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Rupee Set for Prolonged Weakness

NEW YORK ( TheStreet) -- The Indian rupee is one of the world's worst-performing currencies this year, falling to record lows against the U.S. dollar and prompting drastic policy changes from the Reserve Bank of India (RBI).

Most of this currency weakness is being propelled by the country's growing current account deficit, but there are reasons to believe recent efforts to reduce imports and boost capital inflows will have little impact. The rupee is already showing losses of nearly 30% when we look at price activity over the last two years, and it is quickly becoming clear that India could be facing one of its world financial crises in decades.

Restrictions on precious metals imports, the imposition of tighter cash supply, and limitations placed on currency derivatives make up the bulk of the RBI's plans to defend its currency. But these programs do little to attract overseas investment and could have unintended consequences if foreign investors start to view these restrictions unfavorably, withdraw capital, and start to look for new areas to gain exposure to emerging markets.

Most likely, the RBI's strategies will increase borrowing costs both for companies and the government itself, damping prospects for India's GDP outlook into 2014. Add to this the fact that currency defense is a very difficult practice when a country has a large current account deficit, and the chances of success at the RBI deteriorate even further. Official figures suggest India's current account deficit has increased to 4.8% of GDP (another troublesome record), and if capital restrictions negatively influence corporate profits, incentives for investment in the country will be scarce.

At this stage, markets are positioning for reduced stimulus injections from the Federal Reserve, and all of this points to increased uncertainty in emerging markets.

Since the end of May, foreign investors have sold nearly $12 billion in Indian debt, prompting proposals to ease restrictions on foreign investment in some industry sectors. To counter these trends, the RBI will need to make credible assurances that India is be able to attract foreign investment in a sustainable way. But with growing difficulties seen in several major emerging market economies, this will prove to be a difficult task.

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