NEW DELHI (Reuters) - 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 2012 in the world's largest democracy.
RATINGS (Unchanged since December unless stated):
The cost of insuring against default on 5-year sovereign debt, in common with debt markets elsewhere in the world see-sawed violently in the second half of 2011, closing the year at 108.5 basis points, up 41.5 since January.
Following is a summary of key political risks in India:
With a 25 percent drop in 2011, the Sensex stock market was the world's worst performing among major economies. The rupee was the year's worst performer in Asia <EMRG/FRX> with a 16 percent fall, and all eyes are on the current account deficit as funds flow the wrong way and the oil import bill rises.
Growth in the second quarter of the 2012 fiscal year fell to 6.9 percent, the lowest rate for more than two years, while industrial output retreated in October for the first time since 2009.
Asia's No. 3 economy is sitting on a comfortable cushion of $300 billion foreign reserves and a confidence building $15 billion currency swap line with Japan was unveiled in December, so quick comparisons with India's 1991 payments crisis are premature.
But the avalanche of gloomy economic news has hit investor confidence and the political situation is not helping matters, with rifts in the government coalition making it hard to pass legislation to increase foreign investment in the economy.
A reversal late in the year on a flagship reform to allow foreign supermarkets to operate in India was a huge blow for the government of Prime Minister Manmohan Singh.
Like peers Brazil and China, the room for government-led stimulus is limited. 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.
As ever, India's dependence on imported, then subsidised energy is a weakness, with high prices adding to pressure both on the current account and fiscal deficit. A drawn out crisis in Europe could exacerbate the capital outflows and further moderate exports.
December brought some much-needed relief in the form of a sharp fall in food price inflation. That raises expectations of monetary loosening soon to help stoke flagging growth but structural factors are likely to keep prices rising at a fast pace in the medium term.
With hopes dashed for benefits from global supermarket supply chain expertise, India will have to find new ways to reduce food wastage and increase productivity.
What to watch:
-- Headline inflation. If price rises slow, expect the monetary easing India Inc. has been demanding for months.
-- The global economy and domestic demand.
ELECTIONS IN FIVE STATES
Elections in five states in the first two months of the year will test support for the ruling Congress party roughly half way through Prime Minister Manmohan Singh's second term. Elections are hard to predict in India, but opinion polls suggest Congress could do better than a year of corruption scandals and disappointing growth would suggest.
A poor result for Congress would compound the feeling that Prime Minister Singh is a lame duck, and calls could intensify for him to hand over power to someone else in the party.
The party could win in Punjab, while in the 200 million strong Uttar Pradesh any improvement on the 22 seats it currently holds in the 403 seat state assembly would be spun as a victory.
Rahul Gandhi has staked his political reputation on getting a good result in Uttar Pradesh, which may be a barometer for the national mood ahead of general elections in 2014.
Even if the party comes in fourth place but forms a coalition government, he will be seen as a success.
Party chief Sonia Gandhi, who is at least as influential as the prime minister, has shown up in parliament on a number of occasions in recent weeks but has shed no light on illness she is suffering, which some Indian media reports say is cancer.
What to watch:
-- The Gandhi dynasty. Rahul Gandhi has yet to prove himself as an effective politician, raising concerns he will struggle to lead the party if his mother steps down. The Uttar Pradesh election early next year is a key test.
FREE MARKET REFORMS AND WELFARE
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, possibly in March. Fickle coalition partners and a disruptive opposition mean the government is often effectively a minority when it tables bills.
Although it could probably muster the support to survive a no-confidence vote, the government's real saving grace may be the lack of appetite in the opposition Bharatiya Janata Party for an early general election. Despite Singh's woes, it is by no means clear the BJP has won over many voters to its Hindu nationalist cause.
The government will try to argue on the state election trail that its plans for the world's largest food subsidy programme, higher compensation for farmers who lose land to property development or mines, and failed attempt to create an anti-corruption ombudsman are all evidence of its commitment to the common man, thwarted only by a disloyal opposition.
Singh promises to bring in the planned supermarket rules by March, along with the corruption ombudsman. The first stage of a new tax system is planned for April. On current form, nobody should hold their breath though.
What to watch:
-- Political wrangling around the budget for the 2012/13 fiscal year, likely to be announced after the state election results in early March.
BETWEEN CHINA AND PAKISTAN
India's foreign policy focus used to be first Pakistan, then China. Now it is more China, then Pakistan. Relations with Islamabad have improved considerably in recent months, with an upgrading of trade ties and an easing of visa regulations helping the thaw.
Still, it would only take one armed attack in India bearing the hallmarks of Pakistani-based militants to reverse the advances. Partly in response to its worries about China's steadily increasing influence among all its neighbours, not least Pakistan, India has forged closer ties with the United States, Australia, Japan and Vietnam.
Pakistan's own perilous political situation could have far reaching fallout for relations between the nuclear armed neighbours.
This jostling between the China and India is not necessarily dangerous and the risks are offset by growing trade and economic relations, but the rivalry will dominate India's policy decisions for years to come.
India is spending heavily on arms to keep pace with China's growing military might, and the two countries still have unresolved border issues. India is also stepping up its involvement in Afghanistan, possibly at the behest of Washington, worried about a power vacuum as NATO troops withdraw in the next few years.
What to watch:
-- Development of ties with East Asian nations to counter China, not least in the South China Sea. Australia has mentioned the possibility of a tri-lateral security pact with India and the United States. India says this is not on the cards but is stepping up naval cooperation with Australia.
-- Pakistan's domestic problems. If the civilian government there falls, it could undo the progress made on normalising ties in the past year.
(Editing by Daniel Magnowski)
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