final

PREPARED BY:

BAANEE LUTHRA (15636)

SHILPA BABANAGARE (15602)

SIDDHARTH DAS (15638)

TUHINA TANDON (15635)

Relevance of CRR & SLR in Financial Markets | 1

CONTENTS

• Acknowledgement 2

• Monetary Policy Framework in India 3

• Cash Reserve Ratio 6

• Statutory Liquidity Ratio 9

• Macro analysis 12

• Impact Of CRR And SLR On The Financial Framework 13

• Impact on Stock Markets 15

• Impact on Debt Market 17

• Impact on Foreign Exchange Markets 20

• Impact on Different Industries 21

• Impact on Common Man 25

• Monetary Policy of Mexico 26

• Monetary Policy of Korea 28

• Monetary Policy of South Africa 30

• Recent Developments 31

• Conclusion 33

• Bibliography 35

• Annexure 36


ACKNOWLEDGEMENT

“Expression of feelings by words makes them less significant when it comes to statement of gratitude”

We would hereby like to take the opportunity to thank our precious institution “College of Business Studies” for giving us a chance to enhance our skills and enrich our knowledge by means of on this project in the financial service sector.

We would hereby like to take the opportunity to express gratefulness towards Mr. Kumar Bijoy, sharing his invaluable knowledge and experience with us. We are indebted to him for providing me with this wonderful opportunity to undertake this project.

Thanking you,

Baanee Luthra

Shilpa Babanagare

Siddharth Das

Tuhina Tandon

(BFIA – 3rd yr)


MONETARY POLICY FRAMEWORK IN INDIA

In India, the transition of economic policies in general and financial sector policies in particular, from a control oriented regime to a liberalized but regulated regime has been reflected in changes in the nature of monetary management. While the basic objectives of monetary policy, namely price stability and ensuring credit flow to support growth, have remained unchanged, the underlying operating environment for monetary policy has undergone a significant transformation. An increasing concern is the maintenance of financial stability. The basic emphasis of monetary policy since the initiation of reforms has been to reduce segmentation through better linkages between various segments of the financial markets including money, Government securities and forex markets. The key development that has enabled a more independent monetary policy environment was the discontinuation of automatic monetization of the Government's fiscal deficit through an agreement between the Government and the Reserve Bank in 1997. The enactment of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 has strengthened this further. Development of the monetary policy framework has also involved a great deal of institutional initiatives to enable efficient functioning of the money market: development of appropriate trading, payments and settlement systems along with technological infrastructure.

Tools of Monetary Policy

♦ Open Market Operations:

Open market operations are the most important and active tool of monetary policy that the RBI uses. These operations consist of the RBI buying and selling previously issued government securities.

RBI adds extra credit to the banking system when it buys Treasury securities from the dealers, and drains credit when it sells to the dealers. As the laws of supply and demand take over in the reserves market, the cost of funds for the remaining reserves finds its level at the federal funds rate.

The RBI funds rate is the interest rate banks charge each other for overnight loans.


The open market operations are conducted in the following manner:

When the RBI Eases When the RBI Tightens

RBI buys government securities from a firm that deals in them.

RBI sells government securities to a firm that deals in them.

It pays by crediting the account that the dealer’s bank has at RBI.

It pays by debiting the account that the dealer’s bank has at RBI.

The bank in turn credits the dealer’s account.

The bank in turn debits the dealer’s account.

The banking system has more funds to lend.

The banking system has fewer funds to lend.

Downward pressure on the RBI funds rate—the interest rate banks charge each other for overnight loans.

Upward pressure on the RBI funds rate.

Influences other interest rates in the economy—which also go down.

Other interest rates in the economy also rise as a result.

Gives the economy a boost.

Slows the economy and curbs inflation.


Interest rates affect the level of activity in the economy. When rates are low, people find it easier to buy cars and homes, and businesses are more inclined to invest in new machinery and buildings. And when the rates are high the opposite occurs as the Fed tries to curtail inflation and maintain economic growth.

Open market operations typically are conducted several times a week. A majority of the open market operations are not intended to carry out changes in monetary policy. Rather, they are conducted to prevent some technical, temporary forces from pushing money and credit conditions in some undesired direction.

♦ Reserve Requirements:

Reserve requirements are the percentages of certain types of deposits that banks must keep on hand in their own vaults or on deposit at Reserve Bank of India. RBI has the authority to set reserve requirements on checking accounts and certain types of savings accounts.

Reserve requirement Raised Lowered

Impact on bank lending Reduce lending Increase lending


CASH RESERVE RATIO

Definition

The portion (expressed as a percent) of depositors' balances banks must have on hand as cash. This is a requirement determined by the country's central bank, which in the U.S. is the Federal Reserve. The reserve ratio affects the money supply in a country. This is also referred to as the "cash reserve ratio" (CRR). For example, if the reserve ratio in the U.S. is determined by the Fed to be 11per cent, this means all banks must have 11per cent of their depositers' money on reserve in the bank. So, if a bank has deposits of $1 billion, it is required to have $110 million on reserve.

Maintenance of CRR

In terms of Section 42(1) of the RBI Act 1934, Scheduled Commercial Banks are required to maintain with RBI an average cash balance, the amount of which shall not be less than three per cent of the total of the Net Demand and Time Liabilities (NDTL) in India, on a fortnightly basis and RBI is empowered to increase the said rate of CRR to such higher rate not exceeding twenty percent of the Net Demand and Time Liabilities (NDTL) under the RBI Act, 1934. At present, effective from the fortnight beginning October 02, 2004, the rate of CRR is 5 per cent of the NDTL.

Maintenance of incremental CRR

In terms of Section 42(1A) of RBI Act, 1934, the Scheduled Commercial Banks are required to maintain, in addition to the balances prescribed under Section 42(1) of the Act, an additional average daily balance, the amount of which shall not be less than the rate specified by the RBI in the notification published in the Gazette of India, such additional balance being calculated with reference to the excess of the total of the NDTL of the bank as shown in the return referred to in section 42(2) of the RBI Act, 1934 over the total of its NDTL at the close of the business on the date specified in the notification.

At present no incremental CRR is required to be maintained by the Scheduled Commercial Banks.

Liabilities not to be included for DTL/NDTL computation

The under-noted liabilities will not form part of liabilities for the purpose of CRR:

a. Paid up capital, reserves, any credit balance in the Profit & Loss Account of the bank, amount availed of as refinance from the RBI, and apex financial institutions like Exim Bank, NABARD, NHB, SIDBI etc.

b. Amount of provision for income tax in excess of the actual/ estimated liabilities.


c. Amount received from DICGC towards claims and held by banks pending adjustments thereof.

d. Amount received from ECGC by invoking the guarantee.

e. Amount received from insurance company on ad-hoc settlement of claims pending Judgment of the Court.

f. Amount received from the Court Receiver.

g. The liabilities arising on account of utilization of limits under Banker's Acceptance Facility (BAF)

h. Inter bank term deposits/term borrowing liabilities of original maturity of 15 days and above and up to one year with effect from fortnight beginning August 11, 2001.

Procedure for calculation of CRR

In order to improve the cash management by banks, as a measure of simplification, a lag of one fortnight in the maintenance of stipulated CRR by banks has been introduced with effect from the fortnight beginning 6th November, 1999. Thus, all Scheduled Commercial Banks are required to maintain the prescribed Cash Reserve Ratio (which is currently @ 5 per cent with effect from the fortnight beginning October 02, 2004) based on their NDTL as on the last Friday of the second preceding fortnight.

Maintenance of CRR on daily basis

With a view to providing flexibility to banks in choosing an optimum strategy of holding reserves depending upon their intra period cash flows, all Scheduled Commercial Banks, are required to maintain minimum CRR balances upto 70 per cent of the total CRR requirement on all days of the fortnight with effect from the fortnight beginning December 28, 2002. If any Scheduled Commercial Bank fails to observe the minimum level of CRR on any day/s during the relevant fortnight, the bank will not be paid interest to the extent of one fourteenth of the eligible amount of interest, even if there is no shortfall in the CRR on average basis.

