Dealers said that robust demand for dollars from oil refiners and a cash surplus that drove overnight rates to their lowest in nearly seven years spurred investors to pare rupee holdings in exchange for the US currency.
The rupee ended at 40.85/86 per dollar, its lowest close in over a week, skidding sharply off Tuesdays 40.48/49, and further away from Mondays nine-year intra-day high of 40.28.
Sentiment for the carry trade, which has benefited the rupee recently, may have reversed a bit, with investors moving out of less risky assets for the time being, said the chief dealer with a private bank.
Chinese shares slumped 6.5% on Wednesday after Beijing tripled a stamp tax, a move widely seen as an effort to limit speculation in its stock market.
A sell-off in Chinese equities should hurt yen carry trades if it triggers risk aversion, as witnessed in late February, DBS Bank said in a note to clients.
That would lead investors to buy back the yen as they unwind carry trades, which were built by borrowing in low-yield currencies such as the Japanese unit to invest in higher-yielding assets like the rupee. The rupee is Asias best performing currency against the dollar this year, gaining more than 8% on strong capital inflows into the fast-growing economy. Overnight rates, an indicator of cash in the banking system, ended at 1% a level it last tested in early June 2000 and lower than 3.5% at the last close.
Dealers said the rupee could see more pressure on Thursday, but the outlook for the medium term remains sanguine on capital inflows slated for Indian equities, including an IPO by property developer DLF Ltd, which is looking to raise up to $2.4 billion.
The overnight rates fell to their lowest in nearly seven years on Wednesday helped by ample cash, but federal bonds ended steady on worries the central bank may drain funds aggressively.
The yield on the 10-year government bond closed at 8.10 %, unchanged from the previous close. Total volume was a thin Rs 2,325 crore ($568 million).