Protecting the rupee by freeing it

The Rupee has breached new lows while the dollar continues to strengthen to Rs 54 and more. Indeed, the December quarter has already seen a drop of more than 10%, after another 10% fall in the previous quarter. But what has caused the rupee to fall?

The "Current Account" deficit
That's what you hear about. We import things. We export other things. Our beloved NRIs send money home ("remittances"). We pay interest on borrowings from abroad. If you sum these up, you get a "current account" balance which is, for India, usually negative.
From April to November 2011, India exported $192.7 billion worth of goods, while imports were $309 billion. The trade deficit is thus more than $116 billion. Adding transfer payments and software services, the "current account deficit" is about $70 billion for the first seven months of the year.
Much of the deficit is fuel — we have already imported $70 billion worth of oil this year (we import 2/3^rd of what we use).
The fact that we run a current account deficit is not new — we have done it for ages now. How then did the dollar stay low? Answer: People wanted to invest in India, so they sent money through the "capital account" — FIIs (Foreign Institutional Investors) brought in money to buy stocks and FDI (Foreign Direct Investment) into the private sector helped bring in the dollars.
Those flows have now dried up. By definition, a current account deficit is ALWAYS financed; so where you can't offset it with capital account inflows, you will find that a deficit will involve the depreciation of the currency. Essentially, since we run a deficit, we need more dollars than we get. The excess demand for dollars depresses our currency.
But the problem isn't just that we run a current account deficit. It is also that we managed to somehow get hugely dependant on capital inflows, which fuelled our economic growth without letting the rupee depreciate too much. In fact the rupee wasn't allowed to strengthen, with the RBI intervening at every moment possible and printing rupees to buy dollars, just so we could retain the rupee above 40. The RBI now owns more than $300 billion of dollars.
Why not have the RBI just sell the dollars they have?
The RBI doesn't want to intervene, and a falling rupee makes our exports really competitive. But the RBI has intervened in the past, mostly to buy the dollar and thus stop the rupee from rising. Doing that creates inflation, as the RBI prints rupees to pay for the dollars it buys. In the other direction, selling dollars requires that the RBI takes the resulting rupees out of circulation.
But the RBI doesn't want to do that, because there is already a shortage of rupees in the system. With rising interest rates, money is scarce and there is so much demand that banks are borrowing in excess of Rs 100,000 crore per day from the RBI (overnight).
Exits: Europe, Policy Paralysis, Overspending and Debt repayments
The problem in Europe has spooked investors, who will not return until the uncertainty around the area comes down. The European problem is so large that it overshadows our economy by a factor of 10 or more, so we shouldn't expect small mercies from those in the line of fire.
The Indian government has itself in knots. The great corruption scandals of 2010 hurt its credibility, and the resulting outrage has stopped all policy action — including having an entire session of parliament voided after protests. Most reforms have been placed on the backburner, avoiding confrontation with a belligerent opposition. A recent proposal to increase FDI in multi-brand retail — an idea that would at best only legalize what currently happens anyway — was scuttled after politicians convinced an uninformed population that FDI would kill their first-born children. With such policy back-pedaling, even I wouldn't trust any new reform proposal until it has spent a year or so without being "reconsidered".
Worse, the government, in an effort to win votes, keeps diesel prices artificially low. Further, minimum support prices for crops have been raised, despite a bumper crop, to attempt to butter-up farmers. But with government revenue falling considerably over the same period last year, there is no revenue to offset such an increase in cost; so the government's "fiscal" deficit will increase, and they will have to borrow money to pay for the difference. Consider that the European debt crisis is a direct result of overspending by peripheral Euro countries, and you'll see why the foreigners think this is a bad idea.
Lastly, Indian companies that borrowed cheaply abroad five years ago now need to return the money back, and they don't have it. Foreign Currency Convertible Bonds (FCCBs) were issued to foreign entities who could "convert" such loans to shares at a certain price — but most companies now trade at a fraction of those prices; the money has to be returned, in dollars. The total amount, over the next year, is likely to be above $15 billion, which will further hurt the rupee.
But What Can We Do?
There are no easy short cuts. We need to recognize that we need to make India attractive enough to invest, and there continue to be artificial hurdles in the way of doing so. For one, the rupee is not fully convertible and rupee assets cannot be held easily outside the country.  There is no reason why the RBI needs the rupee to stay onshore — how does it matter who holds your currency, especially since we allow corrupt businessmen and politicians to hoard it anyhow?
The counter argument has always been that such a move will increase currency volatility but I ask you, is 20% in six months is not too much volatility already?
Additionally, we need to remove regulatory barriers. FIIs cannot invest in government or private debt (without permission). Foreign individuals can't even directly buy Indian stocks or bonds. Permissions are required from the central bank before an Indian company can invest abroad or vice versa (for sufficiently large amounts). Reporting is required for every stock or bond purchase by NRIs, or by FIIs. This puts investors off.
Finally, we need to remove artificial subsidies like those on diesel. Then, a free rupee will immediately impact the price of fuel, which will then cause people to use less of it, a feedback loop that has been woefully missing all these years. Additionally, it causes the government to be less stressed, and that will attract foreign investors to its bonds, leaving our banks to give credit to private people and companies (currently more than 25% of your deposits are loaned to the government).
Iran wants to be paid for in fully-convertible rupees for the oil we buy, but RBI has balked. Perhaps this crisis will force a rethink; while there have been arguments to free the rupee during good times, it seems that we make decisions only when we have our backs to the wall.