Payment of interest on eligible cash balances maintained by SCBs with RBI under CRR

i. All Scheduled Commercial Banks are paid interest on all eligible cash balances maintained with RBI under proviso to Section 42 (1) and Section 42 (1A) of the RBI Act, 1934. At present, banks are being paid interest at 3.50 per cent per annum (with effect from September 18, 2004)

ii. The Scheduled Commercial Banks were paid 100 per cent interest on CRR balances on receipt of the quarterly interest claim statements in a prescribed proforma. From the month of April 2003 onwards, Scheduled Commercial Banks were paid interest on CRR balances on monthly basis on receipt of interest claim statements. With effect from August


2004, interest on CRR balances is being paid without obtaining interest claim statements from Scheduled Commercial Banks.

iii. The amount of interest payable at the prescribed rate (presently 3.50per cent) is to be worked out on the eligible portion of CRR balances for a period of 14 days. In case the CRR balances held with RBI is less than the amount required to be maintained for any of the fortnights, eligible interest will be paid for that defaulted fortnight only after working out cost of shortfall at the rate of 25 per cent per annum and subtracting the amount so worked out from interest payable amount.

Penalties

Shortfall, if any, observed in the maintenance of the CRR is reckoned against the eligible cash balances required to be maintained on the NDTL. The total amount of interest payable so arrived at is being reduced by an amount calculated at the rate of 25 per cent per annum on the amount of shortfall. In a situation where shortfall exceeds the level at which no interest becomes payable on eligible balances held by a bank on net basis i.e. (after interest deduction on the amount of CRR shortfall) the penal interest as envisaged in sub-section (3) of Section 42 of the RBI Act, 1934 is made applicable.

The Scheduled Commercial Banks are required to furnish the particulars, such as date, amount, percentage, reason for default in maintenance of requisite CRR and also action taken to avoid recurrence of such default.

CRR (1962‐2007)

0246810121416

1962

1976

1982

1985

1988

1992

1995

1998

2001


STATUTARY LIQUIDITY RATIO

Definition

SLR is that amount which a bank has to maintain in the form of cash, gold or approved securities. The quantum is specified as some percentage of the total demand and time liabilities of a bank. This percentage is fixed by RBI. The date which is taken to calculate the demand and time liabilities of the bank is the last Friday of the preceding fortnight.

Maintenance of SLR

Scheduled Commercial Banks, are required to maintain under Section 42 of the RBI Act, 1934, are required to maintain in India,

a) In cash, or

b) In gold valued at a price not exceeding the current market price, or

c) In unencumbered approved securities valued at a price as specified by the RBI from time to time.

An amount of which shall not, at the close of the business on any day, be less than 25 per cent or such other percentage not exceeding 40 per cent as the RBI may from time to time, by notification in gazette of India, specify, of the total of its demand and time liabilities in India as on the last Friday of the second preceding fortnight,

At present, all Scheduled Commercial Banks are required to maintain a uniform SLR of 25 per cent of the total of their demand and time liabilities in India as on the last Friday of the second preceding fortnight which is stipulated under section 24 of the B.R. Act, 1949.

Procedure for computation of demand and time liabilities for SLR

The procedure to compute total net demand and time liabilities for the purpose of SLR under Section 24 (2) (B) of B.R. Act 1949 is similar to the procedure followed for CRR purpose. However, it is clarified that Scheduled Commercial Banks are required to include inter-bank term deposits / term borrowing liabilities of original maturities of 15 days and above and up to one year in 'Liabilities to the Banking System'. Similarly banks should include their inter-bank assets of term deposits and term lending of original maturity of 15 days and above and up to one year in 'Assets with the Banking System' for the purpose of maintenance of SLR. However, both the above liabilities and assets are not to be included in liabilities/assets to the banking system for computation of DTL/NDTL for the purpose of CRR.

Valuation of approved securities for SLR

The entire investment portfolio of the banks (including SLR Securities) will be classified under three categories viz.' Held to Maturity', 'Available for sale' and 'Held for Trading'. Investment


classified under Held to Maturity category need not be marked to market and will be carried at acquisition cost unless it is more than the face value. In such a case, the premium should be amortized over a period remaining to maturity. Individual scrip’s in the Available for Sale category will be marked to market at the year-end or at more frequent intervals. The net depreciation under each classification should be recognized and fully provided for and any appreciation should be ignored. The book value of the individual securities would not undergo any change after the revaluation.

The individual scrip’s in the Held for Trading category will be revalued at monthly or at more frequent intervals and net appreciation/depreciation under each classification will be recognized in income account. The book value of the individual scrip will be changed with revaluation.

Penalties

If a banking company fails to maintain the required amount of SLR, it shall be liable to pay to RBI in respect of that default, the penal interest for that day at the rate of 3 per cent per annum above the bank rate on the shortfall and if the default continues on the next succeeding working day, the penal interest may be increased to a rate of 5 percent per annum above the Bank Rate for the concerned days of default on the shortfall.

051015202530354045

1964

1972

1978

1984

1987

1990

1993

1997


DEPOSITS (9%) 100

Less: Cash Reserve Ratio (7.50%) (7.50)

92.5

Less: Statutory Liquidity Ratio (25%) (23.125)

69.375

Less: Day to day liquidity required 4.375

65.00

Less: Loans (18.46%) 65.00

0.00

To earn interest equivalent to pay on deposits and to meet operating expenses, banks tend to charge a heavy interest rate on loans.

REASONS CAUSING A CHANGE IN RESERVE REQUIREMENTS

Factors leading to a rise in reserve requirements

Expansion of money supply. Expansion in residency based new monetary aggregate which does not directly reckon

non resident foreign currency deposits. Growth in liquidity. Acceleration in inflation causing an increase in prices of both inputs and outputs. Enhanced capital inflows. Strengthening of rupee vis-à-vis dollar.

Factors leading to a cut in reserve requirements

Lower currency expansion. Slower time deposit growth. Fall in money supply. Timely sterilization of capital inflows through open market operations and repo

transactions. Poor performance of small and medium industry and consumer durable goods as they are

being hit the most by monetary tightening. Slow growth of the economy.


MACRO ANALYSIS

Continuing the high growth phase that started in 2003-04, the Indian economy exhibited robust growth during 2006-07. Real GDP growth accelerated to 9.4 per cent in 2006-07 from 9.0 per cent achieved in the previous year on the back of a further firming up of activity in the industrial and the services sectors. Both these sectors recorded double-digit growth, which more than offset the deceleration in the agricultural sector. The services sector continued to be the mainstay of the economy, contributing 71.5 per cent to overall growth. The sustained resurgence in industrial activity in the recent period has reinforced the growth process, and has imparted stability to the growth process.

Real GDP growth averaged 8.6 per cent during the four-year period 2003-04 to 2006-07 and 7.6 per cent during the 10th Plan period (2002-03 to 2006-07), significantly higher than that of 5.7 per cent during the 1980s and 1990s. The actual growth during the 10th Plan period was quite close to the target of 8.0 per cent. Amongst major sectors, growth of the industrial sector averaged 8.0 per cent during 2002-03 to 2006-07.

Growth in monetary and liquidity aggregates accelerated during 2006-07, with broad money growth remaining above the indicative trajectory projected by the Reserve Bank at the beginning of the financial year. Broad money (M3) growth, accelerated to 21.3 per cent at end- March 2007 from 17.0 per cent a year ago and remained above the growth rate of 15.0 per cent projected in the Annual Policy Statement in April 2006.

