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India's central bank shows resolve on rupee ahead of key debt sale

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India's defense of its currency is showing signs of working as the central bank pays the highest yields for short-term debt in years, although its resolve faces a bigger test on Friday, at a sale of longer-dated bonds.

The rupee rose for a second session on Thursday after the Reserve Bank of India agreed to pay double-digit yields to sell 52 billion rupees ($880.01 million) in one- and two-month debt, in its second sale of short-term debt in as many days.

Although the RBI fell short of its plan to sell 60 billion rupees of debt, investors saw the willingness to pay such high yields as an important sign of resolve after it last week rejected all bids in a treasury auction and then sold just over a fifth of longer-dated debt at a separate sale.

(Read more: India's Current Account Good News May Be Fleeting)

A more significant test of the RBI's rupee defense will come on Friday when it is due to sell 150 billion rupees in government bonds, after its surprise strategy to shore up the rupee by draining cash was unveiled two weeks ago and was followed up with more tightening measures on Tuesday.

Willingness to sell debt at higher yields will be essential if investors are to buy into the central bank's plans after debt yields have shot up as a result of the RBI's measures.

Although the central bank is unlikely to want to be held hostage by paying any yield demanded by investors, it will need to meet them at least some of the way, or risk a standoff with markets that imperils future debt sales.

"If these moves are seen to fail, the rupee could come under renewed pressure as markets would conclude that the policy resolve to anchor the currency is missing. For the sake of credibility, therefore, it's important to stay the course," financial services firm J.P. Morgan said in a note to clients.

The rupee rose to a five-week high of 58.76 per dollar on Thursday from its previous close of 59.13, and has now gained 1.7 percent since the RBI announced on Tuesday additional steps to drain cash, including constricting lenders' access to central bank funds.

(Read more: Diving Rupee—Here's How Bad It Can Get for India)

The measures came after the bank's initial steps, announced on July 15, had failed to lift the rupee much above its record low of 61.21 hit earlier this month, as investors questioned the effectiveness of the RBI's plan.

Those doubts are now starting to be dispelled. On Thursday the central bank sold 22 billion rupees in 28-day cash management bills by paying 11.18 percent, although that was less than the 30 billion rupees on offer.

The RBI sold its entire allocation of 56-day equivalents at 11.20 percent.

The rates paid were far above the yields paid at the RBI's last cash management bill sale in November 2011, when it paid around 8 percent for 42-day bills.

(Read more: Indian Rupee Hits Record Low, but Some Relief Ahead)

Thursday's sale comes after the central bank paid the highest yields in at least six years at a separate sale of Treasury bills on Wednesday.

The RBI's sale of 150 billion rupees of debt on Friday, includes 30 billion rupees of 10-year bonds.

The RBI is likely to be mindful of over-paying for the debt, and saddling the country with high interest payments at a time when its fiscal deficit is a key concern for credit agencies, but it can't afford a stand-off with already wary investors.

"The RBI's intent is to make the cost of funding prohibitive," said Suyash Choudhary, head of fixed income at IDFC Asset Management Co, adding that would discourage bond buying. "It's reasonable to expect muted demand at the auction."

Benchmark 10-year bonds have slumped since July 15, although prices recovered somewhat on Thursday, sending yields down 19 basis points.


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