The cash reserve ratio (CRR), an instrument of monetary policy, has been in the news recently for two reasons. On September 17, the Reserve Bank of India, while unveiling its mid-quarter monetary policy review, reduced the CRR from 4.75 per cent to 4.50 per cent. The CRR is the proportion of deposits that commercial banks must maintain with the central bank. The 25 basis points cut would release Rs.17,000 crore of primary liquidity and through a process of monetary multiplier several times more.

CRR is one of the two reserve ratios. The other SLR or Statutory Liquidity Ratio is the proportion of demand and time deposits that banks have to keep invested in unencumbered, approved government securities, gold or cash. SLR, now remains at 23 per cent. The last time it was altered was on July 31 at the time of the first quarterly statement.

The second reason why the CRR has figured prominently in today’s news is that its relevance to today’s bank regulation has been questioned. Some bankers question the rationale behind it — why so much of their deposits should be impounded and kept as interest-free deposits with the central bank. But as can be seen later, the debate is by no means conclusive. As there are many arguments to do away with the CRR, there are many which call for its continuation.

The CRR, SLR as indeed the repo rate or marginal standing facility rates are normally arcane subjects fit for serious discussion by commercial and central bankers, and those intimately connected with the financial sector. The reason why even the proverbial man on the street is getting interested is simply due to the fact that developments in monetary policy are now seen to be impacting everyone in the normal course. Ordinary citizens have a vested interest in, say, the interest rate policy, much more than at anytime in the past. One reason, of course, is that he or she can avail himself/herself of a variety of loans, the educational loan, home loans and other personal loans, whose interest costs are obviously a matter of concern. Many more people are becoming aware of the inflation. On Monday last, the RBI did not alter its policy rates. By restricting monetary action to the CRR cut, the RBI is striking a via media. As has been the case with all recent policy reviews, there was a clamour for a policy rate cut. Economic growth has remained sluggish. The latest Index of Industrial Production (IIP) numbers reveal a bleak picture. These might be no different from what it has been for a few months. But the clamour for interest rate reduction seemed to get an extra legitimacy this time.

Just the previous week, the government had announced some major economic reform measures aimed at stimulating foreign direct investment into the country and getting a handle over the burgeoning fiscal deficit. By opening up the retail sector, the government hopes to receive large capital inflows. The diesel price hike is seen to be a significant step aimed at curbing subsidies. All these created euphoric conditions. The expectation was that the RBI would complement these measures with a rate cut.

On the other side, inflation, in all its manifestations, has worsened. Wholesale price index-based (WPI) inflation was higher in August compared to July, and core inflation (non-food manufactured products inflation) also rose from its level seen in April this year. In terms of the new consumer price index (CPI), inflation has remained in double digits. Looking ahead, very few visualise WPI inflation coming down to RBI’s comfort levels of 7 per cent by the end of the year. Inflation expectations have become unhinged, and for monetary policy to be credible, there cannot be a softening of interest rates at this juncture. The fuel price increase will aggravate inflationary pressures at least over the short-term. All these explain why the RBI is to be commended for choosing a middle path. The CRR, by adding to liquidity, should induce banks to cut rates and lend more. But the bigger question is whether the CRR should remain as an instrument of monetary policy.

Those who argue that CRR should go are of the view that it curbs their ability to lend more. According to them, funds get unnecessarily blocked. They yield no return also. Further, compared to mutual funds, non-banking finance companies (NBFCs) and insurance companies, which are not under any compulsion to follow CRR norms, banks are placed in a disadvantageous position. From the reform perspective, the Narasimham Committee-1 mandated a sharp reduction in the CRR and SLR.

Yet, according to many, the time to do away with these statutory pre-emptions has not yet arrived.

It fulfils an important regulatory function in countries such as India where the Open Market Operations (OMO) that central banks use to check liquidity face some structural rigidities. Central banks rely on CRRs to check inflation by varying money supply. An increase in CRR lowers the multiplier, and, hence, the growth of money supply. The opposite result happens when the CRR is lowered. Banks ought to view the zero interest on CRR balances as a fee paid to the RBI for its supervisory function. Banks alone can mobilise low-cost savings and current account deposits. Mutual funds, NBFCs and insurance companies do not have access to such funds. So, banks are not disadvantageously placed in having to meet CRR obligations.

The debate will continue.