It’s Western economists who have demonised CRR.

Basically, the economic situation facing the country, which will be reviewed by the Reserve Bank (RBI) on September 17, 2012, is no different from what it has been during the recent period.

It can dust off the last review and bring the statistics up-to-date with no changes in the analysis and the policy prescriptions. The position is the same for writers like me as well. I would rather go into some of the fundamental issues arising in the context of the recent controversy on the cash reserve ratio (CRR), that have a bearing on the next policy review.

The debate reveals a misunderstanding of CRR as an instrument of monetary policy. It started as a primary reserve for a prudential reason to ensure that banks had adequate cash to meet the withdrawal of deposits. But it also affects the ability of banks to create money through the deposit/money multiplier, which was discovered by the central banks serendipitously and utilised as a weapon to control money supply.

The Statutory Liquidity Ratio (SLR) is a secondary reserve designed to meet the government’s financial requirements. What is absorbed in SLR gets released to the system when government undertakes its daily expenditures. On the other hand, what is deposited with the RBI under CRR is frozen.

The State Bank of India Chairman is reported to have said that CRR is unfairly imposed on banks and has asked as to why it is not applied to insurance companies and mutual funds, which are also mobilising deposits from the public.

Whether non-bank financial intermediaries are close substitutes for banks has been a subject of debate since the time of the seminal contribution by Gurley-Shaw. The distinguishing characteristic of banks creating deposits that are a means of payment has been questioned. It is too vast a subject to be covered here.

MISUNDERSTOOD NOTION

An increase in CRR lowers the multiplier, and hence the growth of the money supply, while a reduction has the opposite effect. The US and ECB have prescribed reserve ratios. For fighting inflation, the central bank of China raised the reserve requirement several times during 2007-11. At one point of time it was as high as 21.5 per cent.

Countries such as the UK are able to undertake Open Market Operations (OMOs) successfully to carry out monetary policy because of their developed financial markets, and do not need the CRR. In India, because of constraints arising from the absence of autonomy, the RBI has to resort to OMOs to groom the market for the successful floatation of government securities at minimum yields through buybacks, thus monetising fiscal deficit retroactively. Until this situation changes, it has to rely on CRR for having some semblance of control over money supply.

The deemphasising of the CRR after the introduction of financial reforms in the 1990s under pressure from IMF/World Bank was mainly the result of the propaganda of Western economists that it was ‘financial repression’ and a tax on the banking system.

CRR is not a tax but a fee. The banking system benefits from the licence it gets from the central bank to carry on business because it mints money through the working of the multiplier. It is a form of seigniorage enjoyed by the banking system similar to what the government gets through the printing of currency notes. Hence, the question of paying interest on CRR balances does not arise, as the system is amply rewarded by the power to create money.

Those who support the RBI’s debt buyback may cite the example of the US Fed and ECB undertaking similar operations. But the contexts are different.

In the US, the objective is to help the private sector by keeping interest rates low, particularly on long-term credit, to stimulate production and investment.

In the case of the ECB, its President has announced that bond purchases for bailing out distressed States will be fully sterilised to have a neutral impact on money supply.

MISLEADING DATA

There is no reason for the RBI to relax any of its policy measures in view of the persistence of inflation. Over a period of 30 years, I have seen hyperinflation at the micro level.

To give a couple of examples, the price of a dozen bananas has risen from Rs 2 to Rs 36 and an apartment in a middle-class locality in Mumbai, which sold at Rs 200 per sq.ft, now costs Rs 30,000. The annual rates of inflation are 10.1 per cent and 18.2 per cent, respectively.

But look at the tyranny of compounding. The average consumer understands simple growth rates that affect his expectations, not the compound ones.

The simple growth rates of prices end-to-end over the period are 1,700 per cent and 14,900 per cent for banana and apartments, respectively.

A person who started saving 30 years ago with a view to buying an apartment at the end of his career cannot now afford even a toilet! (The costly expenditure on toilets incurred by the Planning Commission may be recalled.)

The definition of hyperinflation (a monthly rate of 50 per cent and above, according to Cagan) needs to be revisited.

Due to the other tyranny of the average, the true face of the suffering of the people is not revealed in the price indices for all commodities. Think about the ‘tolerable’ inflation rate of 5 per cent year after year, one of the bases for the official estimation of the required money supply!

(The author is a Mumbai-based economic consultant blfeedback@thehindu.co.in)

(This article was published on September 10, 2012)
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