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CRR Hike and its Impact On The Economy

With the hike in the CRR in the third quarter review of the monetary policy, the RBI has begun to
move towards monetary tightening amidst a recovery. Going forward, it remains to be seen how
the central bank will face the twin challenges of managing the inflation and exiting from the
stimulus packages and, at the same time, ensuring that the economy does not get derailed from
its projected growth path.

The year 2009 ended on a positive note with most of the developed markets witnessing a
recovery. There is indeed no doubt that much of this recovery was driven by the stimulus
packages announced by the governments and monetary authorities. Although the world
embraced the turnaround with ample relief, there was a concern among many that the stimuli
may fuel inflation. A bubble in the Chinese economy and the dollar volatility are directly related
to his phenomenon. The Reserve Bank has always been hawkish on inflation. With the growth
projections also being very optimistic, a firmer stance on inflation management is on the cards of
the central bank.

In its third quarter review of monetary policy, announced on January 29, 2010, the Central Bank
increased the Cash Reserve Ratio leaving all other monetary policy tools untouched. The Cash
Reserve Ratio or CRR indicates the portion of time and demand deposits that banks need to keep
with the RBI. According to the Banking Act of 1934, this percentage can be revised from time to
time with an upper limit of 20% and a lower limit of 3%. In the recent review, the RBI raised this
rate by 75 bps (basis points), i.e., from 5% to 5.75%. This hike would be done in two phases
and is expected to suck out Rs. 36,000 cr from the economy. Since the market expected the
central bank to increase the rate by 50 bps, the CRR hike of 75 bps came as a surprise.
Figure 1 indicates the hike in CRR in recent years.
Market participants had diverse opinions before the hike was announced. Planning Commission
experts and economic advisors to the Ministry of Finance were apprehensive that the hike in the
rate would curtail growth prospects. Dr. Rangarajan, former Governor of RBI, strongly advocated
monetary tightening. The hike in CRR makes India one of the first few economies in the world to
go in for a tight monetary policy in the face of a recovery. China had raised its CRR and
Australian Central Bank had hiked its policy rates by 75 bps.
The last time that CRR was in the range of 5% was in November 2008. The signals of a change
in the stance of RBI towards interest rates was visible in the second quarter policy review in
October 2009. The RBI had clarified that it was moving from a phase of `managing the crisis' to
a phase of `managing the recovery'. The Statutory Liquidity Ratio (SLR) was increased from
24% to 25% in October. This change was more academic than effective at that time but it gave
a clear message that the central bank would not reduce the interest rates any further. Since the
banks had on an average already invested 28% of their deposits in government bonds, raising
the SLR in October did not have much impact on the market. The RBI had also indicated
withdrawal of refinance facilities for non-banking financial companies, housing finance firms,
mutual funds and exporters. The window for swapping banks foreign exchange liabilities was also
closed. However, none of these moves had much impact on the liquidity.
In the third quarter review, the RBI has made its stance tighter and strengthened its exit policy
with a stronger statement of a CRR hike. The RBI has always been concerned with inflation and
with the recovery of the economy being confirmed by most indicators, it has lost no time in
putting brakes on the rising inflation. Figure 2 shows the inflation levels in current times.
According to the statement released by RBI, the outlook for wholesale price inflation has been
hiked to 8.5% by the end of March 2010. The RBI had earlier projected the inflation to be around
6.5%. Despite the threat of inflation haunting the Central Bank, growth projections have been
impressive at 7.5%. This is higher than the earlier projection of 6%. After the Lehman debacle,
the RBI had put in enough of an accommodating monetary policy by reducing the CRR from 9%
in July 2008 to the current level of 5%. The main concern during that period was a very `fragile'
growth but as the economy struggled to emerge out of the crisis, the fears of inflation became
more apparent. The Wholesale Price Index (WPI) inflation was near about 7.31% in December
2009 and crossed 8% in January this year, as shown in Figure 2.

Inflation in India
Wholesale Price Index (WPI) rose to 7.31% in December, mainly due to higher food prices. It is
expected to reach 10% by March end 2010. The RBI has projected an increase by 200 bps to
Consumer inflation, measured by the Consumer Price Index (CPI), rose to 13.68% in January
2010, compared to the same month a year ago. This was mainly due to the hike in food prices,
rent, fuel and higher education expenses. Figure 3 shows the sharp increase in prices in the
retail market.
Alternative Policy Rates
Although a hike in the CRR was expected, one can wonder why RBI chose not to tamper with any
other monetary policy rates, such as the repo, bank rate, etc.
To increase the liquidity in the system, the RBI had reduced both repo and reverse repo rates in
2008 and 2009. Between October 2008, and April 2009, the RBI reduced the repo rates from 9%
to 4.75%. The reverse repo rate was lowered to 3.25%. The former is used to suck out money
from the system, while the latter injects money. It is expected that if inflation does not moderate
by July, the RBI might consider increasing the reverse repo rates ( Refer Table and Figure 5).
