India's Swelling Deficit Has Potential to Set Off Cascading Economic Troubles

NEW DELHI -- India's slowing economy is beginning to show another big crack: A growing government deficit that could hurt much-needed investment in India's ramshackle infrastructure, boost inflation and undermine growth. A hefty list of expenditures is at the root of India's fiscal woes, especially a once-a-decade salary increase that Standard & Poor's estimates could mean pay increases of as much as 40% for 2.9 million central government employees. Were the government to approve the full amount, the ratings agency figures it could cost as much as the equivalent of 2.4% of gross domestic product. State governments are likely to follow suit. Oil prices also are jacking up government costs. New Delhi is issuing bonds equivalent to 3.6% of GDP to oil and fertilizer companies to partially compensate them for selling their products domestically at lower-than-global prices. While some fuel prices were increased in June, India's domestic fuel prices still significantly lag global ones. Then there is politics. The Congress party, which leads India's fragile governing coalition, is expected to loosen the purse strings before a general election that must happen by May. It already won approval of a debt-cancellation package for many of India's impoverished farmers. Overall, Morgan Stanley predicts, India's fiscal deficit -- including central, state and so-called off-budget items -- will rise to 11.4% of GDP in the fiscal year ending March 31, up from an estimated 7.7% in the previous year. The spending increase is likely to play out in a number of ways that will harm the Indian economy, which has been growing robustly in spite of sporadic instability such as recent bomb blasts in Ahmedabad and Bangalore. (Please see related article on page A6.) It may give another boost to inflation, which is already running at an annual rate of more than 11%. And that could prompt the central bank to continue to raise interest rates, or take other measures to try to keep inflation in check. Along with some other negative factors, the result is that India's growth is likely to ease to between 7% and 7.5% this fiscal year, many economists estimate, down from 9.1% the previous year. The higher spending is also bound to hurt India's efforts to deal with some long-term problems, including modernizing its decrepit ports, roads, power systems, airports and telecommunications infrastructure over the next five years. Among the projects that could be delayed is an infrastructure-development program, Bharat Nirman, to improve drinking water, electricity, roads, telephones and irrigation in rural areas. Many economists say that India needs to improve its infrastructure to sustain rapid economic growth. In the 1990s, India also faced a growing fiscal deficit. Then, too, a key factor was the once-every-decade rise in government pay packages. In the subsequent drive to bring down the deficit, infrastructure spending was curtailed, which especially hurt manufacturers. It was easier for the government to cut back on building roads, hospitals and schools than on government-employee pay or interest payments. Infrastructure has been neglected for so long that the Indian government figures it needs as much as $500 billion in spending over the next several years to equip the country properly. The government hopes to provide much of the money, with the rest coming from private funding. But, "government finances are not in good shape, which does not augur well for increasing investment rates dramatically," according to a Goldman Sachs report. 'India's infrastructure is way behind the rest of the world," said Shiksha Bhatia, a 26-year-old human resources executive at Google Inc. in Gurgaon, near New Delhi. "Roads are not well-built and full of potholes, especially the rural areas," and "power cuts make people's lives miserable." Fans or air conditioning are essential in India's sweltering summer heat. Businesses also suffer. Pramod Bhasin, president and chief executive of Genpact Ltd., in Gurgaon, which runs call centers around the country, said his company must provide its own transportation, power, security and education for its employees. As the outsourcing sector expands outside the major cities, he said, India will require "better regional airports [and] better social infrastructure that invites middle and senior management to move and live" there. The worsening fiscal situation could affect the nation's creditworthiness, and the borrowing prospects of some of its most important companies. Ratings agency Fitch recently changed its view on the outlook for a key rating of Indian debt to negative from stable, saying its move was "based on a considerable deterioration in the central government's fiscal position." Lehman Brothers Asian sovereign credit analyst Yang-Myung Hong said that ratings agencies aren't likely to rush to downgrade India's sovereign debt. But if the fiscal situation and inflation worsens appreciably, he said, "we could actually see the ratings get additional negative pressure." A downgrading of India's sovereign-debt rating could hurt commercial banks, including ICICI Bank Ltd., the country's largest private-sector bank, said Mr. Hong, "because they are pretty much linked to the sovereign rating." More broadly, Indian companies could face higher interest rates at home, because government efforts to finance its deficit could swamp the bond market, analysts warn. That could especially affect industrial enterprises looking to finance large capital projects. Some companies are already scaling back expenditure in anticipation of higher interest rates, said Jigar Shah, head of research for securities firm Kim Eng Securities Ltd. based in Mumbai. Among those vulnerable to higher borrowing costs, he said, are state-run oil-marketing company Indian Oil Corp. and cement companies ACC Ltd. and Ambuja Cements Ltd.