A preview of what can be expected on the economic front and from the stock markets in 2007. By Rex Mathew.

2007 is only a week old and most New Year resolutions would have already been broken and we now have to wait for the year to end before making fresh promises and resolutions. However, promises held out by the economy and the stock markets have all been met and even exceeded expectations for the last few years. Can we expect an encore in 2007 or are we in for some rough weather this year?

Reforms
Economic reforms have almost become a non-issue these days. While there is a near consensus on the need for reforms, it is also well accepted that big-ticket reform moves would take their own time because of the fractured electoral mandate. Economic reforms have assumed a slow and steady pace so that fervent cries for speed have almost faded.

This year is likely to be no different, though the government may try to push a few items if it can strike a bargain with the left parties. Many key states are due to have polls this year, which would shift political priorities far from the need to speed up reforms. Expect more populist policies for the next two years as the political parties would fully switch to election mode by next year.

The power sector may see some more action, mostly on the generation side through the ultra-mega power project policy. Restructuring the power distribution system would need many more years of committed work. Not much action can be expected on financial sector reforms, except for some minor tinkering here and there.

The political battle over the conversion of farm land for industrial use, including SEZ projects, would take centre stage this year. The agitation in West Bengal has reached such a sorry stage where an unnecessary political war is being fought even by sacrificing innocent lives. This may spread to other states when the large multi-product SEZ projects reach implementation stage. The violence and loss of lives in Bengal has already strengthened those opposing these projects in the guise of protecting farmers' interests. It would need considerable political will and initiative on the part of the central government to come out with proper, but uncomplicated, guidelines to ensure a fair deal to everyone and ease the situation.

Interest rates
The RBI hiked the reverse repo rates four times for a total of 100 basis points last year before taking a pause towards the end of the year and opting for a 50 basis point CRR hike to drain out liquidity. However, the economic momentum remains strong and GDP growth may exceed 8 per cent for the fourth year.

Forecasts by both domestic and international institutions predict this trend to continue and the more optimistic among them see India overtaking China by 2008 with growth in double digits.

Inflation is still a worry though crude oil prices have come down substantially and most forecasts predict a subdued trend this year. Prices of primary food products in the domestic market may inch up modestly but manufactured goods prices may stabilise as capacity additions come on stream.

Despite these factors, expectations are that the RBI would go in for a rate hike at its next meeting before going into a wait and watch mode.

Rupee appreciation
The rupee has been appreciating for the last several months against the US dollar on strong foreign inflows into the country. Against other major currencies, the change was not so pronounced.

The currency appreciation has already raised fears of slower export growth this year and would impact margins of exporters, especially in IT services. Exporters of low-margin products like textiles would be worse off, if this trend continues.

For the current year, it is likely that the rupee would remain within a range around the current levels. While overseas inflows are expected to remain steady, analysts are expecting only modest hikes in domestic interest rates. If oil prices remain subdued as expected and there is no US recession to pull down exports, the rupee would have a relatively steady journey through the year. However, if the domestic stock markets see a correction, triggered either by high valuations or a global correction, the rupee would see a short term dip. Movement of the US dollar against other major international currencies would also have considerable bearing on the rupee.

The dollar depreciated against other major currencies like the euro and yen last year and the outlook for the current year is not very different. The US currency has given up 35 per cent against the euro over the last four years and nearly 30 per cent against a basket of major currencies.

Unsustainably high US trade deficit, which now exceeds $900 billion annually, and the economic slowdown would continue to put pressure on the dollar. While a further deceleration in US economic growth this year would see a sharper fall in the currency, any signs of a recovery - even if modest - would support the dollar.

Chances are the US economy may settle down this year, helped by the stabilising housing sector, and the dollar may drift down modestly.

On the contrary, some analysts are arguing that the sustained fall of the US dollar over the last four years may trigger a pullback this year. Some of these analysts think that the dollar is now undervalued by up to 10 per cent, but a possible pullback rally may not last long and gains would be limited because of the underlying fundamental factors.

