The Reserve Bank of India (RBI) Governor YV Reddy has once again surprised the markets by increasing the Cash Reserve Ratio (CRR) by 50 basis points to 7 per cent in an unexpected move. The RBI has left the other policy rates unchanged in the first quarter review of the annual monetary policy for the year 2007-08. The central bank has also kept its target of GDP growth and inflation rate unchanged for the year. At the same time, the RBI has removed the cap on daily reverse repo auction to absorb the excess liquidity sloshing around in the banking system. The RBI has  signalled that its overall stance on the monetary policy in future will continue to emphasise on price stability. Though inflation has come down below 5 per cent, the Bank wants it to remain within that target limit. At the same time, by keeping all other rates unchanged, the RBI wants interest rates to soften and create an interest rate environment that supports export and investment demand in the economy so as to enable continuation of the growth momentum.
The RBI's move to increase CRR, though unexpected, was largely because of the easy liquidity in the system. Large inflow of foreign capital mainly in the stock markets and high remittances have been putting pressure on rupee, leading to its appreciation. To protect the export-oriented industries, which were badly hit in the quarter ending June 2007, the RBI had to purchase dollars heavily so that the price of rupee did not go up further. The 0.50 per cent increase in CRR, which makes banks keep cash with RBI, will suck out around Rs 16,000 crore from the banking system and reduce liquidity.
As the economy is flush with cash, the RBI's move is unlikely to increase the interest rate. In fact, over the last two weeks commercial banks have started lowering interest rates, a clear indication that the tight money situation has eased. On the inflation front the economy is breathing easy as there has been improvement on the supply side. The onset of normal monsoon has raised the hope that firm production will be normal and prices of agricultural produces will not go up sharply. Whether the RBI’s monetary measures will yield the intended results is a big question mark though. Its earlier steps to contain inflation have made a difference but the banking sector's exposure to retail loans and housing finance is still uncomfortably high. The hike in CRR, therefore, may only have a marginal impact in controlling these.