Here’s a simple statistic thrown up by Reserve Bank of India (RBI) data: as on 26 November 2010, the credit-deposit ratio of all scheduled commercial banks was a painfully high 74.5%. The pain is being felt by the banks, which are having to pay 9.4% for a one-year certificate of deposit. It’s being felt by all kinds of borrowers, who are seeing higher base rates and higher interest rates for their housing loans. To put the high credit-deposit ratio in perspective, consider that a year ago, on 27 November 2009, the ratio was at 69.3%. The current recovery has started off with the credit-deposit ratio at much higher levels than during the initial stages of the last boom. For example, in November 2004 the credit-deposit ratio was at just 62.5%.

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The chart shows how the credit-deposit ratio, already high, has moved even higher in the last month or so. And if we take the incremental credit-deposit ratio, we find that while bank deposits contracted by Rs86,895 crore between 22 October and 26 November, bank credit increased by Rs90,978 crore. That’s the reason banks have scurried to raise deposit rates and they have been forced to increase lending rates to protect their margins. How did banks fund the credit growth? They did so partly by selling government securities. Over the period, banks’ investment in government and other approved securities fell by Rs36,612 crore. That selling led to hardening of the yields on government securities.

The situation deteriorated sharply in November. But even if we take the two-month period between 24 September and 26 November, the incremental credit-deposit ratio works out to a huge 179%. Note that this is the period during which foreign institutional investor flows have been strong and there wasn’t any outflow from the system on account of advance taxes. The outflow of advance tax on 15 December will further strain liquidity.

Apart from the government not spending, the other problem has been that people have been keeping more cash in hand, rather than as deposits with banks. “Currency with the public", a component of money supply, is up 13.5% this fiscal, well above the rate of growth of deposits. The reason is that people are keeping more money for transactions due to inflation, although it’s possible the effect was exaggerated in November because of the festive season.

The liquidity squeeze was not expected to last this long. But as RBI does its next review of monetary policy this week, the immediate task before it is to inject liquidity. Gaurav Kapur, senior economist with RBS Bank, points out that the fact that banks have borrowed at high rates means that lending rates, too, will remain high even after the liquidity situation normalizes. That, in turn, could affect expansion plans, capital expenditure and growth.

Graphic by Yogesh Kumar/Mint

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