GO
Loading...

Baptism of fire for India’s new central bank chief

Kiyoshi Ota | Bloomberg | Getty Images

Raghuram Rajan becomes India's central bank chief this week and the well-respected economist is expected to come under immediate pressure to restore confidence in the country's battered currency.

Rajan succeeds Duvvuri Subbarao as Reserve Bank of India Governor under bleak circumstances: the Indian rupee has shed over 25 percent of its value against the U.S. dollar in the space of three months, the economy is growing at its slowest rate since 2009 and inflation is high.

(Read more: Goldman upgrades China growth, cuts India outlook)

India, Asia's third largest economy, is facing its worst predicament since 1990-1991 when a balance of payments crisis led to a sharp devaluation in the rupee, economists say.

Rajan officially becomes RBI Governor on Wednesday and will take charge operationally on Thursday.

"In some ways you could argue that Rajan has made his first mistake before he's formally started in not being active enough in reassuring markets about his commitment to stabilize the rupee," Robert Prior-Wandesforde, director for Asia economics at Credit Suisse, told CNBC Asia's "Squawk Box."

"The market has been crying out for some jaw-boning from him. I hope the RBI and government together set currency stability as their chief priority. If they do not, the rupee could continue to drop, inflation will rise and rates will be forced higher," he added.

The middle of a storm

The rupee traded at around 68 per dollar on Wednesday, close to last week's record high of 68.8. Analysts say that steps such as last week's decision by the RBI to provide dollars directly to state oil companies have helped stabilize the battered rupee, but more needs to be done to restore confidence.

India's wide current account deficit and the slow pace of economic reforms have put the country at the center of the storm sweeping through emerging markets, as investors brace for an unwinding of the U.S. monetary stimulus that has pumped liquidity into global markets in recent years.

Worries about Fed tapering have led to an exit of cash from emerging markets. India's stock market, for instance, has tumbled more than 10 percent since late July and the broader MSCI emerging markets stock index has shed about 4 percent over the same period.

(Read more: Emerging Asia rout start of a multi-year bear market?)

"The market is saying all the money that flooded into India has been misspent, funding a credit bubble, so when that is being unwound you have to kill domestic demand in order to come back to a surplus," independent economist Andy Xie told CNBC.

"India is facing the same situation as Thailand did 15 years ago when it tried to hold onto growth," he added. "It is very dangerous to change the captain in the middle of a huge storm."

The right guy?

One thing that Rajan, a former chief economist at the International Monetary Fund, has in his favor is that he is viewed with credibility in financial markets.

"One is tempted to say that if Rajan can't help restore confidence in India's battered currency, nobody can," Nicholas Spiro of Spiro Sovereign Strategy said in a note.

Others add that the sell-off in the rupee has been blown out of proportion and Rajan would do well to turn the market's focus to how the central bank will help boost economic growth.

Data last week showed India's economy expanded 4.4 percent year-on-year in the April to June period, well short of analyst forecasts for a 4.7 percent rise.

Economists have slashed their forecasts for the full year growth ending in March 2014, highlighting just how much India's economy has slowed from the 8 percent plus growth rates enjoyed just a few years ago.

(Read more: The rupee rout will be over soon)

"The best thing he [Rajan] could do is call the currency speculators' bluff and say: we're not focused on every day currency moves but long-term growth," said Stuart Oakley, managing director for Asian currency trading at Nomura.

—By CNBC.Com's Dhara Ranasinghe; Follow her on Twitter @DharaCNBC

Contact Central Banks

  • CNBC NEWSLETTERS

    Get the best of CNBC in your inbox

    › Learn More