business-standard-The Reserve Bank of India (RBI) hiked the cash reserve ratio over the weekend – the percentage of cash deposits that banks have to maintain with RBI – at 100% of the deposits (NDTL) accrued between September 16 and November 11 as incremental cash reserve ratio. An increase in CRR means that banks have to park more money with the central bank and, hence, a higher CRR sucks out liquidity from the banking system. Most banking stocks reacted negatively to the move, with the slipping 1.3% as compared to 0.2% fall in the Nifty50 index in . Bank of Baroda (BoB), Bank of India (BoI), State Bank of India (SBI), Punjab National Bank (PNB) and Federal Bank lost over 2% each, while Canara Bank, ICICI Bank, YES Bank, Axis Bank and Kotak Mahindra Bank slipped 1.3% – 2%. “The latest change in monetary policy is not likely to impact the banks in any significant manner – we urge investors not to panic and sell the banking stocks. It should be noted that the banks are participating in the demonetisation program in a big way (by buying back the old currencies and soaring up the short-term deposits) as a part of social obligation in government’s efforts to curb black money. Therefore, it is most unlikely that the RBI or the government penalise the banks in terms of suppressing their profits. We suggest investors accumulate quality banking stocks in case they fall significantly,” advises G. Chokkalingam, founder & managing director of Equinomics . Here are three reasons why the RBI hiked the CRR, excerpted from a Citi India economic research report, jointly authored by Samiran Chakraborty, chief economist, Citi India and Anurag Jha, economist, Citi India. FIRST: The surplus in the banking system at Rs 5 trillion (Rs 5-lakh crore) was inching closer to the maximum absorption capacity of the central bank. RBI had Rs 7.5 trillion (Rs 7.5-lakh crore) of g-secs prior to demonetisation drive, which act as collateral to absorb banking system surplus through the reverse repo window. RBI’s estimate of deposit accretion going forward might have prompted them to announce a large CRR hike which would obviate any discussion around RBI running short of g-secs. SECOND: The process of putting in place other liquidity absorption measures like issuance of Market Stabilization Scheme (MSS) bonds was taking time, as mentioned by the RBI Governor recently. Issuance limit of MSS bonds for this year was set at Rs 300 billion earlier, which was too small given the liquidity absorption requirement. THIRD: The strong action could also be aimed at signaling RBI’s reluctance on market interest rates falling too sharply, too soon in the present global context. The surplus rupee liquidity and sharply falling rates was also creating distortions in the forward premia and indirectly impacting the spot USDINR. This liquidity absorption measure could reverse some of these distortions. IMPACT Given excess banking system liquidity, CRR requirement of around Rs 3.2 trillion, the banking system liquidity would remain in surplus even after this measure. However, for a brief period the banking system will need to borrow from repo/term repo window, since large part of the surplus liquidity of the banking system is trapped in longer term reverse repos. Bond yields could see knee-jerk reaction of around 15 basis points (bps) and the reduction in lending and deposit rates might halt for now. WILL THE RBI CUT INTEREST RATES IN DECEMBER? In an uncertain economic environment since the demonetisation exercise, the monetary policy in December 2016 has to focus on a prudent risk-management approach rather than a simple growth-inflation trade-off. The risks of a sharp near-term growth decline may warrant a 25bps rate cut to arrest any spillover effects of the negative shock, and this remains our base case. Yet Citi acknowledges some possibility that RBI stays pat in December to better assess the impact on economic activity / liquidity and keep the open for even an inter-meeting rate cut.