Security issues in India continue to be overshadowed by the deterioration of the political and internal security situation in Pakistan. Most recently, the resignation of Pakistan’s President Pervez Musharraf’s raises fears that the civilian government may have little to no influence over the military or the Pakistani Inter-Services Intelligence agency, which New Delhi, among other things, believes played a role in the recent bombing of the Indian embassy in Kabul. Recent skirmishes along the ‘line of control’ in Kashmir (marking the contested border) and mass protests have also rekindled fears that this infected wound could be reopened again, thereby throwing the peace process (kicked off in 2004, under Musharraf) off track.

Turning to domestic politics, The United Progressive Alliance (UPA) government continues to look unstable ahead of national elections in the coming year in spite of Prime Minister Manmohan Singh’s avoidance of a collapse of the coalition on the back of the Communist Party’s opposition to a nuclear pact with the US. We believe the next government will be led by the Hindu nationalist Bharatiya Janata Party as the Indian Congress (INC) Party looks unlikely to be able to reverse its current unpopularity before the upcoming national elections, which have to be called before May 2009.

On the international political scene, the fate of the nuclear pact with the US is now in the hands of the US Congress, which has been using the deal as a leverage to influence India to limit its burgeoning relationship with Iran. It is the perceived realignment of India, still nominally a non-aligned state, towards US foreign policy which has provoked the anger of the Communists. The deal brings considerable gains for India in the form of nuclear fuel and technology, which will have a sizeable impact on the government’s effort to expand power supply in line with rocketing demand, but it is unlikely that INC will be awarded for this in the upcoming elections. Moreover, increasing military and defence cooperation with the US and Israel could create a rival axis to the expected Chinese regional dominance, and offer India a greater range of arms for procurement. However, it cannot be taken for granted that the US will always be as willing to accord India as favourable terms, especially if New Delhi goes ahead with a proposed US$7.6bn gas pipeline to Iran as discussed with Iranian President Mahmoud Ahmedinejad in late April Although India has been the largest importer of conventional arms among the developing countries, its military exports are comparatively negligible. India has historically had close links with Russia, accounting for a staggering 35-40% of all Russian arms exports. The continuing strength of this relationship is testified to by the recent signing of an Inter-Governmental Agreement for the Joint Development and Production of the Fifth Generation Fighter Aircraft. However, India also has a growing relationship with the US and Israel. India became Israel’s primary importer of defence products in 2006, having amassed sales of US$1.5bn.

Finally, India’s macroeconomic outlook is expected to moderate further. W e see growing downside risk to our forecast of 7.9% GDP growth in FY2008/09 (April-March) as higher prices for fuel, food and other necessities cuts into private consumption and external demand. The sharp tightening of monetary conditions over the year in response to higher rates of inflation will also inhibit spending, but we expect the main impact of this to be felt in FY2009/10 with our GDP forecast for the year standing at 7.65%.

Growth should rebound somewhat beyond FY09/10, but this will be conditional on India addressing its shortages in power supply and infrastructure, which remain as threats to long-term growth.