The Hindu Business Line : Banking on tools

The hike in ‘Cash Reserve Ratio’ (CRR) by the Reserve Bank (RBI) in its Annual Credit Policy last week was widely talked about and debated upon. While a few did expect the CRR hike, bankers who had been betting on an increase in the ‘Repo Rate’ were surprised.

You might have often come across these terms — the CRR, MSS, repo and reverse repo — in the papers and on TV. Why does the RBI deploy these instruments? At any point in time, what prompts the central bank to choose one instrument over another?

Managing Money

One of the major functions of a country’s central bank is to control the volume and cost of credit in the economy and, through that, the supply of money. Control over money supply is crucial because too much money will lead to inflationary conditions while too little money may put the brakes on economic growth. This money management or liquidity management is done by the RBI through three instruments — the Repo and Reverse Repo, the Market Stabilisation Scheme (MSS) and the CRR. What instrument can be used and when depends on the availability of each of these and nature of liquidity.

For example, the MSS (under which Treasury Bills and/or dated securities in addition to the government’s borrowing requirements are issued for the purpose of absorbing liquidity from the system) or the CRR ( which spells out the amount that all banks must park with the RBI) may be used to curb long-term liquidity or sterilise liquidity arising from forex inflows, as was done last year.

The huge surge of foreign exchange, thanks to FII interest in the Indian markets, prompted the government to increase the ceiling for the sum outstanding under MSS first to Rs 1,50,000 crore in August 2007 and later to Rs 2,50,000 in November. The CRR too has been hiked six times since December 2006 from 5.5 per cent to 8.25 per cent now. But all this while, the two policy rates (repo and reverse repo) had been kept unchanged.

Why the hike in CRR now?

That brings us to the question — why the increase in CRR now, why not the repo?

The repo is the rate at which the RBI lends to banks, injecting liquidity into the economy. An inflation of over seven per cent is the perfect setting for a hike. An increase in policy rates would essentially mean that banks too would increase their lending rates and hence make the consumer think twice before availing a loan. This reduced credit offtake will thus bring down the money supply and control inflation — if the inflation is demand-driven.

But what we are witnessing today is an inflation driven more by scarcity of supplies than by a rise in demand. For example, limited land and water resources, low grain stock reserves and increasing diversion of food for bio-fuels, have all constrained availability of food and have taken global food prices to unprecedented highs in 2007-08. Ditto with respect to oil and steel prices.

Added to this, the tightening of credit until now has already taken the wind out of the sails for rate sensitive sectors such as consumer durables and auto, thus slowing consumption. A rise in interest rates now will be punishing, as it might accelerate the pace of the slowdown thus affecting economic growth.

That is why the RBI finds a CRR hike more appropriate at this juncture. This signals that the central bank is trying to achieve price stability without affecting growth. Though monetary policy can do little to control supply-side inflation, this hike will at least control liquidity (banks will have less money lend as they have to keep more with the RBI than before) such that it does not create demand-led inflation as well.

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