MUMBAI India's boldest attempt yet to prevent a rout in the rupee delivered only a modest lift in the currency but shares slumped and bond yields jumped as investors worried that policymakers might overplay their hand and damage economic growth.
The government said on Tuesday the moves were an attempt to stabilise the currency, which hit a record low last week and is down nearly 10 percent since the start of May. Analysts say longer-term economic reforms are what India really needs.
The measures unveiled Monday night in a rare display of tactical force by a conservative central bank would make it harder to speculate in the rupee and are intended to attract foreign inflows needed to fund a record current account deficit.
They also increase the possibility that the Reserve Bank of India's next move on policy interest rates will be a hike.
"We think that the measures, in effect, constitute a shift in monetary stance from pause to tightening," Goldman Sachs economist Tushar Poddar wrote in a note, putting the odds of a rate hike at the RBI's policy review on July 30 at one in three.
The RBI raised short-term borrowing costs, restricted funds available to banks and said it would sell 120 billion rupees in bonds, effectively draining cash from the market, to protect a rupee that hit a record low last week.
The steps are risky and expected to be temporary, with Standard Chartered Bank saying they could only be maintained for up to six months.
"The best case, or what we are all hoping for, is that these are short-term measures purely to drive home a point, that it does not endanger growth in the long term," said Ananth Narayan, co-head of wholesale banking for South Asia at Standard Chartered Bank.
The moves will raise funding costs for banks and companies almost immediately, creating a ripple effect that could crimp growth in an economy expanding at its slowest in a decade.
In a direct response, Bank of America-Merrill Lynch cut its GDP forecast for Asia's third-largest economy to 5.5 percent from 5.8 percent for the fiscal year ending March 2014.
The rupee strengthened to 59.43/44 per dollar on Tuesday from a close of 59.89/90. Last week, it fell to a record low of 61.21.
Montek Singh Ahluwalia, deputy chairman of the government's Planning Commission told TV channel CNBC-TV18 the measures would be reversed when rupee stability was restored.
And Finance Minister Palaniappan Chidambaram said they should not be seen as a signal of a change in policy rates.
"These measures are intended to quell speculation or excessive speculation in the forex market, trying to reduce volatility in forex market," Chidambaram told reporters.
In a further move to attract foreign investment, India late on Tuesday eased foreign direct investment rules in sectors including telecoms, defence, insurance and single-brand retail. Prime Minister Manmohan Singh in a meeting with senior cabinet members cleared a proposal to allow full foreign ownership of local phone carriers, now capped at 74 percent.
The RBI's next policy decision is on July 30 and the predominant expectation is it would leave rates on hold for the second consecutive review, after cutting them by a combined 125 basis points since April 2012 in an effort to revive growth.
If the RBI's measures to support the rupee fail, it could force the central bank to reverse course and raise rates, a measure taken last week by Indonesia.
Benchmark 10-year bond yields surged as much as 54 basis points on Tuesday to their highest since late December, and short-term rates also jumped.
As bond yields surge, India risks making higher borrowing costs harder to reverse, unless they are accompanied by steps to narrow the current account deficit from a record 4.8 percent of gross domestic product in the last fiscal year.
Stocks fell, dragged down by lenders that rely on short-term funding, with Yes Bank (YESB.NS) down nearly 10 percent and IndusInd Bank (INBK.NS) down 8 percent.
Continued losses in the stock and bond markets could spark more foreign outflows. Overseas investors have already sold around $11 billion worth of debt and stocks since late May.
The RBI has been reluctant to intervene aggressively by dipping into foreign currency reserves that cover nearly 7 months of imports, as any rundown of its holdings could further erode foreign investor confidence.
Regulators have instead tried to clamp down on speculative trading by focusing on onshore derivative markets.
Nomura economist Sonal Varma said the latest moves could backfire.
"India's growth is already very weak and tighter domestic liquidity will worsen the financial conditions for corporates and banks, hurting asset quality and the growth outlook," she said in a note.
"The probability of a rate hike, if today's measures are not successful in stemming rupee depreciation, has gone up." (Additional reporting by Swati Bhat, Archana Narayanan, and Abhishek Vishnoi in MUMBAI and Rajesh Kumar Singh, Anurag Kotoky and Devidutta Tripathy in NEW DELHI; Editing by Tony Munroe and John Mair)