Investing in India

Why India's state elections matter

Sajjad Hussain | AFP | Getty Images

India will announce the results of key state elections this weekend, in an important litmus test for the country's two major parties ahead of next year's general elections.

Exit polls indicate the main opposition Bharatiya Janata Party (BJP), led by Narendra Modi, performed strongly in the elections held in Chattisgarh, Madhya Pradesh, Rajasthan and Delhi. The official results of the elections, which were held between 11 November and 4 December, are due on 8 December.

"Results from exit poll surveys may differ from the official results, but the overall trend of BJP performing well seems consistent across exit polls," Nomura strategists wrote in a report on Thursday.

"From an economic perspective, the exit polls, as well as the final state election results, should impact sentiment positively," they added.

BJP is perceived as more business-friendly and willing to implement reforms compared with the ruling Congress party, which has been tainted by poor economic performance and slow pace of legislative changes.

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The Congress party has led coalition governments at a national level in India since 2004, however its support base has been eroded in the recent years due to a string of corruption scandals and rising food prices, among other issues.

Delhi, which has traditionally seen a low voter turnout during state elections, witnessed the highest ever turnout, with the youth coming out in large numbers to cast their ballot for change.

Signs that the BJP is gaining traction have been welcome development by investors, with the rupee strengthening to a five-week high against the dollar, and Indian stocks rising to a one-month high this week.

"We've become pretty constructive on India and the rupee. I think the appointment of Rajan as the new RBI [Reserve Bank of India] governor was very significant. [And] you throw in the elections next year. For us it's a good story," Jonathan Webb, head of FX strategy at Jefferies Bache told CNBC's Capital Connection.

(Read more: Four major emerging nations face crucial elections)

India's opposition party leads in exit polls

Overall, Asia's third largest economy has been struggling to gain momentum, with growth languishing below 5 percent for the fourth consecutive quarter in the July-September period - a far cry from the 8-9 percent growth rates seen just a few years ago.

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.

(Read more: India to stick with austerity despite looming election)

According to Morgan Stanley, the upcoming general elections are arguably the most important in over two decades.

"Elections have probably not been more crucial from an economic standpoint, except perhaps for 1991. We think the coming general elections hold greater importance than usual," said Ridham Desai, managing director at Morgan Stanley.

—By CNBC's Ansuya Harjani; Follow her on Twitter: @Ansuya_H