crr and its impact on economy

8/8/2019 CRR and Its Impact on Economy

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CRR Hike and its Impact On The Economy

With the hike in the CRR in the third quarter review of the monetary policy, the RBI has begun to

move towards monetary tightening amidst a recovery. Going forward, it remains to be seen how

the central bank will face the twin challenges of managing the inflation and exiting from the

stimulus packages and, at the same time, ensuring that the economy does not get derailed from

its projected growth path.

The year 2009 ended on a positive note with most of the developed markets witnessing a

recovery. There is indeed no doubt that much of this recovery was driven by the stimulus

packages announced by the governments and monetary authorities. Although the world

embraced the turnaround with ample relief, there was a concern among many that the stimuli

may fuel inflation. A bubble in the Chinese economy and the dollar volatility are directly related

to his phenomenon. The Reserve Bank has always been hawkish on inflation. With the growthprojections also being very optimistic, a firmer stance on inflation management is on the cards of

the central bank.

In its third quarter review of monetary policy, announced on January 29, 2010, the Central Bank

increased the Cash Reserve Ratio leaving all other monetary policy tools untouched. The Cash

Reserve Ratio or CRR indicates the portion of time and demand deposits that banks need to keep

with the RBI. According to the Banking Act of 1934, this percentage can be revised from time to

time with an upper limit of 20% and a lower limit of 3%. In the recent review, the RBI raised this

rate by 75 bps (basis points), i.e., from 5% to 5.75%. This hike would be done in two phasesand is expected to suck out Rs. 36,000 cr from the economy. Since the market expected the

central bank to increase the rate by 50 bps, the CRR hike of 75 bps came as a surprise.

Figure 1 indicates the hike in CRR in recent years.


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Market participants had diverse opinions before the hike was announced. Planning Commission

experts and economic advisors to the Ministry of Finance were apprehensive that the hike in the

rate would curtail growth prospects. Dr. Rangarajan, former Governor of RBI, strongly advocated

monetary tightening. The hike in CRR makes India one of the first few economies in the world to

go in for a tight monetary policy in the face of a recovery. China had raised its CRR and

Australian Central Bank had hiked its policy rates by 75 bps.

The last time that CRR was in the range of 5% was in November 2008. The signals of a change

in the stance of RBI towards interest rates was visible in the second quarter policy review in

October 2009. The RBI had clarified that it was moving from a phase of `managing the crisis' to

a phase of `managing the recovery'. The Statutory Liquidity Ratio (SLR) was increased from

24% to 25% in October. This change was more academic than effective at that time but it gave

a clear message that the central bank would not reduce the interest rates any further. Since the

banks had on an average already invested 28% of their deposits in government bonds, raising

the SLR in October did not have much impact on the market. The RBI had also indicated

withdrawal of refinance facilities for non-banking financial companies, housing finance firms,

mutual funds and exporters. The window for swapping banks foreign exchange liabilities was also

closed. However, none of these moves had much impact on the liquidity.

In the third quarter review, the RBI has made its stance tighter and strengthened its exit policy

with a stronger statement of a CRR hike. The RBI has always been concerned with inflation and

with the recovery of the economy being confirmed by most indicators, it has lost no time in

putting brakes on the rising inflation. Figure 2 shows the inflation levels in current times.

According to the statement released by RBI, the outlook for wholesale price inflation has been


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hiked to 8.5% by the end of March 2010. The RBI had earlier projected the inflation to be around

6.5%. Despite the threat of inflation haunting the Central Bank, growth projections have been

impressive at 7.5%. This is higher than the earlier projection of 6%. After the Lehman debacle,

the RBI had put in enough of an accommodating monetary policy by reducing the CRR from 9%

in July 2008 to the current level of 5%. The main concern during that period was a very `fragile'

growth but as the economy struggled to emerge out of the crisis, the fears of inflation became

more apparent. The Wholesale Price Index (WPI) inflation was near about 7.31% in December

2009 and crossed 8% in January this year, as shown in Figure 2.

Inflation in India

Wholesale Price Index (WPI) rose to 7.31% in December, mainly due to higher food prices. It is

expected to reach 10% by March end 2010. The RBI has projected an increase by 200 bps to8.5%.

Consumer inflation, measured by the Consumer Price Index (CPI), rose to 13.68% in January

2010, compared to the same month a year ago. This was mainly due to the hike in food prices,

rent, fuel and higher education expenses. Figure 3 shows the sharp increase in prices in the

retail market.


