poor. “Recovery will be slow. In the short-term, the only hope is that it is an election year. Perhaps a change in government after the elections might change investor confidence. In the long term, I think the outflow of dollars will stabilize and the macro factors will be less relevant. The long-term prognosis depends on reform and governance.”

Hosanagar adds that the government needs to restore investor confidence. “It needs to open up more sectors to foreign investment and improve taxation. To address the import-export misbalance and unemployment, and to stir growth, India needs to invest more in its manufacturing. To address the fiscal deficit, the government needs to reduce many subsidies. I doubt they will do that in an election year even though it’s badly needed,” he notes.

According to Hosanagar, one of the biggest issues is that of misgovernance. “This is perhaps best seen through all the infrastructure scams (2G, coalgate, DLF land deal, etc.).”

“I think the ‘disappointment’ with progress to date comes in part from the curse or weight of expectation,” adds David R. Bell, a Wharton marketing professor. “People look at India as a large and diverse place with enormous potential. And it is. But it’s one thing to be the most populous economy and another to realize that potential.”

Bell notes that comparisons with China are inevitable and people expect the boom to come to India as well. “China has progressed and so people assume that India will do the same at the same rate, or at perhaps an even greater rate. ‘Positive’ attributes of India might be touted here — democracy and [a population with] fluency in English. But, again, these alone are not sufficient for realization of potential.”

Pointing out that all economies need both hard and soft infrastructure to grow and thrive, Bell says: “Hard includes basic distribution systems (roads, electricity, Internet, and so on). Soft includes rule of law and absence of corruption. India still needs to progress in the hard infrastructure domain and some recent events and scandals have undermined confidence in the soft infrastructure. The latter is especially sensitive to perception.”