A policy out of sync

O

ne cannot agree more with the Chairman of the Prime Minister’s Economic Advisory Council, C. Rangarajan’s suggestion on phasing out the cash reserve ratio (CRR) requirements of banks and using this measure of credit control “only in extraordinary circumstances”. Currently, for every Rs 100 of deposits they receive, banks have to keep Rs 4.5 with the Reserve Bank of India (RBI), which does not pay them any interest on this impounded money. The CRR, in other words, is a tool for sucking out a portion of deposits kept with banks that they would ordinarily have lent out and earned interest income. Such an instrument may have been in tune with the philosophy of financial repression underpinning the conduct of monetary policy of the pre-nineties. That was a period of administered deposit and lending rates; the RBI having to compulsorily fund the Government by subscribing to the latter’s bonds; selective credit controls; and so on. It was a regime characterised by fiats of all manner and kind. CRR, as an imposition on the banking industry for controlling credit creation, was perfectly in accord with the culture of regulation prevailing then.

But today, interest rates are predominantly market-determined and there is also no automatic monetisation of budget deficits. The RBI can increase or decrease money supply by buying and selling bonds through open market operations that it undertakes independently. The central bank can also influence interest rates, by raising or reducing the ‘repo’ and ‘reverse repo’ rates at which banks borrow from or park money with it. Given these far superior monetary policy options — that are, more importantly, culturally in sync with the current regulatory philosophy — the CRR is an anachronism that ought to be dispensed with, or used in “extraordinary circumstances”, as Rangarajan puts it. The CRR made sense in 2007-08, for instance, when the country was inundated by over $100 billion of capital flows, which posed unprecedented challenges to domestic liquidity management. That is hardly the case now, when forex inflows have moderated considerably and firms are battling liquidity constraints.

Now that Rangarajan, a former RBI Governor himself, has favoured doing away with the CRR, it is time to make a start. By neither reducing the CRR nor the repo rate, the RBI has made it difficult for banks to bring down their cost of funds, without which they cannot lower their lending rates either. The only way out, then, is to reduce deposit rates, which is what the State Bank of India (SBI) has done and others, too, may follow. The SBI Chairman, Pratip Chaudhuri, has defended the move by citing poor credit demand: When there are few takers for loans at current rates, what is the point in attracting deposits that would have to be invested in bonds or, worse, impounded as CRR earning zero interest? The current fiscal (till August 10) has actually seen banks’ investments in government securities, at Rs 192,900 crore, exceed their credit growth of Rs 111,610 crore. Whichever way one looks at it, the case for abolishing the CRR — if not cutting the repo rate — cannot be stronger.