Of late, RBI has been trying one more weapon from its arsenal – that is Cash Reserve Ratio (CRR) to avoid any kind of sterilisation.

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Consequently, these extra funds translate to credit growth in the economy as banks go on a lending binge, which fuels inflation in the economy.

Normally, RBI buys dollars from Indian banks, which increases the supply of rupee in the banking system and domestic banks are left out with increased amount of funds at their disposal. Consequently, these extra funds translate to credit growth in the economy as banks go on a lending binge, which fuels inflation in the economy. And how many of us are oblivious to the fact that inflation targeting is also the mandate of the RBI. RBI tries to sterilise some of the liquidity by issuing bonds but our bond markets are quite underdeveloped for sterilisation to take effect efficiently. Of late, RBI has been trying one more weapon from its arsenal – that is Cash Reserve Ratio (CRR) to avoid any kind of sterilisation. If one were to analyse the recent CRR hike, the purchase of dollars was strangely followed by hike in CRR. The move was to stem the liquidity available to banks, because of dollar purchases, before hand. But punishing domestic banks, for no fault of theirs, make no sense at all. Moreover, for Indian banks, a hike in CRR or overnight rates, automatically translates into an increase in lending rates. Again a major issue!!!

So, after trying all the above mentioned tactics and the rupee still continuing its march ahead, this leaves the central bank in a precarious situation with its exchange rate goals and inflation targeting at loggerheads with each other. As Sunil Sinha goes on to add, “Currently, RBI is facing the famous ‘trilemma’ (stable exchange rate, free capital flows & an autonomous monetary policy) and it has a very difficult situation ahead of it.” The central bank has to choose between rupee appreciation and inflation, with each one of them worse than the other. But then, what’s the way out? There are two broad levels at which this situation can be tackled. One is at the policy level and the other is at the corporate boardroom. First, at the policy level, RBI should create policies, which encourage capital outflows to offset the inflows that are flooding the economy. RBI has gone for some minor activities but then there is scope for more.


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Source : IIPM Editorial, 2008

An Initiative of IIPM, Malay Chaudhuri and Arindam Chaudhuri (Renowned Management Guru and Economist).


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