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CNBC Transcript: Raghuram Rajan, Professor of Finance at Chicago Booth


Following is the transcript of an exclusive CNBC interview with Raghuram Rajan, Professor of Finance at Chicago Booth. The interview was broadcast on CNBC's Squawk Box on 5 June 2018.

All references must be sourced to a "CNBC Interview'.

Interviewed by CNBC's Oriel Morrison, Akiko Fujita and Bernie Lo

Oriel Morrison: We're lucky enough to have Raghuram Rajan, Professor at Chicago Booth, joining us now live from Singapore. He's at the Nomura Investment Forum Asia 2018 and was of course Former RBI Governor, and also the Chief Economist and Director of Research at the International Monetary Fund. Professor always so good to have you with us. Thank you so much for chatting to us once again here on Squawk Box. I wanted to ask you, we seem to be talking quite a lot at the moment about the possibility of the next recession when and if indeed it's likely to happen in the next 12 to 18 months. Now of course a number of years ago now, 10 or 11 years ago or even 12 years ago, you warned of financial imbalances in the run up to the 07/08 Financial Crisis something you and I have discussed a couple of times before. What's the biggest risk as you see it right now?

Rajan Raghuram: Well I think at this point the biggest risk is the combination of rising interest rates and some untoward action on trade. I think it's the perception that with all the leverage that's out there, interest rates rising are already an issue that we'll have to deal with, but that's out there. The great uncertainty is what happens with trade, if we have a trade conflagration in the next few months that could really hamper the global economy.

O: Do you think that's likely? I mean you've said before and you have been vocal about it that a win-win situation is actually possible. As we move through this not purely rhetoric anymore between especially China and the U.S., do you see the chances for a win-win resolution actually increasing or decreasing?

R: Well the key question is whether these bargaining ploys, threats of living tariffs et cetera result in real negotiation which create that win-win situation. Or do entities, do players get locked into positions which mean they eventually have to carry out their threats in which case we are in a lose-lose situation. The problem to some extent at this point is that people have put forward their offers in some sense and we have to see if they actually reach a negotiation point where they can back down. Some of these situations can get out of control very quickly.

Akiko Fujita: Raghuram, you know I was thinking back to the last time Bernie and I sat down with you in March. This is right when the Trump administration had started to roll out some of these tariffs that have been proposed and you were very critical of the administration saying it was taking a very narrow view, an overly narrow view in terms of the trade deficit. Looking at specific trade deficits in certain areas when there was a surplus in other areas like services. You know you talked about the trade deficit expanding as a result of the administrations' policies and I wonder as you've seen these policies being rolled out from the administration over the last several months whether your view has changed in any way.

R: No I think almost surely the trade deficit will expand simply because of the actions that the administration has taken on the fiscal deficit given that the economy is close to full employment. If you increase demand in the economy by running a larger fiscal deficit, it has to fall on something. What it will fall on is goods and services outside. So the trade deficit is likely to increase as a result of the administration's policies. Now, what the administration is trying to do is exert a sort of pressure on other countries to bring down that deficit. But until the U.S. in a sense invests less and saves more, that deficit is not going to come down. So there is action needed also on the U.S.'s side to bring down the deficit if that's a big concern.

Bernie Lo: Doctor, do you feel that the acronyms in the making or the newly minted acronyms given enough time, or not necessarily a lot of time, but given a little bit of time to work like the RCEP or the TPP-11, would that be a wake-up call to the United States? Would it send a message- see what you missed out on, see what you could have been at the very center as a driver rather than as an outside observer? Look what you are missing out on.

R: Well I think we are talking about two different sort of systems. I think the U.S. right now is at the center of a system where it essentially engages in bilateral discussions, something that in fact the U.S. in the past tried to avoid by creating a more global system. And so you're saying the U.S. may feel that it's being left out of the global system. But I think the U.S. administration at this point is rejecting the global system of rules-based trade and is moving towards one where it thinks it can exercise its own power in order to get a better deal from everybody. So the art of the deal in a sense is dominating the U.S. administration's actions here. Now some extent there's a reason why we stayed away from this because there's a potential for threats to turn into actual bad behavior. And I worry that we're getting closer to that point.

