The rupee slumped to a record low in early trade on Tuesday and bond yields hit another five-year high as Asia's third-largest economy bore the brunt of growing money flows out of emerging markets.
The rupee slumped as much as 1.6% to 64.13 to the dollar, adding to its 2.3% rout on Monday, before traders said the central bank was seen stepping in to sell dollars.
The currency recovered slightly in late afternoon, trading at 63.46 at 4pm.
Markets are bracing for further losses, with 1-month non-deliverable forward trading at 64.71.
A spate of measures by the central bank and government has failed to halt the slide, with liquidity tightening measures aimed at making it harder to short the currency pushing up borrowing rates and battering corporate and investor sentiment.
The BSE Sensex index of shares fell 1.2% to an 11-month low. JPMorgan downgraded Indian equities to "neutral" from "overweight", citing strain in the country's balance of payments, while Citi lowered its Sensex target to 18,900 from 20,800.
"India's problems are nowhere near resolution because New Delhi has not done anything - there is no focus on improving productivity, infrastructure or getting FDI (foreign direct investment) back," said Nomura credit analyst Pradeep Mohinani in Hong Kong.
"It's all about stemming the flow of currency and that is not the cause of the problem," he said.
Late on Monday, the Reserve Bank of India increased the foreign direct investment cap in asset reconstruction companies to 74% from 49%.
Earlier on Monday, India banned the duty-free import of flat-screen TVs from August 26.
The 1-month onshore forward rate for the rupee was at 64.47 while the offshore non-deliverable forward was at 64.71, an unusually wide gap that reflected bearish overseas bets against the partially convertible currency.
Emerging market currencies have been under growing pressure from outflows amid expectations the US Federal Reserve will soon start to wind down its super-easy money policy, possibly as early as next month.
Indonesia's rupiah, Brazil's real and South Africa's rand have also been in retreat as investors eye those countries that are most vulnerable to an exodus of foreign capital.
Prime Minister Manmohan Singh's weak coalition government, heading into national elections by next May, has been hamstrung from pushing through reforms to attract more long-term capital.
The rupee's plunge adds to worries about India's ability to fund a record high current account gap and whether finance minister P Chidambaram will be able to meet his goal to pare the fiscal deficit to 4.8% of gross domestic product (GDP) this fiscal year.
Rating agency Moody's said that while the rupee depreciation was a new variable for the economy, the factors underpinning it have been incorporated in its investment grade rating for India.
India is at the lowest investment-grade sovereign rating.
"We believe that meeting the fiscal deficit target will be very challenging this year, given lower than anticipated growth holding back revenue growth and steep rupee depreciation raising the subsidy bill on imported goods," analyst Atsi Sheth said in an e-mailed reply to queries from Reuters.
Bond yields remained at pre-Lehman Brothers-crisis levels for a second straight day. The benchmark 10-year yield was up 20 basis points at 9.43%.
Sensex slips below 18K level
Meanwhile, the BSE Sensex dipped below 18,000 level falling 336.54 points, or 1.79%, to 17,970.98 points in morning trade on sustained selling, extending losses for the third straight day, as rupee plunged to fresh lows amid a weakening trend overseas.
All sectoral indices led by financials and realty trading in negative territory with fall up to 3.08%. Sensex had lost over 1,060 points in the previous two sessions.
Similarly, the wide-based National Stock Exchange index Nifty slipped below 5,400 points mark by falling 91.75 points, or 1.69%, to 5,323.
Brokers said sentiments remained extremely bearish on heavy selling on free-fall in the rupee's value that hit another record low of 64.05 against the dollar, and a weakening trend in the global market as investors bet that the US Fed will soon announce a wind-down of its massive bond-buying programme.
In the Asian region, Hong Kong's Hang Seng index was down 0.30%, while Japan's Nikkei Index shed 0.53 per cent in the morning trade today.
The US Dow Jones Industrial Average ended 0.47% lower in Monday's trade.
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(With inputs from Reuters, PTI, HT)
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