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By Suvashree Dey Choudhury and Tony Munroe
MUMBAI (Reuters) - India left interest rates unchanged, but the rupee lost 1.8 percent against the dollar in its deepest plunge in more than a month as investors worried that further measures will be needed to support a currency that is teetering close to a record low.
The dovish tone struck in the Reserve Bank of India's policy statement had caused the rupee to sag, but it then crumpled when Governor Duvvuri Subbarao poured cold water on chances for a sovereign bond issue to help plug a yawning current account gap.
"In the Reserve Bank's view, the cost of a sovereign bond issue, especially in the current juncture, outweighs benefits," Subbarao told reporters after delivering the final monetary policy statement of his five-year tenure, unless it is extended.
As expected, the RBI left its policy repo rate at 7.25 percent and held banks' cash reserve ratio at a record low 4.00 percent, but said it will roll back recent liquidity tightening measures when stability returns to the currency market, enabling it to resume supporting growth.
Bond investors were initially cheered by that stance, but lost heart once they saw the rupee begin to slide.
The partially convertible rupee tumbled past the symbolically significant 60 per dollar, ending the day at 60.47.
"There were no rupee supportive measures in the policy, like a hike in the policy rate," said Navin Raghuvanshi, associate vice president at Development Credit Bank.
Earlier this month, the RBI took steps to tighten market liquidity and push up short term interest rates in order to make it harder to speculate against the currency after it hit a record low 61.21 to the dollar on July 8.
"Markets will test the RBI again ... and possibly this will provoke new RBI measures," said Dariusz Kowalczyk, senior economist for Asia excluding Japan at Credit Agricole CIB in Hong Kong. "The bank's credibility is at stake now that it is targeting primarily the currency."
Subbarao is in a tough position. The rupee has given up all the gains since the RBI's rescue measures on July 15, which came at the cost of squeezing corporate borrowers and crimping India's already weak growth outlook.
The longer the squeeze goes on the more likely it becomes that commercial banks will have to raise their lending rates -- dealing another blow to an economy that grew at a decade low of five percent in the last fiscal year.
Pratip Chaudhuri, the chairman of State Bank of India, the country's largest bank, said his own bank would take a decision in two or three weeks.
On Tuesday, the RBI cut its growth forecast for Asia's third-largest economy to 5.5 percent from 5.7 percent for the current fiscal year.
Subbarao said that, had the currency been stable, the growth and inflation balance would have allowed for sticking with a monetary easing stance.
"India is currently caught in a classic 'impossible trinity' trilemma whereby we are having to forfeit some monetary policy discretion to address external sector concerns," Subbarao said.
Subbarao repeated his call for the government to take urgent steps to bring down a current account deficit that hit a record 4.8 percent of GDP in the last fiscal year.
However, New Delhi has struggled to implement measures to attract foreign corporate investment, and with elections due by May, Prime Minister Manmohan Singh's weak coalition government has limited room for pushing through further reforms.
Officials in New Delhi said Finance Minister P. Chidambaram would likely hold a news conference on the economy on Wednesday.
Chief Economic Adviser Raghuram Rajan said the government was considering various ways to narrow the current account deficit, including expanding exports.
The current account gap makes India especially vulnerable as global investors move away from emerging markets in anticipation of a winding down of loose U.S. monetary policy.
"Most external vulnerability indicators have deteriorated, eroding the economy's resilience to shocks," Subbarao said.
Turkey, Brazil and Indonesia have all raised rates to counter capital outflows.
Indian policymakers will be hoping the U.S. Federal Reserve doesn't spark a fresh surge in flows away from emerging markets when it holds its policy review this week.
(Additional reporting by Shamik Paul, Subhadip Sircar, Swati Bhat and Neha Dasgupta; Editing by Simon Cameron-Moore)