intention of forcing through reforms on labour and investment laws that many economists say are necessary to attract foreign capital.
At the same time, the country needs to keep attracting foreign investors to fund an $88 billion record current account deficit.
Under the circumstances, the RBI's strategy of using short-term money markets to defend the rupee seemed ideal. By anchoring long-term yields, the central bank could ensure that its policies to defend the currency were contained at the short end of the yield curve and so did not affect other borrowers and investors in the economy.
Only, foreign investors were not convinced.
"You are fighting fires in terms of stabilising the rupee but the real economy has been suffocating for some time in the background now and even if you do stabilise the rupee, you really don't have any growth," said Huw McKay, Asian economist at Westpac Bank in Sydney.
Pushing short-term rates higher was possibly the path of least resistance for India's central bank, since it neither had the will to raise policy rates nor the means to keep intervening, economists said. But they added it seemed to overlook a vital weakness in the banking system: the excessive use of short-term markets by banks.
According to India Ratings, part of the global Fitch ratings group, the composition of bank balance-sheets has changed dramatically over the past few years.
As they lent increasingly to long-gestation infrastructure projects and for mortgages, the proportion of loans maturing within a year to total loans has fallen to about 34 percent from 42 percent in 2002.
At the same time, deposits with tenors of less than a year have increased to nearly 50 percent of total deposits from 29 percent in 2002, leaving banks exposed to fickle money markets.
To make up for the gaps in their funding, banks have borrowed via short-term certificates of deposit and from the central bank's emergency funding window. Borrowing from the central bank costs the banks 10.25 percent, whereas a 10-year bond yields them only 8.4 percent.
As a consequence of such skewed bank balance-sheets and tight monetary conditions, companies have found raising working capital both expensive and scarce, said Atul Joshi, chief executive officer of India Ratings.
"The banks take away the lion's share of short-term funding," he said, adding that the central bank measures have been ineffective. "They have not had the desired impact on the rupee and the flipside is the bond market has come