MUMBAI, May 2 (Reuters) - India's move this week to slash tax on interest income that foreigners pay on local bonds, its most significant measure to boost the debt market in recent years, could draw several billion dollars in investment and provide support for the rupee.
Foreign investors have long complained about the high tax they pay on their earnings on Indian debt. Other Asian countries like Singapore and Malaysia charge little or no such tax.
Finance Minister P. Chidambaram on Tuesday lowered the withholding tax on rupee-denominated government and corporate debt to 5 percent from 20 percent for two years starting in June.
The move, part of an effort to boost inflows as India grapples with a record current account deficit, follows investor presentations last month by Chidambaram in the United States and Canada.
"This has been a long-standing ask of FIIs (foreign institutional investors) and is a very welcome step," said Hitendra Dave, head of global markets at HSBC India in Mumbai.
Over time, the tax cut could draw an additional $18 billion in inflows, figures Samiran Chakraborty, chief economist at Standard Chartered Bank in Mumbai.
Earlier this year, New Delhi scrapped cumbersome limits on debt, such as residual maturity requirements, in a bid to attract longer-term investors like sovereign wealth funds.
The government's move would result in a roughly 100 basis points increase in after-tax government bond yields and comes as Japan's massive stimulus has led to more inflows into regional bond markets, lifting bonds and the rupee.
Nearly 95 percent of the $25 billion limit for foreigners in government debt has been exhausted, while 45 percent of the corporate debt limit of $51 billion has been used, as per capital market regulator data covering until end-April.
Nearly $2 billion has entered India's debt market since April 15.
Barclays Capital expects government bonds to give returns of 6.2 percent, unhedged for forex exposure, over a three-month horizon as yields drop 35-40 basis points over the next three months, prompted by monetary easing.
The Reserve Bank of India is widely expected to cut its policy repo rate by 25 basis points on Friday.
The reduction in withholding tax will support the rupee at a time when sentiment is positive after the recent slump in global commodity prices.
"Along with the anticipated pick-up in FDI, this may perceptibly ease India's balance of payments situation, if all the potential inflows are realised," Standard Chartered analysts wrote in a note. The bank now says the rupee may end stronger than its forecast of 55 to the dollar by end-June.
The rupee hit a two-month high of 53.6625 on Thursday, helped by hopes for more inflows fuelled by the tax cut. Bond yields fell as much as 8 basis points to 7.68 percent, a 33-month low.
Analysts expect the government to further raise government bond limits once the current levels are utilised.
"Moves in this direction should be considered carefully given the need for stable yields ahead of another sizeable market borrowing program this year," said Radhika Rao, economist at DBS in Singapore. (Additional reporting by Archana Narayanan; Editing by Tony Munroe and Simon Cameron-Moore)