In the present days if you go for any news channels or news papers, then you come to hear about CRR. RBI had not changed the rates of CRR, in spite of tightening on the liquidity front due to advance tax outgo. The banks’ borrowing from the RBI has gone up to Rs 1,46,300 crore, from Rs 64,445 crore on Friday. Experts say the tight liquidity condition will continue for a while till the government starts spending, and this makes a case for lowering of CRR. Now I am trying to describe, what CRR is, why it introduced & when it has got increased or decreased.
The cash reserve ratio is a central bank regulation that sets the minimum reserves that each commercial bank must hold (rather than lend out) of customer deposits and notes. These *required reserves* are normally in the form of cash stored physically in a bank vault (vault cash) or deposits made with a central bank. The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country’s borrowing and interest rates by changing the amount of funds available for banks to make loans with. The Reserve Bank, having regard to the needs of securing the monetary stability in the country, can prescribe Cash Reserve Ratio (CRR) for scheduled banks without any floor rate or ceiling rate. Before this, the Reserve Bank could prescribe CRR for scheduled banks between 3 per cent and 20 per cent of total of their demand and time liabilities. RBI uses CRR either to drain excess liquidity or to release funds needed for the growth of the economy from time to time. Increase in CRR means that banks have fewer funds available and money is sucked out of circulation. In other words, Banks in India are required to hold a certain proportion of their deposits in the form of cash. However, actually Banks don’t hold these as cash with themselves, but deposit such cash with Reserve Bank of India (RBI) / currency chests, which is considered as equivalent to holding cash with RBI. This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio. Thus if a bank has increased Rs. 500/- deposits & the CRR rate is 4%, then the bank has to keep Rs. 20/- with RBI i.e it can use only Rs. 480/- out of such amount. So, if CRR increase then the Bank would be able to use lower amount or vice a versa.
There are two purposes got solved by such process:-
- Banks funds are kept with RBI, which will ensure it’s less risk & in case of insolvency of the bank, RBI can proceed with such amount.
- Liquidity in the market got controlled by the RBI i.e. the Central Bank of our country.
Now, the question arises is that when & why it is introduced & when the RBI increase or decrease the rate of CRR. As discussed earlier that RBI can control the liquidity in the market or we can say in our system by increasing/decreasing the Rate of CRR. As we have learned the demand supply rule, i.e. when the supply of anything increase its demand got decreased, prices also got decreased & when the supply got decreased its demand got increased, prices got increased i.e. the inverse relationship between demand & supply. So, when the RBI increase the rate the of CRR, then the supply of the money got decreased & the Banks have to increase their interest rates & demands for the goods /services got decreased due to the non availability of the funds, by this the inflation of the economy goes down. I think you have heard the rule of money multiplier for understanding such concept. But if we link it with our normal rule of demand & supply then the same thing will come in front of us. Increase in interest rates has slowing down the overall growth in the economy. When the CRR increased, in the near term this will have an adverse impact on overall economic growth, from a long term prospective it will be beneficial for the economy (as over the long term inflation is likely to be a lesser concern. So, in nutshell to control inflation & liquidity in economy CRR got introduced.
The rates of CRR from Oct. 1992 to till now
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Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves. They generally prefer to use open market operations (buying and selling government-issued bonds) to implement their monetary policy. The People’s Bank of China uses changes in reserve requirements as an inflation-fighting tool and raised the reserve requirement ten times in 2007 and eleven times since the beginning of 2010. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits and zero on time deposits and all other deposits. The Bank of England holds to a voluntary reserve ratio system, with no minimum reserve requirement set.
If we see the impact of increase in rate of CRR on stock market, then we come to know that it also adverse the stock market. As discussed earlier, by increase in CRR interest Rates also get increased & rising interest rates hit the companies on account of higher interest rates costs that they have to bear on their outstanding loans which impact their stock prices. Higher interest rates increase expectation of returns of investors from the stock market; this has the impact of lowering current stock prices. So, we can say from a short term prospective, higher interest rates should adversely impact stock market sentiment. From a long term perspective however our expectations of returns from the stock market remains unchanged. As mentioned earlier, RBI’s move to tame inflation over the long term augurs well for long term economic growth. This will ultimately benefit well managed companies. From the Debt market prospective, if you want to invest in debt market, you will benefit from higher interest rates on offer. But if you are an existing investor in debt funds it may take a onetime hit.