Global Outlook

Cash Reserve Ratio (CRR)hike can be a solution to the problem of rising inflation

Contributed by Nirmal Bang

By Nirmal Bang

The year 2009 saw investor wealth double and in many cases even triple. This was the most powerful and phenomenal turnaround that any bear market has ever witnessed in the history of the stock markets.

And the best part is that this is not the end of the road for this rally. All technical and fundamental indicators point towards a more robust growth in the economy and a more sustained rally in the stock markets in the year 2010.

But a price has to be paid for this vibrant economic growth. Strong growth leads to stronger demand, which automatically translates into higher prices. And these high prices ultimately culminate into higher inflation.

Inflation appears to be one of the many dark clouds in this otherwise spotless clear blue sky of stock markets.

SO WHAT REALLY IS INFLATION?

Inflation is the rate at which the cost of living increases and reduces the value of your money. For example, you can buy 1 kg of rice for Rs 100 as of today’s date. Assume that the rate of inflation is 8%. The same 1 kg rice will cost you Rs 108 in the same period next year. The purchasing power of your rupee has decreased due to the rise in inflation. Generally growth is accompanied with rising inflation.

Today, the common man is at his wit’s end while planning his monthly budget. The prices of all essential commodities like milk, pulses, vegetables, fruits, etc are soaring to dizzy heights.

Rising inflation can have deleterious effects on the growth, stability and economy of a country. Hence, it is the responsibility of institutions such as the Reserve Bank of India to monitor inflation levels closely and take adequate steps to keep it under check when it threatens to spiral out of control.

The RBI has many tools at its disposal to rein in rising inflation. And the most important and effective tool is the Cash Reserve Ratio or as we more popularly know it, the CRR.

CASH RESERVE RATIO (CRR)

All commercial banks are required to keep a certain amount of their deposits as cash with the Reserve Bank of India. This percentage is referred to as the Cash Reserve Ratio.

If and when the RBI feels that the inflation is rising and getting into uncomfortable territory, one of the first things that it does is hike the CRR rate. A CRR hike acts as potent anti-venom against rising inflation.

How Does A CRR Hike Help In Lowering Inflation?

Whenever the RBI hikes the CRR rate, a lot of excess liquidity is sucked out of the markets. Banks have lesser cash available with them to deploy as loans. Consequently, to maintain their profit margins, they have to increase the lending rates at which they disburse loans.

As loan rates go up, consumers tend to borrow less and eventually spend less. Thus the demand for goods and services goes down. All inflated prices start coming down due to the decrease in demand. And as prices start moving downwards, inflation starts coming down.

But as is the case with every antibiotic, CRR also comes with its own share of side effects. Let us understand the effect that CRR has on various sectors in the industry.

Effect Of CRR Hike On Rate-sensitive Stocks

Rate sensitive stocks bear the direct and brutal brunt of a CRR hike. Banking, real estate and auto sectors are the major sectors whose stocks are mostly affected when CRR rates are increased.

Banking

Increased interest rates lead to lower credit growth and further bring about the overall profitability. Thus, banking stocks might face selling pressure.

Real estate

CRR hike will reduce liquidity in the markets. Consumers will be less inclined to borrow home loans at higher interest rates resulting in a fall in demand. Also construction companies will have to borrow at higher rates thus increasing their overheads.

Auto

The same applies to autos. The demand for automobiles will decrease due to increased lending rates and the cost to company will rise sharply due to increased borrowing rates. Hence, auto stocks can also see a downturn. 

Overall almost all sectors will be affected in some way or the other with a generalized slowdown in industrial growth. Since liquidity is strapped to an extent, consumer demand is low owing to increased interest rates. Companies have to borrow at higher interest rates adding to their cost. Hence, the stock markets on the whole can witness some selling pressure.

Debt markets

CRR hike can also increase paucity of funds in the debt market. But one of the negatives of this move is that the yields of bonds increases as bond prices decrease since banks sell bonds to create liquidity. As the prices of bonds decrease, the returns on debt mutual funds will also plummet.

Effect On Loans

They become costly

Effect On Companies

The cost of funds will go up for small and medium-sized companies that have no access to foreign funds.

Fixed Deposits

There is a silver lining to the CRR hike. Besides increasing interest rates for loans, the interest rates of fixed deposits are also increased. The rise in fixed deposit rates will definitely bring smiles to risk-averse investors as their fixed deposits will fetch higher returns.

A CRR hike has far reaching implications on the economy and the stock markets. Hence, it is very important to understand the complex relationship between CRR hike as well as various sectors and industries and what it means for you as an investor.