The International Monetary Fund report forecast that India’s gross domestic product (GDP) will grow 8.75 percent this fiscal year, which runs through March. The growth will taper off to about eight percent the following year, the report added.

According to the IMF, India had emerged from the global financial slump with a strong recovery since mid-2009 led by domestic demand, particularly infrastructure investment.

“(IMF) executive directors commended the authorities for their economic stewardship which has helped India weather the crisis well,” the multilateral lending agency said. “Growth is among the fastest growing in the world, social indicators are improving, and medium-term economic prospects are favorable.” But the multilateral lending agency cited near-term challenges, including elevated inflation and strong capital inflows as investors chased high yields.

It advised Indian authorities to raise interest rates to curb inflation and push ahead with fiscal and financial reforms to maintain that growth.

“We see a pretty strong underlying inflationary pressure still in there,” IMF’s mission chief Masahiko Takeda said on a video posted on the website of the multilateral lending agency. Monetary policy “has been appropriately tightened,” though “in our view there’s a possibility that further monetary tightening action may be needed to contain the high inflation,” he added.

“More substantial current spending adjustment, mainly by further cutting subsidies and improving the targeting of spending, would help achieve social goals along with medium-term fiscal consolidation,” the IMF said.

India’s strong economic growth has attracted a heavy flow of foreign capital, which can help spur much-needed investment in India but could also complicate macroeconomic management, the IMF cautioned.

The IMF also warned Indian authorities on the country’s current account deficit, which is expected to reach 3.3 percent of GDP in the 2010-11 fiscal.

“As the deficit rises, so does the potential impact of a sudden stop or reversal of capital flows. Another risk is that the scale of the inflows could exceed India’s capacity to absorb them,” the IMF said.

India’s first line of defense against an oversized deficit is a stronger currency, the IMF said. “If the rupee became too strong, the international lender suggested India could intervene in the foreign exchange market or take regulatory measures,” it added.

“Over time, deepening the corporate bond market, increasing the supply of shares and further liberalizing foreign direct investment would increase the country’s capacity to absorb capital from abroad,” the IMF said.

India’s first line of defense against an oversized deficit is a stronger currency, the IMF said. “If the rupee became too strong, the international lender suggested India could intervene in the foreign exchange market or take regulatory measures,” it added.

“Over time, deepening the corporate bond market, increasing the supply of shares and further liberalizing foreign direct investment would increase the country’s capacity to absorb capital from abroad,” the IMF said.

“There are several obstacles to achieving set targets. These include availability of financing, land acquisition, multiple clearances, capacity constraints, and governance issues along with various sector-specific concerns,” it added.

On Wednesday, a separate report by ratings firm Crisil said India economy will maintain an 8.4 percent growth over the next five years. “If some supply-side issues are addressed, it can sustain a 10 percent growth,” it added.