Key political risks to watch in India

A weak economy exposed to an extended euro zone crisis, growing strain on the government coalition, and looming state elections that mean progress on tough reforms are unlikely are some of the risks to watch in early 2012 in the world's largest democracy.

RATINGS (Unchanged since January unless stated):

S&P: BBB-

MOODY'S: Baa3

FITCH: BBB-

The cost of insuring against default on 5-year sovereign debt traded around 88 basis points at the start of February, down around 20 points from the start of the year.

Following is a summary of key political risks in India:

ECONOMIC MALAISE

A feel good rally in Indian markets has given welcome relief to investors after months of gloom that made the currency and the stock market among the world's worst performing last year, but under the surface the problems afflicting Asia's third-largest economy remain largely unabated and unaddressed.

Inflation is down sharply, but almost entirely because of a drop in volatile food prices. And with the government embroiled in political wrangling over corruption scandals and unreliable coalition partners the prospects seem slim for tricky tax reform or a softening of foreign investment rules that could help deal with infrastructure bottlenecks.

The winter session of parliament was an unmitigated disaster from start to finish. As a result of passing no major legislation, the government now has a heavy load of promised reforms to try and push through two fractious houses in the budget session in March. Fickle coalition partners and a disruptive opposition mean the government is often effectively a minority when it tables bills.

Prime Minister Manmohan Singh promises to bring in a stalled policy to allow foreign supermarkets into India by March, along with a corruption ombudsman. The first stage of a new tax system is planned for April. On current form, nobody should hold their breath though.

In December, Goldman Sachs' Jim O'Neill called India the most disappointing of the BRICS countries, and warned of a risk of a balance of payments crisis if policymakers were not careful.

Asia's No. 3 economy is sitting on a comfortable cushion of $300 billion in foreign reserves and a confidence-building $15 billion currency swap line with Japan was unveiled in December, so comparisons with India's 1991 payments crisis are premature.

But as ever, India's dependence on imported, then subsidized energy is a weakness, with high prices adding to pressure both on the current account and fiscal deficits. A drawn out crisis in Europe could exacerbate the capital outflows and further moderate exports.

Morgan Stanley wrote in February that the ongoing fiscal and current account deficits will continue to pressure the rupee against the dollar over the long term.

"As the economy undergoes an extensive deleveraging process, we expect Indian equities and credits to underperform against their regional and emerging market peers during 2012," it said.

What to watch:

-- Headline inflation. If price rises show a sustained slowdown, expect the monetary easing India Inc. has been demanding for months.

-- Moves to accelerate project approvals and implementation.

-- The global economy and domestic demand.