World Economy

Why 2002 riots have some India-watchers worried

Bharatiya Janata Party (BJP) leader Narendra Modi.
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It's still unclear who will win India's long-running national elections, but business interests know who they like: Narendra Modi, a man they hope will spread the same business-friendly climate across all of India that he already brought to Gujarat, the Indian state he now leads.

Yet, some nations are looking at Modi warily, because of a disputed role that Modi may have played in the 2002 riots in Gujarat that killed more than 1,000 people—a majority of them Muslims.

"A number of Muslim-led nations countries would at least be suspicious" of Modi, said Jonah Blank, senior political scientist at Rand Corp. "Modi's rise in India is being watched very closely by Pakistan."

Modi was accused of condoning violence against Muslims during the Gujarat riots. Modi has denied wrongdoing, in the three days of fighting between Hindu and Muslim civilians, and an investigation by India's supreme court cleared him in 2012. According to Blank, animosity remains toward the Gujarat chief minister, and subsequent rhetoric from Modi has worried Pakistan specifically.

Voters showing their ID cards as they stand in a queue to cast their votes at a polling station on April 17, 2014 in Jammu, India.
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"Would India really want to be treated as a hostile nation by Muslim nations?" Blank asked. "Modi's rhetoric is giving everyone a reason to pause and wait to see what the future holds. But Modi's platform is, 'Judge me on economic performance, don't focus on the rhetoric.'"

"The real question is, 'Are Indian Muslims first-class citizens in Modi's eyes? Does he consider himself the leader of India's Hindus or leader of all Indians?" Blank said.

Shares of the India's chief stock index, the Sensex, have been in rally mode, spiking 11 percent over the past two months, outperforming the broader MSCI Emerging Markets Index, which is up 6 percent during the same period.

That rise is tied at least in part to hopes that Modi will steer India's economy out of a morass that began in 2012: a weakening currency, rising inflation and a growing current account deficit.

"If you look at equity markets where politics play a big role, investors tend to bet that promising candidates will infuse change—before they actually do," said Ruchir Sharma, head of Emerging Markets Equity and Global Macro at Morgan Stanley, and author of "Breakout Nations."

Arvind Panagariya, professor of economics at Columbia University, doesn't rule out the possibility that some countries may be hesitant about dealing with Modi, but he indicated that Modi's likely to calm those fears once he's on a national stage.

"Because so much has been written, some countries may think something is wrong," Panagariya said. "But Modi is a nationalist and will do whatever is in the best interests of the nation."

BJP prime ministerial candidate Narendra Modi addressing an election rally on April 3, 2014 in Ghaziabad, India.
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Because of his alleged tie to the Gujarat riots, the U.S. once denied a visa to Modi, who has not sought one since, said Rand Corp.'s Blank. But the analyst pointed out that the U.S., along with the United Kingdom, has signaled a willingness to work with Modi since then.

Reports indicate that Nancy Powell, the U.S. Ambassador to India who recently announced her resignation, was initially reluctant to meet with Modi but finally did so in February of this year after a nine-year boycott.

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Sharma said that, assuming Modi wins, the big event investors will turn their attention to is the budget after the national election is over. The budget isn't only about accounts—policies related to reform will be announced then.

Neil Nathwani, executive director at BNP Paribas Securities India, said investors won't be happy if Modi changes a recent ruling that lets foreign firms invest in big retail ventures in India, as he's indicated he may do. Foreign direct investment (FDI) in that industry could be seen as an indicator for Indian openness to investment from overseas as a whole.

"Investors will be disappointed if he reverses the rule allowing FDI into multi-brand retail...It could send a message to foreign companies that they are not welcome here, though personally I think that this will be a short-term issue, as it's only in the retail sector where (Modi) has a problem with FDI," Nathwani said.

—By CNBC's Seema Mody. Follow her on Twitter @SeemaCNBC