Random Thoughts

The latest CRR rate hike

The decision of the Reserve Bank of India (RBI) to increase cash reserve ratio (CRR) came as a surprise to many. The hike in CRR from 6.5% to 7% will compel banks to keep more cash with the RBI and thus will remove some portion of monetary liquidity from the market.

Theoretically, this may cause an upward movement in cost of funds (interest rates, which I and you pay on the loans taken from banks). This considers the demand-supply principal. Supply of money will shrink as banks are ordered to keep more money with the RBI leading to a drop in available funds for disbursement. As supply has gone down, cost to get it (the interest rates in the economy) would go up. Now, the question is will this happen?

Seems really difficult. Banks are as such facing trouble with parking the funds they have at the current interest rates. There are less takers of credit at these prevailing rates. Further, banks are saddled with the fixed deposit money (again, parked by you and me with various deposit schemes of banks) due to higher interest rates on these. Given this fix, it seems unlikely that banks would further hike interest rates on either side of their business (lending and borrowing).

The RBI has been showing a very high sensitivity to the inflation data. The latest decision to hike CRR stems from the need to curb inflation. The problem is authenticity of the mechanism to determine inflation. The RBI looks at the wholesale price index (WPI), which at the most gives an indication of inflation but not a clear picture. It does not cover many commodities, which are of importance to the industries and consumers.

Labels: Policies

posted by Ranjit @ 7/31/2007 02:06:00 pm