India budget to test investors' faith in Modi's government

MUMBAI, Jan 31 (Reuters): Since his election four years ago, Indian markets have welcomed Prime Minister Narendra Modi's campaign to mend patchy public finances and develop new areas of growth in Asia's third largest economy.

To keep investors' confidence, however, Modi's government will need to be seen containing the fiscal deficit, while also increasing spending in key areas of the slowing economy.

Markets will be focused on how much India widens its fiscal deficit beyond the 3 per cent of gross domestic product projected for 2018-19.

A Reuters poll showed most economists expect a 3.2 per cent deficit as the government looks to increase investments in key areas such as agriculture to bolster its re-election prospects in elections due by 2019.

A modest widening of that nature would calm investors worried that the government may slip away from its judicious spending. Traders say bond yields could fall 10 to 15 basis points, while shares could hit new record highs. Gains could be more pronounced if India sticks to its 3.0 per cent target.

But a deficit above 3.2 per cent could hit shares and send bond yields up by 20-25 basis points, depending on the size of the blowout, on fears of populist policy ahead of next year's elections.

Markets remain nervous after the government's annual economic survey on Monday suggested "a pause" in fiscal consolidation, sending bonds plummeting.

"I think the budget will be focused on both investors as well as the common man," said A Balasubramanian, chief executive officer at Aditya Birla Sun Life Asset Management, adding he expects a deficit of 3.2 per cent.