UPDATE 1-Indian markets hit by political worries; foreign investors key

Last Updated: Tue, Mar 19, 2013 09:30 hrs

* 10-yr bond yield trading at 7.90 pct

* Benchmark BSE index down 1.1 pct

* USD/INR at 54.33/34 from 54.1650/1750 prev close (Updates with details, background, quotes)

MUMBAI, March 19 (Reuters) - Indian stocks and the rupee fell to multi-week lows on Tuesday while the benchmark bond yield hit a six-week high after a regional ally pulled out of the ruling coalition, putting in doubt the fate of the government's reform agenda.

Markets appeared to shrug off a decision by the Reserve Bank of India to cut the benchmark policy rate by 25 basis points and instead focused on its warning that the scope for further monetary easing was limited.

How foreign investors react to the political and economic uncertainties will be key, especially at a time when global markets are under pressure from concerns sparked by a radical bailout plan for Cyprus.

The benchmark index was down 1.1 percent after earlier falling as much as 1.8 percent, the lowest since March 4.

The rupee weakened to as much as 54.38 per dollar from its 54.1650/1750 close on Monday, and was trading at 54.33/34 as of 0828 GMT.

The 10-year bond yield was trading at 7.90 percent, after swinging between a 6-week high of 7.93 basis points to an earlier session low of 7.84 percent. The yield had closed at 7.88 percent on Monday.

"The political development in India has taken centre stage and will have a negative impact," said Sameer Rehman, vice president of fixed income origination and syndication at TD Securities in London.

The regional Dravida Munnetra Kazhagam (DMK) party withdrew from the ruling coalition in protest against the government's position on a United Nations resolution on war crimes carried out during Sri Lanka's civil war.

That decision came at a time when markets were already flat to weaker after the RBI said "the headroom for further monetary easing remains quite limited" in its statement on Tuesday.

The words reinforced market expectations the RBI will only cut interest rates by a further 25 or 50 bps in the new fiscal year starting in April.

Whether foreign investors lose faith in Indian markets poses a key risk, given their strong purchases of stocks and debt last year helped contain the country's record current account deficit.

Investors had hoped a combination of fiscal and economic reforms from the government, along with aggressive central bank rate cuts, would boost an economy set to grow at a decade low of around 5 percent in the fiscal year ending on March.

India faces the prospect of a downgrade into the so-called "junk" debt from Standard & Poor's Ratings Services and Fitch Ratings

These domestic concerns are coming at a time when investors are also growing concerned about foreign flows after Cyprus is keeping risk assets under pressure.

Foreign investors bought a net of around $31 billion in debt and FX markets last year, and around $12 billion so far this year, which were critical to help narrow down a deficit that is expected to widen to a record high in 2012/13.

"Because of the current account gap, we are reliant on flows. If the flows get truncated, it would be difficult. But I think it would be a knee-jerk reaction," said Sanjay Mathur, head of economics research, Asia-Pacific ex-Japan for RBS in Singapore. (Reporting by Rafael Nam; Additional reporting by Archana Narayanan, Shamik Paul and India markets; Editing by Sanjeev Miglani)

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