A CRR hike and a weaver's shrinking salary
A district central co-operative bank in Tamil Nadu holds ₹500 crore of demand deposits and, being conservative, keeps exactly the statutory minimum reserves. In a policy review the RBI raises the cash reserve ratio from 4.0 per cent to 4.5 per cent; the statutory liquidity ratio stays at 18 per cent. The bank's chairman calls the change trivial - 'half a per cent of deposits' - and proposes to protect profits by raising the lending rate. In the same district a handloom weaver's household income has been fixed at ₹24,000 a month for two years by a contract, while local retail prices rose 7 per cent over the last year. The household holds ₹2 lakh in a fixed deposit paying 6.5 per cent and ₹50,000 in cash at home for emergencies.
1. Quantify the effect of the CRR change on this bank and, using the credit multiplier, on the district's banking system if every bank behaved identically. Why is the actual contraction in credit likely to be smaller than your figure?
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At this bank: required CRR balances before = 4% × ₹500 crore = ₹20 crore; after = 4.5% × ₹500 crore = ₹22.5 crore. So ₹2.5 crore is shifted out of lendable funds into reserves that earn no interest. The SLR of 18% is unchanged and already impounds ₹90 crore in government securities.
System-wide, using the simple multiplier 1/CRR: 1/0.04 = 25, so ₹500 crore of primary deposits supports ₹12,500 crore; 1/0.045 = 22.22, supporting ₹11,111 crore. The difference is roughly ₹1,390 crore of deposits and credit - so the chairman's 'half a per cent' is far from trivial in aggregate.
Why the real figure will be smaller: the simple multiplier assumes no currency held by the public, no excess reserves, and banks lending out every possible rupee. In practice households hold cash, banks keep voluntary buffers, weak credit demand limits lending, and SLR impounds 18% before credit creation even starts. Treat ₹1,390 crore as an upper bound, not a forecast. The bank-level ₹2.5 crore, however, is certain and is a real loss of interest income for a small co-operative.
2. Calculate the real interest rate on the fixed deposit and the real purchasing power of the ₹24,000 salary after a year. Who loses and who gains from this inflation?
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Real interest rate (Fisher approximation): 6.5% − 7.0% ≈ −0.5%. The deposit is losing purchasing power even before tax.
Salary: ₹24,000/1.07 ≈ ₹22,430 in last year's prices, so the household loses about ₹1,570 a month, or roughly ₹18,800 over a year, unless the contract is renegotiated.
Deposit: ₹2,00,000 × 1.065 = ₹2,13,000 nominal, but preserving purchasing power needs ₹2,14,000 (₹2,00,000 × 1.07) - a shortfall of about ₹1,000. The ₹50,000 held as cash becomes worth about ₹46,730, a loss of roughly ₹3,270.
Winners and losers: fixed-income earners, pensioners, creditors and cash holders lose; debtors on fixed-rate loans, traders holding stock, and anyone with the market power to raise prices gain. The weaver loses as a contract wage-earner but would gain as a borrower if he holds a fixed-rate loan, since inflation erodes the real burden of repayment - a gain that disappears if his loan is on a floating rate. A persistently negative real rate also weakens the incentive to save, which is the channel the RBI worries about.
3. The bank chairman wants to hold profits steady by raising the lending rate. Evaluate that plan and say what the RBI should watch before tightening further.
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Assessing the plan: the ₹2.5 crore moved into CRR earns nothing, so income does fall and something must be done. But a lending-rate hike is not a costless substitute. The bank's borrowers are handloom and coir units with thin margins; a higher rate may push some into default, converting an income problem into an NPA problem, and may deter exactly the credit demand that generates interest income. For a small co-operative, cheaper options deserve priority: cut administrative cost, grow low-cost current and savings deposits, recover overdue loans, and use the SLR securities portfolio efficiently.
What the RBI should watch: CPI inflation, credit growth, the credit-deposit ratio, and stress among MSME borrowers. It should also remember that instruments differ in kind - CRR is a blunt quantitative tool that hits every bank including small co-operatives, repurchase and bank rates work through price, and open-market operations work through securities. If the problem is a narrow liquidity surplus rather than broad inflation, a price instrument is usually preferable to another CRR hike. Judgement: the chairman's instinct to protect profit is right, but the instrument he has chosen is the riskiest one available to him.