The rupee retreated from a four-month high hit earlier in the session on Monday after the Reserve Bank of India (RBI) kept interest rates on hold, dashing some of the positive impact from the government's big bang reforms.
The RBI disappointed investors by keeping its key repo rate on hold, choosing instead to inject more liquidity by lowering the banks' cash reserve ratio by 25 basis points.
The decision cut some of the rupee's gains, although investors still greeted with optimism the measures announced by India on Thursday and Friday, which included raising diesel prices and steps to attract foreign direct investment.
"Overall there may be some disappointment after today's RBI announcement but I would still expect any USD/INR bounce to be sold into, particularly after the positive reforms announced around FDI and diesel prices etc," said Jonathan Cavenagh, currency strategist at Westpac Banking Corp.
"The market has been starved of good domestic news out of India for a long time, hence the positive sentiment in recent session can run further in our view."
At 1.25 p.m. local time, the rupee was at 54.03/04 per dollar, weakening sharply from a session high of 53.66 hit earlier in the session that had marked its strongest level since May 15.
Despite higher-than-expected August inflation data on Friday, some investors had hoped the RBI could cut rates as early as Monday given the central bank was believed to be on hold until the government acted on fiscal reforms.
Last week's actions failed to spur the RBI to act to boost India's flagging economic growth, but analysts still remained optimistic about the rupee's outlook.
The government's big bang reforms, including opening up the retail and aviation sectors to foreign direct investment, are expected to usher in flows from overseas, which should help narrow down the country's cu r rent account deficit, which hit a record $21.7 billion in the March quarter.
The BSE Sensex rose to a new 14-monnth high earlier in the session before also giving up some of its gains.
Provisional exchange data showed foreign investors bought a net 28.3 billion rupees in domestic stocks on Friday, their biggest single day purchase since July 3.
The government's long-awaited action comes shortly after the Federal Reserve announced a new asset purchase programme that could usher a period of global liquidity.
Analysts say both actions together could provide a major push to the beleaguered rupee, which has rallied as much as 3.2 percent against the dollar since its Thursday close but is still down around 12 percent from levels seen last September.
"These reform moves are necessary to help reverse the drastic FDI contraction seen thus far this year into India," Nizam Idris and Teresa Lam, strategists at Macquarie Bank, said in a research note.
Macquarie advised investors to go long on the rupee versus the dollar, while HSBC raised its rupee forecast to 52 to the dollar by-end December from 57 previously.
