Will increase of cash requirement ratio deliver?

Author Topic: Will increase of cash requirement ratio deliver?  (Read 2382 times)

Offline mshahadat

  • Full Member
  • ***
  • Posts: 229
    • View Profile
Will increase of cash requirement ratio deliver?
« on: July 13, 2014, 04:14:55 PM »
Will increase of cash requirement ratio deliver?
Abul Basher

Bangladesh Bank has recently increased the cash requirement ratio (CRR) by 0.5 percentage points, from 5.0% to 5.5% on daily basis. At the same time, the bi-weekly average has to be 6.0% in the end. This change will be effective from December 15 of this year. The stated objective of this change is “to curb inflationary pressure on the economy.” Given the structure of the economy, the main question is, can this policy change really work to curb acceleration of inflation?

Apart from this question, the logic behind announcing a monetary policy change six months before its implementation is not quite clear. The global practice has been to maintain the secrecy of a change in monetary policy until it is announced; and once it is announced, to make it effective immediately. This system does not give any space to economic agents of any kind to make preemptive adjustment to combat the effects of policy change. The Federal Reserve System (central bank of USA) maintains these two principles in case of undertaking monetary policy. If an economic agent can anticipate or know about a forthcoming change in monetary policy, the change does not work as desired.

Coming back to the question; what can this announced change in monetary policy do in the context of inflation? Probably, nothing much! This policy change will reduce the loanable funds at the disposal of banks. As a result, it can potentially reduce the flow of private credit, reduce policy, and control the amount of private credit. It can reduce people's overall demand as well as ability to consume more goods and services. In particular, people will postpone the consumption of goods and services which are usually credit-financed. This will reduce the total demand for consumption in an economy until the source of adequate and easy credit is restored. This is what the economists call decline in aggregate demand. Prices follow the decline in aggregate demand. Inflation goes down as a result. However, the efficacy of the announced change of monetary policy to control inflation depends on (i) how sensitive our overall consumption is to credit, and (ii) how significant would be fall in credit to increase in CRR. Consumption of all commodities is not equally sensitive to credit. There may be some exceptions, but in general, consumption of basic needs is not dependent on credit. On the other hand, demand for consumer durables and entertainment depend mostly on the availability of credit. Not everyone's demand will be equally sensitive to credit either. The attitude towards consumption, i.e., the decision to save or borrow widely, varies even among people with similar level of income.

Consumption of food is relatively price insensitive, and is not significantly linked with credit. Most people consume a certain amount of food, irrespective of their access to credit. There is a proverb in Bangla that says something like, “people borrow money to buy ghee.” Limited access to credit would limit the consumption of ghee, not of rice. Those who are required to buy rice with credit due to lack of adequate income lack access to the credit market as well. Therefore, it is less likely that the announced change monetary policy to contract would reduce the total demand for food.

However, in case of non-food items, it will be an altogether different story. Consumption of most non-food items is residually determined. People usually use whatever amount of income is left after meeting the demand for food to finance the consumption of non-food items, and availability of credit significantly influences their consumption. This is why monetary policy can potentially influence the consumption of such items.

To understand how much the announced change of monetary policy can do to control inflation, one needs to look at the procedural aspects of its estimation in Bangladesh. Inflation, being a general index, is a weighted sum of change in prices of different commodities of diverse nature, some being very responsive to credit and some being not responsive at all, over a period of time. They are broadly classified as food and non-food items in Bangladesh. The weights assigned to food and non-food items are 58.8% and 41.2%, respectively.

The increase of CRR may affect only the 41.2% of our total consumption to some very limited extent through credit channel, the remaining 58.8% will remain unaffected. A policy which is unlikely to affect 58.8% of our national consumption is also unlikely to affect the overall inflation of the country.

Currently, the overall disbursement of credit is not liquidity-constrained. Rather, demand for credit is not adequate. Banks are holding on to idle cash due to lack of adequate demand for loan. Probably, the increase of CRR will impact the idle cash that the banks are currently sitting on rather than creating a liquidity constraint for them to cut the disbursement of loan. As long as no significant demand side improvement is accomplished, the announced change in monetary policy will not be binding on the disbursement of credit, which is already relatively low. Thus, the anti-inflationary effect of this policy change through the credit channel will be very weak.

Loan is not the only asset that the commercial banks invest in. Their portfolio includes a number of other assets also, like investment in stock market, purchase of government bond, debentures, etc. Bangladesh Bank gave them about six months to adjust the current composition of their portfolios. They can easily reduce the other assets while not compromising with the disbursement of loan if it is deemed to be profitable. Therefore, the announced increase of CRR will not necessarily decrease disbursement of credit in the current situation.

Md.Shahadat Hossain Mir
Senior Administrative officer
Department of Law
Daffodil International University
Campus -3 ( Prince Plaza)
Mail: shahadat@daffodilvsarity@diu.edu.bd