The Hindu Business Line : CRR and the chart horror

You would have heard. The Sensex crashed 400 points on Monday. The numbing hit continued to keep the charts on a disoriented choppy ride, at the time of writing. Down 160 in early trading, up 92 to recover losses, and yo-yoing, as the zoomchart on http://bseindia.com graphically depicts. With the Sensex wrapping the day 5 points below the 13,000 mark, losing another 400 on Tuesday, it's time for a low-down on what they say it was that dealt the deadening blow to the bourses: CRR.

The abbreviation stands for many things. Such as: Current run rate, Centre for Reproductive Rights, carcass return rate, certified real-time reporter, and client relations representative. Of relevance to us is `cash reserve ratio,' which appears sandwiched between case reconciliation review and Centre for Radiation Research, on http:// acronyms. thefreedictionary.com.

Liquidity ratio

CRR, in the context of cash reserves, is a ratio that banks have to maintain in the form of cash reserves or by way of current account with the Reserve Bank, computed as a certain percentage of the banks' demand and time liabilities, defines Accounting Dictionary on www.ventureline.com. "The objective is to ensure the safety and liquidity of the deposits with the banks."

On CRR, also known as the `cash asset ratio' or `liquidity ratio,' Wikipedia informs that the Bank of England holds to a voluntary reserve ratio system. "In 1998, the average CRR across the entire UK banking system was 3.1 per cent. Other countries have `required reserve ratios' (or RRRs) that are statutorily enforced," reads a snatch sourced from, Monetary Macroeconomics, by Pinar Yesin. That the UK used to have a CRR of more than 20 per cent in 1968, one learns from IMF Financial Statistic Yearbook cited on http://en.wikipedia.org. In Turkey, the fall of CRR over three decades was from 58 per cent to 18 per cent.

One such RRR can be found in Section 42 of the Reserve Bank of India (RBI) Act, 1934, which is on `cash reserves of scheduled banks' to be kept with the RBI. This, as per sub-section (1), used to be `an average daily balance the amount of which shall not be less than three per cent of the total of the demand and time liabilities.' The upper ceiling was 20 per cent. However, as a result of an amendment to the Act, the RBI, "having regard to the needs of securing the monetary stability in the country, can prescribe CRR for scheduled banks without any floor rate or ceiling rate," as a June 22 press release on www.rbi.org.in stated.

But, why CRR?

The statutory liquidity ratio (SLR) and CRR are `lifeline and protective insulators' for a commercial bank, says R. Kannan, a former banker who runs an educational Website `devoted to the needs and welfare of bank officers.' The concept of CRR is a tool of modern origin, as the institution of central banks enforcing this appeared on the international banking scene only in the twentieth century, he notes.

Banks depend on depositors' money for their operations, so safety of funds is paramount. At the same time, the bank lends money and assumes risks, to earn profits. Balancing the conflicting demands of safety and profitability, banks distribute their assets in different time buckets, considering the principles of liquidity and spread. Kannan explains how the `principal pillars that provide security' are keeping a portion in cash or with the RBI or its agents, and holding adequate portion in gilt securities that can be quickly converted into cash.

The RBI monitors the levels of these metrics on a weekly basis. What happens if banks violate the reserve ratio norms? "The RBI imposes on the violator a hefty penalty by way of fine. If the default takes place regularly or continuously, the RBI may take a serious view. It may even cancel the licence of the bank. It may declare a moratorium and merge the bank with a bigger entity," writes Kannan on www.geocities.com/kstability/index.html. "It is known that particular banks in the 1980s were forced to borrow heavily on a day-to-day basis from the inter-bank call money market at 25 per cent per annum and above merely to comply with CRR/SLR requirements."

Useful read should be, A Beginner's Guide to the Reserve Ratio on http://economics.about.com by Mike Moffatt. Reserve Requirements: History, Current Practice, and Potential Reform, by Joshua N. Feinman, on www.federalreserve.gov, catalogues how reserve requirements have evolved into `a supplemental tool of monetary policy,' from being `a source of liquidity.' For the avid, there is a clutch of finds on www.bis.org. Such as, Bimal Jalan, former Guv stating in 1998 that our relatively high reliance on the cash reserve ratio has been necessitated by the needs of monetary policy operations. "As financial markets develop, allowing for a greater role for the interest rate in the economy, the dependence on this instrument of monetary policy would need to come down in future."

Changing Role

A contrary signal emerged, though, in the central bank's communiqué on CRR hike, dated December 8. It began with an we-warned-you-so reference to the Mid-Term Review of Annual Policy Statement for the year 2006-07 of October 31, thus: "Containing inflation expectations in the current environment and consolidating gains achieved so far in regard to stability would warrant appropriate, immediate measures and willingness to take recourse to all possible measures in response to evolving circumstances promptly." Fuzzy? Read on.

"The objective is to continue to maintain conditions of stability that contribute to sustaining the momentum of growth on an enduring basis. Towards this objective, the monetary policy stance and measures will need to be in a process of careful rebalancing and timely adjustment." Words that might have sounded nebulous then, but concrete measures are in place now.

The RBI announced its hike plan on Friday. Accordingly, the ratio that has been allegedly rattling the markets is to go up from 5 per cent to 5.25 per cent from December 23, and by a further 25 basis points to 5.50 per cent, on January 6. These tweaks, the Guv is confident, will squeeze out about Rs 13,500 crore from the banking system, and consequently check the growth of credit.

Alas, the squeeze is dramatically evident on market caps. A proof that "higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity" as what can be arithmetically shown, through an example on http://en.wikipedia.org? Doubtful, the site would suggest.

For, `the connection between reserve requirements and money supply is not nearly as strong.' Which lends credence to a sobering view that the chart horror may after all be an exaggerated enactment of the Mint Street script.

ZeroBase@TheHindu.co.in

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