This is a time of the year when the financial markets take a pause and I find myself at a loose end trying to write on something. The only significant event in the assets markets last fortnight that I can think of was the repatriation of the India Millennium Deposits.

These were high-cost funds raised from the Indian diaspora in 2000, which were paid back on December 29 last year. The payback created quite a flutter in the money markets since it effectively sucked out a hefty Rs 33,000 crore (Rs 330 billion) from the money markets and pressured up short-term interest rates. But swift action from the central bank and some bulky inflows cooled the markets off.

I have a feeling that this isn't the last that we've heard of the IMD flows--the market might have tided over the initial 'shock' of the outflow with a bit of help from the Reserve Bank of India [Get Quote]. However, the impact of the payback is likely to linger in the monetary system for some time to come.

The logic behind my claim is simple. The Indian banking system has just returned Rs 33,000 crore of funds to depositors who need not necessarily put the money back with Indian banks.

This exodus of liquidity has come at a time when retail and corporate demand for funds is strong and the government is yet to complete its borrowing programme. Unless these non-resident depositors are induced to put a good fraction of their money back with the Indian banks, or other inflows into the monetary system pick up sharply, the Indian financial sector is bound to find itself running a little low on its supply of cash.

The RBI could, of course, choose to reverse the situation completely by going in for a one-off policy measure like a cut in the cash reserve ratio or a large-scale open market operation with the banks. These "offsets", however, might not kick in quickly enough.

Thus, in the next quarter, the money market is likely to see a much finer balance between the demand for funds and their supply. Excess liquidity will cease to be the norm as it had been for the last three years or so.

Let me try and put some numbers down to explain this. Until the end of October 2005, the banking system as a whole carried excess funds of about Rs 25,000 crore (Rs 250 billion) daily on its books, which it parked with the RBI as "reverse repos" and earned a return of 5 per cent. Since banks were cash-rich, the RBI didn't have to open its liquidity tap. Thus, except for the odd occasion, banks hardly ever bid for 'repo' funds.

In contrast, for the next few months, I would expect the average quantum of funds parked in the reverse repo window to average just about Rs 5,000 crore (Rs 50 billion).

I also see the RBI as a far more active lender to the system, periodically injecting liquidity through its repos. In the six days after the IMD flows, the central bank infused an average of Rs 25,000 crore daily.

The RBI might bridge the gap between the supply and demand for funds by lending through the repo route, but this would effectively jack up the cost of liquidity. In the 'excess' liquidity regime, a bank finding itself short of cash could borrow from the call market at a rate close to 5 per cent. If it is caught in a similar situation now, it will have to borrow from the repo window at 6.25 per cent.

What does it mean for the cost of borrowing in general? Much of the upward pressure on interest rates is confined to short- and medium-term debt, of tenors ranging from overnight funds to two years. That is precisely the segment in which banks raise the bulk of their funds.

So banks' funding costs are likely to go up further. They will try and protect their margins by passing on increase in cost as increased lending rates. This might not always be possible, given that intense competition in segments like mortgage lending has whittled down pricing power entirely. Those who do not have deep enough pockets will reduce their exposure to these markets.

Thus, loan growth will slow down both due to falling demand (as the cost of loans goes up) and reduced supply.

The long end of the market, where the government is a more active borrower, will stay relatively immune to these liquidity shocks. This is essentially because of market segmentation.

Entities like the insurance companies and provident funds are active lenders to the segment since their liabilities are long-term. It is likely that long-term yields will not move up that much. Thus, the Indian yield curve, which maps the maturity of loans to their effective interest rates, will get flatter, much like the United States.

Of all the potential risks for the economy and markets this year, I would put the shortage of liquidity right on top. If rates rise sharp enough, it can have a number of effects. Domestic equity markets have historically moved inversely with short-term yields. Debt-financed consumer spending could suffer and impede growth in these sectors.

Rising interest costs will eat into profitability and compromise earnings growth. How strong the ultimate impact will be will depend on how much rates increase.

That in turn will hinge on how foreign capital inflows behave, domestic inflationary expectations pan out and finally how loose or tight the RBI keeps its monetary policy. Watch this space!