Investors worried PM Modi may sacrifice fiscal prudence ahead of 2019 polls

Foreign investors have this year pulled $4.4 billion from India, including $2.8 billion in May alone amid rising inflation and oil prices

The rupee is the worst performing currency in Asia this year, flirting with an all-time low on worries that India is headed for problems as rising oil prices rewrite the once-shining fundamentals of Asia’s third-largest economy.

India had been in a sweet spot since Prime Minister Narendra Modi came to power in 2014. Its economic expansion is outpacing even China’s, inflation is in check, its budget deficit seemed to be shrinking and its popular prime minister had looked unbeatable. It’s now the world’s fastest-growing large economy.

But since January, it has seen its currency underperform against almost all others. Only those of Argentina, Brazil, Russia and Turkey have done worse.

While most currencies have fallen against the dollar since the start of the year over a strong U.S. economy and rising U.S. Treasury yields, the rupee has given up 6%. It is now trading dangerously close to its February 2016 low of 68.90, and some economists see it sliding to 70 this year.

India is particularly vulnerable to fluctuations in oil prices, shipping in 80% of its energy needs due to demand that far outpaces domestic production. Oil is at around $75 a barrel now, compared with $63 six months ago.

The increased price of oil imports will likely push up inflation in India as the costs of products and services rise and widen the current account and budget deficits.

“As one of the largest importers of oil, the Indian economy is one of the most exposed to this particular shock, so it is not surprising to see some underperformance,” said Kenneth Akintewe, head of Asian sovereign debt at Aberdeen Asset Management Asia Ltd.

Bank of America Merrill Lynch estimates that every $10 increase in oil prices hurts Indian consumption by 0.6% of GDP, threatening to hold back India’s pace of expansion.

India runs a current account deficit, meaning that the value of its imports of goods and services exceeds that of its exports. The deficit could move beyond the 2% of GDP expected for the year that ended March 31, to up to 3% this financial year, Nomura estimates.

India has in the past been cushioned from oil-price rises by strong foreign portfolio investments.

But during an emerging market selloff, foreign investors have this year pulled $4.4 billion from India, including $2.8 billion in May alone. That outflow comes despite central bank efforts to increase corporate bond investment limits and relaxing government bond ownership rules for foreigners.

”You’ve got emerging markets selling off, you’ve got the dollar strength and oil factors which make India and the Indian rupee an easy target,” said Andrew Gillan, head of Asia ex Japan equities at Singapore-based Henderson Global Investors.

Domestic politics aren’t helping. A year ago, analysts saw a 2019 general election win for Mr. Modi as almost certain, but a series of shaky state polls have made that appear less likely. His party this month failed to win enough seats to control the southern state of Karnataka, a local election seen as a bellwether for its success next year.

“The election is still some time away,” said Dhiraj Bajaj, fund manager and head of Asia fixed income at Lombard Odier. “The market knows it’s a long time away and it’s really starting to get nervous.”

Mr. Modi will need to convince voters that last year’s chaotic introduction of a goods and services tax—and his 2016 move to cancel 86% of the currency in circulation—were worth it.

Investors now worry that Mr. Modi’s government will, in a bid to secure another five-year term, increase spending on populist measures and put the reduction of the fiscal deficit at risk. Opposition parties are also calling for him to reduce taxes on retail fuel prices to soften the blow.