(Updates with quotes, background, market reaction)
By Suvashree Dey Choudhury and Neha Dasgupta
MUMBAI, July 23 (Reuters) - India on Wednesday allowed foreign fund managers to hold more government bonds, but also stipulated that in future they will not be able to hold debt of less than three years.
India allowed foreign institutional investors to hold a combined $30 billion in India government debt at any one time, comprising $20 billion for all foreign investors and $10 billion for long-term investors like sovereign wealth funds, multilateral agencies, foreign central banks and pension, insurance and endowment funds.
Under changes announced on Wednesday, the $20 billion limit will be raised to $25 billion but debt bought after the rule comes into force will have to be of at least three years, the Reserve Bank of India said. Previously foreign investors were allowed to buy government debt of more than one year.
Under the new rule, the additional $10 billion of debt earmarked only for sovereign wealth funds, multilateral agencies, foreign central banks and pension, insurance and endowment funds - but not fund managers - will be reduced to $5 billion. That can be held in debt of at least one year.
As a result, the overall debt held by foreign institutional investment (FII) will stay at $30 billion, the central bank said. The effective date of the new rules will be announced later.
India has attracted strong foreign fund inflows on hopes that its new business-friendly prime minister Narendra Modi will ring in faster reforms and give a boost to the country battling the longest spell of less than 5 percent growth in quarter of a century.
"I think a reasonable amount of money will flow in," said Ashish Vaidya, executive director and head of trading and asset liability management at DBS Bank in Mumbai.
Foreign funds have bought a net $11.95 billion in equity and $12.73 billion in debt so far this year.
Government bonds have rallied this week on expectations of changes to the FII limits, after the existing $20 billion cap was almost fully used up. The changes were confirmed after the market close on Wednesday but bonds are expected to rise further on Thursday.
The 10-year benchmark bond yield, which has fallen 11 basis points so far this week, is likely to ease another 3-4 basis points to 8.63 percent on Thursday, dealers said.
Bond dealers expect FIIs to use up the additional limit of $5 billion within six weeks lured by high returns, easing inflation, and Modi's decisive election mandate to conduct financial reforms. (Reporting by Suvashree Dey Choudhury and Neha Dasgupta; Editing by Susan Fenton)