FACTBOX-Key political risks to watch in India

NEW DELHI Aug 2 (Reuters) - With last year's strong election victory India had appeared set to push swift economic reforms, but tackling stubbornly high inflation, a political hot potato, has largely distracted the Congress party-led government.

Here is a summary of political risks to watch in India:

* INFLATION AND MONETARY POLICY

Inflation, particularly of food prices, has been the single major political and policy challenge for a government whose core constituency is predominantly poor and rural.

Headline inflation in India may touch 11 percent for July, which would make it six straight months in double-digits. Inflationary pressures are now generalised and demand side pressures are clearly evident. The central bank has responded by raising interest rates four times since March, most recently on July 27 when it hiked the reverse repo rate INRREP=ECI by 50 basis points, more forcefully than expected to absorb excess cash. With inflation a dominant concern and an economic recovery firmly in place, the stage appears set for more tightening.

The Reserve Bank of India's repeated use of the word "calibrated" to describe its exit from crisis-period monetary policies has been interpreted by markets as increases in key rates of 25 basis points at each of its quarterly reviews for the rest of the fiscal year. A Reuters poll after the July 27 policy review found economists expect the central bank to lift rates aggressively, with most expecting a further increase in rates by the end of September. [ID:nBMA008098]

Analysts expect price pressures to continue because of a government decision in June to lift price controls on gasoline and raise prices of other fuels. The government has left open the option of intervening if global crude prices soar.

What to watch:

-- Comments by policymakers, advisers and central bankers on the outlook for inflation. Hawkish comments raise the likelihood of bigger rate increases and would weigh on bond prices IN063520G=CC.

-- Progress of monsoon rains. The government is counting on strong farm output to curb high food prices.

-- Oil prices. If they soar and the government intervenes to subsidise, then investors may begin to worry about the impact on efforts to keep the fiscal deficit below the forecast 5.5 percent of GDP in 2010/11.

* POLITICAL FALLOUT FROM INFLATION

In a country where voters are known to have kicked out governments over high onion prices, inflation is a handy tool for the opposition which has threatened to block proceedings in parliament if the government does not agree to a discussion and vote on the issue. The government has to resign if it loses such a vote. The left-of-centre Congress has 208 members in the 545-member lower house of parliament, with allies taking it past the half-way mark required to pass ordinary legislation. The slim majority puts it at risk of losing a confidence vote.

The parliament speaker has for now turned down the opposition request, prompting them to stall debate on several key reforms bills, including one to simplify taxation and another giving foreign firms access to India's $150 billion nuclear power market. The opposition shut down parts of India with a national strike last month. The government expects inflation, which was at 10.55 percent in June, to come down to 6 percent by December.

If the opposition manages to capitalise on high prices, the Congress party could be hit in major state elections in early 2011, including in West Bengal and Tamil Nadu. But these elections remain months away and any voter backlash could be mitigated by boosting increased social spending with money saved from fuel subsides and telecom spectrum sales.

What to watch:

-- Signs of protests waning which will brighten prospects for pending reforms bills.

-- The stance of Congress allies. Two of them face elections in their stronghold states and political expediency may force them to distance themselves from painful reforms which could anger voters. But they are unlikely to bring down the government.

* ECONOMIC REFORM

While the Congress-led government had appeared to be in a strong position to press forward with an ambitious economic reform agenda after winning a strengthened mandate in elections last year, progress has been much slower than some investors had hoped. The government has made headway in some areas: it has pledged to reform tax laws, sell stakes in some 60 state-run firms and formed an experts panel to ease foreign investment in the financial sector. [ID:nSGE60D0F4]

June's decision to free up fuel prices was also a signal the government may be getting more serious about reform.

But tackling inflation has distracted the government from pushing reforms, and political expediency in a coalition which includes powerful regional parties eyeing local elections in the coming months will mean slow progress on bold measures like allowing greater foreign stakes in the pensions and insurance sectors and foreign entry into the retail sector.

What to watch:

-- After the fuel price hike, any signs the government will fast-track other reforms will be bullish for markets.

-- Announcement of further stake sales in state firms to raise $8.64 billion to help cut the fiscal deficit.

-- Progress of a nuclear liability bill which would open up India's lucrative nuclear power market.

* MONSOON

The monsoon, which accounts for 75-90 percent of the rainfall in most parts of India and is key to its farm output, is recovering sharply after a 16 percent deficit in June. It is now only 5 percent below normal in the June 1-July 27 period. Rainfall has been well distributed over major crop-growing regions of the country. Good rainfall after last year's drought would help boost farm output, calm inflation and prompt the government to relax curbs on export of wheat and rice. It will also help the government put a tax on sugar imports.

Good rains in the sowing season of July improved sentiment about farm output, but risks remain. If rains fail in the next two months then productivity of key crops such as rice, corn, cane and oilseeds could be hit.

What to watch:

-- Official monthly updates on the progress of the rains.

-- Perennial risks such as floods or storms that are bad for crops.

* SECURITY

India and Pakistan have improved ties since the depths plumbed after the Mumbai attacks that killed 166 people and derailed their 4-year-long sluggish peace process. But the process remains tentative. Another militant attack in India with links to Pakistan could push them to the brink of war.

Anti-India protests in the disputed Kashmir region, which is at the core of the India-Pakistan rivalry, have calmed. Seventeen people were killed in those protests, which New Delhi blamed on Pakistan-based militant group Lashkar-e-Taiba, also accused of the Mumbai attacks.

Violence by Maoist rebels, who want to overthrow the state, is on the rise as they respond to a government security offensive involving thousands of police. India has announced a unified command structure on to help coordinate that offensive, but analysts say the move may not be enough to turn around the battle against the insurgency which the government has described as the country's biggest internal security challenge. The insurgency is strongest in areas which hold most of India's mineral reserves and so has meant substantial loss in business.

The threat from foreign militants also remains high. Some militant groups see India as a key battleground, and Pakistan remains a haven for militants seeking to launch attacks in India.

What to watch:

-- How fast the government can cool tempers in Kashmir.

-- The government has stepped up its offensive against the Maoists but the risk of more attacks, especially on targets with economic importance, has risen.

-- The danger of militant attacks. Markets have proven highly resilient to terrorism -- the impact was very limited even when gunmen rampaged through Mumbai in 2008. But an attack which sharply raised the prospects of conflict with Pakistan would have a strongly negative impact on asset prices, particularly in the current risk-averse climate in global markets. [ID:nGEE5B5050]

(Editing by Surojit Gupta and Andrew Marshall)