Thu, Apr 1 07:57 PM

Investors who had bet on swift economic reforms in India following the strong mandate won by the Congress-led government in elections last year have been disappointed — the government has been wary of pushing through controversial measures, and is now struggling with rising inflation and a weaker position in parliament.

Following is a summary of key risks to watch:

* INFLATION, AND MONETARY AND FISCAL POLICY

Inflation, and in particular spiralling food prices, presents a key challenge for the government, which has struggled to find a solution. In a surprise offcycle move on March 19, the Reserve Bank of India raised key rates by 25 basis points for the first time since it began cutting in 2008.

Rising demand-side pressure, which has begun to push up headline inflation to near 10 percent, means a further rate increase is likely at the next central bank policy review on April 20. Analysts expect a 25 basis points hike, but the central bank’s recent comments on inflationary pressures were hawkish and if the hike is larger, it may hit bonds and stocks. The RBI is less likely to increase banks’ cash reserve ratio.

The government plans to borrow a record 4.57 trillion rupees in 2010/11, 1.3 percent more than the previous year, to fund a fiscal deficit projected at 5.5 percent of GDP. To help fund this it plans bond sales of 2.87 trillion rupees ($64 billion), 63 percent of its record full-year issuance target, in the first half of the new fiscal year.

What to watch:

– Price stability is crucial for economic growth to benefit the broader population. If inflation does not moderate as expected, it could lead to aggressive monetary action which could impact growth and spark political protests.

– Comments by key government and central bank officials on the timing and scale of rate rises. Persistent policy uncertainty and inflation concerns would weigh on debt prices.

– If food prices continue to stoke social discontent, the government may feel less inclined to push ahead with economic reforms, with a broadly negative impact on Indian markets.

– With most developed countries still operating at near-zero percent rate levels, high interest rate in emerging economies provide arbitrage opportunities.

– Bank credit, which is at 15.8 percent, is still far from picking up, so a full-throttle charge to a higher rate regime could pose greater problems for credit growth.

– The volume of government borrowing may exert pressure on bond yields, and the central bank has said managing the government’s debt programme this year will be a challenge. The bank may not buy back as many bonds as it did last year, as it does not want to increase liquidity when inflationary pressures are mounting. The RBI is also constrained by the fact that it has nearly exhausted its stock of Market Stabilisation Scheme bonds which are used to absorb liquidity from the markets.

* ECONOMIC REFORM

While the government had appeared to be in a strong position to press forward with an ambitious economic reform agenda after last year’s wider-than-expected election victory, progress has been much slower than some investors had hoped. The government has made headway in some areas: it has pledged to reform tax laws, disinvest in some 60 state-run firms and formed an experts panel to ease foreign investment in the financial sector — steps markets would regard positively.

But it has repeatedly backtracked after street protests — such as over labour reforms and freeing up farm prices — raising doubts about firm governance needed to implement reform.

The government’s ability to push through key legislation, including financial reforms measures, will be tested when parliament reconvenes from April 15. Its parliamentary majority has narrowed after two of its partners withdrew support because of differences over bills reserving parliamentary seats for women and underwriting liability from nuclear accidents.

What to watch:

– Announcements on moves to privatise some state firms, relax restrictions on foreign direct investment, ease limits on foreign banks, and reform labour laws. The government’s plans to open up insurance and pensions to foreign firms are now in doubt.

– Important reforms such as stake sales in state firms could be hampered if adverse political or global economic developments spark volatility in domestic markets. The government plans to raise 400 billion rupees from stake sales to cut its deficit.

– The failure to move on the nuclear bill has prevented U.S. nuclear firms from accessing India’s estimated $150 billion nuclear power market and frustrated Washington.

* EXTERNAL SECURITY

With India and Pakistan holding their first official talks since the 2008 Mumbai attacks, hopes have risen of a calibrated reduction in tensions, despite a bombing in the western Indian city of Pune and an attack on Indians in Afghanistan. India has so far refrained from pointing a finger of blame towards Pakistan. But relations remain fraught and another major attack in India could severely test India’s patience and put the Indian government under tremendous pressure to stop its tentative dialogue with Pakistan.

The two countries are also jockeying for influence in Afghanistan, preparing for any political vacuum from a U.S. exit. This could further worsen their relations.

Military conflict remains only a very slim possibility. But a limited confrontation cannot be ruled out if Pakistan-based militants once again launch a major attack on Indian soil, making India-Pakistan conflict an unpredictable risk. And Pakistan’s weak government, under threat on several fronts, may have its own reasons to focus popular anger on India.

In comparison, ties between India and China, which remained uneasy throughout 2009 amid reports of border incursions and an occasional war of words, are witnessing a period of calm.

What to watch:

– Signs of further thaw in India-Pakistan ties and progress on more substantive talks. Any sign of rapprochement would be greeted positively by investors, but would not have a significant short-term market impact.

* INTERNAL SECURITY

The risk of violent attacks by domestic insurgent groups or foreign militants remains high, underlined by the recent Pune bombing that killed 16 people. Al Qaeda and affiliated groups see India as a key battleground, and Pakistan is likely to remain a haven for militants seeking to launch attacks in India. Security forces are also battling a Maoist insurgency spreading across large swathes of countryside, much of it rich in minerals.

What to watch:

– The danger of new attacks. Investors have priced in the threat level in India, as the muted market reaction to the Mumbai attacks showed, but attacks causing a serious deterioration in relations with Pakistan would be market-negative.

(Additional reporting by Abhijit Neogy; Editing by Andrew Marshall)
Krittivas Mukherjee