Elevated interest rates and high inflation in India have weighed on small and medium-sized enterprise (SME) borrowers' abilities to meet debt repayments over the past year, according to Moody's Investors Service.

While India's central bank paused its rate rise cycle in April, rate hikes over the past year have increased funding costs for non-banking finance companies (NBFCs).

As their funding costs have risen, NBFCs have increased interest rates for loans against property (LAP) to SME borrowers, which is heightening repayment and refinancing risks for these loans, the credit rating agency says in a report.

With interest rates rising over the past year, Moody's expects loan delinquency rates for asset-backed securities, which have increased over the past year, to continue to rise. "We also expect that India's economy will remain vulnerable to bouts of heightened financial market volatility while interest rates remain restrictive in advanced economies, which will add to the risk of LAP delinquencies," says the rating agency.

The Reserve Bank of India's monetary policy committee (MPC) kept the repo rate unchanged at 6.5% in its first policy statement of 2023-24 in April. The RBI, however, signaled it will remain vigilant about inflation in future rate decisions.

The MPC has increased the policy repo rate by 2.5 percentage points to 6.5% in a series of rate rises since May 2022 to combat inflation.

The higher repo rate, bond yields, and MCLR have pushed up the cost of both market and bank funding for NBFCs, compressing their net interest margins and prompting them to raise rates for loans against property, says Moody's.

"Even if the RBI were to keep rates on hold from here, the repayment amounts will weigh on SME borrowers' capacities to repay debt," the rating agency says.

The rate increases over the past year have reduced the likelihood that loans against property borrowers will be able to refinance their debt on more affordable terms if they can no longer meet repayment amounts, it adds.

The pace of property price growth has slowed in major Indian cities as a result of the rate rises over the past year, according to Moody's. The slower price growth has reduced recovery prospects for defaulted loans against property when NBFCs sell the underlying properties to recoup outstanding debt amounts, which is negative for Indian ABS backed by these loans, the rating agency says.

Follow us on Facebook, X, YouTube, Instagram and WhatsApp to never miss an update from Fortune India. To buy a copy, visit Amazon.