The rupee dropped to its lowest in nearly a week on Monday after the Reserve Bank of India (RBI) kept the key interest rate and the cash reserve ratio unchanged, with a Fitch downgrade of the country's sovereign outlook also hurting.
The rupee fell to as low as 56.04 to the dollar late in the session, and traders fear the currency could approach the record lows of 56.52 hit on May 31, should confidence in the domestic economy deteriorate, or if the global risk environment worsens.
The burden now falls on the government to revive growth and close its fiscal and current account deficits, but it would need to regain the confidence of markets after policy inaction and reversals were key reasons behind the rupee's slump last month.
"We may re-test recent record lows as soon as by the end of this week, and hence need to watch out for RBI, unless we get some positive moves from the government," said Vikas Babu Chittiprolu, a senior forex dealer with Andhra Bank, referring to intervention.
The partially convertible rupee closed at 55.9050/9150 per dollar as per the SBI closing level versus its previous close of 55.39/40 on Friday.
The BSE Sensex dropped 1.4 percent, the biggest percentage fall since June 1, led by a sell-off in lenders after the RBI's surprise move.
The RBI cited its continued concerns about inflationary pressures in declining to ease monetary policy after last cutting the repo rate by 50 basis points in April.
That leaves the rupee beholden to swings in sentiment about the country's fiscal and economic outlooks.
Late on Monday, Fitch Ratings cut India's sovereign outlook to "negative" from "stable", saying growth potential would "deteriorate" unless the country implements structural reforms, and citing "limited progress" on fiscal consolidation.
The action, followed Standard & Poor's outlook cut in April.
"What is required is that the government sends a signal that it is not just watching but is ready to act as well," said Paresh Nayar, head of fixed income and FX at First Rand Bank.
Nayar said India could look at reforms including in pension, foreign direct investment in retail, or in diesel prices.
"They may not do it all, but going by the way the government coalition has reacted in recent days, some reforms look possible and they are very much needed," he added.
The rupee also remains vulnerable to any worsening of the global risk environment.
The euro fell from a one-month high against the dollar as relief on Monday at the election win for pro-bailout parties in Greece quickly gave way to fears over Spain's borrowing costs, which surged to levels seen as unsustainable.
Still, some traders are hopeful about some type of stimulus from the Federal Reserve, which ends a two-day meeting on Wednesday.
The one-month offshore non-deliverable forward contracts were quoted at 56.22 while the 3 month were at 56.96.
In the currency futures market, the most-traded near-month dollar-rupee contracts on the National Stock Exchange, the MCX-SX and the United Stock Exchange all ended around 56.02 on a total volume of $5.5 billion.
