Sensex posts relief gains, but caution remains ahead of budget

By Neha Dasgupta and Aastha Agnihotri

MUMBAI (Reuters) - Indian stocks and bonds rose on Friday after the Economic Survey released days ahead of the union budget contained few surprises, with calls for fiscal prudence and stable inflation and acknowledgements of the risks to growth.

The broader NSE Nifty gained as much as 1.2 percent, while the rupee recovered after earlier falling to as weak as 68.79 per dollar, just fractions away from a record low of 68.85 hit in August 2013.

But plenty of caution remained nonetheless with the report also calling for a review of the country's medium-term fiscal strategy, in a possible indication India may have to borrow more to raise pay for government employees and bail out banks.

Investors will now have to wait for Monday, when Finance Minister Arun Jaitley will unveil the budget for the year starting in April.

Markets are willing to allow for slightly wider fiscal deficits as long as the government undertakes other measures such as pruning subsidies.

Under current targets, India is aiming for a fiscal deficit of 3.5 percent of gross domestic product in 2016/17 and 3 percent in 2017/18.

"(A) re-think of the fiscal framework is likely, which suggests the 3 percent target for FY18 is likely to be pushed out," said Radhika Rao, an economist with DBS Bank in Singapore.

"However, subsequent comments on need for 'credibility and optimality' on the FY17 deficit raises the possibility that the negative 3.5 percent red line might be adhered to on Monday."

The benchmark 10-year bond yield was down 6 basis points (bps) at 7.80 percent, after earlier falling as much as 10 bps.

Bonds had already rallied in the morning after the central bank announced a $1.75 billion bond purchase on Thursday and said it would not allow bailout debt issued by state governments to boost supply and hurt markets.

Recently battered banks were among the leading gainers in stock markets, with State Bank of India up 2.7 percent.

But plenty of risks remain. The budget comes at a critical time for investors, given worries about the government's feeble pace of reforms and a deteriorating global environment.

Foreign investors have sold a net $2.4 billion in shares and $833.5 million in bonds this year, contrasting with $54.6 billion in debt and equity investments over 2014 and 2015.

The outflows have pushed the rupee to nearly a record low. It was last trading at 68.69 per dollar.

($1 = 68.7000 Indian rupees)

(Editing by Rafael Nam)