Relax, oh weary investors, the spring shall release you from the shackles of dwindling stock portfolio values.' So went the line from a newspaper advertisement from investment bank, Merrill Lynch in March this year.

Indian equity investors, who heeded Merrill's advice, would have reason to thank the Wall Street giant. Between March and November this year, Indian stock market indices went up by an average of 47 per cent.

That is an investment of Rs 100 in the stock market in January would yield the investor Rs 147 in the beginning of December.

How is 2004 likely to pan out for the Indian investor or for that matter, the Indian economy as a whole? Quite differently from 2003, I would think.

For one, the year will kick off with a fairly robust recovery in the US economy in the background. This would be quite unlike the start of 2003 when the US was in the throes of a recession.

Other western economies and Japan are also beginning to show signs of life and  all this suggests that 2004 will see a rebound in the major developed economies.

From an investment perspective, the global recovery has some important implications for Indian markets. First, the need for global investors to invest in 'safe havens' that are insulated from global business cycles is likely to wane.

Instead of seeking a hedge against these markets that they did in 2003, they would choose instead to buy into either the developed markets or emerging economies that track the developed market cycles closely.

India, with its relatively closed economy was one such 'safe haven' since its dependence on developed markets is relatively low.

Thus a fraction of the money that came into India in 2003 came in as hedge money against the downturn in developed markets. This 'hedge money' is likely to flow out in 2004.

Most South-east and North Asian economies that, historically, have had a large share of exports to the developed markets in their national incomes (and hence track the developed markets closely) would stand to gain.

Fortunately, there is more to the recent boom in Indian stock-prices than just global cycles. For one, Indian equities are now riding on the somewhat delayed serendipity of foreign fund managers.

After a good five years when the obsession with China's growth story pushed everything else, there seems to be a sudden rise in awareness of the fact that Indian companies have seen some fairly dramatic changes in this period.

More specifically, investors seem to have realised that a combination of restructuring and low interest charges has not only shored up Indian manufacturing bottom lines in the short-run but has made them globally competitive in the long-term.

The service sector boom particularly in the strange-sounding IT enabled services (back office and call centre operations for the uninitiated) is alive and well. The rise in Indian markets is thus, to a degree, a process of  'pricing in' this long-term optimism.

The year  2004, I believe, is likely to witness a growing tension between the pull exerted by the global business cycle that would tend to rein in Indian stocks and the upward momentum of India's pricing in long-term prospects. On balance, the long- term growth story is likely to win.

The absence of large supplies of new equity issues is (that could potentially depress prices) likely to help sustain the upward movement. However, the rise is likely to be much slower than the up-tick in 2003 and more volatile.

The other factor that will tend to slow a bull run in equities down is the possibility of lower global liquidity. As economies start to look up, central bankers are likely to tighten their grip on the monetary levers to prevent an inflationary spiral.

The result: rising interest rates and tighter liquidity. Over the last month, both the Bank of England and the Australian Central Bank  raised their short-term benchmark rates.

With a whopping 8.2 per cent growth in the third quarter of 2003 for the US economy, it will perhaps not be long before the US Federal Reserve raises its rates.

With increasing integration in international money markets, Indian interest rates are likely to fall in line.

The consequence of rising interest rates for stock markets is fairly well documented, even for India. As interest rates rise, fixed yield instruments like bank deposits (which are also a lot less risky than stocks) offer better returns and investors tend to switch away from equity holdings depressing equity prices in the process.

Thus, rising interest rates bring bad news for the stock market. They also bring bad news for bond investors. As interest rates rise, prices of the outstanding stock of bonds begin to fall, resulting in capital losses.

To put it in simple terms, if you hold units of a bond fund, the net asset value (NAVs) of these units would start to decline.

Exchange rate volatility presents an additional risk. After a phase of continuous appreciation in 2003, the rupee started moving down against the dollar from the second week of November.

How does this affect the stock market? Imagine how a FII fund manager would have thought through his decision to invest in Indian stocks if the appreciation continued.

Not only would he gain from the rise in Indian stock prices but every time that the rupee went up, the dollar value of his Indian stocks would go up.

However, if the rupee begins to look vulnerable and seems likely to depreciate, he will have to weigh the gains from appreciating equity prices against the possible losses from currency depreciation.

Currency losses might not be the dominant factor affecting investment decisions but could make a difference at the margin.

It is easy to forget the fundamental problems with the structure of the Indian economy and the business environment if you are in the middle of a bull run in stocks and corporate results look better each quarter. The question is: will corporate performance continue to remain robust in the long-term?

I would argue that for sustained growth in demand in the economy, we need a significant pick-up in physical investments by the manufacturing sector.

Some of this seems to be already in the pipeline as companies reach full capacity utilisation.

However these investments will come from existing players or incumbents. However, an investment cycle driven entirely by incumbents will run out of steam in a couple of years.

For a full-blown investment recovery, there has to be entry by new players setting up new enterprises. Policy changes are critical if this were to happen.

Specifically there has to be a consistent stand on the import-tariff regime in the long-term that will determine how 'contestable' markets are for Indian manufacturers.

More importantly labour market reforms are long overdue if we are to expect investment interest from new players. Unless these policy issues are sorted out, a huge surge in investment is unlikely.

At the risk of sounding like a sanctimonious wet blanket, let me emphasise the fact given the overdose of euphoria about the Indian economy and markets, a quiet reality check is in order.

It is quite likely that the 'India story' has along way to go but there are two critical elements that anyone putting his money on this story needs in 2004: caution and patience.

The writer is senior economist at the Crisil Centre for Economic Research.

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