NEW DELHI (Reuters) - India should review its mid-term fiscal strategy, a government report urged on Friday, in a possible indication that Finance Minister Arun Jaitley may have to borrow more to raise pay for government employees and bail out banks.

India's Finance Minister Arun Jaitley (C) leaves his office to present the 2015/16 federal budget in New Delhi February 28, 2015. REUTERS/Vijay Mathur

The report called India “a haven of stability” in a gloomy international landscape but, as Group of 20 finance ministers gathered for talks in Shanghai, warned too of possible currency turmoil in Asia after China’s recent devaluation.

The Economic Survey, which sets the scene for Jaitley’s third budget on Monday, forecast the Indian economy would grow by between 7.0 percent and 7.75 percent in the 2016/17 fiscal year that starts on April 1.

That would be in line with this year’s expected outturn of 7.6 percent but below earlier expectations that growth would accelerate to over 8 percent.

Although Asia’s third-largest economy has overtaken China’s as the world’s fastest-growing, weak business investment and a growing bad loan problem will compel Prime Minister Narendra Modi to keep the spending taps open to deliver on his promise of jobs for India’s 1.3 billion people.

Modi needs to cover the estimated $16 billion annual expense of a once-in-a-decade pay and pension hike for federal employees.

The report also put the total cost of recapitalising banks at $26 billion in the coming years.

The government will stick to its budget deficit target of 3.9 percent of gross domestic product in the year now drawing to a close, but the coming year will be “challenging” from a fiscal point of view.

The report, written by economic adviser Arvind Subramanian, said that “credibility and optimality” argued in favor of sticking to next year’s deficit target of 3.5 percent of GDP - phrasing that left room for an upward revision.

“The time is right for a review of the medium-term fiscal framework,” the text, handed out in parliament, said.

Analysts said Subramanian was flagging some backsliding on the deficit - if not next year then the year after - to account for an economy that is doing less well than the headline figures suggest.

“My sense is that there is a 20-30 basis points slippage coming in the fiscal deficit number, so basically I’m expecting a 3.7 or 3.8 percent fiscal deficit number for 2017,” said Ritika Mankar Mukherjee, senior economist at Ambit Capital.

Subramanian’s cautious advice to raise the deficit has been rejected by central bank governor Raghuram Rajan, who argues that India should keep its powder dry in case the weakening world economy tips into recession.

Indian bonds, shares and the rupee gained on a view that the government was at least not throwing fiscal caution to the winds.

PAY HIKES

Raising pay for 10 million federal employees would not destabilize prices, the report said, while low inflation has taken hold, leaving room for the Reserve Bank of India to cut interest rates further if needed.

Inflation is expected to decline to a range of 4.5 percent to 5.0 percent in the 2016/17 fiscal year, within the RBI’s target, while the current account deficit would stay low at 1.0 percent to 1.5 percent of gross domestic product.

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With the government tapped out on the spending side, there will be scant cash for capital projects through which it can achieve the growth rates of 8-10 percent needed to create jobs for the 1 million Indians joining the workforce every month.

This “does not augur well for the government capex - the major support to investment today, as private investment sentiment continues to stay weak,” said Rupa Rege-Nitsure, group chief economist at L&T Finance Holdings in Mumbai.

The report flagged steps to broaden India’s narrow tax base, arguing that 20 percent of individuals should pay tax on their earnings compared to just 5.5 percent now. The easiest way to do so would be not to raise thresholds on tax breaks and to review and phase out such exemptions.

India needs to gird itself for the possibility of turmoil on international currency markets and contend with “an unusually weak external environment”.

“India must plan for a major currency re-adjustment in Asia in the wake of a similar adjustment in China,” it cautioned.

Jaitley, making last-minute preparations for his budget address, is skipping this weekend’s G20 gathering.