Is political risk back in Indian stocks?

Fri, 22 Mar Pre-Open

   Previous Close   

   09:30 am   

   11:30 am   

   01:30 pm   

   Closing   

India is going through its worst patch of economic growth in nine years, which has seen the rupee slide to record lows against the dollar and investors clamoring for greater policy action from Prime Minister Manmohan Singh's government. As much as the current global financial turbulence, investors blame a lack of significant policy reforms in the eight years of Singh's government, and its unwillingness to curb popular but costly subsidies, for the slowdown.

The central government under the leadership of Manmohan Singh has been accused for serious lapses in governance. Lurching from crisis to crisis for more than a year, Prime Minister Singh's government has a new front to deal with. This time from its key coalition partner. The Dravida Munnetra Kazhagam (DMK) party, a key ally of the ruling Congress-led United Progressive Alliance (UPA), withdrew support to the federal government citing differences on the issue of atrocities on Tamils in Sri Lanka. This news sent the Indian stock markets into panic mode. Does this mean that political risk is back in Indian equity markets?

Although the central government has the numbers to stay in power, its dependence on two regional parties (SP and BSP) has increased enormously. That support is often manifested in opposing reforms and calls for populist measures. Thus, political turmoil takes away the focus from economics even when things don't look too good on the economic front. Sure, the government has made many reform promises and targeted an ambitious 4.8% of gross domestic product (GDP) fiscal deficit for the next fiscal year. If India does go into election mode, the first casualty would be fiscal consolidation measures announced by Finance Minister P Chidambaram like partial deregulation of diesel prices. Although it may not end the reform process, there could be a slowdown in reforms for sure.

The political risk will thus tell on capital flows as well. So far India has received decent capital flows despite the cracks in the current account deficit, which is expected to top 6% of GDP for the third quarter of this fiscal year. Any increase in uncertainty will cause the capital flows to leave the country. In the worst case scenario of early elections, there could even be some outflows in the near term. That, in turn, will have a debilitating effect on the rupee, setting off a vicious cycle of an increasing current account deficit and depreciating currency.