Global headline inflation remained firm during 2006-07 reflecting the combined impact of higher international crude oil prices in an environment of strong demand and closing of output gaps. Although inflation moderated somewhat with the easing of crude oil prices from August 2006, inflationary pressures continued from other commodity prices and increased capacity utilization rates. As a result, headline inflation remained above the inflation targets/comfort zones in major economies. Headline inflation in India, based on movement in the wholesale price index (WPI), rose to 5.9 per cent as on March 31, 2007.

In 2006-07, the private corporate sector sales grew by 26.2 per cent and net profits grew by 42.2 per cent, both higher than the levels a year ago.

The RBI therefore had a dual task of not detailing the growth any further and at the same time keeping the liquidity situation under control to maintain WPI inflation around 5 per cent for 2007-08. To balance these objectives in its first quarter review, the RBI increased the CRR by 50 basis points to 7 per cent while keeping repo and reverse repo rates unchanged at 7.75 per cent and 6 per cent respectively.


IMPACT OF CRR AND SLR ON THE FINANCIAL FRAMEWORK

♦ Liquidity and Interest Rates

A CRR cut increases the money multiplier since it leaves a larger fraction of deposits free to be disbursed as credit. This helps to improve the liquidity within the banking system without affecting its monetary base.The CRR cut, could put pressure on banks to find ways and means of deployment of funds.

CRR hike is used as an important weapon to mop up liquidity. With a rise in CRR the liquidity in the rupee market will go down forcing banks to sell dollars to generate rupee funds. This would drive up rupee in the short term.

During the first quarter, while the 1-year yield declined from 7.55 per cent at end-March 2007 to 6.84 per cent by July 27, the 10-year yield moderated from 7.97 to 7,89 per cent. The RBI according to its mandate seeks to attain the objectives of ‘promoting price stability and ensuring adequate bank credit to productive sectors’. To maintain the value of currency the RBI therefore intervenes heavily in foreign exchange markets during times of high capital inflows, which results in a build up of foreign exchange reserves.

♦ Inflation

Inflation is actively back as a policy concern now, after Wholesale Price index (WPI) figure of 6 per cent plus, the highest in two years-— a rate higher than the 5-5.5% inflation rate that the RBI has indicated as acceptable. Inflation has been an RBI concern for some time.

Since oil prices are based on global factors and commodity prices of primary articles get affected by short term factors and are often highly volatile, many countries look at “core inflation.” Core inflation basically means excluding the prices of these two highly volatile components from the inflation figures. Even if that’s done, inflation based on prices of manufactured goods, a measure of core inflation, rose by 5.9%.

Analysts opine that Indian economy, is overheating- high growth rate and rising inflation rate, high real-estate prices and rising salaries. The concern is how to pacify this overheating, if there is any. A high interest rate and constraints on liquidity will control the inflation but at the same time will bring down the growth. Despite of being blamed for spoiling the party, RBI has taken a strong step to tighten monetary policy. It has announced a hike of 0.5 percentage points in cash reserve ratio.

A CRR hike means banks will have to hold more cash, rather than pumping it into the economy. The effect of a hike in CRR is to cut the overall amount of money in the system. Since the supply of money is decreased, it’s purchasing value increases. So this should reduce inflation.

Sometime back, banks could sell the government securities, and hence meet the lending demands. Now that the stock of government securities with banks has declined to the SLR (Statutory Liquidity Ratio) levels of 25 percent, any increase in lending will have to come about


only when banks borrow more. The impact of small changes in interest rates will be much higher than it has been.

A CRR cut would pump in liquidity in the markets thereby increasing the money supply in the economy. Enhanced money supply would lead to a rise in input and output prices, thus raising the level of inflation. A continued rise in inflation tends to slow down the growth of the economy.

♦ Exchange Rate

Increasing interest rates tends to increase the foreign capital investment. India is in a transition stage, wherein it’s progressively becoming an open economy from a closed one. The complexities thus increase, because of the linkages between exchange rate movements and interest rates and the impact of increasing capital flows across the border.

The CRR hike and changes to the reverse repo mechanism are not expected to have a direct impact on the exchange rate in the near term.

A cut in reserve requirements would raise the level of liquidity in the system. This will lead to a decrease in inflow of foreign money that is coming into India for interest rate arbitrage and thus would stem the rupee rise higher.

Thus we can say that

A hike in CRR decline in liquidity higher interest rates Rupee depreciates

A 0.50% hike will drain out Rs 150 billion (Rs 15,000 crores) from the economy. It sends a strong signal that the RBI is clearly focused on taming inflation, which in recent months has risen dramatically. While in the near term this will have an adverse impact on overall economic growth, from a long term perspective, it will be beneficial for the economy.

A cut in CRR Rise in liquidity fall in interest rates Rupee appreciates

The 50 basis point cut in CRR will provide the necessary liquidity of Rs 6000 crores to the money market, which has otherwise been witnessing a short-term hardening of interest rates. The liquidity so created through RBI intervention would stem rupee rise higher.


IMPACT ON STOCK MARKETS

A hike in CRR leading to rising interest rates have several implications including -

Slowing down the overall growth in the economy; this effectively means that demand for goods and services, and investment activity, gets adversely impacted

Apart from the fact that overall growth is impacted, companies take a hit on account of higher interest costs that they have to bear on their outstanding loans (to the extent their cost of funds is not locked in)

Since some investors tend to leverage and invest in the stock markets, higher interest rates increase expectation of returns from the stock markets; this has the impact of lowering current stock prices.

An overall decline in stock prices has a cascading effect as leveraged positions are unwound (on account of meeting margin requirements), leading to still lower stock prices

So, from a short term perspective, higher interest rates should adversely impact stock market sentiment.

From a long term perspective however our expectations of returns from the stock markets remains unchanged. As mentioned earlier, RBI's move to tame inflation over the long term augurs well for long term economic growth (there is more predictability and therefore risk premiums are lower). This will ultimately benefit well-managed companies.

It's difficult to say how the stock markets will react; or for that matter to what extent the markets will react. In the last few trading sessions, there has already been a correction of about 4% in the BSE Sensex.

It is impossible to predict near term movement in stock prices. And therefore any investment you consider should be made keeping in mind that in the near term you could be sitting on losses on fresh investments. From a 5 year perspective however we are reasonably confident that a well managed equity fund can deliver returns in the range of 12% - 15% pa. This is not to say that you will make this return every year. There will be years in which you may lose money, and others where you may make far more than what we have projected. Over the 5 year tenure, on a point to point basis, you will average a return of 12% - 15% pa, which in our view is a realistic estimate.

CRR hike has the potential to significantly dent equity markets. The risk involved in such a stance is that the RBI is likely to end the growth party in India. The RBI move might result in lower PE for the market. That being the case, this is not yet the peak for markets overall, but certain sectors will have to struggle; PSU banks, real estate and autos will see a fall.

In Indian equity markets there are three levels of macro risk; a high P/E, a relatively overvalued rupee and interest rates that have stayed relatively low considering the level of economic growth, and we associate these things with growth. The P/E multiples are high because growth is strong,


the rupee has been firm because strong growth has attracted capital and that capital has helped keep interest rates low. With CRR hike RBI is about to end the growth party and if growth begins to slow down then you are likely to see a lower P/E, a low rupee and a potentially higher interest rates.

A cut in CRR would lead to a fall in interest rate. A cut in interest rates would make savings in banks unattractive. Thus, depositors may move to the stock market at a time when the revival of the bourses is crucial for regenerating Indian industry. Thus a reduction in CRR would boost the securities prices and players are also expecting the Government to align the savings rate to the same structural levels.


IMPACT ON DEBT MARKET

An increase in the CRR indicates a liquidity crunch with the bank and to compensate for the crunch it hikes interest rates.

Therefore, an increase in the CRR and the repo rate create paucity of liquidity in the debt market. One of the fallouts of such a move is that the yield of a bond increases as the bond's price decreases (Banks sells bonds to create liquidity). This helps judicious investors.

