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Top Performing Currency in 2013? Not What You Think

Asia's biggest laggard could turn into one of the best performers next year. We are talking about the Indian rupee which has tanked 13 percent since its peak in February, but one expert predicts this beleaguered currency is in for a big turnaround in the new year.

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Weighed down by anemic growth and lack of investor interest as the government struggled to implement economic reforms, the Indian rupee has had a tumultuous year. For example, it fell more than 17 percent over February-June, raising the cost of imports and fueling inflation.

But come 2013 and the rupee will see its fortunes change, according to Bank of America-Merill Lynch (BAML), which expects the currency to rise 10 percent against the U.S. dollar next year.

The bank's forecast is based on expectations of a loosening in monetary policy and more economic reforms from India to attract foreign direct investment. In September, the Indian government came up with a slew of investor-friendly initiatives like opening up the retail and aviation sectors to foreign investment.

"We are in a low global growth, excess liquidity environment, where capital flows will drive the appreciation. It (rupee) could be one of the world's best performing currencies next year," said Claudio Piron, head of Asia ex-Japan fixed income and forex strategy at Bank of America-Merill Lynch.

He added that the Reserve Bank of India (RBI), which has held the benchmark interest rate at 8 percent since April, will cut rates by up to 100 basis points next year, helping to support the country's growth outlook and boost inflows into its equity market — a positive for the rupee.

India's stock market, after being one of Asia's worst performers last year, has risen 25 percent so far this year, attracting more than $19 billion in foreign institutional investor inflows. About $7.5 billion of which entered the market after the government announced its reforms in mid-September.

While India's growth has largely disappointed investors this year, slowing to 5.3 percent in the third quarter, Piron said he expects a pickup in momentum next year to 6.5 percent from around 5.5 percent for 2012. He forecasts inflation to ease to an average of 6.8 percent next year, from 7.6 this year.

Too Many Uncertainties

While, the currency offers value to investors as it is trading at historical lows when measured against a basket of 36 currencies, Justin Harper, strategist at IG markets, said the rupee is a dangerous currency to bet on given the history of Indian politics and the government's track record on u-turning on reforms.

Late last year, the government went back on its promise to allow foreign direct investment into multi-brand retailing under opposition from political rivals.

(Read more: Indian Government Agrees to Vote on Supermarket Reforms)

"If you've had two bad years – there's no reason they can't have 3 bad years," Harper said referring to the fact that the rupee fell 19 percent in 2011, and is likely to end this year lower too.

So far, over the past 10 years, no Asian currency has delivered two consecutive calendar years of losses.

Jonathan Cavanagh, senior forex strategist at Westpac, who is upbeat on the currency, forecasts it to strengthen against the greenback next year, but at a slower pace. He expects the rupee to appreciate a little over 2 percent by the end of next year to around 53 against the greenback, however, agrees there are many risks facing the currency.

"We see the rupee rising against the U.S. dollar next year, but there are many factors at play – how the reform agenda goes, you need to see some real positive steps on the foreign direct investment front," he said, adding that the success of the rupee will also depend on global risk sentiment, how much the RBI is able to cut rates by and whether India is able to reduce its trade deficit.

India has been struggling with a ballooning trade deficit, which surged to $185 billion for the financial year ended March 2012, due to elevated oil prices. The country imports two-thirds of its crude needs.

"From my perspective you need to see a lot of boxes ticked, but if they do get ticked, it could be one of the best performing currencies next year," Cavanagh said.