The Reserve Bank of India announced measures late on Monday to curb the rupee's decline by tightening liquidity and making it costlier for banks to access funds from the central bank.
The RBI raised the Marginal Standing Facility (MSF) rate and Bank Rate each by 200 basis points to 10.25 percent, capped the amount up to which banks can borrow or lend under its daily liquidity window and announced a sale of government securities through an open market operation.
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The RBI said total funds available under its repo window will be capped at 1 percent of banks' deposits - roughly 750 billion rupees ($12.5 billion) - from Wednesday. It announced a 120 billion rupee sale of government bonds for Thursday.
The central bank does not set a target for the rupee, which hit a record low of 61.21 to the dollar last week, but it does take measures to manage volatility.
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"These will come at a heavy cost to the economy as short-end rates will rise and that will make borrowing costlier and affect growth if these measures continue for long," said A. Prasanna, economist at ICICI Securities Primary Dealership.
Bond dealers said short-end rates including interbank call money, 3-month certificates of deposit and one-year overnight indexed swap rates will go up by 100-150 basis points following the increase in the MSF rate and liquidity tightening steps. Government bond yields will rise 25-30 basis points, they said.
The MSF is the rate at which banks can borrow from the RBI at an elevated rate against government securities during times of tight cash. The bank rate is linked to the MSF.
Market participants said the measures will give near-term support to the rupee.
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"This could lead to some increased dollar inflows as overall interest rates in the economy will rise, but it could be temporary - that is, as long as these steps are effective," said a dealer at a foreign bank, requesting anonymity.
The RBI said countries with large current account deficits such as India have been particularly hit by capital outflows triggered by market expectations that the U.S. Federal Reserve could alter its loose monetary policy.
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"The exchange rate pressure also evidences that the demand for foreign currency has increased vis-a-vis that of the rupee in part because of the improving domestic liquidity situation," the RBI said in the statement.