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Analysis: India wins over markets, but now comes the hard part

By Ross Colvin

NEW DELHI (Reuters) - India's Finance Minister P. Chidambaram exudes the self-confidence of a man who, in the eyes of India's cheerleading financial markets, can do little wrong.

In the 11 weeks since he took office, the benchmark BSE index <.BSESN> has surged around 8 percent, due in large part to his hard-charging drive to boost investor sentiment that had soured under his predecessor, Pranab Mukherjee.

But the reality is the steps taken so far will not fix the sluggish economy in the near term, and the window of opportunity for implementing game-changing reforms such as slashing government spending on fuel, food and fertilizer subsidies will narrow as campaigning for a 2014 election gets under way.

"When you are fixated on equity markets and you are doing whatever you can to push them higher that is exactly what you will see," said economist Rajeev Malik of CLSA, Singapore.

"Pushing up equity markets is a lot easier than taking up some of these more difficult moves."

Together with Prime Minister Manmohan Singh, Chidambaram has unveiled a series of big-ticket and small-bore initiatives over the past month that were long demanded by investors and business leaders frustrated by years of policy inaction in New Delhi.

According to government officials, the slew of policy announcements on lifting the bar on foreign investment in the airline, insurance, pensions and retail sectors are part of a two-step government strategy - first, pump up the financial markets, then unveil a road-map for cutting the fiscal deficit.

The first step has worked. Net inflows from foreign investors have surged since Chidambaram's appointment, with $7.7 billion flooding into stocks and bonds since then, according to regulatory data. The next step will be more difficult.

TURF WARS, FRICTION

Reports published by the World Bank, International Monetary Fund (IMF), Standard & Poor's and a government panel over the past 10 days have provided sobering reminders of the huge challenges facing an economy still beset by high inflation and dragged down by ballooning current account and fiscal deficits.

The IMF sharply cut its economic growth forecast for India for 2012 to 4.9 percent from an earlier projection of 6.1 percent growth. The Kelkar budget panel, meanwhile, warned that India was teetering on the edge of a "fiscal precipice" and called for swift action to reduce the deficit, which it said could hit 6.1 percent of GDP this year if no action was taken.

Chidambaram has signaled that he is acutely aware of the dangers, telling a news conference last week that without reforms to curb the deficits, India "risked a sharp and continuing slowdown of the economy". He is expected to unveil a deficit reduction plan soon, possibly before the Reserve Bank of India's next policy review on October 30.

But turf wars within the cabinet, friction among coalition partners, continued weak government at a federal and state level and fears of alienating voters ahead of the 2014 election could still choke off Chidambaram's reform drive.

The Finance Ministry knows it has a "very small window" in which to act, a senior ministry official told Reuters.

There is already disagreement among ministers over a land acquisition bill long sought by Indian business leaders that would make it much easier for companies to buy land for industrial and infrastructure projects. The bill is stalled in cabinet and it is not clear when it will be approved.

The environment minister, meanwhile, has raised objections to another Chidambaram initiative - a national investment board aimed at cutting through red tape that can hold up infrastructure projects for years. The proposal is seen as the government's boldest attempt yet to clear infrastructure bottlenecks that have strangled economic growth.

WEAKENED COALITION

Singh's coalition government has also been seriously weakened by the walkout of a key ally and now governs without a parliamentary majority. It is dependent on support from two fickle allies that have campaigned against some of its flagship reforms, such as allowing foreign supermarkets into India.

That will make it difficult for the government to get pension and insurance reforms, recently approved by the cabinet, through parliament. In fact, there is now a higher risk of the government falling and an early election being called.

Critics question whether, in the face of such challenges, the ruling Congress party will have the political will to follow through with what Singh and Chidambaram have started. The party's powerful chief Sonia Gandhi favors costly welfare measures and had to be persuaded to back the recent reforms.

"If the government were to enter into a populist mode come FY14 budget and roll back any of the reform initiatives, risks of a (credit rating) downgrade will rise come next year," said Radhika Rao, an economist at Forecast in Singapore.

The government has already baulked at the recommendation of the Kelkar deficit reduction panel to phase out fuel subsidies, saying it had a duty to protect India's poorest citizens.

And Oil Minister Jaipal Reddy said last week he was "not so courageous" as to raise diesel prices any time soon after a hike in mid-September sparked a nationwide strike and street protests led by opposition parties.

His comment suggested the government is already viewing policy decisions through the prism of a general election due by mid-2014, when it will face a tough fight to win a third term.

Those political considerations pose a challenge even for someone as single-minded and determined as Chidambaram, finance minister for the third time in a storied political career. The question now is how much time India's political leaders will give him to get the economy firmly back on track.

(Additional reporting by Manoj Kumar and Rajesh Singh Kumar in NEW DELHI and Suvashree Dey Choudhury and Swati Bhat in MUMBAI; Editing by John Chalmers and Alex Richardson)

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