* Indian regulators, policymakers discuss joining Euroclear
* RBI proposes to limit settlements to long-term investors
* Finance ministry, RBI, SEBI to meet Tuesday to discuss proposal (Updates with background, detail, comment)
By Neha Dasgupta and Manoj Kumar
MUMBAI/NEW DELHI, Aug 13 (Reuters) - India is considering joining Euroclear, the world's largest securities settlement system, with the condition that only long-term foreign investors trade Indian government debt for now, three sources familiar with the discussions told Reuters.
The proposal from the Reserve Bank of India (RBI), and submitted to the finance ministry, would allow investors such as sovereign wealth funds, to settle Indian government bonds on the system, but not foreign institutional investors (FIIs).
FIIs are the biggest foreign investors in India and the RBI, the central bank, proposed that their exclusion from settling government debt on Euroclear be reviewed annually, one of the sources said.
Officials from the RBI, the finance ministry and the Securities and Exchange Board of India (SEBI), the capital markets regulator, will discuss the proposal next Tuesday, two of the sources said.
The recommendation to exclude FIIs signals the central bank's skittishness about opening up India's debt market given concerns about sudden destabilising outflows, even as India depends on these foreign investors to fund its current account deficit.
"If right at the start we restrict it to only long-term players, probably the volatility will be much less in the market," one source said. "Afterwards we will see how the market is reacting and then we can open it to others."
The sources declined to be identified because the proposal is not public. Details have still to be worked out and more government consultations are likely to be needed after next week's meeting, a finance ministry source said.
Foreign investors have been calling for India to join Euroclear to make it easier for them to access Indian debt. It does this by removing some of the registration barriers because the financial services company that books the trade, usually a bank, settles and guarantees the trade.
India has long had an uneasy stance about foreign investors. In August last year, intense selling of stocks and bonds by overseas funds sent the rupee to a record low and ushered in the worst market turmoil since a 1991 balance of payments crisis.
That uneasiness is reflected in restrictions on overseas capital, including limits on debt investments. Although India simplified its rules for foreign investors this year, it still imposes stringent know-your-customer registration norms.
At the same time, foreign investors are integral to India.
Hopes the new government led by Prime Minister Narendra Modi would implement big reforms have led to a net $25.6 billion in foreign purchases of debt and equities this year, helping the current account deficit narrow sharply from record highs only a year ago.
The discussions on Euroclear stopped in March ahead of a general election. However, Finance Minister Arun Jaitley announced in the federal budget last month the government would be going ahead with listing Indian debt on Euroclear.
Under the RBI proposal, long-term investors would be allowed to settle bonds via Euroclear as long as the debt they purchase does not exceed the $5 billion limit imposed on them.
India imposes an overall foreign ownership limit of $30 billion for foreign investors, of which the remaining $25 billion is geared for foreign institutional investors such as mutual funds.
Only 46.5 percent of the $5 billion quota for long-term investors had been filled as of Wednesday, compared with 83 percent utilised by FIIs.
Preventing a repeat of last year's turmoil has been a priority for RBI Governor Raghuram Rajan.
The former chief economist at the International Monetary Fund has said he fears the impact on India should the end of accommodative policies in developed economies spark an exodus from emerging markets, going as far as warning of a global market "crash."
But analysts say India would be too cautious if it limits Euroclear settlements for only some investors.
Jan Dehn, head of research at Ashmore Investment Management in London, said Indian policy-makers should not paint all foreign investors with the same brush.
This is good news, but they are still too cautious, in my view," said Dehn, whose firm manages $78 billion in emerging and frontier market assets.
"There are differences between institutional investors. They are not all hedge funds and short-term investors. There are many long-term institutional investors, whose introduction to the Indian market would be very healthy for many reasons." (Additional reporting by Himank Sharma and Suvashree Dey Choudhury in MUMBAI; Editing by Rafael Nam, Jacqueline Wong, Robert Birsel)