A weak recovery from the country's longest growth slowdown in decades is pushing Prime Minister Narendra Modi's advisers to consider loosening fiscal deficit targets, risking the ire of investors, ratings agencies and the Reserve Bank of India (RBI).
Ahead of the budget in February, PM Modi's new team of advisers has argued for higher deficits to fund infrastructure projects needed to remove bottlenecks constraining growth and to create jobs for a burgeoning workforce.
Yet with debt service devouring 42 per cent of government spending, higher deficits would revive risks of a ratings downgrade and delay an interest rate cut by the RBI in its monetary policy meeting.
"Fiscal consolidation is important. But should it be at the cost of growth?" a senior finance ministry official told Reuters, adding, "We cannot afford to compromise with growth forever."
In a mid-year report to the Parliament in December, the finance ministry's new economic adviser Arvind Subramanian urged a comprehensive review of the country's medium-term fiscal strategy to create space for higher capital spending.
Economist Arvind Panagariya, who was appointed by the Prime Minister to run the new NITI Aayog, has also argued for loosening deficit targets to boost capital spending.
Weak investment has been a prime cause of the country's worst economic performance in a quarter century, with two successive years of growth below 5 per cent before a weak recovery began during the 2014-15 financial year.
Portfolio investors pumped US $40 billion into the domestic market in 2014, betting on Modi's promise of 'achche din' (or better days) ahead, putting the domestic equities and bonds among the best performers globally.
To make good on that pledge, the Prime Minister plans to spend up to US $50 billion in the upcoming financial year to March 31, 2016 on new roads, rail lines, ports and irrigation facilities.
"The most urgent priority (is) to build the productive capacity of the economy and launch a supply-side revolution," said Jayant Sinha, a deputy finance minister, adding that the country needed growth rates of 7-8 per cent to prosper.
This strategy could mean ditching targets to trim the fiscal deficit to an eight-year low of 3.6 per cent of gross domestic product (GDP) in the 2015-16 financial year and 3 per cent in the year after.
The slowdown in the domestic economy has depressed tax revenues to just 10 per cent of GDP from a peak of 11.9 per cent in 2007-08, forcing the government to cut spending and roll over outlays to contain the deficit in the past two years.
In FY15, Finance Minister Arun Jaitley will resort to similar methods to plug the deficit at a target of 4.1 per cent, aides say.
With a national debt at 70 per cent of GDP and a consolidated fiscal deficit above 7 per cent, the country's public finances are worse than its peers and it has spent recent years at risk of a downgrade of its sovereign credit rating to 'junk' status.
Success in narrowing the deficit by 1.2 percentage points to 4.5 per cent in FY14 helped ward off downgrades.
Keeping the counrty at the lowest investment grade rating, major rating agencies have urged the government to invest more without increasing borrowing.
"High fiscal deficits constrain India's sovereign credit profile," Atsi Sheth, senior vice president at Moody's, told Reuters.
"If higher public investment was pursued by redirecting expenditures away from current and towards capital spending, thus supporting growth without increasing fiscal risks, it would be credit positive," Sheth added.
Finance ministry officials say it is premature to say whether fiscal targets will have to be jettisoned, as they are banking on windfalls from collapsing global crude oil prices and telecom spectrum and coal block auctions.
With inflation declining steeply to 4.4 per cent in November, the central bank is holding out prospects of a cut in its 8 per cent repo rate, but Governor Raghuram Rajan is waiting for Jaitley's budget before acting.
A higher deficit may compel the RBI to keep rates on hold, which Manish Wadhawan, managing director and head of rates at HSBC, said would spark a sell-off in bond markets that have rallied hard since Modi took power last May.