India’s irrational exuberance

After a shaky summer, the bulls have returned to India. The benchmark Sensex Index gained nearly a fifth between late August and early November. Yet as India's finance minister warns, this looks like "irrational exuberance".

The rebound was based on the US Federal Reserve delaying the start of its taper, whereby it would reduce the pace of its money-printing programme.

Tighter US monetary policy is always a headwind for emerging markets as investors begin to factor in higher interest rates in America and other developed economies, making risky emerging markets less appealing. Money then tends to leave emerging markets.

India, more than most, is "at the mercy of the global liquidity cycle", says Caroline Keen of the Newton Asian Income Fund. It runs a big current-account deficit, meaning it relies on foreign capital to plug the gap. Worse still, this capital is made up of flighty, short-term portfolio inflows rather than more secure and long-term foreign direct investment.

So Indian assets bore the brunt of the emerging markets sell-off when the Fed mentioned tapering in the early summer, and bounced when the US central bank looked set to delay it in early September.

Efforts to temper the current-account deficit by clamping down on gold imports also helped. But due to last week's strong US data, "concern over tapering and its impact on countries with current-account deficits is gradually creeping back into the market", says Tai Hui of JP Morgan Asset Management.

The macroeconomic backdrop isn't encouraging either. India has had an abrupt slowdown. In 2010, GDP expanded by almost 10%, but for the year to next March, growth of 3.7% is being pencilled in. Don't expect a fast turnaround.

The government has been spending too much and there has been only slow progress on deregulation to encourage investment. There is an election due next spring, so further reforms are likely to be off the menu for now.Inflation has crept above 10%, implying further interest-rate hikes to squeeze it out.

Investors have also started to notice that the Sensex is relatively dear on 14 times forward earnings, compared to 10.4 times for emerging markets as a whole. For Indian equities, says Cornell University's Eswar Prasad, this summer's rebound may soon come to be seen as the eye of a storm.