CRR: The proxy war between FM and RBI

The ongoing debate over the status of the CRR (cash reserve ratio) may well be the latest avatar of the age-old war between the RBI and the finance ministry.

Here’s how. The CRR is a percentage of their deposits that banks have to keep idle and not lend. It is obviously a cost to banks because they raise that money at 6 or 7 or 8 percent but can’t earn anything.

The angst of bankers like SBI Chairman Pratip Chaudhuri is understandable. Not only does the CRR impound 4.75 percent of their deposits immediately, the CRR has a multiplier effect. Both loans and deposits have a multiplier effect depending on the speed with which transactions take place. This money multiplier is around 4 to 5 times in India today. Thanks to this, the impact of the CRR is not just 4.75 percent of the deposits but 4 to 5 times that amount.

The CRR is therefore a powerful instrument both while tightening and while loosening monetary policy.

A one percentage point cut in CRR today can release Rs 64,000 crore into the banking system immediately and about Rs 2.5 lakh crore over the year. That will create a truly loose monetary system and bring down rates quite rapidly. And it is this that makes the finance ministry silently applaud Chaudhuri when he takes on the RBI on CRR.

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But those who want the RBI to succeed in its battle against inflation must necessarily hope Chaudhuri doesn’t have his way.

There are other reasons that bring Chaudhuri and the finance ministry on the same page. The more the profits SBI makes, the more it can retain as reserves and the less the government will have to work to find capital for SBI.

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Unfortunately the supporters for a CRR can only be those who suffer most from inflation, India’s poor, silent majority who aren’t qualified to strengthen the hand of the institution that is set up to fight inflation - the central bank.

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There is a separate debate on whether RBI should pay interest on the cash it impounds from banks via CRR. While that may make sense to some, it will also put more cash in the hands of banks and thus blunt the inflation fighting quality of a CRR hike. If such interest is paid, a larger CRR hike will have to be made to have the same impact.

Under current rules RBI doesn’t have the power to pay interest on CRR. This power was taken away from the RBI through an amendment to the RBI Act in 2006, an amendment which RBI itself suggested. Old timers say RBI gave up this power, only because as long as it has the option to pay interest, bankers will always lobby for it .

In fact, that the CRR is really a battle ground between RBI and finance ministry is best evident from the war between the two institutions when these amendments were passed in 2006. That Amendment bill brought a bunch of changes. Hitherto the CRR could not be cut below 3 percent, but the law said that RBI may pay interest on CRR above 3 percent, if it wishes. The 2006 amendment removed the 3 percent lower limit. RBI argued CRR could go to zero if the situation warranted, but at all times it won’t pay interest - a clever move that the finance ministry apparently realised only after the amendment was passed. The finance ministry then refused to notify the amendment. As a compromise RBI paid interest on CRR balances on that year, since the amendments weren’t yet notified and hence not effective.

In exchange the ministry notified the amendments after CRR was paid that year. RBI lost the battle, but seemingly won the war.

The old war is now being fought in a new battle. The sympathies of the finance ministry to lower rates are well known. Even today the finance minister said in the Rajya Sabha that he had asked PSU banks to cut rates on consumer loans. (What does this say of reforms, I wonder. Where is the commercial, professional independence of a bank chairman if the shareholder is going to tell him what rates to charge for each product-but that’s another debate).

Given the predilection of the finance ministry towards lower rates, I won’t be surprised if Chaudhuri’s war cry against CRR is really the finance ministry firing from his shoulders.

The RBI can really lose the battle any time. It only takes an ordinance to amend Acts. If the CRR is, god forbid, indeed taken away, it will be a cardinal sin, the saddest day for the economy. The one institution that is committed to fighting inflation would have lost its teeth.