Indian stocks still defying gravity

Last week, India's stockmarket capitalisation crossed $2trn for the first time, making it the ninth-largest equity market in the world. With an annual growth rate of 7%, the country is now the world's fastest-growing major economy, while foreign direct investment is also at a record high. Over the last few months, confidence has grown in Prime Minister Narendra Modi's reform agenda and in his ability to take tough decisions for the long-term health of the economy. In November, the government abruptly withdrew 87% of the currency in circulation by scrapping 500 and 1,000 rupee notes, the two highest denominations, as part of a crackdown on corruption.

The demonetisation led to the closure of many cash-dependent businesses, but the economy coped relatively well, says Chris Flood in the Financial Times. What's more, banks are now flush with liquidity and interest rates have fallen, which has encouraged savers to move into financial assets this is one of the factors helping push stocks to new highs. Growing enthusiasm for emerging markets among international investors has also helped: India-focused equity funds have drawn net inflows of around $6bn so far this year, compared to $3.8bn over all of 2016.

Sceptics say the rally ignores growing risks, especially in the banking system. Indian bank stocks have rallied 23% in US dollar terms this year, outperforming those in other emerging markets such as China and Brazil. Indian banks now trade on a price-to-book ratio of 2.4 times, compared to 0.9 for Chinese peers. That looks pricey given that bad debts are certainly higher than disclosed, says Andy Mukherjee on Bloomberg. "On a price-to-truth basis, Indian banks look overvalued."

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It's true that valuations look stretched, says Una Galani on Breakingviews. But a "brutal market bust" seems unlikely, not least because "the changing savings habits of ordinary Indians are also driving a structural shift". Rising domestic inflows into equities have outpaced foreign inflows since 2014. This means the Indian market is less affected when foreigners sell. Note also that "investors held their nerve through Modi's recent currency experiment". That implies that they will also probably look past any disruption caused by the rollout of a new national sales tax. So "even if the short-term fundamentals don't quite stack up, gravity-defying valuations may be here to stay".