Recently RBI increased the Cash Reserve ratio. Cash Reserve Ratio determines the amount of money commercial banks have to deposit with Reserve Bank in form of security. The idea is to suck out liquidity from the banking system and encourage commercial banks to lend fewer amounts. Commercial banks will have to deposit larger amounts with Reserve Banks and will have fewer funds available for lending. Less home- and car loans will be given leading to less demand for cement and steel. Businesses will set up fewer factories and stock fewer goods in absence of loans. This will lead to lesser demand for goods in the market and cool down the economy and help control price rise.

These measures are likely to reduce demand both for consumption- and production. Banks will give out fewer loans for purchase of cars leading to lesser demand for cars. At the same time, they will give fewer loans to automobile manufacturers leading to production of fewer cars. The Reserve Bank has left Repo and Reverse Repo rates unchanged. These are the rates at which Reserve Bank lends to commercial banks or at which commercial banks deposit excess monies with the Reserve Bank. These rates are generally for short term lending. Banks prefer to borrow from the public for their long term requirements at rates more favorable than offered by the Reserve Bank under the Repo window.

The two steps taken by the Reserve Bank give contradictory messages. By leaving Repo rates unchanged, the Reserve Bank has encouraged commercial banks not to increase the rate of lending. By increasing the Cash Reserve Ratio, the Reserve Bank is encouraging commercial banks to lend fewer amounts. But reduced liquidity will increase pressure upon commercial banks to increase their lending rates. It must be recognized that the Repo window is used by commercial banks to manage short term requirements of liquidity. It has less relevance for long term rates which are determined by supply and demand of credit as reduced supply of credit due to increase in Cash Reserve Ratio will certainly put upward pressure on lending rates.

 The Reserve Bank is not likely to succeed in controlling prices by these measures because these measures deal only with the domestic component of the economy. The main reason for increase in price at present is not domestic but international. Foreign Direct Investors and domestic companies are busy setting up new factories leading to increase in demand for men and materials. The Reserve Bank has increased the Cash Reserve Ratio to partly neutralize the impact of these inflows. But raising the Cash Reserve Ratio and consequent upward pressure on lending rates is likely to lead to greater inflows of foreign capital.

The Reserve Bank has expressed confidence that the increase in Cash reserve Ratio and unchanged Repo rates will help contain price rise and also maintain Indian economy at the high growth rate of 8 percent. Reduction in demand due to lesser domestic lending will be nullified by increase in demand from FDI and ECB routes. These policies will affect players in different ways. Foreign Direct Investors and foreign banks engaged in arbitrage will stand to gain due to higher levels of activity. Large Indian corporate houses will also be affected only marginally. The smaller Indian business will be hit most.