Tuesday's figures for the Index of Industrial Production show that industrial output rose 5.7 per cent last June, compared to 4.5 per cent in June 2002.

This fiscal, industrial growth has been 5.3 per cent till June, a full percentage point higher than the growth during April to June 2002. Such a rise in industrial activity should normally have led to higher lending by banks, and probably a tightening of liquidity in the money market.

Yet the debt market has never been so flush with funds -- the yield on the benchmark 10-year bonds has been hovering near all-time lows, while banks are putting in record amounts in repos.

What are the reasons for the increased liquidity? Is the central bank, like Alan Greenspan, flooding the market with money? The growth in money supply (M3) so far has been 4.9 per cent, lower than M3 growth of 5.7 per cent (adjusted for the ICICI merger) last year.

If the data is narrowed down to the past two months, however, a different picture emerges. Growth in money supply during the period May 30 to July 25 this year has been, taking the Reserve Bank of India figures, Rs 20,089 crore (Rs 200.89 billion), far more than the rise of Rs 8,346 crore  (Rs 83.46 billion) in M3 during the same period of last year.

The effect of this spurt in money supply growth in the last two months is reflected in the growth in deposits of scheduled commercial banks.

Over the two months from May 30 to July 25, deposits in these banks rose by Rs 21,390 crore (Rs 213.90 billion), more than double the rise of Rs 10,403 crore (Rs 104.03 billion) over the same period last year.

More significantly, over the same two-month period, there has been a substantial decline in bank credit by Rs 3,252 crore (Rs 32.52 billion).

Contrast the same period last year, when bank credit actually rose by Rs 9,456 crore (Rs 94.56 billion).

Also surprisingly, the fall in credit has occurred at a time when industrial growth has been higher. The twin effect of higher deposit growth and lower credit growth has led to increased liquidity with continuing bullishness in the debt markets.

But why has credit not picked up? After all, much of the rise in credit these days is in retail finance, which should show steady growth. Could it be that June and July last year was a period of abnormally high credit expansion?

Not really, considering that credit offtake was strong even in the preceding years. For example, bank credit rose by Rs 8,491 crore (Rs 84.91 billion) over the comparable period of 2001, and by Rs 13,300 crore (Rs 133 billion) in June-July 2000, when the after-effects of the tech boom had yet to wear off. There's no doubt that the recent slowdown in credit offtake has been unprecedented in recent years.

Breaking up the credit figures into those for food and non-food credit helps to clarify the picture. There has been a sharp reduction in the government's holdings of foodstocks in recent months, a fact reflected in the data on food credit.

Taking the same two-month period, food credit declined by Rs 7,770 crore (Rs 77.7 billion) in 2003, it declined by Rs 1,592 crore (Rs 15.92 billion) over the same period last year, while it notched up gains in those months in previous years, reflecting the build-up in foodstocks during those years.

Part of the decline in credit this year can therefore be explained by the drop in foodgrain stocks and the consequent lower level of food credit.

Of course, that makes no difference to the liquidity with banks -- lower food credit means that banks have that much more money in their hands, money that inevitably finds its way into the bond and money market.

But the fall in food credit is by no means the whole story. Despite the pick-up in industrial and manufacturing activity, non-food credit rose by only Rs 4,518 crore (Rs 45.18 billion) over the period May 30 to July 25 this year.

Last year, over the same two months, non-food credit had risen by Rs 11,048 crore (Rs 110.48 billion); in 2001, in the depths of a slowdown in the economy, non-food credit had increased by Rs 6,195 crore (Rs 61.95 billion) in the equivalent period, while in the year 2000, at a time when the economy was wearing rose-tinted glasses, the comparable figure was Rs 12,128 crore (Rs 121.28 billion).

Now consider a longer period. Till July 25 this fiscal, non-food credit growth was Rs 4,388 crore (Rs 43.88 billion), while it was Rs 11,825 crore (Rs 118.25 billion) for the corresponding period of last year, after adjustments are made for the ICICI merger.

What accounts for the lower credit offtake this year? One of the explanations offered has been that with companies becoming ever more efficient at managing their working capital, their cash credit needs have declined.

That's a plausible explanation and this newspaper has reported how companies are sitting on piles of cash, a result of investment decisions being delayed by years.

But it's not that simple. If you were to take the two-month period between December 2002 and February 2003, for instance, the growth in non-food credit was over Rs 26,000 crore (Rs 260 billion), a level of increase not seen in the preceding three years.

As on February 21, 2003, growth in non-food credit during FY 2003 had been Rs 77,747 crore (Rs 777.47 billion), far above the Rs 47,846 crore (Rs 478.46 billion) recorded in the same period of the previous year. Surely, companies haven't suddenly become efficient or cash-rich between February and August this year?

Could it be that top-rung companies are bypassing banks to borrow directly in the bond markets? Not really -- in the two months to July 11 this year, bank investments in corporate paper, including commercial paper, increased by a paltry Rs 1,556 crore (Rs 1556 billion).

Bankers explain the difference by pointing to external commercial borrowings. "Corporate credit needs to be seen in its entirety, including foreign sources of credit," points out Ajit Ranade, chief economist with ABN Amro Bank.

Companies have been running to the foreign markets to fund their credit needs, indeed in some cases using the money borrowed abroad to repay local creditors.

Bankers estimate that ECBs would amount to around $1.7 billion so far this fiscal. Even smaller companies have started accessing this lucrative market, where the costs, on a fully hedged basis, are much lower compared to borrowing domestically.

Does this mean the ECB market will continue to grow, and non-food credit

offtake slow down further? Bank of America's M R Madhavan points to the hurdles.

"There are statutory limits to how much a company can access through ECBs," he points out. "Moreover, the ministry of finance [MoF] needs to be approached if the limit is above $ 100 million, and the MoF has refused permission to all the companies which approached it."

Also, exposure limits to India and to the companies will soon be reached. Not all companies are creditworthy enough to approach the foreign markets.

And finally, the hike in bond yields in the US has reduced the arbitrage between US and Indian interest rates that borrowers sought to exploit.

Bankers point out that it is significant that ECB activity accelerated sharply around May, when forward premiums fell to ridiculously low levels.

And already, as Pramit Jhaveri, managing director and head of India Investment Banking at Citigroup Global Markets (India) Pvt Ltd says, there is a growing over supply of paper in the market.

The expected tapering off of ECBs could well result in the deficit in non-food credit being made up in the months ahead. That need not, however, worry the bond markets too much, because the liquidity in the market is enough to absorb any increase in credit.

Any large rise in investment spending seems unlikely, with National Council for Applied Economic Research's July Business Confidence Survey showing that only 57 per cent of firms report that their capacity utilisation is 75 per cent or more.

And what does a rise or fall of a few thousand crore in non-food credit matter, when banks are parking Rs 40,000 crore (Rs 400 billion) to Rs 50,0000 crore (Rs 5,000 billion) in repos?

With the difference between the call money rate and the 10-year gilt yield at 54 basis points, the key problem for RBI, as Ranade points out, is how to lower interest rates at the short end while managing expectations so that long-term yields stay at realistic levels.