Banks bear the brunt: November 1st 2007, Financial Express

The increase in CRR by the RBI should be examined a little more closely. The RBI’s action in itself is quite straightforward. It wants to control the growth in money supply, and the CRR is a powerful tool as it directly affects the quantity of funds that can be lent. This is the central bank’s way of mopping up excess liquidity from the system and there can really be no quarrel here.
However, the affected parties are the banks that have to bear the cost of the action. The present hike, which is on the entire quantity of deposits, would mean an outflow of around Rs 15,000 crore from the banking system, which means two things for banks. The first is that they would not be able to lend these funds to industry (using this term for the entire set of borrowers), and will also not earn any interest on them. Hence, it is a case of double jeopardy for them, as they lose straight away an earning capacity of, say, 12% on this sum which on an annualised basis is Rs 1,800 crore. Also, the fact that it will have less resources to lend will lead to some kind of rationing of credit under ceteris paribus conditions.
This means that banks could face a cash crunch, given that the surplus funds they were sitting on were estimated at around Rs 20,000 crore—money that was being invested in daily repos. It is this surplus that would now be absorbed at one stroke. In such an event, what happens to the demand for credit—which seems to be growing? Growth in credit during the financial year has been rising quite steadily from 0.5% up to mid-August to 2.8% in mid-Sept to 4.7% in mid-October. The numbers are certainly moderate compared with last year, which has given the illusion that growth is relatively slack. But even so, that is not the end of the story.
The fact is that we are now in the so-called busy season, when growth tends to accelerate. Also, the RBI has acknowledged that GDP growth is going to be steady, and this should indicate that demand for credit will rise over the next few months. We need to ask ourselves what, then, would happen to overall industrial growth—because if banks do not have funds, they will have to increase rates, which will have a negative impact on industrial growth. Admittedly, this is a worst-case scenario being painted here, but nonetheless cannot be ruled out.
There are always countervailing forces, such as rising deposits as well as capital inflows, that can continue to provide liquidity, which is what the RBI had in view when it increased the CRR. But, then weren’t capital inflows the main problem to begin with? If capital flows continue to surge, a stronger possibility with the US Federal Reserve’s rate cut, then liquidity should not be a problem, and on hindsight we may say that the RBI showed good foresight here. But, the same problem would be encountered yet again, which will call for another such move. Remember, we had actually spoken of moving the CRR back to the 2-3% levels but have now gone back to the 2001 level.
So, it is generally agreed that the main motivation here has been capital inflows and possible implications of the Economy overheating. Inflation has been benign, even though the RBI has warned of latent inflation, given the movement in commodity prices, and hence has stuck to its 5% target. All central banks are forward-looking and it is but natural that the RBI has been watching these trends for purposes of extrapolation over the coming months. This means that we need to enquire whether or not there are better ways of tackling these inflows, given that nothing seems to be staunching them. The curbs on ECBs, liberalisation of outflows or the recent panic caused on the PNs front have all failed to deter their velocity.
The RBI has been running out of government paper and the hiking of the MSS limits has not really helped either in conducting open market operations. The most direct way to influence the overall supply of money was to directly impound the resources with banks. But, this move shifts the onus onto banks, which are now worse off, instead of using open market operations—by which at least their sucked-out funds earned around 7-8% per annum. This move therefore appears to injure the profits of banks, which are already under some pressure to meet the new prudential norms set by the RBI and Basel II standards.
There are thus two distinct outcomes of the CRR hike. The first is that the banks will bear the brunt of this move, and will feel constrained. We have not sorted out the problem of copious capital inflows, and have merely shifted part of it from the external sector to the banking sector. Also, we are ironically implicitly assuming that capital inflows would continue to surge to ensure that there is no possibility of a liquidity crunch instead.
This raises an ideological issue of whether or not a major adjustment for an external problem has to be borne internally—especially so since there are alternatives.