No case for CRR cuts with liquidity deficit driven by transitory factors

The overall liquidity of the banking system turned into a deficit starting the second fortnight of December 2024, with the shortfall gradually rising to Rs 2.36 trillion by January 20. This was partly due to a build-up of government cash balances with the Reserve Bank of India (RBI). Net surplus durable liquidity also declined from a peak of Rs 4.20 trillion on July 26, 2024 to Rs 64,350 crore by December 27 (the latest period for which data is available), mainly because RBI intervention in the forex market drained a considerable amount of rupee liquidity from the system. Since forex reserves held by the RBI declined further by about $14 billion (between December 27, 2024 and January 10, 2025), even the durable liquidity might have turned into a deficit by now. 

 

Anticipating the current liquidity deficit, the RBI in its December policy proactively reduced the cash reserve ratio (CRR) of all banks in two equal tranches of 25 basis points (bps) each to 4.0 per cent of net demand and time liabilities (NDTL) in December 2024, thereby releasing primary liquidity of about Rs 1.16 trillion into the banking system. 

 

Some financial newspapers have reported that, in a recent meeting, bankers suggested to the RBI that durable liquidity could be provided by implementing an additional reduction in the CRR. With the CRR now at a critical level, there is a need to exercise utmost caution before considering any further reduction.

 

The CRR, which was once used as a monetary management tool to contain reserve money expansion, now serves two purposes. First, it helps stabilise short-term interest rates by absorbing sudden inflows/outflows in settlement balances (funds used to settle the payment obligations) in accounts maintained by banks with the RBI. Since the CRR is required to be maintained at the end of the day, banks use CRR balances for settlement purposes intra-day. The lower the level of required reserve balances with the RBI, the less leeway banks have to manage their intra-period reserve position without risking an overnight liquidity deficit. Furthermore, a shortfall at the end of the day can be taken care of by CRR balances as the CRR is required to be maintained on an average basis (subject to the minimum daily maintenance of 90 per cent of the prescribed CRR) during the fortnight. This mitigates the pressure on the overnight inter-bank call money rate, which is the operating target of monetary policy. It is with a view to stabilising short-term interest rates that the cash reserve requirement is applied, either mandatorily or voluntarily, even in many advanced economies.

 

Another key rationale for the cash reserve requirement in emerging markets is to address liquidity concerns arising from large and sudden capital flows. In recent years, there have been at least two occasions when the RBI needed to inject massive liquidity into the system on a short notice to calm financial markets. The first occasion was during the North Atlantic Financial Crisis of 2008, when the RBI injected or announced liquidity measures equivalent to over 15 per cent of NDTL, including a cut in the CRR by 4 percentage points from 9 per cent to 5 per cent.

 

The second occasion when the RBI injected extraordinarily large liquidity (of more than Rs 17 trillion — equivalent to 8.7 per cent of India’s gross domestic product — of which more than Rs 14 trillion was only for banks) was during the Covid-19 crisis. It is significant that ever since the CRR was first revised upwards from 3 per cent to 5 per cent in June 1973, it was never allowed to fall below 4 per cent of NDTL,  except for a brief period during the pandemic, when it was cut sharply by 100 bps to 3 per cent of NDTL in March 2020.  Since the CRR was already at a critical level, it was reduced as a one-time dispensation and restored quickly to 4 per cent in two phases within one year.

 

In a crisis, reducing the CRR is the most effective way to swiftly add large durable liquidity at the system level, offering a flexibility that other instruments lack.  For instance, injecting durable liquidity through open market operations (OMOs) is a relatively slow process, making it difficult to add substantial liquidity quickly at one go. Also, only banks with excess statutory liquidity ratio (SLR) securities can participate in OMOs. Furthermore, large OMOs can distort yields on government bonds and impart large volatility to the overall interest rate structure. Unlike other instruments, the RBI is not operationally constrained in any manner to add durable liquidity swiftly by reducing the CRR, and its impact is transmitted uniformly (relative to their NDTL) across banks. In fact, the CRR could be reduced even for the ongoing fortnight as it is required to be maintained with a lag of one fortnight, which enables the RBI to add immediate liquidity into the system.

 

Since the CRR is already at a critical level and we are not in a crisis, it may not be prudent to reduce it below 4 per cent. Moreover, the current liquidity deficit is partly due to transitory factors.  The regular liquidity adjustment facility window of the RBI is meant precisely for addressing such liquidity needs.  Even if durable liquidity is required to be injected, various other options could be explored.

The author is senior fellow, Centre for Social and Economic Progress, New Delhi