By DR Amitendu Palit

National currencies often reflect the health of their economies by the values they take against other currencies. In this respect, the Indian rupee's movements over the last seven to eight months, also reflect the state of health of the Indian economy.

At the beginning of the current financial year, in early April 2011, the rupee was hovering at slightly above Rs44 against the US dollar (US$). The year ended with the rupee at Rs53.26, one of its lowest levels against the US$ in recent times. The new year though has seen the rupee staging a comeback by clawing its way to below Rs50.

It is not that the rupee has been weakening only against the US$. During April-December 2011, it depreciated by almost 20 per cent against the US$. During the same time, it lost around 15 per cent against the pound and 9 per cent against the euro. The steepest fall, however, was against the Japanese yen with the rupee losing around 30 per cent against the yen during this period.

During August-December 2011, the period witnessing the rupee's sharpest fall, it depreciated by around 10 per cent against the Singapore dollar as well.

Indeed, when the rupee was trading at a fairly robust level of Rs44 against the US$ in July last year, few expected it to plunge to a level, within less than six months, where the Reserve Bank of India (RBI) would have to sell US dollars for shoring the value of the rupee. The RBI did so during the middle of December.

From a market perspective, the value of the rupee against other major currencies is determined by forces of demand and supply. More specifically, it is the demand and supply of global currencies like the US$, euro and pound in the domestic market which determines the exchange rate of the rupee vis-a-vis these currencies.

The biggest slumps in the rupee's value happened in the months of August, September, October and December last year, which were the months when foreign institutional investment (FII) from the Indian stock market beat a hasty retreat. These are the months when the stock market weakened considerably with the benchmark Sensex at the Bombay Stock Exchange losing around 3,000 points between August-December 2011.

The steady erosion in FII confidence in the Indian market led to their large pullout and a consequent decline in the stock index and lower supply of US dollars and other foreign currencies in the Indian economy. While the FII shrank sharply and the supply of foreign currencies reduced, the demand for foreign currencies, particularly from exporters and importers, remained unchanged.

The situation reflected an excess demand for foreign currencies, leading to their sharp appreciation against the rupee.

The cycle has begun moving in the opposite direction from January this year with the FII returning to the stock market. This has not only perked up the stock indices, but has also led to the appreciation of the rupee's value.

Clearly, the Indian economy passed through a few months of fairly troubled times during the second half of last year. Several factors were responsible for creating the poor outlook. Global factors like the financial instability in Europe and the moderation in global economic activity cast their adverse spell on India as they did in almost all other emerging markets.

There were equally strong domestic factors at work. Concerns over the slump in GDP growth, rising food prices and the Indian government's inability to arrest inflation, high interest rates choking off private investment and mounting fiscal deficit of the central government were some of the macroeconomic worries denting the outlook. The impact of these developments was accentuated by the government's tardiness in implementing critical economic decisions due to poor political management and the growing perceptions about the government's failure in tackling corruption.

Many of these concerns still prevail. There are improvements noticed on prices, along with signs of some progress in clearing pending economic measures. Coupled with the Indian Supreme Court's favourable verdict for Vodafone in its dispute with the income tax authorities, the possibilities of interest rate cuts and the government's repeated assurances on economic reforms, the outlook has become brighter, thereby boosting the rupee. The future months will reveal whether the current trend will sustain or not.

Dr Amitendu Palit is head of development & programmes and visiting senior research fellow at the Institute of South Asian Studies in the National University of Singapore.