Robust balance sheets key to boost monetary policy impact: RBI study

A reduction in policy rates can boost investment more if balance sheets are healthier, especially among small firms, finds RBI staff study in its June bulletin

Strengthening corporate balance sheets and targeted credit support — particularly for small firms — can enhance the effectiveness of accommodative monetary policy in stimulating investment, a study authored by Reserve Bank of India (RBI) staffers in the June bulletin has suggested.

 

According to the findings of the study, which investigates the existence of a balance sheet channel of monetary policy transmission in India, this channel is active among Indian manufacturing firms, particularly small firms, while no conclusive differences were found across leverage groups. 

 

Monetary policy partly influences investment through the balance sheet channel, wherein interest rate changes affect a firm’s financial health — including cash flow and net worth — which in turn impacts its borrowing capacity and investment decisions.

 

According to the study, a one percentage point reduction in the real policy interest rate can increase the investment rate by about 9 basis points (bps) in the short run and 109 bps in the long run. Tight monetary policy, meanwhile, can weaken firms’ financial positions by lowering equity prices, reducing net worth, and raising borrowing costs — thereby limiting access to credit and curbing investment. 

 

Further, the study reveals that small firms, being more financially constrained, are more sensitive to internal funds under tight monetary policy, whereas large firms, with better access to external finance, are relatively less affected.

 

“While the balance sheet channel of monetary policy transmission operates for both highly leveraged and less leveraged firms, there is no clear evidence of differences in their sensitivity to cash flow,” the study said.