Bullish Indian shares have shot to record highs on bubbling optimism about the coming fiscal budget, cheering investors from the US and Europe to Japan who have poured billions of dollars into the emerging market, but the sheer pace of the rally raises the risk of resistance if New Delhi fails to live up to the high expectations.

There is little doubt the coming week will be the most eventful for financial markets since Prime Minister Narendra Modi was swept to office in May, with his Bharatiya Janata Party (BJP) scoring a thumping victory in national elections. It was the first time in 30 years when a single party won a majority on its own.

This gives the government the muscle to break parliamentary gridlock that thwarted previous administrations from pursuing reforms like opening up sectors to foreign participation, rein in ballooning subsidy bills and make changes to archaic labour laws that have thwarted the manufacturing sector.

So when the budget session of parliament begins on Monday, there are big hopes riding on the Modi administration. The railway budget, which will be kicked off on Tuesday, is expected to set the tone by announcing plans for launching bullet trains, and expanding the metro network at a faster clip. After presentation of a report card on the economy and financial health the following day, the main budget is scheduled to be unveiled on Thursday.

Modi’s pro-business reputation and administrative skills acquired from his helmsman-ship of Gujarat for more than a decade, and his promise to focus on reviving investment and growth by opening up markets and wooing foreign companies, have boosted expectations the new government would roll out the red carpet for investors.

“The budget would be keenly watched, not merely as a yearly fiscal accounting exercise, but also for the direction it gives for the coming five years,” said Motilal Oswal Securities, a leading Mumbai-based brokerage.

Both the top-30 Sensex and the broader 50-share Nifty rallied to their highest close ever, at 25,962.06 and 7,751.60 respectively, gaining 3.4 per cent and 3.2 per cent on the week. Foreign portfolio funds and other overseas investors have moved more than $20 billion into Indian equity and debt since the start of January, according to depository filings with the regulators, with the inflows picking up steam in the last three months.

Weighty challenges

There is a good chance of the stocks rally gaining momentum next week in anticipation of a “credible” budget that lays out blueprint to cut taxes while broadening the base and aggressively pursuing asset sales to help partly bridge revenue shortfalls, and channelising spending to productive sectors from populist giveaways.

“The recent increase in the prices of petrol, diesel and non-subsidised liquefied petroleum gas (LPG) cylinders, and hike in railway freight rates and passenger fares clearly shows that the government is committed to fiscal consolidation, especially by rationalising subsidies,” Nirmal Bang Institutional Equities said.

This may be a good beginning to plug the hole in the budget, but the road ahead is difficult and bumpy. For instance, a sluggish start to the monsoon — rainfall in June was 43 per cent below normal, the fourth lowest in more than 100 years — has put paid to any hopes for a cut in food subsidy.

The escalation in Iraq and the consequent spike in crude oil prices could also spell trouble for India, which imports about 80 per cent of the oil it consumes. Domestic prices of food and fuel have already gone up sharply, piling pressure on inflation and erasing prospect for any monetary easing in the near term.

Modi is an ambitious man who is determined to turn India into a manufacturing hub, but he will have to show immense courage to reform holy-cow labour laws, while raising foreign investment limits and removing cobwebs of legislation and rules that hamper the ease of doing business in India.

“The finance minister and prime minister have stated that harsh steps will be taken to bring Indian economy back on track. We, however, maintain that the government will not announce big reforms in the upcoming budget, with more time, understanding, and analysis, reforms will follow,” Anjali Verma at PhillipCapital (India) Pvt Ltd said in a report titled “Too early to walk the talk”.

Big bang

One thing that should be going for the government is the opportunity to bump up asset sales, thanks to the robust stock markets and voracious foreign appetite for Indian securities. In the past month and an half companies have raised $2 billion through institutional placement, and issues worth another $1.5 billion are already lined up. Nearly all of these are private sector companies.

The interim budget, presented by the previous government in February, had set a 2014-15 divestment target of Rs565 billion, which was seen as overly ambitious at the time because the figure was a sharp jump from the Rs258 billion in the previous year. However, with Modi firmly in the saddle, the street chatter has shifted to an even bigger target — as much as Rs800 billion.

Doubtlessly, New Delhi will push for share sales in government companies in a big way to raise cash for its expenditure plans. A new proposal by the capital market regulator that requires at least 25 per cent free float for state-run companies to be listed on the market should also enable bigger asset sales in the coming months.

Besides removing retrospective tax legislation, which had been a thorn with foreign investors, the government is widely expected to open up sectors such as defence, construction, infrastructure and railways to foreign direct investment as well as ease the investment cap in the insurance sector. There could also be announcement on building 100 new smart cities, a project in which Singapore has showed keen interest to participate.

“If the budget (or the subsequent policy action) succeeds in transforming “hope” into “optimism” then a second leg up in the markets may not be far,” HDFC Securities said, even as it opined that the markets could “top out” either ahead or post the budget because of the sharp run-up in prices and lack of near-term triggers.

It would not be a cakewalk and the odds are stacked against the government. “Expectations of big bang changes in the final budget are already building up. In truth, the new finance minister has very little room to boost spending to revive growth. This is further complicated by the fact that the previous government drafted the interim budget with elections in mind,” Jitendra Sriram and Frederic Neumann at HSBC wrote in a report.

The writer is a journalist based in India