The Indian rupee dropped sharply to two-month lows on Tuesday as banks bought dollars in the spot market to arbitrage offshore, while shares shed nearly 3 percent, sparking fears of further foreign fund outflows. The partially convertible rupee closed at 49.67/68 per dollar, 1.7 percent weaker from Monday's close of 48.84/85. "There was huge dollar demand from banks who were arbitraging between the onshore and offshore markets today, stocks were also lower," a senior dealer at a state-run bank said. Dealers said most of the arbitrage was concentrated in the one-month and three-month forward contracts. The one-month forward contract PNDF was quoting at 50.08/18, weaker than the onshore spot rate. Banks regularly buy dollars locally and sell them offshore to take advantage of the high price differential, weakening the rupee in the spot market. Indian shares .BSESN dropped for a second day on Tuesday, falling 2.9 percent to their lowest close in three weeks, as weak world markets hit sentiment. On Monday, the federal budget for the 2009/10 fiscal year disappointed markets as it failed to deliver any major stimulus for a slowing economy [.BO]. Foreigners have already withdrawn about $1 billion from Indian shares so far this year, after dumping more than $13 billion last year. Inflows have been a major driver for the rupee in recent years. India's central bank sold $318 million in intervention in December, sharply lower than $3.1 billion it sold in November, as the rupee pulled back from a slide, the central bank's bulletin showed. See [ID:nBOM427945]. Dealers said the dollar's strength overseas also hurt rupee sentiment. The dollar rose broadly while the euro hit a more than two-month low on Tuesday, pressed by concerns over a recession in eastern Europe and the knock-on effect on European banks.

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