In a situation of excess liquidity, there are primarily three ways to control it. The first is the repo
window of RBI but here the cost falls on RBI. The second option is to float Market Stabilization
Scheme (MSS) bonds. In this case, the cost falls on the government. The third option is a hike in
CRR, where the cost falls on commercial banks as they lose the interest on the extra amount
kept with the RBI. Thus, this is an apt time for the CRR hike, as postponing the decision would
only make the hike bigger. At present, the banks are flush with liquidity and it is unlikely that
there will be much impact of the current hike on the interest rates. However, by the second half
of March, the advance tax payments will reduce liquidity in the system, and the banks might
need to use the repo window. Also inflation presently is very much supply side driven and
demand management tools may not be so effective. The hike in CRR was mainly to address the
liquidity overhang and the resulting inflation but most bankers feel that interest rates will not
move up. The credit uptake is still low and banks are flush with a lot of liquidity. There is no
reason hence to expect the interest rates to rise in the near future. However, one does observe a
pickup in bank credit. The year-on-year growth in bank credit is currently at 13.7%.
Real Rates
The real interest rates, which are nominal interest rates discounted for inflation, are currently at
their lowest levels since the last seven years. The lending rates were at 6.04% on January 1,
2003 and have since fallen to 3.90%, as on December 1, 2009. Hence there is enough reason for
the RBI to correct them. However, the big debate is that the economy is just poised on the
recovery path and correcting interest rates at this point may not be desirable. However, one
must note that policy rates, such as repo rates, have actually become negative in real terms in
the last few months. The 10- year yield, as at the end of December 2009, was almost zero. The
question is whether the growth rates reaching almost 8% in the July-September quarter was
entirely induced by such low policy rates. Monetary policy is always hurt by a classic dilemma
that while uncontrolled inflation will hurt the consumers, the hike in policy rates will hurt
investors. The situation is no different now. The core inflation in India, which excludes food and
energy, is not only persistent, but also high. The manufacturing inflation calculated by moving
average method is between 4.5-6%. The year-on-year core inflation has been on a positive trend
in the last few months. This has its own implications. Food prices are a big driver in inflation
figures– contributing almost 3% and that is entirely a supply side story. But rise in the core
inflation rates indicate that demand pressures are not negligible any more. Core inflation is
expected to rise even more in the next few years. In the management of inflation, inflationary
expectations need to get controlled as well. Perhaps that is the stance that RBI decided to take.
Global Rating Agency, Moody's stated that there will be `negligible impact' on bank earnings. It
does not expect any upward pressure on bank rates.
The fiscal policy announcements will have a significant impact on how the RBI continues to
maintain its stance in its next quarterly review. Without a fiscal roll back, albeit gradually of the
stimulus package, the monetary tightening will not have much significant effect on inflation.
Impact on Bond Market
Bond yields increased significantly following the announcement. The 10-year yields increased
sharply from the current levels of 7.60%. There is also nervousness about the bond supply. The
RBI Governor indicated that the bond supply for the fiscal year 2010-11 will match, and may
even exceed, the current year's level of Rs. 4,50,000 cr. The Government's financial situation is
weak. The fiscal deficit has already crossed 77.3% of full year's target and tax revenues have
fallen by 2.5%. The 3G spectrum auctions are still uncertain and the fertilizer subsidy bill is
already very high. If the government needs to borrow more than planned, the supply will
increase in the bond market. Yields were higher by at least 5 bps. The cutoffs for the treasury
bills of 91 days, as well as 365 days, saw a hike. Even corporate bonds saw higher yields. Since
the yield curve is now very steep and short-term interest rates negative in real terms, it is
imperative that monetary policy goes beyond just liquidity management. The short rates have to
move up, at least by 300 bps.
The RBI has started a process of monetary exit very gently. While inflation has taken a higher
priority, RBI is still watchful on growth. It is possible that the next step is hiking the policy rates.
It is likely that overnight rates will move up. Once the Union Budget 2010-11 is presented a
clearer picture will emerge on the need to increase policy rates. With the recovery being just
visible, it is more important to reduce the excess liquidity than just increase borrowing costs. It
is important that the economy does not derail from the projected growth path and the decision
taken by the RBI facilitates the growth process.
Hike in CRR: Beginning of The Exit Strategy?
-- Ameena Parveen
Faculty Member, FedUni,
Examination Department, Hyderabad.
RBI has increased CRR by 75 basis points to drain out excess liquidity from the system to contain
the mounting inflation. The forthcoming budget has to clearly formulate the strategies to be
followed for controlling inflation so as to ensure inclusive growth.
