The rupee rose to a five-week high against the dollar and stocks jumped to near record highs on Thursday as exit polls predicted a strong showing for the key opposition party in recent state elections.
Confirmation of a strong showing by the opposition Bharatiya Janata Party when results are out on Sunday would be seen as bolstering its chances of victory in general elections due by May, according to analysts.
The BJP and its prime ministerial candidate Narendra Modi are perceived by many investors in India as being more business-friendly and willing to undertake reforms to tackle an economy growing at its slowest in a decade.
Recent data are signalling the economy may be bottoming out while the current account deficit has shrunk, adding to optimism in Indian markets despite concerns about a potential tapering in the US Federal Reserve's monetary stimulus.
"Markets have already been performing well in India on the back of the notion that a BJP government will move forward more aggressively with investment in energy, infrastructure and overall capex," said Sacha Tihanyi, currency strategist at Scotiabank in Hong Kong, discussing a possible BJP victory in elections next year.
Still, opinion and exit polls have a patchy track record in India. Most surveys forecast the wrong outcome in the 2004 general election.
The rupee rose to as high as 61.52 against the dollar, its strongest level since Oct 31. It closed at 61.7525/7625 compared to its 62.05/06 close on Wednesday, giving up some gains on dollar demand from state-run oil refiners.
However, a Reuters poll of analysts showed that the rupee's strength may dissipate soon on concerns of the tapering with the unit weakening to 64 by May.
Bonds rose in early session in tandem with the rupee, but gave later ahead of Friday's auction. The benchmark 10-year yield closed 2 bps higher at 9.11 per cent.
"It's a tough call to say whether the gains seen will last.
"The gains are because of Modi effect and also the Power Grid FPO proceeds. But I think oil companies are buying in the market thus 61.50 saw the protection (for the dollar)," said Paresh Nayar, head of fixed income and currencies at First Rand Bank.
The benchmark Sensex rose as much as 2.2 percent to a session high of 21,165.60 points, approaching a record high of 21,321.53 points hit on November 3. It ended trade 1.2 percent higher.
The strong showing bucked the trend in Asian shares, which continued to be hit by worries of an early drawdown of US stimulus.
Indian markets have steadily recovered ground since a volatile summer that saw the rupee hit a record low against the dollar when fears of an early Fed tapering first surfaced.
Measures taken by the Reserve Bank of India and the ruling Congress Party have been seen as having helped that recovery.
Economic data has also turned more favourable, with data this week showing the current account deficit narrowed to 1.2 percent of gross domestic product, the smallest deficit since the June quarter of 2009.
Nonetheless investors see a BJP victory as potentially being more beneficial to markets.
"Based on our discussions with investors, markets are positively inclined towards Mr. Narendra Modi led BJP and less so towards Congress, despite some course correction in policies recently by the latter," UBS said in a 2014 outlook note to clients on Wednesday.
Additional reporting by Abhishek Vishnoi & Swati Bhat