Why the cash reserve ratio had to be cut

Use every possible excuse to lower it further, slowly

SS Tarapore

On May 12, 2001 the Reserve Bank of India (RBI) reduced the cash reserve ratio (CRR) from 8 per cent to 7.5 per cent. Depending on the deployment of the released Rs 4,500 crore, and adding Rs 180-220 crore per annum to the bottomline of banks. The CRR is an unfair tax on the banking system and the reduction is welcome. Cassandras would argue that the reduction is a ploy to ensure that the government’s borrowing programme goes through smoothly. Even if this was the main reason for the CRR reduction one would be inclined to support the measure on a number of counts.

First, in the past five years, the management of the borrowing programme and the open market operations (OMO) - a few blips apart - has been exemplary and it would be appropriate to use the OMO tool rather than the blunt and distorting instrument of the CRR to attain the desired degree of monetary control.

Secondly, the CRR generates serious inter se inequity among banks. The exemption of non-resident deposits from the CRR requirement for foreign banks, while exempting inter-bank liabilities, encourages imprudence despite all the regulatory safeguards.

Thirdly, now that the RBI has been enticed into paying higher interest on CRR balances, the danger is that the RBI can find itself on an escalator of a higher interest on CRR balances and a higher CRR prescription.

Fourthly, the authorities’ passion for lower interest rates cannot be consummated without a CRR reduction; in all probability the authorities would bring down the Bank Rate before this column goes into print. The recent interest rate reductions by the UK, the ECB and the US would be too powerful for the RBI to abstain from similar action. Given all these circumstances it is just as well that the RBI has brought down the CRR.

The RBI should use every possible excuse to gradually bring down the CRR. This would be the ideal time for it to impose CRR on non-resident liabilities and inter-bank liabilities and withdraw the leeway to banks on daily maintenance of CRR and simultaneously further bring down the present CRR prescription of 7.5 per cent. The sooner the RBI brings down the CRR to 3 per cent the more efficient it would be as a monetary policy tool. In the mid-’70s the RBI raised the CRR in two sharp steps from 3 to 5 per cent and thereafter to 7 per cent and as soon as the objective of monetary control was achieved it was quickly brought back to 3 per cent. The RBI would do well to revisit its policy responses in the 1970s.

While the RBI has been loquacious in its monetary policy review of April 2001 the CRR reduction of May 12, 2001 is a cryptic statement without any explanation of the underlying rationale. The April review has so much gravitas that much of the insights are lost to observers. It is gratifying that the document on Macroeconomic and Monetary Developments 2000-2001 tracks the reserve money components into the net foreign assets (NFAs) and the net domestic assets (NDAs) which shows that in the recent period NFA has increased sharply while NDA has contracted; this should be of immense comfort to the RBI. The same document makes the percipient point that in a regime of frequent CRR changes, it is useful to adjust reserve money for CRR changes as per the Rangarajan-Anoop Singh formulation.

The same document reveals the RBI’s predilection to avoid the constraint of a single-objective approach for monetary policy and clearly shows its preference for a multiple-objective approach. While one may not agree with this approach, as an RBI-watcher one has to adjust one’s sights to it. What this means is that the monetary policy would, in the immediate future, be unpredictable and incoherent but the RBI would not face problems of accountability!

It is gratifying to note that while in April 2000 the RBI was disinclined to support the proposal to separate debt-management from monetary policy, in its policy of April 2001 it has had a change of heart and proposes to take up with the government the feasibility of further steps for separation of government debt management from RBI. It needs no soothsayer to state that when the Fiscal Responsibility Bill is enacted, the RBI will find its multiple-objective approach to be uncomfortable, and may have a change of heart and prefer the single-objective approach for monetary policy. As Milton said, “They also serve who only stand and wait”.

In a percipient article in the Financial Times (Apr 25) Jose Maria Aznar, prime minister of Spain, argues that governments must recognise that monetary policy is no substitute for sound economic policy. He emphasises that interest rates are not the only tool of economic policy. Is the government of India listening?

The economy cannot be kept on a desired growth path merely by tinkering with interest rates. Misallocation of capital takes place in a credit-led boom when imprudent risks are taken and these problems do not go away by a few interest rate cuts. Donald T Brash, Governor, Reserve Bank of New Zealand, in a recent lecture, ‘Central banks: What they can and cannot do’ argues that central banks can make a modest contribution to trend growth by keeping inflation low and help avoid the social injustices caused by unstable money.

In seeking to keep inflation low central banks have a tendency to smooth the economic cycle; all central banks, even those without a formal mandate on output and employment, watch the impact on the economy of attempts to keep inflation under control. By keeping inflation low it enables actual output to closely track potential output. Central banks can help reduce economic and social distortion caused by booms and busts. Mr Brash cautions that productivity increases are sometimes erroneously attributed to sound monetary policy; they are essentially a result of new technology. While good monetary policy may not impede this development it certainly cannot create new technology. Again, central banks cannot materially alter the trend rate of growth of output and employment. The government of India needs to understand this basic fact.