Modi mania is overdone
Markets have already cast their vote for Narendra Modi as India's next leader, but investors may be underpricing political risks in the country
Financial markets are usually unsettled by the political uncertainty generated by a pivotal general election.
This has not been the case in India, Asia's third-largest economy, whose month-long parliamentary election comes to a close on May 16 amid feverish speculation that Narendra Modi, the charismatic and business-friendly prime ministerial candidate of the Hindu nationalist Bharatiya Janata Party (BJP), will receive a strong mandate to push through sorely needed economic reforms.
India, whose 815 million voters are likely to turn their backs on the ruling Congress party led by Rahul Gandhi (scion of the country's Nehru-Gandhi dynasty) after two years of weak growth and persistently high inflation, has been gripped by "Modi-mania" over the past several months.
Markets have taken note and believe a Modi-led government would be a blessing for India.
Indeed, already in November, just three months after India was the focal point for investor nervousness about emerging markets, Goldman Sachs published a note entitled "Modi-fying our view" in which it took a bullish stance on Indian equities based on expectations that Modi would become premier.
For the time being, this has proved a prescient call.
A pre-election rally drove India's benchmark Sensex index to a record high on April 23, with Indian shares up nearly 8 per cent in the last three months, compared with a 1 per cent rise for equities in developing Asia and a 10 per cent decline in Russian stocks.
Moreover, India's currency, the rupee, which fell a whopping 25 per cent against the US dollar between May and August last year as plans by the US Federal Reserve to withdraw monetary stimulus exposed weaknesses in India's economy, is now one of the best-performing emerging market currencies - up 2.3 per cent this year.
This has led foreign investors to increase their holdings of Indian local currency bonds, helping reduce the yield on Indian 10-year domestic debt by nearly 40 basis points since early April to 8.7 per cent.
This begs the question: are markets in danger of underpricing Indian political risk?
It's still not clear whether the BJP and its close allies, which together form the National Democratic Alliance (NDA), will win the 272 seats needed to secure a majority in parliament.
Investors expect the NDA to win a convincing 250-260 seats, which would give the BJP a strong mandate to form a government with the support of some of India's smaller regional parties.
However, should the NDA win fewer than 220 seats - an unlikely scenario - Modi's authority would be undermined, forcing the BJP to make more meaningful concessions to the smaller regional parties, which have long been averse to the kind of liberalising reforms demanded by foreign investors.
Jayalalithaa, the popular yet controversial chief minister of India's southern state of Tamil Nadu, who herself is known to covet the country's premiership, could emerge as a powerful player in post-election negotiations to form the next government.
There is a risk that India will end up with a fractious and reform-wary coalition, spooking the markets and triggering a sharp sell-off. More importantly, it's still not clear whether Modi himself is the leader India needs.
The chief minister of the northwestern state of Gujarat, one of India's fastest-growing and most successful regions, known as the country's "Guangdong", Modi has shown decisive leadership and a laser-like focus on developing infrastructure, which has made him extremely popular with investors.
He also happens to be a consummate politician, formidable orator and, crucially, was a humble tea seller in his youth, allowing him to exploit - and become the direct beneficiary of - the strong anti-establishment sentiment pervading India's political landscape.
Yet governing Gujarat is one thing; taking charge of the whole of India is quite another.
Not only is Modi's Hindu nationalism a source of concern - particularly given his murky role in the anti-Muslim massacres in Gujarat in 2002 just after he took charge of the state - his party's economic programme is quite tame as far as structural economic reforms are concerned.
The BJP has already made it clear that it will continue to protect India's legions of small shopkeepers - a key source of support for the party - by restricting foreign investment in the country's coveted retail sector.
Even if the BJP-led alliance secures a solid majority in parliament, Modi will still have to contend with India's heavily decentralised form of government, in which the state administrations are responsible for key decisions on investment - the reason why India's large infrastructure projects have been delayed.
There is an inescapable feeling that markets have been taking an overly sanguine view of India's post-election economic prospects.
While India's balance of payments position has improved significantly over the last several months and monetary policy has become much more credible since the well-regarded Raghuram Rajan took the reins of the country's central bank in September, the politics of economic reform are likely to remain one of India's biggest Achilles heels.
Even the Lion of Gujarat, as Modi is called, if he becomes premier, will struggle to unleash India's economic potential.
Nicholas Spiro is the managing director of Spiro Sovereign Strategy