The rupee posted its worst daily fall against the dollar in more than two weeks on Monday, tracking a fall in global currencies after a bailout plan for Cyprus that involved taxing bank deposits sent shockwaves across financial markets.
The move broke with previous EU protocol that citizens' savings were sacrosanct and led to concerns about deposits in the rest of the euro zone, with the ripple effects sparking falls in Asian currencies.
On top of the global risk environment, investors will also await the central bank's policy review on Tuesday, where it is widely expected to reduce rates by at least 25 basis points.
"A 25 basis points rate cut is factored into the market prices, so if the cut is above that or the rhetoric is dovish, then the rupee should rally," said Hari Chandramgethen, head of forex trading at South Indian Bank.
The partially convertible rupee closed at 54.1650/1750 per dollar versus its previous close of 54.02/03. The rupee dropped 0.3 percent on day, its worst daily fall since March 1.
Late dollar selling by custodian banks and the euro's paring of losses against the dollar prevented bigger falls in the rupee.
"Custodian banks sold dollars in the market, helping some recovery while the euro also bounced back from the day's lows, helping the rupee further," Chandramgethen said.
Traders expect the pair to hold in a 54.00 to 54.50 range until the policy review on Tuesday. The RBI is scheduled to announce its decision at 11 a.m.
In the offshore non-deliverable forwards, the one-month contract was at 54.57 while the three-month was at 54.16.
In the currency futures market, the most-traded near-month dollar/rupee contracts on the National Stock Exchange, the MCX-SX and the United Stock Exchange all closed at around 54.30 with a total traded volume of $4.8 billion.