Mr Rajan is a former chief economist for the International Monetary Fund, famed for warning that the US subprime debt bubble was out of control long before the Lehman crisis blew up in 2008.

While Mr Rajan said he wished to return to his academic home and the “realm of ideas” at the University of Chicago, it is an open secret in India that he can no longer work with Mr Modi’s Bharatiya Janata party (BJP). He will step down in early September after just three years.

Mr Rajan’s ‘tough love’ policies are widely credited for averting a currency crisis and an inflationary blow-off during the emerging market ructions three years ago, when the country was shunned as one of the ‘fragile five’ most at risk as the US Federal Reserve began to wind down monetary stimulus. He became the pin-up central banker of the emerging world, a symbol of a new age.

His orthodox policies beefed up India’s financial defences but led to constant clashes with the BJP party. The government’s Keynesian economic guru Subramanian Swamy accused him of a “willful and deliberate attempt to wreck the Indian economy” through deflationary overkill.

Bad loans and restructured loans have reached 14.5pc of the balance sheets of the banks, but this has been festering for a long time and the causes pre-dates Mr Rajan.  The RBI says the banks need a $30bn recapitalization by 2018.

Ed Smith from Rathbones said Mr Rajan has taken exactly the right line. “The quickest way to restore the health of the banks is to crystallize the bad loans, and get everything out in the open. Unfortunately it is sill to be finished,” he said.

The government’s reform agenda is coming off the rails, despite the rhetoric. While it has overhauled the archaic bankruptcy laws, a ‘big bang’ effort to cut through the nightmare of different tax rates has come to little. Plans to end bottlenecks in transport and infrastructure have been paralyzed by land procurement problems.

“All the reforms seem to have stalled. Indian equities are trading at a premium to emerging market peers and we’re running out of reasons to see why this is justified,” said Mr Smith.

India outpaced China last year with stellar growth of 7.5pc but analysts have lost trust in the GDP data, suspecting that the growth rate may have been massaged upwards.

In any case, the boom belies a host of deep structural problems, and is unsustainable without a radical overhaul of the economy. “Modi is not a Thatcherite. He is a conservative who wants to make the old system work better,” said Lord Desai.

Mr Modi does not control the upper house of parliament, so gridlock is built into the system. The 29 states are pulling in different directions. “India has the same governance pathologies as the eurozone,” said one IMF veteran.

David Fuller's view

Here is a PDF of AEP's article.

This last paragraph above touches on a major obstacle in India’s development path.  Its bureaucracy is probably even worse than the EU’s because it has been in place for much longer and therefore is regarded as less unacceptable by many Indians. 

Narendra Modi’s herculean task of making India’s economy more efficient and bringing it into the 21^st Century is in danger of stalling.  He has approximately two years left before he loses his overall majority, or worse, at the next general election assuming that he wishes to remain prime minister.

Modi’s association with loose cannons such as the BJP’s emotional Subramanian Swamy will not reassure overseas investors.  Worse still, pushing the internationally renowned Raghuram Rajan from the RBI will alarm investment managers who assess markets as if they are candidates as in a global beauty contest.  The replacement of Rajan will be viewed a serious blemish, which can only be mitigated if he is replaced by someone generally regarded as of similar calibre.  This will not be easy and governance is everything.

(See also my comments in response to Monday’s lead article.)