Indian bonds and banking shares slumped on Monday after the Reserve Bank of India ordered banks to temporarily boost cash deposits with it in a bid to absorb excess liquidity generated by a government ban on larger notes.
The benchmark 10-year bond yield was up 7 basis points (bps) at 7.31 percent at 0409 GMT, after earlier rising as much as 15 bps, while the overnight call rate surged to 13.6 percent from its 5.90 percent close on Friday.
Banking shares also skidded, with State Bank of India down 2.8 percent, given the action would deprive banks of earning interest from funds deposited with the Reserve Bank of India.
The RBI on Saturday said banks would need to transfer 100 percent of their cash under the RBI's cash reserve ratio from deposits generated between September 16 and November 11, saying it was a temporary measure that would be reviewed on or before December 9.
The move is likely to drain over Rs 3.24 trillion ($47.29 billion) from the banks, according to Reuters estimates.
Since the Narendra Modi government stunned the country by abolishing Rs 500 and Rs 1,000 notes earlier this month, many Indians have deposited their old notes with their banks. The lenders, in turn, plowed this cash into government bonds, sparking a rally in debt markets.
The RBI will review its decision on the cash reserve ratio (CRR) once the government has issued an adequate amount of market stabilisation scheme bonds to soak up liquidity, RBI governor Urjit Patel was quoted as saying by the Press Trust of India.
Citigroup said the RBI also took action because the central bank was running short of government bonds it could offer for collateral under its reverse repo window, as well as to signal to markets its concern about falling bond yields.
Emerging market assets have tumbled since Donald Trump's election as US President on expectations he will pursue an expansionary fiscal policy that will drive inflation higher and lead to higher US interest rates.
"The strong action could also be aimed at signalling RBI's reluctance on market interest rates falling too sharply, too soon in the present global context," Citigroup said.
Overnight index swap rates also rose with the 1-year rate up 7 bps to 6.01 percent, while the 5-year rate up 6 basis points.