CRR hike as double whammy

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What is the reason for RBI’s newfound love of using the cash reserve ratio (CRR) as a policy tool to withdraw liquidity from the banking system? The immediate and obvious answer is to contain inflationary pressures/expectations. To me, the reasons are more than obvious, given that RBI had earlier gone on record as saying, “CRR is not a preferred option, but use of CRR under extreme conditions of liquidity and when all other options are exhausted should not be ruled out”.

The central bank is correct when it says CRR should not be a preferred option, as it is more of a crude tool. In fact, international experience suggests that the use of open market operations (Omo) has become more widespread in various countries, and reserve requirements have been lowered in many. Reserve requirements per se are only useful in circumstances where bank liquidity needs to be adjusted rapidly in markets that are thin, and where the central bank needs to give clear, swift and unambiguous signals on the need for expansion or contraction of money supply.

Let us now come straight to the point: how RBI has used the CRR tool as a double whammy. If we look at the data on RBI intervention in the forex market during the period October 2007 till February 2008 (the latest data), there is an interesting trend. RBI’s outstanding forward purchases have risen steeply to reach $16 billion at the end of February 2008 from nil liabilities in September 2007. Since RBI does not give the break-up of forward outrights (outright forward purchases or sales of dollars) and forward swaps (buying spot dollars and selling them forward, or selling spot dollars and buying them forward) separately, it could be any of these transactions. However, a closer look at the data reveals that these may primarily be buy-sell swaps. Let’s see how.