Moody's Economy.com on Thursday said the Reserve Bank of India [Get Quote] (RBI) could cut interest rates next week as high fiscal deficit was limiting the Centre's ability to step up spending and boost economic activity.

With deficit -- budgeted at 6 per cent this year and at 5.5 per cent in 2009-10 -- the government was also constrained in lowering taxes as the fiscal situation would deteriorate further.

"In fact, the actual fiscal deficits may end up much bigger than projected, as the decline in tax revenue could be more severe than expected, which is likely given the optimistic growth forecast adopted by the government," said Sherman Chan, economist at the Moody's subsidiary.

With the large public debt weighing down investor confidence, she said, the week fiscal position and the lack of major announcements in the Interim Budget was putting pressure on RBI to use the monetary policy for reviving growth.

Since October, the central bank has already used a mix of policy instruments to pump in over Rs 3,88,000 crore into the system for supporting growth. Yesterday, RBI Governor D Subbarao said that there was room for further rate cuts. "The question is whether we should cut rates or not, when should we cut rates and by how much," he said in Tokyo.

Economy.com also said that the Indian economy would grow 6.8 per cent during the current financial year and is expected to see a further moderation in 2009-10 when the gross domestic product is expected to rise 6.1 per cent. Chan warned that the pace of slowdown in manufacturing and construction would be sharper than what has been projected due to a slump in exports and the problems in the real estate sector.

The government expected the economy to expand by 7.1 per cent this year, with the growth in the manufacturing slowing down from 8.2 per cent to 4.1 per cent and in construction from 10.1 per cent to 6.5 per cent.

While advocating a steep rise in government spending to sustain 7 per cent growth, Chan said that the high fiscal deficit would restrict such a move, especially with only a minor improvement in deficit expected next year.

"Financing is a major hurdle to introducing stimulus measures given the already heavy public debt. The subsidies program India has in place may now have been proven problematic, as it was one of the largest expense items," she said in a statement.