The Reserve Bank of India on Tuesday reduced the cash reserve ratio (CRR) by a quarter of a percentage point while leaving key interest rates unchanged. CRR is one of five tools the RBI has in managing monetary policy. Here is a look at them:
Repo and reverse repo rates
Repo is a transaction where securities are sold by RBI and simultaneously repurchased (hence the term repo) at a fixed price. The price is determined in context to an interest rate called the repo rate. The transaction is relevant for banks when they need funds from RBI. The central bank repurchases the securities—akin to lending money to the banks at the decided rate.
The higher the repo rate, the more costly the funds are for banks and hence, higher will be the rate that banks pass on to customers. If the rate is high, it signals that access to money is expensive for banks; less credit will flow into the system, bringing down liquidity and helping lower inflation. This is an actively used tool by RBI to manage inflation. The impact of the rate percolates further into the economy and has an impact on both individuals and companies.
The reverse repo rate is the rate at which banks park excess money with RBI. At present the repo rate is 7% and reverse repo is 8%.
Cash reserve ratio (CRR)
This is the percentage of a bank’s time and demand liabilities that needs to be kept as cash with RBI. The central bank can vary the percentage up to a limit. A high percentage means banks have less to lend and, hence, curbs liquidity, and a low CRR does the opposite. RBI can use the CRR to tighten or ease liquidity by increasing or decreasing it as the situation demands. Unlike the repo rate change, which has a more long lasting impact, CRR is used to manage near-term liquidity. The CRR was reduced by 25 basis points on Tuesday and rests at 4.25%. One basis point is one-hundredth of a percentage point.
Open market operations
This refers to buying and selling of government securities by RBI to regulate short-term money supply. If RBI wants to induce more liquidity in the system, it will buy government securities and inject funds into the system. If it wants to curb the amount of money out there, it will sell these to the banks, thereby reducing the amount of cash that banks have.
Statutory liquidity ratio
Banks are required to invest a percentage of their time and demand liabilities in government-approved securities, referred to as the SLR. At present it is at 23%.
This is the re-discounting rate that RBI extends to banks against securities such as bills of exchange, commercial paper and any other approved securities. In recent years it has been the repo rate rather than the bank rate which has acted as a guideline for banks fixing their interest rates. The bank rate is currently at 9%.
In addition to these specific measures, RBI also uses many qualitative tools through which it can regulate credit flow and cost of credit to the economy and specific sectors within the economy.