By Subhadip Sircar and Rajesh Kumar Singh
MUMBAI/NEW DELHI (Reuters) - Investors tentatively bet the worst may be over for the rupee on Tuesday as the currency rallied to a two-week high and shares surged on the back of improving global market sentiment, while data showed India's trade deficit narrowed sharply.
Surging exports led the trade deficit in August to narrow to a five-month low of $10.9 billion, providing a rare bright spot after a tough few months for Asia's third-largest economy, which saw the rupee tumble to a record low of 68.85 on August 28.
Although the deficit was wider than expectations - some traders had forecast the gap would be even lower than $10 billion - it nonetheless provided a dose of optimism for an economy growing at a decade-low pace and bodes well for a reduction in the country's record high current account deficit.
The BSE Sensex jumped nearly 4 percent to mark its biggest single-day gain since May 2009, while bonds rallied as well, reflecting how sentiment has swung in less than a week.
Still, investors say the recent gains will need to be sustained by government measures to continue curbing non-essential imports. Expectations are also growing for a hike in subsidised diesel prices that would ease concerns about the government's finances.
"Led by exporter-selling and resumption of portfolio flows, we expect the rupee to recover and test the 63 level soon. However, any sharp recovery beyond 63 may not happen as adverse external factors still continue to haunt the currency," said Param Sarma, chief executive at NSP Forex.
The rupee ended at 63.84/85 to a dollar as against 65.24/25 Friday close. It rose to 63.78 in session, its highest level since August 26.
Improving global investor sentiment also helped the rupee on Tuesday.
Russia's proposal to work with Damascus to put Syria's chemical weapons under international control was seen potentially averting planned U.S. military strikes, while China posted better-than-expected industrial output and retail sales data.
Benchmark Brent oil prices fell, extending Monday's slide, a big factor for India since crude oil is its biggest import.
Bond yields fell sharply, tracking the drop in crude oil prices. The 10-year bond yield was down 12 basis points (bps) at 8.51 percent.
The rally was sparked after former International Monetary Fund Chief Economist Raghuram Rajan took the helm of the central bank last Wednesday and quickly unveiled a spate of measures to support the currency and open up markets.
Hopes that Rajan will unveil more market-friendly measures were boosted further after the Reserve Bank of India late on Friday made it easier for it for non-residents to buy shares of listed companies.
Just a week ago, the rupee had lost more than 20 percent Of its value so far for the year. It is still down over 14 percent.
A Reuters poll last week showed that strategists expected the currency to bottom out to around 66 to the dollar in one month, though it was not expected to regain much ground in the coming year.
The switch in sentiment is also being reflected by flows into shares, with foreign institutional investors (FIIs) buying nearly 20 billion rupees worth of Indian cash shares in the previous three sessions.
THE GOVERNMENT'S TURN
Yet traders still believe the government will need to step up to support the rupee with fresh measures to boost growth and narrow the current account deficit.
The need to act is seen as pressing as investors gear up for the Federal Reserve's meeting on September 17-18 that could determine when the U.S. central bank starts to remove its monetary stimulus, which could trigger fresh turmoil for emerging markets.
Despite the improved trade data in August, analysts also warn India's economy continues to be hampered by a dearth of investment.
There are a multitude of stumbling blocks that could make it difficult for exporters to continue reaping the benefits of the rupee's slide, some analysts said. These hurdles range from erratic taxes throttling special export zones to a cash crunch and clogged ports.
Meanwhile, although the government has been able to cap the trade deficit in June by targeting gold imports through duties and restrictions, that will be sorely tested when India's festival season kicks in starting this month - a period that traditionally leads to a spike in demand for the yellow metal.
"Gold imports bill has shrunk significantly. However, the test for gold imports will come in the coming four months because this is the festive time so the demand destruction we saw over the last few months may see some reversal because of the seasonality," said Shubhada Rao, chief economist at Yes Bank.
(Additional reporting by Manoj Kumar, Suvashree DeyChoudhury & Neha Dasgupta; Editing by Kim Coghill)