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Last year, India was identified as one of the “Fragile Five”—countries that were most vulnerable to the beginning of the end of the era of cheap money.  With the start of taper talk, foreign investors rushed for exits leaving Indian stocks and the currency in a downward spiral.

The trend reversed this year with investors returning to emerging markets as they realized that interest rates in the developed world were not going up as earlier feared.

But that’s not the only reason; there have been a number of other positive developments in India that resulted in investors’ recent enthusiasm. (Read: 3 Low Correlated ETFs surging in Shaky Markets)

Election Hopes

The world’s largest democracy is currently going through multi-phase general elections and results will be known on May 16th when all rounds of polling are over. Recent opinion polls suggest that the prospects of National Democratic Alliance (NDA) led by BJP forming the government look pretty strong now.

BJP’s prime ministerial candidate, Narendra Modi is perceived as a reform oriented politician, who has a strong record of economic development as the chief minister of the state of Gujarat.

Polling saw unusual enthusiasm this time with record turnout as many voters are hopeful that the new government will be able to reverse the trend of ballooning corruption and slowing growth. (See: Pharma ETFs—A Safe Haven from the biotech stock slump)

Another positive development on the Indian political horizon is the emergence and rising popularity of Aam Aadmi Party (AAP) which started as an anticorruption movement.  While the new party may get many seats in the current elections, its contribution in making Indian voters aware of their right to clean, transparent and honest governance has been immense.

Is the Worst Over for the Economy?

The Indian economy grew at just 5% during 2012-13 fiscal year, lowest in a decade and much lower compared to ~8% average growth rate achieved during 2006-11. But it appears that the growth bottomed out during Q1 of 2013-14 fiscal year and recorded a marginal improvement in the next two quarters.

The central bank expects a modest recovery to 5%-6% growth during the current fiscal year. The IMF projects a GDP growth rate of 5.4% in 2014, followed by 6.4% in 2015.

Current account deficit has come down recently, thanks mainly to decline in imports as the economy slowed. Gold imports also moderated due to higher duties. Exports on the other hand improved during the second-half of last year as the currency plummeted. 

However the recent currency strength has begun to impact exports. (Read: 3 ETFs you can love forever)

Monetary Policy on the Right Path

Last year, renowned economist Raghuram Rajan took over as the governor of the central bank of India. Since his appointment the central bank has taken a number of positive steps towards liberalizing the financial markets and strengthening the monetary policy framework.

A series of measures announced by the Reserve Bank last year to encourage capital inflows and limit the currency downslide have been quite successful. The Indian rupee has traded in a narrow range of about 60 to 63 per US dollar in the last six months, after plunging to a low of 69 to a dollar in August last year.

The Risks

NDA can effectively execute its agenda only if it wins majority and does not have to depend on smaller regional parties’ support. Further, It is difficult to predict whether Modi’s Gujarat model can be successfully replicated at the national level.

While the CPI inflation declined to a 25-month low of 8.1% in February, it has started creeping up again mainly due to higher food prices. A below normal monsoon predicted for this year may increase the upside risks to central bank’s target of 8% CPI.

The central bank raised the rates three times recently order to tame inflation though higher rates in turn could be crimping growth.

India ETFs

Indian ETFs have been among the best performers in the emerging markets space over the last six months. Most popular India ETF WisdomTree India Earnings Fund (EPI) has jumped 14.8%, while iShares MSCI India Fund (INDA - ETF report) and iShares India 50 ETF (INDY - ETF report) have returned 8.4% and 11.1% respectively, compared with a negative return of 3.6% for the broader iShares MSCI Emerging Markets ETF (EEM - ETF report).

However, the best performance has come from the ETFs focused on smaller companies in India, with EGShares India Small Cap ETF (SCIN - ETF report) and Market Vectors India Small Cap ETF (SCIF - ETF report) surging 27.5% and 36.4% respectively. These were the ones that were hurt the most after the taper talk.



The Bottom Line

In the past few weeks, investors have poured in a lot of money in Indian equities in the hope that with an effective and reform-friendly government at the center, India may again deliver high-growth seen a few years back. 

Fixing India’s structural problems including chronic inflation, wide deficits, massive corruption and crumbling infrastructure will take many years but investors expect the new government to show willingness to resolve these issues and lay out a clear path for action soon.

Further with a central bank committed to keep inflation and current account deficit on track, India’s long-term outlook certainly appears to be brightening.

But expect a big sell-off in case election outcome is not what is being predicted and election opinion polls in India have not really have been very accurate in the past.

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