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Home / Opinion / Online-views /  Is CRR a liquidity or a monetary tool?

Milton Friedman famously said, “Money is far too serious to be left to central bankers." If he had his way, monetary policy would be run through a simple rule with limited intervention from central bankers. However, reality is just the opposite, with the world being increasingly reliant on the wisdom of central bankers to help ride the economic cycles.

Photo: Rajanish Kakade/AP

For the Reserve Bank of India (RBI), in most part of the year, the trade-off was growth versus inflation, but became the rupee depreciation versus liquidity in December. If RBI tried to prevent the rupee depreciation by selling its forex assets and buying rupees, it worsened the already tight liquidity situation in money markets. As pressures on the rupee abated in January in the backdrop of the rise in foreign institutional investor inflows and non-resident Indian deposits, liquidity became the central issue ahead of the monetary policy. Before the policy, trade-off was whether to use the cash reserve ratio (CRR) as a tool to ease liquidity.

In the policy, RBI lowered CRR by 0.5 percentage point to 5.5%, thereby infusing liquidity worth Rs32,000 crore. It will be interesting to see whether RBI will continue its open market operation (OMO) purchases providing additional liquidity to markets.

The problem with this decision is RBI’s change in stance over CRR as a liquidity tool. Before the policy, RBI mentioned that the tools to ease liquidity in order of preference are OMO, statutory liquidity ratio and CRR. CRR was also seen as a monetary tool, and with core inflation still high, RBI was unlikely to reverse its monetary stance and lower CRR.

RBI’s pre-policy macroeconomic report said money multiplier has increased, and there is a need to balance provision of liquidity and inflation control. This reaffirmed market beliefs that CRR was unlikely to be changed as lower CRR leads to both higher money multiplier and higher inflation.

In its policy review, RBI says reducing CRR is not inconsistent with the prevailing monetary stance, as higher deficit liquidity conditions impede monetary transmission and hurt credit flow to the productive sectors. But then liquidity deficit has been over RBI’s comfort zone since October, but it chose to address it only through OMOs. This change in stance over CRR is rather perplexing.

The other decisions came in as expected. Growth forecast for the gross domestic product was lowered from 7.6% to 7% in 2011-12, with a slightly faster growth expected in 2012-13. Inflation projections were retained at 7% and some moderation is expected in 2012-13. RBI’s forward guidance statement said CRR reinforces that future rate actions will be towards lowering rates. It also added that in the absence of fiscal consolidation, RBI will be constrained in lowering rates.

Taking a cue from the introduction, whatever choice RBI would have made would have been criticized. Such is the life of central banks. However, RBI should take a step forward from this criticism and clarify the differences in its liquidity and monetary tools. This is easier said than done as this problem is being faced by most central bankers, with no easy solutions in sight.

Amol Agrawal, economist, STCI Primary Dealer Ltd.

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