The widely reported sordid and ugly exchange between the Chairman of SBI and a Deputy Governor of RBI on the Cash Reserve Ratio has forced me to break my self-imposed strict silence on anything economics or finance in India for three reasons: first is the status that the RBI has given me in the Society. During my tenure as Chief Economic Advisor at the Indian Banks’ Association, as one of the Managing Directors of the Asia-Pacific Rural And Agricultural Credit Association, and as Consultant at the National Stock Exchange, I was often called as “the RBI man’ rather than by name or designation. Second, the exchanges are fiercely (and disgustingly) hot but not bright and hence missed the core points. Finally, nobody, not even in this august group, has commented on this.
Now, on the issue (mainly from basic text books): (i) Banks are special financial institutions in the sense that they alone can create money—not mutual funds, or insurance companies or non-banking financial institutions can do this (Not even the Chairman of SBI could deny this). (ii) The Central Bank of a country (in the present context the RBI) has the responsibility of ensuring a sound banking system. For this purpose, it even plays the role of lender of last resort to banks—and not to other types of financial institutions mentioned above. (Again, not even the Chairman of SBI could deny this). (iii) The point noted in (ii) could also be interpreted to denote the Central Bank as an insurer for the banks. Viewed in this perspective, the cash reserves with it are in the nature of “premium” (I used within quotes because it is only a form and strictly NOT; the quantum does not depend upon the risk—the insurer ensures that there is no risk). Almost nobody recognises this point but jump to the next; (iv) CRR is the most effective monetary policy tool: an increase in CRR, by blocking lendable funds, drastically reduces the banks’ ability to lend. (Any undergraduate economics text book will explain this proposition in detail). The fact is, however, different. The exact effect depends upon the structure of the economy and the balance sheet of the Central Bank. When Lord Keynes stated that ‘with a stroke of pen’ the Central Bank could affect the liquidity in the economy, he was referring mainly of the USA of 1930s and that country’s Federal Reserve System. The Indian conditions and the RBI are vastly different. In India, the stated result is possible only under very restrictive conditions. Usually, in India, the effect of a change in CRR is, at best, neutral and, more often, perverse—an increase in CRR adds to the prime money, mainly currency with the public which, in turn, augment bank deposits. This could be proved with the balance sheet of the RBI. It is strange that the Chairman of SBI is not aware of this because, in mid-1980s, the officer in charge of Treasury at SBI had explained the mechanism to me. From this perspective, the Chairman cannot have any grievance.
- Dr. N. Nagarajan, Former Adviser, DEAP (via e-mail)
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