Five Minutes to Understanding CRR

Indian Express, 19 September 2004

Words like Cash Reserve Ratio seem frightening, but they do impact our financial lives. And really, they are not so difficult to understand

What is CRR?

Indian banks are required to hold a certain proportion of their deposits as cash. In reality they don’t hold these as cash with themselves, but with Reserve Bank of India (RBI), which is as good as holding cash. This ratio (what part of the total deposits is to be held as cash) is stipulated by the RBI and is known as the CRR, the cash reserve ratio. When a bank’s deposits increase by Rs100, and if the cash reserve ratio is 10, banks will hold Rs10 with the RBI and lend Rs 90. The higher this ratio, the lower is the amount that banks can lend out. This makes the CRR an instrument in the hands of a central bank through which it can control the amount by which banks lend. The RBI’s medium term policy is to take the CRR rate down to 3 per cent.

What does a hike in this rate mean?

The hike in CRR from 4.5 to 5 per cent will increase the amount that banks have to hold with RBI. It will therefore reduce the amount that they can lend out. The move is expected to shift Rs 8,000 crore of lendable resources to RBI. In the past few months the money that banks have available for giving out as credit is greater than the amount they have been lending out. This has led to “an overhang of liquidity” in the system. The objective of the CRR hike is to “mop up” some of the “excess liquidity” in the system.

Will this mean a rise in interest rates on my deposits and home loans too? By when and by how much?

The hike in CRR is not likely to lead to an immediate increase in interest rates. There is excess liquidity in the system even after a higher amount is deposited with RBI as reserves.

Unless the demand for credit picks up to the extent that the money is all lent out, banks will not have an incentive to raise interest rates.

The inflation rate may continue to be high, the economy may also continue to witness growth which will keep the demand for credit high, and international trends are for rates to move up. This means that sooner or later interest rates will go up. The first rates to get impacted are yields on government bonds. We have already seen this happening. If the inflation rate keeps rising, RBI may raise the ‘repo rate’, the short term rate at which banks park excess funds with the RBI. This makes it less attractive for banks to lend.

Further, RBI may raise the bank rate, the rate at which it lends to banks.

At this point you may expect interest rates on home loans and fixed deposits to go up as well. Over a year rates could go up by as much as 3 per cent.

Ila Patnaik