The current domestic and global macro conditions remind us of the 1993-1996 cycle. Like in this cycle, unusually low global interest rates and large capital inflows into India (and emerging markets in general) have allowed an expansionary monetary policy.

In the current cycle, the capital inflows have been even larger, resulting in a much higher growth push. During the 1990s cycle, the capex cycle recovered sharply from lows with the support of positive sentiment for emerging markets.

However, it was soon constrained by tightening monetary policy triggered by signs of overheating. A simultaneous reversal in risk appetite for emerging markets and reduced capital inflows caused further tightening in interest rates and affected the corporate sector's ability to raise risk capital, unveiling a significant deceleration in GDP growth.

We believe that, in the current cycle too, the direction of the global financial markets will be critical to the growth outlook. Indeed, in this cycle India has witnessed both leveraged consumption as well as a capex cycle.

Our base-case forecast assumes a soft-landing in consumption and the capex cycle. Domestic overheating problems like those during 1993-96 have already forced the central bank to lift borrowing rates by around 400-450bp from the bottom to the current eight-year-highs.

However, if the recent sell-off of risky assets were to represent the beginning of a reversal in global risk-appetite for trade, it could reduce the access to external sources of risk capital and result in a further rise in the cost of capital in the domestic market, causing deceleration in GDP growth below our conservative estimates.

We believe that, in the event of a sharp risk aversion in the global financial markets and/or a global hard landing, India's growth cycle is far more vulnerable than the rest of Asia. To assess exposure, we compare India's macro balance sheet with Asia Ex-Japan economies on the following parameters.

A high level of aggregate demand growth in India's case is already reflected in inflationary pressure. While the headline inflation rate already corrected to 4.4 per cent as of July 2007 (average) (below the RBI's comfort level of 5 per cent), inflation ex-food and energy is still at 5.2 per cent.

Both headline and core inflation in India are some of the highest in the region. Sharp appreciation in the exchange rate since early March 2007 has helped to reduce the inflation pressure. Any major reversal in global risk appetite could result in depreciation of the exchange rate, adding to inflation concerns.

India is the only country in the region that has witnessed a strong credit growth trend in the current cycle. A sustained slowdown in capital inflows will cause a hard landing in the credit cycle. It will also increase the risk of the credit quality problem. Until recently, banks had not only been lending more to riskier segments but had also been mis-pricing credit.

At the peak of the credit cycle in the first quarter of 2006, banks were making little distinction in pricing credit risk for various types of loan assets. Almost all loans were being priced in a narrow range of around 7.5-8 per cent, similar to the 10-year bond yields at that time.

Indeed, banks' lending behaviour implied that the risk of lending to a low-income-bracket borrower (for whom there is little credit history available) for the purchase of a two-wheeler was not meaningfully different from the risk of investing in government bonds.

A significant part of the fresh lending of $318 billion over the last four years has come at a time when banks have been inadequately pricing credit risk.

Although, there has been a significant improvement in the fiscal deficit trend at the margin, there is little evidence that the government is implementing any major structural reforms to reduce revenue expenditure. Most of the improvement in the deficit is due to the rise in corporate tax to GDP, in line with the corporate profit cycle.

In our view, India is running a pro-cyclical fiscal policy. In the event of a sharp slowdown in growth due to global factors, the condition of India's public finances provides little flexibility to increase public debt aggressively and offset such global pressures.

The most important differentiation between India and the rest of non-Japan Asia is that while India runs a current account deficit, other nations run current account surpluses.

In India, aggregate demand being higher than supply (domestic capacity creation) is also reflected in the current account balance and inflationary pressure. This makes India more reliant on capital inflows.

Unlike other emerging markets, India's balance of payments surplus (a key source of liquidity supply) has been driven by capital inflows. Almost 82 per cent of the total $98 billion of capital flows that India has received over the past four years has been in the form of non-FDI flows.

As a result, India is more exposed than other emerging countries to a potential sharp reversal in global risk appetite. Non-FDI capital inflows account for only 25 per cent of the total in emerging countries (excluding India).