After the banks hiked lending rates last week in response to the Reserve Bnak of India's fairly overt signal in the interim monetary policy review, the finance ministry clamped down on the state-owned banks and asked them to reconsider their decisions. I just hope we are not reverting to the pre-1990s dirigisme and that once these banks present their case clearly, the finance ministry will let them have their way.

However, it is easy to understand why the government is worried about the potential political and economic fall-out of these rate hikes. For a household funding its home purchase through a bank loan, this is the third hike that it has seen over the last seven months.

This means a fairly large dent in monthly cash flows, if, like the majority of borrowers, it has taken a floating rate loan. Companies have not been spared, either. Though the variation in the cost of borrowing is much higher across companies, they would face increases of 1.5-2 two percentage points, on average, in their cost of funds.

But what is the likely impact of these interest rate increases on the economy? Let me start with the impact on banks (for no better reason than the fact that I work for one) and try and address a couple of concerns that people have on the fate of banks in the current scenario.

First, let me talk a little bit about how banks run their businesses. Banks have two main sources of income - the net interest earned on loans (net of deposit costs) and the incomes they make on their investment portfolios. Since bond prices move inversely with interest rates and the bulk of banks' portfolios is in bonds, it is sensible to assume that treasury incomes would fall. Thus, the key to bank profits and performance lies in what happens to net interest incomes.

Banks are trying to make the most of the rising interest rate environment by jacking up the rates on loans. Whether they can get away with this strategy ultimately depends on the elasticity of demand for credit, simply the sensitivity of credit-demand to interest rates.

If the elasticity is high, the fall in the volume of credit demand would completely offset the rise in interest and margins, leaving banks worse off. The good news is that from whatever data that we have got on offtake, the demand for credit is proving to be singularly inelastic.

Despite the fairly sharp rise in rates over the year, credit growth hasn't quite dwindled and the fortnightly average is a little over 30 per cent, pretty much the same growth rates as last year. This is good news for banks - the flipside of low elasticity is high pricing power.

The low sensitivity of credit demand to its price is not something new. Significant changes in credit demand are driven to a large extent by investment activity - firms borrow from banks to invest in capacity. A simple statistical exercise done by my colleagues shows that investment (gross fixed capital formation) has historically been rate-insensitive. (Their sample period spans the period 1980-81 to 2003-04). Thus, credit demand is also somewhat insensitive to rates.

This is not as unintuitive as it may seem at first glance. In a developing economy like India, decisions to create capacity are based on a wide range of factors such as the policy environment, expectations of demand conditions over the longer term, future pricing power, and likely changes in regulation.

Thus, companies don't quite scurry around to find investment projects when the cost of funds drops, nor do they shelve plans when interest rates rise. At the current stage of the business cycle, most companies are convinced that future demand and pricing power will ensure a return on capital that will cover the cost of borrowing even if rates move up a little more.

Some of the companies that I have spoken to seem to be working on the assumption that their effective borrowing rate will move up by another one to one and half percentage points.

What does this mean for economic growth? I am convinced that the key driver of the business cycle this year and the next will be investment, both in capacity expansion and infrastructure. If these are indeed insensitive to interest rates to a considerable extent, then this engine of growth will keep chugging along.

I am less sure about the impact of higher interest rates on household spending, particularly on things like housing and cars. Our calculations show that a household that had taken a floating rate loan of Rs 25 lakh (Rs 2.5 million), say, at the beginning of 2005 is now forced to shell out Rs 43,000 more per annum as a result of the series of rate hikes.

That seems a little steep for a middle class family, if you ask me. A rise of this magnitude should hurt demand for retail assets. There is a counter-argument, though - people who predict continued buoyancy in housing markets point out that the rise in middle-class salaries, particularly urban salaries, have been high enough to pay for this rise in costs.

Besides, housing prices are likely to soften a little and this should help demand.

Be that as it may, I would advise caution in gauging the impact of interest rates on household spending. The rise in interest rates, coupled with a waning wealth effect on the back of a weaker stock market, is bound to take its toll, perhaps just at the margin. Thus, the composition of growth will change with asset creation by companies rather than by households driving the engine.

I would go with a 7.5 per cent GDP growth forecast for the year. However, investment spending cannot be completely insensitive to interest rates. If rates move up sharply again, we could potentially be looking at a potential slowdown. Some central banks (like the Bank of Thailand) are shifting gear and giving growth greater priority over inflation. Should the RBI take note of this?