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India's Tumbling Currency Matters, and Here's Why

Prashanth Vishwanathan | Bloomberg | Getty Images

The Indian rupee has been plunging for more than a month, stoking inflation and spreading fear of a crisis among investors.

Expectations that the Federal Reserve will start tapering its bond-purchasing program this year have strengthened the dollar and sent emerging markets' currencies—including the rupee—plunging.

As of Monday, the rupee has weakened more than 9 percent against the dollar since May 22, when Fed Chairman Ben Bernanke first mentioned the possibility of slowing its asset purchasing.

Adding to the pressure, foreign investors have withdrawn $4.7 billion from Indian bond funds, and the key issue now is whether Indian equities also will see major outflows, analysts from Standard Chartered wrote in a note.

"Indian equities have been one of the largest beneficiaries of the Fed's quantitative easing program among AXJ markets [Asian markets except Japan]. As such, they are quite vulnerable to early tapering expectations," they said in a note.

And with a 6 percent weighting in the benchmark MSCI emerging markets index, weakness in Indian stocks could signal more declines for the broader index.

A weaker Indian currency could add to inflationary pressures, widen the fiscal deficit and slow capital inflows, Standard Chartered analysts warned in another note.

In the past two years, the Indian government has implemented some positive reforms, Steven O'Hanlon, chief investment officer for fixed income at ACPI, told CNBC. Inflation has fallen, he added, and the current account deficit numbers have come in slightly better.

(Read More: Indian Rupee Hits Record Low, but Some Relief Ahead)

"However, the crisis that comes today with the talk of tapering in the U.S. is a little bit early ... in terms of those reforms coming to hard numbers," he said, adding that the current account has improved somewhat and that India is doing better compared with other emerging markets where current accounts are shrinking.

With the Fed's quantitative easing, capital poured out of low-yielding developed markets into emerging markets, but it will have to rebalance as yields pick up in the U.S. and Europe, O'Hanlon said. The question is whether India's reforms are enough to mitigate the outflows, he added.

A weaker rupee will also hurt India's business environment.

"Most Indian exporters deal with buyers who demand discounts whenever the INR weakens, and the lack of a globally recognized 'Made in India' brand forces exporters to provide heavy discounts," Standard Chartered's analysts said in a note.

(Watch Video: Expect a Bout of Reforms From India: Pro)

Weaker currency usually boosts exports, but in this case India gets limited benefits. Rivals such as South Africa and Indonesia—which compete with Indian textile, agriculture and engineering exports—also have seen their currencies devalued, boosting local exports, Standard Chartered's analysts wrote. As of last week, the South African rand has lost more than 18 percent and the Indonesian rupiah around 4 percent against the dollar since the beginning of the year.

"In the short term, the talk of possible Fed tapering and global liquidity concerns will continue pressuring the rupee," O'Hanlon said.

By CNBC's Anna Andrianova. Follow her on Twitter @AndrianovaAnna.