The Hindu Business Line : Increased reliance on CRR

Taking repeated recourse to CRR hikes to tackle inflation only skews further the asymmetric treatment of market players, putting commercial banks at a disadvantage and placing a greater burden on borrowers. Yet, the RBI has no other option, argue M. RAMACHANDRAN and D. SAMBANDHAN, explaining that the central bank will have to increasingly rely on the CRR, given the limited scope for deploying other instruments.

THE RBI IS constrained to conduct the monetary policy via the CRR route, given the inadequate holdings of government securities.

The resurgence of inflation ruling over the acceptable level of 5 per cent has received significant attention from the monetary authority in recent months. Accordingly, the Reserve Bank of India made three successive hikes in the Cash Reserve Ratio (which is up 150 basis points) that will impound around Rs 41,000 crore of commercial banks' lendable resources. The cost of short-term borrowings from the RBI has also been made costlier by hiking the repo rate to 7.75 per cent.

Another significant change introduced by the RBI is that the erstwhile minimum statutory CRR requirement of 3 per cent has been done away with and no interest will be paid on CRR balances from the fortnight beginning March 31, 2007. Thus, "the stance of monetary policy has progressively shifted from an equal emphasis on price stability along with growth, to one of reinforcing price stability." All these policy pronouncements send the clear signal that the RBI is set on squeezing liquidity, ignoring its repercussions on growth.

Why the CRR?

Why should the RBI use the CRR to squeeze liquidity when several committees in the past have argued against its use, as it is principally meant to meet prudential requirements? While such policy instruments as repo/reverse repo are meant for day-to-day liquidity management, the other available instruments, such as the Bank Rate, Open Market Operations and the CRR, are meant for liquidity management in the medium to long term.

However, the Bank Rate can be used effectively only when commercial banks and other financial institutions resort to the RBI significantly for financial accommodation. The progressive decline in the net RBI credit to commercial banks and the commercial sector, from Rs 32,055 crore in 1999-00 to Rs 9,108 crore on March 30, 2007 shows that financial institutions are no longer dependent on the central bank for funds. Under the circumstances, the Bank Rate has lost its significance and has, hence, been kept unaltered at 6 per cent since April 2003.

Although in a growing, market-oriented economy the indirect monetary policy instruments, such as Open Market Operations, are said to be more effective, the RBI is constrained to conduct the monetary policy via the CRR route, given the inadequate holdings of government securities. First, the stock of government securities with the RBI is finite, largely due to the discontinuation of issuing primary government securities to the apex bank. Second, there has been a steady depletion of G-Secs on account of continuous sterilisation of capital inflows in recent years.

Indirect tax on banks

With the scrapping of minimum statutory reserve requirements and the elimination of interest payable on them, the CRR has been elevated to the status of a full-fledged policy instrument. Thus, the cumulative hike in the CRR to 6.5 per cent from the fortnight beginning April 28 will impound commercial banks' reserves to around Rs 95,000 crore. But, remember, these funds have been mobilised by commercial banks largely by issuing deposits bearing interest rates ranging from 3.5 per cent to 9.5 per cent.

Especially when there is a steep rise in credit demand in the face of a liquidity squeeze, commercial banks would also be ready to pay higher interest rates for mobilising the required funds. Against this background, any rise in the CRR is tantamount to an implicit indirect tax burden on commercial banks which they cannot shift, except by hiking their lending rates.

In sharp contrast to the kind of Open Market Operation that enables the central bank to suck excess liquidity from financial institutions having surplus funds to park, a hike in the CRR drains liquidity from commercial banks, regardless of an individual bank's funds position — that is, it does not discriminate between banks with surplus funds and those in deficit.

Such an across-the-board hike in the CRR directly distorts the commercial banks' assets and liability management and, thus, introduces a different kind of financial repression. Perhaps, keeping these problems in mind, the Narasimham Committee had recommended a progressive reduction in the CRR to its then prevailing minimum statutory reserve requirement of 3 per cent.

Taking repeated recourse to CRR hikes tends to strengthen the asymmetric treatment of market players. For instance, while the competing non-banking financial institutions are not subject to the CRR requirement, commercial banks have to bear the burden of every successive CRR hike. This discrimination puts the latter at a disadvantage

Will it achieve its objective?

Impounding reserves through a CRR hike does not necessarily mean a corresponding decline in the amount of credit extended by commercial banks. They can frustrate the impact of a tight money policy by restructuring their asset and liability portfolios. For instance, the growth of non-food credit was ruling over 29 per cent up to March 16, despite draining of substantial liquidity by the RBI. This was made possible as banks could support a larger amount of credit by partly liquidating their investments in G-Secs.

The commercial banks' investment in G-Secs, as a percentage of aggregate deposits, has declined from 43.5 in 2003-04 to 31.39 in 2006-07. More important, commercial banks' credit, as a percentage of aggregate deposits, has steadily increased from 55.9 to 74.54 during the same period, indicating that banks can support the surge in credit demand with the given amount of deposits.

On the other hand, credit explosion and real growth have moved together in recent years despite the tight monetary policy. For instance, the manufacturing sector has been growing at around 9 per cent while non-food credit has been growing at over 30 per cent the last three years. Thus, explosion of credit is largely the consequence of strong growth performance rather than just a liquidity explosion.

Obviously, such tight monetary measures in times of a steep rise in credit demand do not fully succeed in arresting credit flows; instead, they only put a tremendous upward pressure on interest rates. This has occasionally echoed in the call money market, with interest rates reaching dizzy heights.

Cost-push factor

Furthermore, since the increased cost arising out of a CRR hike cuts into commercial banks' profit margins, they will eventually shift this burden to the ultimate borrowers, in the form of a higher lending rate. The resulting cascading effect of interest rate rise will act as a cost-push factor, adding fuel to the inflation fire.

Therefore, the contractionary monetary policy measures aimed at containing inflation seem to be counter-productive. Knowing fully well that monetary contractions by themselves cannot achieve miracles on the inflation front in a situation of supply constraints, the RBI is still attempting to use such means because it has no other options.

If the fever of inflation persists, the RBI will have to increasingly rely on the CRR, given the limited scope for the deployment of other instruments.

The consequent upward pressure on domestic interest rates will bring in fresh capital, which will further complicate the liquidity as well as the exchange rate management in the country.

It is, thus, apparent that the RBI is in an impossible three-cornered situation, as is the case of any central banker having to live with increased capital flows, an inflexible exchange rate and rampant inflation for the fear of currency appreciation. Blaming it all on the RBI will, therefore, just not help.

(The authors are on the faculty of the Department of Economics, Pondicherry University.)

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