A: Let me ask you very quickly. You know we talk so much about the trade issue as a U.S.-China context, but I want to ask about India-China because when you think about when Prime Minister Narendra Modi first came into office, he talked about deepening in his engagement with the U.S. and yet we have seen a bit of a pivot over the last year or so. India warming up to China, visiting in April. We just heard Modi talk over the Shangri-La dialogue about the need for a better future when India and China work together. I wonder what you think has prompted this calculation for the prime minister and whether in fact you think this is sort of a zero-sum as in the warming up to China for India comes at the expense of its relationship with the U.S. as well as Japan and Australia.

R: Well I don't think it need come at the expense of the relationship with these other countries. I do think there is benefit in India having a good relationship with China and vice versa because these are two big countries that can do a lot of activity, economic activity together. I do think that one of the reasons that countries are trying to form better relationships with each other is because of the unpredictability of the U.S. administration at this point. So there is a catalyst out there which is pushing these countries to talk more together. But I think the fact of their talking is a good thing both for the countries and for the world. It's not coming at the expense necessarily of relationships with other countries.

O: Professor, right at the start of our conversation we started off by talking about the risks that are facing the world right now. You specifically of course talked in detail about the risk of a trade conflict. The other point that you mentioned which I'd like to take you up on is that of interest rates. I think it's something we specifically focused on when it comes to what's happening with the U.S. economy right now. What is your, I suppose prediction, first of all, for what we're going to see in terms of rates in the U.S. and what do you actually think needs to happen there?

R: Well I think that the latest news suggests the U.S. economy is actually strengthening, is doing better, is actually doing quite well for an economy in its 92nd year of job creation. So my sense is the Federal Reserve is on a rate raising path which it's not going to step off until it feels it's much closer to neutral and I think most people would say neutral is between 2.75 percent and 3 percent at the short end. That means we're probably looking at three rate hikes this year unless something really untoward happens in Europe or in some of the big emerging markets to create global turmoil. But it has to be really bad in my view for the Fed to stop, step off this rate rising path. Otherwise I think they're going to wait, do what they have to do and then look around to see if they've done enough or they need to do more. So my guess is certainly June appears baked in but probably one to two more this year after which the Fed may start looking around.

O: Do you believe Professor that there is a real risk of yields, the 10-year yield in particular, we've been watching this market very closely surging above that 3 percent level in any major way. And is that a major risk to growth anyway? I mean we've obviously had yields above that level before, in fact significantly above that level. What is the biggest concern when you look at treasury yields? You talked about the biggest risk being something negative happening in the emerging markets of course, but what about within the U.S. economy itself?

R: Well there are certainly areas of very high leverage even in the United States, certain parts of the corporate sector which are highly levered and as much as the interest rates it's also the easy access to financing, the ability to refinance to rollover debt which has been very important in the leveraging over the last few years. As interest rates rise, as people start looking at your capacity to sustain interest payments and debt service over time, the ability to borrow also becomes more fragile. And so my sense is the highly levered areas of the U.S. economy may in fact become more stressed as these interest rates pick up both because it's picking up at the short end as well as if it picks up at the longer end. But this is something that everybody knows. We know that there are levered entities and this is something that's going to happen.

B: Dr. Rajan, when you add on the increases in interest rates there's no turning back on the amount of money which has gone into passivity, into ETF index funds et cetera. The amount of money which is out of active control now- do you worry that a flood, that a recession, well they are different things, but do you see a flood of money coming out of ETFs that is going to just completely mess up the markets because we've never seen that kind of phenomenon again?

R: Well I think where we will have problems is in entities that have a sort of a property, a run-like property. The banks used to be the entity at greatest risk. They've become much better capitalized right now. But the point you mentioned-ETFs, some ETFs have a very run-like character. Once they have to start selling, it sort of feeds on itself and becomes much more problematic. We saw that earlier this year and that's a possibility that one has to be aware of going forward.

B: Doctor thank you so much. Have a great rest of your session there, Raghuram Rajan, professor at Chicago Booth School.


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