A summer drought makes a bad situation worse for an Indian economy already crippled by a sharp slowdown in growth, persistent inflation and a politically hamstrung government.

Late on Thursday, New Delhi confirmed the first drought in three years as monsoon rains are likely to be less than 90 per cent of the long-term average, dealing a blow to Asia's third-largest economy, where more than half the farmland lacks irrigation.

"We already have a scenario in which growth is going down and inflation is going up, so it's going to worsen this further," said D.K. Joshi, principal economist at ratings agency Crisil.

Weak rains in the four-month monsoon that started in June will drive up food prices and erode spending power in a country where more than half the population relies on the rural economy, crimping demand for goods from tractors and motorbikes to soap.

The economy grew at 5.3 per cent in the March quarter, its slowest in 9 years, but headline inflation above 7 per cent has prevented the central bank from cutting interest rates at its last two policy reviews.

This increases pressure on the government of Prime Minister Manmohan Singh to take steps that will revive investment.

Just over halfway through the season, rains are 20 per cent below normal, and the weather office forecast that the El Nino weather pattern should reduce rains again in the second half.

The states of Haryana and Rajasthan in the north, Gujarat and Maharashtra in the west, and Karnataka in south India are hardest hit.

The last drought, in 2009, saw rains that were 23 per cent below normal and pushed up food prices that in turn sent headline inflation into double digits and triggered a series of 13 interest rate increases between March 2010 and October 2011.

Besides growth, drought also threatens to add to India's already-high current account and fiscal deficits.

The government has set a target of cutting its fiscal deficit to 5.1 per cent of GDP this fiscal year, from 5.76 per cent, but this is now looking over-optimistic. Nomura expects a fiscal deficit of 5.8 per cent of GDP.

"Typically what we see in a drought year is that the imports go up, for instance pulses, sugar, edible oil, and exports of a lot of agri-products go down, so current account is negatively impacted," said Sonal Varma, an economist at Nomura in Mumbai.

Relief measures will add to a fiscal deficit that is already stressed by a politically constrained government's inability to raise the price of budget-busting subsidised diesel.

"Government will focus on drought relief measures - more subsidies on pulses and sugar, more employment under the NREGA programme," Varma said, referring to the government's flagship rural jobs scheme.

ASSET QUALITY

The drought also imperils asset quality for banks, with State Bank of India and Punjab National Bank, the two biggest state lenders, most exposed if the central bank allows crop loan payments to be rescheduled in the worst-hit states, said Manish Ostwal, banking analyst at K.R. Choksey.

"Definitely some impact on asset quality of farm loans will be felt, especially in the states where the drought is more pronounced," said P.K. Anand, executive director at state-run Punjab and Sind Bank.

Montek Singh Ahluwalia, deputy chairman of India's Planning Commission, told Reuters this week that the government may have to spend more in rural areas to shore up incomes if the rainfall remained deficient.

"The real danger with a drought is not just the impact on GDP growth, but that it is the incomes of the poorer sections that get hurt. That's why MGNREGA is important," said Ahluwalia adding a drought could shave half a percentage point from GDP.

MGNREGA, the Mahatma Gandhi National Rural Employment Guarantee Act and sometimes just called NREGA, is one of the ruling Congress party's signature policy measures.

A bad monsoon is not as damaging to the Indian economy as it once was, with farming's share of total output now at 14 per cent, down from about 24 per cent a decade ago. About three-quarters of India's rain falls during the summer monsoon.

Still, India is one of the world's biggest food producers and consumers. More than half the Indian workforce is employed in agriculture, and rising rural incomes in recent years have been a key driver of domestic demand.

"We are faced with some very challenging times up ahead of us," said A. Mahendran, managing director of Godrej Consumer Products Ltd, India's largest home-grown maker of personal care goods such as soaps and shampoos.

Earlier this week the Reserve Bank of India cut its growth forecast for the fiscal year that ends in March to 6.5 per cent from the 7.3 per cent target set in April, and lifted its wholesale price index inflation expectation to 7 per cent for March, from its earlier 6.5 per cent target.

Yes Bank estimates that a 10 per cent shortfall in monsoon rains could push up headline inflation by about 40 basis points.

Nomura expects growth to fall to 5.8 per cent this fiscal year, and expects food inflation to exceed 15 per cent in coming months, from 10.5 per cent now, and does not expect another rate cut in 2012.

Mahindra & Mahindra, the world's largest tractor maker, recently cut its tractor sales growth estimates for the current fiscal year to 5 to 6 per cent from 10 to 12 per cent. Sales from April through July rose just 1 per cent.

"Always, a lower monsoon will have an impact in terms of planting and so on, and that drives the demand cycle for tractors," said executive vice-president V.S. Parthasarathy.