Next Thursday, Reserve Bank of India [Get Quote] Governor Y V Reddy unveils his monetary policy for financial year 2006, against a backdrop of great change in markets across the world.

The benign market environment of the past few years -- the product of very low global interest rates, extraordinary levels of liquidity, and strong flows into emerging markets -- is behind us. New and worrying uncertainties have cropped up in the shape of rising oil prices, higher inflation and rising interest rates in the US and a stronger dollar.

The appetite for risk has diminished and with it the appetite for emerging market assets. Foreign institutional investors, who have been instrumental in driving the bull run in the stock markets in the last couple of years, have started selling. Emerging stock markets are nervous, while spreads on emerging market bonds are rising.

Yet was the situation all that different last October, when Reddy announced his mid-term review of monetary policy for financial year 2005? At that time, the Nymex crude oil price had crossed $ 55 per barrel in mid-October, and the Indian 10-year bond yield had moved up to around 6.5 per cent (before the RBI raised the reverse repo rate), thanks to higher oil prices feeding into wholesale price index inflation, which stood, on a point-to-point basis, at 7.1 per cent on October 9.

At first glance, that inflation rate seems very different from the current 5.5 per cent or thereabouts, but if the average rate instead of the point-to-point one is taken, inflation should be around 6 per cent currently, about the same as it was last October.

Nor were the global cues very different. Last October, US interest rates had already started moving up, and the imbalances in the US current account and its mirror image, the Chinese investment boom, were almost as strong as today. Back home, credit was growing by leaps and bounds, just as it is at present.

What were the concerns that the RBI had last October? This is what it had to say about one of them: "With effective SLR investment at 39.7 per cent, lower appetite for SLR securities against expected credit pick-up has implications for government borrowings in an environment of market-determined interest rates."

The review also pointed out that "the market borrowing programme in the remaining part of the year needs to be calibrated carefully in view of strong credit demand". That's very similar to current worries about the government borrowing programme.

So what's different this time? While the fundamentals may not have changed, sentiment in the market certainly has. At the global level, the slow but steady rise in the US Fed Funds rate has finally started hurting the carry trade. Global liquidity has shrunk, and market sentiment is usually a reflection of liquidity.

Back home, there is still ample liquidity in the money markets, with estimates putting the surplus liquidity at Rs 1,10,000 crore (Rs 1100 billion) to Rs 1,20,000 crore (Rs 1200 billion), taking the amounts in reverse repos, market stabilisation securities and the government's balances with the RBI.

But there's a crucial difference this time. While government borrowing turned out to be much lower than expected last year in spite of the RBI's fears, thanks to high collections in small savings and lower expenditure, this year the situation is perceived to be very different, with gross borrowing in the first half budgeted to be 41 per cent higher than in the same period of last year.

The market believes, therefore, that the current liquidity is likely to be temporary in nature, and will be dissipated as government borrowing picks up. The other worry is that credit is likely to continue to show very high growth, if all that capital investment that corporates have been talking about starts in earnest.

There's also the concern that the UPA government's social spending commitments could result in the borrowing target being overshot, especially if the optimistic tax targets for financial year 2006 are not achieved.

One indicator of liquidity being tighter now than at the time of the mid-term review of monetary policy is the credit-deposit percentage. While this was 61.12 per cent on October 29, 2004, it had gone up to 63.91 by March 25, 2005.

That doesn't seem to be too big a change, but a better way of looking at it is to consider the incremental credit-deposit ratio, which was 113 per cent during the period from October 29, 2004 to March 25, 2005.

In contrast, the incremental credit-deposit ratio, (after adjusting for IDBI becoming a bank in the period) was 102 per cent in the period April 1, 2004 to October 29, 2004. While bank liquidity had started tightening by last October, it has now become even tighter.

Note also that over the period from end-October to end-March, bank investment in government and other approved securities increased by a mere Rs 15,572 crore (Rs 155.72 billion). Small wonder that fears about the government being able to push through its borrowing programme this year are being raised.

Another major component of liquidity that was abundant in the second half of financial 2005 -- foreign institutional investor inflows -- may not be so large this year. That could be made up to an extent, however, by higher inflows from external commercial borrowings.

Nevertheless, the mood in the market is very negative, with a marked reluctance to buy bonds for fear of having to book losses -- a fear reflected in the fact that most of the action has shifted to the swap market, which is off the balance sheet. In short, risk is rising in the market.

These worries have also been acknowledged by the RBI in its latest auction, where it adopted the uniform price auction format, allowing all bidders to buy the securities at the same price, thereby eliminating the "winner's curse" and making them more attractive to bidders.

Given the marked bearish sentiment in the market, any increase in interest rates by the RBI will only exacerbate the government's borrowing difficulties. That's why the finance minister has been losing no opportunity to make it clear that he is in favour of keeping interest rates low, a broad hint that most bankers believe the RBI will be left with no option but to echo.

Nevertheless, should the RBI choose to keep interest rates unchanged, it can adduce several reasons for doing so. One of them is the fact that the government has so far successfully been able to keep domestic fuel prices unchanged for months (although it's debatable whether it can continue to do so, given the fact that oil prices show no signs of cooling off).

There are also few signs of pricing power across the board, with the index of manufactured products up 4.6 per cent year-on-year, although the price rise in some segments such as basic metals, alloys and metal products has been much higher. That holds true even if we consider the last two months, when the manufactured products index moved up only 0.7 per cent.

Also, the base effect will continue in the first half of the year, so the RBI can always put off its day of statistical reckoning. But perhaps the biggest factor favouring the status quo on interest rates is the fact that real rates of interest have now turned positive, unlike the situation last October.

The 10-year bond yield had moved up to 7.2 per cent by end-November 2004, after the RBI raised the reverse repo rate in October, but yields had softened thereafter on massive dollar inflows, before going back above 7 per cent.

The conundrum that Greenspan faces -- soft long-term rates in spite of a higher Fed rate -- is not a problem for Reddy, with the long-term rate having gone up since last October's rise in the reverse repo rate. And finally, there's the old debate about the inflation being "imported" and not "demand-pull".

The RBI can always use its market stabilisation securities to impart liquidity to the market, but the worry is that that could well spill over into inflation, with a lag.