The rupee slumped to an over two-year low on Friday, tracking weakness in global markets after the European Central Bank's stimulus package fell short of expectations and renewed fears of a U.S. rate hike.
The rupee was trading at 66.96/97 to the dollar, its lowest since 4 September, 2013. It had closed at 66.6525/66.6625 per dollar on Thursday.
Federal Reserve Chair Janet Yellen, speaking before Congress' Joint Economic Committee on Thursday, said the United States may be "close to the point at which we should be raising" rates.
Meanwhile, haunted by memories of India's 2013 markets crash, the country's central bank is engaging in a tricky balancing act with domestic yields to keep volatility out of its bond markets ahead of the Federal Reserve's historic policy decision this month.
The Reserve Bank of India (RBI) is seeking to prevent wild swings in bond markets by agreeing to pay higher interest rates to investors at bond auctions, people with knowledge of the central bank's operations say, while also buying bonds in the open market to stop yields rising too much.
Although India has outperformed many emerging markets this year, the country has not been immune to Fed jitters, with foreign investors selling around $1.7 billion in bonds and shares last month.
The people familiar with RBI operations say it is worried weak market participation at its auctions ahead of the Fed's 15-16 December meeting could trigger a selloff. In 2013, Fed "taper" fears sent the rupee to a record low.
"It is best to avoid adding any negative news before the Fed," said one of the people.
"When there is so much (bond) supply, yields can't stay low."
The RBI has in its past two weekly government bond auctions allotted tenders to bidders below market prices, effectively paying higher-than-normal yields.
Typically, the RBI sets a maximum cut-off yield for bids and employs a process known as "devolvement" for weak bond tenders in which the auction's underwriting dealers buy up the shortfall in undersubscribed tenders at the cut-off yield.
"A devolving auction could mean that there is not enough demand for bonds, which sends a negative signal," the person said.
