The Indian rupee posted on Friday its biggest daily gain in two-and-a-half months after the government's diesel price hike raised hopes for more fiscal reforms, while the Federal Reserve's stimulus action sparked a rally in global risk assets.
However, the rupee's session was slightly marred by higher-than-expected inflation, which dented hopes the Reserve Bank of India would consider cutting interest rates as early as its policy review on Monday.
Still, analysts said more policy reforms could increase the prospects of monetary easing, given central bank officials have repeatedly pressed the government to take action to shore up its finances first.
Any rate cuts could help boost foreign inflows into stocks and further shore up confidence in the Indian economy at a time when the dollar is under pressure after the Fed's liquidity measures.
"We had everything going right for the rupee today. But I am not too sure how long this will sustain to be honest," said Ananth Narayan, co-head of wholesale banking for South Asia at Standard Chartered Bank on Friday.
"The steps taken by the government are pretty positive. I think the market is re-rating the possibility of a ratings downgrade now and thinking it will not happen. But it doesn't take away the basic issues like the lack of growth, infra projects not taking off, etc.".
Narayan said he expects the rupee to trade in a 53.75-55.00 range next week.
The partially convertible rupee closed at 54.30/31 per dollar, gaining 2.1% from its close of 55.43/44 on Thursday to mark its biggest single-day gain since June 29.
The unit rose as high as 54.29 during the session, its strongest since July 4.
Traders said gains in the domestic shares also boosted the rupee – which gained 1.9% for the week to mark a second consecutive weekly gain – and fuelled hopes for more foreign fund inflows.
India's 14% increase in diesel prices announced on Thursday was widely seen opening up the prospect of further reforms.
After the markets close on Friday, India said it would allow foreign supermarkets to invest in local chains, while also opening up the aviation sector to foreign direct investment.
That, combined with the potential increase in global liquidity from the Fed's decision to revive a new asset purchase programme, could help support Indian markets.
"The government's recent measures to hike fuel prices is likely to, at least temporarily, calm investor anxiety about the domestic fiscal position and ensure that fund flows into domestic markets remain strong," economists at HDFC Bank wrote in a note.
In the offshore non-deliverable forward market, the one-month contract was at 54.43 while the three-month was at 54.98.
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 closed at around 54.29 with a total traded volume of around $7.6 billion.