The greatest challenge for the Finance Minister, Pranab Mukherjee, in his forthcoming Union
Budget would be to make the projected GDP growth rate of 7% for the financial year 2009-10
into reality and also deal with the surging food prices and overall inflation. If not controlled soon,
this soaring inflation might disrupt the ongoing economic recovery.
The Reserve Bank of India (RBI), in its third quarter review of monetary policy for 2009-10, has
hiked the Cash Reserve Ratio (CRR) by 75 bps (basis points) for the first time since January
2009 to 5.75% to squeeze excess liquidity from the system. This was primarily done to control
the rising inflation.
Emerging Asian Economies are experiencing a faster recovery from the recent financial crisis
than their global counterparts on the back of monetary and fiscal stimuli. Economic activity has
picked up faster than expected due to massive public spending by the governments, which led to
excess liquidity in the markets, resulting in inflationary concerns and higher asset prices across
the economies. The major challenge before the central banks is to find the appropriate time to
exit from their expansionary monetary policy. Some economies have already started of with this.
For instance, Australia and Vietnam have hiked their benchmark interest rates by 75 bps and
100 bps respectively in the fourth quarter of 2009. China has also raised its CRR by 50 bps to
16%. With no exception, RBI has recently announced a hike of 75 bps in CRR to 5.75% while
keeping the conventional measures of the monetary policy, such as the repo and the reverse
repo rates, unchanged (Refer Exhibit 1). However, RBI has blown a horn to exit the
accommodative monetary policy by raising the Statutory Liquidity Ratio (SLR) by 100 bps in its
second quarter review of monetary policy for 2009-10. RBI has to look into various
macroeconomic indicators, such as, GDP, money supply and inflation, while deciding upon the
monetary policy.
GDP–The Growth Projector
The Indian economy grew by a robust 7.9% in the second quarter of the fiscal year 2009-10. A
lower than expected decline in agricultural output, and the robust recovery in industrial
performance had led the Central Statistical Organization (CSO) to peg the GDP growth estimate
for the year 2009-10 at 7.2%, substantially higher than the 6.7% growth recorded in 2008-09.
Indian economy is expected to grow in the near future on the back of various factors. As
discussed above, stimulus measures announced by government is driving overall growth. In
addition, private consumption and investments are also picking up. The lagging effect of this
capital expenditure cycle is expected to contribute to the sustainable growth of the economy,
particularly in the infrastructure sector.
With the global economy moving towards stabilization, Indian exports have turned out to be
positive (Chart 1). Gradual pick up in credit growth and easing liquidity situation will further
stimulate the overall economic activity. The impact of poor performance of agricultural sector is
likely to be offset by manufacturing and service sectors. Last, but not the least, GDP growth in
the last quarter of this fiscal year would be comparatively higher because of low base effect.
Inflation—The Role of Food Prices
Wholesale Price Index (WPI) based inflation reached a 12-month high at 7.3% in December 2009
from 4.78% in November 2009. The recent rise in inflation is primarily due to the low base effect
and high prices of food items. As can be observed from Charts 2 and 3, even when the overall
inflation was negative, food inflation, comprising of food items, both from primary articles and
manufactured products group, was hovering in double-digit figures. The reason behind this is the
lower weightage given to food items in WPI. Weak monsoon added fuel to food inflation which
already entered into double digit figures in the month of April 2009. With the failure of Kharif
crop due to bad monsoon, food inflation crossed the 20% mark in the month of November 2009.
A more interesting fact is that, the core inflation, which excludes primary and manufactured food
items, was at a very low level of 2.2% in December 2009.
There has been a debate over the years on the indices to measure inflation. Most of the
economies over the globe use Consumer Price Index (CPI), which is regarded as a real indicator
of inflation, whereas in India, we prefer WPI rather than CPI. For a diverse country like India, it
is understandable to have more than one measure of inflation, but the inconsistencies related to
weightage given to core and non-core items in the two measures does seem anomalous.
Interest Rate and Liquidity Situation
As can be observed from Chart 4, there has been a significant volatility in the yields of the
government securities across both shorter and longer ends of the maturity curve with inflation
being on rising front. The yield on the benchmark 10-year government paper rose to an average
of 7.4% in the third quarter from 7.2% in the second quarter of 2009-10. It further shot up to a
13-month high of 7.7% in December 2009. However, it was condensed by the supply of gilt
papers and excess liquidity. The gap between 10-year bond yield and 1-year G-sec yield rose to
an average 370 bps by the end of November 2009. With higher deposit growth and moderate
growth in credit off-take, the liquidity condition remains healthy in the banking system. This can
also be reflected by the absence of any transaction under repo window of Liquidity Adjustment
Facility (LAF). Instead, banks are parking their idle funds with the RBI through reverse repo
window, signifying that they can meet their funding requirement with internal resources.
