RBI Governor Raghuram Rajan made it apparent from his latest speech that inflation would remain a major concern for India’s economy. Headline inflation in December last year eased to 6.2 percent from 7 percent in the previous month. Notwithstanding, in the Third Quarter Review of Monetary Policy 2013-14, RBI surprisingly raised the repo rate by 25 bps to 8 percent when the market was expecting a cut in interest rate to stimulate the credit demand. This act of RBI demonstrates a new trend, suggesting its focus rather shifting towards consumer prices which remained elevated at close to double digits. In the midst of it all, let’s discuss two important tools of monetary policy: cash reserve ratio (CRR) and repo rate.
Effective date (for RR & CRR) Repo Rate (RR) Cash Reserve Ratio (CRR) WPI Inflation Rate (Y-on-Y)
28-01-2014 8 4 6.2
29-10-2013 7.75 4 7
07-10-2013 7.5 4 7
20-09-2013 7.5 4 7
15-07-2013 7.25 4 5.8
03-05-2013 7.25 4 4.6
19-03-2013 7.5 4 5.7
09-02-2013 7.75 4 7.3
29-01-2013 7.75 4.25 7.3
03-11-2012 8 4.25 7.2
22-09-2012 8 4.5 8.1
11-08-2012 8 4.75 8.0
17-04-2012 8 4.75 7.5
Source: RBI In the Second Quarter Review of Monetary Policy 2013-14, RBI shot the repo rate by 25 bps to 7.75 percent while retaining the CRR at its current level of 4 percent, suggesting that inflation was a concern. Repo rate suggests the interest rate at which commercial banks are allowed to borrow from the central bank for short-term, only when they possess government securities which are used as collateral. While CRR is the proportion of their deposits that commercial banks have to keep with RBI, and no interest is paid on those deposits. The RBI had cut the repo rate by 25 bps in January 2013 when headline inflation eased nearly 7 percent while holding the CRR at then current level of 4.25 percent. Earlier, when the inflation rate was hovering around 8 percent for a couple of months, the RBI resorted to cuts in CRR aiming to provide adequate liquidity in the market amidst high inflation. At the same time, it is noteworthy that repo rate was kept unchanged from April 2012 to November 2012.
These trends suggest that RBI has been much more cautious with the repo rate when there is a need to enhance liquidity in the market and inflation expectations are on the higher side as well. This is broadly in light of the fact that banks can borrow at the ongoing repo (interest) rate as per their requirements, considering that they have excess of mandated government securities that could be used to borrow funds from repo window. Thus, it may cause an excess flow of money over the desired level of the RBI, therefore, causing rise in prices.
On the other hand, CRR has been widely used as an instrument to expand liquidity. It has quite a few benefits over the repo rate, especially when reining in inflation is a priority. A cut in CRR directly expands the liquidity of the banking system in a stipulated amount and banks can possibly lend at cheaper rates. Simultaneously RBI can have a control on sudden rise in prices if required. This is possible by selling off government securities in the open market, which helps in absorbing excess liquidity from the banking system. However, the problem with CRR is that it cannot generate liquidity beyond a stipulated amount and when higher liquidity in the banking system is required, it does not help much. Price of credit remains high and, therefore, higher demand cannot be easily fulfilled. In that case, the RBI resorts to lowering the repo rate. In sum, high inflationary expectations necessarily signify hike in repo rate when the objective is to contain inflation, but CRR is used as a tool when both liquidity and soaring inflation are a matter of grave concern.
1 Banks are mandated to invest 25% of their deposits in government securities, which is known as Statutory Liquidity Ratio (SLR). Only after completing the SLR requirements, the rest of government securities can be used to borrow funds at repo rate.