Thus increase in CRR:

• Increase in bond yields • Fall in interest rates on deposits • Rise in interbank call rate • Rise in interests rates on loans

However, existing investors in debt oriented funds may take a one time hit; but at the same time, since overall interest rates are higher, from here on, such funds will yield higher returns.

Although the interest rates have risen quite a bit, it may still not be the best time to lock in all your money in long term debt instruments.

Short term Fixed Maturity Plans (FMPs), which can yield an annualized return of about 8% on a post tax basis for a three month deposit or well managed Monthly Income Plans (MIPs) offered by mutual funds are attractive in view of rising interest rates. The low risk option (equity less than 20% of assets) with a quarterly dividend option can also be exercised. With higher interest rates and possibly lower stock prices, MIPs could yield an attractive post tax return.

With CRR hike the interest rates rise and if one looks at three-month commercial paper rates, you have gone from around 7 to 9.5, so the market is already tightening.

♦ A rise in Cash Reserve Ratio leads to a rise in market rates both of the deposit and the lending rates. In Collateralized borrowing market, rates rose to 9.7% for the day, after opening at 6.9%. The rates ended the day 7.75% after transactions worth Rs 28,546 crore were carried out.

♦ Impact on bond yields: A hike in CRR aimed at controlling inflationary pressures. Thus bonds are expected to experience some elevation due to CRR and Repo rate hikes.

♦ Rise in lending rates: Buying a home or a car or seeking a personal loan for an overseas trip may pinch a lot more with the rise in cash reserve ratio as most bankers feel that it is imperative that lending rates will shoot up further, at least, by another 25-50 bps.

♦ Impact on government securities: The rise in G-sec yields was limited as compared to the other segment of the bond market. This was mainly on account of the continued incremental Statutory Liquidity Ratio (SLR) requirement of the banks and buying by other large institutional investors. The government securities market started the month on a positive


note with the yield on ten-year bond falling to 7.38% levels against the previous month close of 7.43%. The hike of Cash Reserve Ratio (CRR) leads to a sharp rise in yield on ten-year G-sec. A CRR hike has a negative impact on Liquidity Adjustment Facility (LAF). It tends to tighten the LAF causing LAF balances to fall.

The government securities market remained volatile for most part of the month after CRR hike. The market saw good buying at these levels due to the investment demand and lower than expected inflation numbers. The ten-year yield gradually softened to the levels of 7.59% before closing the month at 7.62%. The liquidity remained strained for most part of the month. The impact of CRR hike was seen immediately after the announcement.

♦ The overnight call rates which remained in the range of 6.00-6.10% in the first week gradually moved up to 11.00-11.50% by month end, touching a high of 19% levels. The tightening of liquidity condition was evident in the Liquidity adjustment facility (LAF) figures of RBI. The rupee liquidity dwindled for the remaining part of the month mainly on account of advance tax outflows and the CRR hike.

♦ Impact on the inter-bank call market: the inter-bank call market rate is expected to rise following the 50-basis point hike in CRR which has mopped up Rs 16,000 crore from the system. The rates went up to 9.75% for the day, after opening at 7.5%.

Cut in reserve requirements:

♦ A cut in reserve requirements leads to a fall in PLR. A cut in CRR would have impact on interest rates on commercial papers, FCNR etc as their interest rates are PLR linked.


♦ Impact on bonds: If RBI decides to lower reserve requirements, this will cause banks to have an increase in the amount of money they can invest. This causes the price of investments such as bonds to rise, so interest rates must fall.

♦ Impact on govt securities: In the monetary and credit policy for 2002-2003, the RBI had announced that the CRR be reduced by 50 basis points from the fortnight beginning June 15, 2002. This cut is aimed at easing off the market tightness. The G-sec market that has been in a slump, post credit policy, with bond prices crashing by Rs 2-3 across maturities triggered by massive sell offs. A CRR cut is aimed to avoid interest hardening situation. The rate cut will help banks show improved profitability for the year ended March 31, 2001. This is because the rate cut will raise the prices of gilts and the valuation of the gilts held by the banks will go up.

A cut in SLR would lead to a:

The short-term sentiment impact, which is already seen with yields on the 10-year g-sec shooting up by 20bps on January’ 12 over a day; and a long-term structural impact which will affect the demand-supply equation of bonds.

♦ Fall in interest rates: A CRR cut is aimed to increase banks' capacity to lend, which will

position the economy when a rebound encourages borrowers to borrow. This would also have an across the board positive impact on appreciation in State Government securities, approved securities and corporate bonds.


IMPACT ON FOREIGN EXCHANGE MARKETS

Rise in reserve requirements: When RBI decides to raise the reserve requirements the amount of money available with banks for investment falls short. This causes an increase in supply of bonds and reduction of bond price. Thus, causing a rise in the rate of interest. Higher interest rates cause the cost of financing capital projects to be higher, so capital investment will be reduced.

A rise in CRR raises the demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate i.e. the value of the domestic currency is now higher relative to foreign currencies. A higher exchange rate causes exports to decrease, imports to increase and the balance of trade to decrease.

The rupee went through a volatile day before ending slightly weaker against the dollar. The local currency ended at 39.36/37 against the dollar, slipping from its previous close of 39.32/33 level. Cut in reserve requirements: If RBI decides to lower reserve requirements, this will cause banks to have an increase in the amount of money they can invest. This causes the price of investments such as bonds to rise, so interest rates must fall. When interest rates are lower, the cost of financing capital projects is less. So all else being equal, lower interest rates lead to higher rates of investment. A cut in CRR lowers the demand for domestic currency and the demand for foreign currency rises, thus causing a decrease in the exchange rate i.e. the value of domestic currency falls in relation to foreign currency. A lower exchange rate causes exports to increase, imports to decrease and the balance of trade to increase. Since bond prices rise, an investor will sell his domestic bond, exchange rupees for foreign currency, and buy a foreign bond. This causes the supply of rupees on foreign exchange markets to increase and the supply of foreign currency on foreign exchange markets to decrease. This causes the domestic currency to become less valuable relative to the foreign currency. The lower exchange rate makes domestic produced goods cheaper and foreign produced goods more expensive in foreign country, so exports will increase and imports will decrease causing the balance of trade to increase.


IMPACT ON DIFFERENT INDUSTRIES

Impact on Banking Industry

♦ Net interest margins:

As a result of the recent CRR hike the net interest margins come under pressure because of the incremental deposits being raised at a fairly high cost. If this trend continues then the NIMs will come under pressure or they will have to increase the lending rates, we expect the liquidity to remain fairly tight and that is probably one of the reasons why the Ministry of Finance has authorized RBI to cut SLR to fund the credit growth. So somewhere the banking sectors will be a little bit under pressure because of the rising deposit growths not equally matching rise in the credit side and hence some pressure on the net interest margin.

♦ Interest rate hike:

A hike in CRR would suck out liquidity from the system. Moreover RBI has reduced its interest outgo towards banks (as interest on CRR maintained) from 6 per cent to 3.5 per cent. Earlier, banks would park in idle cash at the repo auctions. However, with the rise in CRR, the idle cash is likely to reduce, thereby eating into the treasury returns. However, a hike in interest rates is not ruled out after this move. But for competition, the country would surely witness a rate hike.

The cut in the bank rate is a signal for reducing lending rates. However the impact may be limited due to the following reasons: (a) A floor of 4 per cent on the savings deposits reducing the flexibility for cutting prime lending rates (PLR); (b) Competition from the Government’s small saving schemes with administered interest rates leave little room for bank deposit rates to come down; (c) High intermediation costs of banks, which are mainly influenced by their operating costs (2.5 to 3 per cent of the total assets for PSBs at present), keeping spreads and therefore lending and deposit rates sticky; and (d) High cost of fund mobilization, with an average of cost 7 per cent for PSBs, the largest mobilizers of deposits. This would at best give the banks room for cutting their PLR’s marginally by 10 to 15 bp, the margin by which the reserve adjusted cost of funds would go down. Any cut in the lending rates is going to put pressure on the profitability of the banks as it would impact their margins.

