NEW DELHI -- A sense of stalemate is growing over India's monetary policy in the wake of the Indian central bank's decision earlier in December to hold its repo rate steady.
The decision raised a question of why the Reserve Bank of India had to pause on successive rate cuts despite an unstoppable slowdown in the South Asian country's economic growth.
A closer look at the Indian economy reveals that the RBI's easy money policy has failed to stimulate economic activity because loans by financial institutions, burdened by nonperforming debt, are hitting a snag.
Financial market participants were caught off-guard when the Monetary Policy Committee of the RBI decided on Dec. 5 to keep the key interest rate unchanged because more than 30 economists in an advance survey had unanimously predicted a rate cut for the sixth consecutive time.
The MPC "felt it appropriate to take a pause at this juncture" in light of the "evolving growth-inflation dynamics," Gov. Shaktikanta Das said at a news conference following the policy board meeting.
India's consumer price index rose 4.6% in October, topping the central bank's median inflation target of 4%. The rise may have prompted the MPC's decision but was regarded by economists as temporary, resulting from soaring vegetable prices caused by bad weather.
The Indian economy, meanwhile, grew 4.5% year-on-year in the July to September quarter, hitting a six-year low. Although interest rate cuts are needed to underpin the economy, the central bank averted the measure this time because, according to Hiroshi Sugaya, director of the Institute for Indian Economic Studies, it concluded that a cut would not produce "expected policy effects."
Limits on policy effects have been revealed by two "decouplings."
The central bank lowered the repo rate five times in a row from 6.5% in February to 5.15% in October. Despite the drop of 1.35 percentage points, rates charged by financial institutions for loans hardly reacted as the average of lending rates by all banks remained almost level during the period.
The conventional wisdom is that commercial financial institutions can raise funds at lower cost when a central bank reduces its key interest rate. Lenders therefore can cut rates on loans to individuals and businesses.
In India, however, commercial banks do not react even if the RBI cuts its policy rate. The opinion is growing in the Indian financial sector that the stalemated situation is traceable to confusion following the abolition of high-denomination bills.
In November 2016, Prime Minister Narendra Modi decided to invalidate 500- and 1,000-rupee notes in order to eliminate large piles of "black money" held in cash by wealthy people to help them evade taxes. As a result, nearly 200 million new bank accounts were opened and cash hoarded at home was brought to banks.
The policy steeply boosted surplus funds at banks to 6 trillion rupees ($84.1 billion) in early 2017. As banks began to aggressively lend the funds, the outstanding balance of bank loans increased 10.5% on the year in April 2018, compared with 3.4% in January 2017.
But reckless lending led to financial trouble at nonbank lenders. The creditworthiness of nonbank financial institutions collapsed as one of their leaders defaulted on its obligations in the summer of 2018. With the flow of loans from banks to nonbank institutions clogged, citizens lost access to loans for buying automobiles and other products.
The ratio of nonperforming loans to total outstanding lending by banks exceeded 11% in March 2018 and is showing no signs of a decrease. Banks have grown cautious about extending new loans for fear of an increase in bad loans. Interest rates on loans, therefore, have failed to drop despite repeated cuts in the policy rate by the central bank.
Relations between Modi and the RBI remain strained. Das's two predecessors, Raghuram Rajan and Urijit Patel, both of whom are academic experts and emphasized the independence of the central bank, were at odds with Modi and were effectively fired by him.
Since appointing Das, a former vice finance minister who is close to Modi, at the end of 2018 to head the RBI, the prime minister has pushed ahead with interest rate cuts. But the policy has yet to bear fruit.
If monetary policy proves ineffective, fiscal spending will take over the role of stimulating economic activity. But the Indian government is bound to curb its fiscal deficit to 3% of gross domestic product, a target introduced as a result of dole-out measures adopted for rural villages by Modi.
Eager to avoid an increase in the deficit, the Modi administration is unable to introduce measures to promptly prop up the economy.
Returning to his home country India in October, Abhijit Banerjee, who shared the 2019 Nobel Prize in Economics with two other economists, said the shortage of demand is India's most pressing economic problem.
India is falling into an economic tailspin while it fails to introduce effective measures to boost demand.