If we ask why India's economic tempo picked up in the last three years, almost nothing has been as important as the sharp drop in interest rates. Lower rates for retail consumers fuelled a borrowing and spending binge, which created demand.

Lower interest costs improved company results dramatically, so the stock market soared. And the lower interest expenditure on government debt meant that deficits came under control. Above all, lower interest costs mean that companies find it easier to borrow and invest in growth.

But now this all-important development on the financial front is under threat. More than anything else, the government and the RBI should be working out how to tackle a dramatically changed situation.

Two numbers should be focused on. One is the money that has flowed in from overseas, as remittances, portfolio investments and foreign direct investment. In the three-and-a-half years between March 2002 and September this year, the net foreign exchange assets of the banking sector increased by an annual average of Rs 100,000 crore (Rs 1000 billion). It is this unprecedented inflow of cash that has created enormous liquidity in the system, and kept interest rates low.

The second number to focus on is bank credit to the government. Commercial banks and the RBI lent an annual average of Rs 75,000 crore (Rs 750 billion) to the government in the same three-and-a-half years to September. The banks could lend on this scale because of the even greater inflow from overseas (Rs 100,000 crore, as we have already seen).

Without that, the government would have been competing with private companies and individuals for domestic bank money - and that would have driven up interest rates. In short, the inflow of foreign money made the low interest rates possible.

That inflow of dollars has now stopped. Blame the high oil prices. From a surplus in the trade account (for both goods and services) in the three years to March 2004, and a small deficit last year, the deficit this year is expected to balloon to about Rs 90,000 crore (Rs 900 billion). This can be compensated by investment flows.

But when a trade surplus gives way to a trade deficit, the rupee comes under pressure, and overseas investors become nervous about losing in the currency game. In other words, the flow reverses on the investment account too -- as we have seen in recent weeks.

This can mean only one thing -- the net foreign exchange assets of the banking sector will probably decline. Even if you are an extreme optimist, you will concede that the assets will not increase by anywhere near the previous annual rate of Rs 100,000 crore.

But the government will keep borrowing money on the same scale as before -- because the deficit hasn't come down in absolute numbers. So, unless the RBI decides to pump in cash, the deficit has to be financed from the market.

Since there is now no inflow of dollars, the commercial banks will have to lend to the government out of the domestic money that has so far been going into the private credit market. In short, those borrowing money for buying houses and cars, and companies borrowing to invest in growth, will find a competitor-borrower in the government; more than anything else, that is why we should expect interest rates to climb.

Given how vital a part overseas inflows played in helping keep interest rates low, this is a seminal shift. And since it is unlikely that oil prices will nosedive, and unlikely therefore that we will be able to reverse our now adverse trade balance, only two things can prevent a sharp increase in interest rates. One is for the RBI to step in and start lending to the government on a significant scale -- which it can do for some time without causing problems.

The second is for the world to fall so much in love with the India story that it keeps pumping in money anyway (and here, the government has to keep fluttering its eyelashes). So, it is not that policy-makers are helpless. The point is that the financial fundamentals have changed, and if the interest rate story is not to change in tandem, there will have to be some deft footwork.