The rupee weakened on Tuesday after swinging in a wide band after the Reserve Bank of India (RBI) kept both interest rates and its hawkish policy stance intact, depriving the economy of near-term drivers to boost growth.
Instead, the focus is shifting to the government to step in with fiscal reforms and measures to attract foreign investment, both of which will be key to sustain the rupee's rebounds from the record lows seen in late June.
However, investors are losing some of their confidence as the government faces policy disagreements among its coalition allies, while weaker-than-expected rains during the monsoon season further raise the stakes.
"The RBI highlighted India's challenges without offering a clear path to overcoming them, which will be negative for market sentiment," said Dariusz Kowalczyk, an economist with Credit Agricole in Hong Kong.
"Policy makers also commented on other macroeconomic indicators i.e. current account and fiscal balances, saying that failure to narrow the twin deficits may threaten stability. Such talk is negative for the INR," he added.
The partially convertible rupee closed at 55.6450/6550 per dollar, marginally weaker than its close of 55.5850/5950 on Monday.
The pair moved in a wide band of 55.40 to 55.85 during the session, with month-end dollar demand from oil importers seen in morning trade waning towards the close.
After starting July with strong gains, the rally started to fizzle out towards the second half, with the rupee closing down 0.1 percent for the month against the U.S. dollar.
The RBI left interest rates unchanged on Tuesday for the second straight policy review, showing that bringing down stubbornly high inflation is its top priority even as economic conditions deteriorate.
On a more positive note, the central bank separately said it will allow companies to keep all of their foreign exchange earnings while also easing restrictions on forwards contracts.
The actions reverse two regulations passed during periods of intense rupee volatility, and traders say it could indicate the central bank's improved confidence the worst may be over for the rupee.
"Spot got sold off a bit after the release but the steps are broadly positive for rupee sentiment. We can see some good two way movement in the spot in the rest of the week and we could also see some positive news flow as well," said Ashtosh Raina, head of foreign exchange trading at HDFC Bank.
In the near-term, the rupee will likely be driven by global risk factors in a week in which some investors hope the European Central Bank or the Federal Reserve will announce further monetary stimulus measures at their policy meetings this week.
The month-month offshore non-deliverable forward contracts were at 55.92 while the three-month was at 56.56.
In the currency futures market, the most-traded near-month dollar rupee contracts on the National Stock Exchange, the MCX-SX and the United Stock Exchange all closed at around 55.87, with a total traded volume of around $5 billion.
(Editing by Rafael Nam)