The rupee rose to a five-week high as the central bank's aggressive monetary tightening to defend the currency showed some signs of success, while bond market investors demanded higher yields at a government bond 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.
At Friday's auction of 150 billion rupees of bonds, the shortest with a maturity of just above 2 years and the longest a 19-year bond, the central bank was forced to set yields about 50 to 80 basis points higher than they would have bid two weeks ago.
A bond maturing in December 2020 was sold at a cut-off yield of 8.67 percent, far higher than the 8.12 percent coupon on the bond.
Traders said they suspected only a part of the targeted amount was raised at the auction. Details on the amounts raised will be released later in the day.
Bond prices have slumped since the Reserve Bank of India's (RBI) first round of measures on July 15.
Overnight borrowing rates hit a four-month high of 10.20 percent on Friday. The central bank's second round of measures to restrict the daily use of cash by banks kick in on Saturday.
'SLIGHT POSITIVE SENTIMENT'
Sandeep Bagla, executive vice president at ICICI Securities Primary Dealership, said the yields were largely in line with market expectations.
"Though there is some devolvement in the auction, there are good bids in the market due to the slight positive sentiment today," he said, referring to talk that some bonds were unsold. Primary dealers underwrite government bond auctions.
The key question for markets is how long the RBI will stick to its risky strategy. Higher yields raise borrowing costs for banks and firms as well as interest costs for the government, and could further hit an economy already growing at its weakest pace in a decade.
Analysts say the central bank has taken stop-gap measures to avoid an outright hike in interest rates. In their view, the steps do little to tackle India's record current account deficit, a major long-term weight on the rupee.
The RBI will hold a once-in-six-weeks policy review meeting on Tuesday. It is expected to stand pat on policy, neither raising the main repo rate nor signalling the end of a year-long policy easing phase.
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.
It was quoted at 58.82 after the auction, recovering from the day's low of 59.
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.