The Explainer: Cash Reserve Ratio

In 'The Explainer' this week, I will focus on a not-so-well understood economic term: Cash Reserve Ratio (CRR). The Cash Reserve Ratio (CRR) is used by the RBI to control the supply of money in the economy. The amount of money determines the rates of interest and the prices of different commodities.

What is Cash Reserve Ratio?

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 20% of the Net Demand and Time Liabilities (NDTL) under the RBI Act, 1934.

In simple terms, all scheduled commercial banks must keep a 'certain percentage of their total time and demand liabilities with the RBI'. 

This is all Greek to me. Please explain the definition.

A liability is also called a loan. Here, a liability is simply a deposit account with a bank, i.e. what we call a deposit is called a liability by the bank as it would have to repay us (the money in that account). In other words, a deposit is our LOAN to the bank (and hence the interest paid by the bank).

There are two kinds of liabilities (hereon, we will use the term, 'deposit'): (1) time deposit, and (2) demand deposit.

Explain Time and Demand Deposits.

A Time Deposit is a type of account from which you can withdraw your money ONLY after a specified period of time. An example is a fixed deposit account. Hence, it is also called Term Deposit.

A Demand Deposit is one from which you can withdraw your money on demand. For example, from your Savings or Current account, you can withdraw money at anytime. (Also, you must have observed that an ATM is card is typically issued on these kinds of accounts, though they are also issued on some special types of fixed deposits).

Now, having understood the backgrounder on deposits, let's go further on CRR. 

Under the CRR, every scheduled commercial bank has to keep a certain percentage of such deposits with the RBI. The percentage lower limit is 3% while the upper limit is 20%. The current CRR is 6%. (You can access these data points here.)

How does this affect people like us and the economy in general?

As mentioned earlier, the CRR is used by the RBI to control the supply of money in the market. The amount of money determines the rate of interest and the prices of different commodities.

How does this work?

0.25% roughly equals about Rs8000 crore (Rupees Eight Thousand Crore only).

Let us say the RBI increases the CRR by 0.25%. This would mean that banks would have to keep more money with the RBI (Rs8000 crore will go into the RBI). This would reduce the money available with them. So this brings down the overall money supply in the market. A lower money supply would raise the interest rates (as demand for money is always high).

Now look at the reverse scenario. A reduction in CRR by 0.25% would release Rs 8000 crore into the market. As the money supply rises, the interest rates decrease. 

What do we do when the interest rates are high?

Common sense dictates that when interest rates are high we SAVE money and not Spend it. On the other hand, lower interest rates would make us SPEND more and not Save.

Lower interest rates would boost demand for goods and services. In the short run, this results in inflation as supply may not be able to match consumer demand. 

However, in the last three years, the RBI has raised the CRR from 3% to 6%. A higher CRR would mean that there is less money in the market. So there will be less money with people, which would mean that their demand for goods and services would be low. So the prices would be low. Hence inflation will be low. 



Just think about an increase in CRR of 3% in about three years; over Rs2 lakh crore has been sucked out of the system into the RBI! Though such a large amount has gone out of the system, it still has not brought down the rate of inflation.

As we can see today, inflation is very high and is impacting the common man in a very negative way. The RBI has tried various measures, like raising the CRR, to bring down inflation but to no avail. 

Sometime in the next four weeks, I will write on why the inflation rate is so high and how higher interest rates may impact economic growth in a negative way.

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