CRR hike as double whammy

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.

A buy-sell swap is a transaction in which RBI buys spot dollars, creates reserve money in the process, and then sells back the currency at a future date at a pre-negotiated price to scheduled commercial banks. The system, therefore, has excess rupee liquidity till such time as the swap unwinds. Now, if the volume of swap transactions is huge (as was the case during January-February 2008, when the forward liabilities increased by $8 billion), this will obviously result in a decline on forward premia. Interestingly, the data on forward premia actually shows a significant decline during February 2008, when the monthly premium rates turned negative from earlier levels. Clearly, there is reason to believe that RBI had used the swap route more often during this time. By logic, a sell-buy swap transaction may be ruled out, as the rupee was not under any pressure at the time.

What if RBI was using the outright forward purchase route during this time? The only difference could have been that, there could have additional liquidity injected into the system in lieu of forward purchase at a future date, that RBI had to take care of.

There we have the answer to the question of why we think CRR is being sought to be used as a double whammy. Both the buy-sell swap and outright forward purchases that RBI may have taken recourse to during October 2007-February 2008 have to be neutralised through other measures.

Interestingly, as the table (alongside) on monetary and exchange rate management shows, the Omo route has also (surprisingly) injected liquidity during this period, instead of withdrawing liquidity. Thus, the only option left to RBI was to use CRR as an additional instrument to withdraw liquidity. Clearly, the subsequent CRR hikes have been a very smart move by RBI, but the intended purpose was perhaps short-term monetary management.

In the past, RBI has clearly shown its apathy to swap transactions. To quote the bank, ?The extent to which such swaps can be undertaken depends on the depth of the forex market. The recent experience of building up of forward purchase obligations to meet repayment of Resurgent India Bonds (RIB) showed that such operations could result in pressure on the market to meet deliveries. Moreover, sell/buy swaps, even when undertaken on a large scale, do not have any lasting impact in correcting distortions in forward premia. Also, the cost of swaps, as captured in the accounts of the Reserve Bank, has increased with the appreciation of the rupee?.

The central bank has made a conscious effort to make its policies transparent in recent times. It is true that RBI should keep its cards close to its chest so as to take the market by surprise and make it more effective, and this should continue. But the credibility of the bank could be enhanced through more transparency. To this end, for example, any press releases by RBI during a market crisis should be balanced by full disclosure of the actual policy thereafter, to confirm that the initial policy statements were not merely symbolic.

The author is a director with a leading MNC. These are his personal views