Over the last one week, the rate at the overnight call money market - from which commercial banks borrow daily to tide over their temporary liquidity mismatches - has been hovering around a three-year high of 7.20 per cent, almost one percentage point higher than the Reserve Bank of India's [Get Quote] repo rate.

The RBI, on an average, has been pumping in over Rs 20,000 crore (Rs 200 billion) daily into the financial system through its repo window. The yield on the 10-year corporate bond has climbed to around 7.75 per cent now (from around 7 per cent in November), while the benchmark 10-year government bond yield has remained virtually unchanged at around 7.15 per cent or so.

It is against this backdrop that RBI Governor Yaga Venugopal Reddy will unveil the Indian central bank's quarterly review of the monetary policy next week.

In his mid-term review of the policy in October last year, Reddy hiked the repo rate and reverse repo rate by a quarter percentage point each to 6.25 per cent and 5.25 per cent, respectively, but left the bank rate unchanged at its three-decade low level of 6 per cent. (The reverse repo rate is the rate at which banks park their short-term excess liquidity with the RBI, while the repo rate is the rate at which the RBI pumps in short-term liquidity into the system.)

Will Reddy announce another quarter percentage point hike in the repo and reverse repo rate this time? Or, combine this with a bank rate hike? While the market is busy reading the governor's mind, it is quite unlikely that the RBI will tinker with the rates this time.

A rate hike a month ahead of the Union Budget is politically a sensitive issue. Besides, Finance Minister P Chidambaram in his last meeting with public sector bankers made it clear that he would not like them to hike rates for loans given for productive purposes till the end of the financial year.

A more appropriate forum for giving a rate signal could be the RBI's April policy, which will also have the Budget announcement as its backdrop.

There may not be a rate hike for a more fundamental reason. After all, no central bank needs to hike its key rates when the lending rates of banks have already been raised without any direct signal from the monetary authority.

In fact, what successive reverse repo rate hikes could not do over the last one year, sudden tightness in liquidity in the system has done in last two months. Between October 2004 and 2005, the reverse repo rate was increased by 75 basis points in three stages.

However, there was hardly any impact on banks' lending rates. But over the last two months, commercial banks have jacked up their lending rates at least by 75 basis points quietly. The trigger for the rate hike is the sudden tightness in liquidity.

Till recently, Indian corporations were taking liquidity for granted. For instance, they were raising five-year money at the cost of one-year money. This was done by first raising one-year fund and subsequently rolling it over every year.

That has been the case since the beginning of this century. Now, they cannot do this any more. Banks have started refusing to roll over one-year money, which would allow corporations to enjoy long-term funds at short-term rates. In other words, India Inc has started paying a premium for liquidity.

The redemption of India Millennium Bonds in December-end sucked out over Rs 33,000 crore (Rs 330 billion) from the system, which was already strained on account of the huge credit offtake.

In the first three quarters of financial year 2005-06 (between April and December), the banking system's credit grew by Rs 2,52,054 crore (Rs 2520.54 billion), while its deposit kitty rose by Rs 2,40,496 crore (Rs 2404.96 billion).

This means, on an incremental basis, the credit-deposit ratio continues to be over 100 per cent. On a year-on-year basis, the credit growth up to December 31 has been Rs 3,06,932 crore (Rs 3069.32 billion) against deposit growth of Rs 2,68,217 crore (Rs 2682.17 billion).

The tightness has been intensified with the Central and state governments parking around Rs 60,000 crore (Rs 6000 billion) surpluses with the RBI. This fund would flow into the system when the government starts spending.

To ease the strain on liquidity, the RBI has already cancelled MSS worth Rs 39,500 crore (Rs 395 billion). Another Rs 12,000 worth of auction of dated government securities have also been cancelled.

Despite this, the liquidity in the system is still tight because the RBI wants it this way. Had it wanted to ease the liquidity situation, it could have bought dollars from the foreign exchange market and released an equivalent amount of rupee into the system.

It can also cut banks' cash reserve ratio - which is now 5 per cent - to pump in money. The floor for CRR is 3 per cent. However, the RBI seems to be unwilling to do so as the money supply (M3) is veering around 17.9 per cent, above its projection of 14.5 per cent. Fresh supply of money will have an impact on the inflation rate, which is now well within the RBI target.