The government heavy borrowing plans for the 2009-10 fiscal is a damper on the Reserve Bank's efforts to maintain a low interest rate regime, Reserve Bank of India (RBI) governor Duvvuri Subbarao said today.

The government plans to borrow a record Rs362,000 crore  ($77 billion) in the financial year 2009-10 (1 April- 31 March), as per the government's pre-election interim budget.

"Large borrowing by the government runs against the low interest rates that the Reserve Bank is trying to maintain, to spur investment demand in keeping with the stance of the monetary policy," Subbarao said at a financial management summit.

The governor was speaking on `Risk Management in the Midst of the Global Financial Crisis', at a financial management summit organised by the Economic Times.
 
''On the monetary policy front, managing the risk calls for maintaining ample liquidity in the system. The RBI has done so the past six months through a variety of instruments and facilities.  And in the April 2009 policy review, we extended the tenure of many of these facilities. Some will argue, and rightly so, that this might be sowing the seeds of the next inflationary cycle. And this is exactly the kind of risk one has to grapple with. So while the Reserve Bank will continue to support liquidity in the economy, it will have to ensure that as economic growth gathers momentum, the excess liquidity is rolled back in an orderly manner,'' he said.

While the monetary easing has increased liquidity considerably, at the aggregate level this has not been out of line with our monetary aggregates unlike in many advanced countries and as such, the challenge of unwinding will be less daunting for India than for other countries, he added.

''The adjustment in market interest rates in response to changes in policy rates gets reflected with some lag. In India monetary transmission has had a differential impact across different segments of the financial market. While the transmission has been faster in the money and bond markets, it has been relatively muted in the credit market on account of several structural rigidities,'' he pointed out.

The acceleration in inflation coupled with high credit demand had earlier prompted banks to raise deposits at higher rates to ensure longer term access to liquidity. This, in turn, limited banks' ability to cut lending rates at a faster pace, he said.

Although deposit rates are declining and effective lending rates are falling, there is clearly more space to cut rates given declining inflation, he added.

The global economic slump has hit India harder than expected – economic growth has fallen below 7 per cent in 2008-09 from 9 per cent levels in the past, and is seen falling to about 6 per cent in 2009-10. This has put pressure on the government to offer financial support to industry.

To lift growth, the RBI also slashed its key lending rate by 425 basis points since October, and the government cut duties and boosted spending, which has widened the budget deficit, and more stimulus packages are expected.

The combined fiscal deficit of the central and state governments is expected to exceed 10 per cent of gross domestic product (GDP) in 2008-09.

"The first order of economic business for the new government will be the full budget. Given the status of the economy, the pressure to provide more stimulus will persist," Subbarao said.

"However, with every percentage point increase in the fiscal deficit, maintaining adequate liquidity in the system becomes much more difficult. Managing this trade-off between our short-term compulsion and long-term sustainability will be one of the main challenges going forward," he said.

He said the RBI will squeeze out excess liquidity once the economy improves and government effects fiscal consolidation.