In particular, new Reserve Bank of India (RBI) rules that reduce trading limits of Indian banks and companies could have the unintended effect of hampering their ability to hedge, choking off market liquidity and driving a chunk of trading to offshore markets.

The rupee's weakness -- a drop of nearly 20 percent from July highs to a record low last week -- reflects the increasing doubts of foreign investors over the ability of India to tame high inflation, prop up falling growth and rein-in its large fiscal and current account deficits.

Citigroup expects rupee trading volumes to drop by 25 to 30 percent after measures implemented late last week.

Thinning liquidity could amplify volatility, dragging the rupee beyond last week's record low if bearishness morphs into a full-fledged selloff.

"Structurally, it will reduce liquidity and this will mean more volatility in the long run, but this is acceptable as the move reduces pressure for now," said Dariusz Kowalczyk, senior economist at Credit Agricole in Hong Kong .


Restrictions in the onshore market could also drive more flows to the flourishing offshore non-deliverable forwards market, where rupee volumes are exceeded in Asia only by the Korean won and the Chinese yuan.


A senior FX trader at a European Bank in Mumbai said onshore banks would be wary of trading large volumes with their clients on worries they would not be able to offset their exposure.


The best hope for the rupee, traders and economists argue, is for India to get its fiscal and economic house in order.


"As long as India's fundamentals remain weak, these various capital controls will not help the rupee in the longer term," said Ila Patnaik, an economist at the National Institute of Public Finance and Policy in Mumbai.


"By restricting currency trading, the RBI (Reserve Bank of India) is sending a wrong message out to market participants, especially companies with genuine needs," she said.


The RBI has taken a slew of measures to stem the rupee's fall, including raising quotas for foreigners to buy local debt, encouraging domestic firms to borrow more overseas, and even intervening in the foreign exchange market, something it does only in order to ease volatility.


Late on Friday, the RBI lifted the cap on interest rates local banks can pay non-resident Indians on foreign currency deposits, which might attract short term inflows but exposes India to volatile hot money.


On Thursday, the rupee sank to a record low 54.30 to the dollar, down almost a fifth from its July highs, making it the year's worst performing currency in Asia.


It got a bounce on Friday after the RBI took measures to curb speculation but it has resumed its decline since then, with market players saying the only way to improve the outlook for the rupee is to turn around a flagging economy.


"These are measures which will definitely reduce speculation from the market but what will it do is make the market shallow," said
the head of FX trading at an Indian bank in Mumbai.


"Desirable or not desirable, it has shown results. This is the most unsophisticated way of doing things and a very crude way of handling things," said the trader, who declined to be identified.



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