The Reserve Bank of India (RBI) has long been considered to be a model central bank. Top RBI officials are always under pressure to bend to the demands of various interests in government and the corporate world. Thankfully, the RBI has always resisted.
There's no better example of this tussle than the level of interest rates. Corporate India and the government, constantly call for lower rates. They're unable to grasp the fact that the RBI's primary function is to protect the value of the nation's money. Monetary policy is the means to achieve that. It cannot be used as a blunt tool to boost economic growth.
When lowering interest rates (i.e. the repo rate), the RBI has to factor in many variables. Inflation of course is the most important one but it doesn't automatically follow that falling inflation should lead to lower interest rates. The reality is more complicated.
Corporates and individuals benefit from RBI's rate cuts only when banks pass them through in the form of lower EMIs. This can only happen if banks cut their 'base rate'. The base rate is the benchmark rate used by banks to price all their loans. Ideally, when the RBI cuts the repo rate, banks should cut their base rate as well. But the Indian banking system is not in an ideal situation by any stretch of the imagination.
The non performing assets (NPA) menace continues to plague the system. Banks have chosen to restructure bad loans rather than demand repayment (or more collateral) from large borrowers. This has only emboldened influential corporate promoters to take advantage of the situation by further delaying payment in order to get even better terms of repayment.
This has led to a vicious cycle where the total 'stressed assets' (i.e. NPAs + restructured loans) in the banking system has now reached 11% of total advances! Considering the fact that the capital adequacy ratio is around 13% the situation is indeed grave.
Thus, it is not surprising that banks are reluctant to cut interest rates. Lower rates will mean more demand for credit. But their ability to give more loans depends largely on their capital base and the ability to raise deposits. NPAs have negatively affected the former and the latter will be impacted if they cut deposit rates along with lending rates (to protect margins).
It is clear that banks are in a chicken and egg situation when it comes to interest rates. We believe this problem is not going away anytime soon. Until the NPA crisis is resolved, banks won't be able to meaningfully boost the economy. Instead of clamoring for more repo rate cuts from the RBI, corporate India would do well to first pay down their debt.