To cut or not to cut the cash reserve ratio (CRR) seems no longer the dilemma of the Reserve Bank of India. The internal debate in the central bank, it seems, is on the quantum of CRR cut and phasing out of the reserve requirements.

Former RBI deputy governor and committee on capital account convertibility (CAC) chairman SS Tarapore set the ball rolling when early this month in New Delhi he told a workshop of senior Indian Economic Service officers that it was "unconsciable" to continue with a high CRR of 10 per cent. Tarapore said it was erroneous to believe that a reduction in CRR would result in a loss of monetary tool.

"The open market operations (OMO) instrument is now sufficiently developed and the issue is one of which choosing the most efficient instrument of monetary control. The CRR is a blunt instrument which immobilises liquidity across the banking system, while the OMO sucks out liquidity from where it is lodged. More importantly, the shift to OMO will significantly improve the bottomlines of banks," Tarapore had said.

Bankers have been lobbying hard for a reduction in CRR over the years as they strongly feel along with high non-performing assets (on which banks do not earn any return) 10 per cent CRR and 25 per cent SLR (most banks have SLR investments way above the stipulation) are affecting banks' bottomlines. With an effective return of a mere 2.8 per cent, CRR is a major drag on banks' profitability.

The reluctance of the RBI in easing the money supply through a CRR cut perhaps no longer holds water as it can always be counter-balanced with aggressive OMO.

Most countries, except some exceptions like Hong Kong where there are no reserve requirements, impose such requirements on demand savings and time deposits. It often applies uniformly to all types of deposits, sometimes on the ground that differential ratios can be circumvented by banks' shifting deposits from one category to another.

For instance, according to a paper prepared by the Van't Dack of BIS, some countries have higher ratios for short-term deposits so as to lengthen the maturity of deposits (Brazil, Colombia, Israel, Peru, Poland, Saudi Arabia and Thailand). Higher ratios are sometimes imposed on foreign currency deposits in some countries (Peru and Thailand). According to the US Federal Reserve, since the early 1990s, reserve requirements have been applied only to transaction deposits. Required reserves are a fraction of such deposits; the fraction-the required reserve ratio-is set by the Board of Governors.

The Bank of England also has provision for reserve requirements. Banks and building societies are required to place a small proportion-currently 0.15 per cent-of their liabilities with the Bank of England on a non-interest bearing basis. Reserve requirements can serve at least four functions. In the industrialised nations, the United States and England for instance, the main role for these requirements are stabilising the overnight interest rate in the face of changes in liquidity that are sometimes purely technical in nature (buffer function).

In nearly half of the emerging countries, reserve requirements often represent the major determinant of the demand for central bank reserves and are used to perform liquidity management functions. Another function for reserve requirements is that it can be used actively as a means of changing the stance of monetary policy. According to the BIS paper, this was the case years ago in only two industrialised countries but remains the case in some developing countries-India being one of them. Lastly, the reserve requirements can be regarded as a source of revenue for the central bank.

Central banks in emerging markets tend to use reserve requirement variations to offset autonomous influences on bank liquidity more frequently than in indutrialised countries. In some cases, the management of reserve ratio requirements is also guided by the stance of the monetary policy. The phasing out of direct controls on bank credit has often involved the imposition of high reserve requirements as a traditional measure to control liquidity.

Among emerging markets economies, there are substantial differences with regard to frequency of changes in reserve requirement ratios. Four countries -Brazil, Columbia, India and Russia-have very frequently adjusted their ratios for the purposes both of offsetting autonomous liquidity developments as well as controlling the growth of broader monetary aggregates. In contrast, the ratios are changed only infrequently in Indonesia, Korea and Peru primarily to accommodate "structural changes" in liquidity conditions of different sources. Tarapore admits that the phasing out of the CRR as a direct tool will lead to higher reserve requirements. But, according to him, "at least we will be moving towards the right direction in the new millennium".

Present deputy governor YV Reddy also agrees with Tarapore when he says: "It's not that the RBI is not committed to towards moving to a lower reserve requirement regime" (a recent speech delivered at Kathmandu). The medium-term objective of reducing CRR to the minimum prescribed in the statute (3 per cent) and the longer term objective of proposing amendments to the statute to make all the reserve requirements flexible will be pursued, consistent with development in fiscal and monetary conditions, points out ready. But the moot point is: how long will take to achieve the longer term objective?