A key ally of the government, the Dravida Munnetra Kazagham (DMK) party, is quitting the ruling Congress Party-led coalition over a disagreement over parliamentary seats in Tamil Nadu election.
The move comes as Prime Minister Manmohan Singh battles a series of corruption scandals and high inflation that have dented his popularity and emboldened the opposition.
What could happen next? GOVERNMENT FALLS - Unlikely
The DMK from Tamil Nadu has 18 seats, giving the Congress a parliamentary majority. The first key test will be the 2011/12 budget vote this month. If the vote is lost, the government will fall and early elections will be held.
But it is in no one's interest for early elections. The DMK faces a tough state election in April that it could lose. An early general election could see it lose power both at the federal and state levels. The main opposition Bharitya Janata Party (BJP) is also not ready for a general election.
The DMK will most likely vote with the government on the budget and other major votes. If the government falls, traders expect bonds to see a sell-off of around 10 basis points, according to traders, and a sell-off in the stock market.
GOVERNMENT SURVIVES, IF WEAKENED - Most likely
If the budget bill is passed, Congress would then have breathing space until the next parliamentary session, probably in July or August.
The government cannot fall outside parliamentary sessions unless the prime minister resigns, so that would give Congress some breathing room to tie up its parliamentary support with other regional parties. That could see Congress reaching out to other possible coalition allies, including the Samajwadi Party or the BSP in Uttar Pradesh, both of which have more seats than the DMK.
That would make Congress dependent on some notoriously fickle partners and make passing of any reform bills more difficult. The SP has proved its loyalty to Congress in the past, supporting it in a confidence vote in its first term, but its leaders have also been tainted by corruption charges.
There will be little impact on the bond market in this scenario, but the issue has already put pressure on the Sensex and the rupee, contributing to wider problems of the government that are already impacting on markets.
"This issue will be like fuel to the fire, so markets are reacting negatively," said Vikas Chittiprolu, a senior foreign exchange dealer with state-run Andhra Bank. "Oil is also on the rise, which is adding to the pressure."
GOVERNMENT SURVIVES, STRENGTHENED - Possible.
There are signs that this may be part of a grand design of Congress to dump DMK as it has been at the centre of corruption scandals involving the issue of 2G telecoms licences, a scam that may have cost the government up to $39 billion.
There are members of Congress, including family scion Rahul Gandhi, that want Congress to become less dependent on fickle regional allies.
By dumping DMK, Congress could signal it is no longer willing to deal with corruption-tainted parties. The former telecoms minister, A. Raja, a DMK leader, is under arrest in 2G scam case. Congress could ally itself with the main opposition party in Tamil Nadu, the AIADMK, which may do well in the state election.
Congress also hopes to do well in state elections in West Bengal and Kerala this year, while the DMK may lose the Tamil Nadu election in May. If that pans out, Congress may regain political momentum.
DMK BLINKS - Possible
The DMK's tactic of playing brinksmanship with Congress over seat sharing may have backfired - Congress does not appear too upset by the prospect of losing an ally that has supported it since 2004. With the DMK facing a possible loss in the April state election, withdrawal from the ruling coalition could put it out in the political cold. Little impact on markets, with a return to the status quo of a politically weak government.