♦ Taming Inflation:

Inflation tends to have a negative impact on the earnings and performance of banks. Banking sector experienced a fall in earnings in the year 2004-05 ranging from 2.6% to 45%.


Other income (Rs m) 1QFY04 1QFY05 (%) Change SBI 17,529 15,387 -12.2% Oriental Bank 1,817 998 -45.1% Corporation Bank 1,257 1,001 -20.4% HDFC Bank 1,322 1,080 -18.3% IDBI Bank 428 417 -2.6% UTI Bank 1,503 1,101 -26.7%

A rise in CRR would help in controlling the inflationary pressures and improving the profitability of banks. With a cut in reserve requirement rate, the value of investment portfolio of banks would rise. This would have positive impact on the profits of banks and EPS."

♦ Impact on domestic deposits Impact of cut in reserve requirements The likely impact of the bank rate and CRR cut on deposits via deposit rate changes is also going to be marginal. In absence of variable rate term deposits, banks have little room to cut deposit rates, as it can lead to money flowing in to mutual funds or small saving schemes. Besides the scope for a cut is limited by the impact on lending rates i.e. a cut by 10 to 15 bp. Impact of rise in reserve requirements The move will benefit the fixed deposit investors as banks are likely to raise the interest rates on term money. But the flip side is that consumer loans and housing loans will now become costlier. ♦ Impact on foreign deposits Foreign currency deposits were earlier exempt in calculation of CRR, but will now be counted for the same. This means that banks with relatively bigger corpus of foreign deposits, in proportion to domestic deposits, would need to put away more funds toward CRR and hence cost of funds from such deposits would go up. This would require banks to rationalize interest rates on foreign deposits, which traditionally had more aggressive interest rates. Smaller foreign banks which have borrowed heavily from their parent banks will be hit harder. Among all bank groups, foreign banks, witnessed the largest reduction in their intermediation costs (difference in interest income and expenditure) by 38 bp in FY00. The repeal of CRR exemptions can alter this scenario. ♦ Gain from CRR cut All scheduled commercial banks (excluding regional rural banks) will be paid interest on eligible cash balances maintained with RBI under the CRR requirement at the rate of 3%. These balances have generally been viewed as nonperforming assets as average interest earned on such balances is around 2.7 per cent as against 8 to 9 per cent which can be earned by investing in the


government securities or even higher return which can be earned in times of high demand for credit.

Impact on Capital goods industry:

The last three years' soft interest rate regime had a positive impact on India Inc as the industry witnessed lower interest outgo and also cost cutting, which made the Indian markets attractive in the global arena. As a result of low interest rates, companies undertook large capital-intensive projects. However, with an upward shift in interest rates, it is likely that major projects with a positive internal rate of return turn negative as cost of financing goes up. This move would hit the long-term profitability of the industry as major corporates would either postpone or cancel orders.

Impact on Auto industry:

Retail loans form a major part of a bank's loan portfolio. To put things in perspective, more than 80% of vehicle sales are financed by the banking industry. A hike in interest rates is likely to affect this price sensitive segment. Further, material cost increase on account of rising working capital costs would have negative impact on margins. Also, the plans to project the country as a manufacturing hub would take a hit in the face of rising interest rates where financing activities would become costlier. Further, with intense competition, aggressive pricing is the order of the day.

Impact on Infrastructure:

Rise in reserve requirements

The country's budget has laid special emphasis on infrastructure activities with over Rs 400 bn being earmarked for the same. Large construction activities coupled with agricultural projects


(irrigation) shall result in high costs. A hike in interest rates would result in postponement of these plans. This is likely to impact companies catering to the infrastructure segment such as steel, cement and energy. Power projects, which are capital intensive, are likely to be worst hit in the face of rising interest rates as usually; high gestation periods in the segment attract relatively higher costs.

Cut in reserve requirements

Impact of a CRR cut on industry would mainly depend on how banks react to them. In the past, banks had reduced the deposit rates in response to bank rate and CRR cuts, the same has not happened for lending rates of banks. The demand for funds from industry would, however, depend a lot on how growth takes place and the extent to which new investment is undertaken.

The policy focus today is given on infrastructure. RBI has sought to relax certain regulatory and prudential aspects for such finance so as to allow banks to increase their credit to this sector. To begin with the scope of the definition covering infrastructure is to be widened. Raising the single-borrower prudential limit from 15 to 20 per cent of capital funds will help banks to focus more on this sector. Further, by assigning a concessional risk weight of 50 per cent on investment in securitised paper satisfying conditions pertaining to infrastructure activity, we can expect a flurry of activity in this segment. On the whole, the policy can be seen as having positive impulses on the economy as well as industry and infrastructure.


IMPACT ON THE COMMON MAN

Hike in reserve requirements

Higher returns from debt oriented instruments due to high interest rates.

Loans would become costly as the banks would charge a higher rate of interest. As long as the rate of interest on the loan is fixed, the borrower would be immune to any rise in interest rates. However, if he has a floating rate loan, then either the tenure of the loan or the EMI would increase.

The WPI, which is an index of wholesale prices, takes some time to show up in CPI numbers. Thus, we can expect a salubrious movement in CPI to follow the downturn of the WPI by a few months.

Further the CPI places a much greater emphasis on food (46% weight in CPI as opposed to 15% in WPI). Therefore the CPI tends to be less interest rate sensitive and more affected by supply side movements than the WPI. In other words, the problem of inflation has partly already been solved (since WPI is down and CPI follows WPI with a lag), and the portion remaining cannot be solved through monetary tightening since the CPI is affected by non-monetary measures far more than by monetary measures.


MONETARY POLICY OF MEXICO

Mexico follows a zero-average reserve requirement system. The system works within 28-calendar-day maintenance periods in which each bank strives to manage the balances on its current account at the central bank so that, at the end of each period, its daily balances sum to zero. The incentive for doing so lies in the fact that if the accumulated balance is negative, the bank in question would have to pay high interest rates on it, whereas if it is positive, the bank forgoes any return it might have earned by investing the funds elsewhere. This reserve requirement system is designed to induce credit institutions to avoid, on an average basis, overdrafts or positive balances on their current accounts, and offset any excess or lack of resources they might have by lending to other banks or borrowing from them at market interest rates. It is for this reason that, during maintenance periods, the Bank of Mexico does not pay interest on positive balances or charge interest on overdrafts posted at the end of each day, as long as both are kept within certain pre-established limits.

The total accumulated balance may also differ from its target when the current accounts of one or more commercial banks post positive balances or overdrafts exceeding their respective positive or negative limits. The amounts exceeding these limits are not taken into consideration for the computation of the accumulated balances of the banks in question, and therefore are not considered in the total accumulated balance either.

For example, if a bank incurs a 150 million pesos overdraft while subject to a 100 million pesos negative limit, on the following day it will have to pay a penalty equivalent to twice the CETES rate on the 50 million pesos by which it exceeded its limit. Nonetheless, in the future the bank will have to offset a 100 million pesos overdraft only, for the 50 million pesos excess overdraft will not be considered in the computation of the bank’s accumulated balance or in the system’s total accumulated balance. The latter item will then surpass the target announced by the Bank for that day by 50 million pesos. In its intervention in the money market the following day, the central bank will have to reduce the amount of resources provided to the market by 50 million pesos, so as to bring the total accumulated balance to its target.

