Pratip Choudhury, chairman of the country’s largest lender, wants the Reserve Bank of India to give interest on the cash reserve ratio (CRR), the proportion of deposits banks keep with the central bank.
Or else, he wants it to be abolished altogether.
At the outset, paying an interest may look like a viable suggestion. Why shouldn’t the banks get an interest on the deposit they keep with their bank? Moreover, as Choudhury said, a huge amount is lying unproductive in the vault.
According to him, CRR is unfairly put on banks.
Chaudhury is probably emboldened by the finance ministry’s suggestion, reported in The Economic Times recently, that the RBI should pay 7 percent interest on CRR, which will result in a reduction of lending rates in the system.
But Choudhury is not all correct for the simple reason that CRR is essentially a monetary policy tool to control liquidity and paying an interest will infuse cash into the system.
According to an article in the Business Line by renowned economist and former RBI deputy governor S.S. Tarapore, “From the latter part of the 1970s to 1990, interest on CRR balances was raised gradually from 5 percent to 10.5 percent.” The gradual increase in interest rate had rendered the CRR “totally impotent”.
The annual interest paid on the outstanding CRR balances was higher than the annual increase in the balances impounded, the article said.
This had forced the RBI to increase the CRR to 16.5 percent by 1992. The interest was brought down progressively to 3.5 percent and from 2007, the RBI stopped paying interest on CRR.
With this, CRR has regained the statute of a powerful monetary tool.
If, as suggested by the finance ministry, an interest rate of 7 percent is paid on CRR now, the central bank will have to increase CRR from the present 4.75 percent. A 7 percent will, otherwise, reduce the effective CRR to just 2 percent, the article argues.
“Having expiated this sin (of paying interest on CRR) after a 20-year battle of attrition, the Praetorian Guards of the RBI should ensure that it does not revert back to this mortal sin,” Tarapore said in the article.
However, a viable solution in the present circumstance seems to be a reduction in CRR.