By Archana Narayanan and Rafael Nam
MUMBAI (Reuters) - India's auction of quotas allowing foreign investors to buy bonds attracted strong demand on Wednesday, easing some of the concerns about whether a recent sell-off in markets would reduce demand for domestic debt.
The sale comes a day after the RBI issued a cautious stance on monetary policy, and also comes after the Dravida Munnetra Kazhagam (DMK) party withdrew from the ruling coalition, putting in doubt the government's reform agenda.
Bonds have also been under pressure over lingering disappointment about the fiscal budget for the year starting in April unveiled last month, which relied on raising more revenue to meet fiscal deficit targets.
Still, the government has recently eased some of its restrictions against foreign bond investments, including raising the amounts they are allowed to own in government and corporate bonds, and hence enhancing the appeal of Indian debt.
"The broader FII outlook still remains positive. With limits relaxed and restrictions removed, the appetite appears good," said Shubhada Rao, chief economist at Yes Bank in Mumbai, referring to foreign institutional investors (FIIs).
India attracted 215.78 billion rupees worth of orders for its so-called debt auction limits, which give foreign investors the right to invest in debt up to the limit bought.
The amount of orders received was above the 162.39 billion rupees on offer for different categories of government and corporate debt. That was just a fraction of the 666 billion rupees in debt limits sold at last month's auction.
India restricts foreign access to its debt markets because of its reluctance to owe money to overseas investors, and has a complicated system of categories for debt as well as restrictions on which types of investors can bid for the debt.
The Wednesday auction quelled some of the concerns about whether India can sustain the strong foreign inflows that have helped contain a record current account deficit.
Foreign investors bought a net of around $31 billion in debt and stock markets last year, and around $12 billion this year.
But the outlook for bonds has weakened. Benchmark 10-year bond yields have risen 12 basis points since the budget was unveiled on February 28.
That budget raised concerns as the government is paying for increased spending by targeting higher tax revenues to meet the country's fiscal deficit target of 4.8 percent for fiscal 2013/14.
Meeting the fiscal deficit is considered critical for India, given the country's twin deficits were a key reason why Standard & Poor's and Fitch Ratings last year cut India's outlook to negative.
The prospect of political instability is now further raising concerns about the government's fiscal reform agenda, even as it said on Wednesday it was still able to pass key legislation in parliament.
Bond investors are also growing worried after the Reserve Bank of India stuck to its cautious stance on monetary policy on Tuesday, despite cutting interest rates by a quarter percentage point for the second time this year.
(Editing by Nick Macfie)