By the same token, should a bank report a 150 million pesos positive balance in its current account while its positive limit is 100 million, the bank will have the right to overdraw, without cost, up to 100 million pesos on its account during the days remaining to the end of the maintenance period. The 50 million pesos in excess will not be considered in the bank’s accumulated balance or in the system’s total accumulated balance. Therefore, the latter will be 50 million pesos below the amount announced by the central bank for that day. On the following day, the Bank will have to increase the amount of resources provided to the market by 50 million pesos, so as to bring the total accumulated balance to target.

The central bank of Mexico mainly relies on open market operations to correct inflationary pressures in the economy. It as well influences changes in the CETES rates to tackle issues


related to liquidity in the economy. The yield on the one-month T-bills, known as CETES, was expected to edge up to 7.46 percent as on 31st December’ 2007.


MONETARY POLICY OF KOREA

Measures taken to reform monetary policy instruments included the lowering of minimum reserve requirement ratios, a sharp reduction of the aggregate ceiling on the Bank of Korea’s discount window and the introduction of free competitive bidding for open market operations.

Lowering reserve requirement ratios

Until the early 1990s the Bank of Korea made frequent use of changes in reserve requirement ratios for managing domestic liquidity. In particular, they were actively used during the late 1980s when the Korean economy experienced a substantial current account surplus. In an effort to absorb the excess liquidity generated by the external sector, the average reserve ratio of 4.5 % in 1986 was raised to 10.4% in 1990.

Lowering reserve requirements may cause the following 3 problems:

An increase in the ratios places banks at a competitive disadvantage in deposit-taking vis-à-vis non-bank financial institutions which are not subject to reserve requirements. Korean experience was that banks’ share in deposit-taking continued to fall sharply, largely as result of the high reserve requirements imposed on them. More specifically, banks’ share in total deposits fell from 48.8% in 1985 to 34.9% in 1990 and to 28.1% in 1997.

Secondly, since reserve requirements are enforced on the basis of a strict regulatory framework, heavy reliance on changes in reserve requirement ratios for monetary control gives a central bank less scope for implementing market oriented operations. This could in turn well delay the further development of financial markets.

Finally, changes in reserve requirement ratios are probably not an effective tool in managing the liquidity of non-bank financial institutions. In particular, the effectiveness of changes in reserve requirements may well be more limited in managing liquidity where financial markets are more highly compartmentalized.

In view of these problems, the Bank of Korea no longer makes active use of changes in reserve requirements in managing domestic liquidity. The decisive break came with the sharp reduction of reserve requirement ratios undertaken in three steps between April 1996 and February 1997. The main purpose was to improve banks’ profitability and competitiveness in deposit-taking vis-à-vis non-bank financial institutions which had not so far been subject to reserve requirements. The average reserve requirement ratio of 9.4 % in March 1996 was lowered to 3.1% by February 1997. Along with these measures, a 2.0 % reserve requirement was introduced on deposit-taking through the sale of CDs upon the abolition of ceilings on their issuance in February 1997. More recently the Monetary Board decided to raise the permissible ratio of vault cash in banks’ reserve


requirements. Specifically, banks were allowed to hold up to 35%of their reserve requirements as vault cash from 23rd May 1998 against the previous maximum of 25%.

The Bank of Korea (BOK) recently announced a rise in deposit reserve requirement ratio for commercial banks, effective from December 23, 2006. Specifically, the demand reserve requirement ratio will be taken up to 7% from 5%. At the same time, the BOK cut the long-term time deposits reserve requirement ratio to 0% from 1%.

Liquidity growth to recede: While the immediate impact on banks may not be significant, the move by the BOK will reduce liquidity in the economy as it effectively brings the reserve requirement above what the banks are currently holding. If not overtly negative, today’s move undeniably caps the positives in next year’s economic outlook through reducing liquidity, which has been a growth driver in the past two years. On top of that, added pressure comes from an expected decline in the trade surplus, as Korea is heading into an export slowdown. Korea’s overall liquidity conditions will be less favourable in the year ahead.


MONETARY POLICY OF SOUTH AFRICA

The Reserve Bank can create the monetary conditions to obtain a suitable growth rate in the money supply by controlling the reserve assets that banks have to hold or by operating on the level of interest rates. In the Reserve Bank’s previous operating procedures the Bank opted for the so-called classical cash reserve system based on recommendations made by the Commission of Inquiry into the Monetary System and Monetary Policy in South Africa.

A statutory minimum reserve asset requirement has been employed as a monetary policy instrument since the establishment of the Reserve Bank in 1921. The cash reserve requirement has generally been regarded as a useful monetary policy instrument in that it provides a source of demand for central bank reserves in the event of large and sustained changes in domestic liquidity. Variations in cash reserve requirements have generally not been used in the day-to-day management of money market liquidity because they are comparatively unwieldy, take some time to become effective and frequent adjustments could disrupt the efficient management of banks’ portfolios.

The cash reserve requirement has changed considerably over time in South Africa. Changes were introduced to simplify the system or to counter certain practices applied by banks to circumvent the effects of the requirements. Although the reserve ratio was lowered over time, the amount of cash reserves that the banks were required to hold at the Reserve Bank rose from about R2 billion in 1988 to approximately R12 billion in 1997 due to the growth in the amount of deposits held at the banks. As a ratio of total deposits, the cash reserve holdings of South African banks declined during the 1980s to a lower turning-point at the beginning of 1992 of about 1.50%. This ratio then rose relatively sharply and fluctuated more or less between 21/2 and 3% from 1995 to 1997.

The reserve base of the banks for the basic requirement was total liabilities as adjusted for capital and reserves less interbank deposits and repurchase agreements of 31 days and shorter with government bonds and Treasury bills as security. The reserve base for the additional requirement was restricted to only the short-term liabilities less deposits pledged as security for loans granted, the amounts owing by banks and mutual banks, repurchase agreements of 31 days and shorter with government bonds and Treasury bills as security, and 500/0 of remittances in transit.

The eligible assets for reserve requirements consisted of banks’ balances on current and reserve accounts at the Reserve Bank plus their holdings of South African bank notes and coin in their vaults, tills and automated teller machines. Vault cash was included as part of the cash reserve requirements mainly in order to limit the financial, logistical and administrative burden on the banks. If vault cash was not included, some banks could at the end of the day transport it back to the Reserve Bank and redeem it for reserve deposits, thus increasing the administrative burden of the central bank and these banks.


RECENT DEVELOPMENTS

Cut in reserve requirement (year 2002)

Monetary conditions remained stable during 2002-03. Large and persistent capital inflows were sterilized by timely open market and repo operations. Consequently, base money expansion remained moderate. Money supply, in terms of broad money (M3) excluding the effects of mergers as well as the residency based new monetary aggregate (NM3), remained in alignment with initial expectations. The revival in non-food bank credit, which was evident in the last quarter of 2001-02, firmed up throughout 2002-03 reflecting the improvement in the industrial climate. Nevertheless, liquidity in the financial system was ample. This was reflected in the broader measures of liquidity (L1, L2 and L3). Despite the Centre’s market borrowing moderately exceeding the budgeted level, there was a softening of interest rates with varying sensitivity across the spectrum.

M3 (net of the full impact of mergers) moved in consonance with its projected trajectory of 14.0 per cent during 2002-03. Lower currency expansion relative to trend as well as slower time deposit growth restrained the monetary expansion. On the other hand, the relative contribution of demand deposits to aggregate deposits growth rose, indicating a shortening of time preference at the margin. On a year-on-year basis, M3 expansion was 13.3 per cent as on April 4, 2003 as compared with 14.0 per cent a year ago.

Market liquidity was augmented by the Reserve Bank’s primary subscription to the Central Government’s market borrowing programme (Rs.36, 175 crore) and release of resources by way of lowering the cash reserve ratio (CRR) (around Rs.10, 000 crore). In 2002-03 reserve requirements was reduced by a cumulative 75 basis points reduction in the CRR to 5.75%.

