Indeed, the better than expected performance of Indian economy in the last few quarters had a lot to do with a significant fiscal stimulus and loose monetary policy. In fact, two stimulus packages providing tax cuts and increasing infrastructure spending in connection with lower interest rates have supported significantly domestic demand. Yet, with demand growing at a faster pace than supply, inflation is becoming a growing concern. Not surprising, the Reserve Bank of India has raised its benchmark interest rates twice to 3.75%. And it is expected that by the end of June the rate may increase as much as 100 basis points. However, India's central bank should be more cautious in shifting its monetary policy. Tightening too much or too early is likely to squeeze credit availability and weight on growth which is essential in keeping fiscal deficit at sustainable levels.
Looking further, stimulus spending had expanded fiscal deficit from 2.6% of GDP in 2007/08 to 10% in 2009/10. And although due to strong growth numbers the shortfall is more than sustainable, Indian government should be able to better control its expenditure. In fact, while Union Budget for 2011 increases infrastructure spending, raises taxes for petroleum products and reduces for middle-income families it fails to slash inefficient subsidies on fertilizer, fuel and food. More importantly, the new administration is slow in implementing economic reforms promised investors after last year's wider-than-expected election victory. The government has made progress in new tax laws, disinvesting state run companies, it formed an experts panel to ease foreign investment in the financial sector. Yet, labor reforms and farm prices release are far from being executed.