Even a one per cent cut in the cash reserve ratio (CRR) before the end of this fiscal would not mitigate the shortfall in funds in the system, the rating agency said.

In the past one year, interest rates have shown a consistently declining trend with the yields on government securities declining by about 100 basis points across the entire maturity spectrum. However, the mismatch in supply and demand for funds means that the downward trend in interest rates is unlikely to continue into the next millennium.

"The central government gross borrowing in fiscal 1999-2000 is expected to be higher than the targeted level of Rs 86,000 crore by about Rs 18,000 crore on account of lower divestment, lower tax revenues and expenditures on Kargill and elections. In addition to this, the incremental corporate demand for funds from banks is expected to be about Rs 70,000 crore for the current fiscal as against Rs 57,000 crore in the previous year due to an expected increase in industrial production," the agency release said.

"On the other hand the net inflow of funds through foreign institutional investors (FII), foreign direct investment (FDI) and external commercial borrowings (ECB) is expected to remain at last year's level of Rs 27,000 crore. Even the aggregate deposit expansion in the banking system in 1999-2000 is expected to be only about Rs 100,000 crore as against a deposit growth of Rs 110,000 crore last year," Crisil said.

This slowdown in bank deposit growth is expected to continue due to increased investment in real assets, lower mobilisation from external deposits, increased fund mobilisation by mutual funds, increased retail mobilisation of financial institutions (FIs) like ICICI and IDBI (they are expected to mobilise about Rs 8,000 crore this year) and increased investment in capital markets by households due to strong secondary market sentiments.

Thus, according to Crisil, interest rates are expected to harden before the end of the year and this hardening will be more pronounced in case of higher risk corporates due to the risk averse nature of various lending institutions like banks, mutual funds, pension funds and small savings.

Crisil has cautioned that the expected increase in interest rates should be a matter of serious concern for banks and mutual funds as government and corporate securities constitute a large portion of their portfolio. "A one per cent increase in interest rates could lead to as much as a 4 per cent decline in their outstanding portfolio value, wchich at current levels will mean a fall of around Rs 14,000 crore," Crisil said.

It is, therefore, imperative that these institutions increasingly pay attention to managing their interest rate risks.