However, says the international rating agency, Fitch Ratings, in a study on public finances, in its opinion higher growth and general macroeconomic stability are not reasons for complacency and delaying fiscal reforms. In fact, cyclical and some structural factors may have been partly responsible for the favourable macroeconomic environment despite large fiscal imbalances.

For example, the study notes, the link between inflation and the fiscal deficit may have been broken, as the practice of monetising the deficit has been abolished. Also, the global disinflationary environment, increased progress on trade liberalization and ample stocks of food grains may have dampened inflation over the last few years.

Similarly, until quite recently, the upward pressure on interest rates had been avoided.

Indeed, the government has been quite successful at increasing the average maturity of its domestic debt as well as reducing the average yield. Some of the decline in interest rates over the last three years is probably attributable to ample liquidity amid slack credit demand, resulting in the banks holding a larger proportion of their deposits in government securities. However, with the recent upturn in the global and domestic interest cycles - local interest rates have risen by 50-100 basis points over the past six months - and more importantly, the pick-up in domestic activity, competition for domestic savings to finance the fiscal deficit will increase.

Although growth has remained resilient despite large fiscal imbalances, in Fitch's opinion, India's ability to grow at over 8 per cent per year on a sustained basis is being undermined by chronically weak public finances, which lead to the pre-emption of scarce resources by the public sector. The inflexibility of public finances makes it difficult for the government to spend on infrastructure such as roads, ports and energy, which can greatly benefit the private sector.

In addition, a high proportion of government spending is on salaries, pensions and interest payments, leaving little room for spending on social services to address poverty-related issues. More worryingly, the deterioration in the revenue deficit since 1997-98 needs to be addressed more aggressively, as it suggests that the increase in the overall deficit has been driven by higher consumption expenditure.

Moreover, because of the build-up in government debt, interest payments consume a large proportion of total revenue (one-third of the total on a general government basis or over 6 per cent of GDP). Other issues on the expenditure side that need to be dealt with include the phasing out of subsidies, reducing the high wage bill and reversing the trend of higher defence spending.

Weaknesses
In Fitch's opinion, the weak state of India's public finances represents the single-most important constraint on its rating. The general government deficit and its debt indicators are much worse than the 'BB' and 'BBB' median. Other fiscal indicators based on revenue measures also compare relatively unfavorably with investment grade countries. This is because of the government's narrow revenue base, reflecting low tax collection.

The tax structure remains complicated, riddled with loopholes and certain sectors are exempt from paying taxes (e.g. agriculture). In addition, services are still taxed only lightly, with the tax on the services sector only accounting for 0.3 per cent of GDP. This erodes tax buoyancy as services have been the fastest growing sector of the economy.

In contrast, industry is heavily taxed, which reduces its profitability and prevents an efficient allocation of resources. Finally, the decline in the tax-to-GDP ratio in the 1990s is attributed to the decline in trade taxes, which have not been offset by other taxes. Although reductions in tariffs have undoubtedly improved competitiveness and growth in the economy, the government has been unable to achieve sufficient political support to raise taxes elsewhere, which has prevented fiscal consolidation. In this regard, measures to improve tax revenue are important if India wishes to pursue trade liberalisation further.

Besides improving central government finances, measures need to be taken to address the states' weak financial positions. This is because a significant proportion of the deterioration in the general government deficit is attributable to their widening deficits. In recent years, numerous states have implemented reforms, such as rationalising user charges on public services, power sector reforms, tighter expenditure controls and, more recently, passing fiscal responsibility legislation.

Despite this, the states' fiscal imbalances remain large, reflecting sluggish growth in their own tax and non-tax revenue, suggesting that they need to tax more effectively and levy appropriate user charges on public services, including power. The transfer of taxes from central government to the states has also been hit by the weak performance of central government tax collection.

The states' expenditure has risen, reflecting higher interest payments, which continue to absorb around 25 per cent of current receipts. However, some future relief is expected from the central government / state debt swap, under which states are prepaying high-cost debt owed to the central government using cheaper market borrowing and funds from the small savings scheme. Moreover, the states' finances are burdened with high wage bills and pension-related costs. Pension liabilities have risen in recent years, accounting for 10 per cent of current revenues, and they present a structural challenge for the states as these are non-contributory and are not supported by any funding arrangements.

As the general government deficit (especially the primary deficit) remained high in the late-1990s and because the differential between growth and real interest rates narrowed, India's general government debt burden rose sharply from 65 per cent of GDP in 1997-98 to 82 per cent in 2002-03. However, with the decline in interest rates and higher GDP growth recently, the government debt burden has risen more slowly.

However, Fitch believes that if a tight fiscal policy is not pursued, with the turn in the interest rate cycle, the government debt burden could begin to rise at a faster pace. The following graph shows the trajectory of general government debt burden under 'no reform' and 'reform' scenarios. Under the 'reform' scenario, a 3 per cent of GDP fiscal consolidation over the next three years (if sustained) could increase growth and lead to an impressive reduction in the debt burden over the next five years.