A change of instrument

The Reserve Bank of India (RBI) announced on Friday that it was raising the cash reserve ratio (CRR) for the banking system by 50 basis points in two stages. The CRR is the proportion of their deposits that banks must keep in cash, which means it is unavailable for lending. The higher the ratio, the less resources the banks have to lend. This hike is expected to immobilise Rs 13,500 crore.

Monetary tightening by the RBI was expected. After the second-quarter GDP estimates were released on November 30, indicating that growth during the first half of 2006-07 had been over 9 per cent, there was a virtually unanimous opinion that an interest rate hike was coming. That inflation had edged closer to the 5.5 per cent limit in the RBI's preferred band of 5-5.5 per cent would have been a contributory issue. The only question was whether the RBI would follow the normal quarterly cycle of rate hikes, or move sooner. What has surprised observers is that the RBI, after having exclusively used interest rate changes as the instrument of anti-inflationary monetary policy, has now switched to the CRR.

The justifications provided for pushing the brake pedal so soon after the regular October announcement are entirely valid. The GDP estimates were obviously a trigger, but the sharp increase in foreign capital inflow, which is now contributing to a growing balance of payments surplus as the oil import bill declines, is pushing an expansion of liquidity in the system. Under the circumstances, the signal sent by the repo rate hike in October was correctly perceived as being inadequate. That hike was supposed to make it more costly for banks to borrow from the RBI in order to meet their reserve requirements and, thereby, deter them from increasing lending. It assumed that the banking system would be under liquidity pressure as a consequence of the recent credit expansion, which had not been matched by deposit mobilisation. However, expanding capital inflow seems to have neutralised the widening gap between credit and deposits, reducing the likelihood of banks having to raise their deposit and lending rates.

Under these circumstances, the October hike has turned out to have no bite in terms of restraining credit growth. Banks can continue to leverage the inflow of funds from abroad to continue to expand lending. Neither would another rate hike make much of a difference, if the liquidity situation remained in the state it is today. The only alternative was to attack the liquidity situation directly, in the process pushing banks towards a situation in which further credit expansion would require them to use the repo window. This would then make the October hike effective.

The return to quantitative instruments is, essentially, a pragmatic response to the limitations of price-based instruments. The desired impact of monetary tightening, a proportionate increase in market lending rates, while visible, is apparently not enough to moderate the growth impetus to a level consistent with manageable rates of inflation. If this is the case, repo and reverse repo rate increases need to be supplemented with other instruments. If the CRR, as obsolete as it may seem, can do the job, it is certainly appropriate for the bank to use it.