Economic growth
It is reasonably well established that the economy has entered a new growth trajectory since 2003 and it would take a confluence of adverse factors to cool it down substantially.

Though there were some signs of deceleration in industrial growth during the last quarter of 2006, consumption growth and growth in industrial investments remains strong. Industrial investments would only accelerate over the next few years, unless interest rates rise substantially, while the government may step up infrastructure spending.

Government finances have improved, mostly because of better than expected revenue collections, which should help in funding the expected hike in social and infrastructure spending. Lower crude oil prices also bode well and the economic momentum is very likely to continue this year as well.

Among the domestic factors, which could have an adverse impact on growth this year, interest rates could be the most significant. Some economists contend that the RBI, like the US Fed, has gone too far with its rate hikes and the economy may see lower growth rates for the current year. Though inflation has moved closer to the upper end of RBI's target range, they argue that it need not be a cause for concern as the economy has moved into a structurally different growth phase.

Therefore, they believe, the increase in real interest rates over the last year was not fully warranted.

There are no clear signs, as yet, that this prognosis is true. The last time the RBI overreached itself through interest rate hikes in the mid-'90s, the economy paid the price through a prolonged slump, which lasted till 2002. This time around, the overall environment is quite different and the economy has structurally changed. Even if the RBI has indeed gone too far with rate hikes, the underlying momentum may ensure that the economy would escape a crash landing.

The bigger risks to sustained growth this year would be global developments rather than domestic factors. The most potent risk is an economic recession in the US, which looks unlikely as of now. That would pull down global growth rates and a possible fall in the dollar, which would follow, would have a far-reaching impact on the global economy and financial markets.

Even in such a scenario, domestic economic growth may slow down to 7 per cent levels - very desirable even a couple of years back - as the Indian economy is not as dependent on export performance as some of the other major economies in the region.

Stock Markets
Stock market indices have had an extended bull run for the last four years, for a compounded return of over 40 per cent per annum for the Sensex during this period. 2006 was supposed to be a year of consolidation for the market, but the Sensex returned 47 per cent while the Nifty surged 40 per cent for the year. Indices were highly volatile during the year and retail investors did not benefit much as most of them did not stay invested through the volatile period. Large caps outperformed while many mid-cap stocks are yet to recover from the beating received during the May-June 2006 correction.

After a four-year rally, it is easy to say the market is likely to take a pause and consolidate. The next safe thing to do is to predict a correction, at least a modest one, as valuations appear to be stretched after the sustained rise. To forecast a sustained bull run with returns close to the average for last few years would be almost foolhardy.

Domestic factors discussed above may not have much of an impact on the stock markets this year, unless there are drastic variations in any of them. Even a modest contraction in corporate margins may fail to dull the exuberance much as the market is completely sold on the long term India growth story. Of course, there would be short-term reactions to any of these events but the market is likely to pull itself back without much fuss.

However, any major correction in global markets - because of factors including, but not limited to, lower liquidity, sharp currency movements, unwinding of excessively leveraged positions and lower global growth could have a much more severe impact on the domestic indices.

In such a scenario, domestic investors would accentuate the fall as they would take the cues from some foreign investors with a short-term outlook. But the Indian indices would do relatively better in a global downturn as long as the domestic growth story remains intact.

This year would see a large number of IPOs hitting the market, including the mega issue from DLF. Once again there are fears that the bunching of IPO's would lead to a decline in market liquidity and some weakness. If past evidence is anything to go by, large high-profile IPOs bring fresh money into the market - part of which remains even after the issue. That is likely to be the case this year as well, unless the issuers and their merchant bankers overprice the issues.

If the global financial markets remain relatively tranquil, which would help the domestic indices to remain less volatile, domestic investors may increase their equity exposure and drive the market this year - and most likely for the next few years as well. In any case, the way forward is of more modest returns from frontline stocks while young stars would continue to grow and create considerable wealth for shareholders.