The Indian economy appears to be in extremely good shape. But there are some important concerns about the period leading up to 2009. Greater caution is called for, in fiscal policy and in economic reform.

India is now more globalised than we think. Gross flows on the capital account and the current account now add up to over 75 per cent of GDP. Hence, there is inevitably a greater connection with the global business cycle.

In the recent period, the world saw a brief recession after the 9/11 attacks. That recession showed up in India. The world bounced out of that, aided by a remarkable and coordinated monetary policy and fiscal policy in the US. That revival has also showed up in India.

The global economy is now afflicted with fundamental problems in terms of exchange rate rigidity in China, over-investment and low profit margins in China, labour market rigidity in Europe, and the lack of currency and interest rate adjustment in the US.

Macroeconomists have been crying wolf about these global imbalances for a while, while financial markets have become increasingly complacent that these problems will fade away. But thus far, there are no signs of a soft landing, or a slow subsiding of the imbalances.

There is surely a lot that we do not understand about global macroeconomics. But many of the best minds in the field are increasingly worried that things could unwind in an unpleasant way. Even if such a scenario does not arise, the simple fact is that this is a high of the business cycle, which will not last. There is a fair chance that by 2009, world output growth will not be as buoyant as it is today. This slowdown will affect us also.

Then there are the exuberant spending programmes of the UPA, ranging from the plausible (employment guarantee) to the dubious (Sixth Pay Commission). In the short run, it appears that there is a small outgo of hard cash. Optimists believe that the government machinery is incompetent, that the announcements of programmes are just for politicians making speeches, and expenditures will just not materialise.

But this could change. In a few years, the administrative machinery for some of these programmes could come about. Politicians have incentives to fight the administrative battle, both in order to curry favour with voters, and in order to benefit from misutilisation of resources.

The year 2009 looms large in my mind owing to the coming general elections. Whether it is to win votes, or to obtain funds to run election campaigns, there is an incentive to spend in time for 2009.

In the immediate period prior to the elections, more bad economic policy could come about, at two levels. Some bad programmes could be unleashed which seek to quickly spend money in marginal constituencies. And, bad economic policy decisions could be taken which damage India and thus investment by the private sector.

The last piece of the puzzle is the FRBM. If we manage to hit the FRBM targets of no revenue deficit and a fiscal deficit of below 3 per cent by 2008-09, it will be a huge achievement for Indian public finance. But this could be a difficult task.

The social programmes of the UPA, and election year announcements, could hurt in 2008-09. The world business cycle could turn, giving slower GDP growth in India and thus weak tax revenues.

Corporation tax is now an important part of tax collections, and it is more sensitive to the business cycle. By 2008-09, we could be faced with a tough choice of abiding by the FRBM, and engaging in fiscal discipline at a time when it is hardest (in a slowing economy in an election year).

Alternatively, we risk a huge loss of credibility and a potential fiscal mess by failing to hit the targets of 2008-09.

Each of these problems could be dealt with in isolation. But if they come together in 2009, things will be acutely painful. There is every possibility that the present Parliament and the UPA will come up with poor policies if faced with a perfect storm of these dimensions.

This gloomy picture is, of course, not a certainty. But it helps to keep such scenarios in mind so as to lay the groundwork for coping with such a scenario today.

The first key piece is fiscal adjustment. In my mind, the safe thing to fight for is eliminating the bulk of the revenue deficit in 2006-07 and 2007-08, so that few assumptions need to be made about what can possibly get done in 2008-09.

The second front lies on the external sector, where India has an imprudent and highly risky combination of policies. We have a rupee-dollar pegged exchange rate and primitive mechanisms for currency risk management.

If there is a global upheaval, our best defence is a flexible exchange rate. On one hand, if RBI tries to defend the peg when things go wrong, it could snowball into a speculative attack.

More importantly, we have to recognise that with the FRBM, fiscal policy will not help the economy when there is a downturn. Only monetary policy can help in stabilising the macroeconomy.

But our present approach to monetary policy fails on this score. Through the currency peg, we have given Ben Bernanke of the US Fed a big say on India's monetary policy.

A shift away from an Indian rupee that is pegged to the US dollar will help bring Y V Reddy back into the game, so that India's monetary policy can then assist the Indian macroeconomy in a downturn.

The third piece lies in the core business of economic reform. Whether it is FDI in retail, opening up to foreign banks, the PFRDA Bill, the implementation of the NHDP, labour reforms, or the Goods and Services Tax, in all these areas, the UPA has been displaying a complacent approach that is surely influenced by the apparently successful economy.

A better approach would be to use these good times to forge policy packages, which involve executing economic reforms, possibly involving one-time payments to buy off pockets of discontent. The goal should be to carry a strong and well-organised Indian economy into the coming global downturn.