Industrial output in April grew 17.6% over the corresponding period last year, beating analysts’ estimates by a wide margin and coming close to the 20-year high of 17.7%, recorded in December 2009. The Indian economy is clearly performing above potential and there is a strong case for the Reserve Bank of India (RBI) to raise interest rates.

Incidentally, the policy rate in the country has already gone up. I am not joking. It has gone up this month by 1.5 percentage points, from 3.75% to 5.25%. How has this happened? Well, the Indian central bank has two policy rates—the repo rate, or the rate at which it injects liquidity into the financial system, and the reverse repo rate, or the rate at which it sucks out excess liquidity from the system. This means that in a liquidity-surplus situation, which had been the case since October 2008, when RBI started flooding the market with money to tackle the credit crunch in the wake of the collapse of US investment bank Lehman Brothers Holdings Inc., the reverse repo rate is the policy rate. But when liquidity becomes tight, which is the case now, the repo rate replaces the reverse repo rate as the policy rate. The repo rate at present is 5.25%.

On 7 June, the banking system borrowed Rs62,325 crore from RBI. The amount rose to Rs68,055 crore the next day. On average, the system drew around Rs60,000 crore every day from the central bank last week to tackle a sudden liquidity crunch. In contrast, in May, the banks were on average parking close to Rs33,000 crore daily at RBI’s reverse repo window. Even the normally liquidity-flush State Bank of India, the country’s largest lender, was seen borrowing from RBI’s repo window last week.

Also Read | Earlier columns by Tamal Bandyopadhyay

The policy rate has gone up and liquidity is tight, but there has not been any impact on different segments of the financial market yet. For instance, the yield on benchmark 10-year government paper continues to be around 7.6% and the overnight call money rate has not risen beyond 5.25%, the repo rate. Ideally, the price of overnight money should be between the reverse repo rate and the repo rate, but it can go beyond the upper end of the corridor if banks do not have excess bonds to give to RBI as collateral for borrowing money.

Under current norms, banks are required to invest 25% of their deposits in government bonds, known as the statutory liquidity ratio, or SLR, but most banks hold more. When many banks do not have bonds in excess of 25% and, hence, cannot raise money from RBI’s repo window, they crowd the overnight market and the cost of overnight money soars.

This is unlikely to happen now as the average SLR holdings of banks is around 27-28% but liquidity is set to tighten further. Last week, the Indian government raised Rs38,543.31 crore from the auction of broadband wireless access, or BWA, spectrum. In May, nine successful bidders for 3G spectrum had to pay Rs67,719 crore to the government for the 22 telecom circle licences on offer. Banks’ share in both BWA and 3G spectrum payouts is substantial. On top of that, there will be an outflow of Rs35,000-40,000 crore from the banking system on account of advance tax payments this month. Indian companies pay advance tax on their projected profits every quarter.

The biggest challenge for RBI this month will be managing the government’s borrowing programme. The gross annual borrowing programme of the India government rose from Rs2.51 trillion in fiscal 2009 to Rs4.51 trillion in 2010 to bridge the widening fiscal deficit, but RBI did not have much of a problem in managing it as there was plenty of liquidity in the system, with not too many takers for bank credit. In 2011, the borrowing programme has risen further to Rs4.57 trillion and RBI plans to raise 63% of this in the first six months of the current fiscal. But with the sudden tightness in liquidity, the banking system may not have enough money to buy government bonds.

To complicate the situation further, the deposit mobilization in the system has been tardy this year. In the first two months, banks have raised Rs69,626 crore of deposits, almost half of what they raised in the first two months of last fiscal. The year-on-year deposit growth till May-end was 14.9%, down from 22.1% in the previous year. In absolute term, deposit accretion has been Rs5.93 trillion in the past year till May, down from Rs7.18 trillion.

The growth in bank credit, on the other hand, has been higher—Rs4.98 trillion, or 18.1%, in the past year against Rs3.74 trillion, or 15.8%. In the first two months of the current fiscal, credit offtake was still negative but only marginally, Rs1,013 crore. In the corresponding period last year, the system had seen a decline of Rs29,572 crore, or 1.1%, in the banking industry’s credit portfolio.

RBI has already indicated that it would borrow Rs22,000 crore less than what it had planned in June by postponing short-term treasury bill auctions, but there has not been any change so far in its plan to sell medium- and long-term bonds. If the liquidity situation worsens, it will have to go slow in its money-raising plan for the government. Whether the money raised through sale of 3G and BWA spectrum will help the government lower the fiscal deficit is a different story. It will depend on whether the government will implement the recommendations of the Kirit Parikh panel, decontrol petrol and diesel prices and stop subsidizing them.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at