By Rafael Nam and Swati Bhat
MUMBAI (Reuters) - The rupee rose to a five-week high as the RBI's aggressive defence of the currency showed some signs of success, but investors were again set to demand the government pay them handsomely to buy its bonds at an auction on Friday.
The central bank has tightened money supply and pushed up short-term interest rates to try to generate demand for the rupee, which hit a record low on July 8, but that has forced the government to pay abnormally high yields to sell its debt -- including 11 percent on three-month paper earlier this week.
The key question for markets is how long the Reserve Bank of India (RBI) will stick to its risky strategy, because higher yields raise borrowing costs for banks and firms -- and interest costs for the government -- and could further hit an economy already growing at its weakest in a decade.
The next test comes with Friday's auction of 150 billion rupees of bonds.
Investors are set to demand yields of 8 to 9 percent, about 50 to 80 points higher than they would have bid two weeks ago, as bond prices have slumped since the central bank's first round of measures on July 15.
"Today's auction should sail through, but participation will not be very aggressive and market will demand higher yields," said Ashutosh Khajuria, president, treasury at Federal Bank.
Seen as stop-gap measures by the central bank to avoid an outright hike in interest rates, analysts say they do little to tackle India's record current account deficit, a major long-term weight on the rupee.
Raghuram Rajan, India's chief economic adviser, said on Thursday the steps had been geared to do only "minimal damage" to growth and all options were being considered to tackle the current account deficit.
The RBI's measures look to be having some success, after a muted initial response. The rupee rose to a five-week high of 58.69 on Friday, moving further away from its record low of 61.21 hit earlier this month.
Benchmark 10-year bond yields fell 3 basis points to 8.16 percent, although they are still up 61 basis points since the RBI unveiled its first round of measures.
Domestic credit ratings agency CRISIL said on Thursday the steps could make refinancing debt a challenge for Indian companies, and also hit car and home sales.
(Editing by John Mair)