Budget may backfire, choke off recovery

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New Delhi: Record borrowing needed to fund India's plans to ramp up spending this fiscal year threatens to backfire and choke off a nascent economic recovery.

While governments around the world are trying to spend their way out of recession, India's case is special: its economy has remained relatively robust, inflation risks are higher than elsewhere and credit is growing scarce.

With global oil and commodities prices rising in recent months and adding inflationary pressure, India's central bank could even be forced into raising interest rates before Asia's third-largest economy has recovered fully.

The budget unveiled by the newly re-elected Congress party-led government on Monday poses upside risks to rates in terms of higher yields, as well as to inflation, due to its expansionary stance, said DBS economist Ramya Suryanarayanan.

"The budget has definitely increased those chances, and at a time when the economy needs more spending towards infrastructure for a sustainable recovery. More supplies (of government debt) will crowd that out," she said.

The record $93 billion in borrowing planned to fund a 36 per cent spending hike in the 2009/10 budget also risks stifling the flow of credit to businesses and gives banks even more reason to keep lending rates high unless the central bank buys large chunks of the debt, analysts said.

Finance Minister Pranab Mukherjee said this year's fiscal deficit will rise to 6.8 per cent of GDP. With state-level deficits added in, Suryanarayanan expects India's consolidated fiscal shortfall to cross 12 per cent of GDP.

India's yawning fiscal deficit is a problem. The government debt-to-GDP ratio is just under 80 per cent, almost double the norm for emerging Asian markets.

Unlike other emerging economies like South Korea, India's government sells bonds entirely to the domestic market, making it more likely that it will crowd out local corporate borrowers looking to raise funds for operations or expansion.

Then there is timing. The government will be keen to avoid a year-end credit squeeze that begins with the October harvest season and festivals like Diwali, which usually falls in October or November.

That means the government will likely hope to limit any market disruptions to a shorter period by packing in most of its extra borrowing by end-September, taking the weekly borrowing requirement to an unprecedented 138 billion rupees ($2.86 billion) over three months and putting upward pressure on bond yields just as the economy appears to be turning the corner.