The debate over Cash Reserve Ratio (CRR) is getting livelier. More bankers are forthcoming with their thoughts. After all, the RBI regulates only the banks and not the bankers!

The central bank seems to have rested its case on the debate. The CRR is basically a ‘caution deposit’ and to pay interest on it is, as a former RBI Deputy Governor said, ‘‘one of the sins of central banking’’. It is also a major policy lever of monetary control and, to quote the Deputy Governor again, ‘‘it can rise, it can fall, it can remain unchanged but there is no fourth option’’.

In the pre-liberalisation times, pre-emptions in the form of CRR was kept high as the RBI had to tread cautiously to meet the multiple objectives of banking, after the historic decision to nationalise the major banks. The regulator sought to micro-manage the banks to direct precious funds into ‘productive’ sectors of the economy, while taking care not to stoke the fires of inflation. But, often, the result was the opposite because of various external factors.

However, post-liberalisation, CRR pre-emption has been substantially reduced as the money market operations widened and deepened, enabling the RBI to regulate monetary liquidity through open market operations. Nevertheless, it is the RBI’s view that a certain minimum pre-emption is a must as perceived monetary risks are likely to persist for quite some time. Among the emerging economies, India’s banking system is relatively strong and stable. But the ‘seat-belt sign’ is still on. There is turbulence in the air caused by the continuing headwinds of global financial turmoil.

Domestically, inflation is running hand-in-hand or ahead of growth. India is still a long way to go in terms of economic and social infrastructure that can sustain the annual growth of 9-10 per cent and hold inflation at 5-6 per cent.

Dropping CRR

Under these circumstances, it would appear, CRR can be done away with, only to reinvent it later. To simplify the argument, if CRR is removed, it will pump in a flood of liquidity in the hands of the banks.

Given the limited appetite for productive bank credit, banks may tend to venture into riskier areas, leading to moral hazard and adverse selection in credit deployment.

The current reforms in FDI, infrastructure, insurance and pension funds, can translate into investment only with a considerable lag. The result, therefore, will be mounting NPAs followed by higher provisions. Capital formation will slow down further and the banks will have to go back to the government for more and more capital. That will, in turn, add to fiscal deficit and inflation. To contain both, the regulator will have no option but to impose CRR! Bankers’ case for dropping CRR is that it will improve liquidity and pave the way for lowering interest rates.

The banking system has moved away from the kind of frequent liquidity mismatches that were seen in the years following deregulation. Even during the Asian crisis of 1997-98, which was mainly a liquidity crisis, India was scarcely touched. Since then, the regulator has, by and large, ensured sufficient liquidity. There are now enough windows to meet the future liquidity needs of the banks. The second argument is CRR removal will help banks bring down interest rates, irrespective of policy rate changes.

Battling inflation

Post-liberalisation, interest rates were gradually deregulated. This ushered in a new regime of lower rates which, in turn, contributed significantly to achieving higher economic growth.

Interest rates were, however, maintained at a level reflecting the actual generation of domestic capital, and this provided the stability to the system necessary to survive recurring global financial and economic crises in the past two decades.

From 2000 until 2012, Indian interest rates averaged 6.49 per cent with a peak of 14.5 per cent in August 2000 and a low of 4.25 per cent in April 2009. In the last couple of years, India’s rising domestic demand, coupled with domestic supply constraints and a spike in global commodities prices, gave rise to a prolonged phase of sticky inflation.

As interest rates also play an equally crucial role in determining monetary policy, policy rates had to be raised consistently for nearly two years to battle a stubborn inflation which is yet to be tamed.

Feeling the pinch

Higher interest rates may be one, but not the only reason for the current slowdown in growth. There appears to be no significant correlation between higher rates and investment growth in the past.

No doubt, the interest coverage ratio of companies has declined but it does not seem to be of concern to those with low debt-equity ratio. However, those with higher gearing ratios and other sectors whose products are sensitive to interest rates, may be feeling the pinch of higher interest rates. In the circumstances, irrespective of policy rates, banks can consider cut in interest rates, selectively or across the board, within the limits of their respective asset-liability manoeuvrability.

Banks are expected to give competitive rates as well as competitive service. To deny both will not be fair to the customers. In the meantime, they have to learn to live with the CRR.

(The author is an Economist with Indian Overseas Bank.)