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* Potential cash windfall could add to shekel appreciation
* Foreign ownership of local Israeli gov't bonds is 5 pct
* Israel bond market has been strong while stock market slumps
* Graphic: Israel's shekel strengthens bit.ly/2nATbbW
By Ari Rabinovitch and Tova Cohen
TEL AVIV, March 22 (Reuters) - Investment bank Citi is expected to include Israel in its influential World Government Bond Index in coming months, a boost for the local bond market but a potential headache for the central bank as it fights to contain the surging shekel.
An estimated $3 trillion of assets track Citi's index (WGBI). Israel would account for less than 0.5 percent, but it nonetheless could mean an influx of up to $4 billion of foreign money.
That may add to the appreciation of the shekel, which is already near a 15-year high versus the euro, a 2-1/2 year peak against the dollar and its strongest level ever against a basket of foreign currencies.
Further strengthening could be a big problem for a trade-focused economy like Israel's.
Israel is now $1-$2 billion short of the $50 billion index eligibility threshold for outstanding government bonds, a gap Citi's analysts believe will close within a few months.
An analysis this month from Bank of America Merrill Lynch said inclusion could come as early as June, while Citi emerging markets strategist Luis Costa estimates 5-6 months.
"The fact that there would be more demand for Israeli securities is a good thing. It will help liquidity, tradability of the securities ... it could lower the yields needed to issue government bonds," said a senior Israeli government official, who spoke anonymously due to the issue's sensitivity.
"The weight of Israel in the index will be very, very small. It is supposed to cause an inflow, but it will be gradual," he said.
The impact could be particularly strong with Israel because current foreign ownership of local bonds is small, around 5 percent, meaning there is a lot of room for new money. Plus, real yields in Israel are attractive.
For long-term Israeli government bonds, yields are around 2 percent, compared with flat and negative yields in many developed countries.
Bank of America Merrill Lynch, meanwhile, said the Bank of Israel might need to begin a dedicated currency intervention programme to balance out the bond inflow.
The central bank, which has been buying on average $830 million of foreign currency a month to keep the exchange rate in check, declined to comment.
Joining the group of 23 developed countries already on WGBI would be a step up for Israel, which mostly appears on emerging market indices.
Israel's stock market enjoyed a similar upgrade in 2010 when it was promoted to the MSCI's World Index from the emerging markets index, but that had an adverse effect when emerging market passive investors pulled out money.
As daily trade volume in Tel Aviv stocks dropped 40 percent since 2010 to $330 million, corporate bonds became the saving grace for local companies to raise funds, with the stock exchange recovering slowly.
The value of Tel Aviv's corporate bond market has nearly tripled since 2006 to 358 billion shekels ($99 billion).
Last year companies raised 66.5 billion shekels in bonds, nearly double the 2013 level. The market has even attracted U.S. real estate firms seeking to raise money at lower rates than at home.
"Israel is one of most developed markets in terms of bonds," said Hani Shitrit Bach, head of the listing and economics department at the Tel Aviv bourse. "Here the market is open to everyone, it's not an over the counter market like overseas."
But gains in corporates have come at the expense of government bonds, as Israeli institutional investors shifted sharply. With interest rates near zero, daily trade volumes for government bonds are down 18 percent since 2013.
Tal Levi, fixed income director at Halman-Aldubi investment house, reckons WGBI inclusion could mean low interest rates for longer.
Bond trade volumes may rise substantially, he said, but a stronger shekel would further hurt exporters and leave Israel "trapped" at near zero interest rates.
Additional reporting by Steven Scheer Editing by Jeremy Gaunt