By Manoj Kumar and Abhishek Vishnoi
NEW DELHI/MUMBAI (Reuters) - A surprise delay to India's new goods and services tax (GST) marks one of the most painful setbacks suffered by Prime Minister Narendra Modi's government as it nears the end of a first year in power, with markets falling and farmers braced for a poor monsoon.
Investors had hoped that the ruling Bharatiya Janata Party's majority in the Lok Sabha, the lower house of parliament, would ensure Modi could push through reforms far more smoothly, but that assumption has taken a battering.
Late on Tuesday, the government submitted to strong opposition in the Rajya Sabha, the upper house, by agreeing to delay the landmark tax legislation until at least July.
The introduction of the GST would constitute India's biggest tax reform since independence.
The delay to the bill is a blow to a government that is already dealing with rural discontent over proposed land reforms, which have also still to be sent to the upper house for approval.
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The GST would replace a patchwork of levies by the central and state governments, reducing corruption, attracting investment and -- according to the finance minister -- add 2 percentage points to India's growth.
Senior officials said on Wednesday they feared the delay could become yet another "sell" signal for foreign funds, already angered by the government seeking to tax them for several years of previously untaxed gains.
"A delay in parliament approval of the GST bill will send a wrong signal to investors, who are already grappling with tax notices," said one senior government official dealing with economic policy decisions.
India was Asia's second best performing market last year and the government has scored some successes. It has, for example, improved its finances, held successful telecoms and coal block auctions, and allowed more foreign investment into the insurance and defence sectors.
But the shine has worn off. Foreign investors sold nearly $2.2 billion in shares during the last 16 trading sessions.
Ominously for the economy and India's large farm sector, weather forecasts also point to weaker than usual rains during the monsoon season, which begins in the coming weeks.
The government could still implement GST from April 2016, if the reform is passed in July, the official said. But the government will need to pick up the pace of change.
"We are seeing more political rhetoric than reforms on the ground," the official said.
"There is a little sign of improvement in investments in infrastructure or the health of the banking sector, which are necessary for putting the economy on high growth track."
Another senior official who deals with foreign investors said the biggest complaints he received included uncertainty over taxes, higher borrowing costs and the lack of infrastructure.
On Wednesday, HSBC became the first major foreign bank since last year's market rally to downgrade India, cutting its rating on Indian shares to "underweight" from "overweight".
It cited weakening earnings forecasts and little sign of a recovery in capital expenditure.
"The delay in land and tax reforms is adding to the already cautious mood of foreign investors. It does add to the ongoing volatility and confusion," said Taher Badshah, senior vice president & Co-Head Equities at Motilal Oswal, an asset management company in Mumbai.
(Writing by Clara Ferreira Marques; Editing by Simon Cameron-Moore)