MUMBAI (Reuters) - India's cash rate jumped to 10 percent, bond yields surged and banking stocks tumbled on Wednesday after the central bank's intensified defense of the beleaguered rupee raised concerns about the cost to the economy if the attempted rescue failed.
The Reserve Bank of India's strategy will be tested with a series of debt sales this week, starting with Wednesday's auction of $2 billion of treasury bills one week after it rejected yields demanded in the previous sale as too high.
The sharp reaction in credit markets showed the tightrope the RBI is walking -- in trying to keep the rupee above a record low of 61.21 hit on July 8, it risks forcing up borrowing costs for companies as the economy grows at its slowest in a decade.
"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.
A week after it first announced measures to drain cash from the market and raised short-term rates sharply, the RBI on Tuesday further cut the amount banks could borrow from it and also compelled them to meet reserve requirements daily.
Markets are concerned about the collateral risks to the economy while long-term weights on the rupee such as a record current account deficit and stalled reforms remain unaddressed, and are worried more measures may be coming from the central bank.
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 the RBI's first round of measures on July 15.
The one-year overnight swap rate jumped to 9.30 percent, its highest since September 2008 when the collapse of Lehman Brothers was roiling global markets.
The overnight cash rate jumped to 10 percent, its highest since March 28, from a close of 6.50/6.55 percent.
Banking shares, especially for those who are more dependant on short-term funding dropped. Yes Bank Ltd
In contrast, the rupee was little moved. It was at 59.42 per dollar, stronger than its 57.76/77 close on Tuesday but not too far from a July 15 close of 59.89/90.
The RBI is due to sell 120 billion rupees in 91-day and 364-day treasury bills on Wednesday. Six of 15 traders polled by Reuters expected the auction to be scrapped again, while others thought buyers would only be interested at yields above 10 percent. Results are expected after 0800 GMT.
That will be followed by auctions of 60 billion rupees in cash management bills on Thursday and 150 billion rupees in a government bond auction on Friday.
A failure to significantly boost the rupee would raise concerns the RBI would take stronger action to create demand for the currency, such as raising banks' reserve requirements.
It could also resort to an outright hike in the policy rate, analysts said, undoing the 1.25 percentage points in rate cuts since April 2012 to support a slowing economy. Its next policy review is on July 30.
The government is considering options of its own, including raising money from citizens abroad in a bid to reduce its record current account deficit, the key strain on the rupee.
(Additional reporting by Subhadip Sircar; Editing by John Mair)
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