We seem to have a chicken and egg problem here. The liquidity shortage is being blamed for the dire situation that Indian industry finds itself in.

However the fact that liquidity is scarce suggests that there is enough demand for funds from borrowers, particularly domestic companies. A possible inference could be that the fundamentals of Indian industry are, well, not so dire.

Credit growth from the banking system as a whole printed at a robust 27.7 per cent for November 7, up from 24.8 per cent at the end of September. If you consider the fact that inflation is falling rapidly, the pick-up in 'real credit' growth between September and early November would be quite spectacular. Thus companies are not borrowing more just to make up for the rising nominal cost of inventories. There seems to be genuine pick-up in the 'volume' of credit.

I buy the argument that the access to external credit has deteriorated considerably - its substitution by local credit is shoring up the domestic credit growth numbers. However it still does not quite explain why the demand for funds should be so strong if growth has indeed dropped so much.

For one, the problem of prohibitive rates on external borrowings has been around for a while. More importantly, it does not really matter whether Indian companies are borrowing locally or turning to external sources. The bottom-line is that the credit figures suggest that Indian borrowers need funds to keep production and expansion going. That, prima facie, does not appear to be consistent with the raft of formal and anecdotal evidence on growth that's making the headlines.

The solution to this conundrum does not lie in questioning the veracity of industry's claims that things are getting form bad to worse. Reports, for instance, of auto plants going in for unscheduled outages are true and I cannot think of an earthly reason why auto manufacturers would want to fake these claims.

Sales data for sectors like auto and cement are dismal. There is no need to miss this evidence. However, there is enough reason to abandon the 'black-box' approach to liquidity and growth and take a closer look at the nuances.

Let me start with some obvious inferences. A possible explanation for this apparent inconsistency between credit demand and growth could lie in what I would term 'a reporting bias'. Sectors that are hurting the most - automobiles, cement, metals - tend to hog the headlines.

Their problems are real but they need not necessarily represent the trend in all segments of industry or the economy.

There could be sectors that are faring much better - consumer goods or pharmaceuticals, for instance - which do not grab the media's attention. Their growth rates could actually be picking up and the strong demand for loans reflected in the aggregated data could in fact, be picking up the strong credit needs of these segments.

The September IIP data, for example, showed 13.1 per cent in the consumer durables component. Data from white goods producers reported in this paper on Saturday corroborate the fact that consumer goods sales have been strong over the past few months and could get further fillip as the impact of the government salary hikes works its way through the system.

A less benign explanation for the spike in credit has to do with inventory cycles. Past evidence both for India and other economies shows a bulge in final goods inventories at the onset of a sharp slowdown.

The story runs like this. Companies (commodity and cyclical sectors are infamous for this) often fail to anticipate a sharp drop in demand and fail to adjust their production schedules. Consequently, when demand indeed drops, companies are saddled with large inventories of their products. To 'hold' these inventories, they need a large infusion of working capital. Thus, both inventories and working capital tend to spike up in the initial phase of a recession.

As companies reconcile to the prospect of a prolonged downturn, they cut back on production and offload inventories by cutting prices. As this happens, their credit demand comes down sharply and overall credit demand moderates. If that is indeed the case, credit growth could continue to remain high for the next couple of months and then drop sharply as companies begin to reduce production and draw down inventories.

The Indian housing sector is a good example of this. Real estate companies find themselves sitting on a large inventory of unsold residential space. They are, as yet, unwilling to cut prices sharply or even slow construction down in the fear that such action would lead to a market crash. Thus, their appetite for working capital is high though in their specific case, banks are less willing to lend than to other sectors. As they finally succumb to the dictates of their demand-supply balance, their demand for working capital will reduce and the pressure on domestic liquidity from these.

Thus based on credit data, here's my prognosis of what is happening in Indian industry and what's likely going forward. For one, we are still in the early phases of a slowdown and companies are still reconciling to the prospect of sustained demand destruction. As they factor this in, production will decline and companies will start selling from inventories rather than fresh production.

This would drive growth rates down sharply. As this inventory adjustment gets under way, the liquidity situation could improve dramatically as companies won't need as much working capital to hold inventories. Banks could thus face a problem of plenty rather than a shortage of funds in the near future. If this indeed happens, banks might start chasing customers by dropping rates sharply.

Second, there will be some sectors that will buck this trend. The degree to which they remain insulated from the rest of the economy will determine how bleak the growth situation will look in 2009.

The author is chief economist, HDFC Bank [Get Quote]. The views here are personal