Commercial banks have parked an average of Rs. 1.1 tn daily with the RBI under the reverse
repo window in the current fiscal and Rs. 295 bn under Market Stabilization Scheme (MSS). In
addition, bank investments in liquid mutual funds ballooned since April 2009.

Exchange Rate—Unstable
India, which continued to be an attractive destination for foreign capital flows for a long time,
took a U-turn with a sharp decline in the same in the second half of 2008-09. There was a steep
and simultaneous fall in all capital flows except in Foreign Direct Investments (FDI). This led to
severe pressure on corporate funding, along with depreciation of the currency. However, with the
better-than-expected performance by Indian economy in the second quarter of 2009-10 and
higher interest rate differential, considerable amount of foreign capital has begun to flow in since
then (Chart 5). Until now, RBI did not intervene in the substantial increase of capital inflows and
let the currency appreciate (Chart 6), which helped in keeping a check on rising import prices
and thereby helped in combating increasing inflationary pressures. Further, growing current
account deficit has partly absorbed increased capital inflows.
Monetary Policy—Impact
The step taken by the RBI in the recent monetary policy of hiking CRR by 75 bps was to curb
inflation, but it is not likely to serve the purpose, as the current inflation is mainly supply driven.
Instead, a hike in CRR at this point in time may modulate the inflationary expectations that are
building in the economy but would fail to contain inflation as it is not a monetary phenomenon.
Further, an increase in CRR may slightly increase the cost of funds for banks and with excess
liquidity in the banking system, banks may not raise interest rates in the near term, which would
adversely impact their spreads.
Alternatively, if the banks increase the interest rates, it may have a detrimental effect on
economic growth and corporate profitability. Any increase in interest rate would further add fuel
to the already mounting input costs, which would dent the profit margins of corporates.
Particularly for infrastructure projects, even a slight increase in interest rates will have a large
impact as they operate on competitive IRRs.
Fiscal Policy—Expectations
Fiscal Consolidation
The current fiscal deficit of 10.3% of GDP (both centre and state) calls for fiscal consolidation.
The forthcoming budget has to clearly speak out the medium-term strategy for fiscal
consolidation and measures to check inflation to ensure equitable growth. A rational course of
fiscal consolidation would be to curb wasteful expenditure drastically and cut back subsidies (on
oil, fertilizer and food), that are misused and inadequately targeted. For the fiscal year 2009-10,
the total under recoveries of oil companies is estimated at Rs. 50,000 cr, the fertilizer subsidy bill
is at Rs. 99,500 cr, while the food subsidy bill is lined up to exceed Rs. 60,000 cr.
Even if the upcoming budget looks out for fiscal consolidation, the talks of complete stimulus
withdrawal is unjustifiable at this stage because current economic recovery is still not robust and
recovery of the world economy is likely to remain unstable. Undoubtedly, there is a need for
reform in expenditure management and improvement in governance. Moreover, in order to bring
in transparency, all the off-budget liabilities should be reflected in the fiscal deficit.
Tax Reforms
The budget 2010-11 should focus on simplifying the complex tax laws, as even a salaried person
finds it difficult to file his tax returns without the help of a consultant. This simplification of tax
laws will encourage better compliance and discourage tax evasion.
As far as corporate tax rates are concerned, the tax rate should be reduced to 25% and all sorts
of exemptions should be eliminated, as only a few large corporate houses are able to reap the
fruits of such exemptions. This would place all segments, including the micro, small and medium
enterprises (MSMEs), on the same footing without reducing the overall tax revenues of the
Even though 60% of the country's population continues to depend on the agricultural sector for
livelihood, its share in GDP has declined drastically to 17%. There is an urgent need to focus on
this often neglected sector to make the growth process equitable and inclusive. Apart from
providing some incentives to processed foods industries, grain storage facilities should be
upgraded to improve the entire supply chain. Likewise, improvements are needed in interest
subvention schemes. The budget should also extend its support to crop insurance and weather
insurance to protect farmers. Hence, serious and intensive efforts are needed in the coming
years to revamp and ensure a robust growth of this sector.
Rising inflationary pressures and the risk of impinging inflationary expectations forced the RBI to
announce the first phase of exit from the expansionary monetary policy by terminating some
sector-specific facilities and restoring the Statutory Liquidity Ratio (SLR) of scheduled
commercial banks to its pre-crisis level in the Second Quarter Review of October 2009. The RBI
has thus tried to balance the inflation and growth objectives in the current policy. Given the tone
of the policy and RBI's growth and inflation expectations, liquidity mopping measures will mostly
be complemented by a rate hike in the next policy. However, we will have to wait for the
forthcoming budget to know the Government's decision on phasing out the transitory
components of the stimulus packages.