Will the Rupee really appreciate in 2013?

Thequestion whether the rupee will perform better in 2013 as against itsperformance in 2012 remains doubtful.

The Indian currency was mostly unstable in the year gone by. The first twomonths saw the rupee appreciating as the RBI took effective steps such asbanning the rollover of forward contracts and limiting the overnight positionsin currency.

This was assisted by strong capital inflows by the FIIs into the country.However, as the government remained politically inactive and charges ofcorruption emerged almost consistently, the Indian currency spiraled down.Worries about the high twin deficits also led the currency to depreciate byaround 16% from the beginning of March to mid of June.

The situation improved with a slew of reforms in the third quarter. This helpedin arresting the fall in rupee. Increasing the FDI limits in sectors such asretail and aviation and reduction in the diesel subsidy were the domesticmeasures taken by the Indian government. The Federal Reserve's decision tocontinue injecting liquidity led foreign funds into the country therebyimproving demand for rupee. This situation was though short-lived. With the financeminister failing to come up with a proper guidance on restricting the fiscaldeficit to 5.3%, once again the rupee showed weakness and wiped off the gainsin the third quarter.

So, would the current year be positive for rupee or would it continue todepreciate further? The answers to these questions hinge on the movement of interestrates and how successfully the twin deficits are dealt with. Though in the nearterm interest rates are expected to be benign to encourage investments in the economy,there is an uncertainty looming large over how the government deals with twindeficits.

One of the biggest determinants in the movement of the domestic currency willbe the stance taken by the RBI. The central government has been keeping a tightposition on the Repo rate in the wake of high inflation. With the latest inflationnumbers showing positive signs the RBI is expected to pay heed to the flagginggrowth rate. Most of the analysts in the street expect a rate cut in the nextRBI monetary review.

The fall in rates will surely lead to lower foreign investments in the debt market but this will be made up by the investments in the equity market. With lower interest rates, the investment cycle will see a fresh upturn and will bring relief to major sectors such as capital goods, infrastructure and realty, which are currently under stress. To put it simply, reduction in interest rates will set India again on the growth platform.

However, the twin deficits continue to remain a matter of concern for Indian currency. Gold and oil continue to be the major pain points in the country's balance sheet.

The increase in consumption of gold has negated the positive impact of stabilising gold prices. Despite several measures taken by the government to curb demand for gold, the investment in the yellow metal has not shown any signs of relief. A latest report showed the farmers under the NREGA scheme, having excess cash, investing in gold. The government's intention to hike the prices of diesel in a phased manner stands to be a healthy one.

However, it does not come without its set of riders. With 2014 general elections just a year away, populist measures come to the fore. Pressure from the coalition parties also tend to make the government weak and eventually politics outweigh economics. Additionally, an agreement on US fiscal cliff is expected to give strength to the commodities. Oil prices, which have remained weak in the last year, can see a revival. This will swell the oil import bills of India thereby expanding the Current Account Deficit.

A slowdown in the European and US markets has led to a weak performance by the exporting service sector. India's net exports figures have shown a decline in the last seven months. Injection of liquidity by the US central bank maintains the hope for the domestic IT companies. Failure in the implementation of the planned stake sale in several public sector companies and poor participation in the 2G spectrum auction would also add to the skepticism of government meeting its fiscal deficit guidance.

Amid all the uncertainties the street still pins its hope on a bright future for the Indian currency.

This article was originally published in the Economic Times dated 8th January, 2013, written by Gaurav Modi, associated with the Economic Times Bureau.