The 30-share BSE Sensex soared 404 points to end the day at 18,752.83, up 2.20 per cent, while the broader 50-stock NSE Nifty jumped 137 points to close at 5,691.15, up 2.46 per cent.
"Sentiment was beaten out of shape, so this rally was expected. The strength in large caps indicates the rally will continue. Targets of 5,900-5,950 on Nifty are possible now," independent analyst Sarvendra Srivastava said.
On Thursday, the government went ahead with the notification of foreign investment in multi-brand retail, aviation and broadcasting sectors despite the nation-wide strike called by the opposition. Today, it went a step ahead and cut withholding taxes on overseas borrowings by local companies, sparking hopes that more reforms are in the offing to revive capital markets and also the overall economy.
The withholding tax cut boosted infrastructure stocks such as Larsen & Toubro, which are expected to especially benefit from easier access to overseas funding markets.
"Withholding tax cut is a significant thing as it reduces the cost of borrowing for corporates," said Sandip Sabharwal, chief executive officer for portfolio management services at Prabhudas Lilladher. "Whenever market sentiment improves and outlook on economy improves, normally, financials lead the rally.
Excessive allocation to defensives and cash is now getting reallocated," he added.
Boosting the sentiment was Samajwadi Party leader Mulayam Singh Yadav's statement that he would support the government, thus making it clear that there was no immediate threat to the government at the Centre. Notably, Mr Yadav took part in the nationwide strike on Thursday.
The markets are now looking forward to the Reserve Bank of India's second-quarter monetary policy review on October 30. The RBI is expected to cut policy rates and make some big announcements.
"Markets are responding to the fact that there are clear signs that domestic macroeconomic situations are being dealt with," Bharat Shah, executive director at ASK Group, said.
Among sectoral indices, power index stole the limelight with a gain of 4.35 per cent. The rally comes ahead of the financial restructuring of state electricity boards (SEBs), which is likely to get Cabinet go-ahead in three weeks.
Banking stocks also rallied on the back this news, with Bankex closing the day with a gain of 4.05 per cent. Reports indicate that states will take the burden of 50 per cent of the debt and issue bonds against these, while the other 50 per cent of the debt will have to be restructured by banks.
Aviation stocks made significant gains on FDI notification. Kingfisher Airlines soared 5.13 per cent to Rs 13.12, while Spicejet scrip gained 2.45 per cent to Rs 37.70 on the BSE. Jet Airways rose by 2.14 per cent to Rs 367.70. "The Government of India has reviewed the position in this regard and decided to permit foreign airlines also to invest in capital of Indian companies operating scheduled and non-scheduled air transport services up to the limit of 49 per cent of their paid up capital," a notification by the Department of Industrial Policy and Promotion (DIPP) said.
Shares in companies catering to the Indian Railways traded with strong gains on Friday ahead of Railway Minister Mukul Roy's resignation.
Indian Railways is the country’s biggest employer and markets expect reforms in the ministry after Mr Roy's exit. Former railway minister Dinesh Trivedi had to resign for trying to raise passenger fares.
Shares in Kernex Microsystems closed 8.04 per cent higher at Rs 55.75, while Kalindee Rail Nirman ended the day 7.36 per cent higher at Rs 77.30. Shares in Titagarh Wagons wrapped up 4.70 per cent higher at Rs 320.50.
Among specific stocks, Larsen & Toubro rose 4.2 per cent while Bharat Heavy Electricals surged 7.1 per cent. Reliance Capital surged 10 per cent on hopes the government will next consider increasing the foreign direct investment limit to 49 per cent from 26 per cent.
Other financial companies with insurance units also gained, with Bajaj Finserve up 3.5 per cent. State Bank of India rose 4.6 per cent, while ICICI Bank gained 4.7 per cent.
Top five gainers on the BSE were GMR Infra, up 10.64 per cent; Reliance Cap, up 10.11 per cent; JP Infratech, up 9.92 per cent; Reliance Infra, up 9.48 per cent; and IRB Infra, 8.08 per cent.
Top five losers on the BSE were Ruchi Soya, down 3.90 per cent; Astrazeneca, down 3.67 per cent; Hexaware Tech, down 3.59 per cent; Zee Entertainment, down 3.41 per cent; and SJVN, down 2.23 per cent.
Markets in Asia closed with strong gains. European stocks also traded higher as stimulus measures from major central banks continued to buoy investor confidence, offsetting weak economic data.