RBI Study Says Increase In Default Risk Leads To Rise In Interest Rate Spread And Decline In Credit Growth

Reserve Bank of India yesterday released a study titled, Risk Premium Shocks and Business Cycle Outcomes in India. This study investigates the dynamic effects of financial shocks on the business cycle. Against the backdrop of high non-performing assets (NPAs) of banks, a financial shock is conceived to be a shock to the interest rate spread stemming from a change in the default risk of borrowers. It is termed as the risk premium shock and occupies the central stage in this study. Business cycle implications of such a shock have been characterised and quantified in two steps. At the outset, micro-level evidence on the effect of default risk on interest rate spread and credit growth is provided. Then, this micro-level evidence and predictions of dynamic stochastic general equilibrium (DSGE) models have been exploited to identify and estimate the impact of a risk premium shock using a sign-restricted VAR (SRVAR) model. The study notes that bank-level panel data analysis shows that an increase in default risk leads to rise in interest rate spread and decline in credit growth. The SRVAR model estimates suggest that a positive shock to risk premium increases the interest rate spread by 30 basis points and contracts credit and output by 75 and 40 basis points, respectively. It causes a downturn in consumption, investment and price of capital goods, while softening consumer prices. On the whole, the risk premium shock helps in explaining the cyclical variations in key macro-financial variables.

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