MUMBAI/CHENNAI, India (Reuters) - The RBI intervened in the foreign exchange market on Thursday to stop the rupee's slide toward a record low as its defence of the currency, built around draining cash from money markets, came under rising pressure.
With the Reserve Bank of India struggling to hold the line, investors are sceptical whether the government will take swift, credible action to reduce a gaping current account deficit despite Finance Minister P. Chidambaram's assurances.
"The market wants real action," said Param Sarma, chief executive at NSP Forex, a consultancy in Mumbai. "The government and RBI want to keep rupee under control to check inflation and to ultimately reverse tightening measures so they can support growth."
Sarma and many others believe New Delhi could opt to issue a bond aimed at drawing inflows from expatriate Indians, as the central bank has voiced opposition to a sovereign bond issue.
The rupee has lost 11.4 percent since the start of May, and by afternoon was quoted at 60.65 per dollar, as RBI dollar selling brought it off a session low of 60.90 and forestalled a move back toward a July 8 record low of 61.21.
The need to shore up the economy with economic reforms grows more urgent given the prospect the Federal Reserve will at some point start removing its U.S. monetary stimulus, making the global investment environment even more difficult for India.
Goldman Sachs downgraded Indian equities to "underweight" from "market-weight" late on Wednesday, noting the RBI's liquidity tightening measures add to the woes of an economy that grew at a decade-low 5 percent in the last fiscal year and is showing "no signs" of a pickup in investment demand.
RBI Governor Duvvuri Subbarao, whose term ends early next month, reiterated that the central bank's extraordinary liquidity tightening measures last month to curb currency volatility will be maintained until the rupee stabilises.
"These measures will continue until the volatility in the exchange rate is curbed and we are as anxious as everyone else that that is sooner (rather) than later," he said during a speech in Chennai.
Subbarao also spelled out the challenges facing Asia's third-largest economy
"Our growth has significantly moderated, inflation as measured by the wholesale price index has moderated but retail inflation as measured by CPI (consumer price index) is still high, close to double digits. Balance of payments is under stress, our investments have decelerated," he said.
A survey of the manufacturing sector released by HSBC on Thursday showed the slowdown in Indian factory activity deepened in July as order books shrank by the most in over four years. It also showed an uptick in input costs.
Mahindra & Mahindra (MAHM.NS), India's dominant maker of utility vehicles, on Thursday posted a 21 percent annual drop in sales for the month of July and said it would halt production at its plants for up to six days in coming months.
Investors worry Prime Minister Manmohan Singh's weak, minority coalition will be prevented from taking bold action amid political gridlock ahead of elections due by next May.
Numerous economists, as well as the central bank, have cut their India growth forecasts in recent weeks.
"Although the government has taken many policy initiatives on the infrastructure front and pushed through various reforms so far this year, markets may get worried about the potential policy paralysis ahead of the general elections," said Goldman Sachs in its downgrade note.
Chidambaram said on Wednesday the government was looking into various options to attract inflows, including relaxing overseas borrowing rules and curbing some imports.
The Indian economy is stuck in a quagmire of low growth, persistent inflation, a wide current account deficit and a rapidly weakening currency, but policy measures to tackle any one of these will likely worsen the others.
As a net importer, India's import bill is quickly inflated by a weakening rupee, leading to higher inflation and a wider current account deficit, which in turn pressures growth and the country's foreign exchange reserves.
The RBI held its policy interest rates steady on Tuesday, but the high short term rates caused by the liquidity squeeze have already forced some banks to put up lending rates, hurting prospects for investment and economic growth.
The liquidity squeeze has caused bond yields to surge. Benchmark 10-year yields are up around a half percentage point since the RBI's measures.
Foreign investors have been heavy sellers of India debt, unloading almost $9 billion in bonds since late May, and a little under $2 billion in stocks since then.
The central bank has been spotted intervening since May, and as of July 19 its foreign exchange reserves stood at $279.20 billion, roughly enough to cover 7 months of imports. Reserves have fallen from a 2013 peak of $296.37 billion, but not all of the decline is due to currency intervention.
Analysts say that ultimately reforms need to be deepened, perhaps on the scale of 1991, when a balance of payment crisis forced India to liberalise its economy.
"The real solution lies in improving the investment climate by giving a strong push to structural reforms the way it was given in 1991-92 and stimulating key exporting industries," said Rupa Rege Nitsure, chief economist of Bank of Baroda in Mumbai.
Reporting by Rafael Nam, Swati Bhat, and Subhadip Sircar and Manoj Rawal; Editing by Simon Cameron-Moore