With the Indian rupee coming off historic lows, we believe potential foreign direct investment could provide the necessary boost for further currency appreciation.

2011 and 2012 were not great years for the Indian rupee. Persistent concerns about inflation and a slowing global economy created an environment that policy makers and investors found very difficult to navigate.

However, 2013 is off to an encouraging start, with strong flows forcing the currency up from its historic lows reached in June 2012.

With moderating inflation giving it some flexibility to cut interest rates, and in an effort to revive growth, on January 29 the Reserve Bank of India (RBI) went ahead with a 0.25% rate cut for the first time since April of 2012.

While current foreign exchange forecasts are calling for only a moderate appreciation of 2.6%, 1 the high levels of interest carry could be an attractive cushion for investors looking to make an allocation to one of the world’s largest and fastest-growing economies.

Even among its emerging market contemporaries, India, after largely holding rates steady in the previous two years, now sports an attractive level of carry over most other currencies. Specifically, the WisdomTree Indian Rupee Fund (ICN) has a 5.98% embedded income yield as of December 31, 2012. (For standardized performance, including the SEC 30-day yield for ICN click here.) The combination of exposure to local interest rates and movement in the rupee against the U.S. dollar could provide investors with an attractive rate of return in 2013. However, the health and the perception of risk assets in the global economy are crucial.

In 2013, flows could prove to be key. Should money continue to flow into the Indian debt and equity markets, the rupee could finally break its recent bout of underperformance. As our equity group has published in a recent blog, India has an attractive long-term growth story and is a country they consider underappreciated and undervalued.

As investor dollars flow into the country, they must be converted to rupees in order to buy locally denominated assets. While the currency is undervalued by nearly 62% 2 on a purchasing power basis, we believe that the path of modest appreciation seems the most likely. Other potential upside surprises could develop as politicians position themselves for the 2014 elections. After a frustrating series of false starts and missteps, politicians may finally come together to push through structural reforms. We believe even minor steps in this direction could have a significant impact on investor sentiment and tolerance for risk.

While it is still far too early to call 2013 a victory for investors with exposure to India, a series of positive developments have primed the pump for positive performance. With some stimulative policy from the RBI and a generally positive outlook for emerging markets in Asia, we believe India has the potential to be a solid performer in 2013.

Rick Harper is head of fixed income and currency for WisdomTree Asset Management. This post was republished with permission from the WisdomTree blog.

1 Source: Bloomberg, as of 1/29/2013.
2 Sources: World Bank, International Monetary Fund, WisdomTree, as of 12/31/2012.