* India declines to remove cap on FII investment in govt debt
* Faces less pressure due to recovering rupee, c/a deficit
* Foreigners' share in govt debt near 4 pct vs 5.2 pct two years ago
* Rupee drops 0.3 pct against dollar after Reuters report (Adds market reaction)
By Manoj Kumar
NEW DELHI, March 11 India has put on ice plans to join major emerging market bond indexes that would require removal of restrictions on capital inflows, two sources said, taking a decision that knocked the rupee, but showed balance of payments concerns were easing.
A separate plan to explore joining Euroclear, the world's largest securities settlement system, has also been deferred until the next government takes charge after elections in April and May. That plan could have further opened up the market to portfolio capital inflows.
Finance Minister P. Chidambaram and Raghuram Rajan, Reserve Bank of India governor, initiated talks with index compilers including JP Morgan in the hope of attracting billions of investment dollars after the rupee tumbled to a record low last August.
"The plan for joining global bond indices has virtually been dumped over differences of abolishing investment limits on FIIs (foreign institutional investors) in government bonds," a senior official with direct knowledge of the matter told Reuters.
Confirming the failure of talks, a second official said: "As regards the issue of India's plan to enter into JP Morgan debt index and other global indices, no action is being envisaged."
The news caused the rupee to retreat further from its seven-month high of 60.5925 to the dollar hit in early trade. The rupee dropped almost 20 paise after the news to hit the day's low of 60.9450, versus Monday's 60.85/86.
Traders said they were hoping the inclusion plans would materialise sometime over the next year if not immediately, but as they have been put on hold, the wait would likely be longer.
"This has been put on hold till the time we get a new government, so nothing major as of now. All eyes are on election results," said Anubhuti Sahay, economist at Standard Chartered Bank.
Initially, India had hoped to join the government bond indices by December, potentially attracting $20 billion to $40 billion in additional inflows over a year according to Standard Chartered Bank estimates.
A global flight to the U.S. dollar last year, driven by an expected withdrawal of monetary stimulus by the Federal Reserve, sent the partially convertible Indian rupee sliding.
The current account deficit has since narrowed, and the rupee has recovered 8 percent since September, taking the pressure off the government to liberalise capital flows - a step supported by the central bank, investors and many policymakers.
A strong election campaign by opposition leader Narendra Modi, who has a pro-business record running his home state of Gujarat, has also boosted Indian assets.
Investors such as hedge funds and sovereign funds have pumped huge funds into emerging markets like Brazil, Indonesia and South Africa's sovereign debt in the last few years and held $768 billion as of June 2013, the IMF estimates.
Foreign holdings in Indian public debt are expected to decline to around 4 percent by end-March to $728 billion, from 5.2 percent two years ago.
EUROCLEAR PLANS ON HOLD
Plans to join Brussels-based Euroclear bank - the largest provider of cross-border settlement services for securities trades - have also been deferred till the next government takes charge.
Settlement of India's locally-issued government bonds via Euroclear would have removed any regulatory barriers for foreign investors to invest in Asia's third-largest economy.
"We are not yet ready to join the Euroclear due to its tough conditions,"the first official said, without giving details.
"The next government can take a decision."
Talks with Euroclear got a boost after the International Finance Corporation, the World Bank's private-sector arm, issued the first tranche of a $1 billion global offering of rupee-linked bonds last year that would be accessible via Euroclear.
Officials said Euroclear would have to open an account within India, a prerequisite for settling the bonds and would need a raft of regulatory changes in India. ($1 = 60.8750 Indian rupees) (Additional reporting by Swati Bhat in Mumbai; Editing by Douglas Busvine & Kim Coghill/Simon Cameron-Moore)