MUMBAI (Reuters) - Fitch Ratings returned India's sovereign outlook back to "stable" from "negative" a year after its initial downgrade, surprising markets with a validation of the government's efforts to contain the fiscal deficit and revive economic growth.
The upgrade is likely to be a welcome relief to the government, coming during a period when the rupee had slumped to a record low, and be seen as a reward after months of efforts to cut spending, passing fiscal reforms, and wooing foreign investors.
Analysts, however, were sceptical about the upgrade, reflecting their pessimism about economic growth prospects at a time when inflation, although easing, remains high while the current account deficit remains a thorn to policy makers.
Prime Minister Manmohan Singh's minority coalition also faces important state votes due before a national election next year, putting into doubt whether it can keep fiscal discipline and pass additional reforms in a gridlocked parliament.
"Challenges remain on the macro economy front, with the weakening rupee and the uncontrollable current account deficit," said Jagannadham Thunuguntla, equity head at SMC Global Securities in New Delhi.
"There is still a long way to go for a rating upgrade."
The rupee extended gains on the news, ending up at 57.79/80, well above its Tuesday close of 58.39/40 and its record low of 58.98, also on Tuesday.
The benchmark 10-year bond yield recovered from earlier falls, ending down 1 basis point at 7.29 percent. Stock markets were closed when Fitch made its statement.
Government officials had lobbied Fitch hard after its outlook downgrade almost exactly a year ago. That action came after Standard & Poor's first cut India's outlook to "negative" in April, threatening to push the country into "junk" status.
The threat of downgrades had spurred India to unveil a slew of measures since September, including opening up the aviation and retail sectors to foreign investors in spite of strong political opposition.
Finance Minister P. Chidambaram also vowed to contain the fiscal deficit at 4.8 percent of gross domestic product for the year ending in March by cutting spending and raising revenue.
"The authorities were successful in containing the upward pressure on the central government budget deficit in the face of a weaker-than-expected economy," Fitch said.
"The authorities have also begun to address structural factors that have weakened the investment climate and growth prospects."
The credit agency added inflation had shown "pronounced" signs of easing and forecast the economy would recover to growth of 5.7 percent of GDP in fiscal 2014 and 6.5 percent in fiscal 2015.
In upgrading India, Fitch appeared more optimistic than many analysts, or rival Standard & Poor's, which last month reaffirmed its "negative" outlook on India, warning of the need to follow through on reforms and the government's high fiscal deficit and heavy borrowing.
Analysts fear increased government spending on populist welfare programmes ahead of elections due by May 2014. India has also struggled to implement some of its reform measures, especially regarding the retail sector.
In the economy, India continues to be constrained by a current account deficit that hit a record 6.7 percent of GDP in the October-December quarter, although India has recently introduced curbs to gold imports.
As a result, the rupee has been particularly hit as part of a sell-off in most emerging currencies, having fallen more than 8 percent since the beginning of May to record lows.
Although the economy is expected to recover modestly after growing at a decade low of 5 percent in the previous fiscal year, data on Wednesday showed consumer inflation eased only slightly in May.
As a result, the Reserve Bank of India is likely to hold interest rates at its policy review next week after cutting by three-quarters of a percentage point this year.
Indian policy makers are particularly concerned about the falling rupee, with Finance Minister Chidambaram expected to address media on Thursday to discuss the currency's declines and address the Fitch decision.
"I do not think this changes anything at this juncture for the economy. Consumer inflation is still up, industrial production is low. RBI is likely to hold rates steady on June 17," said Anjali Verma, economist at Phillip Capital in Mumbai.
Fitch acknowledged challenges, noting a recovery would remain slow until a healthier investment climate is created, and warning the rupee drop would limit the scope for RBI rate cuts.
Structural budget deficits and high public debt would also constrain India's ratings, Fitch said. (Additional reporting by Subhadip Sircar; Editing by Ron Popeski)