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Alternative Policy Rates

Although a hike in the CRR was expected, one can wonder why RBI chose not to tamper with anyother monetary policy rates, such as the repo, bank rate, etc.

To increase the liquidity in the system, the RBI had reduced both repo and reverse repo rates in

2008 and 2009. Between October 2008, and April 2009, the RBI reduced the repo rates from 9%

to 4.75%. The reverse repo rate was lowered to 3.25%. The former is used to suck out money

from the system, while the latter injects money. It is expected that if inflation does not moderate

by July, the RBI might consider increasing the reverse repo rates ( Refer Table and Figure 5).


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entirely induced by such low policy rates. Monetary policy is always hurt by a classic dilemma

that while uncontrolled inflation will hurt the consumers, the hike in policy rates will hurt

investors. The situation is no different now. The core inflation in India, which excludes food and

energy, is not only persistent, but also high. The manufacturing inflation calculated by moving

average method is between 4.5-6%. The year-on-year core inflation has been on a positive trend

in the last few months. This has its own implications. Food prices are a big driver in inflation

figures contributing almost 3% and that is entirely a supply side story. But rise in the core

inflation rates indicate that demand pressures are not negligible any more. Core inflation is

expected to rise even more in the next few years. In the management of inflation, inflationary

expectations need to get controlled as well. Perhaps that is the stance that RBI decided to take.

Global Rating Agency, Moody's stated that there will be `negligible impact' on bank earnings. It

does not expect any upward pressure on bank rates.

The fiscal policy announcements will have a significant impact on how the RBI continues to

maintain its stance in its next quarterly review. Without a fiscal roll back, albeit gradually of thestimulus package, the monetary tightening will not have much significant effect on inflation.

Impact on Bond Market

Bond yields increased significantly following the announcement. The 10-year yields increased

sharply from the current levels of 7.60%. There is also nervousness about the bond supply. The

RBI Governor indicated that the bond supply for the fiscal year 2010-11 will match, and may

even exceed, the current year's level of Rs. 4,50,000 cr. The Government's financial situation is

weak. The fiscal deficit has already crossed 77.3% of full year's target and tax revenues have

fallen by 2.5%. The 3G spectrum auctions are still uncertain and the fertilizer subsidy bill is

already very high. If the government needs to borrow more than planned, the supply willincrease in the bond market. Yields were higher by at least 5 bps. The cutoffs for the treasury

bills of 91 days, as well as 365 days, saw a hike. Even corporate bonds saw higher yields. Since

the yield curve is now very steep and short-term interest rates negative in real terms, it is

imperative that monetary policy goes beyond just liquidity management. The short rates have to

move up, at least by 300 bps.

Conclusion

The RBI has started a process of monetary exit very gently. While inflation has taken a higher

priority, RBI is still watchful on growth. It is possible that the next step is hiking the policy rates.

It is likely that overnight rates will move up. Once the Union Budget 2010-11 is presented a

clearer picture will emerge on the need to increase policy rates. With the recovery being just

visible, it is more important to reduce the excess liquidity than just increase borrowing costs. It

is important that the economy does not derail from the projected growth path and the decision

taken by the RBI facilitates the growth process.


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Hike in CRR: Beginning of The Exit Strategy?

-- Ameena Parveen

Faculty Member, FedUni,

Examination Department, Hyderabad.RBI has increased CRR by 75 basis points to drain out excess liquidity from the system to contain

the mounting inflation. The forthcoming budget has to clearly formulate the strategies to be

followed for controlling inflation so as to ensure inclusive growth.

The greatest challenge for the Finance Minister, Pranab Mukherjee, in his forthcoming Union

Budget would be to make the projected GDP growth rate of 7% for the financial year 2009-10

into reality and also deal with the surging food prices and overall inflation. If not controlled soon,

this soaring inflation might disrupt the ongoing economic recovery.

The Reserve Bank of India (RBI), in its third quarter review of monetary policy for 2009-10, has

hiked the Cash Reserve Ratio (CRR) by 75 bps (basis points) for the first time since January2009 to 5.75% to squeeze excess liquidity from the system. This was primarily done to control

the rising inflation.

