Recently, a debate has resurfaced on the relevance of the cash reserve ratio (CRR) as a monetary policy instrument. It began with the suggestion of the SBI Chairman, Pratip Chaudhuri, to phase out CRR and pay interest on impounded funds under CRR, till it is phased out. He has pointed out that as CRR deposits do not earn income, the loss to the banking industry is close to Rs 21,000 crore on this account.

In his opinion, this is leading to a cost increase in the banking industry without benefiting anyone. How the SBI Chairman evaluated the benefits of CRR in order to arrive at such a conclusion, is not clear. But there can be no denying that if the RBI agrees to his suggestion, it will boost the bottomline of his bank. There are two critical issues to be considered here.

Interest on CRR Balances

It is obvious that if the RBI pays interest to banks on CRR balances, any increase in CRR as well as expansion in bank deposits, which forms the basis for CRR, will be taxing for the RBI.

In his article “An MRI on health of the economy” ( Business Line, September 7) noted economist and former RBI Deputy Governor S. S. Tarapore has already explained this aspect. He had shown how payment of interest on CRR would make it ineffective as a monetary policy instrument.

There could be situations when interest payments will exceed incremental funds impounded through CRR in a year, and overtime, the spiralling effect will damage the RBI’s balance-sheet. Moreover, the prevailing fiscal position of the Government also warrants not paying interest on CRR balances. If the RBI is saving Rs 21,000 crore as suggested by Chaudhuri, the entire amount will be transferred to the Government as part of the RBI’s profit.

On the contrary, if the RBI pays interest to banks on CRR balances, only a part of Rs 21,000 crore which accrues to public sector banks will be transferred to the Government, while a portion will be reflected in profits of private and foreign banks. Obviously, the former is consistent with the Government’s goal of reducing fiscal deficit.

The RBI itself has contemplated reduction of CRR to its statutory minimum since the late 1990s, as part of rationalisation of CRR with a medium-term perspective. This has been documented in various RBI policy documents.

Phasing out of CRR

In the process, CRR was reduced gradually from 11 per cent in August 1998 to 4.5 per cent in June 2003. Subsequently, with apparent signs of overheating of the economy, CRR was increased.

The CRR is a very effective instrument for monetary tightening, apart from providing a liquidity cushion to banks. It can also play a very helpful role for open market operations of the RBI by ensuring a predictable demand for RBI balances.

Of course, its disadvantage is that it stifles all types of credit expansion, both desirable and undesirable. There is also a cost to the banks as CRR balances do not earn interest, as suggested by the SBI Chairman.

On balance, the RBI is in a better position to judge the suitability and relevance of CRR.

In this regard, it is obvious that commercial considerations will influence the opinion of the SBI Chairman. As rightly noted by K. C. Chakrabarty, RBI Deputy Governor, in the interest of economic and financial stability, CRR is an important regulatory instrument.

If the SBI Chairman wants to expand credit at a cheaper lending rate, SBI can do so as a market leader, by cutting both its lending and deposit rates.

(The author is Reader, Dept of Economics, Pondicherry University.)

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