India's new debt rules may not entice foreign buyers

HONG KONG May 30 (Reuters) - India has freed up rules on bond market investments but analysts say this may not be enough to reverse recent capital outflows and a sliding rupee currency. The moves announced by the Indian government on Thursday to liberalise its bond markets were described as long overdue by foreign investors and a positive step given strong interest from overseas in the country's long-term growth potential.

But analysts said unless policy makers can prevent inflation from eroding the value of Indian government and corporate bonds, the steps will unlikely reverse outflows and stem a free fall of around 8 percent in the rupee INR=IN this year.

"At the end of the day, the fundamentals are going to drive the yields and the rupee," said Binay Chandgothia, chief investment officer at Principal Asset Management in Hong Kong.

"The critical factors are going to be how they deal with inflation, and how they address major issues such as oil subsidies."

India said it would raise the limit for foreign institutional investment (FII) in government and corporate bonds, while raising the amount that companies, especially in the infrastructure sector, can raise abroad.

Attracting foreign money is a must in a country that is facing a widening current account deficit and a slumping currency that is worsening inflationary pressures at home.

INFLATION CLIMBING

India's wholesale price inflation INWPI-ECI rose 8.1 percent in the 12 months to May 17, its highest in more than 3-½ years, data showed on Friday.

The data is likely to increase the chances of interest rate hike by the Reserve Bank of India, or the central bank, especially at a time when the government is expected to take the inflation-inducing step of raising fuel subsidies.

So far the central bank has left its key lending rate, the repo rate, unchanged at 7.75 percent for over a year, preferring instead to tighten cash management over the past 18 months.

JPMorgan said the measures to encourage more foreign investments may not have such an impact in the near term.

"We view the medium-term impact to the currency and the balance of payments as less certain, as elevated oil prices remain the dominant weight against the BoP (balance of payments) and foreign investors continue to withdraw funds from India," JPMorgan said in a research report on Friday.

India tightened its overseas borrowing rules last August, restricting how much local firms could raise overseas and then spend in rupees. The move was designed to reduce high capital inflows which were pushing up the currency.

By increasing foreign investments into debt markets with the new rules, the government is likely to succeed in deepening its bonds markets, analysts said. This will eventually help raise the $500 billion required to modernise the country's infrastructure.

"It shows the government is quite committed to further improving liquidity in the bond market and making sure there's a robust corporate bond market," said Neeraj Gambhir, head of structured finance and high grade credit in India for Lehman Brothers.

"That will be an absolutely essential requirement for making sure there's enough funding and liquidity available for infrastructure projects and to allow Indian companies to be in a position to borrow from local markets."

(Reporting by Rafael Nam; Editing by Jacqueline Wong)