The Hindu Business Line : CRR: Active times ahead?

The blow was as sudden as it was unexpected. But the Reserve Bank of India had no choice. Only weeks back, in its mid-term review, the Central bank had raised its repo rate from seven per cent to 7.25 per cent, leaving the reverse repo rate - the return it pays on surplus funds placed with it by banks - unchanged at six per cent.

And here was the market defying the move to tighten the cost of money. For, after the monetary policy review, money market rates, instead of heading up towards the repo rate, pushed south to six per cent levels - a good one per cent below where the RBI would have liked it to be.

It is not a situation any self-respecting central bank would like. And the RBI naturally took exception. Sensibly, it got to the root of the problem and excised the liquidity in the banking system by increasing the cash reserve ratio (CRR) from five per cent to 5.5 per cent. The reduced system liquidity will (hopefully) lead to alignment of money rates and the repo rate.

The behaviour of interest rates, post-monetary policy review, only buttresses the point that in our money market, the RBI's benchmarks (repo and reverse repo) are of marginal significance.

Generally, liquidity is too much or too little, driving rates well outside the central bank's corridor. And the RBI is constrained in its actions to restore rates to the neighbourhood of its benchmarks.

Mopping up surplus liquidity, as it seems to have wanted to do (and has now done), has its costs. The Market Stabilisation Scheme (MSS) bonds, launched a couple of years ago specifically to drain liquidity, were effective, but transferred the burden of servicing them to Government, which, of course, had no access to the (sterilised) funds.

It was hardly to be expected that this arrangement could go on. More likely than not, the Government would have balked at further issues of MSS bonds, given that it is fighting the deficit reduction battle and the interest outgo on these bonds only add to its woes. Left to fend for itself, the RBI had no alternative but to use the (costless) CRR hike route to shrink system liquidity.

There will be equal challenges when the market is short of liquidity and a CRR cut could be necessary.

Thus, the CRR could emerge as the preferred tool of short-term monetary management.

As in any modern economy and financial market, liquidity and interest rates are a function of Government spending and borrowing. It is the (unfortunate?) responsibility of the central bank to correct money market distortions without sacrificing the goals of growth and price stability, as the RBI seems to have splendidly done in recent times.

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