By Carolyn Cui and Shefali Anand

India has emerged as one of the most prominent victims of November's market turmoil.

The twin shocks on Nov. 8 of Donald Trump's U.S. election victory and Indian Prime Minister Narendra Modi's currency crackdown have unleashed a wave of selling in stock and foreign-exchange markets. It is the latest reversal for Western investors banking on an economic revival in the world's second-most populous nation.

Mr. Modi has announced plans to replace India's largest-denomination bank notes with newly designed ones in an effort to clamp down on corruption, thwart counterfeiters and fight tax evasion.

Since Nov. 8, the MSCI India stock index has dropped 7.1%, vs. a 4.9% decline in emerging markets more broadly, according to MSCI Inc. The rupee has lost more than 3%, hitting an all-time low last week against the dollar.

Foreign investors have pulled $2.6 billion out of Indian shares in November, compared with a net investment of $7 billion between January and October, according to Indian regulatory data.

Many investors believe the currency crackdown will prove wise in the long run, by reducing corruption and increasing tax collections, and that the Trump shock won't be long-lasting. Even so, those who came into 2016 believing India was likely to rank among the strongest emerging-markets investments have been forced to think again.

"It's highly disruptive to the economy in the short term," said Arjun Jayaraman, an emerging-market manager at Causeway Capital Management LLC, who said Indian firms' earnings could be hit for several quarters. Mr. Jayaraman has recently reduced some exposure in the Indian real-estate sector, which is heavily dependent on cash transactions.

India's promise is easy to see. The economy expanded at 7.6% in the financial year ended March 31, ranking among the fastest-growing in the world. Inflation has fallen in recent months, enabling the central bank to cut benchmark interest rates. Mr. Modi has taken several steps to open sectors to foreign investment and make it easier to do business in India.

But Mr. Modi's announcement that the government would ban the use of 500- and 1,000-rupee notes hit an Indian market already reeling following Mr. Trump's victory. The U.S. election ignited a dollar rally that has sharply tightened financial conditions for emerging economies reliant on dollar debt and foreign capital.

Amplifying those ripples, India is a cash-heavy economy. Cash transactions make up around 12.4% of GDP, compared with 5% in Mexico and 4% in Brazil, according to a study by Tufts University. Some analysts fear Mr. Modi's crackdown could slow investment.

Housing Development Finance Corp Ltd., a widely owned Indian company among foreign investors, is down 9% since the ban, as much of India's real-estate transactions are conducted in cash. Hero MotoCorp Ltd., a maker of motorcycles and scooters, at one point was down 15%, as cash-strapped farmers pulled back from buying the vehicles.

Deutsche Bank recently cut its forecast for India's economic growth by one percentage point to 6.5% for the year ending March 31. Corporate profits are also expected to fall over the next six months.

"You have clogs in the artery now. For the short term, it will cause a lot of havoc for many businesses and probably a meaningful retreat in consumption," said Justin Leverenz, a portfolio manager of the $28.4 billion Oppenheimer Developing Markets Fund, which has about 12% of its assets in India. Mr. Leverenz is heading to India next week, looking to scoop up some beaten-down stocks.

The pain for foreign investors has been widespread. As of the end of October, the top 127 emerging-market equity funds, which managed $257 billion of assets, held an average weight of 11.5% in India, well above the benchmark weighting of 8.4%, according to Copley Fund Research.

Gary Greenberg, head of global emerging markets at Hermes Investment Management, took advantage of the selloff to add to his holdings of Hero MotoCorp. India accounts for nearly 16% of his portfolio. "Sometimes the medicine tastes bad," he said.

At around 20%, India is one of the biggest bets in the J.P. Morgan Emerging Markets fund. Portfolio manager Leon Eidelman said he has bought some stocks that have fallen sharply, as he continued to see India as the place to reap the emerging-market benefits of a growing middle class and consumers.

The one bright spot has been for bondholders. Prices of rupee-denominated government bonds have surged as Indian banks used their rising deposits to buy bonds, sending the 10-year yield down to 6.3% from 7% -- at a time when yields were rising around the world.

Between Nov. 8 and Nov. 25, funds parked by banks with the Reserve Bank of India surged 10-fold to 1.5 trillion rupees ($22 billion), prompting the central bank to boost its cash reserve ratio to absorb the liquidity in the banking system.

The bond rally has been good news for Los Angeles-based Capital Group, which has a 5% allocation to Indian bonds in its emerging-market portfolios.

"One thing we found attractive about India is that it's a very idiosyncratic uncorrelated market with broader emerging-market trends," said Rob Neithart, a fixed-income portfolio manager. The country has "tremendous potential" if reforms are implemented in a timely manner, he said.

Write to Carolyn Cui at carolyn.cui@wsj.comand Shefali Anand at

(END) Dow Jones Newswires

December 01, 2016 07:14 ET (12:14 GMT)

Copyright (c) 2016 Dow Jones & Company, Inc.