The rupee rose to a one-week closing high on Monday, buoyed by foreign fund inflows and dollar selling by local banks seeking to raise rupee funds amid a cash squeeze which dragged federal bonds lower.
The partially convertible rupee ended nearly one quarter of a percent stronger at 45.0425/0525 per dollar, taking gains over three straight sessions to 0.44 percent.
It last ended stronger at 45.035/045 on December 19, a two-month closing peak.
"Some of the dollar selling we saw today clearly appeared to be related to the high call (overnight funds) rates, with a lot of long positions being squared off to meet rupee funding requirements," a chief dealer at a North American bank said.
"But with stocks falling in recent sessions and some cash (dollar) demand also likely tomorrow, we could see the rupee slipping back, especially if the dollar holds ground overseas."
Tax outflows of 200 billion rupees earlier this month and expectations that some part of another 330 billion rupees needed by the country's largest commercial bank to meet an expatriate deposit redemption could flow out of the banking system have caused a cash crunch that has made overnight borrowing dearer.
The rupee has been mainly buoyed by strong portfolio inflows into local stocks this month, which at nearly $2 billion have helped swell total investment in 2005 to a record $10.5 billion.
The inflows have partly offset pressure on the rupee from a rapidly widening trade deficit that is forecast to hit $48 billion by the financial year-end in March.
But India's benchmark BSE index fell nearly 2 percent on Monday, taking losses in two days to 3 percent as investors took profits from a recent rally that saw the index scale an all-time peak of 9,442.98 points on Friday. Federal bonds eased as the tight money conditions kept investors at bay. Volumes dipped to about 6 billion rupees from a normal average of about 30 billion.
State Bank of India, the country's largest bank, will redeem $7.3 billion of India Millennium Deposits (IMD) on December 29.