Fitch Ratings, the international rating agency, on Monday issued a comment outlining some of the measures it will be looking for in India's forthcoming budget statement on the February 28.
Shelly Shetty, senior director at Fitch's sovereign group, said: "The weak state of India's public finances represents the single most important constraint on its sovereign ratings: implementation of a credible fiscal consolidation process would hasten India's graduation to investment grade."
Fitch currently rates both India's long-term foreign currency and local currency sovereign debt issues at 'BB+' with a Stable outlook. The short-term foreign currency rating is 'B'.
Fitch noted that with the rebound in economic activity and low interest rates, market concerns about public debt sustainability have receded.
However, the agency said that this is not time for the government to become complacent: public finances have deteriorated since the mid-1990s, with the general government deficit consistently exceeding 9 per cent of GDP and general government debt rising to over 80 per cent of GDP. Such indicators remain far above 'BB' and 'BBB' rating medians.
Moreover, with the upturn of the interest cycle, Fitch said that the debt could start to rise again in the absence of tighter fiscal policy.
Shetty said: "A weak revenue base lies at the root of India's fiscal woes. The tax structure is complicated, riddled with loop holes and heavily skewed towards the industrial sector, while other key sectors remain very lightly taxed."
Thus, services, which account for almost 50 per cent of GDP and are currently the fastest growing sector of the economy, generate less than 5 per cent of total tax revenue.
The Congress-led coalition UPA government of Dr Manmohan Singh inherited a booming economy -- growth is expected to come in at close to 7 per cent in 2004-05 and should remain near this level in 2005-06 -- which should give it the opportunity to pursue more aggressive fiscal reforms.
However, balancing the demands for greater social and capital expenditure -- which it campaigned so successfully for in the last election -- against pressures for much needed fiscal consolidation will be a difficult challenge.
Among the factors that Fitch will be looking for in the forthcoming Budget will be:
Fitch said it drew comfort from the presence of a dedicated group of proven reformists within the government, but cautioned that the realities of coalition politics -- Congress is heavily dependent on the outside support of some left-wing parties - could prevent the government from taking a more aggressive stance.
Fitch said India's sub-investment grade sovereign ratings continue to be supported by the dramatic improvement in the country's external balance sheet, reflecting solid export growth and an impressive build-up in international liquidity.
Although the current account has slid into modest deficit, this has been more than offset by capital inflows (chiefly non-debt creating) and international reserves rose to $125 billion at the end of January.
The rating agency said that the Indian economy's newfound resilience to shocks such as higher oil prices owes much to the positive impact of past reforms. Investment in the IT sectors and the infrastructure and consumer sectors, coupled with trade liberalisation and the restructuring of the corporate sector, may herald an increase in India's potential GDP growth rate.
However, Fitch warned that India's ability to grow at 7-8 per cent on a sustained basis will remain in doubt for as long as the public sector fails to put its financial house in order.