The Rupee was the worst performer among all emerging market currencies in 2011. The fall of the rupee could be partly attributed to European debt crisis that led to relative appreciation in dollar against Euro and the rest of the damage was done by weak domestic fundamentals - rising inflation, interest rate hikes, a high fiscal deficit and foreign Institutional Investor (FII) outflows. But within a short time, the Rupee has managed a stunning recovery.
There are several reasons why rupee has appreciated against USD in such a strong manner. The relentless fall of the Indian rupee forced the Reserve Bank of India (RBI) to intervene in the foreign exchange (Forex) market by selling US dollars. This has deterred away speculators and provided some support to the rupee. In addition this, the central bank introduced curbs on currency contracts, which reined in the ability of speculators to bet on the downward movement of the rupee.
Reserve Bank Of India (RBI) has also freed interest rate on non-resident Indian (NRI) deposits which allowed banks to raise rates on such deposits. Banks immediately raised rates to 8-9%. This eased the dollar supply shortage and contributed to improving the rupee's value.
The government has also raised import duty on gold (2%) and silver (6%) respectively which will further release pressure on the rupee. Gold and silver are the second most expensive items on India's import bill after petroleum products. High imports of both metals have contributed to the country's widening current account deficit (the gap between foreign exchange earnings and payments before taking into account capital flows), which has piled pressure on the rupee.
The Indian stock markets had lost 25% of its value in 2011. But the New Year has begun on a positive note with the benchmark BSE-Sensex gaining 6% since the start of the year. This is due to increase in investments in Indian stock markets by foreign investors. The increasing chances of an interest rate cut in the months ahead and a growing sense that the economy may have bottomed out and some rebound is due this year are tempting foreign investors to once again bet on India, which has added to the improving sentiment on the currency. Thus the volatility of the Indian rupee is giving government, central bank and corporates sleepless nights as it is increasingly becoming difficult to predict where the rupee might end up in the next few months.