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India's rupee hits record lows, here's what it means

Nathan Blaney | Photographer's Choice RF | Getty Images

The broad-based selloff in emerging markets has pushed the Indian currency into free fall, underscoring the need for investors to tread more cautiously.

The rupee has slumped 11 percent this year, touching a record low this week, as investors have pulled cash out of emerging markets on concern the Federal Reserve will ease up on its monetary stimulus as soon as next month. Better growth prospects in the U.S. relative to developing economies have further exacerbated the move away from emerging markets.

"For emerging markets, this is the biggest stress test since Lehman Brothers," Nicholas Spiro of Spiro Sovereign Strategy said of potential Fed tapering. "Clearly now, investors are forced to become more discerning."

Countries including India, Turkey and South Africa have seen their currencies, stocks and bonds hit hard because of their large current account deficits. That makes them more vulnerabie to the withdrawal of Fed stimulus and the resulting rise in capital costs. Other countries, like Russia, which run surpluses are more immune.

(Read more: Wild swings? Emerging currencies have it the worst)

India's current account deficit was 4.6 percent of gross domestic product, or $88 billion, in the fiscal year ending in March, up $10 billion from a year earlier.

To support this massive deficit, India requires steady inflows of capital into its equity markets from abroad. But as the Fed probably will start paring back its bond purchases, investors have fled.

The MSCI India index, a benchmark for international investors, has dropped 15 percent year to date in dollars. The MSCI Emerging Markets index is off 10 percent in 2013.

(Read more: This market may be a 'slow-moving train wreck')

India also has major structural challenges, and politicians have been unable to address the budget deficit or undertake much-needed economic reform.

"India has all the combined vulnerabilities of emerging markets," said Ilan Solot, emerging market currency strategist at Brown Brothers Harriman.

He said the ideal way to stem the currency's decline would be for officials to address India's budget deficit.

The central bank, which has already raised rates to arrest the rupee's fall, could intervene more aggressively. Solot points out that it has $250 billion in foreign exchange reserves to use.

"At this point it [has] become clear that the timid FX intervention by the RBI and the medium- to long-term measures taken by Indian authorities are not enough to alter sentiment towards the rupee," Solot wrote in a note.

But there may be little the central bank and incoming chief Raghuram Rajan can do to solve the longer-term issues.

(Read more: Can the new RBI chief survive India's 'poisoned chalice'?)

"India's economic crisis has been a problem of governance, and that falls squarely on the shoulders of government," said Vansight CEO Anantha Nageswaran. "And it's unlikely to do anything dramatically meaningful and positive for the economy in terms of uplifting the aggregate supply, which is what will bring down the current account deficit and restore long-term growth prospects."

Structural reforms and deregulation are also needed, experts say.

"The growth rate has for several years not been back up to the 9 percent that India is hoping to achieve," Frederic Neumann, HSBC's co-head of Asian economics research, told CNBC. "To achieve that, they need far-reaching structural reforms."

What the recent swoon in India and emerging markets underscores is that some countries will be better able than others to weather Fed tapering, as well as additional challenges—such as a China economic slowdown and the end of the commodities supercycle—facing the asset class.

Spiro is starting to see pockets of attractiveness in emerging markets, but there's still a lot of uncertainty about how this transition is going to play itself out.

"It's a sensitive time for emerging markets assets," he said. Investors looking to get back into emerging markets once the dust settles will need to be more discerning than in the past.

And while emerging market equities overall look fairly cheap, the big theme now is differentiation, said Spiro, adding that "investors really have to do their homework."

Others agree.

"Stock-picking remains the way to go," Slim Feriani of Advance Emerging Capital told CNBC.

By CNBC's Justin Menza. Follow him on Twitter @JustinMenza.