* RBI rejects all bids in 120 bln rupee T-bill sale
* Rejection comes after bids seen too high-source
* RBI to conduct OMO sale of up to 120 bln rupees on Thurs
By Subhadip Sircar and Neha Dasgupta
MUMBAI, July 17 (Reuters) - India's central bank rejected all bids in a $2 billion sale of Treasury bills on Wednesday, highlighting the increased prospect of a clash with investors over the appropriate price for debt securities during a period of surging yields.
The failure to sell any of the scheduled 91-day and 182-day treasury bills came after the Reserve Bank of India decided that investors bids for yields were too high, a source familiar with the central bank's thinking told Reuters.
Investors fear a similar outcome on Thursday when the RBI gears up to sell another 120 billion rupees worth of government bonds via an open market sale as part of its three-prong plan announced on Monday to drain cash from the market to support the faltering rupee.
The plan also includes raising short-term borrowing costs and restricting funds to banks.
Bond investors say they need to be properly compensated after the RBI's action sparked a sell-off in debt markets, with the 10-year bond yield rising as much as 58 basis points over Tuesday and Wednesday.
Yet the RBI is reluctant to agree to interest payments it considers too high, setting up the prospect that it may resort to additional measures to accomplish its objective of draining liquidity, including raising the cash reserve ratio, a far more drastic move than lifting short-term interest rates.
"No bank is going to particularly accept a low yield," said Abheek Barua, chief economist at HDFC Bank in New Delhi.
"Whatever bids are likely to be successful would be at fairly high levels," he warned, adding higher bids could in turn push up yields further across maturities.
India's benchmark 10-year bond yields fell 8 bps to 8.05 pct from the day's highs after the results of the treasury bills were announced.
The 10-year bond prices have wiped out all their gains for the year, with yields at their highest since late December.
The RBI's open market operation (OMO) of 120 billion rupees on Thursday will be followed by another 150 billion auction on Friday. OMOs are bond purchases or sales by the central bank from its own stock to add or drain cash, while it sells bonds for the government, being its debt manager.
India is due to sell 3.89 trillion rupees of bonds in the remainder of the fiscal year ending in March 2014, with issuance especially heavy in July and August as the government needs to borrow enough to maintain its fiscal deficit target of 4.8 percent.
Although the RBI's measures to prop up short-term interest rates are expected to be temporary and are intended to shore up the rupee, they nonetheless are creating uncertainty about the pricing of debt by sparking doubt about how long the central bank will maintain a tightening stance.
The central bank is still seen as unlikely to resort to an actual hike in the repo rate, or India's key lending rate, after cutting it by 125 bps since April 2012, but analysts say it could opt to hike the cash reserve ratio - or the amount of cash banks have to park with the central bank.
Some analysts said such an increase, which would reverse the 200 bps in cuts of the CRR over the last two years, could send a more certain signal than focusing on short-term interest rates.
"I still think what they are trying to do is better done through the cash reserve ratio," said Arvind Chari, a bond dealer with Quantum Asset Management. ($1 = 59.2150 Indian rupees) (Editing by Rafael Nam & Kim Coghill)