Cash Reserve Ratio is one of the country’s multiple monetary policy tools that the central bank uses for controlling money supply in the economy. RBI, which is the central bank of India, manages the monetary supply to various financial institutions such as commercial banks, NBFCs, and other lenders. These institutions then supply money to the rest of the economy.
Here, we will explore the concept of CRR in detail and further try to understand how it works.
What is Cash Reserve Ratio (CRR)?
Cash reserve ratio is the portion of net deposits that banks have to maintain with the RBI as liquid cash. This percentage is determined by the RBI and it can be changed periodically by the central bank. Currently, the CRR is fixed at 4%. This means that for every Rs. 100 worth of deposits it receives, a bank has to maintain Rs. 4 with the RBI.
Objectives of CRR
Cash Reserve Ratio (CRR) is used as one of the reference rates for determining the Base Rate. Base Rate is the minimum lending rate that is established by the Reserve Bank of India (RBI). No bank is allowed to lend funds below the base rate. To ensure transparency of lending and borrowing in the credit market, the Base Rate is fixed at a predetermined value. It is also important in managing the cost of lending by banks. This helps banks to extend more affordable credit to borrowers.
The key objectives of the Cash Reserve Ratio are:
- The Cash Reserve Ratio allows the Central Bank to safely maintain a portion of every bank’s deposit.
- CRR also helps in containing inflation. The RBI may raise the CRR with an aim to bring down the bank’s lendable funds in case the inflation in the economy rises.
Why is CRR essential?
Here is why CRR is considered a crucial regulatory aspect for all commercial banks in India:
- CRR is an important monetary policy tool used by the RBI.
- It aids in establishing and maintaining a healthy banking channel while ensuring that banks retain a certain amount of liquid funds to cater to customer demands.
- It manages the monetary supply in a country’s economy.
- It is used to control inflation or deflation in the economy, mainly by injecting additional funds or draining excess funds from an economy.
Impact of Cash Reserve Ratio
Here is how CRR impacts various segments of the market:
A rising CRR generally slows down the growth of the economy. Thus, when CRR rises, there is a negative impact on the stock markets. This is usually followed by a decline in stock prices. As stock prices of companies decline, it can result in a slowdown in many sectors, like engineering, manufacturing, banking, etc. Therefore, the stock market may face a hit with an increase in the CRR.
If there is an increase in CRR, there is lesser liquidity of funds in the market. Thus, investors may not look forward to investing in real estate or borrow a home loan due to the high interest rates. Additionally, the construction sector may see a slowdown since multiple construction companies can face scarcity of work due to lower demand. In such situations, construction companies will be reluctant to take on more work since it can increase their overhead costs.
Higher investments mean additional funds being injected into the economy. When CRR increases, there may be a shortage of fund availability for investment. This can result in slack and a slowdown in investments. Hence, the economy itself starts slowing down as a result.
Exports and imports
A rise in CRR often means higher interest rates. This limits the production from industries with regards to products and services. As industries deploy lesser resources into production and expansion plans, it can result in people looking for foreign goods and services to fulfil their needs. Thus, imports rise and exports decrease. This results in a downward pressure on a country’s GDP.
Equity and commodity market
When CRR rises, there is lesser investment in the equity market. This affects the commodity market due to the limited availability of disposable funds for investments.
An increase in CRR results in higher interest rates. Thus, the buying capacity of the general public may decrease since it may discourage spending. When interest rates rise, loans also become expensive. However, an existing borrower may not be impacted as neither the EMI nor the loan tenure is affected. In the case of floating interest rates, one can expect the loan EMI or the loan tenure to increase following a rise in CRR.
Investors should keep themselves aware of how CRR works and how it affects interest rates, inflation, and other monetary factors. This helps in making sensible decisions regarding borrowings and savings. It can also help in timing an investment.
- Are there any exemptions to CRR?
The Reserve Bank of India (RBI) exempted banks from maintaining CRR for loans lent to retail and micro, small and medium enterprises for up to five years. The condition is that these loans must have been extended between January 31 and July 31, 2020.
- What is SLR?
Statutory Liquidity Ratio or SLR is the minimum percentage of deposits that a commercial bank has to maintain in the form of liquid cash, gold, or other securities, as fixed by the RBI.
- What is the impact of CRR on the mutual fund market?
A rise in CRR can push up interest rates and impact debt mutual funds negatively. Especially for long-term gilt and income funds, as interest rates and bond prices go in opposite directions. Thus, when the rates go up, the prices of bonds fall.
- Does SLR impact retail investors?
When SLR rises, banks may be unable to lend to borrowers. Thus, retail investors who depend on borrowings to make investments may be impacted.
- What is the frequency of monetary policy changes announced by the RBI?
The Reserve Bank of India announces changes to the monetary policy at least 4 times a year.