Indian government bonds and the rupee slumped today after the country's credit outlook was moved a step closer to junk status by a leading credit rating agency. The move, which was triggered by rapid deterioration in India's public finances, stoked speculation that foreign investors will dump assets in the country.

Meanwhile, Indian shares finished at a new low for the year, closing down nearly 5 per cent on mounting concerns over soaring rates of inflation. Bombay's benchmark Sensex index fell 654.32 points to 12,676.19.

Fitch Ratings downgraded India's local-currency debt outlook to negative from stable, while maintaining a BBB- grade, the lowest investment grade, one step above speculative — or junk — status. The move came close on the heels of a similar downgrade warning by Standard & Poor's.

James McCormack, head of Asia sovereign ratings for Fitch, said: "The revision is based on a considerable deterioration in the central government's fiscal position … combined with a notable increase in government debt issuance to finance subsidies not captured in the budget."

Fitch forecast that the government deficit will increase from 2.8 per cent of GDP in 2008 to 4.5 per cent of GDP in 2009, based partly on higher wages for India's army of civil servants.

The agency also expects bonds issued by the government to oil and fertiliser companies, to subsidise prices paid by consumers, to reach at least 2 per cent of GDP this year and lift the underlying central government deficit to 6.5 per cent of GDP or higher.

India relies on imports for 70 per cent of its oil consumption and the country's finances have been stretched thin by record global crude prices. India's trade deficit hit a record $10.8 billion (£5.5 billion) in May, with the country's oil bill alone increasing by half from a year before.

Foreign institutional investors have sold nearly $7 billion of Indian equities since the turn of the year, another factor behind the rupee's decline. India is also battling wholesale inflation of 11.89 per cent, a 13-year high.

The currency lost 0.7 per cent against the dollar following yesterday's credit revision. The rupee has now lost nearly 9 per cent against the US currency this year.

India's policymakers are battling a flood of negative economic data. Inflation has tripled over the last six months, driven by the soaring cost of food and fuel, while figures published last week suggested that industrial growth is stalling.

Industrial output rose 3.8 per cent in May, compared with the same month last year, down from 6.2 per cent in April.

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