Hike in reserve requirements (year 2007)

The Reserve Bank of India (RBI) unexpectedly hiked the cash reserve ratio (CRR) 50bp to 7.5%, but—as widely expected--kept the repo (the rate at which it injects liquidity, currently at 7.75%) and the reverse repo (the rate at which it withdraws liquidity, currently at 6%) unchanged. The previous hike in CRR was announced in July, and the latest increase is effective November 10 and will withdraw INR160 billion. It is the fifth increase, including the first one in the current tightening cycle in December 2006. The RBI last hiked the repo rate in March.

The central bank maintained the full year GDP growth forecast for 2007-08 (year that began April 1) at 8.5%oya. The inflation forecast has also been left unchanged at 5%, though the RBI has lowered the medium-term guidance to 3.0% from 4-4.5%, an outcome it sees being "consistent with India's broader integration with the global economy".

The latest CRR hike is mainly a liquidity management tool and is not intended to give any interest rate signal. Capital inflows will remain challenging for the RBI, and further hikes in CRR and more restrictions on some kinds of capital inflows are likely. However, the timing of


CRR hikes remains uncertain, as it will depend on the magnitude of capital inflows and the nature of additional measures that are announced to check capital inflows.

In the past 12 months, the RBI has raised CRR by 200 basis points to manage liquidity. There is a growing feel in the banking system that the NIMs in the third and fourth quarter will remain under pressure as although banking have started slashing deposit rates, banks have not yet raised lending rates lately.

The CRR hike may help in checking the inflationary pressures. Still, there are legitimate near-term risks to liquidity: (1) Seasonal tightness from increases in "currency in circulation" owing to the Indian festival

season currently beginning now, (2) Government receipts in excess of spending, especially the excise tax payments in the

second week of November and, (3) The latest CRR hike being effective around the same time. Investors will most likely react by unwinding received positions, leading to higher and flatter curves; the impact will likely be more pronounced on the OIS curve and bonds will likely outperform swaps in this environment. However the impact of the recent CRR hike shall be limited as the additional amounts of funds to be drained is some way below the amount recently injected through foreign reserves.


CONCLUSION

Current banking scenario:

Deposits continue to remain the mainstay of the resource mix of SCBs. As on March 31, 2007 deposits constituted over 77% of the total liabilities of all SCBs as against 81% a year ago.

In last couple of years the growth in deposits has not been able to keep pace with the high credit growth compelling banks to liquidate some of their holdings of government securities. This has now brought down the Statutory Liquidity Ratio in the banking system very close to the minimal level, thereby limiting the scope of further liquidation. This invariably increased the dependence of banks on deposits for funding future credit growth.

This mismatch between the growth in credits and deposits forced banks to shore up interest rates at the shorter end on deposits, transforming the deposit mix in the process.

With the spread between short term and long term deposits being narrowed down, investors preferred short term deposits and were averse to locking their deposits for long periods. The increased preference for short term deposits could also be attributed to lower or comparable returns on other long term maturity instruments like postal deposits, public provident funds etc. As a result the share of short term deposits in total term deposits went down by 40%.

The slowdown of credit growth and the prevailing liquidity condition reduced the dependence of banks on short term deposits by lowering their deposit rates. The current CRR hike might result in further slowdown in credit demands thereby forcing banks to revisit their deposit growth strategies. Thus banks may further reduce their short term deposit rates to manage their margins in the reduced credit takeoff environment.

Do we need a change in reserve requirements?

Indian financial markets have experienced large swings in liquidity and heightened volatility as a result of easing off oil prices, commodity prices etc. money markets have experienced excess liquidity which is reflected from the call rates closing to 1% levels and sinking even further on several occasions.

The monetary measures taken by RBI have had the intended effect. Inflation has come off its peak and is well below the preferred level of 5%. The appreciation of the rupee over the last few months has provided the necessary cushion in controlling inflation. However the unidirectional movement of the rupee has affected Indian export competitiveness.

At the same time RBI had resorted to huge dollar purchases to support the currency. This had resulted in excess liquidity in the system with M3 growing at 21.6% on a year on year basis which was well above the projected level of 17.5%.


Given the strong outlook on capital inflows, potential upside risks to inflation from higher oil and commodity prices and the need to maintain export competitiveness of the Indian industry, the RBI resorted to the following measures to absorb liquidity and to mitigate inflationary pressures:

RBI has lifted the 30 billion cap on daily liquidity absorption at the 6% reverse repo rates.

Increase in CRR: It will force banks to choose between credit growth and margin.

PROS:

∗ The recent monetary tightening will be more effective in checking credit expansion as the banks don’t have the latitude they enjoyed previously in funding loan growth via running down their holding of government bonds.

∗ Since the productive lending is being impacted a cut in SLR ratio would accelerate the loan growth.

CONS:

∗ Between a cut in CRR and a cut in interest rates, the RBI should choose the latter. A cut in CRR will signal intent of boosting liquidity and prevent banks from raising rates if they had intended to do so. However, where an actual boost to liquidity is called for, one cannot avoid a cut in interest rates.

∗ The cut in interest rates will also lead to a decrease in the inflow of foreign money that is currently pouring in to take advantage of the higher rates in India, and thereby control exchange rate appreciation. This would simultaneously rein inflation and trigger exports. If the US decides to cut rates again to quell a growing recession, then this move will help to stem the additional flow that would have arisen in pursuit of interest rate arbitrage.

∗ The aggressive monetary tightening policy along with investment bubble bursting caused the growth in bank lending and IP to collapse, pushing Indian industry into a prolonged slump. Admittedly, the central bank was ultimately able to control inflation, but it did so at a very heavy price.

CRR is an inflexible instrument of monetary policy that drains liquidity across the board for all banks without distinguishing between banks having idle cash balances from those that are deficient. In case, CRR is not remunerated, it has a distortionary impact of a 'tax' on the banking system. CRR is also discriminatory in that it has an in-built bias in favor of financial intermediaries that are not required to maintain balances with the Reserve Bank. As against repos/OMO that can be used flexibly to withdraw liquidity from surplus entitles while injecting liquidity to the deficient ones, CRR is not a preferred option. Hence CRR as an instrument for balancing monetary impact, should only be used under extreme conditions of excess liquidity and that too when other options are exhausted.


BIBLIOGRAPHY

www.rbi.org.in www.sify.com www.thehindubusinessline.com In.answers.yahoo.com www.moneycontrol.com www.mprofit.org www.equitymaster.org www.oecd.org En.wikipedia.org News.surfax.com www.economictimes.indiatimes.com In.reuters.com www.indianexpress.com www.hindu.com www.rediff.com www.iitk.ac.in www.dbs.com www.bis.org www.financialexpress.com


ANNEXURE

Maintenance of Cash Reserve Ratio(CRR) -Section 42(1) of the Reserve Bank of India Act, 1934

DBOD.No.BC. 34 /12.01.001/2001-02October 22, 2001

Ashwin 30,1923 (saka)

To All Scheduled Commercial Banks(Excluding Regional Rural Banks)

Dear Sir,

Section 42(1) of the Reserve Bank of India Act,1934 - Maintenance of Cash Reserve Ratio(CRR)

Please refer to the paragraphs 54 and 57 of the Governor’s statement on Mid-term Review of

Monetary and Credit Policy for the year 2001-02 (circular No. MPD BC 210

/07.01.279/2001-02 dated October 22, 2001) regarding maintenance of Cash Reserve Ratio

(CRR) and payment of interest thereon. In this connection we advise as under:

2. (a) Reduction and Rationalisation of Cash Reserve Ratio (CRR)

All Scheduled Commercial Banks (excluding Regional Rural Banks) are at present required

to maintain with Reserve Bank of India a Cash Reserve Ratio (CRR) of 7.50 per cent of the

Net Demand and Time Liabilities (NDTL) (excluding liabilities subject to zero CRR

prescriptions) under Section 42(1) of the Reserve Bank of India Act, 1934. It has now been

decided to reduce CRR by two percentage points from 7.50 per cent to 5.50 per cent as

indicated below.

