Implication of credit-deposit ratio

B. Venkatesh

STATISTICS published by the Reserve Bank of India (RBI) show that the incremental credit-deposit ratio has increased in 1999-2000 over the previous year.

What is credit-deposit ratio? It is the proportion of loan-assets created by banks from the deposits received. The higher the ratio, the higher the loan-assets created from deposits.

What is the implication? Some experts contend that a high credit-deposit ratio could lead to a rise in interest rates. How?

Consider Bank X which has deposits worth Rs. 100 crores and a credit-deposit ratio of 60 per cent. That means Bank X has used deposits worth Rs. 60 crores to create loan-assets. Only Rs. 40 crores is available for other investments.

Now, the Indian government is the largest borrower in the domestic credit market. The government borrows by issuing securities (G-secs) through auctions held by the RBI.

Banks, thus, lend to the government by investing in these G-secs. And Bank X has only Rs. 40 crores to invest in G-secs.

If more banks like X have lesser money to invest in G-secs, what will the government do? After all, it needs to raise money to meet its expenditure.

The government has two options. One, it can raise yields to make investment by banks in G-secs attractive. Or two, force the RBI to take the securities into its books.

Both the options have a tendency to push up interest rates in the economy. How?

Yields on G-secs serve as a benchmark for interest rates on other debt instruments. A rise in the former, thus, pushes up interest rates on the latter.

But why should interest rates rise if RBI takes G-secs into its books? Because, by doing so, the RBI releases fresh money into the system.

If the money so released is large, ``too much money will chase too few goods'' in the economy resulting in higher inflation levels. This would prompt investors to demand higher returns on debt instruments. In other words, higher interest rates.