Warning Flags For Investors In India

India's stock market has been on a tear. On Sept. 9 the Bombay Sensitive Index crossed the 8,000 mark to close at a record 8,052. The 12.5% surge came just 55 days after the market topped the 7,000 milestone. Foreign investors are pouring $1 billion a month into the market. And why not? Indian corporate profits have been growing at over 30% annually for three years, while the economy is chugging along at 7% growth rates.

But there's a potentially dangerous disconnect between the market in Bombay and the corridors of power in New Delhi. The soaring Sensex doesn't reflect a recent slowdown in reform, or political pressures on Prime Minister Manmohan Singh. In the last few months, Communists in the Congress Party-led ruling coalition have blocked nearly all efforts at economic liberalization. That's a setback for Singh, the architect of India's economic opening in 1991, who became Prime Minister in May, 2004. "The stock market is no longer a real barometer of the economy," argues Prithvi Haldea, chief executive of New Delhi researcher Prime Database.

The implications could prove important for India's longer-term growth. Faced with opposition from hardliner Prakash Karat, leader of the Communist Party of India, and other leftists, Singh has had to take privatization of state-owned companies off the agenda. Labor reform, which would have allowed easier hiring and firing of workers, has stalled, as have plans to lift limits on foreign direct investment in banking and insurance. Only aviation and construction have been opened to private investment, and some limited pension reform introduced. In their latest move, Communists are battling proposals to allow foreign participants in India's retail trade, which they fear will hit mom-and-pop stores. "The Left wants to demonstrate to its constituents that it calls the shots in Delhi, " says Partha Nath Mukherji, a senior researcher at New Delhi's Institute of Social Studies.

A $30 billion hole

Singh also faces resistance from socialists in his own party. Even Sonia Gandhi, the powerful Congress Party leader, is acting more populist than reformist. With an eye on future elections, she is pushing a rural employment scheme that would guarantee one member of each rural household 100 days of labor. That could blow a $30 billion hole in India's finances and boost the fiscal deficit, already 10% of gross domestic product. It would also soak up funds needed for infrastructure improvements.

Business is concerned about the slow reform pace. Nandan M. Nilekani, CEO of software player Infosys Technologies Ltd. (INFY ), maintains that India will keep growing at 7% for now. But he's worried about the longer term, because more than 14 million Indians enter the job market each year. The growth rate "is not enough to meet the demographic challenge. For that we need 9% to 10% growth," Nilekani says.

Is there a way out? Most analysts don't see the Left backing major reforms until it is securely returned to power after regional elections next spring in the Communist-led states of Bengal and Kerala. In the meantime, India could be missing a huge opportunity. Without more liberalization, much-needed foreign direct investment won't pick up, and job growth will be sluggish. If corporate earnings flag, those enthusiastic portfolio investors could take their money elsewhere.

By Manjeet Kripalani in Bombay

Edited by Rose Brady

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