* Retailer to open 25 stores in Asia's third largest economy
* Intends to source $1 bln stock from India in coming years
* Government takes small step towards restoring investor sentiment (Adds quotes, details)
By Nandita Bose and Matthias Williams
MUMBAI/NEW DELHI, June 22 (Reuters) - Swedish retailer IKEA , the world's largest furniture maker, is opening up in India, marking a crucial step for the Indian government whose policy flip flops related to foreign investment have damaged market confidence.
The company, known for huge stores selling flatpack furniture and accessories, said it would invest 1.5 billion euros ($1.9 billion) to open 25 stores in Asia's third-largest economy after initially balking at India's sourcing requirements.
IKEA's plans, announced by the Indian government after a meeting between the company's CEO and India's trade minister in Russia, could give a boost to the embattled government of Prime Minister Manmohan Singh, which was forced in December to backtrack on plans to allow in foreign supermarket operators.
While the government removed foreign investment caps in single-brand retail in January, it imposed a condition that foreign retailers source 30 percent from local small and mid-sized enterprises, dampening the enthusiasm of retailers for the plan.
"It's a baby step but it has definitely sent the right signal out ... The government is trying to convince international investors, India is still open for business," said Devangshu Dutta, consultant with Third Eyesight, a retail consultancy said.
The Indian economy which grew at its slowest pace in nine years has been badly hit by political roadblocks to economic policymaking battering corporate investor sentiment.
But the company, following similar moves in China and Russia, plans to cash in on India's burgeoning urban middle class, which, having grown up on pop culture, generates a strong demand for owning international brands and lifestyle products such as furniture.
On Friday, India said the company had discussed its reservations over the sourcing policy with the government.
"IKEA had certain reservations about sourcing norms which were discussed with the DIPP (Department of Industrial Policy and Promotion) officials; suitable answers of which were provided leading to the decision to invest," the Indian government said in a statement.
The company does not yet have any stores in India but sourced $450 million worth of goods from the country last year, a figure it aims to lift to $1 billion in coming years.
It sources goods such as textiles and carpets from 70 suppliers and 1,400 sub-suppliers in the country, the company said.
"The mandatory sourcing clause that requires goods to be sourced from small and medium enterprises will remain a challenge," IKEA spokeswoman Malin Pettersson Beckeman told Reuters by phone on Friday.
The Singh government is keen to bring global supermarket chains such as Wal-Mart Stores Inc and Carrefour SA into India, in hope of improving the efficiency of supply chains in a country where roughly one-third of fresh produce rots before it gets to market.
However, foreign direct investment in supermarkets has been opposed by owners of one-off shops, which account for roughly 90 percent of India's $450 billion retail sector, as well as by members of the ruling coalition.
IKEA said its investment will be made over 15 to 20 years.
India's Commerce Ministry said IKEA will initially invest 600 million euros and a further sum of up to 900 million.
"These investment estimates have been drawn up based on our experience in countries like China and Russia," Beckeman said.
Industry officials, however, said that the Swedish firm's entry will not really shake things for the domestic market given the number of stores it plans and the period of investment.
"It's not going to shake up the entire domestic market but it will set a benchmark model for others to follow in India's nascent furniture and home products market," Dutta said. ($1 = 0.7933 euros) (Writing by Sanjeev Choudhary; Editing by Tony Munroe and David Holmes)
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