How India’s Credit Structure Weakens the RBI’s Policy Effectiveness

Repo rate cuts are the RBI’s 1st go-to option to control inflation and economic growth. However, the underdeveloped Indian financial markets make it impossible for any change to seep affect all the nooks and corners of the economy.

The rich have figured out a way to take a shortcut here as well. India’s large scale corporates are the least affected by repo rate fluctuations as they still have access to capital markets and bond yields.

This explains why, despite the Reserve Bank of India (RBI) slashing interest rates and infusing liquidity into the economy, credit growth remains sluggish, particularly for small and medium enterprises (SMEs) and the retail segment.

Uneven Transmission of Repo Rate Cuts

The repo rate, the rate at which RBI lends money to commercial banks, serves as the anchor for other interest rates across the economy. When the RBI reduces the repo rate, it ideally should lower the cost of borrowing across sectors. 

However, in India, this transmission remains weak due to structural inefficiencies.

Comparison of Repo Rate vs Lending Rates in Different Sectors
 

While the repo rate has softened from 6.50% in 2023 to 6.00% in 2025, lending rates have not responded in tandem, especially for MSMEs and retail borrowers. This reflects the asymmetric and delayed transmission of monetary policy.

Liquidity Surplus But No Credit Boost

India's banking system currently holds surplus liquidity, meaning banks have more cash than they are lending. Yet, despite this, credit growth is weak. 

According to J.P. Morgan economists, liquidity alone doesn't compel banks to lend more. What matters is demand for credit, borrowers' risk profiles, and banks' willingness to lend.

Liquidity and Credit Growth Trends (2023-2025)
 

The data shows a mismatch: rising surplus liquidity is not resulting in higher credit growth. This indicates the ineffectiveness of monetary policy when structural frictions exist.

Bond Market Example: The Public Impact

Let us consider a fictional 5-year AAA-rated corporate bond issued by ABC Corp in 2023.

• In 2023, when the repo rate was at 6.50%, the bond offered an annual yield of 7.80%.
   
• In 2025, after repo was cut to 6.00%, the bond yield dropped only slightly to 7.60%.

Impact of Repo Rate Cuts on AAA Bond Yield
 

This marginal decline in bond yield illustrates how long-term market rates don't always mirror policy rate changes. For the average investor or borrower, this means limited benefit from central bank easing unless broader market sentiment shifts.

SMEs and Informal Sector are Outside the Credit Umbrella

One of the largest hurdles to effective monetary transmission is India’s two-tier credit structure. While large corporates can access funds through bond markets and negotiate better rates, small and medium enterprises (SMEs), micro businesses, and informal sector players rely almost entirely on banks or NBFCs. Due to higher perceived risk, these sectors face:

• Higher interest rates (10%+ even after policy rate cuts)
   
• Limited access to formal credit due to lack of collateral or credit history
   
• Regulatory caps or conservative lending by banks

As a result, monetary easing rarely reaches the bottom layers of the credit pyramid. The RBI may lower rates, but if banks don’t pass them on to micro borrowers, the policy effectiveness is diluted.

Reform Imperatives

To strengthen the link between RBI’s policy and on-ground credit conditions, the following reforms are essential:

• Deepening corporate bond markets to reduce dependency on banks
   
• Enhancing credit guarantee schemes for MSMEs
   
• Using digital infrastructure for real-time credit evaluation
   
• Encouraging more transparent and uniform risk-pricing by lenders

Without these systemic upgrades, the central bank's rate adjustments will remain a blunt instrument in shaping India’s economic trajectory.

Structural Constraints in Credit Markets

India’s corporate bond market remains shallow, under 20% of GDP, compared to over 100% in developed economies. This means banks carry the bulk of credit responsibility, limiting RBI’s influence to bank lending decisions.

Also, high risk aversion among banks leads to:

• Preference for secured over unsecured loans
   
• Shrinking appetite for small-ticket or informal borrowers
   
• Slow adoption of fintech-based underwriting models

Retail Lending Crackdown: Another Brake

The RBI’s recent crackdown on unsecured retail lending (e.g., credit cards, personal loans) has further slowed credit growth. While it aims to reduce systemic risk, it also dampens demand in a key growth engine.

This move has resulted in:

• Higher capital requirements for NBFCs and banks
   
• Slower disbursal of retail credit
   
• Declining bank profit margins and reduced risk appetite

Conclusion

India’s fragmented credit architecture, overreliance on banks, and uneven financial inclusion restrict the effectiveness of RBI’s monetary policy. Even in a low-interest regime with high liquidity, credit often fails to reach those who need it most. 

Addressing structural gaps and deepening financial infrastructure is imperative for better monetary transmission and broader economic growth.