Modi Litmus Test in State Vote Key to Top Asia Stocks, Rupee

(Bloomberg) -- Indian stocks are leading gains in Asia this year, the rupee has recouped almost all its losses since Donald Trump's U.S. election win and foreigners have pumped $2.4 billion into the country's bonds and equities.

So, as investors wait for the results of one of Narendra Modi's biggest electoral tests since he came to power in 2014, there's a lot more at stake than just the political fortunes of a prime minister who disrupted the lives of Indians with the sudden withdrawal of 86 percent of banknotes in circulation in November.

By opening up India to more foreign investment, tackling corruption and seeking to introduce a goods and services tax, Modi has spurred economic growth to more than 7 percent and made India a favorite with overseas funds. But as Uttar Pradesh, the largest state, prepares to report results of its election on Saturday, investors say the outcome could signal whether the government stays on a reformist path or takes a more populist approach.

The Uttar Pradesh vote is “important because it will be seen as a litmus test of Prime Minister Modi's reforms and popularity ahead of the national elections in 2019,” said Dushyant Padmanabhan, a foreign-exchange strategist at Nomura Holdings Inc. in Singapore. “A victory would be positive for both inflows and the rupee in the near term.”

Padmanabhan is among the more bearish analysts on the rupee, forecasting a 5.1 percent drop to 70.2 a dollar by the end of the year, compared with the median estimate for 68.75 in a Bloomberg survey.

Read More: What this election may mean for Modi.

Of the five states that report election results on Saturday, Uttar Pradesh stands out. With a population of 204 million, it accounts for 31 of the 245 seats in the upper house. Modi swept the state in the 2014 general election, but the local legislature is controlled by the regional Samajwadi Party.

A weak showing by Modi's Bharatiya Janata Party could embolden and unify the opposition, and increase the possibility of more populist policies, Siddhartha Sanyal, chief India economist at Barclays Plc in Mumbai, wrote in a March 7 note. It would also increase the likelihood of a grand alliance between Congress and regional parties to take on Modi in 2019, Sonal Varma, chief India economist at Nomura, said in a Feb. 14 note.

Stellar Growth

India's economic growth, which was 5.8 percent in the first quarter of 2014 before Modi took office, peaked at 7.9 percent in the first three months of last year. It expanded 7 percent last quarter, beating the 6.1 percent analysts had forecast, despite the cash ban disrupting activity.

To read more on the demonetization and Indian economic growth, click here

That's driven an 8.9 percent gain in the S&P BSE Sensex this year through Tuesday, the best performance among Asian gauges at that point, and helped the rupee rebound 3.2 percent from a three-year low in late November. Bonds have fallen so far in 2017 as investors position for Federal Reserve interest-rate increases, pushing the 10-year yield up 33 basis points to 6.85 percent.

The local stocks gauge fell 0.6 percent as of 12:23 p.m. in Mumbai, while the rupee strengthened 0.1 percent and the 10-year yield rose two basis points.

Not everyone is convinced of the importance of Uttar Pradesh. India's economic fundamentals will guide foreign investors and the election won't have a meaningful impact on the reform agenda, said Ashwini Agarwal, a Mumbai-based fund manager at Ashmore India Investment Management LLP.

“If we go by the demonetization decision, the fiscal restraint shown in the budget proposals and progress on the GST, it appears the government doesn't wish to play to the gallery for short-term electoral gains at the state level.”

At Pacific Investment Management Co., Roland Mieth, a Singapore-based emerging markets fund manager, describes Uttar Pradesh as a “mini-referendum” on Modi. 

“A good result will help on the day-to-day governance of the country,” he said. The rupee and bonds will “react positively” to a BJP victory on the view that the reform momentum of the past few years will be less at risk, while a poor showing will increase political uncertainty heading toward 2019, Mieth said.

--With assistance from Subhadip Sircar and Shikhar Balwani

To contact the reporter on this story: Kartik Goyal in Mumbai at kgoyal@bloomberg.net.

To contact the editors responsible for this story: Tan Hwee Ann at hatan@bloomberg.net, Tomoko Yamazaki at tyamazaki@bloomberg.net, Andrew Janes

Also Read: Uttar Pradesh Is The BJP's To Lose. Or Is It?