How CRR, Interest Rates and Inflation Are Related?
In this article, we will discuss what is Cash Reserve Ratio, Significance of CRR, How CRR, Interest Rates and Inflation Are Related and thus how does CRR affect the economy.
Reserve Bank of India (RBI), the central bank, one of its primary functions is to control the supply as well as the cost of credit. Which means how much money is available for the industry or the economy and what is the price that the economy has to pay to borrow that money which is nothing but liquidity and interest rates.
So, RBI has a role to play to control these two things because eventually these two have an impact on the inflation and growth in the economy. For this, RBI has got some tools available in their hands and these tools are maintaining certain basic ratios or maintaining certain rates. CRR is one of the above mentioned tools that RBI uses to control the excess supply of money and thus the inflation.
What is Cash Reserve Ratio?
- Banks are required to maintain a percentage of their deposits as reserves with RBI. This reserve is stored as cash or equivalents in the vaults of the bank or sent to RBI.
We can say that CRR is a tool used by a central bank to control liquidity in the banking system.
- The aim is to ensure that banks do not run out of cash to meet the payment demands of their depositors. Thus, maintenance of this reserve is essential to ensure that banks do not run out of money when customers come demanding for their deposits. Rate of CRR is decided by RBI and reviewed in the quarterly review.
- The trend of India’s CRR as of current date is shown below :
If a bank gets deposits for Rs.100 Crores and the prevailing Cash Reserve Ratio is 4% then the bank has to maintain Rs.4 Crores as cash and use the remaining for the purpose of investment or lending, which is Rs 96 Crores.
Bank’s Demand & Time Liabilities
- When the RBI decides to increase the Cash Reserve Ratio, the amount of money that is available with the banks reduces. This is the RBI’s way of controlling the excess supply of money.
- The cash balance that is to be maintained by scheduled banks with the RBI should not be less than 4% of the total NDTL, which is the Net Demand and Time Liabilities. This is done on a fortnightly basis.
- NDTL refers to the Net demand and time liabilities (deposits) that is held by the banks.
- Banks are glad about a lower CRR because the Cash Reserve Ratio is money that banks park with the RBI for free, without receiving any interest on it. The CRR, now at 4%, is calculated as a percentage of each bank’s net demand and time liabilities (NDTL).
- NDTL refers to the aggregate savings account, current account and fixed deposit balances held by a bank. Demand & Time Liabilities included for the calculations are shown here –
Why is CRR Important?
- When banks source deposits from us, their primary objective is to lend to earn a ‘spread’ which is basically the difference between the money they earned on loans and amount they paid as deposits.
- Left to themselves, banks may like to maximise their lending and keep their idle cash at a minimum so that profits are higher. But if most of the funds are lent out and there’s a sudden rush to withdraw, banks will struggle to meet the repayments & It is to avoid this situation that the RBI specifies both a CRR and an SLR (Statutory Liquidity Ratio) for banks.
- The CRR (4 per cent of NDTL) requires banks to maintain a current account with the RBI with liquid cash. The SLR (20 per cent of NDTL) requires banks to invest in safe and quickly saleable assets such as government securities.
- While ensuring some liquid money against deposits is the primary purpose of CRR, its secondary purpose is to allow the RBI to control liquidity and rates in the economy. In the short term, interest rates swing up or down depending on how much liquidity is available for lending. Too much money leads to a collapse in rates, and too little, a spike
How CRR, Interest Rates and Inflation Are Related?
How Does CRR Affect the Economy?
- Cash Reserve Ratio (CRR) is one of the components of the monetary policy of the RBI which is used to regulate the money supply, level of inflation and liquidity in the country. The higher the CRR, the lower is the liquidity with the banks and vice-versa.
- During high levels of inflation, attempts are made to reduce the money supply in the economy. For this, RBI increases the CRR, sucking the loanable funds available with the banks. This, in turn, slows down investment and reduces the supply of money in the economy. As a result, the growth of the economy is negatively impacted. However, this also helps bring down inflation.
- On the other hand, when the RBI needs to pump funds into the system, it lowers CRR which increases the loanable funds with the banks. The banks thus extend a large number of loans to the businesses and industry for different investment purposes. It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.
Why Should we Care about CRR?
- As a depositor, the CRR and SLR requirements together ensure that a fourth of your deposits with Indian banks remain secure, even if banks make poor lending decisions.
- If you are a bond market investor, it is as important to watch the CRR and SLR requirements of the RBI as it is to watch its repo rate actions. It is liquidity that decides the short-term direction of interest rates in the market.
- If you are an investor in bank stocks, a higher CRR means lower margins for the bank and vice versa.
- Banks maintain CRR on a fortnightly average basis. In case of default in maintenance of CRR requirement penal interest will be recovered for that day at the rate of:
- Bank Rate (again decided by RBI) + 3% per annum of short fall.
- If the shortfall continues on the next succeeding day/s, the penal interest levied is at the rate Bank Rate + 5% per annum.
- And if such a default on CRR continues for more than two fortnights, RBI has the power to prohibit the bank from accepting any fresh deposit.