The Indian rupee hit a new record low of 59.99 against a dollar on Thursday and stock markets crashed with the benchmark BSE Sensex tanking 526 points or nearly 3% after the US Federal Reserve signalled a timeline to wind down its monetary stimulus programme by mid-2014.
India's policymakers moved to soothe nervous markets saying it was ready with an action plan.
"We should not let ourselves be led by the markets into directions we don't want to go," India's chief economic adviser Raghuram Rajan said. "Let me emphasise, we are not short of actions and instruments if and when the need arises."
The Reserve Bank of India (RBI) also swung into action selling dollars through state-run banks to prevent further currency shocks, forex dealers said.
A weak rupee, which has fallen 9% since May and closed at 59.57 to a dollar on Thursday, besides making overseas travel expensive, can also fan inflation by making fuel and other imported goods costlier.
Oil companies fear that if the rupee continues to weaken, petrol prices would have to be hiked again by another Rs. 2 a litre (excluding taxes) by this month-end. Petrol prices were raised by more than Rs. 2.5 a litre last week.
"We cannot sustain losses and will ask the government to pass on a higher 'one-time increase' in diesel prices to consumers as a fall out of the fall in rupee value," a senior oil company official said.
Also, higher inflation will limit RBI's ability to cut interest rates dimming hopes of lower loan EMIs for individuals. Also, the record current account deficit - the difference between dollar inflows and outflows - may restrict RBI's scope to prop up the rupee.
The apex bank could do this by dipping into its $290 billion of foreign exchange reserves, enough to cover imports for seven months, analysts said.
"A ballooning CAD and cloudy outlook of reforms have added to the local currency's woes," said Kuntal Sur, director, KPMG, an audit and consulting firm.
The US Fed is pumping in $85 billion (about Rs. 5 lakh crore) a month in the US economy as part of a plan designed to aid the economic recovery.
Part of these funds came into Indian equities. But, with the Fed siginalling a roll back, portfolio investors have begun withdrawing money from Indian markets.