Raising CRR: What Bangladesh Bank gains, public loses

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Bangladesh Bank (BB) has slapped on an increase in the cash reserve ratio (CRR) by one-half percent on the commercial banks. The CRR now stands at 6.5 percent. It is unlikely that many people will be familiar with this term or what it implies. CRR (also known as required reserve ratio) is the percentage of total deposits of a bank that it must hold as reserves with Bangladesh Bank. This is meant to be a precautionary holding against sudden shortages of liquidity and run on banks. However, these days it is also used by many central banks as an additional monetary policy tool. The central bank can influence the money supply and interest rates, and thereby economic activities, through variations in the CRR.

When the commercial banks are supposedly awash with liquidity and interest rates are falling, the CRR was obviously not raised to prevent illiquidity. BB has divulged that the action was taken for mainly two reasons: (1) to reduce interest costs associated with reverse repo operations and (2) to prevent the excess liquidity of the scheduled banks spilling over to the goods market, which could stoke inflation. These benefits of the increase in CRR should be balanced against any costs imposed upon the economy in order to assess the net benefit of the policy action.

An immediate effect of the increase in CRR is the reduction in the amount of money that the banks can loan out. At the current level of deposits, banks would be required to hold an additional Tk. 3000 crore or more with BB as reserves. Thus BB would have reduced liquidity by this amount through this change without having to engage in reverse repo (i.e. open market purchase of bonds and bills). Since BB pays no interest on reserves, it saves the interest cost of reverse repo. However, this cost is passed on to the banks which are forced to transfer money from interest bearing assets to non-interest bearing reserves. With a lag the banks will pass on this cost to their clients who will receive lower returns on their deposits and/or pay higher charges on loans. In other words, BB’s gain will be ultimately at the expense of the ordinary people.

If the banks have unintended excess liquidity, the increased CRR will not have any other significant effects. However, if they do not have unintended excess liquidity, the higher CRR will translate into a corresponding decline in the money supply. This could push up the interest rates.

It is claimed that the commercial banks are at present awash with liquidity. This must imply that they are not being able to attract sufficient borrowers. It is widely believed that there is stagnancy in investment demand due to governance problems, infrastructure inadequacies, energy shortages and deteriorating security situation. The Finance Minister has on several occasions blamed the lack of business enthusiasm to invest as a drag on economic growth. If this be the case, the challenge facing the economy is to raise aggregate expenditure, not reduce it. Such an in increase in expenditure is unlikely to cause an inflationary spiral. The large deficit in the proposed budget seems to reflect such a view.

According to data in a BB publication (Monthly Economic Trends, May 2014, Table VIII) the general price level has been on a slow upward march during the last 18 months. This was caused entirely by a sharp increase in the food price inflation. The nonfood inflation has actually fallen sharply during this period (see Chart).

m a taslim 1BB has said, quite correctly, that it can do little to moderate food price inflation since it is mostly supply determined. If food price rises due to domestic supply shortages or an increase in the world food price, there is little monetary policy can do to moderate such an increase. But monetary policy has significant influence on nonfood price inflation, which is more akin to ‘core inflation’. Nonfood price inflation has been falling during the last 18 months and is now below the BB’s target inflation. The rapidly falling nonfood price inflation is a reflection of the general slowdown of the economy due mainly to inadequate aggregate expenditure resulting from the paucity of private investment. One of the main objectives of the government as well as of monetary policy is to accelerate economic growth. This requires improvement in the investment climate and an acceleration of private investment. In this event what is needed is a stimulus for the nonfood sector to encourage more investment and production. But the increase in the CRR, a restrictive monetary policy measure, perhaps sends a wrong signal and could conceivably stall or even reverse the falling tendency of the interest rates. This could further discourage investment in the non-food sector. The public stance of BB and its policy would appear to be inconsistent.

The cash (or required) reserve ratio is used by many central banks as a monetary policy measure to stabilise the economy. An advantage of it is that monetary changes can be executed with some precision quite quickly. However, many an economist believes that it is not advisable to use reserve ratio for stabilisation purposes when open market operation is available. The latter is a voluntary market transaction which allows better adjustments and outcomes. The former is mandatory that leaves no room for delaying or strategizing by banks. An increase in the required reserves will not have much impact on a bank that has significant excess reserves, but a bank that runs more tightly will find it difficult to adjust immediately without incurring losses. Hence, reserve ratio has differential impact on banks depending on their liquidity position and loan profile. Hopefully BB has examined the excess reserve position of each bank before slapping on the increase in the CRR in order to minimise its negative impact.

Source: UNBConnect