Until July, the rupee traded between 44 and 45.50 against the dollar. But as euro zone sovereign debt crisis worsened in early August, investors fled to safe-haven US Treasuries, sparking a rally despite Standard and Poor’s cutting the US’ debt rating. Money moved into the dollar, sending yields to their lowest levels in decades.

In the process, the euro weakened and soon other emerging market currencies too lost ground against the greenback. The euro has lost more than 7% against the dollar since August. However, the rupee’s fall hurt more, since it was sharper, and most of it happened within just five months. In November, the Indian currency fell below the then all-time low of 52.18, which it had touched on March 3, 2009. In mid-December, it dropped below 54 for the first time in intra-day trades.

While much of the initial weakness was due to the falling euro, drying capital flows into equity at a time when the country’s oil bill rose worsened the situation. Oil accounts for the biggest chunk of India’s imports and, consequently, oil refiners — the largest dollar buyers in the domestic foreign exchange market — have had a hard time. Despite the RBI clamping down on exporters — banning them for cancelling and re-booking forward contracts — and also paring the overnight dollar open positions of banks, the rupee continues to slide.

In a bid to attract foreign flows, the RBI also freed interest rates on non-resident external (NRE) deposits, following which several banks raised interest rates on NRE deposits. However, economists believe the rupee could weaken further and levels of 58 to the dollar aren’t being ruled out.

“The measures taken by the RBI will only smooth volatility, not prevent the currency from weakening. If you open a parachute while jumping out of an airplane, you can land safely but it doesn’t put you back in the plane,” says David Bloom, global head of currency at HSBC.

Meanwhile, the RBI signalled a pause in the rate tightening cycle, although it says it can’t time rate cuts just yet. But after a brief celebration, the bond markets gave up gains on concerns that the government may borrow more than it had planned to. Yield on the benchmark 10-year bond, which ended below 8% in 2010, nudged closer to 9% during the course of 2011, primarily on account of an increase in the borrowing programme for the second half of 2011-12 amid serial rate hikes to bring down inflation.

The yield on the benchmark bond shot up over 60 basis points to 8.97% in November after the government announced on September 29 that it would need to borrow an additional amount of around R52,900 crore in 2011-12. Some of the auctions failed to attract enough buyers, even though yields were at three-year highs. To boost sentiment, the central bank introduced liquidity support measure in the form of open market operations and increased the ceiling on FII investments in gilts and corporate bonds. The auction of new investment ceilings for FIIs, on November 30, saw oversubscription of about 40% for the $10 billion on offer.

Nonetheless, after returning to 8.28% on December 20, the 10-year bond yield has yet again hardened to 8.50% levels, partly due to shortage of cash in the system but more on concerns that the government will borrow more than it promised. By and large, there was adequate liquidity in the system except for a few days in the second-last week of the year, when banks were borrowing around R1.6 lakh crore from the RBI’s special window and call rates hit three-year highs nudging 9%.

With the growth in deposits fairly robust at 17-18% and credit demand under 18%, banks should not be short of liquidity once the government starts spending. However, bond yields could spike further if the government mops up more money. Economists expect the fiscal deficit could now end up closer to 5.2-5.6% from the targetted 4.6%.