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Why a new government may not boost India’s reform prospects

Leslie Shaffer | Writer for CNBC.com
Wednesday, 25 Dec 2013 | 10:20 PM ET

Hopes for a change of government in India's upcoming elections have helped the subcontinent's currency and shares recover from sharp declines earlier this year, but the optimism may be premature.

After a strong performance in state elections completed earlier this month, many expect the opposition Hindu nationalist Bharatiya Janata Party (BJP), led by Narendra Modi, could oust the current ruling Congress party in national elections set to be held by May. The Congress party's image has been tainted by a poor economic performance and the slow pace of legislative changes.

(Read more: Why India's state elections matter)

Gujarat State Chief Minister and Bharatiya Janata Party’s Prime Ministerial candidate Narendra Modi.
Arvind Yadav | Hindustan Times | Getty Images
Gujarat State Chief Minister and Bharatiya Janata Party’s Prime Ministerial candidate Narendra Modi.

Modi, the prime ministerial candidate of the BJP who is currently serving as the chief minister of Gujarat, has been applauded for his investor-friendly policies that have led the state to double-digit economic growth.

"The perception is that Modi is more pro-market, (that) Modi is more pro-reform and therefore he could do it," Nizam Idris, head of fixed income and currency strategy at Macquarie, told CNBC.

(Read more: 'Universal' frustration with pace of India reforms: Hero CEO)

"However, he also has a history of being divisive. BJP has been divisive. Historically there were even riots in the place that he was a governor," he added. "You need to be a bit more cautious here. It's easy to promise things, but harder to deliver, especially in India."

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Others also have doubts about the wave of optimism spurred by the prospect of a BJP victory.

"I've been surprised by a lot of our clients, how positive they've been," said Timothy Riddell, head of global markets research for Asia at ANZ.

"Whether he can really get a majority is going to be key. The assumptions that a lot of our clients, especially in Europe, are talking about is he's going to sweep in with a huge majority. We don't really see that as being likely," Riddell told CNBC.

(Watch: India's ruling Congress party on backfoot: Expert)

"You could get into a scenario where he comes in talking a bullish story but he can't actually get anything through," he said.

Indeed, BJP's success in state elections hasn't always translated well to a national stage. In 2003, the BJP performed well in the state elections, but lost the national elections held a few months later in 2004.

"He's actually got quite destabilizing policies. He can alienate quite a large section of the Indian community," Riddell said. "His approach toward ethnic diversity is not really what we'd want to see in a country like India," he said.

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The stakes are high as India faces a rocky economic outlook, with concerns stagflation –where accelerating inflation is not met by higher growth rates – might emerge.

Recent data such as industrial production – which contracted 1.8 percent year-on-year in October following a 2.0 percent rise in the previous month – have raised concerns over the growth outlook. Consumer prices, meanwhile, rose at their fastest annual pace on record at 11.2 percent, from 10.1 percent in the previous month.

(Read more: India's November exports up 5.86% on-year)

For investors, the question may also be whether all this optimism has already been priced in by the markets' steady recovery since the May-to-September volatility after the U.S. Federal Reserve initially broached its plan to begin tapering its asset purchases, leading to fund outflows.

The U.S. dollar is now fetching around 61.76 rupees, down from a record high just shy of 70 touched in late August, as the Indian currency strengthened.

India's Sensex stock index has also gone from being one of the region's worst performing to touching a record high of 21,483.74 in the wake of the BJP's state election win. The index closed Tuesday at 21,032.71, marking a more than 8 percent gain for the year.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

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