CRR should not be diluted

Recent media reports regarding the cash reserve ratio (CRR) make a case for revisiting its concept and relevance as an instrument of monetary policy in the Indian context.

The argument for diluting CRR, by introducing interest on its balances, or scrapping it altogether, is not convincing at all.

Media reports

There have been two recent media reports in connection with CRR. First, some policymakers have suggested that scheduled commercial banks (SCBs) should be paid 7 per cent interest rate on the CRR balance kept by them with the Reserve Bank of India (RBI).

Second, a Bank chairman has suggested that CRR be phased out, as it had lost most of its validity.

While the RBI has not publicly reacted to the first, it has, however, done so to the second. This has now become a sensitive issue.

Concept of CRR

The CRR is a direct monetary instrument used by the RBI for monetary policy intervention.

The Reserve Bank of India Act, 1934, was amended in June 2006 with a view to enhancing the RBI’s operational flexibility and providing it with greater manoeuvrability in monetary management.

The Reserve Bank of India (Amendment) Act, 2006, gives discretion to the RBI to decide the percentage of scheduled banks’ demand and time liabilities to be maintained as CRR without any ceiling or floor. Consequent to the amendment, the Reserve Bank was also not required to make interest payment on CRR balances.

Consequent to the amendment in June 2006, the RBI announced the removal of the floor of 3 per cent and ceiling of 20 per cent in respect of CRR. Thus, in an operational sense, there is no prescribed limit of CRR as in the past.

It is the RBI which decides on the magnitude of CRR as per its liquidity comfort zone. It is also a means to control creation of “bank money” by the banking system.

The payment of interest on CRR balances attenuates the effectiveness of the CRR as an instrument of monetary policy. From the fortnight beginning June 24, 2006, it was decided that no interest shall be payable on CRR balances. It is pertinent to note that the decision had the concurrence of the Government of India.

Thus, currently, the RBI maintains CRR at 4.75 per cent of the net demand and time liabilities (NDTL) of the SCBs and no interest is paid.

CRR’s history

It may be recalled that the CRR was mainly used to neutralise the inflationary impact of deficit financing of the government during the 1970s, 1980s and 1990s.

Accordingly, it was gradually raised from its statutory minimum of 3 per cent in September 1962 to 15 per cent by July 1989.

Furthermore, under the monetary targeting framework, M3 (Broad Money) was the intermediate target (nominal anchor for policy) of monetary management, with reserve money as the operating target and the CRR as the key operating instrument.

With the introduction of multiple indicator approach, the use of CRR as an instrument of monetary control was sought to be de-emphasised and liquidity management in the system was increasingly undertaken through indirect instruments such as open market operations (OMO), both outright and repos.

Arguments against CRR

The following arguments are generally put forward against maintenance of CRR.

First, CRR is an inflexible instrument of monetary policy that drains liquidity across the board for all banks without distinguishing between banks having idle cash balances and those that are deficient.

Second, in case CRR is not remunerated, it has the distortionary impact of a ‘tax’ on the banking system.

Third, CRR is also discriminatory in that it has an in-built bias in favour of financial intermediaries that are not required to maintain balances with the Reserve Bank.

In the above context, it is important to note that in order to keep liquidity in the Liquidity Adjustment Facility (LAF) window at the optimal level of plus/minus one per cent of NDTL for effective monetary transmission, the RBI needs to have instruments at its disposal to manage excessive liquidity deficit/surplus conditions. The role of the LAF window is to deal with frictional liquidity deficit/surplus.

Liquidity of a more durable nature needs to be managed with other instruments such as CRR and Market Stabilisation Scheme to deal with the surplus liquidity situation arising out of large capital inflows.

This has been highlighted many a time by the RBI.

To quote from a speech of former RBI Governor Y.V. Reddy (September 7, 2007): “While the preferred instruments are indirect, and varied, there is no hesitation in taking recourse to direct instruments also, if circumstances so warrant. In fact, complex situations do warrant dynamics of different combination of direct and indirect instruments, in multiple forms, to suit the conditions affecting transmission mechanism.”

In view of the foregoing, it can be said that the CRR currently as a monetary policy instrument should not be viewed as a tax on the banking system. To do so, especially in view of the fact that the current CRR rate is just 4.75 per cent, is to gloss over the complexities of liquidity management, as has been rightly pointed out by Reddy.

Therefore, the suggestion that CRR be modified or phased out seems unreasonable.

The arguments against CRR were convincingly set aside in an article by S.S. Tarapore, published in these columns (“Interest on CRR, a big mistake” Business Line , August 24). The present status of CRR, sans interest on balances, is designed to provide greater flexibility to the RBI as the monetary authority to conduct monetary management.

To reiterate, suggestions in favour of abolition of CRR and interest payments on CRR are unwarranted, and best avoided in the interest of monetary policy independence.

(The author is Professor, S.P. Jain Institute of Management and Research, Mumbai.)

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