Short-term interest rates in India are about 2 percentage points higher than long-term government bond yields, which makes the yield curve inverted. Typically short-term rates are lower than longer-term ones.
The swing is the intended result of the central bank's deliberate move to push short-term rates higher, squeezing speculators by making it expensive to sell the rupee.
The central bank measures though are also taking a toll on the banking sector, which is heavily reliant on short-term money markets for capital. Since longer-term yields are lower - they have risen but not to the extent of short-term rates - bank lending has suffered and the value of the bonds on their books has fallen.
"There is a concern here that we have a recession in India, which could trigger further outflows," said Claudio Piron, a strategist with BofA Merrill Lynch in Singapore. The problem was that the Reserve Bank of India lacked credibility, he said.
"That's when the market thinks that you are undermining growth. And if you undermine growth, the fiscal numbers, be they corporate or government balance-sheets, will look worse and you will get more currency weakness and more outflow."
The rise in short-term interest rates, engineered by the central bank in the middle of July, has not stopped the descent of the rupee either. It hit a record low late last week of 68.85 per dollar, for a drop of 20% this year.
"Suffocating"
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The rupee has been one of the worst affected by the turmoil in emerging markets since May, when the US Federal Reserve hinted it may rein in its stimulus programme. Investors are bracing for the end of ultra-easy monetary conditions that had driven many emerging markets to record highs.
The rupee's fall has been far greater than the currencies of Brazil, Turkey, Indonesia and other countries whose vulnerability to foreign portfolio flows has made them an easy target for speculators.
Unlike Brazil or Indonesia, India has refrained from raising policy rates.
Annual economic growth in the April-June quarter dropped to 4.4%, the weakest in four years and half the stellar pace Asia's third-largest economy clocked between 2004 and 2011.
Industrial production is declining and a weak coalition government has shown no intention of forcing through reforms on labour and investment laws that many economists say are necessary to attract foreign capital.
At the same time, the country needs to keep attracting foreign investors to fund an $88 billion record current account deficit.
Under the circumstances, the RBI's strategy of using short-term money markets to defend the rupee seemed ideal. By anchoring long-term yields, the central bank could ensure that its policies to defend the currency were contained at the short end of the yield curve and so did not affect other borrowers and investors in the economy.
Only, foreign investors were not convinced.
"You are fighting fires in terms of stabilising the rupee but the real economy has been suffocating for some time in the background now and even if you do stabilise the rupee, you really don't have any growth," said Huw McKay, Asian economist at Westpac Bank in Sydney.
Short-term funding
Pushing short-term rates higher was possibly the path of least resistance for India's central bank, since it neither had the will to raise policy rates nor the means to keep intervening, economists said. But they added it seemed to overlook a vital weakness in the banking system: the excessive use of short-term markets by banks.
According to India Ratings, part of the global Fitch ratings group, the composition of bank balance-sheets has changed dramatically over the past few years.
As they lent increasingly to long-gestation infrastructure projects and for mortgages, the proportion of loans maturing within a year to total loans has fallen to about 34% from 42% in 2002.
At the same time, deposits with tenors of less than a year have increased to nearly 50% of total deposits from 29% in 2002, leaving banks exposed to fickle money markets.
To make up for the gaps in their funding, banks have borrowed via short-term certificates of deposit and from the central bank's emergency funding window. Borrowing from the central bank costs the banks 10.25%, whereas a 10-year bond yields them only 8.4%.
As a consequence of such skewed bank balance-sheets and tight monetary conditions, companies have found raising working capital both expensive and scarce, said Atul Joshi, chief executive officer of India Ratings.
"The banks take away the lion's share of short-term funding," he said, adding that the central bank measures have been ineffective. "They have not had the desired impact on the rupee and the flipside is the bond market has come to a complete standstill. There are no placements and no trading."
Rates on three-month commercial paper, which businesses use to raise short-term funding, have jumped 400 basis points to around 12.4% since mid July. Scarcely any new commercial paper has been issued since July, traders said.
Economists fear India will be forced to slow down for several reasons, not just because businesses are starved of capital. As authorities push for import controls and higher duties to crimp imports and therefore bring the current account deficit down, there would be consequences for the economy.
"We maintain that India's GDP growth is headed for a far steeper decline than the already muted expectations, as the impact of the currency, current account-deficit-related damage has barely started," Jefferies said in a note this week.
If the current account deficit, currently 4.8% of GDP, was reduced by 300 basis points, "India's GDP could head to sub 1-to-2% growth with massive pain likely for banks," Jefferies said.