India’s staggering recovery: Here’s what can go wrong

Locals play cricket in Kolkata, India.
Getty Images
Locals play cricket in Kolkata, India.

India has come a long way since the "taper tantrum" of 2013, transitioning from a "fragile five" economy into a darling of investors.

The election of Prime Minister Narendra Modi last May combined with stabilization in macro-economic conditions – including easing inflation, a shrinking current account deficit and improving government balances placed the country back on investors' radars. This resulted in a flood of foreign money entering its stock market, which ranked as one of the top performers globally last year.

While the stars may seem aligned, the economy is not fully in the clear yet, analysts warn.

Goldman Sachs, which is broadly optimistic on the market, says the key obstacles to the Indian growth story would be a loss of reform momentum or a slow pace of job creation, leading to demands for more populist policies.

"Reform momentum can slow either due to an inability to pass key legislation in Parliament, or a demand for greater subsidies if economic activity and jobs do not increase at the desired pace," Tushar Poddar, chief India economist at the bank, wrote in a note.

India unveils inflation target
India unveils inflation target   

In the nine months since coming to power, the Modi government made some progress on the reform front, including easing foreign direct investment (FDI) restrictions in some sectors and ending government price caps on diesel, but big-bang measures are lacking.

Overhauling land and labor laws are among the most crucial, says Poddar. "India's labor laws are outdated; for example, one law requires government approval to dismiss workers where the factory size is over 100 employees, which leads to production being kept at a small scale and growing informality," he said.

While Modi is keen to clear these bottlenecks to investment, his party – the Bharatiya Janata Party (BJP) – lacks a majority in the upper house of parliament, making it more difficult to push through contentious reforms.

To get around its lack of representation in the upper house, the BJP has so far resorted to using a series of ordinances to push through contentious laws. In late December, for example, Modi passed an executive order to ease land acquisition rules in sectors like power, housing and defense in order to kick-start billions of dollars in stalled projects.

Read MoreWhat India's budget means for its raging stock rally

However, these laws will ultimately have a short shelf life if both houses of parliament fail to approve them at the budget session of Parliament – which will be held in two phases: February 23-March 20 and April 20-May 8.

"When the government passed through the ordinances, it signaled its intention to push forward despite resistance. But if parliament fails to approve these bills during the current session – in particular the land acquisition bill – it will be concerning," said Radhika Rao, economist at DBS Group Research.

An eye on jobs

The other key risk to India's outlook is the slower-than-expected pickup in economic growth,resulting in a sluggish pace of job creation, Poddar said.

"The decline in rural wages is affecting rural consumption demand and job growth. If this trend is not offset by an increase in investment and faster growth in urban areas, it could lead to demand for more populist policies and subsidies from the government rather than reforms," he said.

Rural wages grew a meager 3.8 percent in November 2014, the lowest since July 2005, as farm output took a hit from the weak monsoon rains.

While these risks exist, Goldman says the case for investing in India remains strong for now.

"The bullish case for India rests on two pillars: its favorable demographics and the scope for catch-up from a very low base in investment, infrastructure and productivity," the bank said.

"With structural tailwinds, and a government that we think is moving in the right direction on structural reforms, we think the case for remaining positive on Indian assets remains strong," it added.