TOKYO -- India is witnessing the unconventional combination of a historic stock rally and a mini-financial crisis.
On June 3, the benchmark BSE Sensex stock index closed above 40,000 for the first time. The rally is stimulating the economy, with higher stock prices increasing the financial assets of the affluent, prompting them to spend more and in turn pushing share prices yet higher.
The day after the index hit its record high, South Korea's Samsung Electronics unveiled its ultra-high-definition 8K TV at a New Delhi shopping mall whose tenants include luxury brands like Rolex.
The 8K TV is the first Samsung product in India that exclusively targets affluent customers. The 82-inch screen, which costs 2.6 million yen ($24,000), is attracting a good deal of attention from business owners and other wealthy people, with the manufacturer receiving unexpected pre-sales orders.
But this seemingly positive cycle is fragile and behind the rally lie signs of potential problems in the financial system.
Indian stocks' average price-earnings ratio is 20, higher than Japan's 13 and 17 in the United States.
Fitch Ratings also downgraded some major banks, including Indian multinational ICICI Bank, to speculative grade on June 3. As news broke of a housing loan company's default the following day, prices of investment trusts that include its bonds nosedived.
Concerns are mounting that, if this situation continues, there could be credit tightening, and companies and households may cut spending. The Reserve Bank of India lowered the key interest rate on June 6, saying it will provide "adequate liquidity" to protect the financial system.
Stock prices have been rising on the back of investor expectations that the central bank will prevent any crisis with monetary easing policies. But if monetary means fail, the stock and consumption boom will come to an end.
"A crisis of confidence and liquidity crunch are becoming harder to resolve, which keeps the risk of massive credit defaults alive," warns Charu Chanana, an economist at Continuum Economics, a British research company for institutional investors.
The financial system has been India's weak spot. The ratio of nonperforming loans in 2018 exceeded 11% because of an economic slowdown and lax screenings. This is higher than Japan's post-bubble peak of around 9% in 2002. A high ratio leads to credit tightening and damages the economy.
The Indian economy grew 5.8% in the first quarter of 2019, marking the fourth straight quarterly slowdown and with a pace of expansion falling below that of China at 6.4%. India needs double-digit growth to provide employment opportunities for more than 10 million job seekers every year, according to one estimate.
That is why Prime Minister Narendra Modi, who has just started his second term in office, should not rely on the stock rally to stabilize the financial system, but should strengthen the country's economic fundamentals.
Modi has styled himself as a reformer through such policies as the demonetization of high-denomination banknotes to eradicate undeclared wealth, but he is losing momentum on this front. The Center for Strategic and International Studies, a U.S. think tank monitoring India's reforms, says the prime minister has not completed a single reform since July 2017.
With the unemployment rate rising, financial markets are waiting for reforms to facilitate business growth that will lead to job creation.
Logistics company Connect India, located in the southern city of Bangalore, is one thriving example of a social business organization which might be able to offer Modi some direction.
Founded in 2015, the company delivers merchandise bought via online retailers to rural areas that used to fall through distribution networks. The company forms partnerships with small shops locally known as kirana and pharmacies, outsources deliveries in "the last mile" to them and shares delivery fees with them. Now 7,500 partners carry out 50,000 daily deliveries by bicycle or on foot. The business has created 30,000 jobs across India.
Connect India aims to become profitable this year and is attracting attention from investors. Aavishkaar, a leading impact investor in the country, has financed the company four times over to help it open logistics hubs. Of the $400 million managed by Aavishkaar, 80% comes from foreign sources, including U.S. public pension funds.
Connect India's growth suggests the unique potential for social business models in India -- a country plagued by poverty, poor hygiene and many other social issues. Government support for social business will help raise people's living standards and stabilize the economy. The more companies get involved in this segment, the more foreign investment can be drawn in as well, which is instrumental for the stability of the rupee.
The precariousness of India's current situation can offer a warning to the rest of the world that economic fundamentals need to be solid if a country is to withstand any future headwinds. Financial markets around the world have seen examples in the past few weeks of central banks, fearing an economic slowdown, easing monetary policy and investors channeling money into stock markets.
What lies ahead is the trap of a bubble economy. History shows that investors' overconfidence in central banks can accelerate bubbles and make a post-bubble slump more severe.
The U.S. in 2007 is one such example. The risks of subprime loans had just been exposed and financial markets were hit by a credit crunch. That August, the Federal Reserve cut the policy rate to calm the situation. The Dow Jones Industrial Average hit a record high two months later. Panic, monetary easing and a historic stock rally. India is now going through exactly the same process.
Back then, the U.S. government and the Fed, breathing a sigh of relief at record stock prices, underestimated the scale of the danger they faced and neglected to fix the financial system. The result was the 2008 financial crisis triggered by the collapse of Lehman Brothers.
Will India and the world lower their guard with the current stock rally, or will they carry out reforms to give the rally substance? Investors who learn from history will take their cue from what happened 12 years ago and start selecting countries to put their money into.