The rupee fell to its lowest in nearly a week on Thursday as a key ally of the country's ruling coalition withdrew its support, raising worries the government may roll back key reforms such as the hike in diesel prices.
Prime Minister Manmohan Singh's government is widely expected to survive the blow to its parliamentary strength, but the planned withdrawal by the Trinamool Congress in opposition to the diesel and retail reforms announced last week will put the fate of the government in the hands of regional parties.
Investors are especially worried the government will roll back some of its measures, and fear the political crisis could threaten future reforms in sectors such as pension and insurance.
The government is considering a limited rollback in the diesel price hike but will offer no U-turn on allowing foreign investment into retail chains, sources told Reuters.
"The rupee's fall is being driven by the political instability," said Ashtosh Raina, head of forex trading at HDFC Bank.
"The rupee may weaken more if there is marked instability over the next few days. However, I do not expect it to weaken beyond 54.50 in the immediate term."
At 11:08 a.m. local time (0435 GMT), the rupee was at 54.32/33 to the dollar from its Tuesday close of 54.01/02.
It fell to 54.42 earlier in trade, its lowest since September 14. The market was closed on Wednesday for a religious holiday.
USD/INR 1-month non-deliverable forwards were bid and last trading at 54.54 versus its previous close of 54.49.
Local stocks were also lower, with the benchmark BSE index down 0.5 percent.
The rupee has gained over 2 percent since the government announced a steep hike in diesel prices and opening up the multi-brand retail sector to foreign direct investment.
The local unit could remain volatile in the days ahead, as investors track political developments.
Opposition parties have called a nationwide strike on Thursday to protest against the government's reform moves, while Trinamool has said the resignations from its ministers in the government will be tendered on Friday.
UBS called Trinamool's withdrawal "political theatre", but warned they could threaten the government's reform initiatives.
Trinamool's decision "raised not only political entropy but also the risk that announced measures may be either diluted or delayed," UBS said in a noted dated on Wednesday, although the bank added "it may still be too soon to capitulate on tactical INR longs."
