Sudhir Kakkar, a business executive in a New Delhi publishing firm, recently needed to borrow money to furnish his house after getting married. Instead of approaching commercial banks for his loan, however, Kakkar joined a 'chit fund' group.

"I needed money urgently. I initially thought of going for a bank loan but bank credit requires too much paperwork and verifications. Also, with interest rates rising, taking a personal loan would have cost me more," he said.

"Joining a chit fund was like paying off my debt every month in a fixed installment without any interest payment."

Kakkar and the millions like him who use informal credit schemes to raise money are a pest for the Reserve Bank of India (RBI) which has ratcheted up interest rates 12 times over the past 18 months in a battle to tame inflation now threatening to surge into double figures.

Last week the RBI lifted its policy lending rate, the repo rate, by 25 basis points to 8.25 per cent and said it was too soon to ease back from its anti-inflationary bias, pressing on with a policy that has done more to slow the economy's growth than contain a relentless rise in prices.

The latest series of interest rate rises is taking its toll on industry. Annual industrial output growth in July slumped to a two-year low of 3.3 per cent in July and the August purchasing managers' index data suggest an upturn is unlikely in the near term. And yet, price pressures remain.

Although it started tightening later than other emerging market economies, the RBI's failure to contain inflation may have as much to do with the heavy use of informal credit schemes that bypass the Indian banking system.

"Monetary policy relies on incremental effect to achieve its objective. However, static rates prevalent in informal money markets tend to counteract that," said Siddhartha Sanyal, an economist with Barclays Capital in Mumbai.

This is not the first time that rate increases have failed to cool inflation.

In 2008, when a surge in global oil prices pushed inflation into double digits, the RBI ratcheted rates up to 9 percent, 75 basis points higher than the current repo rate, but inflation remained stubbornly above 11 percent.

INFORMAL FINANCING ROUTES

Members of a chit fund pool fixed sums of money every month for a certain period, and each month they select a beneficiary among them by drawing a lot or through an auction.

The manager of the fund is responsible for collecting installments from its members, presides over the lotteries or auctions and keeps a record of the cashflow and pay-outs.

He is paid a fixed amount on a monthly basis, usually around five percent of the gross chit amount.

Kakkar says he was introduced to the concept of chit funds by a Delhi-based businessman, Dinesh Sharma, a leather merchant who uses another informal financing mechanism, barter, to pay for his merchandise from Chennai.

"I just need to get in touch with the middlemen," said Sharma. "They arrange payments for my purchases in Chennai. In exchange, I have to pay for purchases made on behalf of Chennai-based businessmen in Delhi."

Moneylenders are a third route of informal financing. They charge rates of 3-10 per cent a month depending on the collateral their borrowers provide, far more than the annual rate of 15-18 per cent on personal loans from commercial banks, but they still do brisk business because credit through these channels is easy to access and less or no paperwork is required to set loans up.

Analysts say that almost 40 percent of India's "unorganized economy" - which itself accounts for nearly half of the $1.6 trillion economy - is driven by financing obtained through informal channels.

Indian commercial banks lent about $800 billion in fiscal 2010/11, the bulk of which is likely to have gone to large and state-run firms, creditworthy borrowers. This squeezes funding for smaller private businesses, forcing them to rely on informal financing markets.

The Centre for Monitoring Indian Economy, a think tank, estimates firms commissioned projects worth only 633 billion rupees in the quarter to June, a fraction of a targeted 8.3 trillion rupees for the fiscal year that ends in March 2012.

In mature economies such as the United States, big firms raise funds from the bond market at a lower cost than bank credit. But in India, the absence of a viable corporate bond market, big firms are forced to depend on banks, crowding out smaller firms.

With a corporate bond market valued at below $250 billion, lower than those in China and South Korea, India has one of the smallest corporate bond markets in Asia, the RBI said in its August bulletin, quoting figures from Asian Bonds Online.

"The key thing to do is to develop the corporate bond market. It is a weak market right now. If that improves (the monetary) transmission mechanism also improves," said Devika Mehndiratta of Credit Suisse.

MILLIONS OUTSIDE THE BANKING SYSTEM

But the problem lies with individuals as well as corporations. Nearly half of India's population of 1.2 billion population does not have a bank account.

A tendency to use moneylenders means that millions make consumption decisions irrespective of what the RBI does to interest rates, which ends up blunting the RBI's monetary tools.

India's cash to economic output ratio is high, at nearly 11 per cent, RBI data shows. Rural households keep nearly 42 per cent of their cash savings at home.

"To make monetary transmission more effective, India needs to bring more and more people under the purview of banking," Sanyal said.

A 2005 government report on countrywide debt and investment found that the share of institutions in the total cash dues of urban households had increased to 75.1 per cent by 2002 from 72 per cent in 1991, while that of moneylenders increased to 14.1 per cent from 10.2 percent over the same period.

In rural households, institutions' share declined to 57.1 per cent from 64 per cent in 1991 and moneylenders' share increased to 29.6 per cent from 17.5 per cent.

"Unlike in economies like the U.S. or Korea, where people rely on credit for durable purchases, barring a few pockets of consumption like housing and autos, the bulk of the consumption for people in India remains non-leveraged," said Mehndiratta.