In the recent period, there have been demands by banks for payment of interest on cash reserve ratio (CRR) balances. Although many analysts have explained that from the point of efficient monetary control, interest should not be paid on CRR balances, the controversy has not died down.

As per law, interest cannot be paid on CRR balances, as CRR is a powerful instrument of monetary control — and payment of interest on these balances attenuates monetary control. This was also explained in this writer’s article (Business Line, August 24).

State Bank of India (SBI) Chairman Pratip Chaudhuri, with the explicit support of the Government, has been emboldened to reiterate his demand that interest at 7 per cent be paid on CRR balances, and that if interest is not paid CRR should be abolished.

Historical Background

With unbridled fiscal deficits since the 1980s, the RBI, ineluctably, had to raise the CRR to the then statutory ceiling of 15 per cent. As interest was being paid at 10.5 per cent on CRR balances, it was almost equal to the incremental amount of CRR balances impounded in a year, and as such the CRR, as an instrument of monetary control, was totally eroded. As the fiscal deficits mounted, in 1989, the law was altered, raising the statutory ceiling to 20 per cent.

During the crisis of 1991, the effective CRR was as high as 16.5 per cent. In an endeavour to regain monetary control, in 1990, interest on cash balances relating to the period up to March 1990 was paid at 10.5 per cent interest, but on incremental cash balances thereafter, the interest was reduced to 8 per cent and eventually brought down to zero.

As a result, the effective interest rate on CRR balances fell to 4 per cent. Eventually, in 2007, interest on CRR balances was abolished by law. With the abolition of interest on CRR balances, the RBI has been able to bring down the CRR prescription to as low as 4.25 per cent.

The choice is between a high CRR prescription with interest, or a low CRR prescription without any interest. Obviously, a low CRR prescription without interest is preferable to a high CRR prescription with interest. This is something that both the SBI Chairman and the Government need to understand.

Abolition of CRR

The basic precondition for abolishing the CRR is to bring down the fiscal deficit way below what the latest fiscal consolidation roadmap indicates. The Government should be genuinely willing to pay higher rates of interest on government borrowing. But the ground reality is that, at present, the government wants to borrow more at lower rates of interest.

The CRR prescription can be abolished only when there is an effective interest rate transmission mechanism. At present, a paramount objective of government policy is an obsession with low interest rates in the economy, despite high rates of inflation. In such a milieu, the policy interest rate cannot be the sole instrument of monetary control.

Scrutiny of RBI Accounts

The Government, in desperation, is turning to scrutiny of the RBI balance-sheet. A central bank’s balance-sheet cannot be examined on the lines of a corporate balance-sheet. When the central bank shows high profits, it often indicates that the economy is precariously placed. Per contra, when the central bank shows low profits as its foreign assets form a larger proportion of its assets, it reflects strength of the economy.

The Government is welcome to study the RBI balance-sheet and, in fact, should do so to better understand the central bank’s imperatives. If interest is paid on CRR balances at 7 per cent per annum, the RBI would have to pay out about Rs 20,000 crore by way of interest. The incremental CRR balances in a year would be around Rs 38,000 crore and, as such, over one half of the CRR balances would be paid back to the banks thereby eroding monetary control.

In 2011-12, the gross income of the RBI was Rs 53,176 crore, of which Rs 27,025 crore was transferred to the internal reserves. The internal reserves of the RBI may appear large, but they are equivalent to less than 10 per cent of the RBI’s total assets, which is very low, given that from time to time, the RBI could face many demands on its internal reserves.

In June 1993, the internal reserves of the RBI fell to as low as Rs 843 crore and the RBI could have gone under. Thus, reducing the proportion of internal reserves relative to total liabilities could be hazardous.

Of the total expenditure of the RBI of Rs 10,137 crore, 70 per cent is non-establishment expenditure, such as bearing costs on behalf of government for security printing charges and agency charges paid to banks on behalf of the government.

Impact of interest payment

Payment of interest on CRR balances will require about Rs 20,000 crore per annum, which will erode profit transfer to the Government.

The RBI cannot pay interest on CRR balances and have sufficient surplus to transfer to Government. At the same time, the CRR as an instrument of monetary control cannot be dispensed with for at least the next 20 years. Thus, the SBI Chairman and the Government should stop looking for a black cat in a dark room which is just not there!

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

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