Mumbai: Fitch Ratings says India's 2006-07 budget presented today confirms that fiscal consolidation is on track, but argues that the pace remains undemanding. While it views positively the central government's outperformance of its 2005 / 06 budget targets, this has to be seen in the context of strong growth, still low interest rates and the movement of some expenditure items off-budget.

The central government deficit came in at 4.1 per cent of GDP (budget 4.3 per cent ) for 2005/06 and the revenue deficit (current revenue less current expenditure) at 2.6 per cent (2.7 per cent budgeted). The process of fiscal adjustment, as mandated under India's Fiscal Responsibility and Budget Management Act (FRBMA), is also set to resume in 2006-07, having been put on hold in 2005-06.

Fitch notes that the FRBMA has injected a greater measure of fiscal discipline and the last three financial years have been marked by a greater degree of fiscal consolidation. However, Paul Rawkins, senior director in Fitch's Sovereign Ratings Group, says, "India's rapid rate of economic growth presents a golden opportunity to accelerate fiscal consolidation, yet the general government deficit has contracted by barely 2 per cent of GDP over five years and public debt has only recently begun to show signs of stabilising."

The government estimates that the general government deficit was around 7.7 per cent of GDP in 2005-06, down from a peak of 9.9 per cent in 2001-02, while Fitch estimates general government debt levelled out at 85 per cent of GDP.

With 86 per cent of revenue receipts earmarked for non-discretionary expenditure on such items as salaries, debt service, subsidies and defence, the government has little room for manoeuvre and has struggled to deliver on its campaign promises of higher outlays on infrastructure and social needs.

With little scope to compress expenditure, the authorities have become ever more dependent on higher economic growth to deliver fiscal consolidation without compromising their more populist campaign objectives. Fitch questions the sustainability of this strategy. "Officials readily admit that they are banking on continued high growth as the engine of further fiscal correction, yet any sudden downturn in growth could manifest itself in a sharp rise in public debt as occurred between 1999 and 2003," says Rawkins.

In the light of the expenditure constraints that all Indian governments labour under, the key to sustainable fiscal adjustment lies in expanding the tax base. Fitch views positively the ongoing measures to further extend the tax net to the rapidly expanding service sector - which have begun to bear fruit -- and notes the significant progress that has been made in overhauling state government finances. Thus, 18 states have now introduced their own FRBM Acts - a necessary measure to qualify for debt relief from the central government - and 25 states and union territories had introduced VAT by end-2005.

Fitch lauds the emphasis on improved tax administration and greater expenditure efficiency, but considers that this will be easier said than done. Once again, the budget sidesteps the issue of the reform of subsidies, where a significant proportion of the cost is sustained off-budget. With higher oil prices set to become a permanent feature of the world economy, India needs to address this issue sooner rather than later. Rationalisation of personal income and corporate taxes has occurred in recent years, but key tax exemptions in other areas remain pervasive, costing an estimated 1.5 per cent of GDP per annum.

On official expectations that the Indian economy can grow at 10 per cent per annum, thus emulating China, Fitch considers this will only be possible if the government is prepared to pursue more aggressive fiscal consolidation, thereby allowing domestic capital markets to meet the growing demands of private investors.

With domestic demand growing strongly and the current account balance reverting to deficit, Fitch notes that the traditional link between public finances and the balance of payments has begun to reassert itself and is likely to constrain growth over time in the absence of a more balance policy mix.

Fitch rates the Republic of India Long-term Issuer Default 'BB+' on both the Long-tern foreign and local currency scales.