In 2011, the rupee emerged as the most vulnerable Asian currency on the block. It depreciated by almost 19 per cent in 2011, while for the others depreciation was mostly in single digits. The Chinese Yuan actually appreciated in this period.

What really explains the relative underperformance vis-a-vis our peers? Clearly, the fact that we run a current account deficit while others sit on surpluses is the key factor. But that is just about as far as easy explanations go.

Equity market performance clearly does not tell us a neat story. The Singapore and Chinese equity markets fell by around the same amount as Indian equity markets did but while the Yuan appreciated, the Singaporean dollar fell by just a about a per cent.

Short-term external debt holdings also do not quite offer a clear insight. South Korea's external debt is much higher than India's (and it possibly faced the same amount of difficulty in rolling over short-term debt during the peak of the European crisis) and yet its currency fell by only about three per cent.

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Using the current account deficit as an explanation for a currency's behaviour, too, has its limits. Take the case of Turkey. Turkey's current account deficit for 2011 is estimated to be a humongous 10.3 per cent of GDP.

Yet, in the last quarter of 2011, when the rupee came under the most intense pressure, the Turkish lira fell by a relatively sedate 1.3 per cent. The bottom line is the following -- easy generalisations don't necessarily yield any real insights into what affects a currency.

The pulls and pressures of a whole bunch of factors at a particular point in time have to be assessed carefully to determine why a currency moved as much as it did. Sentiment and its twin speculation are also important factors. In fact, one can argue that over the last couple of months, the rupee was prey to negative sentiment and speculative pressure.

The rupee, thus, fell below its "fair" value that the fundamental demand-supply balance warranted.

Of course, the flip side of nominal depreciation is an improvement in the competitive position of the Indian economy. This is clear from the real effective exchange rates (REER) that the Bank for International Settlement (BIS) releases on a monthly basis.

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Despite higher inflation rates than our peers (that affects the cost of production and, thus, undermines competitiveness), the BIS' REERs show that the because of its steep nominal decline, the rupee gained the most in terms of its competitiveness relative to its Asian peers. China, incidentally, saw a 6.4 per cent drop in competitiveness.

An undervalued exchange rate helps boost export performance and also curbs imports, favouring domestic producers. While exports could get a leg up, the prospect of slowing global growth means that gains from exports could be limited.

The real benefit could come from import substitution this time around. Anecdotal evidence does show that there has been some degree of import substitution in response to the rapid rupee depreciation, particularly in the small and medium enterprise sector that could restrict the pace of imports growth and subsequently check the deterioration in the current account balance.

Software exports and private transfers are also expected to remain strong. The net result is that the pressures on the rupee could diminish somewhat going forward.

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Tailpiece

What does 2012 hold for the Asian currency block? Asian emerging market currencies are likely to be impacted by the combination of a challenging macro-economic environment with prospective monetary policy responses by global central banks in the advanced economies and the emerging region.

A plausible scenario is that Asian currencies come under some pressure in the early part of the year driven by broad global risk aversion followed by appreciation pressures driven by quantitative easing programmes by the Federal Reserve, European Central Bank and the Bank of England that boosts risk appetite.

Most Asian central banks are also expected to turn accommodative and this could boost sentiment towards assets in the region. However, the main change in 2012 could be that the euro could become a funding currency for carry trades. The strong correlation between the euro and Asian currencies that exists now could break down.

The authors are with HDFC Bank. These views are personal.