Will the Indian Rupee Stage a Big Turnaround in 2012?

The Indian rupee has been among the major beneficiaries of the government’s latest economic reform efforts – gaining over 2 percent against the dollar over the past week – and analysts say this may trigger a greater rebound in the beleaguered currency, which could rise as much as 8 percent by the year-end.

Indian Rupee banknotes
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Indian Rupee banknotes

A combination of positive domestic drivers alongside an improvement in global liquidity conditions, as a result of easing by central banks in the West, will drive the currency higher this year, say experts.

Unlike India’s stock market, which has been among the best performing in Asia, the rupee has been badly hit by concerns over the country’s twin deficits – both current account and fiscal – and slowing economic growth, which hit 5.5 percent in the second quarter. Between February and July this year, the rupee depreciated 12 percent against the U.S. dollar.

Radhika Rao, Economist at financial research firm Forecast, says the rupee could touch 50 against the greenback by the end of 2012, an increase of 8 percent, as investors cheer reforms to boost foreign investment.

Last Friday, the Indian government announced a slew of long over-due measures to boost investment, including approving foreign direct investment (FDI) in broadcast, multi-brand retail and aviation, together with partial privatization of four state-run industries. This came on the heels of a cut in fuel subsidies a day earlier.

These measures drove the rupee to 53.66 against the dollar on Monday - its highest level in four months. The currency has since pulled back slightly trading around 54.

Rao adds the rupee is likely to gain support from monetary easing by the Reserve Bank of India (RBI) in the coming months. The central bank, which has kept its benchmark rate on hold since April, is widely expected to cut rates by 25 basis points before the end of the year, according to a Reuters poll.

While a rate cut is typically negative for a currency, such a move would help strengthen the rupee as it would be seen as positive for growth, she said.

Paul Mackel, Head of Asian Currency Research at HSBC, is also optimistic on the rupee’s outlook, forecasting the currency to touch 52 against the dollar in the near-term, before appreciating further to 49 in 2013.

“The rupee deserves to be on a better footing versus the U.S. dollar on the back of these measures, although there still are implementation risks,” he said.

The Indian government has a history of flip-flopping on policies in the face of political pressure. In December 2011, for example, the government unveiled plans for FDI in multi-band retailing, only to back away from it days later.

Daniel Hui, Head of Emerging Markets Asia FX Strategy at JP Morgan, who also expects the rupee to reach 52 over the next month, says recent monetary stimulus announced by the Federal Reserve will help boost risk currencies in Asia that have been out of favor with investors.

“The rupee has been oversold for the past year. The Fed and also the European Central Bank taking away some of the global tail risk has given the go ahead for the rupee to start recovering,” he said.

However, Jonathan Cavenagh, Senior FX Strategist, Westpac Institutional Bank, says it’s still early days to assess the impact of the new reforms on the currency.

“It would take 3-6 months to see how much FDI is likely to come into India, and what kind of impact that will have,” he said.

By CNBC's Ansuya Harjani