Emerging Asian Economies are experiencing a faster recovery from the recent financial crisis

than their global counterparts on the back of monetary and fiscal stimuli. Economic activity has

picked up faster than expected due to massive public spending by the governments, which led to

excess liquidity in the markets, resulting in inflationary concerns and higher asset prices across

the economies. The major challenge before the central banks is to find the appropriate time to

exit from their expansionary monetary policy. Some economies have already started of with this.

For instance, Australia and Vietnam have hiked their benchmark interest rates by 75 bps and100 bps respectively in the fourth quarter of 2009. China has also raised its CRR by 50 bps to

16%. With no exception, RBI has recently announced a hike of 75 bps in CRR to 5.75% while

keeping the conventional measures of the monetary policy, such as the repo and the reverse

repo rates, unchanged (Refer Exhibit 1). However, RBI has blown a horn to exit the

accommodative monetary policy by raising the Statutory Liquidity Ratio (SLR) by 100 bps in its

second quarter review of monetary policy for 2009-10. RBI has to look into various

macroeconomic indicators, such as, GDP, money supply and inflation, while deciding upon the

monetary policy.


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GDPThe Growth Projector

The Indian economy grew by a robust 7.9% in the second quarter of the fiscal year 2009-10. A

lower than expected decline in agricultural output, and the robust recovery in industrial

performance had led the Central Statistical Organization (CSO) to peg the GDP growth estimate

for the year 2009-10 at 7.2%, substantially higher than the 6.7% growth recorded in 2008-09.Indian economy is expected to grow in the near future on the back of various factors. As

discussed above, stimulus measures announced by government is driving overall growth. In

addition, private consumption and investments are also picking up. The lagging effect of this

capital expenditure cycle is expected to contribute to the sustainable growth of the economy,

particularly in the infrastructure sector.

With the global economy moving towards stabilization, Indian exports have turned out to be

positive (Chart 1). Gradual pick up in credit growth and easing liquidity situation will further

stimulate the overall economic activity. The impact of poor performance of agricultural sector is

likely to be offset by manufacturing and service sectors. Last, but not the least, GDP growth in

the last quarter of this fiscal year would be comparatively higher because of low base effect.


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InflationThe Role of Food Prices

Wholesale Price Index (WPI) based inflation reached a 12-month high at 7.3% in December 2009

from 4.78% in November 2009. The recent rise in inflation is primarily due to the low base effect

and high prices of food items. As can be observed from Charts 2 and 3, even when the overall

inflation was negative, food inflation, comprising of food items, both from primary articles and

manufactured products group, was hovering in double-digit figures. The reason behind this is the

lower weightage given to food items in WPI. Weak monsoon added fuel to food inflation which

already entered into double digit figures in the month of April 2009. With the failure of Kharif

crop due to bad monsoon, food inflation crossed the 20% mark in the month of November 2009.

A more interesting fact is that, the core inflation, which excludes primary and manufactured food

items, was at a very low level of 2.2% in December 2009.

There has been a debate over the years on the indices to measure inflation. Most of the

economies over the globe use Consumer Price Index (CPI), which is regarded as a real indicator

of inflation, whereas in India, we prefer WPI rather than CPI. For a diverse country like India, it

is understandable to have more than one measure of inflation, but the inconsistencies related to

weightage given to core and non-core items in the two measures does seem anomalous.


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Interest Rate and Liquidity Situation

As can be observed from Chart 4, there has been a significant volatility in the yields of the

government securities across both shorter and longer ends of the maturity curve with inflation

being on rising front. The yield on the benchmark 10-year government paper rose to an averageof 7.4% in the third quarter from 7.2% in the second quarter of 2009-10. It further shot up to a

13-month high of 7.7% in December 2009. However, it was condensed by the supply of gilt

papers and excess liquidity. The gap between 10-year bond yield and 1-year G-sec yield rose to

an average 370 bps by the end of November 2009. With higher deposit growth and moderate

growth in credit off-take, the liquidity condition remains healthy in the banking system. This can

also be reflected by the absence of any transaction under repo window of Liquidity Adjustment


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Facility (LAF). Instead, banks are parking their idle funds with the RBI through reverse repo

window, signifying that they can meet their funding requirement with internal resources.

Commercial banks have parked an average of Rs. 1.1 tn daily with the RBI under the reverse

repo window in the current fiscal and Rs. 295 bn under Market Stabilization Scheme (MSS). In

addition, bank investments in liquid mutual funds ballooned since April 2009.

