Following the three schemes under the special dollar-rupee forex-swap facility, introduced on June 8, the Reserve Bank of India (RBI) mobilised over $140 billion, leaving the banking system flush with durable liquidity of over ₹14 trillion. Consequently, the weighted average call rate (WACR) — the operating target — went well below the lower bound of the corridor. Apart from the regular liquidity adjustment facility (LAF), the RBI absorbed about ₹2 trillion through sales under open market operations (OMOs) and sell-buy swaps in September, lifting the WACR above the lower bound, but it still remained well below the policy rate. On October 8, the WACR was at 5.30 per cent even as the RBI had raised the policy repo rate to 5.5 per cent on October 7. To further lift the WACR, banks were required to maintain 99 per cent of the cash reserve ratio (CRR) on a daily basis, up from 90 per cent effective the fortnight beginning October 16. Anticipating this, banks began building CRR balances, pushing up the WACR above the policy rate to 5.55 per cent on October 14 and above the ceiling of the corridor to 5.81 per cent on October 26. Notably, some banks have been accessing the marginal standing facility (MSF).
With the inflation rate above the RBI’s target and the central bank in tightening mode, it was imperative to swiftly align the operating target with the policy rate and the RBI deserves credit for acting promptly. Now that the WACR has crossed the ceiling, there is a case to restore daily CRR maintenance to 90 per cent because the continuation of the 99 per cent requirement has serious side effects.
Banks in the normal course use the flexibility of CRR maintenance to arbitrage with the call-money market. When the WACR goes up, they maintain lower CRR balances and lend in the call market, and vice versa. This arbitrage helps align the operating target endogenously, reducing the need for frequent central bank intervention.
With banks now required to maintain 99 per cent of CRR every day, the vital arbitrage sustaining the call-money market has effectively broken down. This is inimical to the smooth functioning of the call market, whose volumes have shrunk over the years. The 99 per cent rule takes away the incentive to trade, makes the WACR thin, pushes banks into building precautionary excess reserves, and forces more recourse to the MSF window. Some may argue that a 99 per cent daily floor is justified since banks, on average, maintain CRR balances significantly above the prescribed requirement. This, in fact, makes a case for a lower daily requirement, not higher. The issue is not how much banks maintain on average, but how best to ensure smooth arbitrage between the call-money market and CRR maintenance.
The last occasion when the RBI raised the minimum daily CRR maintenance to 99 per cent (from 70 per cent) was in July 2013. Then, however, it was a temporary squeeze to tighten liquidity conditions amid heightened volatility during the taper tantrum. Now it is to absorb a large surplus.
The current reduction in surplus is largely due to government cash balances of close to ₹7 trillion. Once the government spends, the surplus will rise again and the WACR may moderate from the current elevated level and possibly move below the policy rate. Hence the solution lies in addressing the durable liquidity surplus, which is expected to persist, through durable measures. Notably, there are limits to OMO sales and sell-buy swaps.
Though the Foreign Currency Non-Resident (Bank) scheme had stipulated that incremental deposits mobilised under the swap window would be exempt from the CRR/statutory liquidity ratio requirements, this does not prevent the RBI from subjecting all incremental net demand and time liabilities (NDTL) to the CRR or even raising the CRR on outstanding NDTL. A CRR increase is transparent, and it preserves price discovery and drains durable liquidity, leaving call volumes and the averaging mechanism intact.
Admittedly, the CRR is a cost to the banking system because the RBI does not pay any interest on its balances. However, we are in a period of large liquidity surplus and the cost of managing it also needs to be shared by the banking system. As of now, the RBI is bearing the entire cost. It would not be unreasonable if the banking system also bears a part of it.
Beyond cost sharing, there is a macroprudential case for a CRR increase. The CRR is now at a record low of 3.0 per cent. It is no longer a tool for day-to-day liquidity management. It is now a prudential buffer that can be deployed at short notice, even retrospectively, to inject liquidity in difficult times. It will also help build a buffer for future use.
In sum, it is important to durably align the WACR with the repo rate while preserving activity in the call-money market. If a durable surplus persists, as appears likely, raising the CRR from its historic low would be the most transparent and effective signal of durable tightening.
The writer is senior fellow, Centre for Social and Economic Progress, New Delhi. The views are personal
 "RBI, Reserve Bank of India")