When RBI buys dollars, but does not scoop up the liquidity using MSS, reserve money growth remains high. What matters to the economy, however, is broad money (M3) and not reserve money. The banking system takes reserve money as a “raw material” and converts it to broad money. The CRR influences this multiplication process. A higher CRR, where banks are forced to hold money with RBI, induces a smaller multiplication factor. Thus money supply (M3) growth is held back even though reserve money growth is very high.

When banks are forced to hold more reserves with RBI, they lend less, and this is how the central bank seeks to control liquidity, credit and demand, and thus inflation. By not selling MSS bonds, RBI managed to prevent the cost of borrowing for the government to rise. Instead, households and industry were faced with a credit crunch.

There is no free lunch. Someone has to pay for the dollar peg. As the finance minister, P. Chidambaram, correctly pointed out in his budget speech, the interest payment on MSS bonds in the budget constitutes a subsidy to exporters that is borne by the exchequer. By stopping MSS issuance and switching to CRR hikes, the cost of this subsidy was shifted from the government to banks and their users.

With a hike in CRR, banks have to hold a larger proportion of their deposits as cash with RBI. This means the interest earned by them on deposits goes down. The reduction in returns is borne either by banks or their customers. Either depositors get less interest income or borrowers pay higher interest rates. This cost, borne by banks and their customers, is the price of subsidising exporters.

... contd.