Setback for Jaitley Ahead of Budget, Courtesy S&P

Global rating agency Standard & Poor's on Monday said a rating upgrade for India, currently lodged one rung above junk bond territory, may take 3-5 years.

"Improvements in India's weak fiscal balance sheet are likely to be gradual and are thus unlikely to lead to a rating upgrade in the next three to five years," S&P said.

S&P's cautious outlook has stumped investors, who were expecting a rating upgrade following the agency's September 2014 decision to lift the country's outlook from "negative" to "stable". That decision was seen as a vote of confidence for the new government's handling of the economy.

S&P's stance increases the difficulties for the Modi government on two fronts. First, the government will now have to work harder to convince foreign investors to invest in India.

Over the past decade, gross FDI inflows into the country have averaged less than 2 per cent of GDP, according to Deutsche Bank. To attract FDI, Prime Minister Narendra Modi has rolled out a red carpet for foreign investors. He has promised to improve the ease of doing business and cut red tape in bureaucracy.

A rating upgrade would have led to greater confidence in the Indian economy, helping the government's cause. It would also have benefited corporates raise cheaper funds from overseas.

"This (S&P decision) is negative for India since the country is according the highest priority to foreign direct investment," Maybank said in a report on Tuesday.

Second, Finance Minister Arun Jaitley, who is facing immense pressure to increase government spending, will find it difficult to renege on fiscal deficit targets to organise additional resources for the economy.

According to the fiscal roadmap, the government must reduce fiscal deficit to 3.1 per cent of GDP by March 2017.

Rating agencies take a dim view of governments living beyond their means. In 2012, S&P had downgraded India to one grade above "junk" citing the country's high fiscal and current account deficits.

On Monday, S&P again warned that the government must cut its fiscal deficit, among other things, in order to justify an upgrade in a credit rating.

"India's large government debt and heavy interest bill reflect a long history of elevated general government fiscal deficits. India's general government fiscal deficit averaged close to 8 per cent of GDP (centre plus states) over the 10 years to 2013, and the net general government debt stock currently stands at 66 per cent of GDP," S&P said.

In comparison, the 10-year average fiscal deficits for peers range from 0.7 per cent of GDP for Indonesia to 3 per cent for Brazil, the agency said.

Whether Mr Jaitley pays heed to S&P's warning will be known on February 28.

(With inputs from Reuters)