Call money ended at 18.50-19.50%, off an intra-day peak of 20.50%, its highest since January 1998 and well above the reverse repo rate of 6% at which it usually trades when funds are adequate.
A prolonged cash squeeze could increase the cost of funds for banks and force them to increase lending rates in the next few months, eventually making borrowing more expensive for companies, analysts say.
State-owned banks do not have the money to lend. They are unable to sell bonds; many are close to the threshold level for meeting statutory reserve requirements, said a foreign bank dealer.
Bond prices ended higher after inflation data was in line with expectations, although volume had fallen to a trickle. The yield on the 10-year bond ended at 7.62%, one basis point lower than Thursday. Wholesale price inflation was 5.43% in the 12 months to Dec. 16 higher than the previous week's 5.32%.
The RBI through its liquidity adjustment facility injected Rs 34200 crore under its repo auction and absorbed Rs 2515 crore under reverse repo auction on Friday.
The Indian rupee touched a 10-month peak on Friday and ended 1.8% higher on the year, aided by robust foreign inflows and a favourable yield differential over the dollar. The rupee ended at 44.23/44.24 per dollar, up from Thursday's close of 44.25/44.26. It spiked to 44.17 in early deals, its highest since mid February.
The rupee's gains were broadly driven by a cash shortage in the money market, which had banks selling dollars to generate rupees and meet funding requirements.
Analysts said the prospect of rising local interest rates would keep the yield advantage in favour of the rupee as the hawkish central bank tackles inflation.
Given the pace of bank credit growth and money supply, we expect some further monetary tightening in the coming months, said Shubhada Rao, chief economist at Mumbai-based YES Bank.