 "Should RBI pay interest on CRR balances?")
There has been passionate demand in some quarters that the Reserve Bank of India pay interest on the so-called cash reserves that banks maintain with it as part of its monetary policy. The current applicable cash reserve ratio (CRR) is 4% of net demand and time liabilities (NDTL). But there is no logic and reason to paying interest on CRR because CRR is about impounding liquidity with a view to reducing M3 (money supply) through adjustment to reserve money/primary liquidity/high-powered/base money which can universally be created or withdrawn ”only” by a central bank.
Typically, under fractional reserve banking, the required reserve ratio (CRR) sets the theoretical maximum limit on broader money banks can create through making loans out of their deposits. Thus, if CRR is 4% of NDTL, as now, then the theoretical maximum M3 is 1/0.04=25 times the required reserves, ie the money multiplier (MM) is 25. But in actual practice, public preference to keep a chunk of their deposits in the form of cash/currency and banks choosing to accumulate excess reserves, act as a drain on broad money creation resulting in much smaller actual money multiplier.
Thus, currently the actually observed money multiplier (MM) is about 6, obtained by dividing the current M3 of about Rs 108 trillion (currency worth Rs 14 trillion and deposits worth Rs 94 trillion) by Reserve Money of about Rs 18 trillion (currency worth Rs 14 trillion and CRR worth Rs 4 trillion). It is not that RBI cannot, and should not, pay interest on CRR as demanded in some quarters. But to have the desired extent of impounding of liquidity to influence aggregate demand in the real economy, M3 will still need to be reduced by a certain amount. If interest is paid on CRR, the effective contraction/withdrawal of money will be less to the extent of interest - reserve/primary/base money - paid by RBI and so CRR will have to be that much higher than, say 4% at present, to achieve the required contraction in M3.
The author is former executive director, Reserve Bank of India
Typically, under fractional reserve banking, the required reserve ratio (CRR) sets the theoretical maximum limit on broader money banks can create through making loans out of their deposits. Thus, if CRR is 4% of NDTL, as now, then the theoretical maximum M3 is 1/0.04=25 times the required reserves, ie the money multiplier (MM) is 25. But in actual practice, public preference to keep a chunk of their deposits in the form of cash/currency and banks choosing to accumulate excess reserves, act as a drain on broad money creation resulting in much smaller actual money multiplier.
Thus, currently the actually observed money multiplier (MM) is about 6, obtained by dividing the current M3 of about Rs 108 trillion (currency worth Rs 14 trillion and deposits worth Rs 94 trillion) by Reserve Money of about Rs 18 trillion (currency worth Rs 14 trillion and CRR worth Rs 4 trillion). It is not that RBI cannot, and should not, pay interest on CRR as demanded in some quarters. But to have the desired extent of impounding of liquidity to influence aggregate demand in the real economy, M3 will still need to be reduced by a certain amount. If interest is paid on CRR, the effective contraction/withdrawal of money will be less to the extent of interest - reserve/primary/base money - paid by RBI and so CRR will have to be that much higher than, say 4% at present, to achieve the required contraction in M3.
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More generally, if C% be the CRR without interest payment by RBI and i% be interest to be paid by RBI, and C1 be the new CRR accruing interest at i%, then interest accrued on C1 will be i/100*C1 and so effective impounding with payment of interest will be [C1-(i/100*C1)]=C1(1- i/100) which must equal the monetary policy neutral objective of C ie C1(1- i/100)=C or , C1= C/(1-i/100). So, if i= 6.25 % (the current reverse repo rate which RBI would pay on CRR deposits with it) and C=4%, as now, then the required CRR C1 with payment of interest will be: C1=4/(1-0.0625)=4/0.9375=4.27% . Thus, the choice is simple: either have monetary impact neutral CRR of 4% without payment of interest, or have CRR at 4.27% with payment of 6.25 % interest by RBI.
The author is former executive director, Reserve Bank of India