NEW DELHI (Reuters) - The fragile ruling UPA coalition won a vote on allowing foreign supermarkets to operate in Asia's third-largest economy on Wednesday, in a key test of support for Prime Minister Manmohan Singh and his flagship economic reform.
It was a much-needed boost for Singh at a time when he is trying to drive a second wave of reforms through a fractious parliament. The debate over retail reform has proved a costly distraction for the minority government, eating up two weeks of the month-long parliamentary session.
The victory clears the way for voting on bills aimed at attracting foreign investment to the ailing pension and insurance industries, two measures seen by financial markets as important steps in further liberalising an economy in the midst of a slowdown.
The government won the motion with 253 votes to the opposition's 218 with the Bahujan Samaj Party and the Samajwadi Party abstaining.
Expectations the government would win had earlier driven India's stock market to a 19-month high.
"FDI in retail was a barometer to test the government's strength and the government has proved that they have the support in the parliament to push through such reforms," said Samiran Chakraborty, regional head of research at Standard Chartered Bank India.
For a graphic on Wal-Mart in India click link.reuters.com/myp44t
For a graphic on India retail click r.reuters.com/cuh79s
The vote in parliament's lower house - which the government won thanks to abstentions by two powerful regional parties - was non-binding. However, a loss would have made it harder for Singh to defend the policy to bring global chains such as Wal-Mart Stores Inc. (WMT.N) to India's $450 billion retail sector.
Under threat of losing India's investment-grade credit rating, and facing the prospect of fighting a general election during the worst growth slump in a decade, Singh launched the policy amid a flurry of long-delayed reforms in September.
Money has flowed into India's capital markets since, and Goldman Sachs last week upgraded India's outlook, but formidable hurdles remain to get the economy back on track.
The vote was the first big floor test for the government since a partner pulled out of the coalition in protest at the retail policy, which critics say will crush small shopkeepers.
"It is not over, we will fight on the streets," said Shahnawaz Hussain, a member of parliament for the main opposition Bharatiya Janata Party (BJP), which had called for the vote to challenge retail liberalisation.
The government says the reform will help modernise India's dysfunctional food distribution system and slash inflation.
Exploitation by foreign traders was a key complaint in India's independence movement led by Mahatma Gandhi and in the debates leading up to the vote some opposition leaders said the new policy harked back to Britain's former East India Company.
"They came as traders and become Rajas. Is America coming through Wal-Mart to capture Indian power?" asked member of parliament Saugata Roy of the Trinamool Congress party.
Wednesday ended in victory, but the vote underscored how weak Singh's coalition now is. To pass legislation in the lower house the government relies on support from the Samajwadi Party and the Bahujan Samaj Party, two capricious regional rivals who oppose many of the government's policies but abstained this time.
On Friday, the upper house will vote on the same issue. There the government has fewer seats and is likely to lose the symbolic motion.
Another vote on the same day on foreign exchange rules is potentially more serious, since a loss could slow implementation of the supermarket policy. The lower house passed the foreign exchange vote on Wednesday, straight after the retail vote.
Ratings agency Fitch warned on Monday it could cut India's sovereign rating if the government loosens fiscal policy in the run-up to the election, due by 2014, or sees a more prolonged slowdown in economic growth.
India's fiscal deficit is the widest among major emerging economies due to huge spending on subsidies for items such as food, fuel and fertiliser. Few economists believe the government will meet its target of cutting the deficit to 5.3 percent of GDP this year, and spending is likely to rise next year.
While markets have been heartened by Singh's new appetite for reform, Fitch said there was concern the government would lose its focus as electoral issues come to the fore next year.
Topping the government's to-do list are measures to ensure faster decision making for infrastructure works, overhauling the tax system and cutting the deficit to revive capital investment.
Additional reporting by Neha Dasgupta in MUMBAI and Arup Roychoudhury and Satarupa Bhattacharjya in NEW DELHI; Writing by Frank Jack Daniel and Matthias Williams; Editing by John Chalmers and Alex Richardson