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Interest on CRR, a big mistake

S.S. TARAPORE
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Bringing back interest on CRR balances would further denude the effectiveness of monetary policy.

In the recent period, the policy focus has been on devising measures to reduce banks’ lending rates. It has been mooted by some policymakers that scheduled commercial banks should be paid 7 per cent rate of interest on the cash reserve ratio (CRR) balances held with the Reserve Bank of India (RBI).

The issue of paying interest on CRR balances is a long saga. From the latter part of the 1970s to 1990, interest on CRR balances was raised gradually from 5 per cent to 10.5 per cent.

HIGHER INTEREST RATE

The rationale for increasing the interest rate on CRR balances was that increased CRR prescription lowered the profitability of banks and, therefore, to shore up profits, lending rates were being kept high.

To moderate lending rates, interest on CRR balances was gradually raised.

In the 1980s, there was a fascinating debate in the RBI on the question of paying interest on CRR balances.

One view was that the interest rate on CRR balances should be raised as a pragmatic measure, while the other view was that, analytically, it would be wrong to pay interest on CRR balances. Eventually, the pragmatic view prevailed and the interest on CRR balances was gradually raised.

The upshot of raising the interest on CRR balances was that the CRR, which was a powerful tool of monetary control, was gradually rendered totally impotent.

The amount of interest paid on the outstanding CRR balances rose, and eventually the annual interest on the CRR balances was higher than the annual increase in the balances impounded during a year.

EFFECTIVE CRR LEVELS

In response to this, the RBI was forced to increase the CRR prescription. Eventually, the CRR prescription reached the statutory ceiling of 15 per cent of net demand and time liabilities (NDTL). The statutory ceiling was thereafter raised to 20 per cent. By 1992, the effective CRR was 16.5 per cent of NDTL.

From April 1990, the policy tilt was towards reducing the effective interest on CRR balances. Under a two-tier formula, interest was paid at 10.5 per cent on cash balances relating to the liabilities up to the end of March 1990; on the incremental liability, the interest rate on CRR balances was lowered to 8 per cent, and eventually abolished in 1992.

As a result, the effective interest rate on cash balances progressively came down to 3.5 per cent. With the amendment of the RBI Act, from 2007, no interest is paid on CRR balances.

As no interest is paid on CRR balances, an element of monetary control has been regained even though the prescription is as low as 4.75 per cent.

If interest is paid at a rate of 7 per cent as proposed by the Ministry of Finance, the present degree of monetary control would require that the CRR prescription be raised rapidly.

Illustratively, if the NDTL in a year rises by, say, Rs 8,00,000 crore, under the present CRR prescription of 4.75 per cent, an additional Rs 38,000 would be impounded, but Rs 25,000 would be paid out as interest on the entire CRR balances. In other words, in incremental terms, the effective CRR would be reduced from 4.75 per cent to 2 per cent. To maintain the same degree of control, the present prescription of 4.75 per cent (without interest) would need to be raised progressively and, over time, the CRR instrument would become totally ineffective.

A number of countries do not pay interest on CRR balances, while some do. Each country has to tailor its instruments to its specific environment.

OTHER INSTRUMENTS

In India, the Open Market Operations (OMO) instrument is rendered weak as the fiscal deficit is high and the RBI ends up using the OMO as a tool for indirectly financing the fisc.

With the government’s large borrowing programme, the RBI undertakes OMO purchases to create space for the fresh debt to be placed in the market.

The OMO is less of an instrument of monetary control, and is mainly used to keep down yields while government borrowing increases.

Again, the RBI is constrained in using the repo policy interest rate as an effective tool of monetary control, as it is a plank of macroeconomic policy to engineer lower lending rates.

A prerequisite would be lower deposit rates, but as deposit rates are already low (in fact, negative in real terms), any further reduction in deposit rates would trigger savers moving from financial savings to physical assets.

From a macroeconomic policy viewpoint, it is convenient to slur over hard policy options by forcing the RBI to reintroduce interest payment on CRR balances.

It has taken the RBI the good part of 20 years to claw back the effectiveness of the CRR instrument. Many years ago, I had called the payment of interest on CRR balances as one of the mortal sins of central banking.

Having expiated this sin after a 20-year battle of attrition, the Praetorian Guards of the RBI should ensure that it does not revert back to this mortal sin.

The RBI would do well to recall the words of the Prophet Zarathushtra: “He who learns nothing from the past will be punished by the future”.

(The author is an economist. blfeedback@thehindu.co.in)

(This article was published on August 23, 2012)
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Comments:

Reserve ban is requested to pay interest to Banks on cash reseerve balnces since Bank are paying interest to depositors, if Rbi do not pay it is unfair business.
Banks can lower rate of interst on advances provided they get good return on investment , cash reserve balances with Rbi is investment.
Banks have to run from pillar to post for [casa] low cost deposits since depositors are moving away from savings in Banks because of unattractive rate of interest on depoosits, if Banks start getting interest on CRR, Banks net interest margin position shall become comfortable.
I also requst RBI to permitt Banks to invest unutilised balances lying in unclaimed deposits, outstanding draft /pay order accounts, since keeping such fund unutilised for decades has no meaning.
On side Banks are instructed to give loans to many sectors at concessional rate of interest, otherside if Banks do not get interst on cash reserve balances amounts to exploitation of Banks

from:  JAGDIP H VAISHNAV
Posted on: Aug 24, 2012 at 10:12 IST

I dont think banks should get interest on the CRR. Its clearly illogical
if RBI pays interest on what is supposed to be a monetary measure. It
would be better if Banks start minimizing their NPAs to get the required
amount to disburse among the public. To expect from RBI rather than
utilizing the Bank's owned assets properly is meaningless.

Reducing NPAs to give boost to the liquidity is a better option to
gather the money.

from:  Ankit papriwale
Posted on: Aug 25, 2012 at 10:44 IST
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