Soured loans and weak capital positions mean Indian banks cannot cut their interest rates in step with the central bank's main policy rate, reducing the effectiveness of monetary policy, the Reserve Bank of India said in a working paper on Tuesday.
The paper, co-authored by RBI monetary policy committee member Janak Raj and three others, said concerns about asset quality must be addressed and lenders' capital positions strengthened to ensure policy actions have their full impact.
"The study finds that a robust credit channel of monetary transmission exists in India. Its efficacy, however, is impaired by poor asset quality but reinforced by better capital position of banks," the authors said in the paper.
The paper also found that in the short run, transmission of interest rate changes by the RBI to businesses and households via the credit channel was stronger among state-run banks than private banks.
Credit growth in India has slowed sharply over the last two years despite massive interest rate reductions by the RBI. Latest data shows credit grew 5.8% in mid-November compared to growth of around 15% seen in December 2018.
"The accommodative stance of monetary policy and reduction in the policy repo rate (starting from 2019) helped cushion the credit deceleration. In the absence of a sharp cut in the policy repo rate, the slowdown in credit growth would have been far more severe," the paper suggests.
The RBI has cut the repo rate by 115 basis points in 2020 amid the COVID-19 pandemic, following 135 bps of cuts in 2019.
Banks' capital positions may also mean they are unable to cut the rates they charge as far or as fast as the central bank, and improving them could have bolstered credit growth to some extent, the paper said. Analysts believe Indian state-run banks need a capital infusion of around $15-$20 billion.
"For monetary policy actions to have their full impact on the credit channel, it is imperative that the asset quality concerns of banks are addressed and that their capital positions are strengthened," the authors concluded.