By Suvashree Choudhury
MUMBAI (Reuters) - The ability of India's debt-burdened firms to repay their debts has worsened as leverage has increased, straining a banking sector burdened by bad loans, according to a report released by the Reserve Bank of India on Thursday.
The high levels of corporate leverage are hampering banks' ability to pass on lower interest rates and boost loans, as they already have heavy exposure to troubled firms, according to the financial stability report.
It said firms' solvency ratios and ability to service debt, measured by their interest coverage ratios, had worsened.
The report, which was assembled by the central bank with contributions from other sources quoted data from 2013-14 as the most recent available figures.
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Infrastructure remains among the most stressed sectors, accounting for 15 percent of all advances but 29.8 percent of stressed loans, as of December 2014. Five sectors -- mining, iron and steel, textiles, infrastructure and aviation -- account for more than half of bad debts.
"Besides its adverse impact on banks' balance sheets, high leverage of corporates may hinder the transmission of monetary policy impulses, as corporates may not be in a position to benefit from falling interest rates due to high levels of debt," the report said.
Monetary policy transmission has been a major headache for the RBI. India's banks have made only nominal cuts to base lending rates despite a 75 basis point reduction in the central bank's policy rate since the start of the year.
The report also said the banking sector would need to increase cash set aside for loan losses if the economy worsened.
Stress tests carried out on Indian banks showed that gross non performing assets as a ratio to total loans could rise to 4.8 percent by September, from 4.6 percent in March, before dipping to 4.7 percent by March 2016.
Indian banks, especially state-run banks, have been hit hard by a surge in bad loans after the sharp slowdown in economic growth that followed the 2008 financial crisis.
The report said banks should proactively manage their capital and not just adhere to the minimum regulatory requirements. It warned that in a stressed scenario, capital constraints and margin pressure would further impair banks' ability to pass on any monetary policy signal.
If macroeconomic conditions worsened, the RBI forecast the bad loan ratio could rise to around 5.9 percent and banks would have to "bolster" the provisioning to meet expected losses.
Under severe stress, state-run banks' may record a capital adequacy ratio of around 10.2 percent by March 2016 against 11.4 percent this March, the report said.
Detailing additional concerns, the central bank said "a possible sub-normal monsoon and uncertainties about crude oil prices remain significant risks" to inflation.
(Editing by Clara Ferreira Marques and Simon Cameron-Moore)
