* Yields demanded at government bond auction sharply higher
* India bond yields up 40 bps on week; worst since Jan 2009
* Rupee seen propped up by central bank intervention (Recasts after bond auction, adds closing levels, quotes)
By Swati Bhat and Subhadip Sircar
MUMBAI, July 19 (Reuters) - India's measures to protect its currency sent government borrowing costs sharply higher at a bond auction on Friday and dealers said the central bank appeared to have intervened anew in the forex market in support of the rupee.
Earlier, the embattled currency fell close to where it had been before a dramatic rescue mission by the central bank late on Monday, which sent bond yields surging and crimped the growth outlook for Asia's third largest economy.
India's benchmark 10-year bond ended its worst week in four-and-a-half years, with the yield rising 40 basis points, disrupting government debt sales and undermining central bank efforts to mop up liquidity to make it harder to speculate against the rupee.
That in turn fuelled expectations of further measures to generate demand for the rupee, such as increasing the level of reserves banks must hold as cash or issuing offshore bonds.
"Nobody really expects them to roll back these measures. The issue is whether they do anything further," said Hitendra Dave, head of global markets at HSBC India.
Prime Minister Manmohan Singh said on Friday the steps were temporary and did not signal a rise in long-term interest rates.
"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, though he conceded the government's forecast of 6.5 percent economic growth in the fiscal year to March 2014 was unlikely to be met.
However, some economists say the central bank's efforts increase the risk it may have to raise rates even as India's economic prospects weaken.
Private economists have been cutting their forecasts for growth, with Deutsche Bank on Friday slashing its prediction to 5 percent, matching the lowest in a Reuters poll this week.
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. A special bond auction on Thursday fell well short of its target.
The partially convertible rupee ended at 59.35/36 per dollar, half a percent stronger on the day. Traders said the central bank appeared to have been repeating its recent late-session practice of selling dollars through state banks.
The rupee has been hit especially hard in the recent global sell-off in emerging markets because of a current account deficit that hit a record 4.8 percent of India's gross domestic product in the fiscal year that ended in March.
Investors also fret over a lack of structural reforms to attract long-term investment.
For the week, the rupee ended 0.3 percent higher after hitting a record low of 61.21 to the dollar on July 8.
"We will need dollar inflows to fund our current account deficit, otherwise we could end up with a balance of payment deficit," said Ashish Parthasarthy, treasurer at HDFC Bank, who favours an offshore bond issue to attract funds.
"Through intervention, we will end up losing reserves. By losing liquidity and tightening rates, growth will be hurt."
On Friday, the government managed to push through its scheduled sale of 150 billion rupees ($2.52 billion) in bonds, with yields roughly 50 basis points higher than a week ago.
In another sign of disruption, the underwriters for Friday's bond issue demanded 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.
India grew at 5 percent in the fiscal year that ended in March, its weakest in 10 years.
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 problems acquiring land and other hurdles.
The RBI's next monetary policy review is on July 30 and most
economists polled this week expect it to keep the policy rate
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.
($1 = 59.6050 Indian rupees) (Additional reporting by Neha Dasgupta, Manoj Kumar and Suvashree Dey Choudhury; Writing by Tony Munroe, Editing by Gareth Jones)