The Nifty hitting record highs, the Indian rupee rallying sharply and bond yields falling are the market reaction to a resounding win for the main opposition party BJP in the just concluded state elections. The markets expect the BJP to come to power in the 2014 general elections and wipe off all the ills of the economy.
The function of the markets is to believe what it wants to believe. A bear market factors in only the worst even if there are some signs of turning around. A bull market factors in the best, even if the signals are unsustainable. For example, at 40 to the dollar in 2007, the Indian rupee was factoring in sustained growth for the Indian economy. At current levels of 60, the currency is factoring in a long period of slowdown.
The markets now want to believe that a new stable government under the BJP - which in itself is uncertain - will take all necessary tough decisions to put the economy on track. Tough decisions to be taken include axing the subsidies and tax sops, going after wilful defaulters who have more than doubled the non-performing assets of the banking system, bringing down inflation, building infrastructure, deflating the real estate bubble, ending crony capitalism and weeding out corruption.
The question is, will BJP, if it does form a government at the centre in 2014, have the will, foresight and strength to take these decisions that are near-term negative and long-term positive? Indian economy has been a series of near-term policies, irrespective of which party rules. Tough decisions are taken only when economic conditions and markets force the decision on the government.
Ironically, the UPA government woke up from a slumber when the rupee touched record lows in 2013. The finance minister was forced to take some tough decisions such as containing fiscal and current account deficit, opening doors to foreign investments in retail and airline sectors and focusing on inflation.
However, the move came bit too late considering the UPA had 10 years to do the right things.
The economy and financial markets are not yet out of the woods. On the economic front, growth is at decade low levels, inflation is sticking to the elevated levels, interest rates have jumped up by 200 bps after the rupee touched record lows, fiscal stress is high with the government struggling to keep deficit at 4.8 percent of GDP levels amidst falling tax revenues and subsidy bill continuing to mount on high oil prices and food subsidy bill that was passed a few months ago.
The financial markets have to contend with the prospects of the Fed stopping its asset purchase programme, debt overhang in almost all major countries of the world, rising interest rates in China, weak growth in Eurozone and below trend growth in major emerging economies including Brazil and India. The markets have started to do better with equities at record highs in many parts of the world but for high levels to sustain, economic stability is a key factor.
Investors should not give in to the euphoria but can definitely live on hope. At this point in time, hope is driving markets but going forward, the markets will want that hope to be realised and if that does not happen, the fall from highs can be pretty sharp and disastrous.
Arjun Parthasarathy is editor Investors are Idiots.com and INRBONDS.com. Follow him on twitter @investorsidiots