"2012 may mark the beginning of a new and more frightening phase of the world's worst economic calamity in three quarters of a century," prophesized Joseph Stiglitz, renowned economist and Nobel laureate, blithely crushing faint hopes of a happy new year.

For corporate India, the 2010-11 recovery will seem like a mirage, vaporizing just as they get closer. This year will be a painful jolt back to reality as Indian GDP slips below 7 percent, the world economy teeters on the brink, and domestic challenges continue.

Foreign Exchange Desert

Just over a third of the country's $480 billion export industry is marketed in the US and Europe, and troubles there are having a ripple effect in India. "The Euro crises and the US gridlock have created a generally reduced external demand for Indian products," says Dharmakirti Joshi, director and chief economist at CRISIL.

Particularly affected industries, he says, are garments, textile, chemicals, software goods, and policy-dependant industries like mining and iron ore.

"On top of that, India's exports themselves are import-oriented," says Ritesh Kumar Singh, subject matter expert (economic & trade policy), Aditya Birla Group, meaning that many of the products India exports are dependant on imported raw materials. This negates the advantage India's exports should have given the weakening rupee. He points to copper goods as an industry which imports 99 percent of its raw materials.

India's imports however, are seeing no such drop in demand, given that most of India's imports are inelastic. India, for example, depends on imported crude to meet 80 percent of its needs. And this year India imported a whopping 42.7 percent more oil than it did last year.

The result? With less foreign exchange flowing in and more flowing out, India's coffers are parched for foreign exchange.

To make matters worse, India's running a precarious current account deficit--made worse by an unscheduled borrowing the government made in the last week of 2011, of Rs 11, 000 crore. "India has to repay a total external debt of $137 billion that matures within 2011-2012. India runs a vulnerable current account deficit. Any shrinkage in the supply of dollars has a large impact on the rupee," says Joshi.

The Weakening Rupee and Domestic Challenges

Like Joshi says, the poor state of India's foreign exchange has an impact on the rupee, which has dived by over 17 percent since July 2011. The rupee witnessed a low of 53.3 rupees per dollar in December making it the worst performing Asian currency in 2011.

That in turn drives up the prices of India' imports, which affects foreign exchange levels, creating a vicious cycle.

At the same time, India is fast losing it's reputation among foreign investors as a great place to park money. The Sensex, which has been the worst performing index globally, crashed 25 percent from its peak this year. And according to Bank of America Merrill Lynch, India is the least favored BRIC nation among global investors.

"Given the nature of problem in the Euro zone, the risk appetite of foreign investors has come down; capital has flown out and fresh inflows are weak. The rupee, as a result, has depreciated and the access of our business' to foreign capital has reduced," says Shyamal Roy, professor of economics and social sciences, IIMB.

Part of the problem is the slow pace of India's industrial expansion, turning off investors. "Industrial production is down, minus 5.1 percent overall and minus 6 percent for manufacturing," says Joshi.

None of this bodes well for India's fiscal deficit. The finance ministry now expects India's fiscal deficit to reach around between 5.5 and 5.8 percent of GDP this financial year, against a budget estimate of 4.6 percent. Given that the acceptable limit is 3 percent, India will need $50-55 billion to plug that hole--once again affecting its foreign exchange reserves.

But not all of India's woes can be blamed on the West's uncertain economy. "The 2008 slowdown was the result of a global shock. The current slowdown is more because of domestic bungling," says Roy.

"If inflation is due to supply-side factors, like a shortfall in food production, mismanagement, waste, a lack of supply chain, cost and time over-runs the responsibility lies with the government," says Roy.

The burden of controlling inflation has fallen on the RBI. And it's done a fairly good job of controlling the demand side of inflationary pressure (reducing the amount of money available in the market)--through aggressive interest hikes.

"Everywhere in the world, if a central bank has to choose between price stability and growth, it will go for the former. RBI is doing what it should. It is the government which has failed in addressing supply side hurdles," says Roy.

That thought has made the phrase 'policy paralysis' very fashionable. In the face of such consuming worries, it appears that the government of India doesn't have what it takes to introduce reforms the economy requires. The FDI in retail fiasco is one example. It is the same story with GST.

"There are many reform bills pending with the government. However, the opposition is playing such an obstructionist role that nothing is getting tabled, forget being passed. Politicians mustn't try to gain mileage at the cost of the economy," says Roy.

It would have been nice to see the FDI retail bill cleared, agree both Joshi and Singh, if nothing else but to signal that something is being done to attract more FDI in the country.

The amount of attention--and government apathy--that the Lokpal Bill is garnering and upcoming assembly elections in five states including UP, will only push important reforms on the back burner.

When are things likely to look up? It's hard to say, given the over-lapping complexity of the problem and the multiple factors and stakeholders involved. The economy has reached this point due to a combination of bad policies and poor political will coupled with corruption and greed. But one thing is for sure, the way out of this hole will require government will.

"Remember, the blissful run in the 2000s were largely due to the tough reforms taken in the 1990s," says Singh.