Effective fortnight beginning CRR on NDTL (percent)November 3, 2001 5.75

December 29, 2001 5.50

(b) Withdrawal of exemptions in certain categories ofLiabilities from the maintenance of Cash Reserve Ratio

Simultaneous with the reduction in CRR, as indicated above, it has also been decided that all

exemptions on the liabilities will be withdrawn except inter-bank liabilities (as provided vide

our Circulars DBOD.BC.50/12.01.001/1996-97 dated April 15,1997 and

DBOD.No.BC.5/12.01.001/2001-02 dated August 07, 2001), for the computation of NDTL

(for requirement of maintenance of CRR) with effect from fortnight beginning November 3,

2001. Accordingly, it is now advised that the following exemptions provided earlier by the

Bank stand withdrawn for the computation of NDTL for the requirement of maintenance of

CRR with effect from the fortnight beginning November 3, 2001.

? Non-Resident External Rupee Accounts (NRE).

? Non-Resident Non-Repatriable Rupee Accounts (NRNR).

? Foreign Currency Non-Resident (Banks) Accounts [FCNR(B)].

? Exchange Earners’ Foreign Currency (EEFC) Accounts.

? Resident Foreign Currency Accounts (RFCA).

? ESCROW Accounts by Indian Exporters.

? Foreign Credit Line for Pre-Shipment Credit Accounts in Foreign Currency (PCFC).

? Any other bank specific or general exemptions.

In view of the rationalisation of CRR prescription, however, it is clarified that the effective

CRR maintained by Scheduled Commercial Banks on total Demand and Time Liabilities

shall not be less than 3.0 per cent, as stipulated under the Act.

A copy of the relative notification DBOD No.BC 33/12.01.001/2001-02 dated October 22,

2001 together with a copy each of the earlier Notifications issued vide

DBOD.No.BC.45/12.01.001/96-97 dated April 15, 1997 and DBOD

No.BC.102/12.01.001/2000-2001 dated April 19,2001 is enclosed.

(c) Interest on cash balances maintained withReserve Bank of India under Cash Reserve Ratio

At present, all Scheduled Commercial Banks (excluding Regional Rural Banks) are paid

interest on eligible cash balances maintained with Reserve Bank at the rate of 6.0 percent per

annum under Section 42(1B) of Reserve Bank of India Act,1934. In the annual policy

statement of April 2001, it was announced that at a subsequent stage, interest would be paid

at the Bank Rate. It has now been decided that with effect from the fortnight beginning

November 3, 2001, all Scheduled Commercial Banks will be paid interest at the Bank Rate

on eligible cash balances maintained with Reserve Bank under provisio to Section 42(1) and

42(1A) of Reserve Bank of India Act, 1934.

Yours faithfully,

Sd/-(R. C. Mittal)General Manager.Encls : 3

Endt. DBOD No. BC. 675 / 12.01.001/2001-02 of date.

Copy forwarded for information and necessary action to :

1. The Deputy General Manager, Department of Banking Operations andDevelopment, Reserve Bank of India, All Regional Offices,

2. The General Manager, Department of Banking Supervision, Reserve Bank ofIndia, All Regional Offices,

3. The Chief General Manager -in- Charge, Department of Banking Supervision,Reserve Bank of India, Central Office, Mumbai,

4. The Adviser-in-Charge, Department of Statistical Analysis & Computer Services,Reserve Bank of India, Central Office, Mumbai,

5. The Adviser-in-Charge, Department of Economic Analysis & Policy, ReserveBank of India, Central Office, Mumbai,

6. The Adviser-in-Charge, Monetary Policy Department, Reserve Bank of India,Central Office, Mumbai 400 001, with reference to their circular No.MPD BC210/07.01.279/2001-02 dated October 22, 2001.

(Sudarsan Oram)Deputy General Manager

Telegrams“BANKCHALAN”TEL No. 2189131 - 39Post Box No. 6089MUMBAI

Reserve Bank of IndiaCentral Office

Department of Banking Operations & DevelopmentWorld Trade Centre-1, Cuffe Parade, Colaba

Mumbai 400 005.

DBOD.No.BC. 33 /12.01.001/2001-02October 22, 2001

Ashwin 30,1923 (Saka)

NOTIFICATION

In exercise of the powers conferred by the proviso to Sub-section (1) of Section 42 of the

Reserve Bank of India Act, 1934 (2 of 1934 )(the Act) and in supersession of its Notification

DBOD No.BC.121/12.01.001/2000-01 dated May 12, 2001 the Reserve Bank of India hereby

specifies that the average Cash Reserve Ratio (CRR) required to be maintained by Scheduled

Commercial Banks (excluding Regional Rural Banks) shall, from effective dates mentioned

below, be at the percentage points as indicated thereagainst.

Effective date (i.e. thefortnight beginning from)

CRR on net demand and timeliabilities (percent)

November 3, 2001 5.75

December 29, 2001 5.50

2. The Reserve Bank of India further directs that all exemptions granted to Scheduled

Commercial Banks (excluding Regional Rural Banks) under Sub-section (7) of Section 42 of

the Reserve Bank of India Act, 1934 (2 of 1934), stand withdrawn with effect from

November 3, 2001, except liabilities as computed under clause (d) of Explanation to Sub-

section (1) of Section 42, ibid. and as provided under Notifications issued vide

DBOD.No.BC.45/12.01.001/96-97 dated April 15, 1997 and vide DBOD

No.BC.102/12.01.001/2000-2001 dated April 19,2001.

(K.L.Khetarpaul)Executive Director

Telegrams“BANKCHALAN”TEL No. 2189131 - 39 Post Box No. 6089MUMBAI



Mumbai 400 005.

DBOD.No.BC. 45 /12.01.001/96-97April 15,1997,

Chaitra 25, 1919 (Saka)

NOTIFICATION

In exercise of the powers conferred by Sub-section (7) of Section 42 of the Reserve Bank of

India Act, 1934 (2 of 1934 ) Reserve Bank of India hereby exempts with from the fortnight

beginning April 26, 1997, every scheduled commercial bank (excluding Regional Rural

Banks) from maintenance of average Cash Reserve Ratio (CRR) specified in the Notification

DBOD.No.BC. 140/12.01.001/96-97 dated 19, October, 1996, with reference to its liabilities

as computed under clause (d) of Explanation to Sub-section(1) of Section 42, ibid.

2. The exemption stipulated above shall be subject to the CRR maintained by a

scheduled commercial bank at not less than 3 percent of its total of the demand and time

liabilities as computed under section 42 (1) of the Reserve Bank of India Act, 1934.

(J.R. Prabhu)Executive Director

Telegrams“BANKCHALAN”TEL No. 2189131 - 39Post Box No. 6089MUMBAI



Mumbai 400 005.

DBOD.No.BC.102 /12.01.001/2000-2001April 19, 2001

Chaitra 29,1923 (Saka)

NOTIFICATION

In exercise of the powers conferred by Sub-section (7) of Section 42 of the Reserve Bank ofIndia Act, 1934 (2 of 1934 ) and in partial modification of its Notification DBODNo.BC.45/12.01.001/96-97 dated April 15, 1997, Reserve Bank of India hereby exemptsinter-bank term liability of maturity of 15 days and above of all scheduled commercial banks(excluding Regional Rural Banks) with effect from the fortnight beginning August 11, 2001from the prescription of the maintenance of minimum Cash Reserve Ratio requirement of 3.0percent of total of demand and time liabilities in India.

(K.L.Khetarpaul)Executive Director

Changes made Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

final

Documents

active tool of monetary

rbi funds ratethe

nature of monetary management

money market

dealers bank

financial framework

debt market impact

reserves market