The first priority for the RBI is to stabilize the rupee in order to avoid scenarios similar to what was seen in the Indian financial crisis of the 1990s. In 1991, GDP growth dropped to 2.1% (down from 5.6% a year earlier) as deepening budget and current account deficits led to currency declines of nearly 40% over a two-year period. This forced the government to request $2.2 billion in emergency loans from the IMF, and led to drastic reforms in India's foreign investment policies. In the years since, growth rates have seen significant improvement -- with GDP topping out above 9% from 2005 to 2008.
On the positive side, India's $280 billion in foreign reserves put the country in a better position to buy time and reverse some of the negative trends we are seeing now. This amount is sufficient to cover import costs for roughly six months. In 1991, India's reserves were enough to cover imports for only two months. But while the current situation is not as dire as what has been seen in previous years, there is still real cause for concern, and a period of prolonged volatility should be expected for the rupee.
India's GDP is growing at 5%, which is the slowest rate since 2003. The RBI has also revised downward its projections for next year, with a 5.5% print now expected.
The real risk for the country's economy would be seen if foreign investors respond negatively to the RBI's latest policy changes and begin withdrawing capital at faster rates. If this occurs, the RBI's policy changes would actually contribute to the economic negatives those changes were meant to correct.
Either way, the Indian rupee will likely experience a period of continued weakness until meaningful progress is made in balancing its international trade flows. With all this in mind, the rupee remains a sell on rallies.
At the time of publication the author held no positions in any of the stocks mentioned.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.