Yesterday, 6th August, 2013 Prime Minister Manmohan Singh appointed Raghuram Rajan as next Reserve Bank of India's governor for 3 years. Rajan will take the charge from present RBI governor D. Subbaroa whose term is ending on September 4, 2013.
Rajan is taking charge at a crucial stage of economic cycle, where India's growth rate is at decade low, currency is depreciating, CPI denominated inflation is high even though wholesale and its core inflation is under RBI's comfort zone. Its like Rajan will be under the pressure of Trilemma (or also famously known as Impossible Trinity) wherein he has to manage currency, capital flows and independence of monetary policy. In theory it is considered to be impossible to achieve all three at the same time and this is what Raghuram Rajan will be facing!
In recent months capital is flowing out from the emerging countries after U.S. Federal Reserve officials started giving hint of tapering down of monetary stimulus know as Quantitative Easing. These capital outflows aggravated in India as economy was not growing at its potential, has current account deficit problem, government is in back-foot in decision making after series of corruption scams and etc. As a result of this Rupee is leading the depreciation pack in Asia and touching new lows.
To reduce the volatility in foreign exchange as it is claimed by central bank, RBI came into markets in intervals and started selling Dollars. Also took several decisions including liquidity tightening, making gold importing non-conducive and so called Open Market Operation. But it looked like RBI was forced to take certain steps as per its communication with markets and its participants. Which is third leg of Trilemma.
During same time RBI was facing growth concern issues as Indian economy was growing around 5 percent, slowest pace in decade and bottom was not sight! Wholesale inflation was just started reducing from couple of years' double digit mark, so RBI started reducing interest rates.
But thanks to capital outflows and Rupee depreciation, RBI (or forced to) jumped to forex management by tightening liquidity and asking public sector banks to sell dollars on its behalf.
Now RBI caught in between Rupee management, liquidity (or in other term capital flows) control, growth acceleration and getting back the credibility of the independence of monetary authority! Its now Raghuram Rajan trilemma!