The BSE Sensex rose more than 2 percent to its highest close since July 2011 after the government's diesel price hike and the Federal Reserve's monetary stimulus sparked a broad-based rally in blue chips such as Reliance Industries and ICICI Bank.
The steep hike in prices for the heavily subsidised diesel was seen signaling the government's resolve to tackle fiscal reforms at a time when international credit rating agencies threaten to downgrade the sovereign's debt to "junk" status.
(UPDATE: India allowed FDI in multi-brand retail, aviation after market close. Click http://in.reuters.com/article/2012/09/14/india-economy-retail-fdi-reform-idINDEE88D08M20120914 to read story)
Investors are hopeful for more action. A cabinet committee is due to consider a proposal to allow foreign direct investment into the airline sector, while the government could also consider spending cuts on Saturday, according to government sources.
Global factors could also turn in India's favour if the Fed's revival of its asset purchase programme unleashes more liquidity into risk assets, although investors will also eye the negative impact from a potential surge in crude oil prices.
"It is important now that government continues to act. One diesel hike is not enough. FDI in retail and disinvestment program is really important," said Sandeep J Shah, CEO, Sampriti Capital.
"The rally could peter out of there is no continued action by government."
The Sensex rose 2.46 percent to 18,464.27 points, its highest close since July 26, 2011 and gaining for an eighth consecutive session.
The BSE index rose 4 percent for the week, its strongest performance since the trading week ended on June 8. The 50-share NIfty rose 2.62 percent to 5,577.65 points, while ending up 4.1 percent for the week.
Analysts were especially hopeful the twin domestic and U.S. developments would spur more foreign buying of Indian stocks.
Foreign institutional investors have already bought a net 659.54 billion rupees of Indian stocks so far this year, and have been a major reason behind the 19.5 percent gain in the BSE index so far this year.
Blue chips rallied, with Reliance Industries surging 5.3 percent, while Larsen & Toubro
Lenders also surged on hopes that more government reforms could open up the prospect of interest rate cuts, although the Reserve Bank of India is expected to stay on hold at its policy review on Monday after August inflation rose more than expected.
India said on Friday its wholesale price index last month rose 7.55 percent, above expectations for a 6.95 percent increase.
ICICI Bank gained 5.1 percent, while State Bank of India rose 5.6 percent.
Airline shares rose on persistent on hopes the government would target the sector next.
Under current rules, foreign airlines are barred from buying stakes in domestic carriers, although foreign investors are allowed to hold a cumulative 49 percent.
SpiceJet
Among other gainers, Indian retail stocks surged on Friday on market talk the government may also consider opening up the multi-brand segment to foreign direct investment, even if the issue was not expected to be in the agenda for the government cabinet's weekly meeting.
Pantaloon Retail
Companies in which the government may sell stakes also rose. NALCO added 1.6 percent, while Neyveli Lignite Corp rose 1.2 percent.
However, among decliners, Indian oil marketing companies and refiners erased earlier sharp gains and turned negative as the spike in crude prices post-QE3 is seen offsetting the positive impact of the government's diesel price hike.
Hindustan Petroleum Corp
Shares of India's defensive sectors such as drug makers and consumer goods also fell as investors bet the Fed's new asset purchase programme will favour cyclicals and high beta stocks.
Among drug makers, Lupin
Cigarette maker ITC fell 0.5 percent, while personal care products maker Marico
