MUMBAI - The Reserve Bank of India's $5 billion plan to swap rupees for dollars with domestic banks will help achieve its twin objectives of pushing interest rates down while also preventing a sharp appreciation in the rupee, analysts said on Thursday.

In a bid to mop up dollars and pump in rupees, the central bank said on Wednesday it will conduct its first dollar/rupee buy-sell swap auction on March 26, analysts said.

"In order to meet the durable liquidity needs of the system, the Reserve Bank has decided to... inject rupee liquidity for longer duration through long-term foreign exchange buy/sell swap," the RBI said.

Aside from easing cash conditions in the banking system, the swap would increase cash available to borrowers during a tight re-election race for Prime Minister Narendra Modi's government.

"This will achieve multiple objectives including bringing down short-term interest rates for borrowers, helping the RBI to mop up lump sum amounts of dollars at one go, infusing liquidity and preventing any sharp appreciation in the rupee in face of a strong pipeline of flows in the near term," said A. Prasanna, head of fixed income research at ICICI Securities.

Despite cutting its key policy rate last month, the RBI has struggled to get banks to reduce lending rates due to tight cash conditions and high deposit rates. urn:newsml:reuters.com:*:nL3N20313I

Economic growth has slumped to its lowest level in five quarters, posing a challenge for Modi as he seeks a second term in elections set to be held in April and May. urn:newsml:reuters.com:*:nL3N20N68K

The RBI move could increase fund flows to credit-starved shadow banks which accounted for a third of new loans until September 2018, when debt defaults by an infrastructure lender hit the sector, bankers and analysts said.

Despite several measures by the government and RBI to ring-fence weak financial institutions and relax funding lines for non-bank finance companies, banks and mutual funds are reluctant to lend to this sector, adding to the economic slowdown.

The RBI's measure is likely to prod reluctant bankers to cut lending rates as funding conditions improve.

"To the extent RBI is infusing money, if that money stays in the system and overall liquidity improves, then there will be scope to lower lending rates," said Parthasarathi Mukherjee, managing director and CEO at private lender Lakshmi Vilas Bank.

EYE ON MARKETS

After the RBI announcement, the rupee weakened to as much as 69.78 to the dollar, while the one-year forward premium on the unit in dollar-rupee forward contracts INRANPRM1Y=RR fell to 3.63 from 3.89.

The 10-year benchmark bond yield was up two basis points to 7.57 percent as the move reduced expectations for bond purchases by the central bank, traders said.

Under the arrangement, banks can offer to swap dollars for rupees with the RBI at a premium set by the auction process, which could lower hedging costs for the lenders, traders said.

Traders said such a large swap auction could also be aimed at keeping the rupee from rising sharply on large dollar inflows from deals such as ArcelorMittal's MT.AS nearly $6 billion bid for Essar Steel.

"Apart from a liquidity measure, this is also a forex move," said a trader at a foreign bank.

"The RBI is proactively taking steps given that there are so many private equity and acquisition deals in the pipeline."

($1 = 69.5900 Indian rupees)

(Reporting by Suvashree Dey Choudhury; editing by Darren Schuettler) ((suvashree.dchoudhury@thomsonreuters.com; +91-22-61807223; Reuters Messaging: suvashree.dchoudhury.thomsonreuters.com@reuters.net))