Recent CRR hike by RBI and its implication

What is CRR?

This is the amount of money that the banks have to necessarily park with the RBI. The base of this is the total of the deposits that a bank has.

CRR is one of the best ways to remove excess liquidity from the market, thus cooling of the money supply.
As the money is not available with the banks, banks are forced to lend at higher prices and also push for deposits with higher interest rate. Higher interest on loans will drive people away from loans and higher interest on deposits will incline people towards depositing the money in the bank, rather than consuming it. The reserve ratio is sometimes used as a tool in monetary policy, influencing the country's economy, borrowing, and interest rates.

Recent Hike:

Dr. Y. Venugopal Reddy, Governor, RBI, presented the Mid-term Review of Annual Policy for the Year 2007-08 on 30^th Oct 2007, in a meeting with Chief Executives of major commercial banks. RBI hiked CRR by 50 basis point from 7% to 7.5%. Bank Rate, Repo Rate and Reverse Repo Rate kept unchanged. This is aimed to suck out Rs. 16,000 cr. from the system effective from 10^th November. The measure has been taken to manage capital inflow and suck out huge liquidity in system. RBI has aired it concern over huge inflow in real estate and equity market.

Was it expected?

No, it was not. Last time US Fed cut interest rate thus easing monetary policy. So even RBI was expected to follow this and take liberal policy decision.

Reason behind CRR hike

According to RBI governor Y. Venugopal Reddy the step has been taken to stabilize the economy from unwarranted excessive liquidity in system. He said in the bank’s mid-term review of annual monetary policy statement: “Financial markets continue to experience conditions of surplus liquidity, warranting an appropriate response in order to ensure orderly market conditions.”

Reddy also recognized the risks from “the rapid escalation in asset prices—equity and real estate—driven by capital inflows”, saying: “...the biggest challenge for monetary policy is the management of capital inflows and the attendant implications for liquidity and overall stability.” we have seen USD 8.9 billion flow into the Indian market in past one month and apparently Dr. Reddy is concerned about that and he thinks that the asset prices have risen to elevated levels

Sensex in recent past has climbed to new levels. During this month Sensex has gained more than 14%.

Implications

CRR hike generally triggers increase in interest rate. But at this point of time when Repo, Reverse Repo and other key policy rate has remained same, there is no chance of immediate increase in interest rate. In short run equity market will suffer a bit. Investors who find India a long-term attractive story will continue to put in money through various routes through portfolio, private equity, FDI. So in long run this decision has no impact on equity market.

Some public sector banks, like Bank of Baroda chairman A.K. Khandelwal and Punjab National Bank chairman K.C. Chakraborty said they would not hike their lending rates following the CRR hike but deposit rates would certainly go down.

Overall we can see this decision more as liquidity management tool rather than an attempt to increase interest rate.

To get a copy of Mid-term Review of Annual Policy for 2007-08 visit http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=3908&Mode=0#p1