UPDATE 1-India braces for next test of rupee defence with bond sale

MUMBAI/NEW DELHI, July 19 Fri Jul 19, 2013 1:09pm IST

MUMBAI/NEW DELHI, July 19 (Reuters) - The Indian central bank's strategy to staunch the rupee's slide faced further setbacks on Friday, with investors betting a 150 billion rupee ($2.5 billion) bond auction would struggle and the currency trading where it was before this week's rescue mission was launched.

An extended stand-off between the Reserve Bank of India and investors would raise the prospect of it taking other steps to generate demand for the rupee, such as increasing the level of reserves banks must hold, issuing offshore bonds or even raising policy interest rates.

Bond markets have been in turmoil since the RBI's extraordinary move on Monday to support the rupee by draining cash from the market and pushing up short-term interest rates, and a special bond auction on Thursday fell well short of its target.

Prime Minister Manmohan Singh said the steps were temporary and did not signal a rise in long-term interest rates. However, some economists say the central bank's efforts increase the risk it could have to raise rates even as the economy weakens.

The rupee has given up most of its gains since the RBI's move. On Friday it slipped to 59.83/84, close to its close of 59.89/90 on Monday. It hit a record low of 61.21 on July 8.

The benchmark 10-year bond yield was trading around 8 percent, nearly 50 basis points higher than before the RBI's action.

"Once the short-term pressures have been contained, as I expect they will be, the Reserve Bank can even consider reversing these measures," Singh said on Friday, even as he conceded the government's forecast of 6.5 percent economic growth in the fiscal year to March 2014 was unlikely to be met.

Private economists have been cutting their forecasts for growth, with Macquarie this week cutting its to 5.3 percent. Economists and investors say India needs structural reforms in order to draw longer term foreign funds.

India's struggle to attract big-ticket investment was underscored this week when ArcelorMittal and POSCO separately scrapped plans for multibillion dollar steel mills due to difficulties acquiring land and other hurdles.

Asia's third-largest economy grew at 5 percent in the fiscal year that ended in March, its weakest in 10 years.

MARKET TEST

On Thursday, the RBI rejected most bids in a sale of bonds designed to suck funds from the market, selling just over one-fifth of a planned $2 billion of debt as investors demanded higher yields than it would accept.

Signals were for another such stand-off at Friday's auction of government bonds.

A person familiar with the central bank's thinking said markets want higher returns for longer-dated paper, even though it is short-term borrowing costs that have gained the most.

"If the market bids sensibly, they will get the papers. If they don't, we will find other avenues for raising funds," said the official, who did not want to be named.

In another sign of disruption, the underwriters for Friday's bond issue are demanding commissions of between 74 and 98 paise per 100 rupees of debt on issue, much higher than the usual 1 to 2 paise fee. A paise is one-hundredth of a rupee.

However, the central bank has agreed to pay the higher fee for only around 120 billion rupees of the 150 billion rupee bond sale, an indication it does not expect the entire amount to be sold.

"The bond market is presently numb with all the recent shocks," said Anoop Verma, vice president at Development Credit Bank.

"The last time we saw such high commissions was in March 2009 and that time the RBI had cancelled the entire auction and a similar thing could happen today." ($1 = 59.6050 Indian rupees) (Additional reporting by Neha Dasgupta & Swati Bhat; Editing by Tony Munroe and John Mair)

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