* FY12 fiscal gap to be "significantly" worse
* Ahluwalia says credibility depends on fiscal correction
* Uncapped petroleum subsidy a "danger"
* Government has "run out of fiscal space" (Recasts, adds more details, background and quotes)
By Rajesh Kumar Singh and John Chalmers
NEW DELHI, Jan 11 (Reuters) - India risks undermining the credibility of its economic outlook if it fails to reform its public finances, one of the country's top policy advisers warned on Wednesday as the cash-strapped government gears for a dramatic widening of its fiscal deficit.
With a slowing economy, a sharp decline in investment and high oil prices upsetting its budget calculations, Prime Minister Manmohan Singh's government is under growing pressure to curb spending as it heads into the 2012/13 fiscal year.
New Delhi is widely expected to miss by a long chalk its deficit target of 4.6 percent of GDP for the fiscal year that ends this March.
Montek Singh Ahluwalia, deputy chairman of the Planning Commission, said the government must now send out a "credible" signal through its budget announcement in mid-March to shore up investors' faith in India's macro-economic fundamentals.
"The markets have to know that the government is not unconcerned about the fiscal deficit, and I am sure the finance minister will be aware that the credibility of our macro stance next year depends upon both the extent and the quality of the fiscal correction," Ahluwalia said in an interview.
SAME OLD ADAGE
His prescription for reforming public finances is the same decades-old Indian adage: "contain petroleum and fertiliser subsidies."
However, tinkering with subsidies has proved too tough for a succession of governments in a country where welfare schemes for the poor and subsistence farmers help political parties win elections.
The reformists in the government managed to get gasoline prices deregulated in June 2010. At the same time, they succeeded in getting a plan to free up - over a period of time - prices of diesel, which makes up about 75 percent of fuel consumption in India.
Since then, however, diesel prices have been raised just once and the fuel continues to be sold like kerosene and cooking gas at state-fixed prices.
Ahluwalia conceded that reforming the petroleum subsidy would not be easy, but said the government must move forward on this after elections in five states over the next two months.
"If you were to say: 'should the government give a credible signal?' It is a very tough signal to give. But I agree it should give a credible signal."
Subsidies have long been the bane of India's public finances. Spending on subsidies is expected to have risen by 1 trillion rupees ($19.3 billion) in 2011/12 from a budgeted estimate of 1.3 trillion ($25 billion).
With an economic slowdown hitting revenues, the government is forced to rely on market borrowing to fund its hefty subsidy bill. It has already increased its borrowing for 2011/12 by 22 percent from a budgeted 4.17 trillion rupees.
"I am quite sure that the government is very concerned to convey a sense that, like other countries, we have run out of fiscal space and we should now begin the process, seriously, of fiscal consolidation," Ahluwalia said.
BLAME FISCAL PROFLIGACY
India's economic growth has been slowing due to a combination of feeble growth in the United States and Europe, a prolonged spell of monetary tightening to tame high inflation, and a decision-making paralysis in the federal government.
While many government officials blamed the central bank's 13 rate hikes for the deceleration of growth to around 7 percent in the current fiscal year, Ahluwalia put the blame on fiscal profligacy that has pushed up the cost of debt for private borrowers.
"Even if the Reserve Bank of India had not raised the repo rate, if the fiscal deficit expands, which it did ... this would have led to a squeeze on credit and higher interest rates."
Investment proposals in India plunged 45 percent to a five-year low in 2011 as firms halted projects, citing administrative hassles, a move which could worsen the growth slowdown in 2012, according to data from the Centre for Monitoring Indian Economy.
Ahluwalia, a close aide of Prime Minister Singh, said the government is trying to speed up execution of investment projects by addressing bottlenecks.
"A visible demonstration that there is an accelerated processing of these projects will send a signal that the government is actually quite concerned," he said.
GHOST OF 1991
A combination of slowing growth and widening fiscal and current account deficits is weighing on the Indian rupee. The rupee was the worst performer among Asian currencies last year, losing close to 16 percent against the dollar.
This has raised the spectre of a balance of payment crisis for India like the one it faced almost 20 years ago, when the central bank was forced to airlift 47 tonnes of gold to Europe as collateral for a loan to avert a sovereign default.
Ahluwalia, who was involved in navigating the economy out of that crisis, rejects such concerns as "complete nonsense", saying the economy is now better equipped to handle any shock arising from a spike in oil prices.
"Nobody can rule out a balance of payment crisis, if the oil price shoots up to $150, we will have a balance of payment crisis," he said. "We have more than enough cushion to take corrective action." ($1=51.89 Indian rupees) (Editing by Ron Askew)