"With industry showing elementary signs of recovery (April-July industrial growth at 5.8 per cent) the RBI will probably take accommodative measures. Furthermore, going by the RBI's commitment to ensure stable interest rates and comfortable liquidity for banks, a sustained increase in credit would most likely lead to a phased reduction in CRR to relieve the pressure," the report said.

It added that a CRR reduction will not only boost the lendable resources of banks, but will also help to increase the money multiplier and spur deposit accretion over a period of time.

According to JP Morgan, if the trend of increasing credit offtake continues through the rest of the year, particularly in the face of sluggish deposit growth, there could be starin on liquidity later in the year.

"While increase inbank deposits is likely to fall short of the RBI's working estimates, credit offtake seems to be gaining momentum. Non-food credit seems to be gaining momentum. Non-food credit in particular is sharply higher than in the previous two years. Part of this rise in bank credit could be on account of increased domestic borrowings by oil PSUs owing to higher crude oil prices and substitution of foreign currency debt with rupee debt," the report said.

The slower deposit growth can be partly blamed on the large amounts of funds mobilised by the mutual fund industry due to the tax sops given in the budget. While the first half of last year witnessed MFs raising funds to the tune of Rs 2,295 crore, collections in April-August 1999 show that Rs 7,376 crore worth of funds have been raised. "There has clearly been some diversion of funds from bank deposits to MFs," the report said.

It adds that banks unlike last year have not been very aggressive in deposit mobilisation. "The reson being that while on the one handlending rates have declined since the rate cuts in March 1999, it has been difficult for banks to get quality assest apart from government bonds which in turn has put pressure on banks' margin," the report said.

The investment bank said that the last fortnight saw concerns on the liquidity front primarily because of the holidays, state loan issues and advance tax outfllows. "While advance tax outflows remains a concern, its impact is expected to be short-lived as seen on previous occasions. Hence, the adverse factors which kept prices down are now out of the way and we are likely to see a rally in bonds over the next few weeks. Moreover, with 87 per cent of the net borrowing requirements completed for the year, the supply of fresh bonds in the second half will be significantly lower," JP Morgan said.

These factors coupled with an easing in the current tight money market conditions will improve sentiments and lead to increased buying interest in government bonds, particularly longer dated ones, it said.Also, large coupon inflows over the next fortnight and redemption proceeds of the government floating rate bond will inject liquidity and ease overnight rates.

"In sum, most negative factors have abated and this will encourage market participants to build long position ahead of the October review of the monetary policy which in turn will push yields on government bonds," the report concluded.