NEW DELHI (Reuters) - The beleaguered UPA government avoided bold reforms in its annual budget on Friday, opting for cautious steps to shore up growth and modest targets to rein in a bloated deficit after a series of political setbacks exposed its fragility.
Government bond yields leapt to their highest in more than 10 weeks and stocks fell, reflecting disappointment with Finance Minister Pranab Mukherjee's half-hearted attack on the worst fiscal deficit among the emerging-market "BRICS".
"I don't see any populist schemes, but this is not a reformist budget either, it is a status quo budget," said A. Prasanna, an economist at ICICI Securities Primary Dealership as Mukherjee wound up his annual speech to a rowdy parliament.
"I think the political compulsions made them decide that the best way is to play it safe," Prasanna added.
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Mukherjee unveiled a smattering of anti-deficit measures including an increase in services and excise taxes, saying that, like Shakespeare's Hamlet, he had to "be cruel only to be kind".
Indeed, the pain was felt almost immediately. Tata Motors, India's dominant maker of commercial vehicles, raised prices on cars and trucks in response to the excise duty hike.
Mukherjee also called for reducing India's subsidy burden below 2 percent of GDP, from about 2.5 percent, but did not take the politically fraught step of cutting subsidies for petroleum products, which have weighed heavily on government finances especially as oil prices remain stubbornly high.
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With no concrete measures to reduce subsidy spending, Nomura said in a note that the government may overshoot its new 2 percent target.
Prime Minister Manmohan Singh said after the budget speech that the government would eventually need to "bite the bullet" and raise prices, even if it irked its coalition allies.
But India's political realities cast doubt over the prospects for action anytime soon.
The coalition government has been weakened by a string of corruption scandals, while the ruling Congress party was trounced earlier this month in crucial state elections.
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This week, it faced a rebellion within its own ranks over a proposed rise in railway fares, which fanned speculation that the fragile coalition might fall apart and trigger a snap general election.
Cast against this political landscape, Mukharjee's half-measures did little to quiet sceptics about the government's commitment to reform.
"He seems worried about the stability of the government more than trying to revive the economy," said Jagdish Shettighar, an economist with opposition Bharatiya Janata Party.
The finance minister set a fiscal deficit target of 5.1 percent of GDP for the year that begins in April, down from an expected 5.9 percent in 2011/12. But the current year's deficit ended up far above the 4.6 percent targeted in the budget a year ago, as economic growth slowed and spending ballooned.
Even if India manages to cap its deficit at 5.1 percent, which several analysts doubt, its fiscal gap remains wider than those of BRICS peers Brazil, Russia, China and South Africa.
(Breakingviews: India could have its cake and eat it too reut.rs/wm1xVt)
While the government debt burden is far lighter than the United States or Japan, those countries enjoy ultra-low borrowing costs. U.S. two-year Treasury bonds yield just 0.4 percent.
Ratings agency Standard & Poor's said the new budget was "mildly negative" for India's credit rating, noting that the timing remained uncertain for long-awaited reforms, including a goods and services tax, as well as a direct tax code that would streamline tax collection.
With federal elections set for 2014, the budget a year from now is expected to be laden with populist spending, and Fitch Ratings warned that politics may also undermine the discipline needed to achieve the subsidy cuts planned this time around.
"Implementation risk is high ahead of federal parliamentary elections in 2014," the ratings agency said.
Mukherjee said he expected the economy to grow by 7.6 percent in fiscal 2012/13, up from 6.9 percent in the current year, its lowest in a nearly decade excluding the global financial crisis in 2008. The budget assumes wholesale price index inflation averages 6.4 percent during the year. February inflation was 6.9 percent.
Many foreign investors have lost patience with India's slowing economic growth, inconsistent policies and political instability. Because India runs both budget and current account deficits, it needs to attract overseas investment.
The budget set a gross market borrowing target of 5.7 trillion rupees, far more than the 5.3 trillion expected, jolting bond investors already fed up with heavy government borrowing.
The 10-year benchmark bond yield ended up 6 basis points on the day at 8.42 percent, its highest in two-and-a-half months, after the borrowing number was released. The main share index lost more than 1 percent.
"It's more of a populist budget and there's nothing exciting in it that can revive market sentiment," said Taina Erajuuri, portfolio manager at FIM India in Helsinki.
"Foreign investors were anyway a little sceptical about any structural reforms in the budget after the (state) election results, and that fear has come true to a large extent."
The Reserve Bank of India (RBI) has set credible deficit reduction as a key condition to cutting interest rates. The likelihood of a rate cut at the RBI next review on April 17 was diminished by Friday's budget.
"Given the fiscal situation, I would not expect a rate cut in April monetary policy," said Ashish Vaidya, executive director and head of interest rates at UBS in Mumbai.
Mukherjee set a target of selling 300 billion rupees worth of stakes in state companies in the next fiscal year, roughly in line with forecasts. However, India has raised just 139 billion rupees in the current fiscal year from stake sales, far below a budget target of 400 billion as a weak market undermined its plans.
Additional reporting by Annie Banerji, Satarupa Bhattacharjya, Emily Kaiser, Frank Jack Daniel, Matthias Williams, and Arup Roychoudhury; Writing by Tony Munroe; Editing by John Chalmers and Edmund Klamann