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The Reserve Bank of India (RBI) in its Mid-Term Review of Annual Policy Statement for the Year 2007-08 wiped out any hopes of interest rate easing in the near future, as it hiked Cash Reserve Ratio (CRR) i.e. the amount of money banks must hold in cash, by 0.5 per cent to 7.5% to suck out liquidity despite inflation at a five-year low. Good point about the CRR hike that it will stabilize liquidity and further hike in interest rates is unlikely.
We can see this hike by linking the same as a means of liquidity management rather than a signal to check inflation. This move is expected to suck additional liquidity to the extent of Rs. 15,000 Crore from the banking system. This policy echoes concerns raised by Government of India on massive capital flows into the country, Reserve Bank of India (RBI) in its policy document said managing the inflow, related liquidity implications and overall stability were the biggest challenges of monetary policy. Today, in India, we face a problem of enormous capital flows. This is a completely new situation for us. Capital is welcomed but we must learn how to manage capital, how to absorb capital.

RBI Governor Y. V. Reddy sent strong signals about the hawkish stance would continue in order to ensure price stability, credit quality and orderly conditions in the financial market. With increasing liquidity, commercial banks have been reducing the deposit rates to bring down cost of funds and in turn decreasing rates on new retail loans to improve credit offtake. This had raised hopes of interest rates falling further in the future before the policy announcement. I think that by this hike in CRR there will be further slowdown in credit off take. Credit off take since the beginning of this financial year was Rs. 90,262 crore as on October 12. During the corresponding period of the last financial year, it was Rs. 1,30,764 crore. Hiking the CRR, at this juncture was going to translate into lending rate increases. This was because, CRR deposits with the RBI earns zero interest for the banks. Lending rates for top corporates are already close to the prevailing benchmark prime lending rates – ranging between 11.5 and 13 per cent. Besides, many banks continue to offer deposit rates of close to 9 per cent. With inflation currently at 3.07 per cent, interest rates are seen to be on the already on the higher side which will further increase by a hike in CRR.

This hike in CRR can be seen as RBI’s outlook on inflows through Participatory Notes. In the current scenario, although the inflows appear to have tapered down, there could be changes. The changes hinged on the US Federal Reserve Board’s decision. This CRR hike by RBI is at the time when markets world wide are expecting a 25 to 50 basis point reduction in the key Fed Funds rates (this is the rate at which US banks borrow/lend overnight reserves), from the current level of 4.75 per cent. A Fed Funds reduction would raise the arbitrage margins between India and the US. Currently this margin is about 1.25 cent. This was assuming the difference between the funds rate and RBI’s reverse repo rate. An expected Fed Fund rate drop had left RBI with only alternative to tweak the CRR once more. This was to check such arbitrage flows. So this CRR hike is a compulsory measure rather than out of choice by RBI.

By this CRR hike, loan growth will have a negative impact which will have its own downside effect on achievement of 8.5% GDP growth, which is forecasted by RBI in the same policy document. But by this move apex bank may provide solution to one of the important concern of economy as a whole that is with rapid loan growth in emerging markets including India, economy could lead to asset quality problems in the future even as these countries are showing good economic growth.

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* Contributed by: -
Dr. Gourav Vallabh holds Certified Financial Risk Manager (GARP, USA), Chartered Accountant (ICAI, India), Company Secretary (ICSI, India), Ph. D. (UoR), M. Com., L. L. B. qualifications, and is currently Professor (Finance) at XLRI, Jamshedpur .