India rupee gains; reforms key but traders warn about 'euphoria'

* Gains in the euro after Dow Jones report boosts rupee

* Traders hopeful of reforms after presidential elections

* Too much 'euphoria' about reforms after poll-India Forex

By Swati Bhat

MUMBAI, July 19 (Reuters) - The Indian rupee gained on Thursday as a sharp recovery in the euro prompted foreign banks to sell dollars, while a rise in domestic shares spurred custodian banks to also sell the greenback.

However, on the opposite side, good dollar demand from defence and oil companies, limited what could have been a sharper rise in the rupee.

Going ahead, investors have been widely anticipating quick government action to relax investment rules and cut subsidies once the elections for the ceremonial post of president on Thursday are out of the way.

Policy reforms are seen as critical for the government to meet its fiscal deficit target of 5.1 percent for the year ending in March, and bolster confidence in a local currency that just last month had dropped to a record low against the dollar.

"Expectations are rupee positive for the time being. I believe that some reforms will come forth post the Presidential election results," the chief dealer with a state-run bank said.

The partially convertible rupee closed at 55.12/13 per dollar, as per the SBI closing rate, stronger than its close of 55.48/49 on Wednesday.

The one-month offshore non-deliverable forward contracts were around 55.42 while the three-month was at 56.05.

Gains accelerated in the afternoon session as the euro rallied after newswire Dow Jones reported the European Financial Stability Facility would be able to buy Spanish bonds on the primary and secondary markets.

Dealers said foreign banks started selling dollars around 55.30 levels following the move in the euro, while dollar selling by custodian banks -- believed to be tied to gains in local equities -- also boosted the rupee.

India's main BSE index ended up 0.55 percent on Thursday. Foreign investors have turned big buyers of domestic equities, with provisional net purchases so far this month of $1.62 billion almost matching the $1.68 billion in March.

A lot of the broad positive sentiment across Indian markets, has been predicated on the government delivering meaningful policy reforms such as raising diesel prices or opening up the retail sector to foreign investment.

However, some analysts warn against excessive optimism.

"We have a bearish outlook on the rupee with the immediate target being 56 over the next week to 10 days and at 57 over the next three months," said Abhishek Goenka, founder and chief operating officer at India Forex, an advisory firm.

"I personally feel there is too much of a euphoria ahead of the Presidential elections and the market is being too optimistic. We are not going to get any immediate reforms and if nothing happens soon enough, the rupee would start weakening".

In the currency futures market, the most-traded near-month dollar-rupee contracts on the National Stock Exchange, the MCX-SX and United Stock Exchange all closed at around 55.19 with the total traded volume at around $3.8 billion. (Editing by Rafael Nam)