"Considering the fiscal policy is still very expansionary, and the Reserve Bank of India (RBI) has already embarked on easing path faster than warranted, risk of inflation pressures re-emerging is very high," the US-based financial services firm said in a report.
It said that a significant part of the recent deceleration in headline inflation and core inflation can be attributed to delay in hike of administered product prices.
If the government wants to restrict oil subsidy burden to the levels provided in the Union Budget for 2012-13, domestic regulated fuel prices will have to be increased by 39 percent, resulting in WPI inflation increase of 2.47 percent, Morgan Stanley oil and gas analyst Vinay Jaising said in a report.
"Moreover, potential slowdown in capital inflows and its impact on the exchange rate will only add to inflation pressures," the report said.
Inflation based on Wholesale Price Index (WPI) declined marginally to 6.89 percent in March as compared to 6.95 percent in the previous month, while consumer price inflation accelerated to 9.47 percent in the last month of fiscal 2011-12 as compared 8.83 percent in the previous month, according to to the latest available data.
Taking cues from softening in inflationary pressure, the RBI in its annual monetary policy for 2012-13 announced April 17 lowered key policy rates by 0.50 percent. This was the first rate cut by the central bank in three years.
Morgan Stanley said that the government's desire to sustain high domestic demand with less productive public spending at a time when the productive private investment has been declining as percentage of the gross domestic product (GDP) is showing up in form of three key symptoms - persistent high inflation, high current account deficit and tight interbank liquidity and elevated short-term cost capital.
Morgan Stanley warned that there was a high risk of balance of payment 'shock' in India.
"Unless the government initiates major policy action to cut its spending, including subsidies and/or international crude oil prices decline sharply due to improved outlook of global supply soon, India will remain exposed to any potential slowdown in capital inflows increasing pressure on the exchange rate, which in turn could quickly transmit into a rise in the domestic cost of capital hurting growth further," it said.
Even if a balance of payment shock is avoided with capital inflows remaining stable by issuance of sovereign dollar bonds or dollar deposits, unless fiscal policy is truly tightened it will be hard to bring down short-term cost of capital meaningfully and revive growth trend, the report added.