Exchange RateUnstable

India, which continued to be an attractive destination for foreign capital flows for a long time,

took a U-turn with a sharp decline in the same in the second half of 2008-09. There was a steep

and simultaneous fall in all capital flows except in Foreign Direct Investments (FDI). This led to

severe pressure on corporate funding, along with depreciation of the currency. However, with the

better-than-expected performance by Indian economy in the second quarter of 2009-10 and

higher interest rate differential, considerable amount of foreign capital has begun to flow in since

then (Chart 5). Until now, RBI did not intervene in the substantial increase of capital inflows and

let the currency appreciate (Chart 6), which helped in keeping a check on rising import prices

and thereby helped in combating increasing inflationary pressures. Further, growing current

account deficit has partly absorbed increased capital inflows.


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Monetary PolicyImpact

The step taken by the RBI in the recent monetary policy of hiking CRR by 75 bps was to curb

inflation, but it is not likely to serve the purpose, as the current inflation is mainly supply driven.

Instead, a hike in CRR at this point in time may modulate the inflationary expectations that are

building in the economy but would fail to contain inflation as it is not a monetary phenomenon.

Further, an increase in CRR may slightly increase the cost of funds for banks and with excess

liquidity in the banking system, banks may not raise interest rates in the near term, which would

adversely impact their spreads.

Alternatively, if the banks increase the interest rates, it may have a detrimental effect on

economic growth and corporate profitability. Any increase in interest rate would further add fuel


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to the already mounting input costs, which would dent the profit margins of corporates.

Particularly for infrastructure projects, even a slight increase in interest rates will have a large

impact as they operate on competitive IRRs.

Fiscal PolicyExpectations

Fiscal Consolidation

The current fiscal deficit of 10.3% of GDP (both centre and state) calls for fiscal consolidation.

The forthcoming budget has to clearly speak out the medium-term strategy for fiscal

consolidation and measures to check inflation to ensure equitable growth. A rational course of

fiscal consolidation would be to curb wasteful expenditure drastically and cut back subsidies (on

oil, fertilizer and food), that are misused and inadequately targeted. For the fiscal year 2009-10,

the total under recoveries of oil companies is estimated at Rs. 50,000 cr, the fertilizer subsidy bill

is at Rs. 99,500 cr, while the food subsidy bill is lined up to exceed Rs. 60,000 cr.

Even if the upcoming budget looks out for fiscal consolidation, the talks of complete stimulus

withdrawal is unjustifiable at this stage because current economic recovery is still not robust andrecovery of the world economy is likely to remain unstable. Undoubtedly, there is a need for

reform in expenditure management and improvement in governance. Moreover, in order to bring

in transparency, all the off-budget liabilities should be reflected in the fiscal deficit.

Tax Reforms

The budget 2010-11 should focus on simplifying the complex tax laws, as even a salaried person

finds it difficult to file his tax returns without the help of a consultant. This simplification of tax

laws will encourage better compliance and discourage tax evasion.

As far as corporate tax rates are concerned, the tax rate should be reduced to 25% and all sorts

of exemptions should be eliminated, as only a few large corporate houses are able to reap thefruits of such exemptions. This would place all segments, including the micro, small and medium

enterprises (MSMEs), on the same footing without reducing the overall tax revenues of the

government.

Agriculture

Even though 60% of the country's population continues to depend on the agricultural sector for

livelihood, its share in GDP has declined drastically to 17%. There is an urgent need to focus on

this often neglected sector to make the growth process equitable and inclusive. Apart from

providing some incentives to processed foods industries, grain storage facilities should be

upgraded to improve the entire supply chain. Likewise, improvements are needed in interest

subvention schemes. The budget should also extend its support to crop insurance and weather

insurance to protect farmers. Hence, serious and intensive efforts are needed in the coming

years to revamp and ensure a robust growth of this sector.

Conclusion


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Rising inflationary pressures and the risk of impinging inflationary expectations forced the RBI to

announce the first phase of exit from the expansionary monetary policy by terminating some

sector-specific facilities and restoring the Statutory Liquidity Ratio (SLR) of scheduled

commercial banks to its pre-crisis level in the Second Quarter Review of October 2009. The RBI

has thus tried to balance the inflation and growth objectives in the current policy. Given the tone

of the policy and RBI's growth and inflation expectations, liquidity mopping measures will mostly

be complemented by a rate hike in the next policy. However, we will have to wait for the

forthcoming budget to know the Government's decision on phasing out the transitory

components of the stimulus packages.

crr and its impact on economy

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