India's state governments are on the verge of gaining much more discretion in the use of transfers from the central government with the shift of central policymaking to the states and expansion of the middle class Standard & Poor's Ratings Services said on Thursday.

Prime Minister Narendra Modi's scrapping of India's Planning Commission was a significant step in enhancing the autonomy of the states, S&P said.

"Fiscal decentralisation should result in more competition between states in attracting investment and promoting growth, setting the stage for further economic reform and modernisation," said Joydeep Mukherji, a credit analyst at S&P.

"The government has reduced the number of centrally sponsored schemes and given states more flexibility in using the money in those schemes. Moreover, scrapping the Planning Commission also allows states to receive more federal transfers without strings attached, giving them scope to determine their own spending priorities."

Aspirations of the middle class

A bulging young lower-middle income group in large and small cities, with strong aspirations for upward mobility, has swelled the middle class in India, the rating agency said.

Poor GDP growth of recent years has made the middle class more favourable toward economic reforms, which they increasingly see as necessary for rapid economic expansion and their own continued prosperity, S&P noted.

"The combination of growing federalism and a rising middle class sets the larger political context for the economic policies the government is likely to pursue in the next five years. We expect the government to seek to improve the administrative performance of the bureaucracy while pursuing gradual fiscal consolidation," Mukherji said.

Rating and reforms

On 26 September, S&P upgraded its rating outlook for India to stable from negative while affirming its 'BBB-/A-3' rating, saying the newly elected government will be able to implement economic reforms that spur growth, which in turn improves fiscal performance.

However, the Modi government will seek to win as many state elections as possible, especially in the next two years, to gain seats in the upper house of parliament and ease the passage of legislation, according to the rating agency.

Moreover, the Modi government has inherited several weaknesses that will constrain economic growth, at least in the next year or two, S&P said.

Inflation is likely to remain high, around 8% in 2014 and 7% in 2015, while the general government fiscal deficit is likely to exceed 7% of GDP in fiscal year ending March 2015 and remain above 6% in fiscal 2016.

"We believe that India's economic performance will disappoint optimists through 2015 but will likely be better than the fears of pessimists over the long term," Mukherji said.