The Hindu Business Line : Return of the Reserve Ratio

The rising inflation has driven the central bank to raise the CRR to suck liquidity out of the system. Though given up as an indirect instrument, the CRR seeks to impact the level of money supply by affecting the value of the multiplier and is thus on a par with Open Market Operations, currently the preferred monetary tool, says A. SESHAN.

Within a few weeks the Reserve Bank of India (RBI) has raised the Cash Reserve Ratio (CRR) once again, this time from 6 per cent to 6.5 per cent in two instalments, besides upping the repo rate. The rise in inflation driven by the burgeoning liquidity in the economy has forced the central bank to impose the additional burden on banks.

An RBI press release of February 23, contained an important piece of information missed by many observers. The Reserve Bank of India (Amendment) Act, 2006 was enacted in June 2006. The Extraordinary Gazette notification No S.O.21(E), dated January 9, 2007 of the Central Government notified January 9, 2007 as the date on which all the provisions, except Section 3 of the Reserve Bank of India (Amendment) Act, 2006 shall come into force.

Section 3 of the Act provided for the removal of: the ceiling and floor on the CRR to be prescribed by the RBI and [by omission of sub-Section 42(1B)] the provisions for interest payment on eligible CRR balances (that is, the amount of reserves between the statutory minimum CRR and the ratio prescribed by the RBI). It gave a clue to the retention of CRR as an important instrument on traditional lines.

Money Market Turbulence

Perhaps, in the interests of inter se equity, the burden could have been in terms of the incremental growth in deposits, related to a base date, as it differs from bank to bank.

The RBI had followed this practice in the past. That might have avoided the type of turbulence seen in the call money market in recent days. The frequent increases in the CRR mark a fundamental departure in the use of monetary weapons.

In the first place, they herald a return of the CRR as a powerful instrument to regulate money supply. Second, for a long time, whenever it raised the CRR, the RBI provided lip-service to banks saying that it was committed to the goal of reducing it to the minimum 3 per cent. Now even this pro forma declaration is absent in its announcement. It is all for the good!

The CRR is no longer present in developed economies such as those of Canada. In the UK a nominal ratio of 0.5 per cent of deposits is levied as a tax on the system to pay for the expenses of the Bank of England. But it is very much in the armoury of the US Federal Reserve. And China has used it many times in the recent period to deal with the heating of the system.

Prudential Measure

Historically, the CRR was devised as a prudential measure to ensure that banks had adequate funds to finance withdrawals by depositors. As the knowledge of the working of the banking system improved it was found that though an individual bank cannot create deposits or money, the system can.

It led to the incorporation of the CRR as an important weapon in the hands of the central bank to deal with systemic problems of either excess supply or deficit of money. It held the field for many years until alternative instruments, particularly the Open Market Operations (OMO), developed.

The West has seen fast growth in the development of financial markets making it possible to deal with monetary problems using OMO. But many developing economies have yet to develop them. This was the case in India till the onset of the economic reform process in the early 1990s. So there was no alternative to the CRR and the Bank Rate, besides Selective Credit Control to deal with monetary problems. Now the Indian market is well developed and on a par with those of the West.

OMO — a key tool

OMO has become an important strategy besides the Liquidity Adjustment Policy, the latter to deal with short-term problems of either excesses or deficits in the system. However, it has not made CRR completely dispensable. In the first place, OMO requires adequate stock of government securities for dealing in the market.

With the running out of its stocks of securities the RBI had to set up the Market Stabilisation Scheme (MSS) to mop up liquidity without giving the benefit of the accruing funds to government. (The RBI Act provides for dealing in private sector bonds also but it has not been done.) There were occasions when the limits prescribed for issuing securities under the MSS had to be raised even as the RBI ran out of those stocks also.

Second, OMO/reverse repo operations for mopping up liquidity involve the payment of a substantial return to banks for investment in the bonds, which also adds to liquidity. On the other hand, the CRR has low nominal interest liability, as of now. The LAF is intended to deal with the short-term problem of, and not a secular trend in, liquidity.

Necessary Evil

The de-emphasising of the CRR after the introduction of financial reforms in the 1990s under the aegis of the IMF/World Bank was mainly the result of the propaganda that it was tantamount to `financial repression' and a tax on the banking system.

Extending the argument and employing the Friedman logic (Capitalism and Freedom) one can say that all forms of control repress the system. Yet we know that they are a necessary evil because government is dealing not with divine beings, but ordinary mortals with their weaknesses and penchant for making a quick buck when an opportunity presents itself.

Further, the supporters of the abolition of CRR considered it a direct instrument and tried to show that indirect instruments such as OMO are preferable to them. Both the objections are conceptually wrong.

In the first place, the CRR is not a tax but a fee levied on the banking system. The difference between a tax and a fee is that there is no direct measurable benefit from the former unlike in the case of the latter. The banking system benefits from the licence it gets from the central bank to carry on business because it can literally mint money through the working of the deposit multiplier.

Kind of a fee

An initial injection of reserve money gets multiplied by the system through its operations contributing to its business income. It is a form of seigniorage enjoyed by the banking system similar to what the government gets through the printing of currency notes.

Second, the CRR is not a direct instrument but an indirect one. It seeks to impact the level of money supply indirectly by affecting the value of the multiplier and is thus on a par with OMO. It is only an instrument, like the Selective Credit Control, which directs the flow of bank funds into desirable channels or restricts their deployment in specific sectors and thus may be considered a direct instrument.

However, despite the official aversion to direct instruments today, the system abounds with them. Forty per cent of outstanding bank credit has to be channelled into priority sectors. There are further directives issued from time to time on credit to agriculture, Dalits, minorities, and other disadvantaged groups.

Perhaps for the benefit of those for whom who says something is more important than what is said, it may be pointed out that the IMF, reputed to be the ultimate repository of all wisdom in economic matters, considers the CRR an indirect instrument.

(The author is a former officer-in-charge of the Department of Economic Analysis and Policy, RBI.)

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