NEW DELHI (Reuters) - The drought threatening India due to elusive monsoon rains will make it politically harder for the government to raise prices of subsidised fuel, delaying a reform urgently needed to rein in the country's fiscal deficit, Montek Singh Ahluwalia, deputy chairman of the Planning Commission, told Reuters.
So far India's monsoon rains are 22 percent below average and are unlikely to pick up enough to avert a drought, which could dent both crop output and rural incomes and increase reliance on subsidised fuel such as diesel to irrigate farmland.
It will inveitably hit growth, warned Ahluwalia, making it unlikely that Asia's third-largest economy will do any better in 2012/13 than it did in 2011/12, when it recorded its slowest rate of growth in nine years.
The critical pressure point for the government is its fiscal deficit.
"Between the economics of what needs to be done and the politics of what is feasible there is usually a gap," Ahluwalia, one of India's best known bureaucrats, said in an interview on Monday. "That gap increases if there is a drought."
Last year, India overshot its deficit target due to slowing growth and increased spending because of higher fuel and fertiliser subsidies.
The government has promised to narrow the fiscal gap in 2012/13, in part by increasing the prices of subsidised fuels, especially diesel, which have not been revised for a year. New Delhi has said it plans to reduce spending on subsidies to under 2 percent of the GDP this year from 3.2 percent last year.
But, Ahluwalia, a close aide of Prime Minister Manmohan Singh, said the government may have to spend more in rural areas to shore up incomes if the rains do not pick up in coming weeks.
"In my view there is a good economic case for adjusting oil prices," he said said. "It's also no secret that these things become politically difficult, and maybe a little more difficult in a drought year."
Over half of the country's population depends on agriculture for a livelihood. And while Singh's Congress party does not face a national election until 2014, cutting subsidyies during a drought would be seen callous by poor rural voters who have been hit hard by inflation running over 7 percent for the past two years.
Ahluwalia said a drought could shave up to 0.5 percentage point off India's GDP, which he said is expected to grow by between 6.0 and 6.5 percent in 2012/13. That is far short of the 7.6 percent target set by the government in mid-March.
With the growth rate falling, the Reserve Bank of India (RBI) has resisted calls for an interest rate cut, saying the government needs to bring down the fiscal deficit, something that looks out of reach in the short term.
"It's very clear that growth this year is not going to be 7.5 percent, which is what the Finance Ministry assumed when they made the budget. If we want to be realistic we should plan for between 6 and 6.5 percent," Ahluwalia said.
"Slower growth means less revenue and some deterioration in the fiscal deficit as a result is inevitable."
Against this background, a record current account gap, policy flip-flops and waning global appetite for risk have hammered its currency, the rupee.
Ratings agency Standard & Poor's last month warned that worsening public finances and policy inaction could together cost India its investment-grade sovereign debt rating.
The government is aiming to narrow its fiscal gap to 5.1 percent of the GDP in 2012/13 after it overshot last year's budgeted deficit of 4.6 percent by 1.2 percentage point, but analysts foresee more slippage unless subsidies are cut.
All this piles pressure on Prime Minister Singh, architect of the transformational opening of India's economy in the 1990s, to push ahead with a raft of stalled reforms.
After he took charge of the finance ministry last month, Singh promised to revive the "animal spirits" of the economy. But investors say talk has not been backed by enough action.
Ahluwalia said a delay in raising fuel prices should not be seen as a lack of commitment to reducing the fiscal deficit over the medium term. He added that the underlying fiscal situation would be less alarming if India switched from targeting a fixed deficit to taking a medium-term view on a structurally adjusted basis.
"I don't believe that if something gets delayed because of a drought, it should be the basis of a final verdict on whether India is on a fiscally responsible path," he said.
"The rating agencies criticise us for missing the stated fiscal deficit. They are technically correct ... but they should recognise that what we should be looking at a structurally adjusted fiscal deficit."
Ahluwalia said the government has moved effectively to address concerns over rules introduced in March to target firms and investors routing investments through tax havens.
A lack of clarity on the general anti-avoidance rules (GAAR) panicked foreign investors, forcing the government to defer its implementation by a year.
The prime minister recently set up an independent panel that is due to finalise guidelines by the end of September on implementing rules to combat the tax-evasion regime.
"There are some issues that we have to address that would make investors feel that we are welcoming foreign investment," Ahluwalia said. "Most immediate of those was correcting the negative signal that went out because of the GAAR and associated tax changes. The government has responded to that pretty speedily."
Editing by Simon Cameron-Moore