NEW DELHI (Reuters) - India is on the edge of a "fiscal precipice" and should urgently slash fuel, food and fertilizer subsidies to curb a budget deficit that could hit 6.1 percent of gross domestic product this fiscal year, a government panel warned.
The panel's report, published on Friday, will feed worries about the state of Asia's third-largest economy, where growth has slowed sharply and a large deficit caused by a ballooning subsidy bill has sparked fears of a rating downgrade.
"We cannot overemphasize the need and urgency of fiscal consolidation. Growth is faltering and inflation seems to be embedded. The external payment situation is flashing red lights," the panel said.
The report recommended phasing out subsidies on diesel and cooking gas, and reducing subsidies on food, kerosene and fertilizer. It also recommended stepping up sales in state-owned companies, slashing factory gate duties in order to stimulate growth and overhauling the country's Byzantine tax system.
The proposed subsidy cuts, if implemented, would likely spark a massive political backlash and put the ruling Congress party's re-election bid in 2014 in doubt. The government said in a statement that a certain level of subsidies was necessary and unavoidable in a poor country like India.
Analysts doubted the measures would be implemented in full.
"It's difficult to implement most of these measures over the next six months because it may not be politically palatable," said Shubhada Rao, chief economist at Yes Bank in Mumbai.
The report comes after Prime Minister Manmohan Singh unveiled a series of big-ticket reforms on September 14 seen as key to reviving sluggish economic growth. It provided a sobering reminder of the challenges still facing the government.
Singh, in a rare televised address last Friday, warned his countrymen that "money does not grow on trees" on the same day that his biggest ally quit the government in protest against the reforms, which included opening up the country's retail sector to foreign supermarkets.
Failing to tackle the deficit means India could potentially face a worse situation than the balance-of-payments crisis in 1991, when the country was bailed out by the International Monetary Fund (IMF), the report said.
INDIA ON FISCAL PRECIPICE
The three-member panel, headed by former finance secretary Vijay Kelkar, had been tasked by the government to recommend ways of improving government finances. It delivered its report to the finance ministry earlier this month.
"The Indian economy is presently poised on the edge of a fiscal precipice, making corrective measures aimed at speedy fiscal consolidation an imperative necessity if serious adverse consequences stemming from this situation are to be averted in an efficient and timely manner," it said.
The report was released on the same day as at least one of the key pressure points on the Indian economy eased after data showed the current account deficit shrank from an all-time high in the April-June quarter.
The data helped turn India's balance of payments to surplus after a worrying slide towards dangerous territory, but a big reason for the improvement on the external front was falling imports due to the domestic economy's weakness.
India's economy slowed to 5.5 percent growth in the April-June quarter, the lowest level in nearly three years and far below the country's expectations of near double digit growth.
Markets expect the government to overshoot its fiscal deficit target for the financial year ending March 2013 - seeing it at 5.8 percent of GDP from a budgeted 5.1 percent. The fiscal deficit in April-August rose to 65.7 percent of the full-year target, government data showed on Friday.
The panel, whose recommendations are not binding, warned that failing to curb subsidies would see a flight of foreign capital and a potential credit rating downgrade.
But, slashing subsidies is a political minefield in a country with hundreds of millions of poor. The government has won back-to-back elections on higher social welfare spending.
"The government is of the view that in a developing country where a significant proportion of the population is poor, a certain level of subsidies is necessary and unavoidable," Arvind Mayaram, a senior finance ministry official, said in a statement after the report was released.
(Additional reporting by Arup Roychoudhury and Manoj Kumar in NEW DELHI, Neha Dasgupta and Himank Sharma in MUMBAI; Writing by Matthias Williams, editing by Ross Colvin and Simon Cameron-Moore)
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