Neither affordable nor relevant

Is it time to review the need to maintain CRR funds with the central bank?

India’s banking regulator has the unenviable task of nursing the banking sector back to health as well as address macro growth challenges. On the one hand, the country's banks, particularly PSU banks, are struggling with reduced profit and eroding capital, on the other, the RBI’s is trying to revive credit growth by reducing the interest rate and enhancing liquidity. A wide range of decisions have been taken to address the issues facing industry. While the efforts continue it is somewhat surprising that not much action was seen on the cash reserve ratio (CRR) front. Indian banks currently maintain an estimated Rs 5.25 trillion with the RBI, without any income from the same. However, they incur a deposit cost of about Rs 25,000 crore annually. Rethinking CRR might help address some of the challenges the RBI is trying to address. 

Textbooks continue to tout the money-multiplier (MM) argument for CRR (or reserve requirement in a global context). However, the credibility of the money multiplier argument based on the fractional reserve banking (FRB) construct has waned over the years. The whole hypothesis was weak to start with. There are at least six countries — Australia, Canada, Denmark, New Zealand, Norway, and Sweden — where the legal reserve requirement is zero. Clearly the money multiplier does not become infinite!

Jaromir Benes and Michael Kumhof of the IMF state that the logic of RR enabling high-powered money (M1) to get multiplied by bank lending is contrary to the operational mechanism of credit and money creation. The same researchers find that central banks oblige whenever banks require money to compensate for depleted reserves. Thus the argument that banks need to keep cash in vaults or with the central bank is less tenable than popularly believed. With the two popular reasons for CRR either theoretically untenable or practically irrelevant, one might ask why India persists with CRR and that too at the current levels.

Is CRR useful? CRR along with open market operations (OMO) and standing facilities are a central bank’s tools to operationalise monetary policy. CRR is a quick way to adjust the demand for liquidity while the other two tend to impact the supply of liquidity (O’Brian, Federal Reserve Board, Washington). In the past, developing countries have used RR in conjunction with domestic interest rate as a macro prudential tool.

Between 1970 and 2011, India was one of the most active users of CRR as a monetary stabilisation tool (Frederico, Vegh, Vuletin; 2014). This was a classic developing market behaviour. In that context, the fact that the CRR rate has remained at 4 per cent since February 2013 suggests a significant divergence from the pre-2011 behaviour. Of course, the RBI did increase the incremental CRR to 100 per cent during the demonetisation period, but it was used as a temporary measure. 

Not using the CRR as a macro-prudential tool is a significant evolution in India’s behaviour. Stable, infrequently altered reserve requirements, is a feature of OECD nations.

India’s reduced dependence on CRR may not be coincidental. India’s overall macro-prudential strategy is closer to the OECD playbook. The country has adopted inflation targeting and its stated fiscal deficit target is based on a target debt-to-GDP ratio of 60 per cent (NK Singh committee). The same debt-GDP ratio is required for European countries as per the Maastricht Treaty, an eligibility criteria for Eurozone membership. You can have too much of a good thing and that is equally applicable to macro-prudential norms. The existence of CRR and that too at current levels looks out of misplaced.

After hovering at peak rates of 14.5-15 per cent between 1988 and 1994 the trajectory of our CRR has been largely falling in line with most of the world. During that period quite a few countries reduced RR to zero, while a number of OECD and other industrial nations have got them at levels of 1.5-2 per cent.

If deployed as interest earning asset, the current CRR an interest income to the tune of Rs40,000 crore or more. To put things in perspective, PSU banks’ cumulative annual PBT for FY19 is estimated at Rs 1.15 trillion. Two-thirds of the CRR can safely be attributed to PSU banks. Any support coming via redeployment of CRR will have a meaningful impact on PSU profitability. Not to mention the fact that it would unleash Rs 5.25 trillion worth of liquidity into the market.

A conservative and calibrated reduction of CRR to a level of 1.5 per cent over the next couple of years is a viable option. In any case there should be a debate on whether India needs a CRR in the first place. Burdening banks with CRR may not be in the best interest of the economy.

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The writer is a visiting faculty of Finance at IIM Calcutta & a risk consultant