In the 2nd June 2015 RBI policy review, the Central Bank kept the Cash Reserve Ratio (CRR) of scheduled commercial banks unchanged at 4% of Net Demand and Time Liabilities (NDTL). RBI has kept CRR rate unchanged at 4% for the last 13 policy reviews. Few of the market participants expected a CRR cut and felt it was a better measure than the Repo Rate cut. The following Five reasons will give a clear picture on why RBI cut the Repo Rate instead of CRR.
- CRR is a liquidity tool for RBI and unless there are structural liquidity issues, injection of funds through CRR cut is not required. System liquidity is structurally positive after RBI infused over Rs 3.5 trillion of liquidity through fx operations in the last fiscal year. Read our Liquidity Cheat Sheet for Liquidity Analysis.
- CRR cuts inject permanent liquidity into system and given structurally positive liquidity conditions, RBI would have had issues in maintaining overnight money market rates around the operating policy rate, which is the Repo Rate. Excess liquidity could lead to money market rates moving towards the Reverse Repo rate that is 100bps below the Repo Rate and RBI will then have to reabsorb liquidity by selling bonds to maintain its balance sheet dynamics and bring money market rates towards the Repo Rate for effective monetary policy transmission.
- CRR is uncompensated deposits of banks kept with RBI and by maintaining CRR rate at 4%, RBI is able to use other policy tools to drive monetary transmission.
- CRR is primary monetary instrument and to reduce cost of capital and reduce lending rates in the economy policy rate, which is the Repo Rate, is more effective. Study shows that 100 bps cut in CRR can reduce lending rates by 7-8 bps effectively but 25 bps Repo Rate cut can provide 25 bps transmission in lending rate cut over a period of time.
- RBI will continue to buy USD to shore up fx reserves to prepare the country for a potential hike in interest rates by the Fed. USD purchases inject primary liquidity into the system and RBI would be using MSS (Market Stabilization Scheme) bonds and OMO (Open Market Operations) sale auctions to absorb excess liquidity. CRR cut is definitely not warranted when RBI is grappling with managing excess system liquidity.