First, distinguish the Indian phenomenon from what we have seen in Western credit markets. In the latter, the crisis was primarily about a lack of confidence in the financial system, and the evaporation of trust between agents because of uncertainty about exposure to mortgage-related assets. In short, the problem was a diminished supply of credit. Even the inability of firms to raise capital in the commercial paper market similarly reflected an unwillingness of banks and the public to supply finance to firms that were believed to be exposed to toxic assets.

The Indian variant is somewhat different. The private sector's funding from foreign sources and from the non-bank public (through the issuance of bonds and raising equity) has dried up because of combination of capital outflows and declining share prices. In 2007/08, for example, 40 per cent of funds available to Indian industry were raised through external commercial borrowings and new equity issues.

Funding for Indian companies that have borrowed abroad has also dried up because of trouble in foreign credit markets, forcing these companies to turn to the domestic banking system for credit. And firms' own funding has declined as profits have headed south.

This reduced supply of non-bank and foreign funding has led the private sector to turn to banks to make up this shortfall: that is, there has been a sharp increase in the demand for domestic bank credit. Of course, with banks lending to finance the losses of oil companies, there has been an additional squeeze (crowding out) of credit to the private sector as a result of preemption of bank credit by the government.

So, the answer to the analytical question is yes, there is a credit crunch despite torrid credit growth because the demand for credit has gone up. Price (the call interest rate) not quantity is the right signal.

The policy question then is: how can this additional credit be provided to the private sector? Or to put it in accounting terms how can the aggregate size of the balance sheet of the banking system as a whole be increased?

Simple macroeconomic accounting suggests that additional supply of credit can come from five sources: government; the RBI; firms' own profits; the non-bank public, and from abroad. 

If the government could reduce its deficit, more of the existing credit could be made available for the private sector.  With oil prices declining, this channel should, unless the government increases its deficit for other reasons, start kicking in.

The RBI could also facilitate greater credit supply by reducing the cash reserve ratio (CRR), allowing banks to reduce their balances at the RBI and to make them available to the private sector. The RBI has been using this policy tool vigorously and perhaps will, and should, continue doing so. Of course, there is a natural floor to the CRR stemming from prudential considerations.

Cutting the statutory liquidity ratio (SLR) is more complicated. It makes available additional resources for the private sector, only if the non-bank public is willing to hold government paper in its portfolio. If the result of cutting SLRs leads to a re-allocation of these bonds within the financial sector, there is no extra resources from the banking system as a whole.

How can the non-bank public augment the supply of credit? Only if it is willing to hold more bank deposits which the banks would lend to the private sector. But this would require making bank deposits more attractive and hence an increase in interest rates. Indeed, some banks have been attempting to raise deposit rates to attract customers.

How can the rest of the world augment credit? Increases in remittances and in NRI deposits into the Indian banking system could help achieve this. But again this would require making the holding of deposits more attractive, entailing raising interest rates and avoiding the risk of depreciation.

Here then is the dilemma for interest rate policy. Reducing interest rates can help the current credit crunch in a number of ways. First, by reducing the cost of bank's funding and raising their spreads, bank profitability increases. Second, it could also help corporate profitability which has two positive effects: by increasing the own source of funding (profits) it reduces firms' demand for bank credit; and by improving the asset quality of banks, it frees up resources to expand credit.

Finally, lower rates by helping corporate profitability could serve to attract foreign capital into the equity market.  This would again, for the reasons discussed above, alleviate the credit crunch by increasing non-bank funding of firms and hence reducing their demand for bank credit.

On the other hand, lowering rates would reduce remittances and NRI inflows, which are known to be interest-sensitive. It could also lead the public to take money out of the banking system to put in other assets or hold it as cash. Some money could also find its way abroad through direct and indirect (for example, trade) channels. All of these would reduce the supply of credit, aggravating the credit crunch.

The policy implications are then clear for alleviating the ongoing credit squeeze. Unambiguous ways of helping would be to reduce government claims on credit and reducing the CRR so that implicitly the RBI finances credit creation. On the other hand,  cutting interest rates does not have an unambiguously positive effect. Policy makers should take note of that. Whoever said that conducting monetary policy would be easy?

The author is Senior Fellow, Peterson Institute for International Economics and Center for Global Development, and Senior Research Professor, Johns Hopkins University.