How Long Will Indian Equities Stay Hot? WSJ

Despite many reasons for foreign investors to avoid India, they're pouring money in. What gives?

Overseas institutional investors bought $3 billion of Indian equities in the last two months. That compares with an outflow of $358 million last year.

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Partly, they may be betting on market friendly reforms from new Finance Minister, P. Chidambaram. Investors hope he presses ahead with changes to allow more foreign money to flow into India's retail, insurance and aviation sectors, buoying stocks in those areas.

There's also a strong rupee play -- the Indian currency has fallen by about 20% against the U.S. dollar in the last twelve months, and languishes near record lows. Some investors might think it can't get much worse.

And Indian equities are still relatively cheap on a historic basis. Shares in the benchmark 30-stock Sensex are trading at 13 times forecasts for next year's earnings, compared with an average of close to 16 times over the last five years.

There are plenty of reasons to worry about India though. The economic outlook remains cloudy.

Consumer prices are still rising at near 10% from a year ago, and that pace has been steady since 2010. Interest rates are high too. Both factors are putting a dent in demand for cars and housing.

As far as reforms on investment are concerned, there is still no concrete action. Parliament has been adjourned for seven straight days with politicians deadlocked over allegations of corruption in the sale of telecom licenses and coal mining rights.

Indeed, policy changes represent a big risk to further foreign investment. A tax rule proposed in April -- the general anti avoidance rule, or GAAR -- would have imposed onerous charges on foreign investors, and was to be applied retroactively for 17 years. That proposal was a major cause of foreign money flooding out of India between April and June -- FIIs pulled $350 million out in that period.

While the GAAR has not been implemented, the reaction of foreign investors should be a warning to India's markets. India looks cheap right now, but foreign money can be fickle, especially so when fundamentals are weak and policy is unpredictable.