Current Fitch rating:

• 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 notes that with the rebound in economic activity and low interest rates, market concerns about public debt sustainability have receded. However, the agency says 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 believes that the debt could start to rise again in the absence of tighter fiscal policy. Shetty says "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 outlook notes that 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 on which the Congress party campaigned to power during the last general elections, 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:

• A more aggressive pace of fiscal consolidation than that implied by the Fiscal Responsibility and Budget Management Act;
  
• A broadening of the tax base in line with the recommendations of the Kelkar committee;
  
• Implementation of a state-level VAT scheme;
  
• Phasing out of subsidies and;
  
• Renewed impetus on privatisation and the liberalisation of the foreign investment climate.

Fitch draws comfort from the presence of a dedicated group of proven reformists within the government, but cautions that the realities of coalition politics — the Congress is heavily dependent on the outside support of "some left-wing parties" — could prevent the government from taking a more aggressive stance.

Fitch says 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 believes that the Indian economy's new found 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 warns that India's ability to grow at 7-8% on a sustained basis will remain in doubt for as long as the public sector fails to put its financial house in order.