Interest on CRR itself can be used as a monetary tool to effectively regulate the money supply in the system.

It is generally believed that both the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) are monetary tools in the hands of Reserve Bank of India. SLR, in fact, is not a tool to regulate the liquidity in the system.

SLR investments are made in government bonds, which will come back to the system as and when the government spends the money mobilised through issuing bonds. Therefore, only CRR serves as a monetary tool in the hands of RBI by moderating the money multiplier effect.

SLR is primarily aimed at restricting the expansion of bank credit as also to ensure solvency of banks.

Raging debate

In banking circles, whether interest should be paid on CRR balances has been raging for long. Those against paying interest argue that the purpose of CRR is to reduce the money supply or liquidity in the system and payment of interest would reduce the efficacy of CRR.

It is argued that the incremental CRR balance kept with the RBI during a year due to increase in deposits can be taken back as interest on CRR.

Interest on CRR itself can be used as a monetary tool to effectively regulate the money supply in the system.

At present, the RBI increases the CRR to suck out the excess liquidity in the system. By paying attractive interest on the entire balance kept with the RBI, including the excess CRR balance, the apex bank can ensure that the funds are transferred to itself and, thereby, reduce the liquidity in the system.

In the current situation, if 8-9 per cent interest is paid on the balance kept with the RBI, banks will most likely rush to keep funds with central bank and that will reduce the liquidity in the system.

It may be noted that banks maintain 6-7 percentage points more SLR than the required 23 per cent when the risk-free return on SLR securities is 8-9 per cent. Therefore, it can be safely assumed that if 8-9 per cent interest is paid liquidity will automatically flow from the system to the RBI. The liquidity impounded will be 10-12 times the interest paid.

Similarly, when the system requires more liquidity, the interest paid on the balances kept with RBI may be reduced which will compel the banks to draw the funds from their accounts with the RBI and use for advances or investment.

This way, a variable nature of interest on CRR can be used as a monetary tool even while compensating the banks for the cost of funds incurred on the balance kept with RBI.

Implicit tax

There may be objection as to why the RBI should pay interest on the balances kept with it when it is not earning anything out of those funds. The answer is that payment of interest is the cost of sucking excess liquidity which is harmful to the economy.

If liquidity is sucked through CRR and no interest is paid on it, this would amount to an implicit tax with the public bearing the cost of regulating liquidity in the system. In any case, there is a cost involved in monetary control. If no interest is paid on CRR, the cost is borne by the public in the form of implicit tax. If interest is paid on CRR, the cost is to be borne by the central bank or the Central Government.

It may be noted that when foreign exchange inflows are more, liquidity in the system increases due to purchase of foreign exchange. And in order to suck the resultant excess liquidity, the RBI pays interest under the Market Stabilization Scheme (MSS). Recently, even the Finance Ministry expressed its openness to paying interest on CRR.

Besides, the RBI often uses open market operations (OMO) to regulate the money supply. Through OMO, the RBI can either inject (open market purchases) or suck (open market sale) liquidity.

Open market purchases will achieve the same effect of increasing the liquidity in the system as the reduction in CRR does. Similarly, by resorting to open market sale of securities which were purchased by the RBI due to devolvement or otherwise, the liquidity in the system can be reduced without increasing the CRR.

Both open market purchase and sale of securities involve interest element attached to the respective securities.

To illustrate, when liquidity is reduced by selling securities through open market operations, the banks and other market participants that purchased the securities from RBI will start getting periodical interest on the securities and, to that extent, the RBI will get lesser interest on securities.

Similarly, when liquidity is injected into the system by resorting to open market purchases, the future interest on those securities will be received by the RBI only and to that extent RBI will get more interest on securities. In spite of the interest effect, the RBI is often resorting to open market operations to supplement use of CRR as a monetary tool.

On excess balances too

On the same logic of paying interest while using other monetary tools such as OMO and MSS, the RBI may pay interest on CRR balances too. In fact, the RBI would do well to pay interest not only on the statutory CRR balances but also on the excess balances.

Banks also can keep the surplus funds with the RBI at the reverse repo rate of 7 per cent. However, this cannot happen infinitely as it involves transfer of securities from the RBI to banks. The securities so transferred serve no purpose as they are not considered for SLR.

Therefore, the RBI may very well accept excess CRR balances and pay interest.

Interest on reserves should be used as a monetary tool and when liquidity is required to be increased, the rate on reserves need to be reduced to such a level that it becomes a disincentive to keep balance with the central bank.

(The author is a banker. The views are personal.)

(This article was published on November 25, 2012)
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