By Rafael Nam and Swati Bhat
MUMBAI (Reuters) - India's cash rate jumped, bond yields surged and banking stocks tumbled on Wednesday after the RBI's intensified defence of the beleaguered rupee raised concerns about the cost to the economy if the attempted rescue failed.
The rupee rose to a one-week high in afternoon trade after the Reserve Bank of India (RBI) showed it was serious about propping up the currency by accepting abnormally high yields in an auction of 120 billion rupees of treasury bills.
The sharp moves in credit markets showed the tightrope the RBI is walking -- in trying to keep the rupee above a record low of 61.21 per dollar hit on July 8, it risks forcing up borrowing costs for companies as the economy grows at its slowest in a decade.
The RBI accepted a yield of 11.0031 pct on three-month bills and 10.4649 pct on one-year paper, the highest yields in at least six years and above market expectations, one week after rejecting all bids as too high.
Its strategy will be further tested with two more debt sales this week to raise a combined 210 billion rupees, as continuing to accept high yields could prove costly for a country trying to tame its fiscal deficit.
"The higher T-bill yields signal the clear intention of the central bank to pull out liquidity from the system," said Shakti Satapathy, fixed income analyst at AK Capital.
"Though today's auction were accepted at a higher rates, the sustainability of higher yields wouldn't be acceptable in the subsequent weeks."
LONG-TERM PROBLEMS
The rupee rose to 59.08 per dollar after the auction, up more than 1 percent on the day, but was still not too far from a close of 59.89/90 on July 15, when the RBI said it would drain cash from the market and raise short-term rates sharply.
On Tuesday, it further cut the amount banks could borrow from it and also compelled them to meet reserve requirements daily.
The steps may create short-term demand for the currency by creating a shortage of cash, but none of the RBI's measures are expected to help resolve long-term weights on the rupee such as a record current account deficit and stalled reforms.
A failure to significantly boost the rupee would raise concerns the RBI would have to take stronger action to create demand for the currency, such as raising banks' reserve requirements or raising its policy interest rates. Its next policy review is on July 30.
"The establishment has been telling the nation that the measure is only short term in nature and there is no change in the stance of the central bank on long-term interest rates. Believe it at your own peril," Jyotheesh Kumar, executive vice president of HDFC Securities, said in an email to clients.
The benchmark 10-year bond yield hit a 14-month high of 8.50 percent, up 33 basis points on the day and 95 basis points since July 15.
The overnight cash rate jumped to a four-month high of 10 percent, before easing back to 8.50 percent. That was still up around 200 basis points from Tuesday's close
Banking shares dropped, especially those who are more dependant on short-term funding. Yes Bank
Another concern is that having to pay higher interest rates for a prolonged period could endanger the government's pledge to cut the fiscal deficit to 4.8 percent of gross domestic product by next March.
Standard & Poor's already has "negative" outlook on the country's rating, and a cut would lower it to "junk" status.
The government is considering options of its own, including raising money from citizens abroad in a bid to reduce its record current account deficit. (Additional reporting by Subhadip Sircar; Editing by John Mair)
