Central Banks

Rajan exit spurs warnings of outflows from India

Getty Images

Raghuram Rajan's exit from the Reserve Bank of India (RBI), the country's central bank, may not be great news for investors bullish on the Indian economy.

Emerging market fund managers and global analysts have warned that the exit could mean a long term era of uncertainty and markets don't like that. Indian indexes slipped into negative territory on the news Monday with the rupee falling to a near one-month low at 67.4 against the dollar.

The so-called "rockstar" central banker, as he is referred to by the international investor community, announced on Saturday that he would not seek a second term after September and would return to academia instead.

Analysts have suggested that his departure could lead to massive outflows. India has enjoyed an investor-friendly status in the past couple of years that has led to a number of U.K. and U.S. fund managers to include India in their portfolio. But the uncertainty surrounding the appointment of a new governor has roiled markets.

Alberto Gallo, head of macro strategies at Algebris Investments, says Rajan's successor will face a huge challenge of appearing both independent and credible to investors after the current episode that he describes as "an attack on the central bank from factions within the government."

"These factions are likely going to try to influence the RBI into easing, and to push state banks to restart lending. The conclusion is likely to be a short-term, short-sighted stimulus today, which will be paid for with higher inflation and weaker banks tomorrow. This weakens the investment case for India," Gallo told CNBC via email.

Gallo further warned that Rajan's decision to step down at the end of his current term means the current government – led by Prime Minister Narendra Modi - has taken two steps back. However, he hopes to see Rajan as the next IMF managing director.

Raghuram Rajan
Munshi Ahmed | Bloomberg| Getty Images

Global analysts have commended Rajan on his efforts to bring India's inflation down from its double-digit highs in 2013 to around 5 percent currently.

However, the central banker endured a constant battle with a government that wanted to lower rates in order to pull the economy out of recession. Rajan initially gradually hiked the key interest rate from 7.25 percent to 8 percent when he joined the RBI in September 2013, after which he slowly began cutting rates from January 2015 to the current levels of 6.25 percent.

"The news that Mr Rajan, RBI Governor, declined a second term is a negative for Indian asset markets, especially for currency and bonds," warns Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers, told CNBC via email adding that during his tenure Rajan instituted a number of reforms that are likely to form a base of the Indian central banking framework.

While some analysts have said they will adopt a wait-and-watch approach towards India given the current situation, others such as Aberdeen Asset Management - that manages country-focus India funds - says it will be business as usual for them since they are long-term investors in the country.

Meanwhile, Lombard Odier's Ahmed is confident of the country's economic growth despite Rajan.

"Our fundamental-driven approach continues to show India as one of the strongest emerging market local currency sovereign credits, given low oil prices, positive reforms and improving macro dynamics. Overall, we continue to believe that the fundamental driven case for India remains intact though uncertainty is likely to remain high till clarity emerges around Mr. Rajan's successor and any subsequent shifts in RBI policies."

Crisis ahead?

Rajan assumed office in September 2013 in the midst of a crisis for the Indian economy. An allegedly corrupt government, a hefty current account deficit and the over-dependence on external factors such as the U.S. Federal Reserve's monetary policy had been plaguing the economy. Following this, India along with Brazil, Russia, Turkey and Indonesia were grouped under the "fragile five" moniker, although the country was one of the first to exit the group.

"Assuming the role in the depths of 2013's 'taper tantrum', Governor Rajan was instrumental in averting a balance of payments crisis. He helped to re-establish the RBI as a credible inflation targeting institution," Ed Smith, Asset Allocation Strategist at Rathbones told CNBC via email, adding that the exit along with Modi's structural reform agenda going off-track may further inject uncertainty in the region and "lead investors to question whether Indian equities still deserve to trade at premium valuation multiplies relative to its emerging market peers."

Although Rajan still has until September to lead the RBI, the search for a new governor has already begun. A number of names are already being speculated about and the government has reassured that the new governor will also be a "good person."

Follow CNBC International on Twitter and Facebook.