Here are 3 possible risk scenarios in India's monetary policy woes

INR weakness continues to accelerate.

According to Bank of America Merrill Lynch, Indian Rupee's (INR) weakness accelerated today with spot reaching a historical high of 68.755 intraday, a fall of 2.75%.

In ytd terms, this represents a fall of 19.3% - the steepest fall since the balance-of-payments crisis in 1991. This begs two key questions: First, what is driving this dynamic and second, what are the risks.

Here's more:

INR depreciates and we have to wait for the current account to correct and assume less FII inflows under Fed QE tapering. A conservative estimate is USD/INR goes to 70 year-end and 75 by-end 2014 based on NDF forward pricing.

#1 Very likely policy action – NRI (Non- resident Indian) bond issue. We stabilize USD/INR at current levels, but stay in elevated trading range USD/INR 63-69.

#2 Likely policy action – hike rates. Failure to attract capital inflows amid Fed tapering and 2014 India election uncertainty runs the risk of a crisis of confidence.

This would likely accelerate INR weakness to 75 by year-end and induce emergency rate hikes, but cause an earlier stabilization and recovery in USD/INR back to 65-70 levels by mid-2014.

#3 Unlikely – capital controls: This goes against India’s FX legislation and will deter the future inflows required to fund the existing current account deficit.

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