India's record high capital inflows are more a cause for concern than a sign of comfort, according to Deloitte Research, a part of Deloitte Services LP.

Outlining India's Economic Outlook 2008, Deloitte said though foreign investors are pouring in millions in India, betting that the country's strong growth will continue apace, however, the ''vast majority'' of this foreign investment is in the form of portfolio investment rather than direct investment.

The Deloitte research said, ''Much of this money is going to equity markets, helping to drive equity and property prices to dizzy heights. This form of investment is worrisome as money can flow out just as easily as it can flow in. This sets the stage for potential financial market turmoil if and when the emerging market equity bubble bursts''.

Incidentally, the International Monetary Fund (IMF), in its Annual Economic Health-Check bulletin published on 4 February has also pointed out that while India's recent ''stellar'' economic performance, attracting large capital inflows, has been a boon, however, ''inflows also complicate monetary, exchange rate policies. To sustain growth, India needs to tackle fiscal issues and implement structural reforms''.

According to IMF, huge capital inflows caused the Indian rupee to appreciate by seven per cent in ''real effective terms'' and this has raised concerns about India's competitiveness, particularly in the labour-intensive textile, garment and leather industries.

Besides, the capital inflows have also increased the money supply which invariably raises the inflationary pressure. In short, said IMF, India is confronted with the policy challenges of the ''impossible trinity'': ''When there is free movement of capital it is impossible to both target the exchange rate and maintain an independent monetary policy''.

Other than the concern of capital inflow, the Deloitte study also points to the problem of India bulging budget deficit. Deloitte said since the country continues to run a large budget deficit of four per cent of GDP, it only shows that India is ''eating up a portion of domestic savings, thereby increasing the cost of capital. This subtracts from potential investment in productive capacity''.

The Deloitte paper observes that India' business investment and investment in human capital remain weak relative to the needs of a rapidly growing economy. This imbalance, said Deloitte, cannot endure. Besides, inefficiencies in the country's labour and product markets, the result of excessive regulation also inhibit long-term growth.

Deloitte also emphasised that any failure to enact reforms, improve fiscal discipline and invest sufficiently in human capital and infrastructure ''could ultimately result in slower growth''.

Referring to India's ''strong economic growth'' Deloitte said it was primarily driven by the services and manufacturing sectors. The services sector, said Deloitte, notably financial and business services, has made significant contributions to India's growth momentum. ''The only thing likely to hold this back is the supply constraint on human capital'', said Deloitte.

India's manufacturing sector, ''a bit at odds with conventional wisdom'', has accelerated significantly. According to Deloitte, ''India probably cannot maintain breakneck growth based on business services alone. Manufacturing will be critical to improve the lot of the relatively uneducated masses''.

Interestingly, said Deloitte, the preponderance of manufacturing growth is due to domestic demand rather than export demand. ''The former has been fuelled by the strong liquidity that has also fuelled the growth of the financial sector. That liquidity is, in part, the result of large capital inflows from overseas. Unfortunately, the net effect of this has been to cause a currency appreciation which will damage the competitiveness of exports''.

The IMF has predicted that India's vibrant outlook and sizeable capital demands mean that capital inflows are likely to remain large. This, said IMF, would be ''consistent with the experience in other Asian countries around growth take-offs''. Since restrictions on capital inflows are not likely to be effective, allowing greater exchange rate flexibility and improving liquidity management may be a better way to deal with continued capital inflows, advocated IMF.

Talking in tune with IMF, the Deloitte study also pronounces that India faces a delicate balancing act in the near term. ''It must avoid inflation while at the same time avoiding excessive credit constriction. The latter could burst the property price bubble and thereby crimp domestic demand. That would do damage to the nascent expansion of the manufacturing sector'', said Deloitte.